Introduction

Hong Kong has long been known for its territorial-based principle of taxation, in which non-Hong Kong sourced income is not subject to Hong Kong profits tax. However, as this could give rise to double non-taxation on a project, such a tax treatment principle was deemed to be harmful to international tax standards and raised great concern from the European Union (EU).

To address the EU concerns, the Hong Kong Government introduced the Foreign-Sourced Income Exemption (“FSIE”) regime with effect from 1 January 2023, which brought about significant impact on the concept of “source of income” under Hong Kong's taxation system. Taxation of foreign-sourced passive income has been changed, under which dividend income is no longer automatically 100% non-taxable in Hong Kong, while offshore claims in Hong Kong are also impacted. Additional rules have been imposed on the offshore claims of four types of income:

·           Interest income

·           Dividend income

·           Disposal gains (equity interest, extended to all assets from 1 January 2024 onwards)

·           Intellectual property (“IP”) income

 

Active income, such as trading profits and service income, are not covered under the FSIE regime.

Base rules under the FSIE regime

The FSIE regime only targets the Hong Kong constituent entities of multinational enterprise (“MNE”) groups. An MNE group is a group that includes at least one entity or permanent establishment that is not located or established in the jurisdiction of the ultimate parent entity of the group. It also specifically targets passive income that is received in Hong Kong.

By following the approach adopted in Singapore, an income is regarded as received in Hong Kong if:

·           it is remitted to Hong Kong (e.g., remitted to a Hong Kong bank account);

·           it is used to settle debt incurred in respect of a business carried on in Hong Kong; or

·           it is used to buy movable property, which is subsequently brought into Hong Kong.

 

Protection from double-taxation under the FSIE regime

Under normal circumstances, a tax credit is generally available to taxpayers in Hong Kong in the case of double-taxation issues for Hong Kong’s Comprehensive Double Taxation Agreement (“CDTA”) partners. In other words, no tax credit is available in non-DTA partners.

However, if a non-Hong Kong sourced passive income becomes subject to Hong Kong profits tax under the FSIE regime, a tax credit will be available in Hong Kong if the concerned income is also subject to tax of a similar nature in other tax jurisdictions, no matter whether the counterparty is a DTA partner or not. The rationale is that the FSIE regime is enacted solely in response to pressures from the EU, rather than to raise tax revenues in Hong Kong.

As a result, taxpayers who have already paid foreign tax on their passive income should be more relaxed under the FSIE regime.

Hong Kong’s source rule on passive income

The basic principle of determining the source of the four types of passive income under Hong Kong’s profits tax regime is shown below:

Type of passive income	Source rule
Interest income	Provision of credit test / operation test
Dividend income	Tax residency of the investment (100% non-taxable under all scenarios)
Disposal gains	Listed shares: location of stock exchange Other assets: place where the sales contracts are affected
IP royalty income	Contract effected test: Intellectual property DEMPE functions location

Interest income: For simple loan arrangements, provision of the credit test applies where the source depends on the location in which the loan funds were first made available to the borrower. For moneylenders, corporate treasury centres and more complicated situations, the operation test applies. It is worthwhile noting that the Hong Kong Inland Revenue Department increasingly uses the operation test to determine the source of interest income.

Dividend income: As Hong Kong-sourced income is also exempt from Hong Kong profits tax, dividend income was 100% non-taxable in Hong Kong before the introduction of the FSIE regime.

Disposal gains: Long-term investment capital gains are non-taxable in Hong Kong, which is the cornerstone of Hong Kong’s taxation system. FSIE regime overrides the long-established non-taxable capital gains claim benefits of the Hong Kong tax system.

IP income: The contract effected test and the place of usage of the IP are the two traditional criteria for determining the source of royalty fees. Following international practice, the location in which the DEMPE functions (development, enhancement, maintenance, protection and exploitation) of the IP is carried out is now also an important criterion.

Four specific income types covered by FSIE regime

In addition to the above source rules, taxpayers have also to fulfil the following rules under the FSIE regime in order to pursue an offshore profits claim in Hong Kong:

Covered offshore income	Applicable rule
Interest income	Economic substance rule
Dividend income	Economic substance rule or participation exemption
Disposal gains (Equity Interest)	Economic substance rule or participation exemption
Disposal gains (IP asset)	Nexus approach
Disposal gains (Other assets)	Economic substance rule
IP income	Nexus approach

All covered passive income received by covered taxpayers not in-scope of the exemption rules are liable to profits tax in Hong Kong.

Economic substance rule (interest income, dividend income, disposal gains)

Pursuant to the economic substance rule, taxpayers have to build up economic substance in Hong Kong in order to successfully pursue an offshore claim in Hong Kong. The logic is that the taxpayers have to demonstrate that Hong Kong (rather than other tax jurisdictions) possesses the taxing rights under international standards because its economic substance is in Hong Kong. The taxpayers in the end do not have to pay tax due to the local legislation in Hong Kong. This is similar to the current economic substance law in offshore jurisdictions (such as the BVI and the Cayman Islands).

