Hong Kong’s Evolving Tax Landscape: How Audits Are Adapting to New Laws

Hong Kong’s tax environment has undergone unprecedented transformation in recent years, driven by international tax cooperation initiatives, EU compliance requirements, and the global implementation of BEPS 2.0 measures. These changes have fundamentally reshaped how the Inland Revenue Department (IRD) conducts tax audits and enforces compliance. For multinational enterprises and local businesses operating in Hong Kong, understanding these evolving audit priorities is essential for maintaining compliance and managing tax risk effectively.

Recent Legislative Changes Reshaping Hong Kong’s Tax Framework

The past two years have witnessed a series of significant legislative changes that have fundamentally altered Hong Kong’s tax landscape. These reforms reflect Hong Kong’s commitment to international tax cooperation while maintaining its competitiveness as a global financial center.

Overview of Major Tax Law Changes (2024-2025)

1. Pillar Two Global Minimum Tax Implementation

On June 6, 2025, Hong Kong gazetted the Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance 2025, implementing the OECD’s BEPS 2.0 Pillar Two framework. This landmark legislation introduces:

• Hong Kong Minimum Top-Up Tax (HKMTT): A domestic minimum top-up tax ensuring MNE groups pay at least 15% effective tax rate on Hong Kong-sourced income
• Income Inclusion Rule (IIR): Effective retroactively from January 1, 2025, requiring parent entities to pay top-up tax on low-taxed foreign subsidiaries
• Postponement of UTPR: The Undertaxed Profits Rule has been postponed for further study
• EUR 750 Million Threshold: Applies to MNE groups with annual consolidated revenue of at least EUR 750 million in two or more of the preceding four fiscal years

Filing Requirements and Timelines:

• Top-Up Tax Notification: Must be filed within 6 months of fiscal year end, informing the IRD that the group is within scope and identifying the designated filing entity
• Top-Up Tax Return (including GIR): Must be filed within 15 months of fiscal year end (18 months for the first transition year)
• Example Timeline: For fiscal year ending December 31, 2025, notification is due by June 30, 2026, and the return by March 31, 2027

The IRD has proactively issued bulk letters to in-scope MNE groups, requesting entities to assess whether they belong to an in-scope group and complete reply slips within two months. This represents a significant expansion of the IRD’s audit and compliance monitoring capabilities.

2. Foreign-Sourced Income Exemption (FSIE) Regime Expansion

The FSIE regime was originally introduced (FSIE 1.0) on January 1, 2023, in response to Hong Kong’s inclusion on the EU’s grey list of non-cooperative tax jurisdictions. The expanded FSIE 2.0 regime, effective January 1, 2024, significantly broadens the scope of covered income:

Key FSIE 2.0 Changes:

• Expanded Asset Coverage: Now covers foreign-sourced gains from disposal of all types of assets—movable property, immovable property, financial assets, and non-financial assets—regardless of whether capital or revenue in nature
• Previous Scope (FSIE 1.0): Only covered dividends, interest, IP income, and equity disposal gains
• Intra-Group Transfer Relief: New relief mechanism to defer taxation when property is transferred between associated entities, subject to anti-abuse rules
• Trader Exclusion: Foreign-sourced disposal gains from non-IP assets derived by asset traders are excluded from the FSIE regime
• Historical Cost Basis: Disposal gains are calculated based on historical acquisition cost (the EU rejected Hong Kong’s rebasing proposal)

Tax Certainty Enhancement Scheme:

Alongside FSIE 2.0, Hong Kong implemented a tax certainty scheme for onshore equity disposal gains from January 1, 2024. Under this scheme, onshore equity disposal gains are treated as capital in nature (non-taxable) if the investor entity has held at least 15% of equity interests continuously for at least 24 months before disposal, subject to specific exclusions.

Financial Sector Carve-Outs:

The FSIE regime provides exemptions for foreign-sourced interest, dividends, and non-IP disposal gains earned by:

• Regulated financial institutions
• Investment funds
• Family offices

On February 20, 2024, Hong Kong was successfully removed from the EU watchlist, confirming that the FSIE 2.0 amendments satisfied international tax cooperation standards.

