Understanding IRD Enforcement Priorities in 2025

The Hong Kong Inland Revenue Department (IRD) has significantly intensified its enforcement approach in response to global pressure from the OECD and EU, particularly regarding Base Erosion and Profit Shifting (BEPS) activities. For taxpayers operating in Hong Kong, understanding what triggers IRD scrutiny and how disputes typically arise is essential for maintaining compliance and avoiding costly controversies.

Primary IRD Audit Focus Areas

1. Offshore Claims and Territorial Source Principle

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

The IRD does not follow a fixed checklist for substance. Instead, it applies an “adequacy test”, which asks whether the people, premises, and activities in Hong Kong are sufficient and proportionate to the nature and scale of your business. Determining whether core business activities are carried out outside Hong Kong is now the top review element, as the IRD attempts to prevent tax evasion through abuse of offshore exemptions.

What the IRD examines:

• Contracts, invoices, and shipping records
• Bank statements and payment flows
• Proof of where and how business decisions were made
• Location of key personnel and management
• Evidence of economic substance outside Hong Kong

2. Transfer Pricing and Related Party Transactions

The IRD has notably escalated its enforcement of transfer pricing regulations, driven by bilateral considerations and mounting pressure from competent authorities worldwide. Stricter IRD reviews are in place, with more scrutiny being paid to intra-group transfer prices. It is anticipated that the IRD will conduct transfer pricing reviews and audits on taxpayers on a larger scale and more regular basis.

High-risk transaction types:

3. Foreign-Sourced Income Exemption (FSIE) Regime

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

Specified foreign-sourced income categories:

• Dividends
• Interest income
• Intellectual property (IP) income
• Disposal gains from equity interests

These four types of offshore passive income received in Hong Kong by members of multinational enterprise (MNE) groups are subject to profits tax unless they meet the economic substance requirement (ESR), participation requirement, or nexus requirement.

Economic Substance Requirements:

Notification requirements: Covered taxpayers who receive specified foreign-sourced income in Hong Kong to which no tax exemption applies must inform the IRD of its chargeability within 4 months after the end of the basis period. Record-keeping requirements mandate retention of thorough financial records for at least seven years.

Common Tax Dispute Triggers and Red Flags

The IRD has been adopting initiatives to counter BEPS activities and taking a more conservative and stringent approach during reviews in recent years. This means Hong Kong taxpayers are facing enormous pressure from the IRD to justify their tax filing positions. There has been an unprecedented surge in tax disputes involving technical issues and disagreement about facts.

Red Flags That Trigger IRD Enquiries

IRD Audit Process and Timeline

Hong Kong operates under an “assess first, audit later” approach. A notice of assessment or statement of loss is issued after the tax return has been processed. Taxpayers may be subject to post-assessment investigation or field audit based on risk areas or under computerised random selection procedures at a later date.

Stages of IRD Investigation

Stage 1: Initial Review
The IRD conducts a desk review of the 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. The IRD looks for evidence including:

• Contracts and agreements
• Travel records and itineraries
• Transfer pricing reports
• Emails and correspondence
• Invoices and receipts
• Bank transaction records

Stage 3: Field Audit
Sometimes documents alone aren’t enough, and the IRD decides to dig deeper with a field audit. This is the more serious stage, where they might:

• Visit business premises
• Review accounting systems in detail
• Interview directors or staff to confirm where operations really take place

This detailed investigation can stretch six months or more.

Board of Review Case Patterns

Recent Board of Review decisions reveal emerging patterns in tax disputes, particularly regarding source of income determination and apportionment issues.

