7 July 20227 minute read

New Economic Substance Requirements and Nexus Approach Regarding Tax Exemption for Offshore Passive Income in Hong Kong

Hong Kong was placed on Annex II of the EU’s list of non-cooperative jurisdictions for tax purposes, commonly known as the EU “watchlist” last year.  In response, the Hong Kong government pledged to make changes to its foreign source income exemption (FSIE) regime in relation to certain types of passive income by the end of 2022.  After several rounds of discussions, the Hong Kong government and the EU agreed on the required changes to the FSIE regime in June this year.  Upon implementation of the new FSIE regime (the target date being 1 January 2023), it is generally expected that Hong Kong will be removed from the EU watchlist upon the next review.  Under the new FSIE regime, only the following types of offshore passive income, interest income, dividends, disposal gains and IP income (In-scope Offshore Passive Income), will be affected, and active income will not be affected.  For the In-scope Offshore Passive Income, new economic substance rules and a nexus approach have been introduced for non-IP income and IP income respectively.

Under the new FSIE regime, the In-scope Offshore Passive Income will be deemed to be sourced from Hong Kong and chargeable to profits tax if:

  • the income is received in Hong Kong by a constituent entity of a multinational enterprise (irrespective of its revenue or asset size); and
  • the recipient entity fails to meet the relevant economic substance requirements (for non-IP income), or fails to comply with the nexus approach (for IP income).
Economic Substance Requirements for Offshore non-IP Income

A taxpayer will need to satisfy the following economic substance requirements in order to claim income tax exemption for its offshore interest income, dividends and disposal gains:

  1. Substantial economic activities requirement: There are substantial economic activities conducted by the taxpayer in Hong Kong.
  • For a pure equity holding company, such activities will include holding and managing its equity participation, and complying with the corporate law filing requirements in Hong Kong.
  • For companies other than a pure equity holding company, such activities include making necessary strategic decision, and managing and assuming principal risks in respect of any assets they acquire, hold or dispose of.
  • Outsourcing of the economic activities will be permitted provided that there is adequate monitoring of the outsourced activities conducted in Hong Kong by the taxpayer.
  1. Adequacy requirement: There should be an adequate number of qualified employees and adequate amount of operating expenditures incurred in Hong Kong in relation to the above economic activities.
Participation Exemption for Dividends and Disposal gains

If a taxpayer does not meet the above economic substance requirements, it may still claim participation exemption in respect of its offshore dividends and disposal gains, provided that the following conditions are satisfied:

  1. the investor company is a Hong Kong resident person (i.e. a company incorporated in Hong Kong, or if incorporated outside of Hong Kong, normally managed or controlled in Hong Kong), or a non-Hong Kong resident person that has a permanent establishment in Hong Kong;
  1. the investor company holds at least 5% of the shares or equity interest in the investee company; and
  1. no more than 50% of the income derived by the investee company is the In-scope Offshore Passive Income.

Note that the availability of above participation exemption is subject to the following anti-abuse rules: 

  • Switch-over rule: If the income concerned or the profits of the investee company is subject to tax in a foreign jurisdiction with a headline tax rate below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit.
  • Main purpose rule: If the main purpose or one of the main purposes of any arrangement is to obtain a tax advantage that defeats the purposes of the exemption, participation exemption will not be available.
  • Anti-hybrid mismatch rule: Where the income concerned is dividends, participation exemption will not apply to the extent the dividend payment is deductible by the investee company.
Nexus Approach for Offshore IP Income

Under the new FSIE regime, the extent of exemption from profits tax for offshore IP income depends on the nexus between the income receiving benefits and the expenditures contributing to that income, which is in line with the nexus approach adopted by the OECD.  Under the nexus approach, only income from a qualifying IP asset (see note 1 below) can qualify for preferential tax treatment based on a nexus ratio as follows:

Qualifying expenditures (see notes 2 to 4 below)
Overall expenditures incurred by the taxpayer to develop the IP asset

Note that:

  1. Qualifying IP assets only cover patents and other IP assets which are functionally equivalent to patents (e.g. copyrighted software), and do not cover marketing-related IP (e.g. trademark and copyright).
  1. Qualifying expenditures only include R&D expenditures that are directly connected to the qualifying IP assets, and do not include acquisition costs.
  1. The expenditures on R&D activities cover:

a. activities undertaken by the taxpayer in Hong Kong;
b. activities outsourced to unrelated parties to take place inside or outside Hong Kong; and
c. activities outsourced to related parties in Hong Kong to take place inside Hong Kong.

  1. A 30% uplift on the qualifying expenditures subject to the extent that the taxpayer has incurred non-qualifying expenditures may be allowed.
Unilateral tax credit

As a new double taxation relief, unilateral tax credit in respect of the In-scope Offshore Passive Income will be provided to taxpayers who have paid taxes in jurisdictions which have not entered into double taxation agreements with Hong Kong. 

Next Steps for the Hong Kong Government

The Hong Kong government is currently seeking comments on the details of implementation of the above changes.  It is aiming to have the amendment bill passed by the end of this year, such that above changes will be effective from 1 January 2023.

It is also expected that the Hong Kong Inland Revenue Department will issue further guidance on the implementation of the changes, including factors for determining the compliance with the economic substance requirements, and application of the nexus approach, participation exemption and unilateral tax credit.

Our recommendations

While Hong Kong will continue to adopt the territorial source principle of taxation, the new FSIE regime will undoubtedly present some challenges to companies that have been claiming offshore profits in respect of their passive income received in Hong Kong.  In light of the upcoming new FSIE regime, we would recommend that companies consult their tax advisors to see if the income received in Hong Kong will fall within the ambit of the new regime, and structure their business operations accordingly.  We will provide further information and analysis when the draft bill is available.

Taxpayers are also reminded to actively track the developments on Pillar Two of the framework for international tax reform on base erosion and profit shifting (BEPS 2.0) and ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) by Hong Kong.  More on this in due course.