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Hong Kong introduced an updated regime for foreign source income exemption (FSIE)

June 9, 2023

To align with global initiatives against tax evasion and ensure fair taxation, Hong Kong has revised its Foreign Source Income Exemption (FSIE) regime for passive income. The amendments were made in accordance with the European Union's (EU) Guidance on FSIE regimes, following Hong Kong's inclusion in the EU's watchlist of jurisdictions with potentially harmful tax practices in 2021.

The changes were implemented through the Inland Revenue (Taxation on Specified Foreign-sourced Income) Ordinance 2022, which came into effect on January 1, 2023. Under the new FSIE regime, certain passive income earned by multinational group entities operating in Hong Kong will be treated as derived from Hong Kong and subject to profits tax upon receipt in the territory.

The amendment also introduces provisions for relieving double taxation on specific foreign-sourced income and addresses transitional matters. These adjustments adhere to international tax standards, which require taxpayers benefiting from preferential tax treatment to have a substantial economic presence and establish a clear connection between income and actual business activities within the jurisdiction.

Many countries and regions have implemented various legislative measures to avoid being labelled as a tax haven and to prevent potential countermeasures. For instance, the British Virgin Islands and the Cayman Islands introduced economic substance requirements in 2019.

In line with these global trends, Hong Kong took steps to enhance its tax regime and address concerns raised by the EU, which designated the city as a non-cooperative jurisdiction for tax purposes and identified its tax regime as harmful and non-compliant with international standards.

In response to its pledge to the European Union (EU), Hong Kong has undergone amendments to its foreign-sourced income exemption regime, effective December 2022. The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022 was approved by the Hong Kong government last year, introducing the Foreign Source Income Exemption (FSIE) regime under the Inland Revenue Ordinance (IRO).

Previously, Hong Kong's profits tax was only applicable when an individual or entity engaged in trade, profession, or business within the region, and the profits were derived from or arose in Hong Kong. It resulted in multinational companies with offshore passive income, lacking substantial economic presence in Hong Kong, being exempt from profits tax. Consequently, some of these companies benefited from "double non-taxation," evading taxes in Hong Kong and the jurisdiction where the profits were generated.

The newly implemented FSIE regime ensures that multinational entities (MNEs) can no longer exploit double non-taxation for specified foreign-sourced income. However, individuals and local companies not affiliated with a multinational group remain exempt from the FSIE regime. This distinction recognizes that MNEs have greater flexibility to exploit differences in tax systems and relocate their operations to low-tax jurisdictions, enabling tax avoidance. Conversely, individuals and local companies face more limitations in doing so.

Section 15I of the IRO mandates profits tax on specified foreign-sourced income received in Hong Kong by an MNE entity, irrespective of its revenue or asset size, unless the recipient meets one of three exceptions: the economic substance requirement, the nexus requirement, or the participation requirement. Specified foreign-sourced income includes interest, dividends, disposal gains, and intellectual property (IP) income. It's important to note that the new FSIE regime does not currently cover foreign-sourced incomes that do not fall within the definition of specified foreign-sourced income.

An MNE entity must meet the economic substance requirement to qualify for the exemption from profits tax on foreign-sourced interest, dividends, and disposal gains received in Hong Kong. The specific criteria depend on whether the MNE entity is a pure equity-holding entity, which solely holds equity interests in other entities and earns dividends, disposal gains, and related income.

For non-pure equity-holding entities, additional obligations apply. They must employ an adequate number of employees in Hong Kong to engage in specified economic activities, such as making strategic decisions and managing principal risks related to acquired, held, or disposed assets. Non-pure equity-holding entities must demonstrate a higher substantial economic presence than pure equity-holding entities. Adequacy tests apply to both types of entities.

Under the economic substance requirements, an MNE entity can outsource some or all of its specified economic activities to third parties or group entities. However, it must demonstrate sufficient monitoring and control over the outsourced activities and fulfil other outsourcing-related requirements.

Alternatively, the participation requirement can be fulfilled to claim tax exemption. This requirement applies if the MNE entity is a tax resident of Hong Kong or, in the case of non-Hong Kong tax residency, maintains a permanent establishment in the jurisdiction to which the foreign-sourced dividends or disposal gains can be attributed.

Furthermore, the participation requirement is met when the MNE entity holds a continuous equity interest of at least 5% in the relevant investee entity for a minimum period of 12 months preceding the accrual of the foreign-sourced dividend or disposal gain. Consequently, if an MNE entity acts as a parent or intermediate holding company for over 12 months, it can fulfil the participation requirement by being a tax resident of Hong Kong or possessing a permanent establishment within the jurisdiction.

However, to prevent abuse, specific anti-abuse rules are in place that restrict the application of participation exemptions. These rules include the "subject to tax" condition, anti-hybrid mismatch rule, and main purpose rule.

The nexus requirement exclusively pertains to foreign-sourced income derived from intellectual property (IP) and determines the extent of such income eligible for profits tax exemption. The nexus requirement establishes that only revenue generated from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio. The nexus ratio represents the proportion of overall expenditures incurred by a taxpayer in developing an IP asset.

The Hong Kong government has expressed its commitment to refining the FSIE regime, ensuring that foreign-sourced capital gains related to both financial and non-financial assets received by MNE entities in Hong Kong will be exempt from tax, provided they comply with the economic substance requirement.

It is advised that multinational companies reassess their tax compliance strategies in light of the FSIE regime, as Hong Kong upholds the territorial source principle of taxation.

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