Hong Kong: Amendments to the Foreign-Sourced Passive Income Exemption Regime

Following the European Union’s (“EU”) placing of Hong Kong on to the watchlist of non-cooperative jurisdictions for tax purposes, the Hong Kong Special Administrative Government proposed changes to its foreign-sourced income exemption (“FSIE”) regime for passive income, which came into force on 1 January 2023 with no transition period. Under the reformed FSIE regime, all kinds of offshore passive income received by a constituent entity of a multinational enterprise group – interest, income derived from intellectual properties (“IP”), dividends, disposal gains in respect of shares or equity interest – shall be deemed to be sourced in Hong Kong and, therefore, subject to profits tax in certain cases. 

On 28 October 2022, the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Bill 2022 (“Amendment Bill”) was gazetted. 

On 14 December 2022, the Legislative Council passed the Amendment Bill and the corresponding amendments to it. 

The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022 (“Amendment Ordinance”) came into effect on 1 January 2023.

It is advisable to study the Amendment Ordinance in conjunction with the Inland Revenue Department’s (“IRD”) guidance, which elucidates the operation of the amended regime in practice.

Background

Simplicity, certainty and competitiveness have always been the hallmark of Hong Kong’s taxation system. No tax is levied on passive income whether it be earned onshore or offshore. Hong Kong adheres to the territorial source principle of taxation (vis-à-vis a worldwide tax system), which means that only income sourced in Hong Kong is taxable; income sourced elsewhere is not.

In light of ramped-up efforts to combat cross-border tax evasion and stop the “race to the bottom” in its tracks, the EU added jurisdictions deemed to have “harmful” FSIE regimes – including Hong Kong – to Annex II of the Council conclusions on the revised list of non-cooperative jurisdictions for tax purposes in October 2021. Committed to reforming its FSIE regime, Hong Kong had been granted until 31 December 2022 to make the necessary legislative changes. Upon the passing of the relevant amendments, Hong Kong would not be put on the EU’s blacklist, nor would Hong Kong-based enterprises be subject to defensive tax measures imposed by EU member states, such as withholding tax measures, controlled foreign company rules, limited deductibility of costs, limitation of participation exemption on profit distribution, etc.

Although tackling harmful tax practices has been high on the EU’s agenda in recent years, the EU clarified in its Guidance on foreign source income exemption regimes issued in October 2019 that FSIE regimes which operate territorially are not problematic in themselves. Exemption of foreign profits is considered acceptable and, in some cases, even advisable to prevent double taxation. The problem, however, lies in such regimes’ tendency in furthering the practice of double non-taxation. This is particularly prevalent in jurisdictions where the definition of what constitutes exempt income, especially in respect of foreign source passive income, is too loosely defined without any caveats, and/or where a nexus definition is not in keeping with the definition of a permanent establishment according to the Organisation for Economic Co-operation and Development’s (“OECD”) Model Tax Convention.

To whom do the changes apply?

It is important to note that the Amendment Ordinance only applies to constituent entities of multinational enterprise groups carrying on a trade or business in Hong Kong, which refer to separate entities within a corporate group operating in more than one jurisdiction that prepare their own financial accounts for reporting, tax, regulatory and internal management control purposes.

The reformed FSIE regime applies irrespective of the amount of offshore passive income, as well as the revenue or asset size of the constituent entity or the corporate group of which it is a part.

Evidently, an important guiding principle behind the reformed FSIE system is to deter multinational enterprise groups from engaging in exploitative tax planning arrangements, which lead to tax leakage and a higher risk of BEPS. Therefore, it should be emphasised that offshore passive income earned by locally based standalone enterprises with no offshore operations, as well as by entities belonging to local corporate groups, will not be subject to the reformed regime and can continue to enjoy a zero-percent tax rate on passive income. Since most SMEs fall under this description, they can continue to be exempt from tax in this regard.

A closer look at the changes

The Amendment Ordinance provides that specified foreign-sourced income – that is interest, IP income, dividends or disposal gains arising in or derived from a territory outside Hong Kong – shall be deemed to be Hong Kong-sourced and chargeable to profits tax if the following applies:

1. The income is received in Hong Kong by a constituent entity belonging to a multinational enterprise group regardless of its revenue or asset size; and
2. The entity receiving the income fails to meet the economic substance requirement* in respect of non-IP income or fails to comply with the nexus approach** in respect of IP income.

Disposal gains are defined as any gain or profit derived from the sale of equity interest (other than partnership interests) in an entity.

Interest, dividends and disposal gains derived by regulated financial entities, such as banks and SFC-licensed entities, fall outside the purview of the Amendment Ordinance.

IP income is defined as income derived from intellectual property in respect of the exhibition or use of, or a right to exhibit or use (regardless of whether in or outside Hong Kong) the property.

Income that is deemed to be excluded from the scope of the Amendment Ordinance includes:

• Foreign-sourced interest, dividends and disposal gains  derived from or incidental to the activities of an entity as a regulated financial body;
• Foreign-sourced interest, dividends and disposal gains derived from or incidental to the activities that generate profits subject to a preferential tax regime, such as for qualified insurers, ship lessors, aircraft lessors and corporate treasury centres;
• Foreign-sourced interest, dividends and disposal gains accrued to an entity that has exempt sums under the preferential tax regime for ship-owners carrying on business in Hong Kong.

The constituent entity would firstly have to establish whether the offshore passive income received falls within the scope of the reformed regime and, secondly, determine whether the income is received in Hong Kong based on the following definition:

• The sum is remitted to, or is transmitted or brought into, Hong Kong;
• The sum is used to settle any debt incurred in respect of a trade, profession or business carried on in Hong Kong; or
• The sum is used to purchase movable property, which is brought into Hong Kong.