Key 2024 Case: Patrick Cox Asia Limited v Commissioner of Inland Revenue

The Court of Appeal handed down its judgment on October 17, 2024, addressing critical issues in trademark sub-licensing arrangements:

Issues in dispute:

1. Whether upfront payments were sourced from Hong Kong
2. Whether royalty income was sourced from Hong Kong
3. Whether upfront payments were capital or revenue in nature

Court’s findings:

• The Court of Appeal upheld that the upfront payment was revenue in nature and Hong Kong sourced
• However, the Court ruled the Board erred in determining that all royalty income was Hong Kong sourced
• The decision introduces the potential for apportioning royalties between Hong Kong and offshore sources
• The case was remitted back to the Board for rehearing on the sourcing issue

This decision highlights the complexity of tax disputes, especially in identifying the geographical location of profit-producing transactions distinct from antecedent or incidental activities. The introduction of apportionment for royalties could significantly impact previously infeasible offshore claims.

BEPS 2.0 and Global Minimum Tax Implementation

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, including:

• 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

This development adds another layer of compliance for large multinational groups operating in Hong Kong.

Penalties for Non-Compliance

The IRD has a structured penalty regime for various offences:

Late filing penalties:

• First-time offense: HKD 1,200
• Failure to resolve within 14 days: HKD 3,000, with potential legal prosecution
• Repeat offenses: Immediate penalty of HKD 3,000, rising to HKD 8,000 if unresolved within 14 days

Transfer pricing penalties: For pure transfer pricing adjustments, penalties can be up to 100% of the tax undercharged.

Extended assessment period: The time limit for making additional assessments is extended to ten years after the end of the relevant assessment year when a taxpayer has not been assessed or is under-assessed due to fraud or wilful evasion.

Penalty mitigation: The IRD confirms that maintenance of transfer pricing documentation is relevant in mitigating any penalty exposure. Intentional under-reporting or non-disclosure of profits or over-reporting or fabrication of expenses would generally trigger a high level of penalty.

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. Transfer Pricing Documentation

• Multinational groups should harmonise transfer pricing documentation into OECD-compliant Master File and Local File
• If the Master File is prepared by an overseas parent, ensure the IRD receives the right information
• Keep clear and comprehensive records documenting all aspects of intercompany pricing arrangements
• Track statutory deadlines and required contents stipulated under DIPN58

3. 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 commencing from 2022/23 or any subsequent years. Processing typically takes one month.

Advance Pricing Arrangements (APAs): For transfer pricing matters, multinationals can consider using APA services recently launched by the IRD to obtain certainty for related party transactions. The IRD is prepared to consider bilateral or multilateral APAs; unilateral APAs are only considered under exceptional conditions.

4. Proper Tax Return Disclosures

• Make proper disclosures in tax filings
• Maintain sufficient documents to substantiate tax positions taken
• Respond completely and accurately to IRD enquiries
• Incomplete or inaccurate responses could trigger further questioning and expansion of scope

5. 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

Industry-Specific Considerations

Trading Companies

Companies engaged in cross-border trading face particular scrutiny on where purchase and sale contracts are negotiated and concluded. The location of risk-taking, decision-making, and relationship management is critical.

Regional Headquarters

Regional headquarters charging management fees to affiliates must demonstrate genuine services provided with adequate substance, including qualified personnel and actual time spent on services.

IP Holding Companies

Companies receiving royalty income or licensing IP must carefully document the nexus between IP development, management, and exploitation to support source of income claims.

Investment Holding Companies

Under the FSIE regime, pure equity-holding entities have lighter substance requirements but must still demonstrate compliance with holding and managing equity investments.

Looking Ahead: 2025 Compliance Priorities

As Hong Kong’s transfer pricing regime matures and BEPS 2.0 implementation proceeds, taxpayers should prioritise:

1. Enhanced documentation quality: Simply updating transfer pricing documentation reports may no longer suffice—the IRD expects comprehensive, high-quality analysis
2. FSIE compliance systems: Implement robust systems to track specified foreign-sourced income and ensure economic substance requirements are met
3. Transfer pricing governance: Establish clear policies and procedures for related party transactions with regular reviews
4. Proactive engagement: Consider advance rulings and APAs for complex or high-value arrangements
5. Global minimum tax readiness: Large MNE groups should prepare for HKMTT compliance from 2025