Understanding Hong Kong’s Anti-Avoidance Framework

Hong Kong’s tax system is unique in maintaining a relatively low tax rate while implementing robust anti-avoidance provisions. The Inland Revenue Department (IRD) has increasingly utilized these provisions to challenge transactions that lack commercial substance or are primarily motivated by tax considerations. For taxpayers and advisors, understanding how these rules affect audit outcomes is critical to maintaining compliance and avoiding significant penalties.

The Legislative Framework

Hong Kong’s anti-avoidance provisions are codified in the Inland Revenue Ordinance (Cap. 112), with Sections 61, 61A, and 61B forming the cornerstone of the IRD’s powers to combat tax avoidance schemes. Unlike many jurisdictions that rely on a single general anti-avoidance rule, Hong Kong operates a dual GAAR system supplemented by specific anti-avoidance provisions targeting particular types of transactions.

Detailed Analysis of Anti-Avoidance Provisions

Section 61: Artificial and Fictitious Transactions

Section 61 IRO represents Hong Kong’s original general anti-avoidance provision. It empowers the Commissioner of Inland Revenue to disregard transactions or dispositions that are deemed artificial or fictitious. The key characteristics of Section 61 include:

• Scope: Applies to transactions or schemes that have created a tax advantage through artificial or fictitious arrangements
• Limited Remedy: The Commissioner’s only power under Section 61 is to completely disregard the transaction as if it never occurred
• No Substitution: Unlike Section 61A, the IRD cannot substitute an alternative transaction or recharacterize the arrangement
• Objective Test: Focus is on whether the transaction is artificial or fictitious in nature, regardless of the taxpayer’s subjective intent

Section 61A: The Sole or Dominant Purpose Test

Section 61A is Hong Kong’s more comprehensive general anti-avoidance rule, introduced to provide the IRD with greater flexibility in addressing tax avoidance schemes. This provision has been applied effectively since its introduction and forms the primary weapon in the IRD’s anti-avoidance arsenal.

The Seven Statutory Factors

Under Section 61A(1), the Commissioner must have regard to seven specific matters when determining whether a transaction was entered into for the sole or dominant purpose of obtaining a tax benefit:

Enhanced IRD Powers Under Section 61A

The critical distinction between Section 61 and Section 61A lies in the remedies available to the IRD. Under Section 61A, the Commissioner has two powerful options:

1. Disregard the Transaction: Similar to Section 61, the Commissioner can treat the transaction as if it never occurred
2. Substitute with Hypothetical Transaction: The Commissioner can replace the actual transaction with a reasonable postulated alternative, typically an arm’s length transaction that would have been entered into absent tax considerations

This substitution power is particularly significant in audit scenarios, as it allows the IRD to reconstruct what it considers to be the appropriate tax outcome based on commercial reality rather than simply denying the tax benefit claimed.

Section 61B: Sale of Loss Companies

Section 61B specifically targets the trafficking in tax losses through the sale of loss-making companies. This provision prevents taxpayers from acquiring companies primarily for their accumulated tax losses, which could then be used to offset profits generated from unrelated businesses.

Key features of Section 61B include:

• Applies when there is a change of shareholding exceeding 50% in a loss-making company
• Restricts the ability to carry forward losses if the company’s business changes significantly
• Requires continuity of beneficial ownership for loss utilization
• Places burden on taxpayer to demonstrate commercial rationale for acquisition

How Anti-Avoidance Rules Affect IRD Audits

IRD Audit Strategy and Anti-Avoidance Provisions

The IRD frequently employs anti-avoidance provisions in the alternative when conducting tax audits. When a particular transaction or deduction is challenged, the IRD typically disputes it on multiple grounds:

• Primary Challenge: Under specific provisions such as Sections 16 or 17 IRO (deductibility requirements)
• Alternative Challenge: Under Section 61 and/or Section 61A as a backup position
• Burden Shifting: This approach forces taxpayers to defend transactions on both substantive and anti-avoidance grounds

Audit Red Flags That Trigger Anti-Avoidance Scrutiny

Based on recent IRD practices and case law, the following transaction characteristics commonly attract anti-avoidance attention during audits:

The Burden of Proof in Anti-Avoidance Cases

A critical aspect affecting audit outcomes is the statutory burden of proof. Under Hong Kong tax law:

• Taxpayer’s Burden: The taxpayer bears the burden of proving that any tax assessment is incorrect or excessive
• No IRD Burden: There is no corresponding burden on the IRD to prove that its assessment is correct
• Practical Impact: Taxpayers must affirmatively demonstrate commercial substance and genuine business purpose for challenged transactions
• Documentation Critical: Contemporaneous documentation of business rationale is essential to discharge this burden

Recent Case Studies and Audit Outcomes

The 2024 BVI Management Company Case

A significant September 2024 case illustrates how the IRD applies Section 61A in practice. The case involved a taxpayer engaged in manufacturing and trading fabric and yarn who appointed a BVI company as its management agent.

