Increased scrutiny on offshore claims It would follow that “offshore claims” (that is, a taxpayer filing a Hong Kong tax return on the basis that it does not have any Hong Kong source profits, and is therefore not chargeable to tax in Hong Kong) have been subject to greater scrutiny by the IRD. Many taxpayers who enjoyed exemption from profits tax in the past have recently been audited by the IRD and requested to furnish comprehensive documentation to substantiate their offshore claims. Unsurprisingly, the IRD has begun to treat profits it traditionally accepted were sourced outside of Hong Kong as being taxable, which has in turn led to an increase in tax disputes. Mariani commented: “The IRD’s increasingly aggressive approach can partly be explained in the context of a global movement to combat MNE’s tax avoidance practices. Some fiscal policymakers view that Hong Kong’s attractive territorial tax system might not be in line with modern international taxation principles. Although Hong Kong does seem keen to protect its tax system, the IRD may feel urged to critically review Hong Kong tax structures, including those banking on successful offshore claims. It is not so much a question of law, but of interpretation and administrative practice.” Traditional risk mitigation strategies Within the local tax community, it is no secret that the restrictive approach of the IRD to the territorial tax regime has become the leading tax risk in Hong Kong. To reduce the risk of being challenged on the territoriality point, taxpayers may deploy several strategies, of which Mariani summarises three: • Documentation. Comprehensive contemporaneous documentation is crucial with respect to offshore claims and should be prepared with a view to being supplied promptly to the IRD if called upon. The IRDmay inquire into, amongst other matters, the contractual basis of profitmaking transactions, how those transactions were booked, how and where clients were solicited, and merchandise was stored. To supply credible and comprehensive responses to IRD inquiries, taxpayers should produce and retain contemporaneous documentation evidencing each stage of its commercial and decision-making activities. Similarly, where the carrying out of certain activities in Hong Kong is internally prohibited to prevent the triggering of substantive commercial activity in the jurisdiction, it is important that the internal procedures in place to procure the geographic segregation of functions be clearly set out in internal documentation and applied stringently. • Advance ruling. It is possible to request for an advance ruling from the IRD. Taxpayers should be
wary of this option as it could result in an adverse ruling which would not be appealable (absent judicial review). An adverse ruling will send the taxpayer back to ‘square one’, guaranteeing that the IRD, who is bound to the assessment, will raise an additional assessment. • Apportionment. Where the same unit of profit has both onshore and offshore components, taxpayers may wish to argue that at least the offshore component should not be chargeable to profits tax. This is where the concept of apportionment comes into play. Apportionment is appropriate where profit-generating activities or value-addition take place both in and outside of Hong Kong. The effect of this would be that only the portion of profit arising in Hong Kong is taxable. Though the IRD prefers an ‘all or nothing’ approach, it does not exclude apportionment of profit in its published guidance. Tax Liability Insurance as an alternative While said strategies may lower the risk of challenges from the IRD, they may not fully eliminate it. Taxpayers are, therefore, left with uncertainties as to whether their ‘offshore claim’ or zero-tax position in Hong Kong will be respected. Additionally, taxpayers also need to consider the risk of the IRD asserting that profit tax returns have been incorrectly filed and imposing severe penalties. This is where TLI can be utilised to gain a critical risk management advantage. A TLI policy offers the taxpayer a quick and capital-efficient tool to eliminate a financial exposure by transferring offshore claim risks to an insurer. In exchange for a premium payment, the insurer covers the potential financial loss resulting from the IRD’s successful challenge of an insured offshore claim position. Insurable offshore claim risks Insurers generally prefer to underwrite tax risks with a low probability of materializing and a high quantum. Furthermore, there must be a sound legal basis for the tax position being taken as insurance cannot be obtained for an incorrect tax position based only on detection risk. Before considering underwriting an offshore claim risk, an insurer will require a tax opinion from a reputable law/tax advisory firm supporting the technical soundness of the offshore claim. Such advise should detail (i) the tax-technical analysis of the taxpayer’s position; (ii) the financial exposure; and (iii) the likelihood of IRD success in challenging the offshore claim before a tribunal or court. Insurers normally will not require a percentage to be attributed to the chance of success if challenged, rather they would expect to see a ‘should’ or ‘more likely than not’ level of opinion.
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