To address the EU's concerns over double non-taxation of certain foreign sourced passive income under Hong Kong's territorial tax system, the government has recently proposed refinements to its foreign source income exemption (FSIE) regime for passive income.
No change will be made to the FSIE regime with regard to active income. According to a consultation paper issued by the Financial Services and the Treasury Bureau, the "territorial source principle of taxation will continue to apply in general. As the primary goal is to tackle cross-border tax evasion, only taxpayers who fail to meet the economic substance requirement with regard to offshore passive non-IP income or fail to comply with the nexus approach for offshore passive IP income will no longer enjoy tax exemption."
The most important changes are summarized below.
Covered taxpayers and covered income
The proposed refinements to the FSIE regime will only affect MNE groups. As stated in the government's October 2021 announcement, the refined FSIE regime will not increase the tax burden of financial institutions since their offshore interest income is already subject to profits tax at present.
Offshore passive income consisting of interest, IP income, dividends or disposal gains ("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 constituent entity of an MNE group ("covered taxpayer") irrespective of its revenue or asset size; and
- the recipient entity fails to meet the economic substance requirement (if the income is non-IP income), or fails to comply with the nexus approach (if the income is IP income).
The definition of an MNE group and other related terms will be the same as under the Global Anti-Base Erosion (GloBE) rules.
Economic substance requirement for non-IP income
In-scope offshore non-IP income will continue to be exempt from profits tax if the taxpayer conducts substantial economic activities in Hong Kong with regard to the relevant passive income ("relevant activities"). To meet the economic substance requirement, the taxpayer will need to meet the adequacy test in terms of employing an adequate number of qualified employees and incurring an adequate amount of operating expenditure in Hong Kong in relation to the relevant activities.
The paper sets out the following details:
- for a taxpayer that is not a pure equity holding company, relevant activities include making necessary strategic decisions, and managing and assuming principal risks in respect of any assets it acquires, holds or disposes of;
- for a taxpayer that is a pure equity holding company, a lower test applies under which relevant activities will only include holding and managing its equity participation, and complying with the corporate law filing requirements in Hong Kong; and
- outsourcing of the relevant activities will be permitted provided that the taxpayer is able to demonstrate adequate monitoring of the outsourced activities and that the relevant activities are conducted in Hong Kong.
The economic substance requirement and the source of profits will be considered separately.
Nexus approach for IP income
Under the nexus approach, only income from a qualifying IP asset (i.e. patents and other IP assets which are functionally equivalent to patents) can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures (i.e. R&D expenditures that are directly connected to the IP asset) as a proportion of the overall expenditures that have been incurred by the taxpayer to develop the IP asset.
Participation exemption for dividends and disposal gains
Participation exemption for offshore dividends and disposal gains will be available if the following conditions are satisfied:
- 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 passive income.
The participation exemption will also be subject to anti-abuse rules, including the switch-over rule, main purpose rule and anti-hybrid mismatch rule.
Introduction of unilateral tax credit
In respect of in-scope offshore passive income that is subject to tax in both Hong Kong and a jurisdiction which has not concluded a double tax agreement with Hong Kong, a unilateral tax credit will be available as double taxation relief.
The consultation ends on 15 July 2022. The government plans to introduce an amendment bill into the Legislative Council in October 2022. If approved, the refined regime will take effect on 1 January 2023 with no grandfathering arrangement. Administrative guidance will be issued to provide detailed rules.