Expert Insights: What Hong Kong Tax Authorities Look for in Dispute Cases

📋 Key Facts at a Glance

Primary Audit Focus: Offshore claims remain the IRD’s top priority, with strict scrutiny on where core business activities actually occur
Transfer Pricing Enforcement: The IRD has significantly escalated transfer pricing reviews, particularly for inter-company trading and management services
FSIE Compliance: Mandatory since January 2023, requiring economic substance for foreign-sourced dividends, interest, IP income, and disposal gains
Global Minimum Tax: Hong Kong enacted BEPS 2.0 Pillar Two legislation effective January 1, 2025, with a 15% minimum tax rate
Record Retention: Taxpayers must maintain comprehensive records for at least 7 years to support all tax positions

Are you confident your Hong Kong business could withstand an IRD audit? With the Inland Revenue Department intensifying enforcement across multiple fronts—from offshore claims to transfer pricing and the new FSIE regime—understanding what triggers IRD scrutiny has never been more critical. This guide reveals exactly what tax authorities look for in dispute cases and how to stay compliant in 2025’s evolving regulatory landscape.

The IRD’s Enforcement Evolution: Why 2025 is Different

Hong Kong’s Inland Revenue Department has transformed its approach in response to global pressure from the OECD and EU on Base Erosion and Profit Shifting (BEPS) activities. What was once a relatively straightforward territorial tax system now features sophisticated enforcement mechanisms targeting multinational enterprises. The IRD now employs data analytics, international information exchange, and risk-based auditing to identify potential non-compliance.

⚠️ Important: Hong Kong operates on an “assess first, audit later” system. You’ll receive your tax assessment first, but the IRD can conduct post-assessment investigations for up to 6 years (extended to 10 years for fraud or willful evasion).

Primary IRD Audit Focus Areas in 2025

1. Offshore Claims: The Territorial Source Principle Under Scrutiny

Offshore claims remain the IRD’s most intensive area of scrutiny. The department has tightened its interpretation of Hong Kong’s territorial source principle, examining whether core business activities—contract signings, board decisions, operational management—genuinely occur outside Hong Kong.

The IRD applies an “adequacy test”: Are the people, premises, and activities in Hong Kong sufficient and proportionate to your business scale? They’re looking for substance, not just paperwork.

What the IRD Examines	Why It Matters
Contracts, invoices, and shipping records	Evidence of where transactions actually occur
Bank statements and payment flows	Tracks money movement and economic substance
Proof of where business decisions were made	Determines true management location
Location of key personnel and management	Assesses operational substance
Evidence of economic substance outside Hong Kong	Validates offshore claim legitimacy

2. Transfer Pricing: Heightened Enforcement Across All Industries

The IRD has significantly escalated transfer pricing enforcement, conducting reviews on a larger scale and more regular basis. Driven by international pressure and bilateral agreements, the department now scrutinizes intra-group transfer prices with unprecedented rigor.

High-Risk Transaction Types	Why IRD Focuses Here	Key Evidence Required
Inter-company Trading	Hong Kong’s territorial tax system makes it attractive for profit shifting to exempt jurisdictions	Transfer pricing documentation, comparable market prices, value chain analysis
Management Services	Regional headquarters often charge fees that may lack substance	Service agreements, time sheets, benefit allocation, cost-plus markup justification
IP Licensing	Cross-border royalty arrangements can shift profits to low-tax jurisdictions	Valuation reports, royalty rate benchmarking, IP development nexus
Intra-group Loans	Interest deductions can erode Hong Kong tax base if not properly substantiated	Loan agreements, arm’s length interest rates, commercial rationale

3. Foreign-Sourced Income Exemption (FSIE) Regime: New Compliance Frontier

Since January 1, 2023, Hong Kong’s FSIE regime has fundamentally changed how specified foreign-sourced income is treated. The regime was further refined from January 1, 2024, adding complexity to compliance requirements for multinational enterprises.

Specified foreign-sourced income categories:

Dividends – Income from equity investments
Interest income – Returns from debt instruments
Intellectual property (IP) income – Royalties and licensing fees
Disposal gains from equity interests – Profits from selling shares

Entity Type	Economic Substance Requirements
Pure Equity-Holding Entities	Lighter obligations: mainly holding/managing equity investments and meeting compliance filings
Non-Pure Equity Entities	Must demonstrate strategic decisions made locally, adequate local staff, and real operating expenses in Hong Kong

⚠️ Important: Covered taxpayers receiving specified foreign-sourced income must notify the IRD of chargeability within 4 months after the end of the basis period if no tax exemption applies. Record-keeping requirements mandate retention of thorough financial records for at least seven years.

