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Update on Hong Kong’s Foreign Source Income Exemption

Insight 27 July 2022

Update on Hong Kong’s Foreign Source Income Exemption

As a response to address the European Union’s concerns around double non-taxation in Hong Kong, the Hong Kong Government set out proposals in order to refine its Foreign Source Income Exemption (“FSIE”) framework. By way of background, the EU had placed Hong Kong on its October 2021 “watchlist” for jurisdictions which have “committed to amend or abolish their harmful foreign-source income exemption regimes”. The Government is set to draft the new tax framework in October 2022, with a target effective date of 1 January 2023.

The updated FSIE regime will apply to four types of passive income (“in-scope passive income”):

InterestIP Income
DividendsEquity disposal gains

Currently, under Hong Kong’s territorial source principle of taxation, income that is not sourced from Hong Kong is generally not subject to tax in Hong Kong.

Scope

Under the refined FSIE regime, offshore in-scope passive income will be deemed to be sourced from Hong Kong and chargeable to profits tax if:

  1. The income is received in Hong Kong by a constituent entity of an MNE[1] group (“covered taxpayer”) irrespective of its revenue or asset size; and
  2. The recipient entity fails to meet the economic substance requirement for in-scope, non IP, offshore income, or fails to comply with the nexus approach for IP income.

Economic substance requirements (non-IP income)

In-scope, non-IP, offshore passive income received in Hong Kong by a covered taxpayer will continue to be exempt from profits tax if the taxpayer conducts substantial economic activities (“relevant activities”) with regard to the relevant passive income in Hong Kong.

  • Taxpayer is not a 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;
  • Taxpayer is a pure equity holding company: a reduced substantial activities test can be applied such that the relevant activities will only:
    • include holding and managing its equity participation, and
    • comply with the corporate law filing requirements in Hong Kong; and
  • Outsourcing of the relevant activities: those 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 Government also specified that safeguards will be put in place to prevent the use of outsourcing for circumventing the economic substance requirement.

Additionally, taxpayer entities will be required to meet adequacy tests, as set below:

  • Employ an adequate number of qualified employees; and
  • Incur an adequate amount of operating expenditures in Hong Kong in relation to the relevant activities

The Government clarified that the Hong Kong Inland Revenue Department will consider a series of facts for each case (e.g. nature of business, scale of operations, profitability, expenditures and details of employees) when assessing economic substance requirements.

Participation exemption for dividends and disposals of gains

Should the economic substance test not be met, the Hong Kong Government will introduce a participation exemption for offshore dividends and disposal gains, which will result in them continuing to be tax-exempt if the below three conditions are met:

  1. The investor company is a Hong Kong resident person or a non-Hong Kong resident with a permanent establishment in Hong Kong;
  2. The investor company holds at least 5% of the shares/equity interest in the investee company;
  3. No more than 50% of the income derived by the investee company is in-scope passive income.

The participation exemption is designed to avoid possible double taxation and reduce compliance burdens, as well as to prevent the use of shell entities for resident entities with no nexus to Hong Kong. The Government has subjected the participation exemption to complying with anti-abuse rules:

  • Switch-over rule: if the income or the dividends of the investee company are to tax in a foreign jurisdiction where the headline tax rate is below 15%, the tax relief available to the investor company will switch from participation exemption to foreign tax credit.
  • Main purpose rule: arrangements setup with the main purpose of obtaining a tax advantage will be excluded from the participation exemption. Those arrangements will be seen as nongenuine as not in place for valid commercial reasons which reflect an economic reality.
  • Anti-hybrid mismatch rule: where the income is dividends, participation exemption will not apply to the extent that the dividend payment is deductible by the investee company.

Nexus approach for IP income

Under the nexus approach, which was adopted by the OECD as a minimum standard under Action 5 of the 2015 BEPS package, only income from a qualifying IP asset can benefit from a preferential tax treatment. This will be subject to 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.

The nexus approach will include the following features:

  1. Qualifying IP assets: cover patents and other IP assets functionally equivalent to patents if those IP assets are both legally protected and subject to similar approval and registration processes;
  2. Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset;
  3. A jurisdiction may permit taxpayers to apply a 30% uplift on the qualifying expenditures if the taxpayer has incurred non-qualifying expenditures; and
  4. The jurisdictional approach will be adopted for determining the scope of qualifying expenditures to ensure that the IP benefits are commensurate with the relevant domestic R&D activities.

As a consequence to the above, income from other IP assets such as marketing income (e.g. copyrights) will be excluded from the exemption, as will acquisition costs of IP assets in relation to qualifying expenditures.

[1] Multinational Enterprises, as defined under the GloBE Rules.

  • Hong Kong will continue to adhere to the territorial source principle of taxation;
  • Hong Kong’s simple, certain and low-tax regime will be upheld with a view to maintaining the competitiveness of Hong Kong’s business environment; and
  • Compliance burden of corporates will be minimised.

Sanne’s team of experts spans a global office network and has a proven track record in assisting clients and entities administered through new compliance requirements. Our service offering is orientated around the provision of a full suite of asset class specialist fund and corporate administration services, including expertise across listed and regulated fund structures, loan agency and capital market specialisms. Please reach out to Paul Sejournant, James Russell, Catherine Law and Robert Glasspool directly.

For additional information, or to discuss any of the topics highlighted above, please get in touch with Paul, James, Catherine and Robert directly.

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