Case Facts:

• Taxpayer entered into a management agreement with a BVI company for production management tasks
• Agreement provided for service fees “at a fixed rate or any other rate as may be mutually agreed upon”
• Amounts claimed for deduction were not calculated according to the written agreement terms
• IRD challenged deductions under Sections 16, 17, and 61A

Outcome:

The deduction was denied under Section 61A. The IRD successfully argued that the BVI company was interposed with the sole or dominant purpose of siphoning off profits from the taxpayer to avoid Hong Kong taxation. Key factors in the decision included:

• Lack of adherence to contractual terms in practice (form versus substance issue)
• Use of a BVI entity with questionable commercial substance
• Inability to demonstrate genuine commercial rationale beyond tax savings
• Failure to maintain documentation supporting the business purpose of the arrangement

Patrick Cox Asia Limited v Commissioner (2024)

The Court of Appeal handed down its judgment on 17 October 2024 in this trademark sub-licensing case, which has important implications for source analysis and anti-avoidance considerations.

Key Holdings:

• Upfront payments under trademark sub-licensing arrangements held to be revenue in nature and Hong Kong sourced
• Court remitted royalty income sourcing issue back to Board of Review for rehearing
• Demonstrates judicial scrutiny of arrangements designed to shift income offshore
• Reinforces importance of substance over form in licensing arrangements

Board of Review Decisions (2023-2024)

Recent Board of Review decisions published in Volumes 37 and supplements reveal several important trends:

Commissioner’s Discretionary Powers and Audit Process

Assessment and Reassessment Powers

When the IRD invokes anti-avoidance provisions during an audit, the Commissioner possesses broad discretionary powers:

• Protective Assessments: The Commissioner may issue assessments for very large amounts to secure tax pending appeal
• Additional Tax (Penalties): If Section 61A applies, the IRD can levy additional tax of up to three times the under-charged amount
• Holdover Discretion: The Commissioner has discretion whether to grant holdover of tax pending objection, and may require security (tax reserve certificates or bank guarantees)
• No Statutory Time Limits: Unlike some jurisdictions, the IRD’s assessment powers in anti-avoidance cases are not subject to strict time limitations in certain circumstances

Field Audit Procedures

The IRD’s field audit process for potential anti-avoidance cases typically follows this pattern:

1. Initial Contact: IRD issues audit notification requesting documents and information
2. Document Review: Extensive examination of contracts, agreements, emails, and internal communications
3. Information Requests: Multiple rounds of queries focusing on business rationale and substance
4. Interview Stage: Face-to-face meetings with taxpayer representatives and key personnel
5. Preliminary Position: IRD indicates concerns and potential application of anti-avoidance provisions
6. Taxpayer Response: Opportunity to provide additional evidence and submissions
7. Assessment: IRD issues revised assessment if anti-avoidance provisions apply

Penalty Considerations

The IRD’s penalty policy distinguishes between different levels of cooperation and timing:

• Prompt Disclosure: Field audit cases (including anti-avoidance cases) closed within 3 months from initial interview may qualify for reduced penalties under “Disclosure with Full Information Promptly on Challenge”
• Investigation Cases: More serious cases have a 6-month threshold for the same treatment
• Compounding vs. Prosecution: The Commissioner has discretion to compound the case (settle with penalties) or institute prosecution depending on severity
• Relevant Factors: Strength of evidence, tax undercharged amount, sophistication of scheme, and time period of non-compliance all affect penalty determination

2024 Developments: Pillar Two and Extended GAAR Application

Global Minimum Tax and Domestic Minimum Top-Up Tax

Significant developments in 2024 extended Hong Kong’s anti-avoidance framework to new international tax regimes. The Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Bill 2024 was passed in May 2025, implementing:

• GloBE Rules: Global anti-base erosion rules aligned with OECD Pillar Two
• HKMTT: Hong Kong Minimum Top-Up Tax for multinational enterprise groups
• Modified Section 61A Application: The sole or dominant purpose test applies, with modifications, to these new regimes as their GAAR

Key Features of Modified Section 61A for Pillar Two

The modified Section 61A for GloBE and HKMTT regimes includes these important provisions:

