The Hong Kong government is currently seeking consultation on its proposal to refine Hong Kong’s foreign source income exemption (“FSIE”) regime.
Since 2017, the European Union (“EU”) has been monitoring its member states and other jurisdictions to refrain them from introducing any harmful tax measures. Under the EU guideline, a tax system that fully excludes passive income with a foreign link from taxation, without any conditions, is harmful.
In October 2021, the EU included Hong Kong on the watchlist of non-cooperative jurisdictions for tax purposes. The EU is of the view that the FSIE regime in Hong Kong may result in double non-taxation for offshore passive income as it does not require any conditions on the recipient entities or requirement of substantial economic presence in Hong Kong.
If Hong Kong does not address the concern of the EU timely, it will be blacklisted by the EU for tax purposes. Hong Kong-based entities may face defensive measures by the EU member states in the tax area.
In order for EU to remove Hong Kong from the watchlist, the Hong Kong government has conducted a few rounds of discussion with the EU and committed to amending the FSIE regime by 31 December 2022.
Who and what would be affected?
Only covered taxpayers who receive covered income and fail to meet the economic substance requirement or comply with the nexus approach would be affected.
What is Covered Income?
The following four types of offshore passive income are identified as “in-scope offshore passive income”:
- interest
- dividends
- disposal gains in relation to shares or equity interest (“disposal gains”)
- income from intellectual properties (“IP income”)
Who are Covered Taxpayers?
A constituent entity (“CE”) of a multinational enterprise (“MNE”) group, irrespective of its revenue or asset size, would be a covered taxpayer.
In defining CE and MNE group, the Hong Kong government will use the same definitions of “MNE group” and other related terms as in the context of the Global Anti-Base Erosion (“GloBE”) Rules promulgated by the Organisation for Economic Co-operation and Development. Under GloBE Rules:
- MNE group is defined as a group that has at least one entity or permanent establishment (PE) that is not located in the jurisdiction of the ultimate parent entity. “Group” generally refers to a collection of entities that are included in the consolidated financial statements of the ultimate parent entity; or are excluded from the consolidated financial statements of the ultimate parent entity solely by means of size, materiality or the entity is held for sale.
- CE is defined as an entity that is included in an MNE group or a PE of a main entity that is included in an MNE group.
What are the changes?
Under the proposed refinements, in-scope offshore passive income will be deemed to be sourced from Hong Kong and subject to profits tax if:
- The income is received in Hong Kong by a CE of an MNE group; and
- The recipient entity fails to meet the economic substance requirement for non-IP income, or fails to comply with the nexus approach for IP income.
Economic substance requirement (non-IP income)
For in-scope offshore passive income that is not IP income received by a covered taxpayer, such income will continue to be exempt from profits tax if the taxpayer conducts substantial economic activities in Hong Kong in relation to the relevant passive income (“relevant activities”).
The requirement on economic substance is slightly different between a non-pure equity holding company and a pure equity holding company.
For a non-pure equity holding company, the relevant activities will include making necessary strategic decision and managing and assuming principal risks in respect of any assets it acquires, holds or disposes of.
For a pure equity holding company, it is subject to a reduced substantial activities test where the relevant activities will only include holding and managing its equity participation, and complying with the corporate law filing requirements in Hong Kong.
In general, in relation to the relevant activities, a taxpayer should meet the adequacy test in terms of:
- Employing an adequate number of qualified employees in Hong Kong; and
- Incurring an adequate amount of operating expenditures in Hong Kong
It should be noted that outsourcing of the relevant activities will be allowed if a taxpayer can demonstrate adequate monitoring of the outsourced activities and that the relevant activities are performed in Hong Kong.
