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On 5 October 2021, the European Union (EU) placed Hong Kong on its Watchlist because of its foreign-source income exemption regime (for more details, please click here to read our news on this topic). In response to the EU’s concerns, Hong Kong government proposed a new foreign source income exemption regime. Under this scheme, offshore passive income will be deemed to be sourced from Hong Kong and subject to Hong Kong tax if certain requirements are met.
This article highlights the key features of the new foreign sourced income exemption (FSIE) regime. Certain aspects of the new regime are complicated, but we would encourage any companies that receive foreign-sourced passive income via their Hong Kong entities to pay attention to the tax note above and – if needed – to review their current structures.
After various rounds of discussions with the European Union (EU), the Taxation on Specified Foreign-sourced Income Bill has finally been published on 28 October 2022, which introduces refinements to Hong Kong’s FSIE regime for four types of offshore income:
- interest,
- dividends,
- disposal gains from the sale of equity interests, and
- income from intellectual property (IP).
This regime – expected to take effect from 1 January 2023 – will apply to Multinational Enterprise (MNE) entities that carry on a trade, profession or business in Hong Kong. On the other hand, individual taxpayers, standalone local companies with no operation outside Hong Kong in the form of permanent establishments, as well as local groups without overseas constituent entities, shall all fall outside the scope of this new regime.
Foreign-sourced income is regarded as a receipt arising in or derived from Hong Kong in the year of assessment in which it is received in Hong Kong. It means that this passive income will be deemed taxable and subject to Hong Kong profits tax if received by a constituent of a MNE in Hong Kong – regardless the revenue or assets size of this MNE – and such constituent fails to meet the economic substance requirements (for non-IP passive income), the nexus approach (for IP income) or the participation exemption (for dividends and equity disposal gains).
These three exceptions requirements above-mentioned need to be met in the year of income accrual rather than in the year in which the income is received.
- Economic substance requirements for non-IP income
Non-IP passive income including interest income, dividends and disposal gains would not be deemed sourced from Hong Kong and subject to taxation in Hong Kong if the taxpayer conducts substantial economic activities in relation to the relevant passive income in Hong Kong.
In order to avoid taxation, the following requirements are to be noted:
- For non-pure equity holding company, substantial economic activities have to be conducted, including making necessary strategic decision, managing and assuming principal risks in respect of any assets it acquires, holds, or disposes of.
- For pure equity holding company – which is defined as an entity that 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 – a reduced substantial activities test will be applied. Under this test, a pure equity-holding entity is required to comply with every applicable registration and filing requirement under the relevant corporate law in Hong Kong and have in Hong Kong adequate human resources and premises for holding and managing its equity participation in other entities.
The activities are not required to be carried out by an own organization. Outsourcing of relevant activities would be permitted if the taxpayer can demonstrate adequate oversight of the outsourced activities and that the relevant activities are conducted in Hong Kong.
- Nexus approach requirement for IP income
For income derived from IP assets, there must be a direct nexus between the beneficiary income and the expenses contributing to that income. Under this nexus approach, only a certain ratio of offshore IP income will be deemed “qualifying expenditures” exempted from Hong Kong Profits Tax.
Formula to determine the amount of IP income qualifying for profits tax exemption:
Qualifying IP assets only cover patents and other IP assets that are functionally equivalent to patents. Income from other IP assets (e.g., trademarks and copyrights) would not be qualified for the exemption.
Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset and exclude acquisition costs of the IP asset. The R&D activities of the qualifying expenditures must be:
- Undertaken by the taxpayer in Hong Kong,
- Outsourced to unrelated parties to take place in or outside Hong Kong, or
- Outsourced to resident related parties to take place in Hong Kong.
- Taxpayers are allowed to uplift their qualifying expenditures by 30%.
- Participation exemption for dividends and equity disposal gains
Regardless of the economic substance requirement, offshore dividends and disposal gains would continue to be excluded from taxation if the taxpayer satisfies the following conditions and certain anti-tax avoidance rules:
- The investor company (i.e., the taxpayer) is a Hong Kong SAR resident person (i.e., a tax resident company incorporated or managed or controlled in Hong Kong SAR) or a non-Hong Kong SAR resident person that has a permanent establishment in Hong Kong SAR; and
- The investor company has continuously held not less than 5% of equity interests in the investee entity for a period of not less than 12 months* immediately before the income accrues.
* The condition that the investee company should not earn more than 50% of its income as passive income, as proposed in the consultation stage, has been removed and replaced with this 12-month holding period requirement.
The participation exemption would be subject to specific anti-abuse rules, including a subject to tax rule. Indeed, the dividend income or disposal gains, or the underlying profits from which dividends are paid, would be required to be subject to tax in a foreign jurisdiction at an applicable rate of at least 15%. The underlying profits from which dividends are paid would be required to be at least as much as the dividend itself, such that the entirety of the dividend can be considered to have been paid from profits that are “subject to tax”. If this condition is not met, the participation exemption would switch over to a foreign tax credit.
The requirement that disposal gains must be subject to tax could be problematic, as it is common for taxpayers to structure the disposal of an equity interest in a tax-free manner. Accordingly, it is unclear how often taxpayers would be able to make use of the participation exemption in respect of disposal gains.
If you have any questions/concerns regarding the tax regulations in Hong Kong, please do not hesitate to contact our experts at contact@orbis-alliance.com.