To fulfil the economic substance rule, covered taxpayers need to meet the adequacy test as follows:

·           employ an adequate number of qualified employees; and

·           incur an adequate amount of operating expenditure in Hong Kong in relation to the relevant activities.

 

Outsourcing of income-producing operations to another Hong Kong company is possible, provided that the taxpayers have control over the outsourced operations’ activities.

The exact number of employees or the amount of expenses required is not specified, but it is noted that, for a pure equity holding company which derives dividend income and equity interest disposal gains only, the requirements are more relaxed.

For interest income recipients, the taxpayers have to demonstrate that the relevant strategic decisions and the relevant loan financing arrangements are made in Hong Kong first, before the application of the interest income source rule (that is, the provision of the credit test or operation test).

Participation exemption (dividend income, disposal gains re equity interest)

Even if the offshore dividend income or disposal gains do not fit the economic substance requirements, taxpayers are still eligible to pursue an offshore claim in Hong Kong when they meet the participation exemption requirements.

Under participation exemption, all of the following rules must be satisfied in order to pursue a non-taxable claim in Hong Kong:

1.       the income recipient (holding company) is a Hong Kong tax resident or a Hong Kong Permanent Establishment of a non-tax resident;

 

2.       the income recipient holds at least 5% of the shares or equity interest in the investee company;

 

3.       the income recipient has continuously held its shares or equity interest in the investee company for 12 months or longer before the income accrues to the income recipient;

 

4.       switch-over rule: The corporate income tax rate of the investee company is at least 15%;

 

5.       main purpose test (general tax anti-avoidance rule): If the Inland Revenue Department considers that the main purpose of the whole arrangement is for tax avoidance, participation exemption will not be fulfilled; and

 

6.       anti-hybrid mismatch rule: The dividend payments of an investee company should not be tax-deductible.

 

MNE groups very often have complicated shareholding structures, in which the direct investee company of the Hong Kong holding company may not be the operating entity. In the case of dividend income, a “see-through” approach is adopted such that the underlying dividends and/or profits of up to five tiers of investee entities will be considered when assessing whether the switch-over rule (Point 4 above) is met. The tax bill does not mention whether the same approach shall apply in the case of disposal gains.

Nexus approach (IP income)

First of all, the exemption introduced in the regime only covers income from patents and other IP income of a similar nature. Other intellectual property, such as trademarks or copyrights, is not applicable to any exemption and, therefore, all in-scope IP income generated from trademarks and copyrights would be deemed as taxable in Hong Kong. However, taxpayers are reminded to go through the base rules of the regime to ascertain whether the IP income is in-scope or not (i.e., if the income recipient is part of an MNE group and the income is received in Hong Kong).

For income from patents, the nexus approach will be used to calculate the IP income qualifying for non-taxable claims under the FSIE regime (that is, in addition to the above source rule requirement). The calculation formula is as follows:

Qualifying expenditure incurred by the taxpayer to develop the IP assets

/

Overall expenditure incurred by the taxpayer to develop the IP assets

X

IP income from the qualifying IP asset

Based on the above formula, the next question would be the determination of “qualifying expenditure” (i.e., the numerator of the above formula).

In order to qualify as qualifying expenditure, the location requirement under different scenarios is as follows:

 

Persons responsible for the research & development (R&D) work	Location requirement
Taxpayer itself	Hong Kong or overseas
Outsourced to an unrelated party	Hong Kong or overseas
Outsourced to a related party	Hong Kong

Another point to note is that qualifying expenditure does not include the acquisition costs of the IP asset. However, the amount of qualifying expenditure can be uplifted by 30% (subject to a cap equal to the overall operating expenses incurred by the Hong Kong taxpayer).

Based on the above formula, if the majority or all of the R&D work of the Hong Kong company is outsourced to an overseas related party, it is unlikely that the Hong Kong company can pursue an offshore claim on the IP income.

Another important note is that the R&D expenses paid by a Hong Kong taxpayer to overseas group companies are unlikely to be tax-deductible. If the corresponding IP income is not eligible for an offshore claim in Hong Kong, the Hong Kong company may end up having significant Hong Kong profits tax liabilities.

Significant impact on MNEs

Offshore claims in Hong Kong are a significant part of the tax planning of MNE groups, which often maintain limited or even no economic substance in Hong Kong. As such, the FSIE regime affects a significant number of MNE groups.

The FSIE regime requires MNE groups to build up economic substance in Hong Kong in order to enjoy preferential tax treatment. While it may increase the financial burden on MNE groups, the regime can potentially enhance the employment market in Hong Kong. MNE groups pursuing offshore claims in Hong Kong are advised to consult their tax advisors to perform a tax health check and to make the necessary operational reforms.

For enquiries, please feel free to contact us at:

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

Published by ONC Lawyers © 2024