With effect from January 1, 2023 and without a grandfathering period, Hong Kong is set to make considerable changes to its foreign source income exemption (FSIE) regime for passive income.
The changes are included in The Inland Revenue (Amendment) (Taxation of Specified Foreign Income) Bill 2022, which was published in the gazette on October 28.
The changes are intended to fulfil commitments made by Hong Kong to the European Union in 2021 to amend the regime, to remove harmful effects.
“The new FSIE regime not only upholds the territorial source principle of taxation, but also maintains the tax competitiveness of Hong Kong. Under the regime, multinational enterprise entities which have a substantial economic presence in Hong Kong will continue to be able to claim tax exemption for specified foreign-sourced passive income, namely interest, dividends, and disposal gains in relation to shares or equity interests, received in Hong Kong” Treasury and Financial Services Secretary Christopher Hui said.
Foreign-sourced intellectual property income from qualifying intellectual property received in Hong Kong will also be exempt to the extent that the (modified nexus approach) requirement is complied with.
The changes will only affect, as defined in the Global Anti-Base Eriosion (GloBE) Rules, MNE groups – generally those with annual revenues of EUR 750M or more. The offshore income of standalone local companies with no offshore operation and companies belonging to purely local groups will continue to be exempt from tax.
Under the refined FSIE regime, in-scope offshore passive income will be deemed to be sourced from Hong Kong and chargeable to profits tax if:
the income is received by a constituent entity of an MNE group in Hong Kong, irrespective of its revenue or asset size; and
the recipient entity fails to meet the economic substance requirement (if the income is non-IP income), or fails to comply with the nexus approach (if the income is IP income).
However, the Government of Hong Kong has also announced that it will introduce a participation exemption for offshore dividends and disposal gains, with anti-abuse rules, which will result in some income that would otherwise be caught by the rules remaining tax exempt.
The participation exemption will apply 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% of the shares or equity interest in the investee company, with no minimum holding period; and
no more than 50% of the income derived by the investee company is passive income (interest, income from IP, dividends, and disposal gains)
The Hong Kong Government explained: “Participation exemption aims to avoid possible double taxation (e.g. first on the investee company in the paying jurisdiction and later on the investor company on Hong Kong) and to relieve the compliance burden (i.e. claim for relied for double taxation by the way of tax credit if applicable).”
A switch-over rule; a main purpose rule; and an anti-hybrid mismatch rule, are the three anti-abuse rules that will apply.
The switch-over rule provides that if the investee company (in the case where the income concerned is dividends) or the income concerned is or are subject to tax in a foreign jurisdiction the headline tax rate of which is below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit. The Government explained that, in other words, the investor company will remain subject to Hong Kong profits tax in respect of the income concerned but with a deduction from tax of foreign tax paid attributable to the income concerned and/ or the profits of the investee company.
“As it is not our policy objective to generate fiscal revenue through the refined FSIE regime” The Government has explained further on double tax relief, unilateral tax credit will be provided to those taxpayers who have paid taxes in those jurisdictions which have not entered comprehensive avoidance of double taxation agreements with Jong Kong as double taxation relief.
The economic substance rules for non-IP income are the following:
For a taxpayer that is not a pure equity holding company, the relevant activities will include making necessary strategic decision and managing and assuming principal risks in respect of any assets it acquires, hold, or disposes of;
For a taxpayers that is a pure equity holding company, a reduced substantial activities test can be applied such that the relevant activities will only include holding and managing its equity participation, and complying with the corporate law filling requirements in Hong Kong; and
Outsourcing of the relevant activities will be permitted provided that the taxpayer is able to demonstrate adequate monitoring of the outsourced activities and that the relevant activities are conducted in Hong Kong. The Government said “appropriate safeguards will be put in place to prevent the use of outsourcing for circumventing the economic substance requirement.”
Tax breaks for IP income will follow the modified nexus approach, suggested by the OECD as part of its work on BEPS Action 5, on harmful tax practices.
A taxpayer is allowed to benefit from an IP tax regime and its beneficial tax rates, only to the extent that I can show that it itself incurred expenditures, such as on research and development, that gave rise to IP income in that territory, as stipulated in the “modified nexus approach”. Tax breaks are limited to those activities with substance in the territory providing the concessionary treatment.
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