By K.F. Yan, Senior Accounting Manager
To be one of the best jurisdictions in Asia for foreign investors looking for investments opportunity and assets management, Hong Kong enjoys a good geographical location, efficiency in tax management, sound legal system and availability of skilled workforce.
Relatively low tax rate together with the adoption of territorial source principle of taxation which lead to tax exemption for foreign-sourced profits. A Hong Kong entity might ends up with profits not taxable in Hong Kong nor in other jurisdictions. In 2022, Hong Kong was placed on the European Union (EU) list of non-cooperative countries and territories for tax purposes. This was mainly attributable to the offshore taxation regime.
To remain an attractive financial hub, Hong Kong tax system keeps embracing international standards, among The Organisation for Economic Co-operation and Development (OECD) norms regarding the taxation of passive income that is dividends, interest, capital gain and royalties. To remedy this situations, Hong Kong government adopt a bill amending the “Forgeign Sourced Income Excemption” regime (“FSIE”) for passive income. Effective from 1st January 2023 with no grandfathering clause, a new regime has come into effect make four types of passive income received in Hong Kong by the constituent entity of a multinational enterprise (MNE), regardless the revenue or assets size of this MNE, will be deemed taxable and subjected to Hong Kong Profits Tax.
Under the New Regime, certain types of offshore passive income, namely interest, dividends, equity disposal gains and income from use of intellectual properties will be covered. These four types of passive offshore income will be considered as derived from Hong Kong and thus subject to profits tax if
1. The income is received in Hong Kong by a constituent entity of a multinational enterprise (MNE) group (covered taxpayer) regardless of its revenue and asset size, and
2. The covered taxpayer fails to meet the economic substance requirement (for non-IP income) or fails to comply with the nexus approach (for IP income)
In other words, 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, shall all fall outside the scope of this New Regime.
| Exceptions | Specified foreign-sourced income | |||
|---|---|---|---|---|
| Interest | Dividends | Equity disposal gains | Income from use of intellectual property | |
| Economic substance requirement | ✓ | ✓ | ✓ | |
| Participation requirement | ✓ | ✓ | ||
| Nexus requirement | ✓ | |||
A taxpayer will remain exempted from profits tax for offshore interest, dividends and equity disposal gain provided that the taxpayer can demonstrate enough economic substance in Hong Kong. Examples can be having an office, hiring sufficient numbers of qualified employees and operating expenditures in Hong Kong. No minimum threshold is identified so each tax case need to be assessed on a case-by-case basis. A pure equity holding company will be able to undergo reduced substantial activities test while other types of entities could only claim for exemption if demonstrating that all strategic decisions, management and risk factors are assumed in Hong Kong. Outsourcing of the economic activities will be permitted given that the taxpayer manages to demonstrate adequate monitoring of the outsourced activities conducted in Hong Kong.
If an MNE entity receives foreign-sourced dividend or equity disposal gain, the participation requirement provides an alternative to the economic substance requirement about tax exemption. A participation exemption will be applied if the investor company is a Hong Kong-resident person or a non-Hong Kong resident person that has a permanent establishment in Hong Kong; the investor company holds at least 5% equity interests in the investee entity concerned for a period of not less than 12 months immediately before the foreign-sourced dividend or equity disposal gain. Certain anti-abuse rules are in place to disallow the participation exemption. As regards foreign-sourced IP income, the nexus approach, which was adopted by the OECD will be applied to identify the extent of such income to be excluded from the exemption rules. In brief, certain portion of the income derived from a qualifying intellectual property can be exempted from profits tax, and that portion is referred to as “excepted portion”. The nexus approach aims to establish a direct nexus between the income receiving benefits and the expenses contributing to that income.