Thanks to the relatively low tax rate, Hong Kong has long been one of the renowned locations for business registration. Specifically, the adoption of the territorial principle which could lead to offshore taxation allowed tax exemption for foreign-sourced profits, leading to situations where profits generated by a Hong Kong entity were not taxable in Hong Kong and were also not taxable in other jurisdictions.
However, as stated in our earlier article, Hong Kong was placed on the European Union (EU) list of non-cooperative countries and territories for tax purposes last year. This was mainly attributable to the offshore taxation regime. Regarding the concerns of the EU over this double non-taxation, the Hong Kong government recently released a consultation paper for a proposal to refine Hong Kong’s FSIE (foreign source income exemption) regime for passive income. It is expected that the new regime will take effect on 1 January 2023 and thus enable Hong Kong to be removed from the watchlist upon implementation.
“Only individual taxpayers, standalone local companies with no operations outside Hong Kong and a local group without overseas constituent entities will be exempt from this regime, as long as they meet the economic substance requirements.”
Affected income and affected taxpayers
Pursuant to the proposed FSIE regime, certain types of offshore passive income, namely interest, IP income, dividends and capital gains, will be covered. These four types of passive offshore income will be considered as derived from Hong Kong and thus subject to profits tax if:
“the income is received in Hong Kong by a constituent entity of a multinational enterprise (MNE) group (covered taxpayer) regardless of its revenue or asset size"; and
"the covered taxpayer fails to meet the economic substance requirement (for non-IP income) or fails to comply with the nexus approach (for IP income)” (Paragraph 10(a)-(b) Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Regime for Passive Income).
In other words, only individual taxpayers, standalone local companies with no operations outside Hong Kong in the form of a permanent establishment and local groups without overseas constituent entities will be exempt from this regime, as long as they meet the economic substance requirements.
However, taxation for other forms of income, deemed to be active income, such as trading profits or service income, will remain unchanged and the taxpayer can still apply for tax exemption of the profits gained from offshore activities.
“To meet the economic substance requirement, the taxpayer will need to employ an adequate number of qualified employees and incur an adequate number of operating expenditures in Hong Kong regarding the relevant activities.”
Economic substance requirement: offshore non-IP income
Offshore interest income, dividends and disposal gains which are received in Hong Kong by a taxpayer will remain exempted from profits tax, provided that the taxpayer undertakes substantial economic activities in relation to the relevant passive income ("relevant activities") in Hong Kong.
Non-pure equity holding company: For a non-pure equity holding company, such activities will include making necessary strategic decisions, managing and assuming principal risks in Hong Kong.
Pure equity holding company: For a pure equity holding company, the scope of relevant activities can be reduced to holding and managing its equity participation and complying with the corporate law filing requirements in Hong Kong.
Outsourcing of the economic activities will be permitted given that the taxpayer manages to demonstrate adequate monitoring of the outsourced activities conducted in Hong Kong (Paragraph 12 (a)-(c), Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Regime for Passive Income).
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 number of operating expenditures in Hong Kong regarding the relevant activities (Paragraph 14, Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Regime for Passive Income).
Participation exemption: offshore dividends and disposal gains
Irrespective of whether the above-mentioned economic substance requirement is met, a participation exemption will be applicable to offshore dividends and capital gains, whereby the relevant income will continue to be tax-exempt, if the following requirements are fulfilled:
the investor company is a Hong Kong-resident person or a non-Hong Kong resident person that has a permanent establishment 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 (Paragraph 18 (a)- (c), Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Regime for Passive Income).
Yet, the application of participation exemption is restricted by several anti-abuse rules.
“The nexus approach will apply in identifying the extent of offshore IP income to be excluded from the exemption rules under the proposed FSIE regime.”
Nexus Approach: Offshore IP Income
With respect to offshore IP income, the nexus approach, which was adopted by the OECD (Organisation for Economic Co-operation and Development), will be applied to identify the extent of such income to be excluded from the exemption rules under the proposed FSIE regime. The nexus approach aims to establish a direct nexus between the income receiving benefits and the expenses contributing to that income. The major features of the approach are as follows:
Qualifying IP assets only cover patents and other IP assets which are functionally equivalent to patents, for example, copyrighted software.
Marketing-related IP assets, such as trademark and copyright are excluded from preferential tax treatment.
Only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures as a proportion of the overall expenditures that have been incurred by the taxpayer to develop the IP asset.
Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset and exclude acquisition costs.
Qualifying expenditures on relevant domestic R&D activities cover: (i) activities undertaken by the taxpayer in Hong Kong, (ii) activities outsourced to unrelated parties to take place in or outside Hong Kong, or (iii) activities outsourced to resident related parties to take place in Hong Kong.
A 30% uplift on the qualifying expenditures subject to the extent that the taxpayer has incurred non-qualifying expenditures may be permitted (Paragraph 17, Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Regime for Passive Income).
A covered taxpayer who has received in-scope offshore passive income that is deemed to be sourced from Hong Kong under the proposed refined FSIE regime will need to report the income in its profits tax return for the tax year in which the income is received and provide certain information in connection with the income (Paragraph 27, Legislative Council Panel on Financial Affairs Refinements to Hong Kong’s FSIE Exemption Regime for Passive Income).
FSIE Regime Primarily Affects Shell Companies
The proposed refinements to the FSIE regime primarily affect shell companies and entities that have been claiming offshore profits regarding their foreign-sourced passive income. The entities should be alert to the implications of the new FSIE regime and make essential changes to their business structure in order to retain tax efficiency.
The Hong Kong government pledged to uphold Hong Kong’s territorial source principle of taxation and safeguard the simple and low-tax regime. Notwithstanding the proposed adoption of the nexus approach, the tax haven and international finance centre could hardly be threatened, provided that the nexus approach is an international standard widely adopted in comparable jurisdictions. Yet, clearer instructions on the compliance with the economic substance requirement and detailed elaboration of the application of the nexus approach and participation exemption is vital to all parties concerned.
Our team at Ravenscroft & Schmierer will offer further updates regarding the forthcoming tax reform once the amendment bill is introduced to the Legislative Council.
Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.
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