With the intention of supporting international efforts in combating cross-border tax evasion and preventing double non-taxation, Hong Kong amended its Foreign Source Income Exemption (FSIE) regime for passive income in accordance with the Guidance on FSIE regimes promulgated by the European Union (EU).
This action fulfilled the commitment made by Hong Kong to the EU, after it was listed in 2021, in an EU watchlist as one of the jurisdictions with harmful tax regimes.
The Inland Revenue (Taxation on Specified Foreign-sourced Income) Ordinance 2022, which amended the provisions in relation to the FSIE regime under the Inland Revenue Ordinance (Cap. 112) (IRO), came into effect on January 1, 2023.
According to the new FSIE regime, certain foreign-sourced income accrued to a member of a multinational group (MNE entity) carrying on a trade, profession or business in Hong Kong is to be regarded as arising in or derived from Hong Kong and chargeable to profits tax when it is received in Hong Kong.
The Ordinance amended the IRO to provide for relief against double taxation in respect of certain foreign-sourced income and transitional matters.
International tax standards require a taxpayer benefitting from a preferential tax treatment in a jurisdiction to have substantial economic presence in the jurisdiction, and to establish an explicit link between the relevant income and real activities in the jurisdiction.
To avoid being designated as a tax haven or targeted by countermeasures, many countries or regions have implemented different legislative measures. For example, places such as the British Virgin Islands and the Cayman Islands introduced economic substance requirements in 2019.
In 2021, Hong Kong was listed by the EU as a non-cooperative jurisdiction for tax purposes and as having a harmful tax regime that did not conform with international tax standards.
Immediately after this, Hong Kong promised the EU to amend its foreign-sourced income exemption regime by December 2022.
Last year, Hong Kong’s government approved the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022, which introduced the FSIE regime under the IRO.
In Hong Kong, profits tax is only chargeable where a person carries on a trade, profession or business in Hong Kong, and the profit arises in or is derived from Hong Kong. In the past, offshore passive income received by multinational companies with no substantial economic presence in the region, were not subject to profits tax.
Some of these companies enjoyed “double non-taxation”, which means that they didn’t pay taxes neither in Hong Kong, nor in the jurisdiction where the profits were generated.
The new FSIE regime establishes that MNE entities will no longer be able to enjoy double non-taxation in respect of specified foreign-sourced income.
Individuals and local companies that do not belong to a multinational group are exempt of the FSIE regime. This is because MNE entities can take advantage of the differences in tax systems and move their operation to low-tax jurisdictions to avoid taxation, whereas individuals and local companies are less able to do so.
Section 15I of IRO mandates profits tax on specified foreign-sourced income if the income is received in Hong Kong by an MNE entity regardless of its revenue or asset size; and the recipient of income is unable to meet one of the three exceptions: the economic substance requirement, the nexus requirement, and the participation requirement.
Specified foreign-sourced income includes interest, dividend, disposal gain and intellectual property (IP) income.
Foreign-sourced incomes that do not fall within the meaning of specified foreign-sourced income are not currently covered by the new FSIE regime.
An MNE entity may benefit from the exemption from profits tax in respect of foreign-sourced interest, dividends and disposal gains received in Hong Kong if it fulfils the economic substance requirement.
The exact requirements depend on whether or not the MNE entity is a pure equity-holding entity, which only holds equity interests in other entities and only earns dividends, disposal gains and income incidental to the acquisition, holding or sale of such equity interests.
Non-pure equity-holding entities are required to employ an adequate number of employees to carry out the specified economic activities – making necessary strategic decisions and managing and bearing principal risks in respect of any assets the entity acquires, holds or disposes - in Hong Kong.
Non-pure equity-holding entities must demonstrate more substantial economic substance than pure equity-holding entities. Both are subject to adequacy tests.
The economic substance requirements allow an MNE entity to outsource some or all of its specified economic activities to third parties or group entities as long as it demonstrates adequate monitoring and control of the relevant activities carried out by the outsourced entity and fulfils other outsourcing requirements.
An alternative to the economic substance requirement to claim tax exemption is the participation requirement, which applies if the MNE entity is a Hong Kong tax resident, or where it is a non-Hong Kong tax resident, it has a permanent establishment in the area to which the foreign-sourced dividend or disposal gain is attributable.
It also applies when the MNE entity has continuously held no less than 5% of equity interests in the investee entity concerned for a period of no less than 12 months immediately before the foreign-sourced dividend or disposal gain accrues.
Therefore, an MNE entity that is a parent or intermediate holding company for more than 12 months may satisfy the participation requirement if it is a Hong Kong tax resident or has a permanent establishment in Hong Kong.
However, there are certain anti-abuse rules in place to disallow the participation exemptions, namely: “subject to tax” condition, anti-hybrid mismatch rule and main purpose rule.
The nexus requirement applies only to foreign-sourced IP income and is used to determine the extent of such income to be exempt from profits tax.
The nexus requirement states that only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio (a proportion of the overall expenditures that have been incurred by a taxpayer to develop an IP asset).
The Hong Kong government informed that it would continue to refine the FSIE regime so that foreign-sourced capital gains in relation to assets, regardless of their financial or non-financial nature, received by MNE entities in Hong Kong will be exempt from tax provided that the economic substance requirement is complied with.
According to local authorities, Hong Kong will maintain the territorial source principle of taxation.
Multinational companies should reevaluate their tax compliance taking the FSIE regime in to account.
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