Participation Exemption (dividends and disposal gains)
Despite the requirement on economic substance on non-IP income, offshore dividends and disposal gains received by covered taxpayers will continue to be tax exempt under participation exemption if the following 3 criteria are met:
- The investor company is a Hong Kong resident person or a non-Hong Kong resident person that has a PE in Hong Kong;
- The investor company holds at least 5% of the shares or equity interest in the investee company; and
- No more than 50% of the income derived by the investee company is in-scope offshore passive income
With reference to participation exemption regimes in other relevant jurisdictions and to address to EU’s anti-abuse rules, the proposed participation exemption will further be subject to the following rules:
Switch-over rule – if income concerned or profits of the investee company is/are subject to tax in a foreign jurisdiction at headline tax rate below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit.
Main purpose rule – if the investor company has put in place any arrangement for the main purpose or one of the main purposes of obtaining a tax advantage that defeats the purpose of the exemption, such arrangement will be ignored.
Anti-hybrid mismatch rule – if the income concerned is dividends, participation exemption will not apply if the dividend payment is deductible by the investee company.
Nexus Approach (IP income)
For in-scope offshore passive IP income, the nexus approach will be used to determine if such income can be exempt.
Under the nexus approach, only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio defined as the qualifying expenditures as a proportion of the overall expenditures that have been incurred by a taxpayer to develop the IP asset.
Qualifying IP assets cover patents and other IP assets which are functionally equivalent to patents (e.g. copyrighted software) only. Marketing related IP assets such as trademark and copyright are excluded from preferential tax treatment.
Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset. Acquisition costs of the IP assets are not considered as qualifying expenditures and therefore excluded from the preferential tax treatment. It should be noted that an uplift of 30% on the qualifying expenditures may apply subject to the extent that the taxpayer has incurred non-qualifying expenditures.
To ensure the IP benefits are commensurate with the relevant domestic R&D activities, a jurisdictional approach will be used to determine the scope of qualifying expenditures. Under the jurisdictional approach, qualifying expenditures cover expenditures on R&D activities that are:
(a) undertaken by the taxpayer in Hong Kong;
(b) outsourced to unrelated parties to take place in or outside Hong Kong; and
(c) outsourced to resident related parties and take place in Hong Kong.
Double taxation relief
It is expected that under the proposed changes, some in-scope offshore passive income could be subject to tax in Hong Kong and a foreign jurisdiction that has no double tax agreement with Hong Kong. In order to avoid double taxation, a unilateral tax credit will be introduced to cover only in-scope offshore passive income chargeable to profits tax in Hong Kong under the proposed deeming provisions.
What would remain unchanged under the FSIE regime?
No change will be made to the FSIE regime with regard to active income.
The proposed refinements will not affect non-MNE groups. In other words, offshore income generated by non-MNE groups will continue to be exempt from tax in Hong Kong.
Future Requirement
Under the refined FSIE regime, a covered taxpayer who receives in-scope offshore passive income that is deemed to be sourced from Hong Kong needs to report the income in its profits tax return for the year of assessment in which the income is received. The taxpayer is also required to provide the Inland Revenue Department (“IRD”) on the general information (such as the type of passive income, where and how the income has been received) relating to the in-scope offshore passive income and further details to facilitate the IRD to determine whether the income can be tax exempt.
The Timeline
The Hong Kong government is currently seeking consultation from the public on the proposed refinements. It plans to introduce an amendment bill into the Legislative Council in October 2022 and expects to pass the bill by the end of 2022. The refined FSIE scheme is expected to come into force on 1 January 2023 with no grandfathering arrangement.
The Impact
While the Hong Kong government emphasises the territorial source principle of taxation will continue to apply in general and proposed refinements to the FSIE regime will only affect MNE groups, the proposed refinements do introduce new hurdles for offshore passive income to continue to be tax exempt in Hong Kong. MNE groups with Hong Kong investment holding vehicles can no longer take for granted that offshore disposal gains that are capital in nature and dividends can be exempt from profits tax.
As the Hong Kong government is determined to refine the FSIE regime in order to remove Hong Kong from EU’s watchlist, MNE groups should immediately take action to review if they have covered taxpayers in Hong Kong that receive in-scope offshore passive income. If they do, depending on the type of offshore passive income received, they should plan ahead to ensure they will meet the economic substance requirement test or comply with the nexus approach.