Introduction

To address tax avoidance and double non-taxation, the Foreign-Sourced Income Exemption (“FSIE”) regime was introduced in Hong Kong with effect from 1 January 2023. The move was prompted by Hong Kong’s inclusion in a 2021 watch list by the European Union, which identified Hong Kong as one of the jurisdictions with potentially harmful tax regimes. The FSIE regime aims to enhance economic substance requirements and anti-abuse rules.

Incomes covered

Hong Kong’s FSIE regime encompasses four categories of foreign-sourced passive income:

·           dividend income;

·           interest income;

·           share disposal gains; and

·           income derived from intellectual property (“IP”).

FSIE regime applies only to foreign-sourced income received within Hong Kong. To qualify as being “received in Hong Kong”, the income must meet specific criteria:

·           remittance, transmission, or being brought into Hong Kong, typically implying a transfer into a local bank account or integration into the Hong Kong economy;

·           utilisation to offset trade, profession, or business-related debts in Hong Kong; and

·           use for the purchase of movable property subsequently brought into Hong Kong.

Entities affected

The primary objective of this FSIE regime is to prevent MNE entities from exploiting the benefits of double non-taxation. It specifically targets members of multinational group entities (“MNE entities”) engaging in trade, profession, or business within the region, which receive foreign-sourced income in Hong Kong, but have little or no economic substance in Hong Kong. The FSIE regime does not apply to:

·           independent local enterprises with no offshore operations;

·           companies in purely local groups, with no overseas constituent entities; and

·           individual taxpayers.

 

Furthermore, regulated financial entities and MNEs benefitting from Hong Kong’s pre-existing preferential tax regimes are typically exempt from the new FSIE regulation, subject to the conditions discussed below.

Exemption requirements

MNE entities can qualify for exemption under the FSIE regime through three routes:

1.      the Economic Substance Requirements;

2.      the Participation Requirements; and

3.      the Nexus Requirements.

 

It is important to note that these exemption requirements vary for each type of foreign-sourced income. The specific requirements applicable to each income type are summarised in the table below:

	Economic Substance Requirements	Participation Requirements	Nexus  Requirements
Interest Income	ü
Dividend Income	ü	ü
Share Disposal Gains	ü	ü
IP Income			ü

 

Economic Substance Requirements

The Economic Substance Requirements apply to foreign-sourced interest income, dividend income, and share disposal gains. MNE entities are required to demonstrate economic substance in Hong Kong based on international standards in order to claim offshore benefits. Adequacy tests are employed, which involve (1) employing a sufficient number of qualified employees and (2) incurring an appropriate level of operating expenditure in Hong Kong related to the relevant activities. Outsourcing is allowed with adequate supervision and fulfilment of outsourcing requirements.

The specific requirements for the number of employees and expenses vary on a case-by-case basis, but pure equity holding companies with dividend income and equity interest disposal gains are subject to less stringent requirements. Non-pure equity-holding entities receiving interest income must show that relevant strategic decisions and loan financing arrangements occur in Hong Kong before applying the interest income source rule, such as the credit test or operation test.

Participation  Requirements

Participation Requirements apply to foreign-sourced dividend income and share disposal gains. To qualify for exemption, the following conditions must be met:

·           the recipient of the income (holding company) must be a Hong Kong tax resident, or a firm establishment of a non-tax resident; and

·           the income recipient must hold a minimum of 5% of shares or equity interest in the concerned investee entity for a continuous period of at least 12 months before earning the passive income.

Under the Inland Revenue Ordinance, Participation  Requirements are subject to the following anti-abuse rules aimed at preventing misuse:

·           Switch-over rule: The investee company must have a corporate income tax rate of at least 15%;

·           Main purpose test (General Tax Anti-Avoidance Rule): If the Inland Revenue Department determines that the primary objective of the entire arrangement is to avoid taxes, the participation exemption will not be applicable; and

·           Anti-hybrid mismatch rule: The dividend payments made by an investee company must not be tax-deductible.

Nexus Requirements

Tax exemption is available for foreign-sourced passive income from patents or software-related copyrights if the Nexus Requirements are satisfied. However, marketing-related IP assets like trademarks and copyrights do not qualify for this exemption and are taxable.

Tax-exempt IP income is calculated by the following formula:

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

 

In respect of qualifying expenditure, it should be noted that:

·           the R&D work can be conducted by the taxpayer itself or outsourced to an unrelated party, regardless of location;

·           if the R&D work is outsourced to a related party, it must be conducted in Hong Kong;

·           IP acquisition costs are not considered qualifying expenditure;

·           qualifying expenditure can be increased by 30% (up to the limit of total operating expenses);

·           outsourcing R&D work to overseas parties limits offshore benefits;

·           R&D expenses paid to overseas group companies are generally not tax-deductible; and

·           if IP income does not qualify for offshore benefits, significant Hong Kong Profits Tax liabilities may arise.

The table below summaries income types and their corresponding exemption requirements:

Exemption	Economic Substance Requirements	Participation Requirements	Nexus Requirements
Passive Income(s) Applicable	·       Interest Income ·       Dividend Income ·       Share Disposal Gains	·       Dividend Income ·       Share Disposal Gains	·       IP Income
Requirements	·       Employ a sufficient number of qualified employees; ·       Incur an appropriate level of operating expenditure in Hong Kong related to the relevant activities; ·       Outsourcing allowed with adequate supervision and meeting outsourcing requirements.	·       Recipient must be a Hong Kong tax resident or a firm establishment of a non-tax resident; ·       Minimum 5% shareholding for at least 12 months before earning passive income; ·       Anti-abuse rules apply.	·       Only applies to qualifying IP assets (patents, software-related copyrights); ·       Calculation based on qualifying expenditure incurred by the taxpayer to develop the IP assets; ·       IP acquisition costs are not considered qualifying expenditures.

 

Advance ruling

To reduce compliance burdens for MNE entities, the FSIE regime includes an advanced ruling provision. MNE entities can apply for advance ruling with the Inland Revenue Department (“IRD”). Once granted, the ruling is legally binding and valid for up to five years. Applications can be made individually by the MNE entity or on behalf of a group. Group applications are subject to specific requirements, such as specified economic activities that should be outsourced to a single entity through a joint service agreement. Written approval from other MNE entities and the submission of the service agreement are also necessary.

Applications can be submitted at any time. It typically takes about 21 working days for the IRD to process an application. If the ruling is favourable, the MNE entities will be granted the profit tax exemption under the FSIE regime. In case of an unfavourable ruling, MNE entities have the opportunity to explore alternative tax planning strategies, such as business restructuring, to enhance tax efficiencies. However, it is not advisable for MNE entities to apply for the advanced ruling without first seeking professional advice, as it may impact the final outcome.

Conclusion

With the implementation of the FSIE regime in Hong Kong, it is high time for MNE entities to prepare for this new regulatory landscape to minimise the impacts on their tax obligations for passive income.

Should you have any queries regarding the effects of the FSIE regime on your business or other taxation matters, please do not hesitate to contact us to schedule a confidential preliminary consultation with our team of tax experts.

For enquiries, please feel free to contact us at:

E: tax@onc.hk                                                                      T: (852) 2810 1212 W: www.onc.hk                                                                    F: (852) 2804 6311 19th Floor, Three Exchange Square, 8 Connaught Place, Central, Hong Kong

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 © 2025