Profits tax is levied under the Inland Revenue Ordinance on the "assessable profits" of corporate entities, partnerships, trusts and sole proprietorships. It is levied according to the "territorial principle" meaning that it is the source of the income rather than the residential or non-residential status of the entity that determines whether or not trading income is or is not subject to Hong Kong profits tax.

The territorial principle means that only income which meets the following 3 preconditions is subject to Hong Kong profits tax:

• The entity must trade in Hong Kong
• The income must arise from such a trade
• The income must arise in or be derived from Hong Kong

The residential or non-residential status of the entity is irrelevant as is the fact that the income is or is not exempt from tax in a foreign jurisdiction. Advance tax rulings are available in the SAR and are particularly favored and recommended on the question of whether or not for profits tax purposes trading income is deemed onshore and taxable or offshore and tax exempt.

"Source of income" for profits tax purposes has been defined as the geographical location of the operation which substantially gave rise to the income, but the Inland Revenue's Practice Note No 21 adds more precise criteria:

The establishment of an office in Hong Kong: does not of itself render a company liable to profits tax where that office is not generating profits from within the territory.

Place where the contract was negotiated and executed: A key criterion is the place where the contract was negotiated and signed. Income relating to a sale contract negotiated by the seller from the territory by way of facsimile or telephone where the negotiation did not require travel outside the territory is deemed Hong Kong source income for profit tax purposes. Likewise if the contract is negotiated and signed outside the territory and the goods sold are not sourced from within the territory then any income arising is not deemed Hong Kong source income for profits tax purposes. This is often achieved by utilizing an offshore company which re-registers in the territory as a foreign company but whose directors both remain non resident and negotiate and execute the contract from the offshore jurisdiction.

Booking Center: Where the Hong Kong entity is merely a booking center in the sense that it does not negotiate or draft the sale agreement (which is carried out abroad) but merely issues an invoice on instructions, operates a bank account and maintains accounting records covering the transaction then the income from such a transaction is not deemed Hong Kong source income for profits tax purposes.

Shares & Securities : Gains from shares and securities purchased and sold on the territory's stock exchange are deemed Hong Kong source income for profit tax purposes (assuming the entity is subject to profit tax on such an activity).

Cross Border Land Transportation: Income from cross-border land transportation is deemed Hong Kong source income if the passengers or goods are normally uplifted in Hong Kong.

Loans : Loan interest on a loan made available to the borrower within the jurisdiction of Hong Kong is deemed to be Hong Kong source income for profits tax purposes and taxable in the hands of the Hong Kong lender whereas loan interest on a loan made available to the borrower in a foreign jurisdiction is not deemed Hong Kong source income and is therefore not taxable.