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To address harmful tax competition, the European Union (“EU”) requires Member States to refrain from introducing any new harmful tax measures and amend any laws or practices deemed to be harmful. Regarding non-EU jurisdictions, the EU has also evaluated their tax regimes against international tax standards and put in place a list of noncooperative jurisdictions for tax purposes (“EU List”). In October 2021, the EU placed Hong Kong on the watchlist of the EU List because of the possible risks of double non-taxation arising from the tax exemption for passive offshore income in the absence of any requirement for recipient companies to have a substantial economic presence in Hong Kong. The EU’s primary concern is the possible exploitation of the tax arrangement by shell companies for tax benefits.
To consolidate Hong Kong’s status as an international financial centre, minimize reputational risk arising from non-compliance with international standards and protect Hong Kong businesses against potential defensive measures that may arise from EU decisions; Hong Kong has proposed changes to the offshore regime for passive income.
The government has recently released a consultation paper on its proposal to refine the FSIE regime. In its consultation paper, the government stated that it would uphold the following principles to protect Hong Kong’s interests:
In refining our FSIE regime, the government will give due regard to the EU’s criteria for a non-harmful FSIE regime concerning passive income:
No changes will be made to the FSIE regime concerning active income. The salient features of the refined FSIE regime are summarized below:
Covered income and covered taxpayers
Covered income or in-scope offshore passive income, i.e. interest, IP Income, dividends and Disposal Gains, will be deemed to be sourced from Hong Kong and chargeable to tax if:
Economic substance requirement
In-scope offshore passive non-IP Income which is received in Hong Kong by a covered taxpayer will continue to be exempt from profits tax if the taxpayer conducts substantial economic activities concerning the relevant passive income in Hong Kong:
To meet the economic substance requirement, the taxpayer will need to meet the adequacy test in terms of employing an adequate number of qualified employees and incurring an adequate amount of operating expenditures in Hong Kong with the relevant activities. The Inland Revenue Department (“IRD”) will consider the totality of facts of each case, including the nature of the business, the scale of operation, profitability, details of staff employed, the amount and types of operating expenditures incurred etc.
Nexus approach for IP Income
For offshore IP Income, the nexus approach will be applied to determine the extent of exempting such income. Under the nexus approach, only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures as a proportion of the overall expenditures that the taxpayer has incurred to develop the IP asset. The proportion of research and development (“R&D”) expenditure is a proxy for substantial economic activities. This seeks to ensure that there is a direct nexus between income-receiving benefits and expenditures contributing to that income. The nexus approach includes the following features:
Participation exemption for dividends and Disposal Gains
The government will introduce participation exemption in respect of offshore dividends and Disposal Gains so that the income concerned will continue to be tax-exempted if:
The proposed participation exemption aims to avoid possible double taxation and relieve the compliance burden for claiming relief for double taxation through a tax credit. Anti-abuse rules will be introduced at the same time to prevent non-Hong Kong resident entities having non-nexus with Hong Kong from benefiting from the exemption by use of shell entities:
To maintain Hong Kong’s tax competitiveness and ease the compliance burden for MNE groups, Hong Kong will introduce unilateral tax credit in respect of in-scope offshore passive income to supplement the existing double taxation relief.
Hong Kong will provide a unilateral tax credit to avoid double taxation if a taxpayer fails to get tax exemption but has already paid tax in non-CDTA jurisdiction.
The government plan to introduce a bill on the proposed refinements on FSIE regime in October with a view to bringing the changes into force from 1 January 2023.
The proposed changes are intended to prevent the use of shell companies to benefit from tax exemption. However, they could have far-reaching implications. The proposed new rules apply to all types of passive offshore income regardless of the amount of income concerned, the size of the revenue or assets of the taxpayer or the MNE group which the taxpayer belongs. Introducing participation exemption, nexus approach, switch over rule, and anti-hybrid mismatch rule will make Hong Kong's tax system no longer as "simple" as it used to be. It represents a significant change to our existing tax system.
To continue enjoying the tax exemption, the economic substance requirement requires taxpayers to conduct substantial economic activities concerning the relevant income in Hong Kong. While the government stated in the consultation that the source of profits and economic substance requirement would be considered separately, the changes will inevitably affect many offshore claims. In addition, offshore Disposal Gains of a capital nature are not excluded / exempted under the proposed refinements. This may cause capital gain claims for certain offshore Disposal Gains to no longer be available. As preferential tax treatment based on the nexus ratio will only apply to income from qualifying IP assets, offshore royalty income for marketing-related IP assets may not be able to get any tax exemption.
The proposed new regime will only apply to passive offshore income received in Hong Kong. Therefore, foreign passive income, which a covered taxpayer in Hong Kong does not receive, should not be taxable. Hopefully, the amendment bill will spell out clearly how the term will be construed.
MNE groups should review whether they have Hong Kong companies and/or Hong Kong PEs that receive in-scope offshore passive income. If so, assess the current investment structure and mode of operation and consider making necessary adjustments to preserve the exemption status.
[1] "MNE Group" means any group that includes two or more enterprises the tax residence for which is in different jurisdictions or includes an enterprise that is resident for tax purpose in one jurisdiction and is subject to tax with respect to the business carried out through a permanent establishment in another jurisdiction.
[2] "Pure equity holding company" means a company which, as its primary function, acquires and holds shares and equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interest.
[3] Under jurisdictional approach, qualifying expenditures cover the expenditures on R&D activities (a) undertaken by the taxpayer within the jurisdiction providing the IP regime ("IP regime jurisdiction"); (b) outsourced to unrelated parties to take place inside or outside the IP regime jurisdiction; and (c) outsourced to resident related parties to take place within the IP regime jurisdiction.
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