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Hong Kong to adopt a new foreign-sourced income regime in 2023.

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The Inland Revenue (Amendment) (Taxation on Specified Foreign-Sourced Income) Bill 2022, which proposed changes to Hong Kong’s foreign-sourced income exemption (FSIE) regime, was announced on 28 October 2022 in response to the European Union’s list of non-cooperative jurisdictions for tax purposes. The new Bill will come into effect on 1 January 2023, with no grandfathering arrangement.

Specified foreign-sourced income (interest, dividends, disposal gains and intellectual property (IP) income) will be considered taxable in Hong Kong and subject to profits tax if the following conditions are satisfied:

  • The income is received by a multinational enterprise (MNE) engaging in trade, profession or business in Hong Kong, irrespective of its revenue or asset size
  • The recipient entity fails to meet the economic substance, nexus or participation requirements

Income received in Hong Kong

Income will be deemed as received in Hong Kong if one of the following conditions is met:

  • Remitted to, or is transmitted or brought into Hong Kong
  • Used to satisfy debt incurred concerning a trade, profession or business carried on in Hong Kong
  • Used to buy moveable property, which is brought into Hong Kong. The income is regarded as received when the moveable property is brought into Hong Kong.

If the MNE entity fails to comply with the economic substance requirement, nexus requirement or participation requirement, specified foreign-sourced income will be subject to profits tax in the year of assessment when the income is received in Hong Kong.

Exemption requirements

If an MNE entity satisfies the exemption requirements for specific types of incomes, specified foreign-sourced income received in Hong Kong will not be deemed taxable:

  • The economic substance requirement applies to interest, dividends and disposal gains
  • The nexus requirement applies to IP income
  • The participation requirement applies to dividends and disposal gains

Economic substance requirements for interest, dividends and disposal gains

The following requirements must be taken into consideration to avoid taxation:

Pure equity-holding entity

A pure equity-holding entity refers to an MNE entity that only holds an equity interest in other entities and earns dividends, disposal gains and income incidental to the acquisition, holding or sale of such equity interests.

To satisfy the economic substance requirements, MNE entities are required to:

  • Comply with every applicable registration and filing requirement under the Companies Ordinance, the Limited Partnerships Ordinance and the Business Registration Ordinance
  • Carry out the specified economic activities in Hong Kong
  • Have adequate human resources and premises for carrying out specified economic activities

Specified economic activities for pure equity-holding entities refer to holding and managing its equity participations in other entities.

Non-pure equity-holding entity

A non-pure equity-holding entity refers to an MNE entity that is not a pure-equity holding company.

The economic substance requirements for non-pure equity-holding entities are:

  • Employ an adequate number of employees with the necessary qualifications to carry out the specified economic activities in Hong Kong
  • Incur adequate amount of operating expenditure for carrying out specified economic activities in Hong Kong

Specified economic activities for non-pure equity-holding entities refer to making strategic decisions and managing and bearing principal risks in respect of any assets the entity acquires, holds or disposes of; and managing and bearing principal risks in respect of such assets.

Outsourcing to a third party or group company

An MNE entity can outsource all or some of the specified economic activities under the economic substance requirements. Outsourcing refers to contracting with, delegating to, or outsourcing to third parties of group companies. Outsourcing of specified economic activities must not be used to violate the economic substance requirement.

Nexus requirement for IP income

The nexus requirement was adopted by the Organisation for Economic Co-operation and Development (OECD) and determines the amount of foreign-sourced income that will be exempted from profits tax.

Qualifying IP includes the use of patents and copyrighted software. Only qualifying IP income derived from qualifying IP can be exempted from profits tax based on a nexus ratio proportional to the research and development expenditure.

Qualifying IP income is derived from the following:

  • The exhibition or use of, or a right to exhibit or use (whether inside or outside Hong Kong) the IP
  • The imparting or, or undertaking to impart, knowledge directly or indirectly connected with the use (whether inside or outside Hong Kong) of the IP

Participation requirement for dividends and disposal gains

The participation requirement is an additional method that allows MNE entities to be exempted from taxation for dividends and disposal gains.

The conditions for the participation requirement are:

  • The MNE entity is a Hong Kong resident person or has a permanent establishment in Hong Kong in which dividends or disposal gains are attributable.
  • The MNE entity has continuously held not less than 5% of equity interest in the invested entity concerned for not less than 12 months immediately before the income accrues

The participation requirement is subject to anti-abuse rules as follows:

  • Switch-over rule
  • Anti-hybrid mismatch rule
  • Main purpose rule

Tax reporting and compliance

The tax obligations of an MNE entity are:

  • Report specified foreign-sourced income and amount of chargeable specified foreign-sourced income in the profits tax return for the year of assessment in which the income arises in Hong Kong
  • If no profits tax return has been issued for the year of assessment in question, it must inform the IRD in writing within four months of the end of the basis period of the year of assessment during which the income is received in Hong Kong that it is subject to profits tax
  • Notify the IRD in writing of the withdrawal, abandonment or refusal of a patent application for which an expected portion of qualifying IP income was considered as not subject to profits tax in the prior year of assessment within four months of the end of the basis period of the year of assessment in which the withdrawal, abandonment or refusal occurs
  • Keep track of all transactions, acts and activities involving the specified foreign-sourced income for at least seven years after they were completed or seven years after the income was received in Hong Kong

Final thoughts

The Hong Kong government amended the Bill regarding the FSIE regime to avoid being blacklisted by the European Union, and this Bill will be effective from 1 January 2023. It is important that entities understand any new changes to the FSIE regime before the Bill comes into effect. Businesses should also review their corporate structure for eligibility for tax exemption. If you have any questions, do not hesitate to contact Acclime Hong Kong.


About Acclime.

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Hong Kong to adopt a new foreign-sourced income regime in 2023