Hong Kong: Proposed changes to offshore regime for passive income
Response to the European Union’s concerns about Hong Kong’s offshore regime for passive income
Response to the European Union’s concerns about Hong Kong’s offshore regime for passive in
The government of Hong Kong—in response to the European Union’s concerns about Hong Kong’s offshore regime for passive income—proposed a revised foreign-source income exemption regime. The proposed changes include:
- A participation exemption regime for dividends and gains from disposal of equity interests
- The economic substance requirement
- The OECD’s nexus approach for income from intellectual properties
Unilateral tax credit would also be introduced to avoid potential double taxation of offshore passive income.
Subject to the completion of the legislative process, the changes would be effective 1 January 2023 with no grandfathering arrangement and would apply to multinational enterprise groups only.
The European Union (EU) put Hong Kong on the “watchlist” of its list of non-cooperative jurisdictions for tax purposes since October 2021. The EU’s main concerns are that the existing foreign-source income exemption (FSIE) regime in Hong Kong provides a tax exemption to a broad range of passive income without specific conditions and a substance requirement, and this may lead to double non-taxation of passive income booked in a Hong Kong shell company.
Proposed revised FSIE regime for passive income
After discussion with the EU, the Hong Kong government proposed a revised FSIE regime for passive income in Hong Kong. Key features of the proposed regime are summarized below and are illustrated in a table [PDF 591 KB] prepared by KPMG tax professionals.
Covered taxpayers and covered income
- Covered taxpayers—Only a constituent entity of a multinational enterprise (MNE) group would be in-scope. An MNE group would be within the scope irrespective of the group’s revenue or asset size. The definitions of constituent entity and MNE would be the same as those under the global anti-base erosion
(GloBE) rules—that is, an MNE group means any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the ultimate parent entity (UPE) whereas a constituent entity effectively would mean an entity with financial results consolidated on a line-by-line basis in the group’s consolidated financial statements. As such, associates and joint venture entities within an MNE group that are not included in the group’s consolidated financial statements, stand-alone local companies, and purely domestic groups without any offshore operations would not be affected.
- Covered income—Dividends, gains from the disposal of shares or equity interest (equity disposal gains), interest and income from intellectual properties (IP income) with an offshore source would be in-scope offshore passive income.
Offshore passive income deemed to be Hong Kong sourced and taxable
Under the proposed regime, a constituent entity of an MNE group would first need to determine whether the in-scope passive income is with an offshore source and then whether the income “is received in Hong Kong.” In-scope offshore passive income that is “received in Hong Kong” by a constituent entity of an MNE group would be deemed to be sourced from Hong Kong and taxable unless the economic substance requirement (for non-IP income), the nexus approach requirement (for IP income) or the participation exemption conditions (for dividends and equity disposal gains) are met.
Economic substance requirement for non-IP income
- Offshore dividends, equity disposal gains, and interest would be tax-exempt if substantial economic activities relevant to the income are conducted in Hong Kong.
- Covered taxpayers would need to employ an adequate number of qualified employees and incur an adequate amount of operating expenditures in Hong Kong for carrying out the relevant activities. Instead of setting the minimum threshold requirements, the totality of facts of each case would be considered in determining whether the adequacy test is met.
- A reduced substantial activities test would be applied to a “pure equity holding company” under which the relevant activities would only include: (1) holding and managing its equity participation; and (2) complying with the corporate law filing requirements in Hong Kong. A “pure equity holding company” means a company that, as its primary function, acquires and holds shares or equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interests.
- Outsourcing of the relevant activities would be permitted, provided that they are conducted in Hong Kong and being adequately monitored by the covered taxpayer.
Participation exemption regime for dividends and equity disposal gains
- A participation exemption regime would be introduced to provide tax exemption for offshore dividends and equity disposal gains regardless of whether the above economic substance requirement is met, provided that all of the following four conditions are fulfilled:
- The investor company is a Hong Kong resident person or a non-Hong Kong resident person with a permanent establishment in Hong Kong.
- The investor company holds at least 5% of the shares or equity interests in the investee company.
- No more than 50% of the income derived by the investee company is passive income.
- The passive income or the underlying profit of the investee company (for dividends) is subject to tax in a foreign jurisdiction with a headline tax rate of 15% or above.
- The switch-over rule—if the headline tax rate mentioned in item 4 above is below 15%, the dividends would be subject to Hong Kong profits tax, but double tax relief would be switched over from participation exemption to foreign tax credit. The foreign tax credit would be limited to the amount of Hong Kong profits tax attributable to the passive income concerned.
