Hong Kong tax authorities have decided to strengthen current legislation to better combat cross-border tax avoidance arising from double non-taxation, targeting more specifically offshore passive income such as dividends, disposal gains in relation to shares or equity interest, interest income, and income from intellectual property.
The Inland Revenue Taxation on Specified Foreign-sourced Income Bill 2022 (the Bill), which came into effect January of 2023, was created to update the Foreign-sourced Income Exemption (FSIE) regime to maintain Hong Kong’s tax competitiveness.
The package of measures seeks to minimize the tax compliance burden for corporations, mitigate possible double taxation, and enhance tax certainty, according to the HK government.
Last December, the Inland Revenue Taxation on Foreign-sourced Disposal Gains Ordinance 2023 was published to refine the FSIE regime to match the updated FSIE Guidance promulgated by the European Union (EU). The Refined FSIE Regime came into effect January 1, 2024.
The current Foreign-sourced Income Exemption (FSIE) regime offers tax exemptions for specified foreign-sourced passive income, namely interest, dividends, disposal gains in relation to shares or
equity interests (disposal gains) and intellectual property (IP) income, received in Hong Kong by multinational entities (MNE).
Proposed Refinements
The Refined FSIE Regime expands the scope of foreign-sourced disposal gains to cover all types of property (instead of only covering disposal gain from sale of equity interests). The existing exception requirements, economic substance requirement, participation requirement and nexus requirement remain unchanged and equally applicable to different types of disposal gains.
Additionally, the document introduces several new exclusions regarding disposal gains.
To facilitate corporate restructurings, a new intra-group relief is available if the property concerned is transferred between associated entities, subject to specific anti-abuse rules.
Another new exclusion is related to traders. Where non-IP disposal gain that accrues to a trader and is derived from or is incidental to its business as a trader, such income would fall out of the scope of the Refined FSIE Regime.
The existing exclusion to regulated financial entities has also been expanded to cover non-IP disposal gains which accrue to a regulated financial entity and are derived by or are incidental to its business as a regulated financial entity.
Offshore passive income
Under the FSIE regime, four types of offshore passive income including dividends, disposal gains in relation to shares or equity interest, interest income and income from IP (in-scope offshore passive income) would be deemed sourced from HK and subject to profits tax under the following circumstances:
The income is received in Hong Kong by a constituent entity of a multinational enterprise group ("covered taxpayer") irrespective of its size of income or assets. A constituent entity means an entity with financial results consolidated on a line-by-line basis in the group's consolidated financial statements.
The covered taxpayer fails to meet the economic substance requirement (for non-IP income), the nexus approach requirement (for IP income) or the participation exemption (for dividends and equity disposal gain).
Offshore equity disposal gains that are deemed taxable would not be excluded from assessable profits even if they are capital in nature.
The passive income should be "received in Hong Kong". However, what constitutes passive income "received in Hong Kong" requires further definition. It is expected that the approach similar to Singapore, i.e. on remittance basis, might be adopted.
As an international financial center, Hong Kong prides itself on being a responsible and cooperative player in international taxation. The FSIE regime aligns with the international tax standard of requiring a corporate taxpayer benefitting from preferential tax treatment in a jurisdiction to have a substantial economic substance in that jurisdiction and prevents shell companies from deriving tax benefits through double non-taxation.
In 2021, the European Union (EU) placed Hong Kong on a watchlist on the grounds that the non-taxation of foreign-sourced passive income was not accompanied by adequate substance requirements and robust anti-abuse rules.
The EU invited Hong Kong to amend its FSIE regime and put it into effect January 1, 2023. To avoid being blacklisted by the EU as a non-cooperative jurisdiction, Hong Kong agreed to amend its tax law and implement it by 2023.
Extensive consultations with tax professionals, local and foreign chambers of commerce, trade and professional bodies and representatives of the financial services sector in respect of the legislative proposals were held.
The new FSIE regime puts in place an economic substance requirement to safeguard against possible exploitation of HK's tax arrangement by shell companies to achieve double non-taxation in respect of foreign-sourced passive income.
