Understanding the IRD’s Approach to High-Net-Worth Individuals

Hong Kong’s Inland Revenue Department (IRD) has evolved its compliance approach to address the complexities of wealth management and high-net-worth individual (HNWI) taxation in an era of global tax transparency. While Hong Kong does not operate a dedicated “HNWI audit unit” like some jurisdictions (e.g., South Africa’s SARS or the U.S. IRS), the IRD employs sophisticated risk-based case selection programs that naturally flag higher-value taxpayers and complex structures for enhanced scrutiny.

Hong Kong’s territorial tax system—which taxes only Hong Kong-sourced income—creates both opportunities and compliance challenges for wealthy individuals. The absence of capital gains tax, wealth tax, and withholding tax on dividends makes Hong Kong an attractive wealth management hub, but this also means the IRD focuses intensively on verifying that claimed offshore income genuinely originates outside Hong Kong.

The IRD’s Tax Audit Framework

Risk-Based Selection Methodology

The IRD employs multiple approaches to identify cases for audit:

• Computerized risk assessment: The IRD uses an “Assess First Audit Later System” and computer-assisted risk-based case selection programs to identify high-risk cases
• Human expertise: Experienced tax professionals review flagged cases and apply judgment based on industry knowledge and patterns
• Random selection: Some audits are conducted on a random basis to maintain general compliance discipline
• Specific triggers: Certain claims or circumstances automatically trigger review (discussed below)

In 2023-24, the IRD processed 1,802 tax audits across all taxpayer categories. The IRD has emphasized that its review procedures “apply to all taxpayers irrespective of their industries or backgrounds,” though in practice, higher-value and more complex structures receive enhanced attention.

The Two-Stage Audit Process

IRD audits typically unfold in two stages:

Stage 1: Desk Review

The IRD initially reviews tax returns and accompanying audit reports. If questions arise—particularly regarding offshore income claims—the IRD issues an enquiry letter requesting further explanations or supporting documents. This letter may arrive weeks or even months after submission.

The desk review focuses on:

• Consistency between tax returns and audited financial statements
• Reasonableness of offshore income claims relative to business operations
• Adequacy of documentation supporting tax positions
• Compliance with Foreign-Sourced Income Exemption (FSIE) requirements

Stage 2: Field Audit

If desk review responses are inadequate or raise further questions, the IRD may conduct a field audit. This more serious stage involves:

• Visits to business premises
• Detailed review of accounting systems and internal controls
• Interviews with directors, staff, and advisors
• Examination of contracts, invoices, bank statements, and operational records
• Verification of where business decisions are actually made

Field audits can extend for months and may result in protective assessments if the IRD believes tax is at risk.

Common Audit Triggers for High-Net-Worth Individuals

Offshore Income: The IRD’s Top Scrutiny Area

The “Operations Test” and Totality of Facts

Hong Kong’s territorial tax system is based on the “operations test”: the guiding principle is “What has the taxpayer done to earn the profits in question and where have they done it?”

The IRD applies a “totality of facts” approach, examining:

• Contract negotiation and execution: Where were contracts discussed, negotiated, and signed?
• Decision-making authority: Where do board meetings occur? Where are key business decisions made?
• Operational activities: Where are goods sourced, stored, and shipped? Where are services performed?
• Banking and payment flows: Where are funds received and paid? What do bank statements reveal about transaction locations?
• Customer and supplier locations: Are these genuinely overseas relationships or Hong Kong-based with offshore billing?

Determining whether core business activities (such as contract signings and board decisions) are carried out outside of Hong Kong is now the top review element by the IRD, reflecting efforts to stop tax evasion through abuse of offshore exemptions.

Documentary Requirements for Offshore Claims

The burden of proof falls squarely on the taxpayer. The IRD requires robust documentation including:

• Contracts showing negotiation and execution outside Hong Kong
• Minutes of board meetings held overseas
• Correspondence demonstrating where decisions were made
• Invoices and payment records showing foreign transactions
• Shipping and logistics documentation (for trading companies)
• Evidence of overseas offices, employees, and operational infrastructure
• Bank statements from foreign accounts reflecting offshore operations

Once you lodge an offshore claim, the IRD will almost certainly send a detailed questionnaire designed to forensically examine your business model, transaction flows, and operational structure. Approval is never guaranteed, and claims can be rejected, delayed, or even overturned years later, resulting in back taxes plus penalties.

Foreign-Sourced Income Exemption (FSIE) Regime

The FSIE regime, which took effect from January 1, 2023, represents a significant compliance layer for multinational enterprises (MNEs) and wealthy families using Hong Kong structures. The regime aligns Hong Kong with global BEPS 2.0 standards and EU concerns about tax avoidance.

