Source of Profits – The Foreign Sourced Income Exemption Regime in Hong Kong

Overview

Where a taxpayer is a part of a multinational enterprise (“MNE”) group which obtains preferential tax treatment for group income in a tax jurisdiction, European tax standards require the taxpayer to demonstrate both a substantial economic presence in that jurisdiction and a linkage between that income and the activities undertaken by the taxpayer in that jurisdiction. To address EU criticism that Hong Kong’s territorial tax system was inconsistent with these standards, Hong Kong introduced amendments to the Inland Revenue Ordinance (“IRO”) which took effect in January 2023, deeming certain foreign sourced income earned by Hong Kong taxpayers within MNE groups to be subject to Hong Kong profits tax unless such taxpayers can demonstrate economic substance in Hong Kong.

Recently, under an updated guidance promulgated by the EU in December 2022, jurisdictions with FSIE regimes were requested by the EU to refine their FSIE regimes by further amending their tax treatment of certain foreign sourced income. As a result, Hong Kong passed supplemental legislation to amend the IRO to broaden the scope of foreign sourced income subject to economic substance requirements. This supplemental legislation took effect from January 2024.

Background to Territorial Tax System

The IRO establishes a territorial tax system which taxes profits based on source of profits. It provides for profits tax to be charged on every person carrying on a business in Hong Kong in respect of its assessable profits arising in or derived from Hong Kong for that year from such business. Under this system, the profits which a taxpayer earns from carrying on a business in Hong Kong are only subject to profits tax where such profits are sourced in Hong Kong, meaning they arise in or derive from Hong Kong.

A business may thus earn income earned outside of Hong Kong which falls outside the scope of Hong Kong profits tax even though the business is carried on in Hong Kong.

Background to Foreign Sourced Income Exemption Regime

In 2021 the EU included Hong Kong in its watchlist as it expressed concern that Hong Kong’s territorial tax system may encourage MNE groups to shift taxable income to a Hong Kong entity, thus opening up the possibility that such income may be neither taxed in the jurisdiction where the economic activities to earn the income took place nor in Hong Kong. Though any base erosion and profit shifting (“BEPS”) legislation in the jurisdiction where the economic activities took place would likely require a MNE group to allocate income to that jurisdiction in proportion to economic substance in that jurisdiction, the EU criticisms in effect sought to impose tax disincentives for the MNE group to allocate income tax-free to Hong Kong in the absence of economic substance in Hong Kong.

Specified Foreign Sourced Income

Covered Income

The 2023 amendments to the IRO introduced provisions which deem specified types of foreign sourced income earned by a Hong Kong entity within an MNE group, namely interest, income from intellectual properties (referred to as IP income), dividends, and disposal gains in relation to shares or equity interest, to be sourced in Hong Kong (and thus subject to profits tax) if the Hong Kong entity fails to meet the economic substance requirement (for interest, dividend and non-IP disposal gain) or fails to comply with the nexus approach (for qualifying general IP income and qualifying IP disposal gain). These deeming provisions apply irrespective of the revenue or asset size of the Hong Kong entity.

The 2024 amendments to the IRO expanded the foreign sourced income covered under the FSIE regime to include disposal gains in relation to all assets, covering both movable property and immovable property.

Exclusion for Investment Businesses Related Income

The FSIE regime carves out foreign sourced income in the form of interest, dividend or non-IP disposal gain earned by regulated financial institutions, investment funds and family offices. The carve out recognizes that many financial institutions, investment funds and family offices operating in Hong Kong may earn investment income sourced outside Hong Kong.

The carve-outs cover:

• Investment Income Earned by Regulated Financial Institutions – Specified foreign sourced income excludes interest, dividend or non-IP disposal gain that accrues to an entity regulated by (i) the Hong Kong Monetary Authority (“HKMA”) as an authorized institution, (ii) the Securities and Futures Commission (“SFC”) as a licensed corporation under the Securities and Futures Ordinance, or (iii) the Insurance Authority (“IA”) as an insurer, and that is derived from, or is incidental to, the entity’s business as a regulated financial entity.in personam;

• Investment Income Earned by Funds- Specified foreign sourced income excludes interest, dividend or non-IP disposal gain that accrues to an entity that is exempt from tax under the unified funds tax exemption regime (for a recap of that regime, see our earlier article titled “DIPN 61 Guidance on the New Unified Funds Tax Exemption for OFCs and Limited Partnership Funds”)

• Investment Income Earned by Entities Subject to Concessionary Rates - Specified foreign sourced income excludes interest, dividend or non-IP disposal gain that accrues to certain entities who may benefit from concessionary tax rates. In the context of the finance industry, these entities may include insurance brokers licensed by the IA, private equity fund sponsors earning carried interest and investment holding vehicles of family offices as well as entities carrying out corporate treasury functions.

