Since profits tax is levied only on Hong Kong-source income, other types of revenue flow will escape taxation. The residential or non-residential status of an entity is irrelevant. Advance tax rulings are available on the question of whether or not for profits tax purposes trading income is deemed onshore and taxable or offshore and tax exempt. The Profits Tax Ordinance in itself is not that helpful on the subject, beyond giving a definition of taxable income as follows:

• The entity must trade in Hong Kong
• The income must arise from such a trade
• The income must arise in or be derived from Hong Kong

Hong Kong is a common law jurisdiction, and there is a considerable amount of case law that bears on the question of taxability. Much of this is summarised in the Inland Revenue's Practice Note No 21. Some of the rules that have developed are as follows:

• The establishment of an office does not of itself render a company liable to profits tax where that office is not generating profits from within the territory. A key criterion is the place where the contract was negotiated and signed. Income relating to a sale contract negotiated by the seller from the territory by way of facsimile or telephone where the negotiation did not require travel outside the territory is deemed Hong Kong source income for profit tax purposes. Likewise if the contract is negotiated and signed outside the territory and the goods sold are not sourced from within the territory then any income arising is not deemed Hong Kong source income for profits tax purposes. This is often achieved by utilizing an offshore company which re-registers in the territory as a foreign company but whose directors both remain non-resident and negotiate and execute the contract from the offshore jurisdiction.
• Where the Hong Kong entity is merely a booking center in the sense that it does not negotiate or draft the sale agreement (which is carried out abroad) but merely issues an invoice on instructions, operates a bank account and maintains accounting records covering the transaction then the income from such a transaction is not deemed Hong Kong source income for profits tax purposes.

Advance tax rulings are available in the SAR and are particularly favored and recommended on the question of whether or not for profits tax purposes trading income is deemed onshore and taxable or offshore and tax exempt. There are a number of specific full or partial exemptions from profits tax:

• Interest on a loan made available to the borrower in a foreign jurisdiction is not deemed Hong Kong source income and is therefore not taxable.
• An entity whose business is to grant rights to use a trademark, copyright, patent, know how or other types of intellectual property pays a flat profit tax of 1.75% (or 17.5% on 10%) of the payment received with all related expenses being non tax deductible. If the recipient of the payment is a related offshore licensing company the Hong Kong company must withhold and hand over 1.75% of the fee paid over.
• Income from the international operations of shipping companies is exempt from tax unless the ships are operating in Hong Kong waters or proximate to the same in which case only that proportion of income earned in Hong Kong is subject to local tax of 17.5%. Shipping profits meeting the conditions of the double taxation agreement with the USA are exempt from profits tax in Hong Kong.
• Dividend income received by a Hong Kong parent company from either a resident or foreign subsidiary is not deemed income in the holding company's hands and is thus not subject to an assessment to profits tax.
• Interest or capital gains made on qualifying maturity debt instruments are taxed at 8%
• The re-insurance of offshore risks is taxed at 8% of assessable profits
• Life insurance businesses are assessed at 5% of the value of the premiums arising in Hong Kong.
• For airline companies, irrespective of whether or not the company is managed and controlled from Hong Kong assessable profits are the proportion of income arising within Hong Kong (from the uplift of passengers and freight locally) to the proportion of worldwide income. Under a number of international aircraft double taxation agreements the government has agreed to include income arising abroad for taxation in Hong Kong where that income is exempted abroad under the agreement. Likewise profits meeting the conditions of the double taxation agreements are exempt from profits tax locally.
• The sale of goods on consignment from Hong Kong on behalf of a non resident is subject to a tax of 1% of the turnover without any deductions unless the non resident can produce accounts to show that he would have paid less profit tax than consignment tax in which case a normal rate of tax will apply .The selling of goods on consignment is deemed to be the equivalent of creating a permanent establishment.
• Profits remitted to a Hong Kong parent which represent the profitable disposal of its shareholding in a resident or non resident subsidiary are not assessed to tax in the territory both because the gains are capital gains and because (in the case of a non resident company) income arising outside jurisdiction is exempt from tax under the principle of territoriality.
• The profitable disposal by a Hong Kong entity of foreign real estate is not assessed to tax in the territory both because the gains are capital gains and because of the principle of territoriality. This includes a disposal effected by means of the Hong Kong entity selling 100% of the shares in a company whose sole asset is the foreign real estate.
• The transfer by a Hong Kong entity of capital assets to a foreign or resident subsidiary or branch at market value and at a profit is considered a capital gain and thus does not attract tax in Hong Kong (unless the assets are classified as revenue assets).
• Rental income from foreign real estate is not assessable income in Hong Kong for profit tax purposes. (However depreciation & interest payments on loans made to finance the real estate tax are not deductible in the territory).
• Interest income received by a resident or non resident business entity on deposits lodged with a financial institution are exempt from profits tax (By way of exception if the deposit was made by a "financial institution" then any interest received by the financial institution is deemed trading income for profits tax purposes and taxed accordingly).
• The following sources of trading income are exempted from profits tax
  • Interest received or capital gains made on the purchase, retention or sale of a Government bond issued under the Loans (Government Bonds) Ordinance;
  • Exchange fund debt instruments;
  • Hong Kong dollar denominated multi–agency debt instruments;
  • Specified investment schemes which comply with the requirements of a government supervisory authority are exempt from tax. Specified investment schemes include investments in unit trusts and mutual funds.
• The repayment by a foreign subsidiary to its Hong Kong parent of the principal of loan capital or share capital is free of tax in the territory including where the repayment is by way of a capital reduction or a final dividend distribution in a liquidation.

