DIPN 21: Understanding the Locality of Profits in Hong Kong Tax

DIPN 21 and the Locality of Profits in Hong Kong Tax

Hong Kong’s profits tax system rests on the territorial source principle: only profits arising in or derived from Hong Kong are chargeable, regardless of the taxpayer’s residence. The Inland Revenue Department’s guidance on determining the locality of profits is set out in DIPN 21 Hong Kong, formally titled Departmental Interpretation and Practice Note 21. DIPN 21 interprets the source rules, the operation test used to apply them, and the key scenarios that arise in practice.

Locality of Profits Hong Kong: The Operation Test

The central question for any profits tax assessment is whether the profits are sourced in Hong Kong. DIPN 21 codifies the “operation test”. It focuses on where the profit-generating activities occur, not where the contracts are signed or where the company is registered. The test asks: what operations produced the profit, and where were those operations performed?

For trading businesses, the operation is the negotiation of the contracts of purchase and sale, the conclusion of those contracts, and their execution. If these operations take place outside Hong Kong, the profits are likely offshore. If they take place in Hong Kong, the profits are assessable.

For manufacturing profits, the source is the place where the manufacturing operations occur. A Hong Kong company that manufactures goods in Hong Kong and sells them abroad derives its profits in Hong Kong. A company that manufactures entirely outside Hong Kong but sells from a Hong Kong office derives profits sourced where the manufacturing took place, provided the Hong Kong office does not perform the selling operations.

For service income, the source is the place where the services are performed. A Hong Kong consultant who renders services entirely abroad derives offshore service income. A consultant who renders services partly in and partly outside Hong Kong must apportion the profits.

The Inland Revenue Department applies the operation test on a case-by-case basis, looking at the totality of the taxpayer’s activities. DIPN 21 provides extensive examples.

Territorial Source Principle Hong Kong: Legislative Basis

The territorial source principle is embedded in section 14 of the Inland Revenue Ordinance (Cap. 112). It charges profits tax on “any person carrying on a trade, profession or business in Hong Kong” in respect of “profits arising in or derived from Hong Kong from that trade, profession or business”. The words “arising in or derived from” are not defined in the Ordinance. The courts and DIPN 21 have given them meaning through the operation test, drawing on a long line of Hong Kong tax cases.

This principle is fundamental. A company can be incorporated and managed in Hong Kong but still have no Hong Kong profits tax liability if its profit-generating activities occur outside Hong Kong. Conversely, a foreign company that carries on business in Hong Kong through a permanent establishment will pay tax only on the profits attributable to the Hong Kong operations.

Hong Kong Offshore Claim: How It Works

A taxpayer who believes its profits are sourced entirely outside Hong Kong may make an offshore claim. This is not a separate application. The taxpayer simply reports the profits as non-assessable in the profits tax return and provides supporting evidence. The Inland Revenue Department will review the claim and may issue a tax assessment based on its own determination of the source.

For a corporation, the relevant return is Form BIR51. For an unincorporated business, Form BIR52 applies. Non-resident persons use Form BIR54. Supplementary forms S1 to S18 accompany the return, and the taxpayer must complete the relevant supplementary schedules showing the basis of the offshore claim.

The burden of proof rests on the taxpayer. The Inland Revenue Department expects documentary evidence of the operations performed outside Hong Kong: contracts, purchase orders, invoices, correspondence, bank records, and details of where staff performed their duties. A claim supported only by a general assertion that profits are offshore will not succeed.

DIPN 21 Guidance: Practical Application

DIPN 21 guidance provides the framework for applying the operation test in common commercial scenarios. The Departmental Interpretation and Practice Note includes detailed examples for:

• Trading concerns: The key question is where the contracts for purchase and sale are negotiated, concluded and executed. A Hong Kong trader who buys goods from a supplier in Japan and sells them to a customer in the United States, with all negotiations and execution handled by staff in Hong Kong, will have onshore profits. If the same trader delegates all those functions to an overseas office, the profits are offshore.

• Manufacturing: If the manufacturing process occurs entirely outside Hong Kong, the profit from that manufacturing is offshore. However, if the Hong Kong company also performs selling activities in Hong Kong, a separate profit from those selling activities may be onshore. DIPN 21 discusses the distinction between the profit from manufacturing and the profit from trading.

• Service businesses: The source of service income is the place where the services are performed. A Hong Kong engineering firm that designs a bridge in Hong Kong and supervises its construction in Vietnam will have a Hong Kong source for the design work and an offshore source for the supervision work. Apportionment is required.

• Loan and interest income: The source of interest income is the place where the credit is made available. If a Hong Kong company lends money to a borrower outside Hong Kong and the loan agreement is executed in Hong Kong, the interest is onshore.

Distinguishing Offshore Claim From FSIE

The offshore claim under DIPN 21 is distinct from the foreign-sourced income exemption (FSIE) regime that took effect on 1 January 2023 and was expanded from 1 January 2024 to cover disposal gains.

The offshore claim applies to any taxpayer who has profits sourced outside Hong Kong, regardless of entity type or group structure. The taxpayer demonstrates that the profit-generating operations occurred outside Hong Kong.

The FSIE regime applies only to members of multinational enterprise groups. It covers specified foreign-sourced income received in Hong Kong: dividends, interest, royalties, and disposal gains. If the income is received in Hong Kong, it is deemed to be derived from Hong Kong and chargeable unless an exception applies. The principal exceptions are the economic substance requirement, the nexus requirement for intellectual property income, and the participation exemption.

A taxpayer who makes an offshore claim under DIPN 21 is asserting that the source of the profit is outside Hong Kong. A taxpayer who relies on the FSIE is accepting that the source is Hong Kong but relying on a statutory exemption. The two analyses are complementary but different. DIPN 21 does not address the FSIE; the Department has issued separate guidance on that regime.

Practical Considerations for Taxpayers

When preparing a profits tax return, a taxpayer must consider the locality of each category of profit. The Inland Revenue Department may challenge an offshore claim if the supporting evidence is weak. Penalties may apply under section 80 or section 82A of the Inland Revenue Ordinance if the claim is found to be incorrect without reasonable excuse.

The Department publishes a block extension letter for each year of assessment, setting later filing dates for profits tax returns based on the accounting date. For a company with a 31 December year end, the extended deadline is in November of the following year. Check the current block extension letter on the Inland Revenue Department website.

For businesses with connected entities, only one entity in a group may elect the two-tiered profits tax rates: 8.25% on the first HK$2,000,000 of assessable profits for corporations, 16.5% on the remainder. The other entities are charged at the upper rate on all profits. This election is separate from the locality analysis and does not affect whether profits are onshore or offshore.

Transfer pricing rules may apply to transactions between connected entities, particularly where one entity makes an offshore claim and the other derives onshore profits from the same transaction. The Department expects arm’s length pricing and may adjust profits under the transfer pricing provisions if the pricing does not reflect the economic substance of the arrangement.