On 13 October 2023, the Inland Revenue (Amendment) (Taxation on Foreign-sourced Disposal Gains) Bill 2023 (“2023 Amendment Bill”) was gazetted to further refine the foreign-sourced income exemption (“FSIE”) regime. Under the reformed FSIE regime that came into operation on 1 January 2023, offshore passive income received by a constituent entity of a multinational enterprise (“MNE”) group is subject to profits tax in Hong Kong. This includes interest, income derived from intellectual property (“IP”), dividends, and gains from the disposal of equity interests. Such income is deemed to be sourced in Hong Kong and, therefore, chargeable to profits tax.
The 2023 Amendment Bill expands the scope of disposal gains to include gains derived from the disposal of all kinds of assets, including movable and immovable property.
On 29 November 2023, the Legislative Council passed the Bill containing the additional amendments to the reformed FSIE regime. The relevant Amendment Ordinance is expected to be gazetted in December 2023, with its implementation scheduled for 1 January 2024.
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Background: Updated guidelines on FSIE regimes from the EU
At the end of 2022, the EU issued a revised Guidance that specifically mandates the inclusion of disposal gains under the FSIE regime. In the Guidance, the EU called upon jurisdictions currently undergoing FSIE reforms, including Hong Kong, to further adjust their tax policies in respect of foreign-sourced disposal gains. Hong Kong must bring its FSIE regime in alignment with the EU’s revised Guidance by the end of 2023 for implementation in January 2024. Until the relevant legislative changes have been made, the city will remain on the EU’s watchlist.
Disposal gains, also referred to as capital gains by the EU, pertain to the gains derived from the disposal of assets. The refined FSIE regime will apply to asset disposal gains irrespective of whether they are classified as revenue or capital in nature. Disposal gains of a revenue nature arise from the sale of assets that are held for the purpose of generating profits as part of a company’s normal business operations. Such gains contribute to the company’s net income and fall under revenue generated from regular business activities on the income statement. On the other hand, disposal gains of a capital nature arise from the sale of non-current assets that are not intended for sale in the regular course of business. They form part of a company’s capital transactions.
To whom does the refined FSIE regime apply?
The definition of covered taxpayers subject to the refined FSIE regime remains unchanged. According to the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022 (“2022 Amendment Ordinance”), only constituent entities of MNE groups fall within scope. Individuals, locally based standalone enterprises with no offshore operations, and exclusively local corporate groups will not be subject to the FSIE regime.
Under the 2022 Amendment Ordinance, an MNE group refers to a group comprising at least one entity or permanent establishment that is not situated or established within the jurisdiction of the group’s parent entity. To ascertain whether the entity concerned belongs to a group, the guiding principle is to observe the accounting consolidation guidelines. If the relevant accounting standards do not necessitate the consolidation of an entity’s financial results – combining assets, liabilities, income, expenses, and cash flows – with its parent or related entities, then that entity will not be deemed as part of the group.
Overview of the refined FSIE regime
Under the refined FSIE regime, specific types of foreign-sourced income will be treated as originating from Hong Kong and subject to profits tax if:
(i) The income is received in Hong Kong by an MNE entity engaged in a trade, profession, or business in Hong Kong, regardless of its revenue or asset size; and
(ii) The different exception conditions do not apply.
The conditions for asserting exemptions from being subject to profits tax under the refined FSIE regime remain unchanged. These are the economic substance requirement, participation requirement, and nexus requirement.
For a detailed analysis of the refined FSIE regime that came into effect on 1 January 2023, click here.
Expanded scope of covered income
The original 2022 Amendment Ordinance provides that foreign-sourced passive income derived from or arising in a territory outside Hong Kong is chargeable to profits tax in the usual manner. Specifically, this applies to the following types of income:
- Interest
- Dividends
- Disposal gains from the sale of equity interests in an entity
- Income derived from intellectual property
Under the 2023 Amendment Bill, the scope of disposal gains has been broadened to include any gains or profits generated from the disposal of any type of asset, including immovable and movable property. The EU has emphasised the need to adopt a non-exhaustive approach when determining the scope of covered assets. Such an approach has also been adopted elsewhere.
According to the Inland Revenue Department (“IRD”), the definition of property encompasses both immovable and movable property. Immovable property refers to (i) land (irrespective of whether it is submerged in water) and (ii) any estate, right, interest, or easement in or over any land, and objects affixed to land, or permanently attached to any such object. Movable property, on the other hand, covers all types of property that are not deemed immovable property.