Unless it meets the economic substance requirement for non-IP income*, the nexus approach for IP income**, or the participation exemption for dividends and disposal gains*** applies, the income shall be taxable.

*Economic substance requirement for non-IP income

There are two components to the requirement:

1. Substantial economic activities
   For a pure equity holding entity – that is, an entity that only holds equity interests in other entities and merely derives dividends, disposal gains and income incidental to the acquisition, holding or sale of such equity interests – a modified substantial activities test will be applied. The entity will only be required to hold and manage its equity participation and comply with the corporate law filing requirements in Hong Kong to fulfil the substantial activities part of the requirement.

   For a non-pure equity entity, substantial economic activities shall include making strategic decisions, as well as managing and assuming principal risks in relation to assets it acquires, holds or disposes of.

   Outsourcing the relevant activities is allowed as long as the entity can show that it can properly oversee the outsourced activities and that the activities are undertaken in Hong Kong.

2. Economic substance
   To determine whether the activities carried out are of economic substance, an adequacy test will be applied, which is based on whether the enterprise employs a sufficient number of qualified employees and incurs a sufficient amount of operating expenditures in Hong Kong with reference to the activities in question.

   The IRD will take a holistic approach to assessing whether the enterprise has passed the adequacy test by taking all relevant facts in their entirety into consideration on a case-by-case basis, including the nature of business, scale of operation, profitability, details of employees, the amount and types of operating expenditures, etc.

**Nexus approach for IP income

Adopted by the OECD under Action 5 of the BEPS package of measures introduced in 2015, the nexus approach will be used to determine the extent to which offshore IP income is to be tax-free under the reformed FSIE regime.

The nexus approach dictates the following:

1. Only income from qualifying IP assets can be exempted, which cover only patents and other related IP assets that are equivalent to patents in terms of function. Marketing-related IP assets, i.e., trademarks and copyrights, are excluded.
2. The extent to which offshore IP income is to be exempted is established using a nexus ratio, which refers to the qualifying expenditures as a proportion of the overall expenditures that have been incurred by the entity to develop the IP asset. The aim is to ensure that there is a sufficient nexus between the income subject to preferential tax treatment and the expenditures incurred in generating that income.

   Qualifying expenditures cover only research and development (“R&D”) expenditures that are directly linked to the IP asset and, as such, do not cover acquisition, management and commercialisation costs of the IP asset. An uplift of 30% on the qualifying expenditures may, however, be permitted, depending on the extent to which the entity has incurred non-qualifying expenditures.

   Qualifying expenditures cover expenditures on R&D activities detailed in the following points:

• Those that are carried out by the entity in or outside Hong Kong;
• Those that are outsourced to unrelated parties and carried out inside or outside Hong Kong; or
• Those that are outsourced to resident related parties and carried out in Hong Kong.

***Participation exemption for dividends and disposal gains

Dividends and disposal gains will continue to be tax-exempt if all the following conditions are satisfied:

• The investor company is a person who is either a non-Hong Kong resident person that has a permanent establishment in Hong Kong or a Hong Kong resident person – that is, a resident for tax purposes in Hong Kong. In the case of a company, this means a company incorporated in Hong Kong or, if incorporated outside Hong Kong, a company normally managed or controlled in Hong Kong;
• The income is a dividend or disposal gain in the case of the entity being a Hong Kong resident person, or the income is a dividend or disposal gain attributable to the entity’s permanent establishment in Hong Kong in the case of the entity being a non-Hong Kong resident person; and
• The investor company holds not less than 5% of equity interests in the investee company for a period of not less than 12 months immediately before the specified foreign-sourced income accrues to the multinational enterprise entity.

To safeguard against fraudulent practices and to align with the EU’s position on participation exemption regimes, the participation exemption as outlined above is subject to the following anti-abuse rules:

1. Switch-over rule
   If the income or the profits of the investee company are subject to tax in a foreign jurisdiction where the headline tax rate is below 15%, the tax relief will switch over from participation exemption to foreign tax credit. This means that the investor must pay profits tax on the income in Hong Kong but with a deduction, having regard to the foreign tax paid on that income.
2. Main purpose rule
   The main purpose or one of the main purposes of any arrangements shall not be to obtain a tax benefit. Any arrangement lacking a solid commercial basis will be deemed not genuine.
3. Anti-hybrid mismatch rule
   The participation exemption shall not apply if the dividend payment is deductible by the investee company.

Unilateral tax credit

It has been highlighted in the policy document that the objective of the reformed FSIE regime is not to generate fiscal revenue; therefore, unilateral tax credit will be available to taxpayers who have paid tax on offshore passive income – deemed chargeable to profits tax under the reformed regime – in a foreign jurisdiction that currently has no income tax treaty with Hong Kong.

Record-keeping

An entity subject to the reformed FSIE regime shall preserve relevant records of transactions, acts or operations at least for seven years after the completion of those transactions, acts or operations, or at least for seven years after the receipt or deemed receipt of the income in Hong Kong.

Timeline and implementation

The Amendment Bill was introduced into the Legislative Council on 28 October 2022, and the Amendment Ordinance was brought into effect on 1 January 2023 so as to comply with the deadline imposed by the EU. As an interim measure, an arrangement allowing taxpayers to consult the Commissioner of Inland Revenue on whether they meet the economic substance requirement had been introduced prior to the Amendment Ordinance taking effect, which aimed to provide taxpayers with greater certainty.

For more information, visit the IRD’s website.

Updated on 4 January 2023

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