The Hong Kong tax authorities have decided to strengthen current legislation to better combat cross-border tax avoidance arising from double non-taxation, targeting more specifically offshore passive income such as dividends, disposal gains in relation to shares or equity interest, interest income, and income from intellectual property.
The Inland Revenue Taxation on Specified Foreign-sourced Income Bill 2022 (the Bill) will be introduced into the Legislative Council on November 2. It is expected to take effect on January 1, 2023.
A package of measures will be put in place to minimize the tax compliance burden for corporations, mitigate possible double taxation, enhance tax certainty, and maintain Hong Kong's tax competitiveness, the HK government informed.
The Bill creates a new Foreign-sourced Income Exemption (FSIE) regime that will offer 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 multinational enterprise entities (MNE).
According to the existing territorial source principle of taxation, only income sourced from Hong Kong is subject to profits tax in HK, and offshore passive income is exempted from profits tax.
Under the proposed FSIE regime, four types of offshore passive income including dividends, disposal gains in relation to shares or equity interest, interest income and income from IP (in-scope offshore passive income) would be deemed sourced from HK and subject to profits tax under the following circumstances:
- The income is received in Hong Kong by a constituent entity of a multinational enterprise group ("covered taxpayer") irrespective of its size of income or assets. A constituent entity means an entity with financial results consolidated on a line-by-line basis in the group's consolidated financial statements.
- The covered taxpayer fails to meet the economic substance requirement (for non-IP income), the nexus approach requirement (for IP income) or the participation exemption (for dividends and equity disposal gain).
- Offshore equity disposal gains that are deemed taxable would not be excluded from assessable profits even if they are capital in nature.
- The passive income should be "received in Hong Kong". However, what constitutes passive income "received in Hong Kong" requires further definition. It is expected that the approach similar to Singapore, i.e. on remittance basis, might be adopted.
A HK government official commented that as an international financial center, Hong Kong prides itself on being a responsible and cooperative 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.
In 2021, the European Union (EU) placed Hong Kong on a watchlist 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 effect from January 1, 2023. To avoid being blacklisted by the EU as a non-cooperative jurisdiction, Hong Kong agreed to amend its tax law by the end of 2022 with a view to implementing the new FSIE regime in January 2023.
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.
The new FSIE regime will put in place an economic substance requirement to safeguard against possible exploitation of HK'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 HK.
For a taxpayer that is not a pure equity holding company, it is proposed that the relevant activities will include making necessary strategic decisions and managing and assuming principal risks for the company's assets. For a pure equity holding company, the relevant activity will only include holding and managing its equity participation and complying with the Hong Kong corporate law filing requirements.
Although taxpayers may outsource the relevant activities, they would still have to demonstrate adequate monitoring and such activities should be conducted in Hong Kong and not used to circumvent the economic substance requirement.
To meet the economic substance requirement, the Inland Revenue Department ("IRD") may look at the number of qualified employees and adequate amount of operating expenditure incurred in Hong Kong. The IRD will also consider the totality of facts of each case, such as the business nature, operation scale, profitability, roles and other details of employees, and the amount and types of operating expenditure incurred.
According to a circular issued by the HK tax authorities, for foreign-sourced IP income, taxpayers need to comply with the nexus requirement promulgated by the Organization for Economic Cooperation 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.
Under the Bill, different "nexus test" will be applicable for certain IP income to qualify for preferential treatment. Only income from qualifying IP assets can receive preferential tax treatment, but this category only covers patents and other IP assets with equivalent functions. Marketing-related IP assets such as trademark and copyrights are excluded.
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 signed a tax treaty with HK.
In addition, to minimize 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 minimize compliance burden;
- Advance rulings by the IRD on compliance with the economic substance requirement, valid for up to five years, to provide more tax certainty;
- Administrative guidance with illustrative examples will be uploaded on the IRD website 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, taxpayers may apply for a "Commissioner's Opinion" in respect of their compliance with the economic substance requirement and refer to specific guidance on the IRD website to better determine tax liabilities.
The FSIE regime will seek to maintain Hong Kong's competitiveness, targeting only four types of foreign-sourced passive income whereas foreign-sourced active income will not be covered; covering MNE entities only, exempting foreign-sourced income from tax if the economic substance requirement or the nexus requirement (IP income) are satisfied and allowing an additional pathway for MNE entities receiving foreign-sourced dividends and disposal gains to claim tax exemption and minimize their tax burden.
The HK government will continue to look for ways to further enhance the competitiveness of the tax regime, including exploring a preferential tax regime for HK-sourced IP income to encourage more R&D activities and appropriate measures to enhance tax certainty for onshore transaction