• Applies to transactions entered into for the sole or dominant purpose of obtaining a tax benefit in relation to top-up tax liability
• Maintains consistency with existing GAAR mechanism while addressing Pillar Two-specific concerns
• Grandfathering provision: Generally will not apply to transactions entered into on or before 30 November 2021
• Aligns with OECD guidance on what constitutes avoidance or abuse for Pillar Two purposes

Foreign-Sourced Income Exemption (FSIE) Regime

Hong Kong’s foreign-sourced income exemption regime for dividends, interest, and IP income also incorporates anti-avoidance protections:

• Specific anti-abuse rules apply to the participation exemption
• Sections 61 and 61A continue to apply to FSIE cases
• Economic substance requirements must be satisfied
• Audits increasingly focus on whether offshore structures claiming FSIE benefits have genuine substance

Practical Strategies for Audit Defense

Building Commercial Substance

To withstand IRD scrutiny under anti-avoidance provisions, taxpayers should focus on demonstrating genuine commercial substance:

• Business Rationale: Document non-tax commercial reasons for transaction structures
• Economic Substance: Ensure entities involved have genuine operations, employees, assets, and decision-making authority
• Arm’s Length Pricing: Support related party transactions with transfer pricing documentation
• Contractual Compliance: Ensure actual practices align with written agreements
• Contemporaneous Documentation: Maintain real-time records of business decisions and rationale

Documentation Best Practices

Given the taxpayer’s burden of proof, comprehensive documentation is critical:

Advance Ruling Considerations

For significant transactions with potential anti-avoidance implications, taxpayers should consider seeking an advance ruling from the IRD:

• Provides certainty on IRD’s position before implementing transaction
• IRD publishes Departmental Interpretation and Practice Note No. 31 on advance rulings
• Requires full and frank disclosure of all relevant facts
• Binds the IRD if facts as presented materialize
• Particularly valuable for complex restructurings or new business models

Managing Audit Disputes

When facing an audit involving anti-avoidance issues, taxpayers should consider:

1. Early Engagement: Respond promptly and comprehensively to IRD queries
2. Professional Representation: Engage experienced tax advisors familiar with anti-avoidance defenses
3. Strategic Submissions: Address all seven Section 61A factors proactively in written submissions
4. Alternative Arguments: Present multiple lines of defense (substantive provisions and anti-avoidance)
5. Settlement Discussions: Consider pragmatic resolution where exposure is significant
6. Holdover Applications: Apply for holdover of disputed tax pending objection/appeal to manage cash flow
7. Appeal Rights: Preserve objection and appeal rights through timely filings

Looking Ahead: Future Trends

Increased International Cooperation

Following Hong Kong’s removal from the European Union’s watchlist in February 2024, the jurisdiction continues to demonstrate commitment to international tax cooperation and combating cross-border tax avoidance:

• Enhanced information exchange under Common Reporting Standard (CRS) and Country-by-Country Reporting (CbCR)
• Implementation of BEPS measures increases IRD access to global tax information
• Greater scrutiny of transactions involving multiple jurisdictions
• Coordination with foreign tax authorities on anti-avoidance cases

Evolving IRD Approach

Recent trends suggest the IRD is taking a more assertive approach to anti-avoidance enforcement:

• Increased use of Section 61A in combination with specific provisions
• Greater focus on economic substance over legal form
• Heightened scrutiny of offshore structures and related party transactions
• Willingness to issue protective assessments and demand payment pending appeals
• More frequent application of penalty provisions in anti-avoidance cases

Technology and Data Analytics

The IRD is increasingly leveraging technology to identify potential avoidance arrangements:

• Data analytics to detect patterns and anomalies in tax returns
• Risk profiling systems to target audits on higher-risk taxpayers
• Cross-referencing of information from multiple sources (CRS, CbCR, tax returns, public records)
• Enhanced ability to compare taxpayer arrangements with industry norms

Sources:

• • HKWJ Tax Law – Anti-Avoidance Rules in Hong Kong
• • EY – IRD 2024 Annual Meeting with HKICPA
• • IRD – Global Minimum Tax and Hong Kong Minimum Top-Up Tax
• • HKSAR Government – Inland Revenue Amendment Bill 2024
• • PwC Hong Kong – Tax Review 2024
• • Timothy Loh LLP – IRD Audits & Investigations FAQs
• • IRD – Penalty Policy
• • PwC – Hong Kong SAR Tax Administration
• • CLIC – Objection and Appeal Against Tax Assessment
• • KPMG – Patrick Cox Asia Limited Court of Appeal Case