In addition, the IRD draws a distinction between IP disposal gains and non-IP disposal gains in the 2023 Amendment Bill. IP disposal gains refer to gains derived from the sale of IP assets. Non-IP disposal gains refer to gains derived from the sale of non-IP assets, including gains derived from the sale of equity interests in an entity.
Disposal gains from assets other than equity interests will be exempt, i.e. not taxable, if the entity meets the economic substance requirement.
Exclusion for traders
Non-IP disposal gains accrued to traders through their trading activities or incidental to their trading business fall outside scope. A trader is defined as an entity engaged in the sale of, or offering to sell, property in the normal course of business.
This exclusion dovetails with the territorial basis of taxation on which Hong Kong operates. Only income sourced in Hong Kong is taxable; income sourced outside Hong Kong is not. Where traders receive gains from the disposal of non-IP assets in the ordinary course of business, such gains are considered active business income, rather than passive income with which the FSIE regime is concerned. In order to determine whether a disposal gain is foreign-sourced, the Inland Revenue Ordinance will be applied as well as the broad guiding principle in determining the territorial source of profits.
Read our Hong Kong Tax Guide to learn more about Hong Kong’s territorial basis of taxation.
Intra-group transfer relief for disposal gains
The proposed tax relief mechanism allows associated entities within the same MNE group to transfer assets without immediately triggering tax liabilities. In other words, taxation of foreign-sourced disposal gains accrued in Hong Kong within an MNE group can be deferred until the asset is no longer held by the group.
Two entities are deemed to be associated if:
- Entity A holds a minimum of 75% of either direct or indirect beneficial interest in Entity B, or has the direct or indirect right to exercise or control the exercise of no less than 75% of the voting rights in Entity B; or
- Entity C holds a minimum of 75% of either direct or indirect beneficial interest in both Entity A and Entity B, or has the direct or indirect right to exercise or control the exercise of no less than 75% of the voting rights in both Entity A and Entity B.
Intra-group transfer relief is available providing that the conditions below are met:
- The entity in the MNE group selling the asset receives foreign-sourced disposal gains.
- The disposal gains come from an intra-group transfer.
- The property from which the disposal gains arise is acquired by another group entity.
- Both the entity selling the asset and the entity acquiring the asset are subject to profits tax at the time of the sale.
Anti-abuse measures will be implemented to deter misuse of the relief. The relief for intra-group transfers shall become void if, within two years following the sale associated with the income in question:
- The selling entity or the acquiring entity is no longer subject to profits tax under the IRO; or
- The selling entity or the acquiring entity are no longer affiliated with each other.
Under the IRO, a person engaged in any trade, profession, or business in Hong Kong is liable for profits tax arising in or derived from Hong Kong. It follows, then, that the person will no longer be subject to profits tax if they discontinue their trade, profession, or business in Hong Kong.
Commissioner’s Opinion: Transitional measure
As an interim measure, an arrangement to provide greater tax certainty and alleviate the burden of compliance has been introduced. MNE entities have the option to seek the Commissioner’s Opinion. This is to ensure that they meet the economic substance requirement for disposal gains from the sale of assets specified in the 2023 Amendment Bill.
Where an MNE entity has already been granted a positive Opinion confirming that it satisfies the economic substance requirement for other foreign-sourced covered income, i.e., interest, dividend, and equity interest disposal gains, it can apply for an extension of the assessment to include disposal gains from assets accrued on or after 1 January 2024.
After the passage of the 2023 Amendment Bill and the subsequent implementation of the amendment ordinance, this interim measure will no longer be applicable. Instead, businesses can avail themselves of advance ruling to address the economic substance requirement. An advance ruling is a written confirmation provided by the Commissioner that clarifies the application of provisions to a particular transaction or arrangement. This confirmation offers assurance to the applicant, who can rely on it in most circumstances.
How CW can help
With over thirty years of professional experience, our team of seasoned tax experts offers a wealth of expertise and knowledge in providing tax advisory services to clients across various industries, including manufacturing, wholesale, retail, real estate, information technology, hospitality, logistics, shipping, aviation, and financial services. Proficient in the intricacies of local tax laws, we can assist you in analysing the implications of the new FSIE regime and its applicability to your business as well as your optimising tax efficiency.
Contact us to find out how we can help.
Updated on 21 December 2023