Concerns expressed by offshore hedge funds located in Hong Kong that their tax status may change were relieved in June, 2005, when the Revenue (Profits Tax Exemption for Offshore Funds) Bill 2005, which seeks to amend the Inland Revenue Ordinance to implement the proposal to exempt offshore funds from profits tax, was gazetted.

First proposed by the Hong Kong government in the 2003/2004 Budget, the idea to exempt offshore funds from profits tax is designed to reinforce the status of Hong Kong as an international financial centre, and bring the territory into line with other major financial centres across the globe.

"The proposed exemption will help attract new offshore funds to Hong Kong and to encourage existing ones to continue to invest here," noted a government spokesman, continuing that: "Anchoring offshore funds in Hong Kong markets could also help maintain international expertise, promote new products, and further develop the local fund management industry. The proposal would lead to an increase in market liquidity and employment opportunities in the financial services and related sectors.

"Hong Kong is facing keen competition from other major IFCs in attracting foreign investments. Major financial centres such as New York and London as well as the other major player in the region, Singapore, all exempt offshore funds from tax. The financial services industry has expressed the view that it is vital for us to provide tax exemption for offshore funds, or otherwise some of these funds may relocate away from Hong Kong, leading to loss of market liquidity and a negative read-across impact on other financial services, including downstream services such as those provided by brokers, accountants, bankers and lawyers."

Under the proposal in the Bill, offshore funds, i.e. non-resident entities (which can be individuals, partnerships, trustees of trust estates or corporations) administering a fund, are exempt from tax in respect of profits derived from dealings in securities, dealings in futures contracts and leveraged foreign exchange trading [as defined in the Securities and Futures Ordinance (Cap. 571) (SFO)] in Hong Kong carried out by specified persons such as corporations and authorized financial institutions licensed or registered under the SFO to carry out such transactions.

The exemption provisions would apply with retrospective effect to the year of assessment commencing on 1 April 1996, in order to provide legal certainty on the tax liability of offshore funds in respect of past years, which is much called for by the industry as otherwise there would be huge problems for offshore funds to finalise their tax liabilities for past years.

In March, 2006, Hong Kong's Legislative Council finally passed the Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2005.