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In response to its inclusion on the “watchlist” for non-cooperative jurisdictions for tax purposes by the European Union (“EU”), the Hong Kong government launched a consultation on the proposed refinements to Hong Kong’s FSIE regime for passive income, mapping out significant changes to address the EU’s concerns such that Hong Kong would not be “blacklisted” by the EU for tax purposes.
The amendment bill in relation to the proposed refinements will be introduced into the Legislative Council in October 2022. The Financial Services and the Treasury Bureau aim to secure the passing of the amendment bill by the end of 2022 and bring the refined FSIE regime into force from 1 January 2023. The Inland Revenue Department will issue administrative guidance on requirements for exemptions and tax credits (please see part 2 below).
- What is taxable and who is the taxpayer?
Under the FSIE, offshore passive income is deemed to be sourced from Hong Kong and chargeable to profits tax if it is:
- interest, dividends, disposal gains or intellectual properties (“IP”) income (collectively, “In-scope Offshore Passive Income”);
- received in Hong Kong;
- by a constituent entity of an MNE group (a “Covered Taxpayer”); and
- the Covered Taxpayer fails to meet the relevant economic substance requirement or nexus approach requirements.
The proposed refinements will only apply to multinational enterprise groups (“MNE”) which is defined under the Global Anti-Base Erosion (“GloBE”) Rules promulgated by the Organisation for Economic Co-operation and Development as “any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the ultimate parent entity”.
Hence, the proposed refinements are not applicable to: (1) stand-alone local companies, (2) purely local group companies or (3) individuals.
Exemptions and tax credit
According to the consultation paper, by meeting the relevant economic substance requirements or nexus approach requirements, or qualifying under the participation exemption, an In-scope Offshore Passive Income could still be exempt from profits tax.
Step 1 and 2: economic substance / nexus approach & participation exemption
|Interest||Dividends||Disposal gains||IP income|
Can the covered income fulfill these requirements?
1a. If yes, the income would not be deemed taxable.
1b. If no:
For interest and IP income, check if the income is qualified for foreign tax credit or unilateral tax credit (see Step 3 below).
For dividends and disposal gains, check if the income is qualified for participation exemption (see Step 2 below).
Economic substance requirements
· The Covered Taxpayer has to conduct substantial economic activities (“Relevant Activities”) with respect to the relevant passive income in Hong Kong:
o for a non-pure equity holding company, the Relevant Activities will include (i) making necessary strategic decision, and (ii) managing and assuming principal risks in respect of any assets it acquires, holds or disposes of.
o for a pure equity holding company (i.e. a company which, as its primary function, acquires and holds shares or equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interest), a reduced substantial activities test applies and the Relevant Activities will only include (i) holding and managing its equity participation, and (ii) complying with the corporate law filing requirements in Hong Kong.
· It is possible for the Covered Taxpayer to outsource the Relevant Activities if it is able to demonstrate (i) adequate monitoring of the outsourced activities, and (ii) that the Relevant Activities are conducted in Hong Kong.
How is “substance” being measured?
· Non-pure equity holding companies have to meet the adequacy test in terms of:
o (i) employing an adequate number of qualified employees; and
o (ii) incurring an adequate amount of operating expenditures in Hong Kong in relation to the Relevant Activities.
· The Inland Revenue Department (“IRD”) will consider whether a taxpayer has met the adequacy test after taking into account a list of factors, including:
o (i) nature of business;
o (ii) scale of operation;
o (iii) profitability;
o (iv) details of employees employed;
o (v) the amount and types of operating expenditures incurred, etc.
· As the adequacy test will be determined based on a totality of facts, there will be no minimum objective threshold in terms of number of employees or operating expenditure.
· Pure equity holding companies have to meet the reduced substantial activities test, which may be satisfied by:
o (i) having a director who is a Hong Kong tax resident;
o (ii) holding annual board meetings;
o (iii) fulfilling annual filing requirements under the Companies Ordinance, etc.
o subject to further guidance from the IRD and the draft legislation.