3. Stamp Duty Abolition for Residential Properties

In the 2024/25 Budget delivered on February 28, 2024, the Financial Secretary announced the immediate abolition of all demand-side management measures (DSMMs) for residential properties, marking the end of over 13 years of “spicy measures” designed to cool the property market.

Abolished Measures (effective February 28, 2024):

• Buyer’s Stamp Duty (BSD): Previously imposed on non-Hong Kong permanent residents and companies acquiring residential property
• Special Stamp Duty (SSD): Previously charged up to 20% on properties sold within 24 months of acquisition
• New Residential Stamp Duty (NRSD): Previously imposed at 15% on certain categories of buyers

The Stamp Duty (Amendment) Ordinance 2024 was passed by the Legislative Council on April 10, 2024, and gazetted on April 19, 2024. Any instrument executed on or after February 28, 2024, for the sale and purchase or transfer of residential property is no longer subject to these additional stamp duties.

Market Context:

The abolition was implemented against a backdrop of declining property prices (down 7% in 2023) and reduced transaction volumes (approximately 43,000 transactions in 2023, down 5%), driven by rising interest rates and external economic uncertainties.

4. Transfer Pricing Enforcement Intensification

The IRD has significantly escalated transfer pricing enforcement in response to bilateral pressure from competent authorities worldwide and Hong Kong’s commitment to OECD guidelines. The 2025 Pillar Two legislation also updated Hong Kong’s transfer pricing rules to align with the 2022 OECD Transfer Pricing Guidelines.

Enhanced Documentation Requirements:

• Master File and Local File: Must be prepared within 9 months of accounting year end
• IR1475 Form: Summary of transfer pricing information that must be submitted within one month upon IRD request
• Exemption Thresholds: Hong Kong entities are exempt from preparing Master/Local Files if they satisfy any two of the following: total revenue ≤ HKD 400 million, total assets ≤ HKD 300 million, or average employees ≤ 100

Controlled Transaction Exemption Limits:

• Goods: HKD 220 million
• Services: HKD 110 million
• Intangibles: HKD 110 million

Penalties for Non-Compliance:

Failure to submit the IR1475 form or inclusion of errors can result in prosecution and fines up to HKD 100,000, as well as transfer pricing adjustments. The IRD is conducting transfer pricing reviews and audits on a larger scale and more regular basis.

Milestone Achievement:

In late 2023, Hong Kong concluded its first Hong Kong-Mainland China Mutual Agreement Procedure (MAP) case for resolving double taxation relating to transfer pricing disputes. This represents a major milestone for taxpayers with cross-border related-party transactions.

How IRD Audits Are Adapting to the New Legal Framework

The IRD has fundamentally restructured its audit approach to address the complexities introduced by recent legislative changes. Unit 4 of the IRD, responsible for combating tax evasion and avoidance, has expanded its capabilities to ensure compliance across these new regulatory dimensions.

Current IRD Audit Focus Areas

Pillar Two Audit Procedures

The implementation of Pillar Two has introduced entirely new audit procedures and compliance requirements:

IRD Outreach and Identification:

The IRD has issued bulk letters to potentially in-scope MNE groups, requesting recipients to:

• Assess whether they belong to an in-scope MNE group (revenue ≥ EUR 750 million)
• Complete and return reply slips within two months
• Designate a filing entity for the group
• Identify the jurisdiction providing the GIR to Hong Kong

GloBE Safe Harbours:

Hong Kong has implemented several OECD-approved safe harbours to reduce compliance burden:

• Transitional Country-by-Country Reporting Safe Harbour: Relieves full GloBE calculations when certain CbCR conditions are met
• Transitional UTPR Safe Harbour: Temporary relief from UTPR calculations
• QDMTT Safe Harbour: Recognition of qualifying domestic minimum top-up taxes
• Simplified Calculations Safe Harbour: Available for non-material constituent entities

IRD audits will verify safe harbour eligibility and ensure calculations are properly supported.