Types of Passive Income Covered

Four types of offshore passive income may be subject to Hong Kong tax under FSIE if certain conditions are met:

1. Interest income
2. Dividend income
3. Intellectual property (IP) income (royalties, licensing fees)
4. Disposal gains from share sales and equity interests

When Foreign-Sourced Passive Income Is Taxable

Foreign-sourced passive income is taxable in Hong Kong if:

• It is received in Hong Kong by a Hong Kong resident entity, OR
• It is used in Hong Kong (e.g., brought into HK bank accounts, applied to HK operations)

However, exemptions apply if the taxpayer satisfies one of the following:

The FSIE regime has created a multi-tiered system of complexity. The IRD’s scrutiny is intense, particularly for MNEs using Hong Kong as a holding company jurisdiction or IP holding location without genuine substance.

CRS/AEOI: The Global Information Exchange Framework

How CRS Works in Hong Kong

The Common Reporting Standard (CRS), an OECD initiative for Automatic Exchange of Information (AEOI), became effective in Hong Kong on January 1, 2017. The first exchange of information occurred in 2018.

The CRS mechanism works as follows:

1. Financial institutions in Hong Kong identify accounts held by tax residents of reportable jurisdictions (over 80 partner countries)
2. They collect account holder information and financial account details annually
3. This information is reported to the IRD
4. The IRD automatically exchanges this information with the tax authorities of the relevant jurisdictions

Scope of Reporting

Financial institutions must report on:

• Individual account holders who are tax residents of reportable jurisdictions
• Entity account holders (companies, trusts, partnerships) tax resident in reportable jurisdictions
• Passive Non-Financial Entities (NFEs) whose controlling persons are tax residents of reportable jurisdictions

Information reported includes:

• Account holder name, address, tax identification number, date of birth
• Account number and balance
• Income paid into the account (interest, dividends, other income)
• Sale proceeds from financial assets

2025 Compliance Focus: Beyond Traditional Financial Institutions

Recent IRD enquiry letters underscore that the scope of AEOI review extends beyond traditional financial institutions to include:

• Trust and Company Service Provider (TCSP) licensees
• Private investment companies
• Family office vehicles that may meet the definition of “Investment Entity”

This development emphasizes the importance for non-traditional financial institutions to carefully review and reassess their AEOI obligations. Penalties for knowingly or recklessly providing false information in CRS self-certifications can reach HK$10,000.

Implications for HNWIs

For high-net-worth individuals, CRS means that:

• Their offshore financial accounts are no longer private from their home country tax authorities
• Tax authorities worldwide can cross-reference CRS data with tax returns to identify discrepancies
• Unreported investment income, capital gains (in jurisdictions that tax them), or undisclosed foreign assets are increasingly detectable
• Complex structures involving multiple jurisdictions are subject to reporting in each jurisdiction where financial assets are held

The Family Office Tax Regime: Opportunities and Compliance

Current Framework

Hong Kong’s dedicated tax concession regime for family-owned investment holding vehicles (FIHVs) managed by eligible single family offices (ESFOs) was enacted through the Inland Revenue (Amendment) (Tax Concessions for Family-owned Investment Holding Vehicles) Ordinance 2022.

Key benefits include:

• 0% profits tax on investment profits from qualified assets
• Exemption for incidental income (interest, dividends) subject to a 5% threshold
• No capital gains tax, sales tax, VAT, or withholding tax on dividends and interest
• No pre-approval requirement: Qualifying family offices perform self-assessment and apply the concession in annual tax returns

Structural and Operational Requirements

2025/26 Enhancements

The Hong Kong government is actively enhancing the family office regime to compete with Singapore and other Asian wealth hubs:

• Expanded qualifying assets: Proposed inclusion of virtual assets, insurance-linked securities, and interests in non-corporate private entities (partnerships)
• Greater flexibility: Enhanced flexibility in handling incidental transactions
• Increased transaction types: Broader scope of qualifying transactions
• Legislative timeline: Details to be finalized in 2025, with legislative proposals submitted to the Legislative Council for consideration in 2026, effective from year of assessment 2025/26

As of early 2025, InvestHK’s FamilyOfficeHK team assisted 50 family offices to set up or expand in Hong Kong in just the first five months, representing a 19% increase year-over-year. Approximately 150 additional family offices have indicated preparation or decisions to establish in Hong Kong, with expectations of over 200 new family offices during 2025.

IRD Audit Considerations for Family Offices

While the family office regime offers significant tax benefits, family offices should expect IRD scrutiny on:

• Genuine family ownership: Verification that the 95%/75% family ownership threshold is met and maintained
• Substantive operations: Confirmation that the HK$2 million expenditure and 2-employee requirements represent real economic substance, not artificial arrangements
• Qualified asset limitations: Ensuring that investments fall within the defined scope of qualified assets
• Incidental income threshold: Proper calculation and monitoring of the 5% incidental income limit
• AEOI compliance: Family office vehicles that meet the definition of “Investment Entity” may have CRS reporting obligations

Penalties and Enforcement

Late Filing Penalties

Hong Kong has implemented stricter penalties for overdue tax submissions:

Record-Keeping Offenses

The Inland Revenue Ordinance (IRO) requires every person carrying on a trade, profession, or business in Hong Kong to keep sufficient records for at least 7 years. Failure to comply constitutes an offense punishable by fine. The absence of sufficient records may prompt the IRD to assess tax based on alternative methods, often resulting in higher tax liabilities.