Nexus approach requirements
· Income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio
· Nexus ratio = Qualifying expenditures incurred by the taxpayer to develop the IP asset / Overall expenditures incurred by the taxpayer to develop the IP asset
· This proportion of research and development (“R&D”) expenditures is a proxy for substantial economic activities.
Qualifying IP asset
· Only covers (i) patents and (ii) other IP assets which are functionally equivalent to patents if those IP assets are both legally protected and subject to similar approval and registration processes (e.g. copyrighted software)
· Marketing-related IP assets (e.g. trademark and copyright) are excluded from the preferential tax treatment
· Only include R&D expenditures that are directly connected to the IP asset
· Acquisition costs of the IP asset are excluded
· Only cover expenditures on R&D activities (i) undertaken by the taxpayer within the jurisdiction providing the IP regime (“IP Regime Jurisdiction”); (ii) outsourced to unrelated parties to take place inside or outside the IP Regime Jurisdiction; and (iii) outsourced to resident related parties to take place within the IP regime jurisdiction
· Taxpayers may be permitted to apply a 30% uplift on the qualifying expenditures, subject to a cap equal to the overall expenditures incurred by the taxpayer
For dividends and disposal gains that are already deemed taxable, can the participation exemption requirements be fulfilled?
2a. If yes, the income can be exempt.
2b. If no, check if the income is qualified for foreign tax credit or unilateral tax credit (see Step 3 below).
· The income concerned will continue to be tax-exempt if:
o (i) the investor company is a Hong Kong resident person (i.e. a company incorporated in Hong Kong, or if incorporated outside Hong Kong, normally managed or controlled in Hong Kong) or a non-Hong Kong resident person that has a permanent establishment in Hong Kong;
o (ii) the investor company holds at least 5% of the shares or equity interest in the investee company; and
o (iii) no more than 50% of the income derived by the investee company is passive income.
· In terms of the requirement of “Hong Kong resident person”, it may not be necessary for companies to apply for a Hong Kong Tax Resident Certificate. The company should be able to fulfill this requirement by demonstrating control of the company in Hong Kong, having a majority of directors who are Hong Kong residents, conducting business activities in Hong Kong, having meetings in Hong Kong etc.
· (i) Switch-over rule
o If the income concerned or the profits of the investee company is or are subject to tax in a foreign jurisdiction the headline tax rate of which is below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit.
· (ii) Main purpose rule
o If there is any arrangement or series of arrangements undertaken by the investor company with a main purpose (or one of the main purposes) of obtaining a tax advantage that defeats the object or purpose of the exemption, the participation exemption will not be available.
· (iii) Anti-hybrid mismatch rule
o Where the income concerned is dividends, the participation exemption will not apply to the extent that the dividend payment is deductible by the investee company.
Step 3: double taxation relief – unilateral tax credit
For taxpayers who would suffer double taxation if they fail to get exemption under the refined FSIE regime, it is proposed that a unilateral tax credit will be provided to these taxpayers who paid tax in a jurisdiction which has not entered into a comprehensive avoidance of double taxation agreement with Hong Kong (“Non-CDTA Jurisdiction”).
The proposed unilateral tax credit will only be provided in respect of the In-scope Offshore Passive Income which is taxable under the refined FSIE regime. No such tax credit will be available for:
- In-scope Offshore Passive Income which is exempt from profits tax under the refined FSIE regime;
- Tax paid in a Non-CDTA Jurisdiction which relates to income other than the In-scope Offshore Passive Income; or
- Tax paid in a jurisdiction that has a tax treaty with Hong Kong (in such case tax credit would be made available under the tax treaty).
The change in Hong Kong’s FSIE regime is happening soon (possibly on 1 January 2023 as aforementioned) for Hong Kong to keep up with the latest international tax standards. While we await the introduction of the amendment bill, it is advisable for businesses to keep an eye on the latest developments, review the corporate structure with reference to the information currently available and consult a tax adviser if in doubt.
If you have any question regarding the topic discussed above, please contact our partner Victor Ng at firstname.lastname@example.org for further assistance.
Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.
Authored by: Victor Ng and Katherine Ho