Hong Kong: Changes on Foreign Source Income Exemption Regime

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published on 26 October 2022 | reading time approx. 5 minutes

 

Over the decades, the preferential tax regime of Hong Kong along with its well-developed financing platform has made it popular as the Holding Hub for many multinational groups. However, the European Union has concern over potential double non-taxation arising from tax exemption for offshore passive income in Hong Kong. Hong Kong government has recently released a consultation page to refine foreign source income exemption ("FSIE") regime for passive income in Hong Kong. The proposal is expected to become effective on 1 January 2023 with no grandfathering arrangement.

 

   


Prevailing Regulation regarding Taxation of Foreign Income in Hong Kong

According to the existing territorial source principle of taxation, only income sourced from Hong Kong is subject to profits tax in Hong Kong, and offshore passive income such as dividends, disposal gains in relation to shares or equity interest, interest income, income from intellectual properties ("IP") is exempted from profits tax.

   

Planed Changes on Offshore Passive Income

Under the proposed FSIE regime, 4 types of offshore passive income including dividends, disposal gains in relation to shares or equity interest, interest income and income from IP (collectively known as "in-scope offshore passive income") would be deemed sourced from Hong Kong and subject to profits tax under certain circumstances:

  • The income is received in Hong Kong by a constituent entity of an multinational enterprise group ("covered taxpayer") irrespective of its size of income or assets. A constituent entity means an entity with financial results consolidated on a line-by-line basis in the group's consolidated financial statements.
  • The covered taxpayer fails to meet the economic substance requirement (for non-IP income), the nexus approach requirement (for IP income) or the participation exemption (for dividends and equity disposal gain).
  • Offshore equity disposal gains that are deemed taxable would not be excluded from assessable profits even if they are capital in nature.
  • The passive income should be "received in Hong Kong". However, what constitutes passive income "received in Hong Kong" requires further definition. It is expected that the approach similar to Singapore, i.e. on remittance basis, might be adopted.
    

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:

  

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.

   

Pure equity holding company:

  • Primary function is acquiring and holding shares or equitable interests in companies and only earns dividends and disposal gains in relation to shares and equity interests.
  • A reduced substantial activities test would be applied.
  • Relevant activities would only include holding and managing its equity participation, and complying with the corporate law filing requirements in Hong Kong.

    

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.

    

Furthermore, similar to the German regulations, in order to meet the economic substance requirements, it is required that the taxpayer employs a reasonable number of qualified employees and also expends a reasonable amount of operating expenses in connection with the relevant activities.

   

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 all the following conditions:

  • The holding company is resident in Hong Kong or constitutes a permanent establishment in Hong Kong;
  • The holding company holds at least 5% of the equity interest in the investee company; and
  • No more than 50% of the income derived by the subsidiary is passive income.

   

Anti-abuse Rules Applicable to Participation Exemption

  • If the passive income or the underlying profit of the subsidiary (for dividends) is subject to tax in a foreign jurisdiction of which the headline tax rate is below 15%, the tax relief available to the holding company would switch over from the participation exemption to a foreign tax credit. The foreign tax credit would be limited to the amount of Hong Kong profits tax attributable to the passive income concerned (Switch-over rule).

 

  • If the dividend payment is deductible as operating expense for tax purposes in a foreign country, no tax exemption will be granted in Hong Kong (Anti-hybrid mismatch rule).

 

  • If the exemption is secured through an arrangement set up for the main purpose or a dominant purpose of obtaining a tax advantage that defeats the object or purpose of the exemption, anti-avoidance rules might apply (Main purpose rule).

    

Nexus Approach Requirement for IP Income

  • For income derived from the qualifying IP assets, there must be a direct nexus between the beneficiary income and the expenses contributing to that income.
  • 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%.

   

Unilateral Tax Credit

A unilateral tax credit would 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 tax arrangement with Hong Kong.

 

Overview of the Proposed Refined FSIE Regime


Recommendation

Many German Groups use intermediate holding companies in Hong Kong to hold Chinese subsidiaries or other Asian subsidiaries. The new FSIE regime should lead to a higher tax acceptance of Hong Kong intermediate holding companies for German tax authorities. The decisive factor will be how much economic substances can actually be built up in Hong Kong and to what extent Hong Kong's requirements are in line with German regulations.

 

However, based on the proposal, it is likely that the new FSIE regime would affect the taxability of interest income received from overseas related companies by a Hong Kong intermediate holding company if the company cannot fulfill the economic substance requirements. Furthermore, the new regime will also influence the license income received from IP other than patents as such income would be deemed sourced from Hong Kong no matter whether or not the company has economic substance in Hong Kong. On the other hand, most intermediate holding companies in Hong Kong (even if they fail to meet the economic substance requirements in Hong Kong) would rely on the participation exemption rules to claim exemption on dividend income received from subsidiaries and gains on disposal of subsidiaries' equity.

 

It is expected that once the legislation process is completed, administrative guidelines will be issued by the Hong Kong Inland Revenue Department to clarify the application requirements of economic substance and nexus approach, the rules governing the participation exemption and unilateral tax credit, and the meaning of "received in Hong Kong".

 

We suggest clients having intermediate holding companies in Hong Kong to pay attention to the requirements of the proposal, and review the potential consequences at local level along with the implementation of the new scheme in Hong Kong. For instance, China has introduced "beneficiary ownership" for dividend distribution since years. Dividend distribution to Hong Kong holding company without furnishing sufficient business substances would not be entitled to treaty benefit. In addition, non-resident company's indirect share transfer in China has been always the anti-tax avoidance focus from Chinese tax authorities these years. The new scheme in Hong Kong is expected to lead impacts in these areas for the Hong Kong held Chinese subsidiaries in the future.

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