Hong Kong Franchise Royalties and US Tax: Characterization of Franchise Fees Under US-HK Treaty

The 2017 US tax reform (Tax Cuts and Jobs Act, TCJA) introduced IRC § 59A, the base erosion and anti-abuse tax (BEAT), which fundamentally altered the US tax treatment of cross-border payments, including royalties. For US citizens and Green Card holders residing in Hong Kong who own or operate franchise businesses — from fast-food chains to retail brands — the characterization of franchise fees under the US-Hong Kong Double Taxation Agreement (DTA) has become a critical, and often misunderstood, compliance issue. The US Internal Revenue Service (IRS) is increasingly scrutinising outbound payments from US entities to related foreign parties, and Hong Kong-based franchisees are squarely in its sights. The potential for double taxation is high if the fees are mischaracterised as royalties (subject to a 30% US withholding tax) versus business profits (potentially exempt under the DTA’s permanent establishment provisions). The 2024 IRS Large Business & International (LB&I) compliance campaign on cross-border royalty payments signals that this is a live audit risk for the 2025-2026 examination cycle. This article dissects the precise treaty provisions, the critical distinction between franchise fees and royalties, and the practical steps for US-HK taxpayers.

The US-HK DTA Framework for Franchise Income

The characterisation of franchise fees is not a matter of common law precedent but of treaty interpretation, specifically Articles 12 (Royalties) and 7 (Business Profits) of the US-HK DTA, which entered into force in 2010. The operative tax position is that a franchise fee is prima facie a royalty under Article 12(3)(c), which defines royalties as “payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.” A franchise agreement inherently grants the right to use a trade mark, a business system, and often secret formulas or processes, placing it squarely within this definition. However, the treaty provides a carve-out for business profits that is far more favourable to the taxpayer.

The “Effective Connection” Test for Business Profits

The key to avoiding US withholding tax lies in Article 7(1), which states that profits of an enterprise of a Contracting Party (Hong Kong) shall be taxable only in that State (Hong Kong) unless the enterprise carries on business in the other State (the US) through a permanent establishment (PE). For a Hong Kong resident franchisee operating a franchise in Hong Kong, with no US PE, the franchise fee paid to a US franchisor is not subject to US tax on the profits derived from that franchise. The critical question is whether the fee itself is subject to US withholding tax as a royalty.

The pivotal distinction is drawn in Article 12(5): royalties “arising in a Contracting Party” (the US) and “beneficially owned by a resident of the other Contracting Party” (Hong Kong) are taxable only in Hong Kong. This is a complete exemption from US withholding tax. The term “arising in a Contracting Party” is defined by reference to the source of the payment. Under US domestic law (IRC §§ 861(a)(4) and 862(a)(4)), royalties for the use of intangible property in the US are sourced to the US. For a Hong Kong franchisee operating a store in Hong Kong, the use of the trademark and business system occurs entirely in Hong Kong. Therefore, the fee is sourced to Hong Kong, not the US. The IRS Chief Counsel Advice (CCA) 2012-12-004, while not directly on point for franchises, reinforces the principle that the source of a royalty follows the place of use of the underlying property. For a Hong Kong franchisee, the place of use is Hong Kong.

The PE Trap: When a Hong Kong Franchisee Creates a US Permanent Establishment

A significant risk arises if the Hong Kong franchisee’s operations extend into the US. The US-HK DTA Article 5 defines a PE as a fixed place of business through which the business of an enterprise is wholly or partly carried on. If a Hong Kong-based franchisee opens a single company-owned store in San Francisco, or even sends a manager to the US for a prolonged period to supervise operations, that could create a US PE. In such a scenario, the profits attributable to that PE (including a portion of the franchise fee) would become subject to US net-basis taxation under Article 7, and the PE’s income would be subject to the US corporate income tax rate (currently 21% under TCJA). The Hong Kong franchisee would then need to file a US corporate income tax return (Form 1120-F) and potentially a state return. The 2023 IRS LB&I directive on “Franchise Operations” specifically flags the misattribution of income between a foreign franchisor and a US-based franchisee as a compliance priority.

The IRC § 861 Source Rules and the “Place of Use” Doctrine

The foundation of the Hong Kong franchisee’s argument for no US withholding tax rests on the IRC § 861 source rules. Under IRC § 861(a)(4), gross income from royalties for the use of intangible property is sourced to the US only if the property is used in the US. The corollary, under IRC § 862(a)(4), is that royalties for use outside the US are sourced outside the US. The burden of proof is on the taxpayer to demonstrate that the franchise’s intangible property — its trademarks, trade secrets, and business system — is used exclusively in Hong Kong.

The “Substance Over Form” Challenge from the IRS

The IRS will not automatically accept a Hong Kong franchisee’s self-characterisation of fees as non-US-source. The IRS’s “substance over form” doctrine, codified in IRC § 7701(o) for economic substance, applies. If the franchise agreement is structured such that the US franchisor retains significant control over the Hong Kong franchisee’s operations — for example, requiring the use of a specific US-based supply chain, mandating US-based software systems, or sending US-based trainers to Hong Kong — the IRS could argue that the “place of use” includes the US. This would re-source a portion of the franchise fee to the US, triggering the 30% withholding tax (unless a treaty exemption applies). The Tax Court case of Hospital Corporation of America v. Commissioner, 81 T.C. 520 (1983), while concerning management fees, established the principle that the source of income follows the location of the activities that generate it. If the US franchisor’s activities are integral to the generation of the franchise fee, a portion of that fee may be re-sourced.

