Amendments to FSIE Regime
Further to the introduction of the FSIE regime in 2022 effective from 1 January 2023 (FSIE regime 2022) which covers interest, dividends, disposal gain on equity interest and income from use of intellectual property (IP) accrued to and received in Hong Kong by a member of a multinational group (MNE entity), Hong Kong has amended the Inland Revenue Ordinance to expand the covered income to disposal gain on any type of property, including movable and immovable property, with effect from 1 January 2024.
The exception requirement under the FSIE regime 2022, i.e. economic substance requirement, participation requirement and nexus approach requirement remain unchanged and are equally applicable to different types of disposal gains.
A disposal gain from property is exempt from taxation under the expanded FSIE regime if the exception requirements are met. Nexus approach requirement is applicable to disposal gain on IP assets. Economic substance requirement will apply to disposal gain on non-IP property. However, a MNE holding assets other than equity interest cannot be regarded as a pure equity holding company and the reduced substantial activities test cannot be applied. In order to meet the economic substance requirement, the MNE needs to conduct substantial economic activities, including making necessary strategic decision, and managing and assuming principal risks in respect of any assets it acquires, holds, or disposes of, in Hong Kong and the adequacy test in terms of employing an adequate number of qualified employees and incurring an adequate amount of operating expenditures in Hong Kong in relation to the relevant activities must be met.
For details of the exception requirements, please refer to our previous newsletter “Proposed changes to offshore regime for passive income in Hong Kong” dated 23 December 2022.
Exclusion relating to traders (non-IP disposal gain)
The covered foreign-sourced income does not include any non-IP disposal gain derived by an MNE from its business activities as a trader of the covered assets. Trader means any entity that sells property in the entity’s ordinary course of business.
Intra-group transfer relief for all disposal gains
An intra-group transfer relief is introduced in the amendments to FSIE regime. Any tax charged on foreign-sourced disposal gain (including equity interest disposal gain) received in Hong Kong from a transfer of an asset between two associated companies is to be deferred. Two entities are associated with each other if:
- One of them has at least 75% direct or indirect controlling interest (beneficial ownership or entitlement to exercise, or control the exercising of, the voting rights) in the other; or
- A third entity has at least 75% direct or indirect controlling interest in both of them.
As specific anti-abuse measures, the intra group transfer relief will be revoked if, within 2 years after the asset transfer, (i) the selling entity or the acquiring entity ceases to be chargeable to profits tax under the Inland Revenue Ordinance; or (ii) the selling entity and the acquiring entity ceases to be associated with each other.
Tax Certainty Enhancement Scheme (TCES) for Onshore Disposal Gain on Equity Interest
Hong Kong has introduced the TCES effective from 1 January 2024 to provide greater upfront certainty of non-taxation of onshore disposal gains on equity interest that are of capital in nature. Under the TCES, any onshore disposal gain on eligible equity interest derived by an eligible investor entity meeting the equity holding conditions is to be regarded as capital in nature and not chargeable to profits tax. This treatment saves the need for applying the badges of trade analysis (such as the frequency of similar trades, the holding period, the holding percentage, reason for purchase or sale of the equity interests, etc.) to determine whether a gain is of a capital in nature. The application of the Scheme is not compulsory and tax payers can choose whether to apply or not.
Considering the uncertainty about the application of the FSIE Regime and its exemption requirement, taxpayers may choose to conduct transactions onshore in Hong Kong following the introduction of the TCES. By applying the TECS, the disposal gain on equity interest would not fall within the scope of the FSIE regime.
Eligible investor entity
An investor entity must be a legal person (not including a natural person) or an arrangement that prepares separate financial accounts, such as a partnership, a trust and a fund. The Scheme does not apply to an investor entity which is an insurer. However, entities (e.g. subsidiaries of the insurers) that are not chargeable to profits tax in accordance with the relevant provisions of the Inland Revenue Ordinance applicable to insurance businesses would not be excluded from the Scheme.
Eligible equity interest
Eligible equity interest refers to an interest that carries rights to the profits, capital or reserves of the investee entity and is accounted for as equity in the books of the investee entity under applicable accounting principles. Nevertheless, the Scheme does not apply to the following equity interests:
- equity interests that are regarded as trading stock for tax purposes; or
- non-listed equity interests that are in an investee entity which engages in property trading, property development or property holding and does not satisfy the exception conditions (excluded investee entity).
Equity interests (specified equity interests) held by a holding entity are regarded as trading stock if any unrealised fair value gain or loss or provision for diminution in value of such interests has been brought into account for tax purposes. Where the specified equity interests were acquired by the investor entity together with other equity interests on the same occasion, the specified equity interests are regarded as trading stock if any unrealized fair value gain or loss, provision for diminution in value, or disposal gain/loss of the same lot of equity interests as that of the specified subject interests, has been brought into account for tax purposes.
An investee entity is an excluded entity if it carries on a business of property trading in the relevant basis period (i.e. in the basis period of the investee entity for the year of assessment in which the disposal occurs). For the purposes of the Scheme, an investee entity that engages in a regular business other than property trading but has carried out a one-off property trading transaction which is an adventure in the nature of trade would not be regarded as an excluded entity.
An investee entity is an excluded entity if it undertakes or has undertaken property development, in Hong Kong or elsewhere, in or before the relevant basis period. However, there is an “Business-use” exception that an investee entity is not an excluded entity if it has not undertaken property development for at least a continuous period of 60 months before the relevant disposal and the immovable properties held by it are used by it to carry on its trade or business (including used for its letting business) and none of the immovable properties held by it is for sale.
Property holding covers an activity of holding immovable properties other than those which fall within the scope of property trading and property development. An investee entity is an excluded entity if it holds any immovable properties situated in Hong Kong or elsewhere, directly or indirectly, in the relevant basis period and the percentage of value of such immovable properties out of the entity’s total assets in that basis period exceeds 50%. However, the immovable properties used for carrying on the investee entity’s own trade or business (including property letting business) and not held for sale is to be excluded from the numerator in computing the relevant percentage.
Equity holding conditions
Under the Scheme, onshore gains derived from disposal of eligible equity interests in an investee entity by an eligible investor entity is regarded as capital in nature and non-taxable if the equity holding conditions, which relate to the holding period and holding percentage of the equity interests in an investee entity, are met. The threshold for the holding period is 24 months and that for the holding percentage is 15%.
For the purposes of the 15% ownership threshold, the amount of equity interests held can be measured on a group basis. That is, the threshold is satisfied if the investor entity and its closely related entities have together held at least 15% of the equity interests in the investee entity throughout the reference period. Two entities are regarded as “closely related” if:
- One of them has at least 50% direct or indirect controlling interest in the other; or
- A third entity has at least 50% direct or indirect controlling interest in both of them.
An investor entity may dispose of its long-held equity interests in tranches. After disposal of each tranche, the investor entity’s equity holding in an investee entity may fall below the 15% threshold. To cater for disposal of equity interest in tranches, the Scheme provides for an exception to the equity holding conditions subject to a 24-month restriction.
We suggest clients having MNE entity in Hong Kong to assess whether they are affected by the expanded FSIE regime and consider if there are any potential options to mitigate the impact, e.g. applying the exclusion for traders, building up the economic substance in Hong Kong or reorganizing the non-IP disposal gains as onshore sourced for meeting the conditions for capital claim under the TCES.
Hope you find this helpful in understanding more about the expanded FSIE regime and the TCES. If you have any questions about this topic, feel free to contact us.
