Hong Kong committed to amend its Foreign-sourced Income Exemption (FSIE) regime by 31 December 2022 after the European Union deemed that the non-taxation of foreign-sourced passive income was not accompanied by adequate substance requirements or anti-abuse rules.
In particular, the EU considered that corporations without substantial economic activity in Hong Kong and that were not subject to Hong Kong tax in respect of certain foreign sourced passive income – such as interest and royalties – could lead to situations of ‘double non-taxation’.
The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022 was based on the legislative building blocks confirmed by the EU Code of Conduct Group (Business Taxation). Due regard was given to the EU’s promulgated Guidance on Foreign Source Income Exemption Regimes and its parameters.
The new FSIE regime upholds Hong Kong’s territorial source principle of taxation such that determination of the source of profits will not be affected. Under the regime, taxpayers can still be exempted from tax in respect of the specified foreign-sourced passive income received in Hong Kong, provided they have a substantial economic presence in Hong Kong.
Taxpayers that benefitted from the previous preferential tax regimes generally fall outside the scope of the new FSIE regime. It allows tax exemptions for specified foreign-sourced passive income – namely interest, dividends, disposal gains in relation to shares or equity interests (disposal gains) and intellectual property (IP) income – received in Hong Kong by relevant multinational enterprise entities (MNEs) subject to certain conditions.
Only MNEs carrying on a trade, professions or business in Hong Kong are subject to the new FSIE regime. Individuals and local companies are not affected. Foreign-sourced interest, dividend and disposal gains generated by regulated financial entities from the carrying on of their regulated businesses are also not chargeable to tax under the regime.
An MNE wishing to claim a tax exemption is required to meet the economic substance requirement by employing an adequate number of qualified employees and incurring adequate operating expenditures in Hong Kong.
An MNE that is a pure equity-holding company is subject to a reduced economic substance requirement involving only the holding and managing of equity participations and complying with the corporate law filing requirements in Hong Kong.
For foreign-sourced IP income, taxpayers need to comply with the nexus requirement set out by the OECD in respect of preferential tax regimes for IP under which tax exemption must be substantially tied to the qualifying research and development (R&D) expenditures that are attributable to a qualified IP asset.
To mitigate possible double taxation, a range of enhancement and mitigation measures were introduced:
- A participation exemption regime as an alternative to the economic substance requirement to enable taxpayers that receive foreign-sourced dividends and disposal gains to claim tax exemption. The taxpayer must be a Hong Kong resident person (or a non-Hong Kong resident person that has a permanent establishment in Hong Kong) that holds at least 5% of the investee company’s shares or equity interest for at least 12 months immediately prior to the accrual of the relevant dividends or disposal gains.
- Tax credits for taxpayers who have paid taxes outside Hong Kong in respect of the specified foreign-sourced income, including taxes paid in jurisdictions that have not entered into a tax treaty with Hong Kong.
To minimise the compliance burden and enhance tax certainty, a business-friendly four-pronged approach is taken:
- Simplified reporting procedures requiring only essential, high-level information and declarations in the tax return to demonstrate compliance with the economic substance requirement.
- Advance rulings by the HKIRD on compliance with the economic substance requirement, valid for up to five years, to provide more tax certainty.
- Administrative guidance with illustrative examples is available on the HKIRD website to help ascertain tax liabilities and provide more tax transparency.
- A dedicated unit within the HKIRD provides technical support to taxpayers and respond to enquiries.
Appointing Sovereign as your Tax Representative in Hong Kong will ensure compliance with all relevant requirements and minimise your costs. Our Tax Compliance services include:
- Identifying the best approach to satisfy the IRD and acting as the Tax Representative of the company in all dealings with the IRD
- Preparing the relevant tax returns together with the supporting tax computations (if applicable) for the company’s review and approval
- Claiming tax exemptions (no tax is levied on profits arising abroad)
- Preparation / submission the tax returns, tax computations and audited financial accounts to the IRD and obtaining the IRD tax assessment.
- Responding general IRD tax queries