Incorrect or False Information

Under the AEOI framework, providing knowingly or recklessly misleading, false, or incorrect information in a material particular when making a self-certification to financial institutions is an offense carrying a penalty at Level 3 (HK$10,000).

Additional Tax and Interest

Beyond fixed penalties, the IRD can impose:

• Additional tax (penalties) for understatement of income or incorrect returns
• Interest charges on late payment of tax
• Estimated assessments when taxpayers fail to provide adequate information, often calculated conservatively (unfavorably to the taxpayer)
• Prosecution for serious cases of tax evasion

Best Practices for HNWI Tax Compliance

1. Maintain Comprehensive Documentation

Given that the burden of proof rests with the taxpayer, maintain meticulous records:

• Contracts with clear evidence of where negotiation and execution occurred
• Board meeting minutes showing overseas locations
• Correspondence demonstrating decision-making locations
• Detailed transaction records (invoices, payment confirmations, shipping documentation)
• Evidence of overseas offices, employees, and infrastructure
• Bank statements from foreign accounts supporting offshore operations

2. Build Economic Substance

Substance is more than paperwork—it’s about actual operations. Ensure that offshore structures have:

• Real employees with appropriate skills and authority
• Physical office space commensurate with operations
• Genuine decision-making occurring in the claimed jurisdiction
• Arm’s-length transactions with proper commercial rationale
• Expenditure levels consistent with claimed activities

3. Understand FSIE Implications

For passive income streams:

• Assess whether income qualifies for Economic Substance Requirement (ESR), Participation Exemption, or Nexus Requirement
• Document the activities and expenditure that support ESR claims
• For dividend income, verify minimum holding periods and investee company tax rates
• For IP income, maintain records of R&D activities conducted in Hong Kong
• Consider restructuring to ensure exemptions are available before income arises

4. Prepare for CRS Transparency

Accept that financial account information is shared globally:

• Ensure CRS self-certifications to financial institutions are accurate and complete
• Report all relevant income in your home jurisdiction (if you’re tax resident elsewhere)
• Understand how CRS information from Hong Kong accounts will be used by your home tax authority
• Review complex structures to ensure they don’t create inadvertent reporting obligations or penalties

5. Respond Promptly and Thoroughly to IRD Enquiries

When the IRD issues an enquiry letter:

• Don’t delay: Respond within the specified timeframe
• Be comprehensive: Provide all requested documentation and explanations
• Be accurate: Incorrect or misleading responses can escalate to field audits and penalties
• Seek professional advice: Engage experienced tax advisors to help navigate complex enquiries
• Maintain communication: If you need more time or clarification, communicate proactively with the IRD

6. Leverage the Family Office Regime Properly

If establishing a family office structure:

• Ensure all structural requirements (ownership, employees, expenditure) are met from inception
• Implement robust governance and investment policies
• Monitor qualified asset limitations and incidental income thresholds
• Stay informed about upcoming enhancements and consider restructuring to benefit
• Maintain clear documentation supporting self-assessment of eligibility

7. Plan Proactively, Not Reactively

Tax compliance should be integrated into business and investment decisions:

• Structure transactions with tax implications in mind from the outset
• Obtain advance tax advice for significant transactions or structural changes
• Consider voluntary disclosures if past positions may be questionable
• Review and update tax positions annually as facts, operations, and laws evolve
• Engage with the IRD’s advance ruling system for complex or uncertain positions

Recent Developments and Future Outlook

Global Minimum Tax (BEPS 2.0)

Hong Kong is implementing the OECD’s Global Minimum Tax (GMT) framework and a domestic Minimum Top-up Tax. While primarily targeting large MNEs (revenues €750 million+), this development signals Hong Kong’s alignment with global tax standards and may influence IRD compliance priorities.

Enhanced Family Office Incentives

Following the Wealth for Good in Hong Kong Summit (March 2025), the government has committed to further enhancements of preferential tax regimes for:

• Single family offices
• Asset and wealth management funds
• Carried interest structures

Legislative proposals are expected in 2026, with implementation targeted for the 2025/26 year of assessment.

Expanded AEOI Scrutiny

The IRD’s recent focus on non-traditional financial institutions (TCSPs, private investment companies) indicates that AEOI compliance reviews will broaden. Entities that may not have considered themselves “financial institutions” should reassess their obligations.

Competition with Singapore

Singapore currently hosts 59% of Asia’s family offices (as of 2023), creating competitive pressure on Hong Kong to enhance its regime. This competition may drive further tax incentives and streamlined compliance processes, but also means the IRD will be vigilant against abusive structures that undermine Hong Kong’s reputation.