On 28 October 2022, the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Bill 2022 was gazetted which introduces refinement on the Foreign-Sourced Income Exemption (FSIE) regime on the four types of offshore passive income: (1) Interest income; (2) Dividend income; (3) Disposal gain (on equity interest); and (4) Intellectual Property ("IP") income. The target enforcement date is 1 January 2023.  Under the FSIE regime, these four types of passive income will be deemed to be taxable in Hong Kong under certain circumstances. Active income, such as trading profits and service income, are not covered under the FSIE regime.

The refined FSIE regime only targets the Hong Kong constituent entities of multinational enterprise (MNE) groups carrying on a business in Hong Kong. It also specifically targets passive income that is received in Hong Kong.

Treatments on double-taxation under the FSIE regime

Under normal circumstances, a tax credit is generally available in Hong Kong in the case of double-taxation issues for Hong Kong's Comprehensive Double Taxation Agreement (DTA) partners. In other words, no tax credit is available to non-DTA partners.

However, if a non–Hong Kong sourced passive income becomes subject to Hong Kong Profits Tax under the FSIE regime, a tax credit will be available in Hong Kong if the concerned income is also subject to tax of a similar nature in other tax jurisdictions, no matter whether the counterparty is a DTA partner or not. The rationale is that the FSIE regime is being enacted solely in response to pressures from the Europe Union on double non-taxation arising from tax exemption for offshore passive income in Hong Kong, rather than to raise tax revenues in Hong Kong.

As a result, taxpayers who have already paid foreign tax on their passive income should be more relaxed under the proposed FSIE regime.

Proposed FSIE regime

In addition to the existing source rule of Hong Kong, in order to pursue an offshore profits claim in Hong Kong, taxpayers also have to fulfil the following rules under the proposed FSIE regime:

All covered passive income received by covered taxpayers not in-scope of the exemption rules are liable to profits tax in Hong Kong.

Economic substance rule – for interest income, dividend income, disposal gains

Pursuant to the economic substance rule, taxpayers have to build up economic substance in Hong Kong in order to successfully pursue an offshore claim in Hong Kong. To meet the economic substance requirement, the taxpayer will need to meet the adequacy test in terms of (1) employing an adequate number of qualified employees and (2) incurring an adequate amount of operating expenditures in Hong Kong in relation to the relevant activities, taking into consideration the totality of facts of each case. There will not be any prescribed minimum threshold.

The proposal does not specify the exact number of employees or the amount of expenses required, but does note that, for a pure equity holding company which derives dividend income and equity interest disposal gains only, the requirements are more relaxed, such that the relevant activities will only   include holding and managing its equity participation, and complying with the corporate law filing requirements in Hong Kong.

For interest income recipients, the taxpayers have to demonstrate that the relevant strategic decisions and the relevant loan financing arrangements are made in Hong Kong first, before the application of the interest income source rule (that is, the provision of the credit test or operation test).

Outsourcing of income-producing operations to another Hong Kong company is possible, provided that the taxpayers have control over the outsourced operations' activities.

Participation exemption – for offshore dividends and disposal gains

Even if the offshore dividend income or disposal gains do not fit the economic substance requirements, taxpayers are still eligible to pursue an offshore claim in Hong Kong when they meet the participation exemption requirements.

Under participation exemption, all of the following rules must be satisfied in order to pursue a non-taxable claim in Hong Kong:

1.     The income recipient (holding company) is a Hong Kong tax resident or a Hong Kong Permanent Establishment of a non-tax resident;

2.     The income recipient holds at least 5% of the shares or equity interest in the investee company;

3.     The income recipient has continuously held its shares or equity interest in the investee company for 12 months or longer before the income accrues to the income recipient;

4.     Switch-over rule: The corporate income tax rate of the investee company is at least 15%;

5.     Main purpose test (General Tax Anti-Avoidance Rule): If the Inland Revenue Department (IRD) considers that the main purpose of the whole arrangement is for tax avoidance, participation exemption will not be fulfilled; and

6.     Anti-hybrid mismatch rule: The dividend payments of an investee company should not be tax-deductible.

MNE groups very often have complicated shareholding structures, in which the direct investee company of the Hong Kong holding company may not be the operating entity. In the case of dividend income, it is further explained in the tax bill that a "see-through" approach will be adopted, such that the underlying dividends and/or profits of up to five tiers of investee entities will be considered when assessing whether the switch-over rule (Point 4 above) is met. The tax bill does not mention whether the same approach shall apply in the case of disposal gains.

Nexus approach – for income re intellectual properties e.g. royalty

The exemption introduced in the proposed regime only covers income from patents and other IP income of a similar nature. Other intellectual property, such as trademarks or copyrights, is not applicable to any exemption and, therefore, all in-scope IP income generated from trademarks and copyrights would be deemed as taxable in Hong Kong.

However, taxpayers are reminded to go through the base rules of the proposed regime to ascertain whether the IP income is in-scope or not (i.e., if the income recipient is part of an MNE group and the income is received in Hong Kong).

For income from patents, the nexus approach will be used to calculate the IP income qualifying for non-taxable claims under the FSIE regime (that is, in addition to the above source rule requirement). The calculation formula is as follows:

Based on the above formula, the next question would be the determination of "qualifying expenditure" (i.e., the numerator of the above formula).

In order to qualify as qualifying expenditure, the location requirement under different scenarios is as follows:

Another thing to note is that qualifying expenditure does not include the acquisition costs of the IP asset. However, the amount of qualifying expenditure can be uplifted by 30% (subject to a cap equal to the overall operating expenses incurred by the Hong Kong taxpayer).

Based on the above formula, if the majority or all of the R&D work of the Hong Kong company is outsourced to an overseas related party, it is unlikely that the Hong Kong company can pursue an offshore claim on the IP income.

Compliance requirements

A covered taxpayer who has received in-scope offshore passive income that is deemed to be sourced from Hong Kong under the proposed refined FSIE regime will be required to report the income in its profits tax return for the year of assessment in which the income is received together with certain information in relation to the income. The Inland Revenue Department will then determine whether (1) the economic substance requirement has been met; (2) the nexus approach has been complied with; (3) the participation exemption is applicable; or (4) tax credit should be granted, on a case-by-case basis.

Also taxpayer is NO LONGER go for another route of local capital claim (e.g. for dividend income) in case it is determined to be taxable under FSIE regime.

Implications on MNEs

The proposed FSIE regime is undoubtedly going to affect a significant number of MNE groups. Taxpayers are strongly advised to consult their tax advisors to review their existing offshore structure for eligibility of the exemption claim and to assess the potential exposures and to make the necessary operational reforms.

The Inland Revenue Department (IRD) also published on a dedicated webpage of its website, an administrative guidance on the refined FSIE regime which includes frequently asked questions, illustrative examples and procedures for applying for a Commissioner’s Opinion on the compliance with the proposed economic substance requirement.

For details, please refer to https://www.ird.gov.hk/eng/tax/bus_fsie.htm.