Hong Kong starts to tax
17 January 2023
In response to the EU’s concerns, Hong Kong government amended its foreign-source income exemption (FSIE) regime.
Under the new FSIE regime specified foreign-sourced income accrued to a member of an MNE group (MNE entity) carrying on a trade, profession or business in Hong Kong is to be regarded as arising in or derived from Hong Kong. It means that once income is received in Hong Kong it might be chargeable to tax there.
The changes came into effect from 1 January 2023.
Specified foreign-sourced income means any of the following income arising in or derived from a territory outside Hong Kong:
· disposal gain from the sale of equity interests in an entity (disposal gain)
· intellectual property (IP) income
There some exclusions. For example, provided the requirements are met, it does not include any interest, dividend or disposal gain derived by a regulated financial entity or an entity that is a ship-owner.
Generally, MNE groups have a greater incentive to adopt aggressive tax planning strategies and as such there are higher base erosion and profit shifting risks. So, only members of MNE groups (MNE entity) will be subject to the new FSIE regime. The Amendment Ordinance provides the following definitions:
Treatment of Specified Foreign-sourced Income
Deeming provision. Under the new FSIE regime, specified foreign-sourced income will be deemed to be sourced from Hong Kong and chargeable to profits tax if:
(a) 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; and
(b) the recipient entity fails to meet the economic substance requirement (if the income is foreign-sourced interest, dividend or disposal gain), or fails to comply with the nexus requirement (if the income is foreign-sourced IP income), or fails to comply with the participation requirement (if the income is foreign-sourced dividend or disposal gain).
Income Received in Hong Kong
A specified foreign-sourced income is regarded as received in Hong Kong when:
· the income is remitted to, or is transmitted or brought into, Hong Kong;
· the income is used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong; or
· the income is used to buy movable property, and the property is brought into Hong Kong. The income is regarded as being received at the time when the moveable property is brought into Hong Kong.
Exceptions from the Deeming Provision
Specified foreign-sourced income received in Hong Kong will not be brought into charge if the MNE entity meets the exception requirements specifically for the particular types of incomes:
Exception 1: Economic Substance Requirement
Foreign-sourced interest, dividend or disposal gain received in Hong Kong by an MNE entity will continue to be exempt from profits tax if the economic substance requirement is met for the year of assessment in which the income accrues.
(A) Pure equity-holding entity
(B) Non-pure equity-holding entity
Adequacy tests. As the mode of operation of MNE entities varies from industry to industry, it was neither feasible nor appropriate to specify any minimum thresholds for determining whether the adequacy tests are satisfied for the purposes of economic substance requirement. Each case will be considered on its own facts and circumstances.
Factors that will be taken into account include:
· the average number of employees having regard to the nature and level of the specified economic activities;
· whether the employees are employed on a full-time or part-time basis;
· whether the qualifications of the employees are related to the nature of the specified economic activities;
· the quantitative and qualitative aspects of the management and the administration of the MNE entity; and
· whether office premises have been used for undertaking the specified economic activities and whether the premises are adequate for such activities.
Outsourcing of specified economic activities. The economic substance requirement allows an MNE entity to outsource some or all of its specified economic activities. Outsourcing, in this context, includes outsourcing, contracting or delegating to third parties or group entities. Outsourcing of specified economic activities should in no circumstances be used to circumvent the economic substance requirement.
Provided the outsourcing requirements are met, the resources of the outsourced entity in Hong Kong will be taken into consideration when determining whether the MNE entity can satisfy the adequacy tests in relation to premises and human resources (for pure equity-holding entities), or qualified employees and operating expenditures (for non-pure equity-holding entities).
Exception 2: Nexus Requirement
As regards foreign-sourced IP income, a nexus requirement is in place to determine the extent of such income to be exempt from profits tax. In brief, certain portion of the income derived from a qualifying intellectual property (qualifying IP income) can be exempt from profits tax, and that portion is referred to as “excepted portion”.
What is the nexus requirement?
The nexus requirement means the nexus approach adopted by the Organisation for Economic Cooperation and Development (OECD) as a minimum standard under Action 5 of the package of actions to tackle base erosion and profit shifting (BEPS) promulgated in 2015 (the BEPS Action 5 Report).
Under the nexus approach, only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio. A nexus ratio is defined as the qualifying expenditures to a proportion of the overall expenditures that have been incurred by a taxpayer to develop an IP asset. The proportion of research and development (R&D) expenditures is a proxy for substantial economic activities. This seeks to ensure that there is a direct nexus between the income receiving benefits and the expenditures contributing to that income.
Under the new FSIE regime, the provisions relating to the nexus requirement should be read in the way that best secures consistency with the requirements and guidance in Chapter 4 of the BEPS Action 5 Report.
What is qualifying IP income
"Qualifying IP income" means income derived from qualifying intellectual property in respect of:
(a) the exhibition or use of, or a right to exhibit or use (whether in or outside Hong Kong) the property; or
(b) the imparting of, or undertaking to impart, knowledge directly or indirectly connected with the use (whether in or outside Hong Kong) of the property.
