Hong Kong: Developments with respect to foreign-sourced income exemption regime
Clarifications/updates contained in the government’s responses; “headline rate” approach for participation exemption
Clarifications/updates contained in the government’s responses
Draft legislation implementing the revised foreign-sourced income exemption (FSIE) regime, along with administrative guidance from the Inland Revenue Department (IRD) on the FSIE regime, was published on 28 October 2022. Read TaxNewsFlash
Following issuance of the draft legislation in the gazette, the Legislative Council formed a committee to consider the legislation and invited comments on the proposed law. The government subsequently provided responses to the comments received. In addition, the government recently indicated that it has reached an agreement with the EU to adopt the “headline rate” approach for the participation exemption under the FSIE regime. Both of these developments are discussed below.
Key clarifications/updates contained in the government’s responses
- Scope of dividend income: “Dividend” generally refers to a payment of part of the profits for a period in respect of a company’s share and does not include distributions from a partnership (that is not a legal person), unit trust or other non-corporate entities and profit distributions from a branch.
- Scope of interest income: “Interest” generally refers to the sum payable for the use of money and is in the nature of compensation for the deprivation of such use. However, the government’s responses did not clarify whether finance lease income would be regarded as “interest” under the FSIE regime.
- Equity disposal gains: The government will discuss with the EU the possibility of rebasing the value of the equity interest sold to the fair value as of 31 December 2022 for the purpose of computing the quantum of the in-scope foreign-sourced equity disposal gains.
- Definition of “pure equity holding entity” (PEHE): Borrowing money for financing its equity investment and earning incidental income (e.g., exchange gains) from such borrowing does not disqualify an entity from being a PEHE. However, an entity that makes interest-free loans to its investee entities, lends the surplus funds arising from the foreign-sourced dividends to a group treasury company, or uses the surplus funds to participate in a group cash pooling arrangement to earn interest income does not qualify as a PEHE.
- Reduced economic substance (ES) requirement for PEHE: In assessing whether a PEHE has satisfied the reduced ES requirement, the IRD will take into account the commercial reality of the taxpayer, having regard to its entire operations. The IRD will also provide examples to illustrate the meaning of “holding and managing equity participations” in administrative guidance to be issued.
- Outsourcing arrangement: It would be sufficient for a taxpayer to have an internal master service agreement or other proper documentation about the outsourcing arrangement to prove that outsourcing of specified economic activities and its monitoring have taken place. Whether the service fee charged under the outsourcing arrangement needs to be at arm’s length is subject to the applicability of the transfer pricing rules.
- The “15% subject to tax” condition under the participation exemption: The government has agreed with the EU to adopt the “headline rate” approach, which is discussed below. When the specified foreign-sourced income is a dividend, the IRD will explore whether the aggregation of (1) similar tax on both dividends and the underlying profits in a territory outside Hong Kong and (2) similar tax on the related downstream income in territories outside Hong Kong can be allowed for the purpose of determining whether the “15% subject to tax” condition is met.
- Foreign tax credit: The threshold of adequate equity interest (i.e., 10%) for foreign tax credit claim on the underlying profits out of which the dividends are paid is consistent with the threshold stipulated in Hong Kong’s income tax treaties with China and Vietnam, which are the only existing tax treaties allowing Hong Kong to provide tax credit in respect of underlying profits out of which dividends are paid. An “income-by-income” basis (i.e., the approach adopted under the current tax credit system) will be adopted in determining the tax credit available under the FSIE regime.
The “headline rate” approach for participation exemption
In a letter addressed to the committee considering the proposed law (dated 23 November 2022), the government indicated that the following “headline rate” approach will be adopted for the purpose of determining whether the specified foreign-sourced income, underlying profits or related downstream income is subject to tax at not less than 15% under the “15% subject to tax” condition of the participation exemption:
- The applicable rate generally refers to the headline rate (i.e., the highest corporate tax rate) of the foreign jurisdiction in which the specified foreign-sourced income, underlying profits or related downstream income is taxed. The headline rate needs not to be the actual tax rate imposed on the income concerned.
- However, if the income concerned is taxable under a special tax legislation (e.g., a preferential tax regime) at a lower rate than in the main legislation, and the lower rate is not a tax incentive for carrying out substantive activities, the headline rate would be the highest stipulated tax rate in the special legislation.
However, it is yet to be seen how the “headline rate” approach will be adopted in situations when (1) the tax rate applicable to equity disposal gains derived by non-residents is lower than the headline corporate tax rate (e.g., 10% in China), (2) a foreign jurisdiction provides a tax exemption on capital gains, and (3) a reduced tax rate or tax exemption is applicable for equity disposal gains under a tax treaty.
Tax practitioners are hopeful that the IRD will provide more guidance and examples that are in line with the real-life commercial situations to better illustrate how the various requirements under the FSIE regime will be administered in practice.
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