- The main purpose rule—any non-genuine arrangements that have been put in for the main purpose or one of the main purposes of obtaining a tax advantage that defeats the object or purpose of the participation exemption would be ignored.
- The anti-hybrid mismatch rule—when the income concerned is dividends, participation exemption would not apply to the extent the dividend payment is deductible by the investee company.
Nexus approach for IP income
- Only income derived from a patent or an IP asset similar to a patent (qualifying IP income) woud be entitled to a tax exemption under the nexus approach. The nexus approach was adopted by the OECD as a minimum standard for preferential tax regimes for IP income under Action 5 of the BEPS 1.0 Action Plan.
- Income derived from other IP assets (e.g., trademarks and copyright) would be excluded from the tax exemption.
- The portion of the qualifying IP income that is exempt from tax would be computed based on the nexus ratio (i.e., the qualifying expenditure as a proportion of the overall expenditure that have been incurred by the covered taxpayer to develop the IP asset).
- A “qualifying expenditure” would be an expenditure on R&D activities that are directly connected to the IP asset and (1) undertaken by the taxpayer in Hong Kong, (2) outsourced to resident related parties and that take place in Hong Kong, and (3) outsourced to unrelated parties to take place in or outside Hong Kong. Acquisition costs of IP assets would not be a qualifying expenditure. The 30% uplift on the qualifying expenditure under the OECD’s nexus approach could be applied in computing the nexus ratio if the covered taxpayer has incurred a non-qualifying expenditure.
Introduction of unilateral tax credit in Hong Kong
To provide double tax relief for in-scope offshore passive income that is subject to tax in both Hong Kong and a foreign jurisdiction that does not have an income tax treaty with Hong Kong, a unilateral tax credit would be provided. The unilateral tax credit would only be applicable to in-scope passive income and would not be available for other income even though it may be subject to tax in both Hong Kong and overseas.
The Hong Kong government plans to introduce a tax bill on the proposed FSIE regime in October 2022, and on completion of the legislative process, the regime would be effective 1 January 2023. The Inland Revenue Department then would issue administrative guidance on the FSIE regime, including the factors that would need to be considered in determining whether the substance requirement is met; the rules relating to participating exemption regime; and the application of the nexus approach.
Tax professionals believe that the revised FSIE regime for passive income represents a significant change to the long-established offshore regime in Hong Kong. Companies potentially subject to the new regime and that have been relying on an offshore claim for non-taxation of offshore passive income need to closely monitor the future developments in this area, in particular the detailed rules to be set out in the coming tax bill. These companies also need to revisit their Hong Kong profits tax positions and consider if any changes to their holding structures or operating models are desirable. In performing their assessment, the following points may need to be considered:
- The definition of constituent entity under the revised FSIE regime would follow that definition under the GloBE rules. Under the GloBE rules, a constituent entity does not include an entity that is an “excluded entity” (e.g., an investment fund that is a UPE of an MNE group). It has yet to be confirmed whether similar exclusion will be available under the regime.
- The term “received in Hong Kong” would not be limited to “remitted into Hong Kong” or “physical transfer of the monies to a Hong Kong bank account,” it may also cover the situation when the offshore passive income concerned is used to offset an intercompany payable of a Hong Kong group company.
- Complex group structures with a Hong Kong parent company carrying out mixed activities (e.g., equity holding and provision of loans to group companies) and (1) one or more layers of intermediate passive investment holding vehicle, or (2) intermediate parent companies located in low tax jurisdictions may present significant challenges.
- Under the revised FSIE regime, for an equity disposal gain that is both offshore and capital in nature, a covered taxpayer apparently would need to meet either the economic substance requirement or the participation exemption conditions for the gain to be tax-exempt and could no longer rely on a capital claim to treat it as non-taxable.
- Under the revised FSIE regime, offshore IP income unrelated to a patent (e.g., offshore royalty income from licensing of a trademark) apparently would be deemed taxable and a covered taxpayer could no longer rely on an offshore claim to treat it as non-taxable.
- The interaction between the revised FSIE regime and the global minimum tax under Pillar Two of BEPS 2.0 or a domestic minimum tax regime (e.g., the impact of offshore passive income exempt from tax under the revised FSIE regime on the computation of effective tax rate in Hong Kong) would need to be considered.
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