FSIE Audit Scrutiny

The expansion of the FSIE regime from January 1, 2024, has created new audit challenges, particularly around disposal gains from all asset types:

Key Audit Verification Points:

• Asset Categorization: Verifying whether disposal gains are properly classified as capital or revenue in nature
• Foreign vs. Domestic Source: Ensuring disposal gains are genuinely foreign-sourced and meet exemption criteria
• Economic Substance: Confirming that CIGA (Core Income Generating Activities) or NREO (Nexus Requirements for Equity Interests and Immovable Property) requirements are satisfied
• Historical Cost Documentation: Verifying acquisition costs since rebasing was not permitted
• Intra-Group Transfer Relief: Ensuring anti-abuse conditions are met when claiming deferral

The IRD is particularly focused on companies claiming FSIE exemptions for disposal gains beyond traditional equity interests, as this represents a new area of compliance risk.

Offshore Income Claim Verification

Hong Kong’s territorial tax system means only Hong Kong-sourced income is taxable. However, the IRD has intensified scrutiny of offshore income claims, which remains a primary audit trigger:

Substance Over Form Analysis:

The IRD examines where profit-generating activities actually occur, not just where contracts are signed or nominal structures are located. Key evidence includes:

• Location of decision-making authority
• Where negotiations take place
• Location of key personnel performing income-generating activities
• Physical presence and operational substance
• Customer interaction locations

Companies must maintain robust documentary evidence demonstrating that income-generating activities occurred entirely outside Hong Kong. Contractual arrangements alone are insufficient.

Transfer Pricing Audit Escalation

Transfer pricing has become a major audit priority, with the IRD conducting reviews on a larger scale and more regular basis:

High-Risk Indicators Triggering Audits:

• Significant related-party transactions exceeding exemption thresholds
• Profit volatility or declining profitability despite stable revenues
• Transactions with tax haven jurisdictions
• Group structures susceptible to double non-taxation
• Insufficient documentation or delayed IR1475 submissions

Advance Pricing Arrangements (APAs):

Given the increased audit risk, more taxpayers are utilizing the IRD’s APA program to obtain certainty on prospective transfer pricing arrangements. APAs can be:

• Unilateral: Agreement with Hong Kong’s IRD only
• Bilateral: Agreement between the IRD and another country’s tax authority
• Multilateral: Agreement involving more than two jurisdictions

The successful conclusion of Hong Kong’s first Mainland China MAP case in late 2023 demonstrates the increasing effectiveness of bilateral resolution mechanisms.

Compliance Best Practices in the New Environment

1. Establish Robust Documentation Systems

The foundation of audit defense is comprehensive, contemporaneous documentation:

• 7-Year Retention: Maintain all business records, invoices, contracts, and correspondence for at least 7 years
• Audit Trail Completeness: Ensure all financial transactions are fully traceable from source documents through to tax returns
• Real-Time Documentation: Document decisions, substance, and rationale contemporaneously, not retrospectively during audits
• Digital Systems: Implement secure, organized digital filing systems for easy retrieval during IRD inquiries

2. Proactive Pillar Two Compliance for MNE Groups

For groups potentially within the EUR 750 million threshold:

• Revenue Monitoring: Track consolidated group revenue across the four preceding fiscal years
• Early IRD Engagement: Respond promptly to IRD letters and complete reply slips within deadlines
• GIR Preparation: Begin preparing GloBE Information Returns well in advance of filing deadlines
• Safe Harbour Analysis: Evaluate eligibility for available safe harbours to reduce compliance burden
• E-Filing Readiness: Prepare for mandatory e-filing of profits tax returns from assessment year 2025/26
• Effective Tax Rate Monitoring: Calculate and monitor effective tax rates by jurisdiction to identify potential top-up tax exposure

3. FSIE Compliance Framework

Given the expanded scope of FSIE 2.0:

• Asset Disposal Tracking: Implement systems to identify and track all asset disposals, not just equity interests
• Historical Cost Records: Maintain detailed acquisition cost documentation for all assets
• Substance Documentation: For FSIE exemption claims, maintain evidence of CIGA or NREO compliance
• Intra-Group Transfer Planning: Document the business purpose and anti-abuse compliance for intra-group transfers claiming deferral relief
• Tax Certainty Scheme: For onshore equity disposals, verify 15% ownership and 24-month holding period requirements

4. Strengthen Transfer Pricing Governance

To manage escalating transfer pricing audit risk:

