Offshore income and capital gains have been exempted from Hong Kong Profit Tax. With the introduction of the refined FSIE regime, certain offshore passive income received by a Hong Kong entity of a MNE Group will become taxable.
To support international efforts in combating cross-border tax evasion and address the concerns of the European Union over double non-taxation, the “Inland Revenue (Amendment) (Taxation on Specified Foreign-Sourced lncome) Bill 2022” (the “Amendment Bill”) was gazetted on 28 October 2022. It was introduced to the Legislative Council on 2 November 2022. If enacted, the new Foreign Source lncome Exemption (“FSIE”) regime will be brought into force from 1 January 2023.
The objectives of the Amendment Bill are to provide a legal framework to regard offshore passive income as taxable and to provide for relief against double taxation in respect of such income.
Generally, offshore passive income, i.e. interest income, income from intellectual properties (“IP income”), dividends or disposal gains on equity interests (notwithstanding arising from the sale of capital assets), will be deemed under the new FSIE regime to be sourced from Hong Kong and chargeable to Hong Kong Profits Tax if:
(i) The income is received in Hong Kong by a taxpayer (“MNE entity”) of a multinational enterprise group (“MNE group”), and
(ii) Such MNE entity fails to meet the economic substance requirement (for non-IP income) or fails to comply with the nexus approach for IP income in the year of assessment in which the income accrues.
Offshore active income is not covered under the Amendment Bill. As such, the Profits Tax status of offshore trading income and offshore service income, for examples, earned by taxpayers will not be affected by the new FSIE regime.
As only MNE group is covered under the new FSIE regime, the tax positions of group companies which only involve local companies are not covered. Also, interest, dividend or disposal gain derived by a “regulated financial entity” (e.g. an insurer authorized under the Insurance Ordinance(Cap.41), an authorized institution under the Banking Ordinance (Cap.155) or an entity licensed under the Securities and Futures Ordinance (Cap. 571)) are excluded from the scope of the new FSIE regime. A Hong Kong entity which benefits from the existing preferential tax regimes of Hong Kong is also excluded.
Income Received in Hong Kong
Whilst the determination of whether an offshore passive income is exempted/taxable is based on the year of assessment in which the income is accrued, such income is only subject to tax in the year of assessment in which it is “received”by the MNE entity in Hong Kong.
Income is regarded as received in Hong Kong when:-
(i) the income is remitted to, or is transmitted or brought into Hong Kong,
(ii) the income is used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong, or
(iii) the income is used to buy moveable property, and the property is brought into Hong Kong.
Non-IP Income - Economic Substance Requirement
Foreign-sourced interest, dividend or disposal gain received in Hong Kong by an MNE entity will be exempt if:-
(i) For a pure equity-holding entity, the entity complies with every applicable registration and filing requirement under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), the Limited Partnerships Ordinance (Cap. 37), the Business Registration Ordinance (Cap. 310) and the Companies Ordinance (Cap. 622) and in the Commissioner's opinion, has adequate human resources and premises for carrying out the holding and managing its equity participations in other entities in Hong Kong.
(ii) For a non-pure equity-holding entity, the Commissioner is in the opinion that the entity employs adequate number of employees with necessary qualifications in Hong Kong and incurs adequate amount of operating expenditure in Hong Kong to make necessary strategic decisions in respect of any assets the entity acquires, holds of disposes of, and managing and bearing principal risks in respect of such assets.
However, the minimum thresholds for number of employees and operating expenditure required to satisfy the economic substance requirement are not specified. The IRD will base on the totality of facts of each case, including the nature of business，the qualifications of employees, the nature of office premises used to undertake the relevant activities etc. to consider the position.
Outsourcing of the above specified economic activities to third parties or group entities is permitted provided that the MNE entity exercises adequate monitoring to ensure that the relevant activities are carried out by the outsourced entity in Hong Kong. Factors to be considered by the IRD in this regard include the nature and level of activities performed by the outsourced entity, whether the outsourced entity has adequate number of employees and premises as well as incurs operating expenditure to perform the outsourced activities in Hong Kong and the number of MNE entities to which the outsourced entity provides such services.
As the number of qualified employees and the amount operating expenditure incurred by the outsourced entity in Hong Kong will be considered by the lRD, the MNE entity will need to provide details of such resources employed by its outsourced entity.
