Charity Operations Tax: Conditions and Obligations for Tax-Exempt Status

The Inland Revenue Department (IRD) has intensified its scrutiny of charitable institutions under Section 88 of the Inland Revenue Ordinance (Cap. 112), with a specific focus on operational compliance rather than merely stated charitable objects. A series of 2024-2025 tax cases and IRD departmental rulings have clarified that tax-exempt status is not a permanent entitlement but a conditional privilege requiring ongoing adherence to strict operational boundaries. For Hong Kong’s 9,000+ approved charities, the 2025/26 tax year brings heightened audit risk, particularly around the commercial operation of thrift shops, the provision of fee-based services, and the deployment of funds in offshore investments. The IRD’s updated “Guidance Notes for Application for Exemption from Tax under Section 88 of the IRO” (2024 revision) explicitly warns that any activity generating profits—even if the profits are applied to charitable purposes—may breach the “profits application test” if the activity itself is not incidental to the charity’s primary objects. This article examines the specific conditions that must be maintained to preserve Section 88 status, the tax obligations that arise when those conditions are breached, and the operational strategies that compliant charities are adopting in the current enforcement climate.

The Statutory Framework: Section 88 and the “Charitable Purpose” Test

The foundation of charitable tax exemption in Hong Kong is Section 88 of the IRO, which states that “any charitable institution or trust of a public character” is exempt from tax. The IRD has historically interpreted this provision through a two-stage test: first, the entity must be established for a purpose that is exclusively charitable under Hong Kong law; second, the entity must operate in a manner consistent with that purpose. The landmark 2014 Court of Final Appeal decision in Commissioner of Inland Revenue v. The Hong Kong Buddhist Association (FACV 20/2013) confirmed that the scope of “charitable” in Hong Kong follows the four heads established in Commissioners for Special Purposes of the Income Tax v. Pemsel [1891] AC 531: relief of poverty, advancement of education, advancement of religion, and other purposes beneficial to the community. However, the 2024 IRD guidance notes add a fifth operational criterion: the charity must not be “carrying on a trade or business for the purpose of profit-making, even if the profits are applied to charitable purposes.”

The Profits Application Test vs. The Trade Test

A critical distinction that many charity operators misunderstand is the difference between applying profits to charitable purposes and conducting a trade that generates those profits. Under Section 88, a charity may engage in trading activities, but only if those activities are “incidental to the carrying out of the objects of the charity.” The IRD’s 2024 guidance provides a specific example: a charity that operates a second-hand clothing shop to fund its educational programs must demonstrate that the shop’s operation is itself a means of advancing the charity’s educational objects—for instance, by providing vocational training opportunities—rather than being a separate business that merely funds the educational work. The IRD’s Departmental Interpretation and Practice Notes (DIPN) No. 46 (Revised 2023) states at paragraph 12 that “where a charity carries on a trade or business that is not ancillary to its charitable objects, the profits arising from that trade or business will be subject to profits tax, even if the charity applies those profits to its charitable purposes.”

The “Public Character” Requirement

Section 88 requires that the institution or trust be “of a public character.” This means the charity’s benefits must be available to a sufficient section of the public, not confined to a private group of individuals. The IRD has increasingly scrutinized charities that appear to serve only a narrow membership base. In a 2024 IRD ruling (DIPN 46, Example 3), a sports club that provided scholarships to its members’ children was denied Section 88 status because the benefits were limited to a private class. The IRD’s position is that “public character” requires that the charity’s doors be open to beneficiaries who are not predetermined by family, employment, or membership ties. For family offices considering charitable structures, this presents a particular challenge: a private family foundation, no matter how generous its distributions, will not qualify for Section 88 exemption unless its benefits are available to the public at large.

Operational Compliance: What Charities Must Do to Maintain Exemption

Maintaining Section 88 status requires more than simply filing an annual return. The IRD expects charities to demonstrate ongoing compliance with five operational conditions derived from Section 88 and the IRD’s published guidance. Failure to meet any of these conditions can result in retrospective revocation of exemption, with tax liabilities dating back to the year the breach occurred.

