Blog

European Union ("EU") expressed its concern over Hong Kong's foreign source income exemption (FSIE) regime which provides a tax exemption to a broad range of passive income without specific conditions and a substance requirement  leading to double non-taxation of passive income booked in a Hong Kong shell company.   As a response to their concerns, the Hong  Kong Government has recently proposed a revised on FSIE regime.  Under the proposal, Hong Kong will continue to adhere to the territorial source of principle of taxation. 

1.   However, Hong Kong constituent entities of a multinational enterprise (MNE) group, wherever headquartered and irrespective of group asset size and revenue, will be subject to a refined FSIE regime in respect of in scope offshore passive income received in Hong Kong. It means that the in scope offshore passive income will continue to be exempt from profits tax in Hong Kong if the entity satisfies the economic substance or nexus approach requirements.  Pure equity holding companies will be subject to a reduced economic substance requirement. 

2.   Participation exemption will be introduced for offshore dividends and disposal gains of equity interests such that the relevant income will continue to be tax-exempt in Hong Kong if the conditions for the participation exemption are satisfied, regardless of whether the economic substance requirement is met.

3.   Unilateral tax credit is introduced to avoid potential double taxation of offshore passive income.

The changes are expected to take effect from 1 January 2023 and apply to multinational enterprise groups only.

Refined FSIE Regime

Covered Taxpayers
The in-scope taxpayers only apply to a Hong Kong constituent entity (CE) of a multinational enterprise (MNE) group, irrespective of the group's revenue or asset size.

The definitions of CE and MNE are the same as those under the Global Anti-Base Erosion (GloBE) Rules promulgated by the Organization for Economic Cooperation and Development (OECD).  An MNE Group refers to any Group that includes at least one Entity or Permanent Establishment (PE) that is not located in the jurisdiction of the Ultimate Parent Entity (UPE) whilst a CE is an entity that is related through ownership or control such that whose financial results are consolidated on a line-by-line basis in the group’s consolidated financial statements.  As such an associated company that an UPE does not control would not normally regarded as a constituent entity of an MNE group.  

In other words, the following will not fall within the refined FSIE regime.

• individual taxpayers
• standalone local companies with no operations outside Hong Kong in the form of a PE
• purely domestic groups without any overseas constituent entities or PEs

Covered Income

In-scope passive income includes:
- Interest income
- Dividends
- Gains from the disposal of shares or equity interest (equity disposal gains)
- Income from intellectual properties (IP income)

An active income (e.g. service income, trading income, etc.) is not a covered income and will continue to be exempt from profits tax if it is regarded as offshore sourced based on Hong Kong's existing source rules.

Condition For Exemption Under The Refined FSIE Regime

Covered income received in Hong Kong by a covered taxpayer will continue to be exempt from profits tax only if the taxpayer meets the relevant economic substance or nexus approach requirements.   Failing the relevant requirements would render the covered income deemed as having a Hong Kong source and will be subject to profits tax in Hong Kong.

The Economic Substance Requirement For Interests, Dividends, Equity Disposal Gains (Non IP Income) :
-  For non-pure equity holding, income will be tax-exempt if substantial economic activities relevant to the income are conducted in Hong Kong. Test will ascertain whether the covered taxpayers employ an adequate number of qualified employees and incur an adequate amount of operating expenditures in Hong Kong for carrying out the relevant activities. Totality of facts of each case instead of a minimum threshold will be the considered.
-  For pure equity holding company, a reduced substantial activities test will be applied under which the relevant activities will only include (1) holding and managing its equity participation and (2) complying with the corporate law filing requirements in Hong Kong.
-  Outsourcing of the relevant activities will be permitted provided that they are conducted in Hong Kong and being adequately monitored by the covered taxpayer.

The Nexus Approach Requirement For IP Income (Qualifying IP Assets)
-  Only income derived from a patent or an IP asset similar to a patent (qualifying IP income) can be entitled to a tax exemption under the nexus approach.

-  The portion of the qualifying IP income that is exempt from tax will be computed based on the nexus ratio i.e. the qualifying expenditure as a proportion of the overall expenditure that have been incurred by the covered taxpayer to develop the IP asset.

Below formula applies to determine the amount of income qualifying for profits tax exemption under the refined FSIE regime:

Qualifying expenditures incurred

To develop the qualifying IP asset

------------------------------------   X   IP income from the qualifying IP asset

  Overall expenditures incurred 

To develop the qualifying IP asset 

-  Qualifying expenditure only include expenditure on R&D activities that are directly connected to the IP asset and (i) undertaken by the taxpayer in Hong Kong, (ii) outsourced to resident related parties and take place in Hong Kong; and (iii) outsourced to unrelated parties to take place in or outside Hong Kong. Acquisition costs of IP assets are not qualifying expenditure.

-  Taxpayers are allowed to uplift their qualifying expenditures by 30%, subject to a cap equal to the taxpayer's overall expenditures. 

-  Profits tax exemption will not be available for (i) income derived from other IP assets (e.g. trademarks and copyright) and (ii) income from qualifying IP assets in excess of the nexus ratio.

The Participation Exemption For Dividends And Equity Disposal Gains :
-Tax exemption  for offshore dividends and equity disposal gains will be introduced regardless of whether the above economic substance requirement is met if the following conditions are fulfilled:

i)     the investor company is a Hong Kong resident person or a non-Hong Kong resident person with a permanent establishment in Hong Kong;
ii)    the investor company holds at least 5% of the shares or equity interests in the investee company;
iii)   no more than 50% of the income derived by the investee company is passive income; and
iv)  the passive income or the underlying profit of the investee company (for dividends) is subject to tax in a foreign jurisdiction with a headline tax rate of 15% or above.

Nonetheless, the proposed participation exemption is subject to the following anti-abuse rules:

-  The switch-over rule. If the headline tax rate of iv) above is below 15%, the tax relief available to the investor company will switch over from the proposed participation exemption to a foreign tax credit.

-  The main purpose rule.  The main purpose of any arrangement or series of arrangements undertaken by the investor company is to obtain a tax advantage that defeats the object or purpose of the participation exemption.
-  The anti-hybrid mismatch rule.  Where the income concerned is dividends, participation exemption will not apply to the extent the dividend payment is deductible by the investee company.

Introduction Of Unilateral Tax Credit in Hong Kong

To provide double tax relief for in-scope offshore passive income that is subject to tax in both Hong Kong and a foreign jurisdiction that does not have a Double Taxation Agreement with Hong Kong, a unilateral tax credit will be provided. Unilateral tax credit is only applicable to in-scope passive income and will not be available for other income even though it may be subject to tax in both Hong Kong and overseas.

Timetable And Effective Date
The HK Government plans to introduce a legislative bill on the proposed amendment to the Inland Revenue Ordinance in the last quarter of 2022 to have the refined FSIE regime effective from 1 January2023.    The Inland Revenue Department will issue administrative guidance on the FSIE regime, including the factors that will be considered in determining whether the substance requirement is met, the rules relating to participating exemption regime and application of the nexus approach.

If you want to set up your offshore entity in Hong Kong or would like to know more about this amendment, please contact us:

Whatsapp : (852) 6499 4686

Phone : (852) 2186 6936

Email : info@intershores.hk

Disclaimer:

Whilst reasonable care has been taken in provision of information above, it does not constitute legal or other professional advice. INTERSHORES does not accept any responsibility, legal or otherwise, for any error omission and accepts no responsibility for any financial or other loss or damage that may result from its use.  In particular, readers are advised to take appropriate professional advice before committing themselves to any involvement in jurisdictions, vehicles or practice.