Red Flags That Trigger IRD Enquiries

Understanding what catches the IRD’s attention is crucial for proactive compliance. Here are the most common triggers that lead to detailed enquiries:

Red Flag Category	Specific Indicators
Offshore Claims	• Directors or key personnel based in Hong Kong • Board meetings held in Hong Kong • Contracts signed in Hong Kong • Bank accounts maintained in Hong Kong • Lack of substance in claimed offshore jurisdiction
Transfer Pricing	• Significant volume of transactions with related parties • Transactions with entities in tax havens • Persistent losses or low profit margins • Lack of transfer pricing documentation • Pricing inconsistent with arm’s length principle
FSIE Compliance	• Specified foreign income received without ESR evidence • Misclassification of domestic vs. foreign-sourced income • Failure to notify IRD of taxable foreign income • Inadequate economic substance in Hong Kong
Documentation Issues	• Incomplete or inconsistent records • Missing Master File or Local File • Failure to retain records for seven years • Unsubstantiated claims in tax returns

The IRD Audit Process: What to Expect

Hong Kong’s “assess first, audit later” system means you receive your tax assessment before potential investigation. Here’s how the process typically unfolds:

Stage 1: Initial Review – The IRD conducts a desk review of your tax return and supporting documents. If potential red flags are identified, a detailed review is triggered.
Stage 2: Detailed Enquiry – The IRD issues an enquiry letter with a detailed information request list. They’ll ask for contracts, travel records, transfer pricing reports, emails, invoices, and bank transaction records.
Stage 3: Field Audit – If documents aren’t sufficient, the IRD may conduct a field audit. This involves visiting business premises, reviewing accounting systems in detail, and interviewing directors or staff to confirm where operations really take place.

💡 Pro Tip: Always respond completely and accurately to IRD enquiries. Incomplete or inaccurate responses could trigger further questioning and expansion of the audit scope.

BEPS 2.0 and Global Minimum Tax: The 2025 Compliance Frontier

Hong Kong has joined over 130 jurisdictions in supporting the OECD’s two-pillar solution to address BEPS risks. The 2024-25 Budget confirmed Hong Kong’s adoption of the BEPS 2.0 framework, with legislation enacted on June 6, 2025, effective from January 1, 2025.

Global Minimum Tax: 15% minimum tax rate applicable to MNE groups with annual consolidated revenue of at least EUR 750 million in any two of the past four years
Hong Kong Minimum Top-up Tax (HKMTT): Effective from 2025, ensuring Hong Kong collects tax where the effective rate falls below 15%
Income Inclusion Rule (IIR): Requires ultimate parent entities to pay top-up tax on low-taxed income of constituent entities

Penalties for Non-Compliance: Understanding the Risks

The IRD has a structured penalty regime that can significantly impact non-compliant taxpayers:

Late filing penalties: First-time offense: HK$1,200; failure to resolve within 14 days: HK$3,000 with potential legal prosecution
Transfer pricing penalties: Up to 100% of the tax undercharged for pure transfer pricing adjustments
Extended assessment period: Extended to ten years after the relevant assessment year for fraud or willful evasion
Interest on held-over tax: 8.25% from July 2025 on outstanding tax amounts

💡 Pro Tip: Maintaining proper transfer pricing documentation can significantly mitigate penalty exposure. The IRD confirms that documentation is relevant in penalty considerations.

Best Practices for Compliance and Dispute Avoidance

1. Maintain Comprehensive Documentation

Keep thorough financial records separating offshore and local profits
Retain all contracts, invoices, bank statements, and operational documents
Maintain records for at least seven years as required by the IRD
Prepare contemporaneous transfer pricing documentation even if not mandatory

2. Leverage Advance Rulings and APAs

FSIE Advance Rulings: Taxpayers can apply for advance rulings under section 88A of the Inland Revenue Ordinance on whether their covered income is exempt from tax under the FSIE regime. Applications may cover a maximum of five years of assessment.

Advance Pricing Arrangements (APAs): For transfer pricing matters, multinationals can use APA services to obtain certainty for related party transactions. The IRD considers bilateral or multilateral APAs; unilateral APAs are only considered under exceptional conditions.

3. Implement Regular Compliance Reviews

Conduct periodic reviews of offshore claim justifications
Update transfer pricing documentation annually
Monitor changes in business operations that may affect source of income
Stay informed about IRD guidance updates and Board of Review decisions

✅ Key Takeaways

The IRD has intensified enforcement across offshore claims, transfer pricing, and FSIE compliance, requiring higher standards of documentation and substance
Offshore claims face strictest scrutiny with the IRD applying an “adequacy test” to determine if activities outside Hong Kong are proportionate to business scale
Transfer pricing documentation is becoming mandatory in practice, with the IRD conducting reviews on a larger scale and more regular basis
FSIE compliance requires economic substance for specified foreign-sourced income (dividends, interest, IP income, disposal gains) received in Hong Kong
BEPS 2.0 implementation from 2025 adds global minimum tax compliance requirements for large MNE groups with revenue exceeding EUR 750 million
Best practices include maintaining comprehensive documentation, considering advance rulings and APAs, and conducting regular compliance reviews

In today’s evolving tax landscape, proactive compliance is no longer optional—it’s essential for business continuity. By understanding what triggers IRD scrutiny and implementing robust documentation and substance requirements, Hong Kong businesses can navigate audits confidently while focusing on growth rather than disputes. Remember: The best defense against tax controversies is a well-documented, substantiated tax position that reflects your actual business operations.

📚 Sources & References

This article has been fact-checked against official Hong Kong government sources and authoritative references:

Inland Revenue Department (IRD) – Official tax rates, allowances, and regulations
IRD Transfer Pricing Documentation – Master File and Local File requirements
IRD FSIE Regime – Foreign-sourced income exemption guidelines
IRD Global Minimum Tax – BEPS 2.0 Pillar Two implementation
GovHK – Official Hong Kong Government portal
Legislative Council – Tax legislation and amendments
OECD BEPS – International tax standards and guidelines

Last verified: December 2024 | Information is for general guidance only. Consult a qualified tax professional for specific advice.

Tax.HK