Condition 1: No Distribution of Profits to Members or Trustees

Section 88 implicitly prohibits any distribution of the charity’s income or property to its members, trustees, or officers, except as reasonable remuneration for services rendered. The IRD’s 2024 guidance is explicit: “A charity must not be operated for the private profit of any individual.” This includes indirect benefits, such as below-market rental of property owned by a charity to a trustee’s related company. In a 2023 IRD audit case (unreported but cited in the IRD’s 2024 Annual Report), a charity lost its Section 88 status because it had leased a portion of its premises to a trustee’s business at 30% of market rent. The IRD assessed profits tax on the deemed rental income for six years of assessment, plus penalties of 5% per annum under Section 82A of the IRO.

Condition 2: Trading Activities Must Be Incidental or Ancillary

As discussed above, the IRD distinguishes between trading that is “incidental” to charitable objects and trading that is a separate business. The practical test is whether the trading activity is necessary for the charity to achieve its objects, or whether it is merely a means of raising funds. A charity running a bookshop on campus to support an educational institution passes the test; a charity running a chain of retail stores across Hong Kong to fund its charitable work does not. The IRD’s DIPN 46 provides a “substantiality test” at paragraph 18: if the trading activity accounts for more than 50% of the charity’s total income for three consecutive years, the IRD will presume the trading is a separate business unless the charity can demonstrate otherwise.

Condition 3: Proper Record-Keeping and Annual Filing

Section 88 charities are required to maintain proper books of account and to file annual tax returns (Form IR1249) with the IRD, even if they have no tax liability. The 2024 IRD guidance notes emphasize that “failure to file annual returns for three consecutive years will result in automatic revocation of Section 88 status.” The IRD’s 2024-25 annual report indicates that 127 charities had their Section 88 status revoked in the 2023/24 tax year for non-filing, up from 89 in the previous year. For charities that have been dormant or have had no income, the IRD still requires a nil return to be filed each year.

Condition 4: Application of Funds Within a Reasonable Timeframe

The IRD expects charities to apply their funds to charitable purposes within a reasonable period after receipt. While there is no statutory deadline, the IRD’s guidance suggests that funds should be applied within three years of receipt. A charity that accumulates reserves without a specific plan for their application risks losing its exemption. In a 2024 IRD ruling (DIPN 46, Example 7), a charity that had accumulated HKD 50 million in reserves over five years without any disbursement to charitable projects was deemed to be operating as a “fund-holding entity” rather than a charitable institution, and its Section 88 status was revoked.

Condition 5: No Political Activities Beyond a De Minimis Level

Section 88 charities are prohibited from engaging in political activities that are not incidental to their charitable objects. The IRD’s 2024 guidance defines “political activities” broadly to include lobbying for legislative change, supporting or opposing political candidates, and conducting advocacy campaigns. The de minimis threshold is 5% of the charity’s annual expenditure; any expenditure on political activities exceeding this amount will result in a review of the charity’s Section 88 status. This condition has become particularly relevant in the 2025 environment, where several environmental charities have faced IRD inquiries regarding their advocacy work on climate policy.

Tax Obligations When Exemption Is Lost or Breached

When a charity loses its Section 88 status—either through voluntary surrender or IRD revocation—or when it breaches the operational conditions, it becomes subject to the full range of Hong Kong tax obligations. The implications are significant and often catch charity operators by surprise.

Profits Tax on Trading Income

The most immediate consequence is the imposition of profits tax on any trading income generated by the charity. The IRD will assess profits tax at the standard rate of 16.5% (for the 2024/25 year of assessment) on the net profits from any trade or business that is not incidental to the charity’s objects. Importantly, the IRD may assess this tax retrospectively for up to six years of assessment under Section 60 of the IRO, which allows the Commissioner to raise an assessment within six years after the end of the year of assessment in which the tax became chargeable. For charities that have been operating a substantial trading business for years under the mistaken belief that their Section 88 status protected them, the retrospective liability can be crippling.

Property Tax on Rental Income

Charities that own property and generate rental income are generally exempt from property tax under Section 88, provided the rental income is applied to charitable purposes. However, if the charity’s Section 88 status is revoked, the rental income becomes subject to property tax at the standard rate of 15% on the net assessable value (80% of the gross rent). The IRD’s 2024 guidance notes that property tax liability arises from the date the exemption is lost, not from the date of revocation. This means that if a charity’s Section 88 status is revoked in 2025 due to a breach that occurred in 2022, the property tax liability may be assessed from 2022 onwards.

