What if your Hong Kong business could save up to HK$165,000 in taxes every year? Since 2018, Hong Kong’s two-tiered profits tax regime has been delivering exactly that for SMEs. This powerful tax incentive has transformed the landscape for small and medium enterprises, offering substantial savings while maintaining Hong Kong’s reputation as a business-friendly jurisdiction. But with great benefits come important rules—especially the critical “one entity per group” restriction. Let’s explore how your business can maximize these advantages while staying fully compliant.

Understanding Hong Kong’s Two-Tiered Profits Tax Structure

Hong Kong’s two-tiered profits tax system represents one of the most significant SME-friendly tax reforms in recent years. Designed to reduce the tax burden on smaller businesses, it applies preferential rates to the first HK$2 million of assessable profits, providing immediate and substantial tax relief. The system operates on a territorial basis—only Hong Kong-sourced profits are taxable—and integrates seamlessly with Hong Kong’s broader tax advantages.

Who Qualifies for Two-Tiered Rates?

Virtually all businesses operating in Hong Kong can benefit from the two-tiered regime, provided they meet basic eligibility criteria. The system is intentionally broad to maximize SME support:

• Corporations: Limited companies incorporated in Hong Kong or registered non-Hong Kong companies
• Partnerships: Both general and limited partnerships carrying on business in Hong Kong
• Sole Proprietorships: Individual business owners operating in Hong Kong
• Non-resident Persons: Provided they have no connected entity or no connected entity has elected for two-tiered rates

The Critical Connected Entity Rules: Preventing Tax Avoidance

The connected entity restriction is the cornerstone of the two-tiered regime’s anti-avoidance framework. This measure prevents larger businesses from artificially splitting operations into multiple entities to multiply tax benefits. Understanding these rules is essential for compliance and strategic planning.

What Makes Entities “Connected”?

Entities are considered “connected” when specific control relationships exist. According to the Inland Revenue Department (IRD), an entity is connected to another if:

• One entity owns or controls more than 50% of the issued share capital of another entity
• One entity is entitled to exercise or control more than 50% of the voting rights in another entity
• One entity is entitled to more than 50% of the capital or profits of another entity
• In the case of a natural person carrying on a sole proprietorship, the same person carries on another sole proprietorship business

The One-Entity Election Rule: Why It Matters

For a group of connected entities, only one entity may elect to be chargeable at the two-tiered profits tax rates for any given year of assessment. This fundamental restriction ensures that:

• Related businesses cannot each claim the preferential 8.25%/7.5% rate on separate HK$2 million profit tranches
• The tax benefit is applied at the group level, not multiplied across artificially separated entities
• Larger businesses pay their fair share of tax while SMEs receive targeted relief

The Election Process: How to Claim Your Tax Benefits

Making an election for two-tiered rates requires careful attention to declaration requirements and timing. The process is straightforward but carries important compliance obligations.

Key Election Considerations

1. Irrevocability: Once made, the election is irrevocable for that year of assessment
2. Annual Basis: Elections must be made separately for each year of assessment; different entities within a group may elect in different years
3. Group Coordination: Connected entities must coordinate to ensure only one makes the election
4. Verification Requirement: Entities must verify the connected entity status at the end of the basis period

Strategic Tax Planning for Connected Entities

For groups of connected entities, strategic planning can optimize tax outcomes under the two-tiered regime. The key is selecting the right entity to claim the benefit each year.

Optimal Entity Selection Strategy

When deciding which entity should elect for two-tiered rates, consider these factors:

• Profit Distribution: Nominate the entity with assessable profits closest to or exceeding HK$2 million to maximize the preferential rate benefit
• Future Projections: Consider expected profit trends across entities for the upcoming year
• Tax Loss Positions: Avoid electing for an entity in a tax loss position; instead nominate a profitable entity
• Year-to-Year Flexibility: Different entities may be nominated in different years based on changing circumstances

Real-World Example: Maximizing Group Benefits

Scenario: Company Group has three connected entities with projected profits:
– Entity A: HK$1.5 million
– Entity B: HK$3.8 million
– Entity C: HK$500,000

Optimal Strategy: Elect Entity B for two-tiered rates.

