Did you know that the Hong Kong Inland Revenue Department (IRD) conducted over 1,800 tax audits in 2023-24, with offshore profit claims accounting for nearly half of all investigations? As Hong Kong’s tax landscape evolves with new regulations like the Global Minimum Tax and enhanced transfer pricing rules, proactive internal audits have become essential for businesses seeking to avoid costly penalties, back taxes, and reputational damage. This comprehensive guide shows you exactly how to conduct effective internal audits that preempt IRD scrutiny and keep your business compliant in 2025.

The Changing IRD Audit Landscape in 2025

Hong Kong’s Inland Revenue Department has significantly intensified its enforcement measures in recent years, with particular focus on offshore claims, transfer pricing arrangements, and cross-border related party transactions. The IRD’s sophisticated “Assess First Audit Later System” combines computerized risk assessment with human expertise to identify high-risk cases for investigation.

With the Government’s budget priorities and the IRD’s enhanced capabilities, businesses should expect stricter reviews of intra-group transfer prices, offshore profit claims, and documentation adequacy. Conducting proactive internal audits serves as your first line of defense against potential tax adjustments, penalties, and operational disruptions.

Why Internal Tax Audits Are More Important Than Ever

Hong Kong’s territorial tax system relies fundamentally on voluntary compliance. While the IRD doesn’t operate a formal “voluntary disclosure program” like some jurisdictions, it actively encourages taxpayers to make full voluntary disclosure of omissions or underreporting, with significant penalty mitigation for those who act promptly and completely.

Top 5 IRD Audit Triggers You Must Address

1. Offshore Profit Claims – The #1 Audit Trigger

The IRD takes an exceptionally rigorous approach to offshore tax claims, especially given Hong Kong’s territorial tax system and competitive corporate tax rates. The Department scrutinizes whether profits are genuinely derived outside Hong Kong or if the offshore claim is merely a tax planning structure.

2. Transfer Pricing Documentation Gaps

With stricter IRD scrutiny on cross-border related party transactions in 2025, transfer pricing documentation has become a critical compliance area. Hong Kong follows a three-tiered documentation framework aligned with OECD standards.

3. Record-Keeping Deficiencies

Under-documented transactions and inadequate record retention are among the most common audit triggers. Hong Kong law requires companies to maintain precise financial records that accurately show transactions within six-month intervals, with all records retained for seven years.

• Detailed ledgers of all transactions
• Bank statements and reconciliations
• Invoices (both sales and purchases)
• Contracts and agreements (including related party arrangements)
• Shipping and delivery documentation
• Transfer pricing documentation (Master File, Local File)
• Supporting evidence for offshore profit claims

4. Late Filing and Non-Compliance

Under Section 51 of the Inland Revenue Ordinance, failing to submit a Profits Tax Return (PTR) on time triggers a tiered enforcement process with severe consequences:

• Fixed penalty: Up to HK$10,000
• Additional tax charge: Up to three times the unpaid tax amount
• Potential court summons in extreme cases
• Company dissolution for persistent non-compliance

5. Other High-Risk Indicators

• Significant year-over-year fluctuations in reported profits without clear explanation
• Unusually low profit margins compared to industry benchmarks
• High levels of director’s loans or related party receivables
• Inconsistencies between tax returns and audited financial statements
• Aggressive tax planning structures that lack commercial substance

Your Step-by-Step Internal Audit Framework

Adopt a Risk-Based Approach

Rather than attempting to review every transaction and compliance area, effective internal audits focus on areas posing the greatest financial and operational risks. For Hong Kong businesses, high-risk areas typically include:

• Offshore profit claims and supporting documentation
• Transfer pricing policies and related party transactions
• Tax compliance and expense tracking
• Record retention and documentation adequacy

Implement a Periodic Review Cycle

Waiting until year-end to conduct audits can lead to unpleasant surprises and limited time to implement corrective measures. Best practice recommendations include:

1. Quarterly reviews: Monitor high-risk areas such as related party transactions, offshore income documentation, and expense classifications
2. Semi-annual comprehensive reviews: Conduct broader assessments of tax positions, compliance status, and documentation adequacy
3. Annual tax health check: Comprehensive internal audit 6-12 weeks before financial year-end to allow time for remedial actions

Comprehensive Internal Audit Checklist

How to Handle Self-Identified Issues

The Voluntary Disclosure Protocol

When internal audits identify material compliance issues, voluntary disclosure offers the best opportunity for penalty mitigation. The IRD’s penalty framework distinguishes between different levels of cooperation:

• Full voluntary disclosure before challenge: Maximum penalty mitigation
• Disclosure with full information promptly on challenge: Penalties around 100% of tax undercharged
• Incomplete or belated disclosure: Penalties potentially up to 300% of tax undercharged

Steps for Effective Voluntary Disclosure

1. Act promptly: Speed is critical—early disclosure receives more favorable treatment
2. Provide complete information: Full disclosure of all material facts, affected years, and tax calculations
3. Quantify the shortfall: Calculate tax undercharged with supporting workings
4. Propose resolution: Suggest payment terms or adjustments for IRD consideration
5. Demonstrate good faith: Show corrective measures implemented to prevent recurrence

2025 Compliance Priorities You Can’t Ignore

Transfer Pricing Documentation Deadlines

For companies with 31 December 2024 year-end, Master File and Local File must be prepared by 30 September 2025 (9 months from year-end). Ensure exemption threshold calculations are documented even if exempt from filing requirements.

Global Minimum Tax Compliance (Large MNEs)

The Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance enacted on 6 June 2025 applies 15% global minimum tax to MNE groups with annual consolidated revenue ≥ €750 million. Affected groups must:

• Assess effective tax rates by jurisdiction
• Calculate potential top-up tax obligations
• Prepare for Qualified Domestic Minimum Top-up Tax (QDMTT) compliance
• Align with OECD Pillar Two framework requirements

Enhanced Offshore Claim Scrutiny

Given the IRD’s tightening approach to offshore claims, businesses claiming offshore status should conduct comprehensive reviews of offshore documentation adequacy and verify operational evidence supports offshore claims (not just contractual arrangements).

In today’s evolving tax environment, waiting for the IRD to identify compliance issues is a risky strategy that can lead to significant financial penalties and operational disruptions. By implementing a proactive internal audit program focused on high-risk areas, maintaining robust documentation, and staying current with regulatory developments, your business can navigate Hong Kong’s tax landscape with confidence. Remember: the cost of prevention is always lower than the cost of correction when it comes to tax compliance.