Hong Kong: Draft legislation on foreign-sourced income exemption regime
Changes and further details of the foreign-sourced income exemption regime
Draft legislation for implementing the revised foreign-sourced income exemption (FSIE) regime was published on 28 October 2022.
To assist taxpayers/companies in Hong Kong to better understand how the regime would be implemented in practice, administrative guidance on the FSIE regime was also issued by the Inland Revenue Department (IRD). The FSIE bill needs to be read together with the IRD’s administrative guidance, which contains general and sector-specific examples to illustrate the practical application of the regime.
Below is a summary of the changes and further details of the FSIE regime reflected in the legislation, as compared to the proposal released in June 2022.
Entities covered by the regime
- A multinational enterprise (MNE) entity not carrying on a trade or business in Hong Kong would be not affected by the regime.
- An overseas permanent establishment (PE) of a Hong Kong resident MNE entity would be regarded as a separate MNE entity carrying on a trade or business in the jurisdiction in which the PE is established—such PE would therefore not be affected by the FSIE regime (on the basis it does not carry on any trade or business in Hong Kong).
- The definition of an excluded entity is based on the one adopted in the global anti-base erosion (GLoBE) rules under Pillar Two of BEPS 2.0, with the following major modifications:
- An investment fund and a real estate investment vehicle that is an ultimate parent entity (UPE) would be an excluded entity, but the special purpose vehicle (SPV) held by them would not.
- The definitions of “investment fund” and “real estate investment vehicle” would be expanded and include an entity that is tax-exempt under the unified fund exemption regime in Hong Kong and an entity that is a tax-exempt specified foreign corporation (SFC) authorised collective investment scheme under the Inland Revenue Ordinance (IRO) would also be regarded as an investment fund.
- An insurance investment entity would be an excluded entity.
- An entity that is eligible for one of the concessionary tax regimes in Hong Kong would be an excluded entity.
- An entity with profits derived from operating of ships that are tax-exempt in Hong Kong under section 23B of the IRO would also be an excluded entity.
- A person that acts for an MNE group or an entity included in an MNE group would be within the scope of the regime.
Types of foreign-sourced income covered by the regime
- Specified foreign-sourced income covered by the regime would be interest, dividends, disposal gains, and IP income arising in or derived from a territory outside Hong Kong.
- Disposal gains means gains derived from the sale of equity interests in an entity (including a trust that prepares separate financial accounts) but do not include gains from disposal of partnership interests.
- IP income means income derived from the use of, or a right to use, specified intellectual property (which also include model, plan and information concerning industrial, commercial or scientific experience).
- Interest, dividends, and disposal gains derived by regulated financial entities (e.g., banks, insurance companies and SFC licensed entities) from their regulated businesses would be carved out from the regime.
Meaning of “received in Hong Kong”
Following the approach that has been adopted by Singapore, a sum is to be regarded as received in Hong Kong if:
- It is remitted to, or is transmitted or brought into, Hong Kong
- It is used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong
- It is used to buy movable property, and the property is brought into Hong Kong
Definition of “pure equity-holding entity”
A pure equity-holding entity (PEHE) means an entity that (1) only holds equity interests in other entities, and (2) only earns dividends, disposal gains and income incidental to the acquisition, holding or sale of such equity interests.
Economic substance (ES) requirements
Largely the same as the requirements set out in the June 2022 proposal, the FSIE bill confirms that (1) the ES requirements would be assessed in the year of accrual (instead of year of receipt) of the income, and (2) for a PEHE, the “corporate law filing requirements” in Hong Kong under the reduced ES requirements would include company registration, limited partnership registration, and business registration—whichever are applicable to the MNE entity.
Participation exemption for dividends and disposal gains
- A key refinement to the participation exemption regime is the requirement that not more than 50% of the income of the investee entity is passive income has now been removed and replaced with the requirement that the MNE entity has continuously held not less than 5% of equity interests in the investee entity for not less than 12 months immediately before the specified foreign-sourced income accrues to the MNE entity.
- In the case of foreign-sourced dividends:
- One of the conditions for the participation exemption to apply is the amount of the underlying profits out of which the dividends are paid is equal to or larger than the amount of the dividends.
- The “subject to tax at 15%” condition—a “see-through” approach—would be adopted such that the underlying dividends/profits of up to four tiers of investee entities would be taken into account when assessing whether the condition is met.
Nexus requirement for IP income
- The tax exemption under the nexus requirement would only apply to qualifying IP income, which means income derived from the use of, or a right to use, “qualifying intellectual property” (i.e., patent or copyright subsisting in software).
- A key refinement to the nexus requirement is that the qualifying R&D expenditure would include expenditure on R&D activities undertaken by the MNE entity itself both inside and outside Hong Kong.
- For the purpose of computing the R&D fraction (nexus ratio), an uplift of maximum of 30% of the qualifying R&D expenditure would be allowed if non-qualifying expenditure has also been incurred, but the amount after the uplift (i.e., the numerator) would be capped at the total amount of qualifying R&D expenditure and non-qualifying expenditure incurred (i.e., the denominator).
- “R&D activity” for the purpose of the nexus requirement would be defined in the same way as for the tax deduction of R&D expenditure in Hong Kong.
Losses from sale of offshore equity interests or in respect of qualifying intellectual property
Losses sustained by an MNE entity from a sale outside Hong Kong of equity interests (other than partnership interests) could be used to set off against the MNE entity’s assessable profits, subject to the following conditions:
- The sale proceeds were received in Hong Kong
- Had a gain been derived from such sale and received in Hong Kong, the gain would have been chargeable to profits tax under the FSIE regime
- The losses can only be used to set off against the assessable profits derived from chargeable specified foreign-sourced income under the FSIE regime
Similarly, the losses sustained by an MNE entity regarding a qualifying intellectual property from which chargeable qualifying IP income has been derived by the MNE entity may be used to set off against the MNE’s assessable profits, subject to specified conditions.
Double taxation relief and unilateral tax credit
To provide double taxation relief for specified foreign-sourced income that is taxable in both Hong Kong and the relevant foreign jurisdiction that does not have a double tax arrangement (DTA) with Hong Kong, unilateral tax credit (UTC) would be provided as if a DTA containing the specified provisions for allowing a tax credit were made between Hong Kong and that foreign jurisdiction—that means UTC would only be available if the MNE entity is a Hong Kong tax resident.
- When the specified foreign-sourced income is a dividend, tax credit would be allowed regarding 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.
Notification and record keeping requirements
An MNE entity deriving chargeable specified foreign-sourced income under the FSIE regime must:
- Notify the IRD in writing within four months after the end of the basis period of the year of assessment during which the income is received in Hong Kong
- Retain transaction and business records relating to the specified foreign-sourced income at least until the later of the expiration of (1) seven years after the completion of those transactions, or (2) seven years after the income is received, or deemed to be received, in Hong Kong.
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