IP Income - Nexus Approach
Simply speaking, under the nexus approach, only qualifying lP income from a qualifying lP asset can be exempt based on a nexus ratio which is calculated as follows:
Qualifying IP income x Qualifyng RSD expenditure x 130%
Qualifying RSD expenditure + Non-qualifying expediture
Qualifying IP income refers to income derived from qualifying IP in respect of the exhibition or use of, or a right to exhibit or use (whether in or outside Hong Kong) the property, or the imparting of, our undertaking to impart, knowledge directly or indirectly connected with the use (whether in or outside Hong Kong) of the property.
Qualifying IP means patents, patent registrations or copyrighted softwares. Other IP asset such as trademarks and copyrights are not included.
Qualifying R&D expenditure means expenditures (including capital expenditure) incurred by the MNE entity for an R&D activity that is connected to the qualifying IP and is carried out either by the MNE entity, by a non-associated person of the MNE entity or by the MNE entity's Hong Kong resident associated person in Hong Kong. Qualifying R&D expenditure and Non-qualifying expenditure do not include interest payments, payments for any land or buildings, or for any alternation, addition or extension to any building and acquisition cost of the subject IP from another person.
Participation Requirement for Offshore Dividend and Disposal Gains
Even if a MNE entity is unable to comply with the economic substance requirement, the participation requirement provide the MNE entity an alternative way to claim tax exemption on foreign-sourced dividend or disposal gain received in Hong Kong.
Under the participation requirement, if a MNE entity meets the following conditions, its foreign-sourced interest income will be exempt:-
(i) the MNE entity is a Hong Kong resident person (i.e. a person who is a resident for tax purposes in Hong Kong and in case of a company, the company is incorporated in Hong Kong or if incorporated outside Hong Kong, it is normally managed or controlled in Hong Kong), or a non-Hong Kong resident person who has a permanent establishment in Hong Kong, and
(ii) the MNE entity has continuously held not less than 5% of equity interests in the investee entity for a period of not less than 12 months immediately before the income accrues.
However the participation requirement is subject to the following anti-abuse rules:-
(i) Switch-over rule: lf the relevant income is not subject to a qualifying similar tax (i.e. a tax that is substantially the same nature as Profits Tax and the tax rate is at least 15%) in a foreign jurisdiction, the tax relief available to the MNE entity will be switched over from full exemption to tax credit.
(ii) Anti-hybrid mismatch rule: In case of dividend, the participation requirement will not apply if the dividend is allowed for deduction when computing the amount of tax of the investee company.
(iii) Main purpose rule: lf the Commissioner is satisfied that the main purpose, or one of the main purposes, of the MNE entity in entering into the arrangement is to obtain a tax benefit, the participation requirement will not apply.
Double Tax Relief
As it is not the Government's policy objective to generate fiscal revenue through the introduction of the new FSIE regime, tax credits will be granted to a MNE entity who is a Hong Kong resident person and has paid income tax in a foreign jurisdiction (regardless of whether avoidance of double taxation agreements has been signed with such jurisdiction) in respect of the taxable foreign-sourced income. The amount of tax credit will be the lower of foreign tax paid and the Profits Tax that would have been payable on such income.
In case of dividend income, tax credits will not only include the foreign tax paid on the dividend, but also the foreign tax paid on the investee's underlying profits out of which the dividend is paid, provided that the MNE entity has held at least 10% equity interest of the investee.
Where the MNE entity is not a Hong Kong resident person, a deduction may be allowed for the foreign tax paid in respect of such income.
Commissioner's Opinion on Compliance with the Economic Substance Requirement
Whilst the Amendment Bill has not been enacted and therefore the Advance Ruling mechanism is not applicable, a taxpayer can seek for the Commissioner's Opinion on its compliance with the economic substance requirement for non-IP income. Once the enacted economic substance requirement is substantially the same as the Amendment Bill,the lRD will apply the taxpayer's case in accordance with the Opinion if the arrangements and parameters stated therein are adhered to.
The introduction of the new FSlE regime, once enacted, will definitely have significant impacts on the Profits Tax position of a MNE entity. in particular various offshore passive income as we as capital gains the MN entity receives in Hong Kong may become taxable after 1 January 2023. Although various exemptions will also be introduced, the exact requirements of these exemptions (e.g. the level of resources to carry out the specified economic activities in Hong Kong for economic substance requirement) remain uncertain. Further guidance from the IRD such as implementation rules and probably another Departmental Interpretation and Practice Notes are required to clarify the uncertainties. MNE entities will also need to be prepared to meet the additional tax compliance burdens associated with the new FSlE regime. Taxpayers are strongly recommended to seek professional tax advices to review its impacts on its Profits Tax position and take appropriate actions if necessary immediately.