Foreign Source Income Exemption (“FSIE”) regime – effective from 1 January 2023
The latest international tax standards require a taxpayer benefitting from a preferential tax treatment in a jurisdiction to have substantial economic presence in the jurisdiction, and to establish an explicit link between the relevant income and real activities in the jurisdiction. With a view to supporting international efforts in combating cross-border tax evasion and preventing double non-taxation, Hong Kong committed to amending its FSIE regime for passive income in accordance with the Guidance on FSIE regimes promulgated by the European Union.
The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) provides a new framework for Hong Kong’s FSIE regime with a view to bringing the regime into force from 1 January 2023. The Amendment Bill aims to amend the Inland Revenue Ordinance (Cap. 112) (IRO) to regard certain foreign-sourced income as arising in or derived from Hong Kong and to provide for relief against double taxation in respect of certain foreign-sourced income.
Only members of Multinational Enterprise groups (“MNE group”) will be subject to the new FSIE regime. MNE group is a group that includes at least one entity or permanent establishment that is not located or established in the jurisdiction of the ultimate parent entity of the group. The governing principle to determine whether an entity is a part of an MNE group is to follow the accounting consolidation rules. If the accounting rules do not require the financial results of an entity to be included in the consolidated financial statements of its ultimate parent entity on a line-by-line basis (except that its exclusion is solely on size or materiality grounds or on the grounds that it is held for sale), the entity will not form part of a group and the new FSIE regime will not be applicable to it.
An MNE entity which benefits from the existing preferential tax regimes of Hong Kong will be regarded as an excluded entity and excluded from the scope of the new FSIE regime. This is due to the fact that the substantial activities requirements of the preferential tax regimes largely overlap with the economic substance requirement of the new FSIE regime.
Treatment of Specified Foreign-sourced Income
Under the new FSIE regime, specified foreign-sourced passive income, including interest, dividend, disposal gain from the sale of equity interests in an entity (“disposal gain”) and intellectual property (“IP”) income, will be deemed to be sourced from Hong Kong and chargeable to profits tax if the income is received in Hong Kong by an MNE entity carrying on a trade, profession or business in Hong Kong irrespective of its revenue or asset size. However, it does not include any interest, dividend or disposal gain derived by a regulated financial entity from the carrying on of a business as such a regulated financial entity.
The new regime continues to allow taxpayer to claim tax exemption based on fulfilling criteria, or to apply specific exemption requirements:
- Non-IP passive income: Companies with substantial economic activities in Hong Kong
- IP-related income that meets specific nexus requirements, and
- Dividend income and disposal gain that meet the participation requirements
The main concern for companies is the ‘economic substance’ test. To meet the test, the company will need to employ an adequate number of qualified employees and incur an adequate amount of operating expenditures in carrying out relevant economic activities in Hong Kong. A pure equity holding company might further qualify under a “reduced economic substance test”, fulfilling compliance requirements under Companies Ordinance.
Exemption for dividend income or disposal gain can be claimed through the participation requirement, provided the company is:
- Resident in Hong Kong or has permanent establishment in Hong Kong,
- Holds at least 5% of the investee company’s share or equity interest, and
- Has held the investment for at least 12 months.
However, there are several rules to disallow the participation exemption, including Switch-over rule (to make sure tax is paid somewhere), Anti-hybrid mismatch rule (to avoid double tax benefits and Main purpose rule (to avoid aggressive tax planning).
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