October 26 2022

Government to stengthen regime against cross-border tax avoidance

Source: Inland Revenue Department

The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Bill 2022 (the Bill) will be gazetted on October 28 and will be introduced into the Legislative Council (LegCo) on November 2.

Through the Bill, Hong Kong's tax regime will be refined and strengthened to better combat cross-border tax avoidance arising from double non-taxation. A package of measures will be correspondingly put in place to minimise the tax compliance burden for corporations, mitigate possible double taxation, enhance tax certainty and maintain Hong Kong's tax competitiveness.

The Bill creates a new Foreign-sourced Income Exemption (FSIE) regime that will allow 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 (MNE entities) provided that certain exemption conditions as described below are met.

The Bill upholds Hong Kong's territorial source principle of taxation to the effect that determination of the source of profits will not be affected by the new regime. Under the new regime, taxpayers can still be exempted from tax in respect of the specified foreign-sourced passive income received in Hong Kong if they have a substantial economic presence in Hong Kong.

"As an international financial centre, Hong Kong prides itself on being a responsible and co-operative player in international taxation. The Bill aligns with the international tax standard of requiring a corporate taxpayer benefitting from preferential tax treatment in a jurisdiction to have a substantial economic substance in that jurisdiction, and prevents shell companies from deriving tax benefits through double non-taxation," a Government spokesman said.

The European Union (EU) has placed Hong Kong on a watchlist since October 2021 on the grounds that the non-taxation of foreign-sourced passive income is not accompanied by adequate substance requirements and robust anti-abuse rules. The EU invited Hong Kong to make a commitment to amend its FSIE regime by December 31, 2022, and that the amended regime would take place with effect from January 1, 2023. To avoid Hong Kong being blacklisted by the EU as a non-co-operative jurisdiction for tax purposes, Hong Kong publicly committed in October 2021 to amending its tax law by the end of 2022 with a view to implementing the new FSIE regime in January 2023.

"The Bill was drawn up based on the legislative building blocks confirmed by the EU Code of Conduct Group (Business Taxation) (COCG) in June 2022. Due regard has been given to the EU's promulgated Guidance on Foreign Source Income Exemption Regimes and the parameters as communicated to us by the COCG," the spokesman added.

Extensive consultations with tax professionals, local and foreign chambers of commerce, trade and professional bodies and representatives of the financial services sector in respect of the legislative proposals have been held since mid-June 2022.

"Stakeholders generally recognised the need for undertaking the legislative amendment and welcomed the Government's proactive steps to minimise the compliance burden, provide tax certainty and maintain Hong Kong's competitiveness," the spokesman said.

The new FSIE regime will put in place an economic substance requirement to safeguard against possible exploitation of Hong Kong's tax arrangement by shell companies to achieve double non-taxation in respect of foreign-sourced passive income.

Only MNE entities carrying on a trade, professions or business in Hong Kong will be subject to the new FSIE regime. Individuals and local companies will not be affected.

Taxpayers benefitting from the existing preferential tax regimes will generally fall outside the scope of the new regime.  Foreign-sourced interest, dividend and disposal gains generated by regulated financial entities from the carrying on of their regulated businesses will not be chargeable to tax under the regime in the first place.

Under the new regime, an MNE entity wishing to claim a tax exemption relating to foreign-sourced interest, dividend and disposal gains will need to meet the economic substance requirement by employing an adequate number of qualified employees and incurring adequate operating expenditures in Hong Kong. An MNE entity that is a pure equity-holding company will be 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 promulgated by the Organisation for Economic Co-operation and Development in respect of preferential tax regimes for IP under which tax exemption will be substantially tied to the qualifying research and development (R&D) expenditures attributable to a qualified IP asset.

To mitigate possible double taxation, a range of enhancement and mitigation measures would be introduced:

  • ¬†A participation exemption regime (Note) as an alternative to the economic substance requirement to facilitate taxpayers who receive foreign-sourced dividends and disposal gains to claim tax exemption; and
  • Tax credits for taxpayers who have paid taxes outside Hong Kong in respect of the specified foreign-sourced income, including taxes paid in jurisdictions which have not entered into a tax treaty with Hong Kong.

In addition, to minimise the compliance burden and enhance tax certainty, a business-friendly four-pronged approach will be taken:

  • Simplified reporting procedures requiring only essential, high-level information and declarations in the tax return to demonstrate compliance with the economic substance requirement and hence minimise compliance burden;
  • Advance rulings by the Inland Revenue Department (IRD) on compliance with the economic substance requirement, valid for up to five years, to provide more tax certainty;
  • Administrative guidance with illustrative examples, which will be uploaded on the IRD website upon the gazettal of the Bill, to help ascertain tax liabilities, providing more tax transparency; and
  • A dedicated unit within the IRD to provide technical support to taxpayers and respond to enquiries, to assist with compliance.

To help prepare for the introduction of the new regime after the gazettal of the Bill, taxpayers affected by the new regime may apply for a "Commissioner's Opinion" in respect of their compliance with the economic substance requirement as a transitional measure upon gazettal of the Bill and refer to the specific guidance on the IRD website to better determine tax liabilities.

The FSIE regime would maintain Hong Kong's competitiveness. Features include:

  • Targeting only four types of foreign-sourced passive income whereas foreign-sourced active income will not be covered;
  • Covering MNE entities only, with stand-alone local companies and purely local groups falling outside the scope of the regime;
  • Exempting foreign-sourced income from tax if the economic substance requirement (applicable to foreign-sourced interest, dividend and disposal gains) or the nexus requirement (for IP income) are satisfied, without a need to consider if such income has been subject to tax elsewhere;
  • Allowing an additional pathway for MNE entities receiving foreign-sourced dividends and disposal gains to claim tax exemption and minimise their tax burden through the participation exemption regime; and
  • Allowing taxpayers to claim tax credits in respect of foreign tax paid on foreign-sourced dividend and the related underlying profits under a business-friendly "look-through" approach which will further reduce the possibility of double taxation and hence tax burden for in-scope taxpayers.

The Government will continue to look for ways to further enhance the competitiveness of Hong Kong's tax regime, including exploring a preferential tax regime for Hong Kong-sourced IP income to encourage more R&D activities in Hong Kong and appropriate measures to enhance tax certainty for onshore transactions in respect of disposal of shares or equity interests.

The spokesman said, "We will request the EU to remove Hong Kong from the watchlist once the Bill is passed by the LegCo."

The full text of the Bill will be available from the Government Gazette website on Friday (October 28).

Note: The conditions for participation exemption are that the taxpayer is a Hong Kong resident person (or a non-Hong Kong resident person that has a permanent establishment in Hong Kong) which holds at least 5 per cent 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.

Source: Inland Revenue Department