Similar exclusions apply to interest, dividend or non-IP disposal gain earned by eligible entities in the aircraft and shipping industries.

Exclusion for Non-IP Gains Earned by Traders

The FSIE regime carves out foreign sourced income in the form of non-IP disposal gains which are derived from, or are incidental to, the carrying on of a business as a trader (e.g. gains from the sale of immovable properties by property developers). The carve out recognizes that such non-IP disposal gains are foreign sourced active income which is not intended to be covered by the FSIE regime.

Scope of Deeming Provisions

The provisions deeming foreign sourced income to be sourced in Hong Kong require:

• Multinational Group Recipient – The income must be received in Hong Kong by an MNE entity carrying on business in Hong Kong. For this purpose, an “MNE entity” means a person that is, or acts for, an MNE group or an entity included in an MNE group.
  In turn, an “MNE group” is a collection of entities that are required under applicable accounting principles to be included in the consolidated financial statements of the ultimate parent entity of the collection and that includes at least one entity or permanent establishment that is not located or established in the jurisdiction of this ultimate parent entity. Entities include legal arrangements that prepare separate financial statements, such as partnerships and trusts, but exclude natural persons.

• Income Sourced Outside Hong Kong – The income must not be otherwise chargeable to profits tax and must arise in or derive from a territory outside Hong Kong.

• Income is Investment or Intellectual Property Related – The income is any interest, dividend, disposal gain or IP income.
  For this purpose, a “disposal gain” includes any “IP disposal gain” as well as “non-IP disposal gain”. The former is any gain or profit from the sale of intellectual property, and the latter is any gain or profit derived from the sale of property other than intellectual property.
  “IP income” is income derived from intellectual property including in respect of the exhibition or use of the intellectual property.

Exception Based on Economic Substance for Non-IP Income & Non-IP Disposal Gain

The deeming rules will not apply to foreign sourced income received in Hong Kong by an MNE entity if (a) the income is interest, dividend or non-IP disposal gain; and (b) the economic substance requirements are met. The economic substance requirements will differ depending on whether the MNE entity is a pure holding company or not.

Pure Holding Companies

If the MNE entity is a pure equity-holding entity, economic substance requirements will be met if:

• Due Registration - The entity complies with applicable registration and filing requirements under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”), the Companies Ordinance (“CO”), the Limited Partnerships Ordinance (“LPO”) and the Business Registration Ordinance (“BRO”).

• Specified Economic Activities – The entity either holds and manages its equity participations in other entities in Hong Kong or has arranged for such activities to be carried out in Hong Kong.

• Adequate Staff and Office Arrangements – The Commissioner of Inland Revenue (Commissioner) must be of the opinion that the entity has adequate human resources and premises for carrying out the specified economic activities.

Operating Companies

If the MNE entity is not a pure equity-holding entity, economic substance requirements will be met if:

• Specified Economic Activities – The entity either (i) in Hong Kong, makes necessary strategic decisions in respect of any assets it acquires, holds or disposes of and manages and bears principal risks in respect of such assets, or (ii) arranges for such activities to be carried out in Hong Kong.

• Adequate Staff – The number of employees in Hong Kong to carry out the specified economic activities who have qualifications necessary for doing so must be adequate in the opinion of the Commissioner.

• Adequate Operating Expenses – The total amount of operating expenditure incurred in Hong Kong for carrying out the specified economic activities must be adequate in the opinion of the Commissioner.

Exception Based on Nexus Requirement for Qualifying IP Income & IP Disposal Gain

The FSIE regime does not deem intellectual property related income to be sourced in Hong Kong to the extent of its development nexus in Hong Kong. Under this nexus approach, a certain portion (referred to as “excepted portion”) of the income derived from qualifying intellectual property can be exempt from profits tax based on a nexus ratio which considers the proportion which qualifying expenditures bear to the overall expenditures that have been incurred by the MNE entity to develop the intellectual property.