What is qualifying intellectual property
“Qualifying intellectual property” means:
· a patent granted under the Patents Ordinance (Cap. 514);
· a patent application made under Cap. 514;
· a copyright subsisting in software under the Copyright Ordinance (Cap. 528); or
· any of the above intellectual properties granted, made or subsisted under the law of any place outside Hong Kong.
What is the R&D fraction
The definition of “R&D fraction” in the Amendment Ordinance is modelled on the nexus ratio referred to in the BEPS Action 5 Report. The R&D fraction is calculated in accordance with the following formula and capped at 100%–
F = QE × 130% / QE + NE
where F means the R&D fraction;
QE means the qualifying R&D expenditure incurred in respect of the qualifying intellectual property to which the qualifying IP income relates; and
NE means the non-qualifying expenditure incurred in respect of the same qualifying intellectual property.
The R&D fraction is used to calculate the excepted portion of qualifying IP income received by an MNE entity, which is ascertained in accordance with the following formula:
P = I × F
where P means the excepted portion;
I means the qualifying IP income; and
F means the R&D fraction applicable to the qualifying IP income.
Exception 3: Participation Requirement
The participation requirement provides an alternative to the economic substance requirement to facilitate an MNE entity which receives foreign-sourced dividend or disposal gain in Hong Kong to claim tax exemption.
Conditions for the participation requirement:
· the MNE entity is a Hong Kong resident person, or where it is a non-Hong Kong resident person, it has a PE in Hong Kong to which the foreign-sourced dividend or disposal gain is attributable; and
· the MNE entity has continuously held not less than 5% of equity interests in the investee entity concerned for a period of not less than 12 months immediately before the foreign-sourced dividend or disposal gain accrues.
Switch-over rule (Subject to tax condition)
If the specified foreign-sourced income is a disposal gain, the participation exemption only applies if the disposal gain is subject to a qualifying similar tax in a territory outside Hong Kong (foreign jurisdiction).
If the specified foreign-sourced income is dividend, the participation exemption only applies if any of the following sums is subject to a qualifying similar tax in a foreign jurisdiction:
a. the dividend; or
b. the underlying profits out of which the dividend is paid
A sum is subject to a qualifying similar tax in a foreign jurisdiction if the sum is subject to a tax that is of substantially the same nature as profits tax in the foreign jurisdiction (foreign tax); and the tax rate applicable to the sum (applicable rate) is at least 15%.
If an MNE entity satisfies the participation requirement but fails on the subject to tax condition in respect of a foreign-sourced dividend or disposal gain received in Hong Kong, the tax relief available in relation to the income concerned will be switched over from full exemption to tax credit.
In other words, the MNE entity will remain subject to profits tax in respect of the income but with a deduction from the profits tax of foreign tax paid on the income and underlying profits / income.
Anti-hybrid mismatch rule
Where the specified foreign-sourced income is a dividend, and tax is charged on the underlying profits of the dividend in a territory outside Hong Kong, the participation exemption will not apply to the extent that the dividend is allowable for deduction when computing the amount of tax of the investee entity.
Main purpose rule
If the Commissioner is of the opinion that the main purpose, or one of the main purposes, of entering into an arrangement is to obtain a tax benefit in relation to a liability to pay profits tax, the participation exemption will not apply.
Double Taxation Relief
If an MNE entity receives specified foreign-sourced income chargeable to profits tax and has paid tax in a territory outside Hong Kong, double taxation relief will be available regardless of whether that territory has entered into a comprehensive avoidance of double taxation arrangement (CDTA) with Hong Kong or not.
The amount of tax credit is capped at the lower of foreign tax paid and the profits tax that would have been payable on the same income.
Tax credit under CDTAs
For any similar tax payable on specified foreign-sourced income in a territory outside Hong Kong with which CDTA has been made, bilateral tax credit pursuant to the relevant CDTA will be granted to the MNE entity if it is a Hong Kong resident person.
To align the treatment on foreign tax paid in a CDTA territory and a non-CDTA territory, tax payable in respect of the underlying profits out of which a foreign-sourced dividend was paid but not allowable as bilateral tax credit under the CDTA may be allowed as a unilateral tax credit against profits tax charged on the foreign-sourced dividend.
Unilateral tax credit
For any similar tax payable on specified foreign-sourced income in a non-CDTA territory, unilateral tax credit will be provided to the MNE entity if it is a Hong Kong resident person. Any tax credit allowed will be set off against the profits tax payable in respect of the specified foreign-sourced income concerned.
In other words, unilateral tax credit will be provided when the income is received in Hong Kong. Also, no tax credit will be available if the specified foreign-sourced income is exempt from profits tax under the new
FSIE regime or if the tax paid in a non-CDTA territory relates to income other than specified foreign-sourced income.
Where the specified foreign-sourced income is a dividend, tax credits will be allowed in respect of not only the foreign tax paid on the dividend, but also the foreign tax paid on the investee entity’s underlying profits out of which the dividend is paid, provided that the MNE entity has held at least 10% equity interests in the investee entity when the dividend is distributed.
Deduction as expenses
Where the MNE entity is not a Hong Kong resident person, the foreign tax paid on the specified foreign-sourced income which is chargeable to profits tax in Hong Kong may be allowed as deduction under section 16(1)(ca) of the IRO.