Hong Kong's tax system is based on its unique territorial principle, which taxes only income that originates within Hong Kong. This means that income coming from overseas is not subject to local taxes in most cases. However, as the global tax framework evolves, Hong Kong's tax laws seem relatively lenient compared to other regions, particularly concerning the exemption policies for foreign income and capital gains, and there is no requirement for economic substance in taxation matters.
In October 2021, the European Union pointed out that Hong Kong's tax exemption policy for foreign income could lead to situations of "double non-taxation," and as a result, Hong Kong was once again included in the EU's gray list for tax cooperation. Facing the EU's concerns, the Hong Kong Special Administrative Region government responded promptly, promising to revise its tax laws by the end of 2022 and to introduce specific requirements for economic substance.
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Targeted Tax Items
Dividends
Interest
Gains from the disposal of equity interests
Income related to intangible assets
Entities that are members of multinational corporate groups and collect the above four types of offshore passive income in Hong Kong must satisfy the "economic substance requirements" to maintain their tax-exempt status.
If the "economic substance requirements" are not met, the related offshore passive income will be presumed to originate from Hong Kong and will be subject to profits tax.
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Exceptions from the Deeming Provision
By the 2023 Amendment Ordinance, an intra-group transfer relief has been introduced to defer charging of tax on foreign-sourced disposal gain derived from the transfer of property between associated entities, subject to specified anti-abuse rules.
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Economic substance requirement
To comply with the norms of substantial economic activity, taxpayers must satisfy the so-called "economic substance requirements" test. This includes hiring an adequate number of qualified employees in Hong Kong for their business activities and incurring corresponding operational costs. When assessing whether a taxpayer meets this standard, the tax authority will consider a range of factors such as the company's type of business, scale of operations, profitability status, specific information about employees, and the number and nature of the operational costs incurred.
At the same time, when taxpayers choose to outsource certain business activities, they must still demonstrate that they have sufficient control over these outsourced activities and ensure that these activities are substantially completed in Hong Kong. The tax authority will implement necessary safeguard provisions to prevent taxpayers from circumventing the requirements of substantial economic activity through outsourcing.
Nexus Requirement
As regards foreign-sourced qualifying IP income, a nexus requirement is in place to determine the extent of such income to be exempt from profits tax. In brief, certain portion of the income derived from qualifying intellectual property (qualifying IP income) can be exempt from profits tax, and that portion is referred to as “excepted portion”.
What is the nexus requirement
The nexus requirement means the nexus approach adopted by The Organisation for Economic Co-operation and Development (OECD) as a minimum standard under Action 5 of the package of actions to tackle base erosion and profit shifting (BEPS) promulgated in 2015 (the BEPS Action 5 Report). It has been applied by the OECD Forum on Harmful Tax Practices to evaluate the harmfulness of preferential tax regimes for IP income put in place by tax jurisdictions. All member jurisdictions of the Inclusive Framework on BEPS with IP regimes have either adopted the nexus approach or abolished their non-compliant regimes.
Under the nexus approach, only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures as a proportion of the overall expenditures that have been incurred by a taxpayer to develop an IP asset. The proportion of research and development (R&D) expenditures is a proxy for substantial economic activities. This seeks to ensure that there is a direct nexus between the income receiving benefits and the expenditures contributing to that income.
Under the FSIE regime, the provisions relating to the nexus requirement should be read in the way that best secures consistency with the requirements and guidance in Chapter 4 of the BEPS Action 5 Report.
Participation Requirement
The participation requirement provides an alternative to the economic substance requirement to facilitate an MNE entity which receives foreign-sourced dividend or equity interest disposal gain in Hong Kong to claim tax exemption.
Conditions for the participation requirement
the MNE entity is a Hong Kong resident person, or where it is a non-Hong Kong resident person, it has a permanent establishment in Hong Kong to which the foreign-sourced dividend or equity interest disposal gain is attributable; and
the MNE entity has continuously held not less than 5% of equity interests in the investee entity concerned for a period of not less than 12 months immediately before the foreign-sourced dividend or equity interest disposal gain accrues.
Certain anti-abuse rules are in place to disallow the participation exemption. These rules are as follows:
Switch-over rule (Subject to tax condition)
If the specified foreign-sourced income is an equity interest disposal gain, the participation exemption only applies if the equity interest disposal gain is subject to a qualifying similar tax in a territory outside Hong Kong (foreign jurisdiction).
If the specified foreign-sourced income is dividend, the participation exemption only applies if any of the following sums is subject to a qualifying similar tax in a foreign jurisdiction:
the dividend; or
the underlying profits out of which the dividend is paid
A sum is subject to a qualifying similar tax in a foreign jurisdiction if:
the sum is subject to a tax that is of substantially the same nature as profits tax in the foreign jurisdiction (foreign tax); and
the tax rate applicable to the sum (applicable rate) is at least 15%.
The applicable rate refers to the corporate tax rate of the foreign jurisdiction at which the foreign tax applies to the sum as business income. If the foreign tax is chargeable at the time the sum accrues, the applicable rate will be the corporate tax rate of the foreign jurisdiction applicable at that time. If the foreign tax is chargeable for the taxable period in which the sum accrues, the applicable rate will be the corporate tax rate of the foreign jurisdiction applicable for that taxable period.
Generally, the applicable rate refers to the headline rate (i.e. the highest corporate tax rate) of the jurisdiction in which the specified foreign-sourced income, underlying profits or related downstream income is taxed. This headline rate need not be the actual tax rate imposed on the income or profits concerned. If an income or profits are taxable under a special tax legislation at a lower rate than in the main legislation of the jurisdiction, and the lower rate is not a tax incentive for carrying out substantive activities, the headline tax rate should be the highest stipulated tax rate in the special legislation. If an income or profits are subject to the foreign tax at more than one rate (e.g. progressive corporate tax rates), the applicable rate will be the highest corporate tax rate applied to that income.
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