Calculation:
– Entity B pays 8.25% on first HK$2 million = HK$165,000
– Entity B pays 16.5% on remaining HK$1.8 million = HK$297,000
– Total tax on Entity B = HK$462,000
– Tax saving = HK$165,000 (versus paying 16.5% on all profits)

Entity A and Entity C pay the standard 16.5% rate, but the group maximizes the benefit from the two-tiered regime by applying it to the entity with the highest profits.

2025 Update: Global Minimum Tax Considerations

From January 1, 2025, Hong Kong has implemented the OECD’s Pillar Two global minimum tax framework. This introduces new considerations for certain businesses, but brings good news for most SMEs.

Additional SME Support and Tax Benefits in Hong Kong

Beyond the two-tiered profits tax regime, Hong Kong offers a comprehensive ecosystem of tax advantages and support for SMEs. These benefits combine to create one of the world’s most competitive business environments.

Hong Kong’s Unique Tax Advantages

• No Capital Gains Tax: Capital gains remain untaxed, providing a significant advantage for businesses selling assets or investments
• No VAT/GST: Hong Kong has no Value Added Tax or Goods and Services Tax, unlike many jurisdictions with VAT rates up to 20%
• No Dividend Tax: Dividends received from Hong Kong companies are not subject to tax
• No Withholding Tax on Interest: Interest income paid to non-residents is generally not subject to withholding tax
• Territorial Tax System: Only Hong Kong-sourced income is taxable; offshore profits may qualify for exemption under specific conditions

2024/25 Government Support Measures

The Hong Kong government continues to demonstrate support for SMEs through various initiatives:

• Tax Relief: Ongoing support through the two-tiered profits tax regime with maximum annual savings of HK$165,000
• SME Funding Schemes: Hong Kong offers multiple funding schemes across various industries to support SME growth and development
• SME ReachOut Service: Dedicated team assists businesses in identifying eligible schemes and navigating application processes

Compliance Best Practices for SMEs

To ensure full compliance with the two-tiered profits tax regime and maximize benefits, businesses should adopt these best practices:

1. Document Connected Entity Relationships: Maintain clear records of ownership structures and control relationships. Update documentation when shareholdings or control arrangements change, and review connected entity status at the end of each basis period.
2. Coordinate Group Elections: Establish internal processes to coordinate elections across connected entities. Designate a responsible person or team to manage group tax planning, and communicate election decisions clearly to all relevant entities before filing deadlines.
3. Maintain Accurate Records: Keep detailed profit and loss records to support tax computations. Retain documentation for at least 7 years as required under Hong Kong law, and ensure financial statements are prepared in accordance with Hong Kong Financial Reporting Standards.
4. Seek Professional Advice: Engage qualified tax professionals to review complex connected entity situations. Obtain advice on optimal election strategies for groups, and ensure compliance with all IRD requirements and declaration obligations.

Common Questions and Misconceptions

Can a company elect for two-tiered rates every year?

Yes, provided it meets the eligibility criteria each year and no connected entity has elected for that year of assessment. The election must be made annually in the tax return.

What if we discover a connected entity relationship after filing?

If two connected entities both elected for two-tiered rates in error, you should notify the IRD immediately and amend the relevant tax returns. Voluntary disclosure may mitigate penalties.

Can we change which entity elects from year to year?

Yes. While each year’s election is irrevocable, different entities within a connected group may elect in different years based on changing business circumstances and strategic considerations.

How does this apply to offshore profits?

The two-tiered rates apply only to profits chargeable to Hong Kong Profits Tax. If profits are genuinely offshore and qualify for tax exemption, the two-tiered regime is not relevant to those profits.

Hong Kong’s two-tiered profits tax regime represents a powerful tool for SME growth, delivering meaningful tax savings of up to HK$165,000 annually. By understanding the connected entity rules, making strategic elections, and maintaining proper compliance, businesses can maximize these benefits while contributing to Hong Kong’s vibrant economic ecosystem. With the added advantage of no capital gains tax, no VAT, and a territorial tax system, Hong Kong continues to offer one of the world’s most attractive environments for small and medium enterprises to thrive.