New foreign-sourced income exemption regime in Hong Kong
Due to pressure from the European Union, the Hong Kong government is proposing to change the foreign source income exemption (FSIE) regime for the taxation of passive income. The government has submitted a draft of the new tax provisions to Legislative Council. The proposed changes are due to take effect on 1 January 2023 (which is the deadline imposed on Hong Kong by the European Union).
Hong Kong constituent entities of a multinational enterprise (MNE) group, wherever headquartered and irrespective of group asset size and revenue, will be in-scope. Standalone local companies and purely domestic groups without any offshore operations would not be affected.
In-scope offshore passive income
Specified foreign-sourced income received in Hong Kong:
- Interest income;
- Gains from disposal of shares or equity interest (equity disposal gains); and
- Income from intellectual properties (IP income)
A specified foreign-sourced income is regarded as received in Hong Kong when:
- the income is remitted to, or is transmitted or brought into, Hong Kong;
- the income is used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong; or
- the income is used to buy movable property, and the property is brought into Hong Kong. The income is regarded as being received at the time when the moveable property is brought into Hong Kong.
Conditions for exemption under the revised FSIE regime
Under the revised FSIE regime, in-scope offshore passive income received in Hong Kong by a covered taxpayer will continue to be exempt from profits tax only if the taxpayer meets (A) the economic substance requirement (for non-IP income), (B) the nexus approach requirement (for IP income) or (C) the participation exemption conditions (for dividends and equity disposal gains).
(A) Economic substance requirement (for non-IP income)
- For a covered taxpayer that is not a pure equity holding company#, the taxpayer will need 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, with regard to the relevant passive income in Hong Kong. # “Pure equity holding company” means a company which, as its primary function, acquires and holds shares or equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interest.
- The covered taxpayer will need to meet 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. The totality of facts of each case will be considered in determining whether the adequacy test is met. No minimum threshold in terms of number of qualified employees and operating expenditures will be specified in the revised FSIE regime.
- For a covered taxpayer that is a pure equity holding company, a reduced substantial activities test can be applied such that the relevant activities to be undertaken in Hong Kong will only include holding and managing its equity participation, and 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 the covered taxpayer is able to demonstrate adequate monitoring of the outsourced activities
(B) Nexus approach requirement (for IP income)
- 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. Income derived from other IP assets (e.g. marketing-related IP assets such as trademark and copyright) are excluded from the 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 which is defined as the qualifying expenditures as a proportion of the overall expenditures that have been incurred by the covered taxpayer to develop the IP asset.
- Qualifying expenditure is expenditure on R&D activities that are directly connected to the IP asset and (1) undertaken by the taxpayer in Hong Kong, (2) outsourced to resident related parties and take place in Hong Kong and (3) outsourced to unrelated parties to take place in or outside Hong Kong. Acquisition costs of IP assets are not qualifying expenditure. If the covered taxpayer has incurred non-qualifying expenditure, 30% uplift on the qualifying expenditure (subject to a cap equal to the taxpayer’s overall expenditures) can be applied in computing the nexus ratio.
(C) Participation exemption conditions (for dividends and equity disposal gain)
A participation exemption regime will be introduced to provide tax exemption for offshore dividends and equity disposal gains regardless of whether the above economic substance requirement is met if the following three conditions are fulfilled:
- the investor company is a Hong Kong resident person or a non-Hong Kong resident person that has a permanent establishment in Hong Kong;
- the investor company holds at least 5% of the shares or equity interest in the investee company for a period of not less than 12 months immediately before the income accrues; and
- c) the passive income or the underlying profit of the investee company (for dividends) is subject to tax in a foreign jurisdiction with a tax rate of 15% or above.
However, the proposed participation exemption is subject to the following anti-abuse rules:
- The switch-over rule
If the tax rate mentioned in (c) above is below 15%, the dividends will be subject to Hong Kong profits tax, but double tax relief will be switched over from participation exemption to foreign tax credit
- Main purpose rule
Any arrangement or series of arrangements undertaken by the investor company for the main purpose or one of the main purposes of obtaining a tax advantage that defeats the object or purpose of the participation exemption will be ignored.
- Anti-hybrid mismatch rule
Where the income concerned is dividends, the proposed participation exemption will not apply to the extent that the dividend payment is deductible by the investee company.
Double Taxation Relief
Recognizing that covered taxpayers would suffer double taxation if they fail to meet the conditions for exemption under the revised FSIE regime, a unilateral tax credit will be provided 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. 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.
For any similar tax payable on in-scope offshore passive income in a foreign jurisdiction with which Hong Kong has entered into a Double Taxation Agreement, bilateral tax credit pursuant to the relevant agreement will be granted to the MNE entity.
The Government introduced a tax bill on the proposed changes in October this year, so as to bring the revised FSIE regime into force from 1 January 2023. The Inland Revenue Department has issued administrative guidance which is available at their website.
We suggest clients having MNE entity in Hong Kong to review if the FSIE regime will lead tax impacts on their passive income and whether any actions for strengthening the economic substance in Hong Kong and modifying their current group structure should be undertaken.
Hope you find this helpful in understanding more about the FSIE regime. If you have any questions about this topic, feel free to contact us.