Qualifying Intellectual Property

For this purpose, “qualifying intellectual property” means, a patent granted (or a patent application made) under the Patents Ordinance, a copyright subsisting in software under the Copyright Ordinance, or any of the foregoing intellectual properties granted, made or subsisted under the law of any place outside Hong Kong.

Qualifying Expenditures

“Qualifying expenditures” refer to qualifying research and development (“R&D”) expenditure incurred in respect of the qualifying intellectual property to which the income relates. This treats the proportion of R&D expenditures as a proxy for substantial economic activities in Hong Kong and seeks to ensure that there is a direct nexus between the income receiving benefits from such activities and the expenditures contributing to that income.

xception Based on Participation for Dividend & Equity interest Disposal Gain

Even if an MNE entity is unable to meet economic substance requirements, it may be exempted from the provisions deeming foreign sourced income to be sourced in Hong Kong if:

• Hong Kong Nexus – The MNE entity is a Hong Kong resident person or a non-Hong Kong resident person which has permanent establishment in Hong Kong.

• Income is Equity Related Investment Income Taxed at Source Territory – The income takes the form of a dividend or an equity interest disposal gain in circumstances where the income (or the underlying profits giving rise to dividend income) has already been subject to tax in the source territory at a rate of 15% or more. Where the MNE entity is a non-Hong Kong resident person, this income must be attributable to a permanent establishment in Hong Kong.

• Non-Trivial Long Term Holding – The MNE entity must have continuously held an equity interest of not less than 5% in the investee entity (i.e. the entity which distributes the dividend, or the shares of which are sold to give rise to the disposal gain), for a period of not less than 12 months immediately before the income accrued.

The exception is intended to reduce the risk of double taxation which may arise, for example, where the investee entity distributing the dividend has already been taxed on the income which is being distributed, and to relieve the compliance burden of needing to claim relief against double taxation.

As a result, the participation exemption is subject to some anti-abuse rules:

• Switch-Over Rule – If the income (or the underlying profits giving rise to dividend income) is subject to tax in the source territory at a rate below 15%, a switch-over rule might apply to switch over the tax relief available to the taxpayer from the participation exemption to foreign tax credit. This means that the taxpayer would remain subject to Hong Kong profits tax in respect of that income, but with a deduction from Hong Kong profits tax of foreign tax paid attributable to that income (or the underlying profits giving rise to that dividend income).

• Main Purpose Rule – The participation exemption does not apply where the Commissioner is satisfied that the main purpose (or one of the main purposes) for the arrangement giving rise to the foreign sourced income is to obtain a tax benefit.

• Anti-hybrid Mismatch Rule – Where the income concerned is a dividend, the participation exemption only applies to the extent that the dividend payment is not deductible by the investee entity when computing the amount of foreign tax payable on the underlying profits giving rise to that dividend income.

Exception for Intra-group Transfers for Disposal Gain

Foreign sourced income in the form of disposal gain is deemed to result in no taxable gain if the income is received in Hong Kong by an MNE entity (the “selling entity”) from a sale of property to another entity (the “acquiring entity”), both the selling entity and the acquiring entity are chargeable to profits tax and the sale is an intra-group transfer.

Intra-Group Transfer

An “intra-group transfer” is a transfer where at the time of the transfer, both the selling entity and the acquiring entity are associated. The entities would be considered as “associated” where:

• one of the entities has at least 75% of direct or indirect beneficial interest, or is directly or indirectly entitled to exercise or control the exercise of at least 75% of the voting rights, in or in relation to the other entity concerned; or

• a third entity has at least 75% of direct or indirect beneficial interest, or is directly or indirectly entitled to exercise or control the exercise of at least 75% of the voting rights, in or in relation to each entity concerned

Anti-Abuse Rules

The intra-group transfer relief is subject to anti-abuse rules. Under these rules, relief will cease to apply where, within 2 years after the sale concerned:

• the selling entity or the acquiring entity ceases to be chargeable to profits tax in Hong Kong; or

• the selling entity and the acquiring entity cease to be associated with each other.