Following the fusion of the economy of the Mainland and Hong Kong, enterprises have operations in both sides should know more about the impact of doubt tax on income and its avoidance. The following only serves as a brief introduction. For more detailed information, please consult your accountant, Inland Revenue Department ("IRD") or APEX Accountants.

All information stated here refer to the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation on Income ("ADTI") as detailed in IRD's Departmental Interpretation & Practice Note No 32. ADTI applies to income derived from Hong Kong in any year of assessment commencing on or after 1 April 1998 and to income derived from the Mainland on or after 1 July 1998.

1. The territorial source principle of taxation

Hong Kong adopts a territorial source principle of taxation. Only profits, which arise in or are derived from Hong Kong are subject to Profits Tax. Profits, which are sourced outside Hong Kong are not taxable.

2. Resident

ADTI applies to a person who is a resident of either the Mainland or Hong Kong or is a resident of both. According to Article 6 of ADTI, the term "resident" means any "person" who is liable to tax of One Side by reason of his residence, domicile, place of effective management, place of head office or any other criterion of a similar nature in accordance with the laws of the respective Sides. The term "person" is defined to include an individual, a company, and any other body of persons. Our discussion will concentrate on company instead of Individual.

(1) Resident "company"

The term "company" means any body corporate or any entity which is treated as a body corporate for tax purposes. Neither ADTI nor the Inland Revenue Ordinance (Cap.112) ("IRO") contains a definition of a "resident company". Case law has established that a company is resident in Hong Kong if its central management and control is in Hong Kong, i.e., the place where business is being carried on. The issue is purely a question of fact.

(2) Resident "body of persons"

The term "person" in Article 7 also refers to "any other body of persons". The Inland Revenue Department ("IRD") regards this as a reference to separate taxing entities such as partnership. IRD considers a partnership is resident where is effective management and control is located.

(3) Certification of resident status

When applying for benefits under ADTI, an applicant may be required to substantiate his resident status. In such a situation he may apply for a certificate of resident status from the competent authority of the Side where he is resident. If he is unable to produce such a certificate he will be denied the benefits of ADTI.

In the case of a Hong Kong resident who is required to substantiate his resident status, the Mainland tax authority will first issue a referral letter to the applicant for forwarding to IRD. This, together with a properly completed "Application for Certification of Resident Status", is to be submitted to IRD. The latter form can be obtained from IRD.

IRD will examine the information supplied and if it is sufficient, issue a "Certificate of Hong Kong Resident Status". If the application is rejected, the applicant will be notified accordingly.

3. Taxes covered

4. Enterprise

ADTI does not define the term "enterprise" and it is to be interpreted in accordance with the domestic laws of Hong Kong and Mainland.

5. Procedures for applying for benefits under ADTI

A Hong Kong resident who wishes to obtain the benefits of ADTI, including claiming a tax credit, can do so at the time he submits his Profits Tax Return for the relevant year of assessment, or in writing not later than two years after the end of the relevant year of assessment. Details should be provided of the income on which relief is being sought, the nature of the tax paid in the Mainland and the amount of tax credit claimed a copy of the Mainland notice of assessment and documentary evidence that the tax has been paid and is not subject to further adjustment are required to be submitted with application. In addition, the applicant must be resident in Hong Kong for that year of assessment.

Any adjustment to the amount of the income doubly assessed or the amount of tax paid subsequent to the lodgment of the claim must be notified in writing to IRD so that corresponding revision can be made.

6. Permanent establishment

A permanent establishment is a fixed place of business of a permanent nature where an enterprise carries on the whole or a part of its business activities. The Mainland authority may impose tax on the enterprise if it is held to have a permanent establishment in the Mainland. However, the enterprise will only be subject to tax on only so much of the profit as is attributable to the permanent establishment.

(1) A permanent establishment normally has the following features:

(a) it is a place of business for the carrying out of business activities;
(b) it is a fixed place of business of a permanent nature; and
(c) the enterprise carries on the whole or a part of its business activities at the place of business.
(2) Activities that do not constitute a permanent establishment

Activities of a preparatory or auxiliary nature carried out at a fixed place of business that do not of themselves produce profits will generally not be considered to constitute a permanent establishment. Such activities include:
(a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
(b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of
(i) storage, display or delivery; and
(ii) processing by another enterprise;
(c) the maintenance of a fixed place of business solely for
(i) the purpose of purchasing goods or merchandise, or of advertising, or of collecting information, for the enterprise;
(ii) the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; or
(iii) any combination of the activities mentioned in items (a), (b), (c)(i) and (c)(ii) above, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

7. Representative office

A representative office will not be regarded as a permanent establishment and subject to tax if the following conditions are satisfied:

(1) the activities are for the enterprise itself;
(2) the activities do not directly generate profits; and
(3) the functions of the representative office are only of a supportive nature. If the representative office conducts supervisory management functions or manages business operations for the enterprise, its activities would not be regarded as being of the required character. In this event, the representative office would be regarded as a permanent establishment.

8. Processing or assembly ADTI with a Mainland entity

When a Hong Kong manufacturing enterprise enters into a processing or assembling ADTI with a Mainland entity, ADTI any take one of the following forms :

(1) A co-operative processing unit

The Hong Kong enterprise provides the raw materials, technical know-how, design, training, management and supervision, etc, and the Mainland entity provides the factory premises, the land and labour and is responsible for processing, manufacturing and assembling the good. In law, the Mainland processing unit is a contractor separate and distinct from the Hong Kong manufacturing enterprise. Profits arising from the sale of processed goods to the latter are subject to tax in Hong Kong, and the question of apportionment does not arise. However, IRD is prepared to concede that the profits in question can, generally, be apportioned on a 50:50 basis (see Point 15 for the relevant tax credit).