Salaries Tax on Employee Remuneration

Charity employees are generally subject to salaries tax on their remuneration, regardless of the charity’s Section 88 status. However, the charity itself may be liable for employer’s contributions to the Mandatory Provident Fund (MPF) and for the employer’s portion of the salaries tax (which is not separately assessed but is reflected in the employee’s tax liability). When a charity loses its Section 88 status, it also loses its ability to claim deductions for charitable donations made to other charities, as these deductions are only available to entities that are themselves subject to tax.

Strategic Considerations for Compliant Charity Operations

For charities that wish to maintain their Section 88 status while engaging in income-generating activities, several operational strategies are available under Hong Kong law. These strategies require careful planning and documentation but can preserve the charity’s tax-exempt status while allowing it to generate sustainable revenue.

Segregation of Trading Activities into a Separate Entity

The most common strategy is to segregate any substantial trading activities into a separate, taxable entity—typically a company limited by shares—while the charitable arm retains its Section 88 status. The trading entity pays profits tax on its trading profits, then makes charitable donations to the Section 88 charity. The trading entity can deduct the donations under Section 16D of the IRO, subject to the cap of 35% of the trading entity’s assessable profits. The charitable arm receives the donations tax-free under Section 88. This structure has been endorsed by the IRD in DIPN 46 (paragraph 24) and is widely used by Hong Kong’s largest charities, including the Community Chest of Hong Kong.

Documentation of Incidental Trading

For charities that wish to keep trading activities within the charitable entity, the key is to document how each trading activity is incidental to the charity’s objects. This requires a written policy approved by the board of trustees, annual reviews of the trading activity against the charity’s objects, and contemporaneous records demonstrating that the trading activity is not a separate business. The IRD’s guidance suggests that charities should maintain a “trading activity log” that records the purpose of each trading transaction, the connection to the charity’s objects, and the proportion of total income represented by the activity.

Reserve Management and Application Plans

To avoid the “fund-holding entity” risk, charities should maintain a written reserves policy that specifies the maximum level of reserves the charity will hold and the timeframe within which reserves will be applied to charitable projects. The IRD’s guidance suggests that reserves should not exceed two years’ operating expenses unless the charity has a specific, documented plan for their application. Charities that accumulate reserves for a specific capital project—such as building a new school—should maintain a project plan with timelines and budget estimates to demonstrate that the reserves are being held for a specific charitable purpose rather than for investment.

Offshore Investment Management

Charities that invest their reserves in offshore markets—such as US equities, European bonds, or Asian private equity—face additional compliance risks. The IRD’s position is that investment income is generally exempt from tax if the investments are held as “capital” rather than “trading” assets. However, the IRD may characterize active trading of investments as a separate business, particularly if the charity employs professional investment managers and generates significant trading profits. The 2024 IRD guidance notes at paragraph 31 that “where a charity engages in frequent buying and selling of investments with a view to profit, the profits may be subject to profits tax, even if the profits are applied to charitable purposes.” Charities with significant investment portfolios should seek a specific IRD ruling on the tax treatment of their investment activities.

Actionable Takeaways

1. Conduct an annual “Section 88 compliance audit” that reviews all income-generating activities against the IRD’s five operational conditions, with particular focus on the “incidental trading” test and the 50% income threshold from DIPN 46.
2. Segregate any trading activity that generates more than 20% of total charity income into a separate taxable entity, with the trading entity making deductible charitable donations to the Section 88 charity.
3. Maintain a written reserves policy that limits accumulated reserves to no more than two years’ operating expenses, and file annual Form IR1249 returns even in years with no income.
4. Document all trustee and officer transactions at arm’s length, with independent valuations for any property leases or service agreements between the charity and related parties.
5. For charities with offshore investments, obtain a specific IRD ruling on whether the investment activity constitutes a trade or business, and maintain records demonstrating that investments are held as capital assets with a long-term horizon.

本文不構成稅務建議。涉及個人稅務情況請諮詢持牌會計師或稅務師。This does not constitute tax advice. Consult a licensed CPA or tax advisor for your specific situation.