Only MNE entities carrying on a trade, professions or business in Hong Kong will be subject to the FSIE regime. Individuals and local companies are not affected.
Taxpayers benefiting from existing preferential tax regimes generally fall outside the scope of the new regime.
Under the new regime, an MNE entity wishing to claim a tax exemption relating to foreign-sourced interest, dividend and disposal gains needs to meet the economic substance requirement by employing an adequate number of qualified employees and incurring adequate operating expenditures in HK.
An MNE entity that is a pure equity-holding company is subject to a reduced economic substance requirement involving only the holding and managing of equity participations and complying with the corporate law filing requirements in HK.
For a taxpayer that is not a pure equity holding company, the relevant activities include making necessary strategic decisions and managing and assuming principal risks for the company's assets. For a pure equity holding company, the relevant activity only includes holding and managing its equity participation and complying with the Hong Kong corporate law filing requirements.
Although taxpayers may outsource the relevant activities, they would still have to demonstrate adequate monitoring and such activities should be conducted in Hong Kong and not used to circumvent the economic substance requirement.
To meet the economic substance requirement, the Inland Revenue Department (IRD) may look at the number of qualified employees and adequate amount of operating expenditure incurred in Hong Kong. The IRD will also consider the totality of facts of each case, such as the business nature, operation scale, profitability, roles and other details of employees, and the amount and types of operating expenditure incurred.
According to HK tax authorities, for foreign-sourced IP income, taxpayers need to comply with the nexus requirement promulgated by the Organization for Economic Cooperation and Development in respect of preferential tax regimes for IP under which tax exemption will be substantially tied to the qualifying research and development (R&D) expenditures attributable to a qualified IP asset.
Different "nexus test" will be applicable for certain IP income to qualify for preferential treatment. Only income from qualifying IP assets can receive preferential tax treatment, but this category only covers patents and other IP assets with equivalent functions. Marketing-related IP assets such as trademark and copyrights are excluded.
To mitigate possible double taxation, there is a range of enhancement and mitigation measures:
A participation exemption regime (Note) as an alternative to the economic substance requirement to facilitate taxpayers who receive foreign-sourced dividends and disposal gains to claim tax exemption; and
Tax credits for taxpayers who have paid taxes outside Hong Kong in respect of the specified foreign-sourced income, including taxes paid in jurisdictions which have not signed a tax treaty with HK.
In addition, to minimize the compliance burden and enhance tax certainty, a business-friendly four-pronged approach is taken:
Simplified reporting procedures requiring only essential, high-level information and declarations in the tax return to demonstrate compliance with the economic substance requirement and hence minimize compliance burden;
Advance rulings by the IRD on compliance with the economic substance requirement, valid for up to five years, to provide more tax certainty;
Administrative guidance with illustrative examples will be uploaded on the IRD website to help ascertain tax liabilities, providing more tax transparency; and
A dedicated unit within the IRD to provide technical support to taxpayers and respond to enquiries, to assist with compliance.
Taxpayers may apply for a "Commissioner's Opinion" in respect to their compliance with the economic substance requirement and refer to specific guidance on the IRD website to better determine tax liabilities.
The FSIE regime seeks to maintain Hong Kong's competitiveness, targeting only four types of foreign-sourced passive income whereas foreign-sourced active income will not be covered; covering MNE entities only, exempting foreign-sourced income from tax if the economic substance requirement or the nexus requirement (IP income) are satisfied and allowing an additional pathway for MNE entities receiving foreign-sourced dividends and disposal gains to claim tax exemption and minimize their tax burden.
The new FSIE regime affects the taxability of interest income received from overseas related entities by a Hong Kong intermediate holding company if the company cannot fulfill the
economic substance requirements. It also influences the license income received from IP other than patents as such income would be deemed sourced from HK no matter whether the company has economic substance or not.
Any foreign firm belonging to a group of companies not located or established in the jurisdiction of the ultimate parent entity of the group, carrying on a trade, profession or business in HK and receiving any foreign-sourced income in HK, may need to seek professional counsel on how Hong Kong's recently widened foreign-sourced passive income tax regime may affect it.
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