Hong Kong was placed on Annex II of the EUs list of non-cooperative jurisdictions for tax purposes, commonly known as the EU watchlist last year. In response, the Hong Kong government pledged to make changes to its foreign source income exemption (FSIE) regime in relation to certain types of passive income by the end of 2022. After several rounds of discussions, the Hong Kong government and the EU agreed on the required changes to the FSIE regime in June this year. Upon implementation of the new FSIE regime (the target date being 1 January 2023), it is generally expected that Hong Kong will be removed from the EU watchlist upon the next review. Under the new FSIE regime, only the following types of offshore passive income, interest income, dividends, disposal gains and IP income (In-scope Offshore Passive Income), will be affected, and active income will not be affected. For the In-scope Offshore Passive Income, new economic substance rules and a nexus approach have been introduced for non-IP income and IP income respectively.

Under the new FSIE regime, the In-scope Offshore Passive Income will be deemed to be sourced from Hong Kong and chargeable to profits tax if:

Economic Substance Requirements for Offshore non-IP Income

A taxpayer will need to satisfy the following economic substance requirements in order to claim income tax exemption for its offshore interest income, dividends and disposal gains:

Participation Exemption for Dividends and Disposal gains

If a taxpayer does not meet the above economic substance requirements, it may still claim participation exemption in respect of its offshore dividends and disposal gains, provided that the following conditions are satisfied:

Note that the availability of above participation exemption is subject to the following anti-abuse rules:

Nexus Approach for Offshore IP Income

Under the new FSIE regime, the extent of exemption from profits tax for offshore IP income depends on the nexus between the income receiving benefits and the expenditures contributing to that income, which is in line with the nexus approach adopted by the OECD. Under the nexus approach, only income from a qualifying IP asset (see note 1 below) can qualify for preferential tax treatment based on a nexus ratio as follows:

Note that:

a. activities undertaken by the taxpayer in Hong Kong; b. activities outsourced to unrelated parties to take place inside or outside Hong Kong; and c. activities outsourced to related parties in Hong Kong to take place inside Hong Kong.

Unilateral tax credit

As a new double taxation relief, unilateral tax credit in respect of the In-scope Offshore Passive Income will be provided to taxpayers who have paid taxes in jurisdictions which have not entered into double taxation agreements with Hong Kong.

Next Steps for the Hong Kong Government

The Hong Kong government is currently seeking comments on the details of implementation of the above changes. It is aiming to have the amendment bill passed by the end of this year, such that above changes will be effective from 1 January 2023.

It is also expected that the Hong Kong Inland Revenue Department will issue further guidance on the implementation of the changes, including factors for determining the compliance with the economic substance requirements, and application of the nexus approach, participation exemption and unilateral tax credit.

Our recommendations

While Hong Kong will continue to adopt the territorial source principle of taxation, the new FSIE regime will undoubtedly present some challenges to companies that have been claiming offshore profits in respect of their passive income received in Hong Kong. In light of the upcoming new FSIE regime, we would recommend that companies consult their tax advisors to see if the income received in Hong Kong will fall within the ambit of the new regime, and structure their business operations accordingly. We will provide further information and analysis when the draft bill is available.

Taxpayers are also reminded to actively track the developments on Pillar Two of the framework for international tax reform on base erosion and profit shifting (BEPS 2.0) and ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) by Hong Kong. More on this in due course.

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New Economic Substance Requirements and Nexus Approach Regarding Tax Exemption for Offshore Passive Income in Hong Kong - Lexology