The new foreign-sourced income exemption regime in Hong Kong

The proposed new regime's law Bill, made public on 28 October 2022, will be implemented from 1 January 2023. The Inland Revenue Department (IRD) simultaneously released certain guidelines (the Bill) to help targeted businesses better comprehend the real-world effects of this reform.

Who is affected

Companies based in Hong Kong that are part of a multinational enterprise (MNE) are affected by the FSIE. As per the Bill, a MNE is defined as a group that consists of at least one entity or permanent establishment that is not located in the jurisdiction of the group's ultimate parent entity.

How are companies affected

The Bill states that foreign-sourced income will be considered as received in Hong Kong if it meets the following criteria:

• It is sent to, brought into, or remitted to Hong Kong;
• It is utilized to pay off debt incurred while engaging in a Hong Kong-based trade, profession, or company; or
• It is used to purchase movable property that is transported into Hong Kong.

Dividends, interest, royalties, and capital gains are the four categories of passive income that will be covered under the new FSIE regime. If the receiving Hong Kong entity is a subsidiary of a MNE, it will be taxed at the usual rate of 16.5%, once the income is received in Hong Kong.

Exceptions

Individual taxpayers, standalone local entities with no operation outside Hong Kong in the form of permanent establishments, and local groups without overseas constituent entities are exempted. Entities benefitting from preferential tax regimes of Hong Kong are also not affected.

Additionally, three main exemptions apply:

1. Exemption for economic substance

If the receiving entity can prove economic substance in Hong Kong, interest, dividends, and capital gains will be excluded from Hong Kong profits tax.

How do you define economic substance? Taxpayers who do not classify as pure equity-holding corporations must show that they have made efforts to engage in "defined economic activity" in Hong Kong by employing competent personnel and incurring operational costs. While pure equity-holding taxpayers only need to demonstrate that they have the necessary facilities and human resources to engage in "specified economic activities."

2. Participation exemption

Hong Kong profits tax may not apply to offshore dividends and capital gains in the following circumstances:

• The investor resides in Hong Kong, or has a permanent establishment there;
• The investor owns at least 5% of the equity stakes or shares of the investee companies from whom it earns passive income; or
• Passive income accounts for no more than 50% of the revenue received by these investors.

3. Nexus exemption

If the underlying intellectual property assets are patents or functionally equivalent to patents, some exemptions will be given for offshore passive income. However, when compared to interest, dividends, and disposal gains, IP income will be subject to different exemption conditions.

The Nexus approach considers the amount of IP income from foreign sources that is to be exempted, rather than applying the economic substance criteria. The exemption is based on a fraction of the R&D spend and the IP income may be exempt based on a proportion that considers the qualifying R&D expenditure on the overall R&D expenditure incurred in developing the IP asset.