• Timely Documentation: Prepare Master Files and Local Files within the 9-month deadline
• Annual Updates: Review and update transfer pricing documentation annually to reflect current operations
• Arm’s Length Testing: Conduct regular benchmarking studies to verify pricing is within arm’s length range
• IR1475 Readiness: Maintain summary information ready for submission within one month if requested
• APA Consideration: For significant related-party transactions, evaluate whether an APA would provide valuable certainty
• Cross-Border Coordination: Ensure transfer pricing policies are consistent across jurisdictions to avoid MAP disputes

5. Offshore Income Claim Substantiation

For companies claiming offshore income exemptions:

• Operations Mapping: Document where each profit-generating activity physically occurs
• Personnel Records: Maintain records of where key employees are based and work
• Decision Documentation: Record where business decisions, negotiations, and contract executions occur
• Customer Evidence: Document customer locations and where services are performed
• Regular Review: Reassess offshore income claims whenever operational facts change

6. Annual Audit Compliance

Under Hong Kong’s Companies Ordinance Part 9, every Hong Kong-incorporated company (except dormant companies) must have annual audited financial statements:

• Licensed CPA Requirement: Engage a licensed Certified Public Accountant for statutory audits
• Timely Filing: File profits tax returns by the specified deadline (typically one month from issuance, with extension available)
• New 2024/25 Items: Note that the 2024/25 profits tax returns include new items such as deductions for leased premises reinstatement costs
• Estimated Assessment Risk: Avoid delays; the IRD may issue estimated assessments requiring immediate payment if returns are late

Penalties and Consequences of Non-Compliance

Understanding penalty structures is essential for managing compliance risk:

Looking Ahead: Future Tax Developments

Hong Kong’s tax landscape will continue to evolve in response to international developments:

Potential Future Developments

• UTPR Implementation: While currently postponed, the Undertaxed Profits Rule may be implemented following further study and international coordination
• Enhanced CbC Reporting: Expansion of Country-by-Country Reporting requirements in line with OECD developments
• Digital Economy Taxation: Potential implementation of Pillar One measures addressing digital economy taxation
• ESG Disclosure Integration: Possible integration of tax transparency with ESG reporting frameworks
• Automatic Exchange Expansion: Continued expansion of automatic exchange of information agreements
• Technology-Driven Compliance: Increased use of data analytics and artificial intelligence by the IRD for audit selection and risk assessment

Preparing for Continuous Change

To remain compliant in this dynamic environment:

• Monitor Legislative Updates: Regularly review IRD announcements, departmental interpretation and practice notes (DIPNs), and legislative changes
• Professional Advisors: Engage qualified tax professionals to navigate complex compliance requirements
• Internal Training: Ensure finance and tax teams receive ongoing training on new requirements
• Technology Investment: Implement tax technology solutions to manage increasing data and reporting requirements
• Scenario Planning: Model potential impacts of future tax changes on business operations and effective tax rates

Conclusion

Hong Kong’s tax landscape has undergone transformative change over the past two years, with the implementation of Pillar Two, expansion of the FSIE regime, abolition of residential property stamp duties, and intensified transfer pricing enforcement. The IRD has adapted its audit methodologies to address these new compliance dimensions, focusing on sophisticated areas such as global minimum tax calculations, asset disposal gain sourcing, economic substance verification, and transfer pricing documentation.

For businesses operating in Hong Kong, maintaining compliance requires moving beyond reactive tax return preparation to proactive tax governance. This includes establishing robust documentation systems, monitoring international tax developments, engaging professional advisors, and implementing technology-enabled compliance solutions. Companies that invest in comprehensive compliance frameworks will be better positioned to manage audit risk, avoid penalties, and maintain Hong Kong’s attractiveness as a business and financial center.

The two-tier profits tax system (8.25% for the first HKD 2 million, 16.5% thereafter for corporations) remains among the world’s most competitive, and Hong Kong continues to offer a business-friendly environment. However, the days of minimal tax compliance requirements are over. The modern Hong Kong tax environment demands sophisticated compliance capabilities, particularly for multinational enterprises and companies with cross-border operations.

As the global tax landscape continues to evolve with BEPS 2.0 implementation, digital economy taxation initiatives, and enhanced transparency requirements, Hong Kong will continue to adapt its tax framework and enforcement practices. Businesses that stay informed, maintain excellent documentation, and proactively address compliance requirements will thrive in this evolving environment.