The US-HK DTA Article 12(5) as a Shield

Even if the IRS successfully re-sources a portion of the fee to the US, the US-HK DTA Article 12(5) provides a powerful shield. As noted, it provides a complete exemption from US withholding tax for royalties beneficially owned by a Hong Kong resident. The key is “beneficial ownership.” The Hong Kong franchisee must be the true economic owner of the fee, not a mere conduit. The IRS will examine whether the Hong Kong entity has the power to use and enjoy the franchise rights without being subject to a contractual or legal obligation to pass the fee on to another party. The OECD’s 2014 report on “Preventing Treaty Abuse” (Action 6 of the BEPS project) has heightened scrutiny on conduit arrangements, but for a genuine Hong Kong franchisee operating its own business, the beneficial ownership test should be satisfied.

Practical Compliance for the US-HK Franchisee

For a US citizen or Green Card holder living in Hong Kong who owns a franchise, the compliance obligations are twofold: US international information reporting and Hong Kong profits tax reporting. The failure to correctly characterise the fee can lead to penalties under both jurisdictions.

US Reporting: Form 1040, FBAR, and Form 8938

The US citizen/GC holder must report the franchise fee on their US individual income tax return (Form 1040). If the fee is correctly characterised as a non-US-source royalty, it is not subject to US tax, but it must be reported on Schedule B (Interest and Ordinary Dividends) if it exceeds USD 1,500. The more critical reporting obligation is for the Hong Kong franchisee entity itself. If the US citizen owns more than 10% of the Hong Kong franchisee company, they must file FinCEN Form 114 (FBAR) if the aggregate value of the company’s financial accounts exceeds USD 10,000 at any time during the calendar year. Additionally, if the individual’s specified foreign financial assets exceed USD 50,000 on the last day of the tax year (or USD 75,000 at any time during the year) for a single filer living abroad, Form 8938 (Statement of Specified Foreign Financial Assets) must be filed with the Form 1040. The penalty for failing to file an FBAR can be up to 50% of the account balance or USD 100,000, whichever is greater.

Hong Kong Profits Tax: The Territorial Source Principle

The Hong Kong Inland Revenue Department (IRD) applies a strict territorial source principle for profits tax (Inland Revenue Ordinance, Cap. 112, s. 14). The franchise fee paid to the US franchisor is a deductible expense for the Hong Kong franchisee, provided the profits from the franchise operation are derived from Hong Kong (i.e., the franchise store is in Hong Kong). The IRD will scrutinise the deduction to ensure it is not excessive or artificial. The Hong Kong franchisee must maintain contemporaneous documentation demonstrating that the fee is arm’s length and that the franchise’s intangible property is used exclusively in Hong Kong. The IRD’s Departmental Interpretation and Practice Notes (DIPN) No. 21 (Profits Tax: Deductibility of Expenses) reinforces that expenses must be incurred in the production of chargeable profits. A franchise fee for a Hong Kong-based operation clearly meets this test.

The Statute of Limitations and IRS Examination Cycles

The IRS generally has three years from the date of filing to assess additional tax (IRC § 6501(a)). However, this period can be extended to six years if the taxpayer omits more than 25% of gross income (IRC § 6501(e)(1)(A)). For a US citizen/GC holder in Hong Kong, the risk of an audit is heightened by the IRS’s “Living Abroad” compliance campaign. The 2025-2026 LB&I priority list includes “High Net Worth Individuals” and “International Tax Compliance,” both of which directly target this demographic. The IRS uses data from FATCA (Foreign Account Tax Compliance Act) and the US-HK Tax Information Exchange Agreement (TIEA) to identify non-filers and under-reporters. A mischaracterised franchise fee could be the trigger for a full-scale examination.

Actionable Takeaways

1. Characterise the fee correctly: A franchise fee paid by a Hong Kong franchisee to a US franchisor for a Hong Kong-based operation is sourced to Hong Kong under IRC §§ 861(a)(4) and 862(a)(4), and is exempt from US withholding tax under US-HK DTA Article 12(5), provided the franchisee is the beneficial owner and has no US PE.
2. Avoid creating a US PE: A Hong Kong franchisee must not maintain a fixed place of business in the US or have a dependent agent in the US, as this would trigger US net-basis taxation under Article 7 of the US-HK DTA.
3. File all required US information returns: The US citizen/GC holder must file FBAR (FinCEN Form 114) and Form 8938 if thresholds are met, in addition to the Form 1040 with Schedule B.
4. Maintain contemporaneous documentation: The Hong Kong franchisee must document the arm’s length nature of the fee and the exclusive Hong Kong use of the intangible property to satisfy both the IRS and the IRD.
5. Be aware of the IRS examination cycle: The 2025-2026 LB&I campaign on cross-border royalties and living abroad taxpayers makes this a high-risk area for audit.

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.