In October 2021, the European Union (EU) has put Hong Kong on the “greylist” or “watchlist” of non-cooperative jurisdictions for tax purposes. The EU’s main concerns are that Hong Kong‘s existing foreign source income exemption (FSIE) regime provides a tax exemption to a broad range of passive income in absence of specific conditions and a substance requirement, and this may lead to double non-taxation of passive income booked in a Hong Kong shell company.
To address the EU's concern, the Hong Kong government plans to propose a Bill to the Legislative Council in October 2022 on the proposed refinements to Hong Kong’s FSIE regime for passive income. The key features of the proposed regime are summarized below:
Covered taxpayers
Only a constituent entity (CE) of a multinational enterprise (MNE) group will be in-scope. An MNE group will be within the scope irrespective of the group’s revenue or asset size. An MNE Group means any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the ultimate parent entity whereas a CE effectively means an entity whose financial results are consolidated on a line-by-line basis in the group’s consolidated financial statements. As such, associates and joint venture entities within an MNE group that are not included in the group’s consolidated financial statements, standalone local companies and purely domestic groups without any offshore operations would not be affected.
In-scope offshore passive income
- interest
- dividends
- gains from the disposal of shares or equity interest (equity disposal gains)
- income from intellectual properties (IP income)
Exemption requirements for in-scope offshore passive income
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Interest |
Dividend & equity disposal gains |
IP income |
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Economic substance requirement |
Economic substance requirement |
Nexus approach |
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(1) Substantial economic activities are conducted in Hong Kong. Relevant activities include making necessary strategic decision, and managing and assuming principal risks in respect of any assets it acquires, holds or disposes of
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(1) Substantial economic activities are conducted in Hong Kong. Relevant activities include making necessary strategic decision, and managing and assuming principal risks in respect of any assets it acquires, holds or disposes of
For “pure equity holding company”, a reduced substantial activities test will be applied under which the relevant activities will only include:
(1) holding and managing its equity participation; and
(2) complying with the corporate law filing requirements in Hong Kong
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(1) Only income derived from a patent or an IP asset similar to a patent (qualifying IP income) can be entitled to a tax exemption under the nexus approach
(2) Income derived from other IP assets (e.g. trademarks and copyright) are excluded from the tax exemption
(3) The extent of the qualifying IP income that is exempt from tax will be computed based on the nexus ratio, i.e. the qualifying expenditure as a proportion of the overall expenditure that have been incurred by the covered taxpayer to develop the IP asset
(4) Qualifying expenditures only include R&D expenditures (exclude acquisition costs of IP asset) that are directly connected to the IP asset and - undertaken by the taxpayer in Hong Kong, - outsourced to resident related parties and take place in Hong Kong; or - outsourced to unrelated parties to take place in or outside Hong Kong |
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(2) Adequacy test (a) employ an adequate number of qualified employees in Hong Kong; and
(b) incur an adequate amount of operating expenditures in Hong Kong |
(2) Adequacy test (a) employ an adequate number of qualified employees in Hong Kong; and
(b) incur an adequate amount of operating expenditures in Hong Kong |
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Participation exemption It provides tax exemption for offshore dividends and equity disposal gains if the following four conditions are fulfilled (regardless of whether the above economic substance requirement is met):
(1) the investor company is a Hong Kong resident person or a non-Hong Kong resident person with a permanent establishment in Hong Kong;
(2) the investor company holds at least 5% of the shares or equity interests in the investee company;
(3) no more than 50% of the income derived by the investee company is passive income; and
(4) the passive income or the underlying profit of the investee company (for dividends) is subject to tax in a foreign jurisdiction with a headline tax rate of 15% or above |
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Note: A few anti-abuse rules are added to the participation exemption regime, including switch-over rule, main purpose rule and anti-hybrid mismatch rule. |
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Unilateral tax credit
To avoid double taxation, a unilateral tax credit will provide double tax relief for in-scope offshore passive income that is subject to tax in both Hong Kong and a foreign jurisdiction that does not have a Double Taxation Agreement with Hong Kong (non-CDTA jurisdiction). For tax paid in a CDTA jurisdiction, the taxpayer may claim foreign tax credit according to the existing IRO. Unilateral tax credit is only applicable to in-scope passive income and will not be available for other income even though it may be subject to tax in both Hong Kong and overseas.
Effective date
Subject to the completion of the legislative process, the new regime will be effective from 1 January 2023
For more information, please contact Ms. Amie Cheung at amie.cheung@lccpa.com.hk
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