(2) An independent sub-contractor

A Hong Kong manufacturing enterprise, who contracts the processing work to an independent Mainland sub-contractor and pays for the processing on an arm's length basis, is not regarded as having been involved in the processing work. The sub-contracting charges payable to the Mainland sub-contractor will be subject to Enterprises Income Tax in the Mainland. Profits arising from the sale of goods to the Hong Kong manufacturing enterprise are chargeable to Profits Tax.

9. A building sit, a construction, assembly or installation project

The IRO imposes tax on profits derived from contracting work carried out in Hong Kong without regard to the duration of the work. However, ADTI provides that the profits from such projects will only be subject to tax if the project lasts for more than 6 months. Profits from a project that does not last for more than 6 months will not be regarded as constituting a permanent establishment in Hong Kong and profits derived therefrom will not be subject to tax in Hong Kong. A Hong Kong resident with a project in the Mainland will be accorded similar treatment. Calculation of the duration of a project:

(a) The period for which a project is carried out is counted from the date the contractor commences work (including all preparatory activities) up until the date of completion of the work and the hand over of the work completed.
(b) If the period covers two years, the period is counted on a continuous basis over the years in question.
(c) In a case where two or more sub-projects are contracted for at the same site or for the same project, the period is counted from the date of commencement of the first sub-project to the date of completion of the last sub-project. In other words the sub-projects are part of a single project.
(d) Where the sub-projects are situated at different localities and are contracted for different projects, the respective periods may be counted separately.

10. Provision of services by an enterprise

A Hong Kong enterprise is regarded as having a permanent establishment in the Mainland if it provides services, including consultancy services, through employees or other personnel situated therein. The services have to be furnished for the same project or a connected project for a period or periods exceeding in the aggregate 6 months in any 12-month period.

The scope of consultancy services includes:

(1) improvement of production facilities and products, selection of technical know-how, or enhancement of supervisory and management skills, etc; and
(2) the feasibility analysis of investment projects and the selection of design plans.

11. Business agent

12. Business profits

13. Passive income

14. Shipping, air and land transport

(1) Shipping Transport

(a) ADTI provides that Hong Kong has the right to tax a Hong Kong resident on profits derived from its shipping business and will be exempt from Enterprises Income Tax and Business Tax in the Mainland.
(b) It should be noted that in calculating the assessable profits of a ship-owner carrying on business in Hong Kong, section 23B of the IRO already provides that sums derived from relevant carriage shipped aboard a Hong Kong registered ship and towage operation undertaken by it at or from any location within the waters of Hong Kong and proceeding to sea are exempt from Profits Tax.
(c) One half of any sums derived from charter hire in respect of the operation of a ship navigating between any location within the waters of Hong Kong and any location within river trade waters are also tax exempt. These exemptions still apply after ADTI has come into effect.

(2) Air Transport

(a) ADTI provides that Hong Kong has the right to tax a Hong Kong resident on profits derived from its air transport business and will be exempt from Enterprises Income Tax and Business Tax in the Mainland.
(b) In accordance with section 23C(2A) of the IRO sums derived from any relevant carriage and charter hire from the Mainland derived by a Hong Kong resident, that are exempt from tax in the Mainland under ADTI, are included as "relevant sums" in calculating profits chargeable to tax in Hong Kong.

(3) Land Transport

(a) ADTI provides that Hong Kong has the right to tax a Hong Kong resident on profits derived from its cross-border land transport business and will be exempt from Enterprises Income Tax and Business Tax in the Mainland.
(b) A cross-border land transport business between the Mainland and Hong Kong usually takes the form of a co-operative enterprise. Typically the Hong Kong resident will make his investment in the form of vehicles and capital. The Mainland resident will be responsible for the application of permits and licenses, tax compliance and other management services. This kind of co-operative enterprise is regarded as a joint business of cross-border transport operated by a resident of the Mainland and of Hong Kong. The share of revenues and profits derived by the Hong Kong resident will be exempt from tax in the Mainland and subject of Profits Tax in Hong Kong.

15. Tax credit

(1) In case of a Hong Kong resident deriving income that is subject to tax in Hong Kong, except the following:
(a) Any tax paid in the Mainland in respect of that income shall be allowed as a credit against the Hong Kong tax payable on that income. The amount of the tax credit cannot exceed the amount of tax payable in respect of that income, computed in accordance with the provisions of the IRO.
(b) The total amount of the tax credit to be allowed for a year of assessment cannot exceed the total Hong Kong tax payable for that year of assessment.
(c) In the case where the Hong Kong tax payable for a year of assessment is "NIL", e.g. in a loss situation, a tax credit is not allowable for any Mainland tax paid nor can the Mainland tax be carried forward and allowed as a tax credit in a subsequent year of assessment.

(2) In the case of a Hong Kong manufacturing enterprise whose profits are apportioned on a 50:50 basis and where the Mainland regards more than one-half of such profits as derived from the Mainland, a tax credit will only be allowed in respect of the tax paid in the Mainland on those profits in excess of one half of the total profits.

16. An assessment issued by the Mainland authority is not in conformity with the provisions of ADTI

Hong Kong resident considers that an assessment issued by the Mainland authority is not in conformity with the provisions of ADTI, he should:

(1) First lodge his objection with the Mainland authority in accordance with the procedures and time limits provided by the Mainland tax laws.
(2) In the event that the claim cannot be settled unilaterally or is not dealt with expeditiously through normal procedures, the taxpayer may apply through IRD to have the problem dealt with through mutual consultation.