In line with international standards combating cross-border tax evasion, the Hong Kong government is amending its Foreign-Sourced Income Exemption (‘FSIE’) regime. On October 28th, 2022, the legislative bill of the proposed new regime (the ‘New Regime’) was released. Simultaneously, the Inland Revenue Department (‘IRD’) issued some guidelines enabling targeted enterprises to better understand the practical consequences of this reform (together, draft legislation and IRD guidelines, the ‘October Release’).
When: The New Regime shall enter into force on January 1st, 2023, without grandfathering arrangements.
What: Four types of passive incomes fall under the scope of the reform: foreign interests, dividends, capital gains and royalties (IP income), when received in Hong Kong. October Release brings an important clarification to the New Regime, specifying that foreign-sourced income will only be considered as received in Hong Kong if and when such income is:
(a) remitted to, transmitted or brought into Hong Kong; or
(b) used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong; or
(c) used to buy movable property, and the property is brought into Hong Kong (in this case the income is regarded as being received at the time when the movable property is brought into Hong Kong).
The above 3 criteria, including the remittance principle, may further alleviate the potential taxation of passive foreign income.
Who: Hong Kong companies being constituent entities of a Multinational Enterprise (‘MNE’). Individual taxpayers, standalone local companies with no operation outside Hong Kong in the form of permanent establishments, as well as local groups without overseas constituent entities, all fall outside the scope of this New Regime. Similarly, “Excluded Entities”, i.e. MNEs benefitting from existing preferential tax regimes of Hong Kong, are not affected by the new FSIE regulation.
How: Foreign passive income will be deemed to be derived from Hong Kong and thus subject to profits tax (at the standard rate of 16.5%), if received in Hong Kong by MNEs engaged in trading, profession, or business in Hong Kong.
Exemptions: 3 main exemptions apply:
Economic substance requirement (ESR)
Nexus requirement (NR)
Participation requirement (PR)
We invite you to refer to our previous article for the main features of each exemption.
Pursuant to October Release, further details have been published, clarifying the way to assess these 3 exemptions:
1. Different level of requirements shall be met to satisfy the Economic Substance requirement depending on the taxpayer’s business scope. As such, taxpayers who are not pure equity-holding entities shall demonstrate hiring qualified employees and incurring operative expenditures to carry out “specified economic activities” in Hong Kong. While taxpayers who are pure equity-holding entities simply need to demonstrate a commensurate level of HR and premises to carry out “specified economic activities”.
MNEs can outsource their specified economic activities (all or part of it), which might help satisfying the adequacy tests for both pure equity-holding entities (premises and HR) and non-pure equity-holding entities (qualified employees and operating expenditures). Outsourcing can be done through external providers, as well as through group entities (such as subsidiaries). In both cases, proper documentation shall be in place, and adequate supervision of outsourced arrangements shall be put in place.
Last, it is worth noting that companies carrying out investment activities, such as investment in securities, can still make offshore claims and be tax-exempted as long as they meet the economic substance requirement.
2. Regarding the Participation requirement, contrary to what was announced before, the 50% cap for passive income has been removed. Instead, that the investment shall be held for a minimum of 12 months before any income is distributed to the MNE (holding at least 5% of the shares or equity interest in the investee from which the passive income derives).
3. No major change has been published regarding the Nexus Exemption.
The ESR, NR, or PR exemptions shall be assessed during the year in which the passive income accrues to the MNE entity (year of accrual). If the ESR, NR or PR exemptions are not satisfied, foreign-sourced income will be deemed taxable and thus subjected to Hong Kong profits tax in the year of assessment during which that income is effectively received by the entity in Hong Kong (year of receipt).
Ruling: To avoid tax uncertainties and get ready on time, taxpayers falling under the scope of the New Regime are encouraged to seek the Commissioner’s opinion on the compliance of a specific set-up in terms of economic substance requirements. This shall be done before the entry into force of the amendment ordinance (until 31st December 2022).