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FSIE: What do the proposed changes to the tax regime mean to Hong Kong?

21 September 2022

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Hong Kong has long been an attractive jurisdiction for trade and tax-efficiency. But will changes to its tax-exemption regime on foreign-sourced passive incomes have a negative effect? Donald Tsang, executive director and head of corporate services, Greater China, and Larry Lai, associate director, taxation, look at the possibilities

Hong Kong is one of the most attractive jurisdictions for foreign entities to manage their assets and investments in Asia. It’s tax efficient, is one of the world’s largest financial centres, and has a robust legal framework and financial system with a highly skilled workforce.

But, like many other financial centres, Hong Kong is looking to be more in harmony with international tax frameworks.

This line of thinking was fast-tracked in October 2021, when the EU placed Hong Kong on its watchlist. It was particularly concerned about possible tax exploitation by shell companies for tax benefits.

It is feared that companies without a substantial economic presence in Hong Kong could make use of its tax exemption for offshore passive income to create a double non-taxation scenario.

To address these concerns, Hong Kong has committed to refining its foreign source income exemption (FSIE) regime for passive income by the end of 2022.

What we have seen so far of the proposals suggests business substance requirements will be similar to other jurisdictions.

The final draft will be tabled to the legislative council in Hong Kong and, once passed, will be effective from January 1, 2023, but with no grandfathering arrangement.

Companies who have or plan to have holding company structures in Hong Kong are keeping their eyes on the development of FSIE. We are confident that with forward planning many of those in-scope will have several options to retain their tax-exempt status.

For example, under the proposed new rules, covered taxpayers’ in-scope offshore passive income received in Hong Kong will be deemed to be sourced from Hong Kong and chargeable to profits tax.

Covered taxpayers include:

  • A Hong Kong constituent entity (CE) of a multinational enterprise (MNE) group, irrespective of its revenue or asset size
  • The same definitions of MNE group and CE as those under the GloBE Rules endorsed by the OECD

Covered income includes:

Offshore passive income received in Hong Kong:

  • Interest
  • Income from intellectual property – qualifying versus non-qualifying
  • Dividends
  • Disposal gains in relation to shares or equity interest

Tax exemption is still possible under FSIE

Exemption is still possible if the recipient entity meets the economic substance or nexus approach requirements for IP income. Moreover, participation-exemption protocols will be introduced for dividends and disposal gains in the event that the substance requirements are not met.

It is anticipated that the legislative procedures will be completed within Q4 2022 and that the new FSIE regime will be effective from January 2023 onwards.

In preparing for the forthcoming changes by FSIE, we recommend that companies who receive foreign-sourced passive income via their Hong Kong structures to take three simple steps:

  • Reviewing their current structure
  • Keeping eyes on the eventual guidance from the Inland Revenue Department on the implementation details of FSIE
  • Planning and building substance carefully and with guidance

Building an economic substance case in Hong Kong

One measure in-scope companies can take to ensure their foreign-sourced passive income remains tax-exempt is to assess and evaluate whether their activities in HK entail the substance requirements.

The tax authority in Hong Kong will examine the totality of facts regarding the in-scope taxpayers to determine whether they have sufficient economic substance in Hong Kong. Two primary requirements are that they have an adequate number of qualified employees and have incurred an adequate amount of operating expenditure in Hong Kong.

The comforting aspect in all of this is that these requirements can be satisfied through outsourcing. This is where our network of specialists and corporate services can be of assistance.

We can also help clients understand how to meet and report the proper proof of substance requirements (full or reduced) for the Inland Revenue Department.

Alongside our colleagues across the globe, we are working with clients on a continual basis to guide them through every aspect of setting up and running companies, trusts and investment vehicles with extensive knowledge of local rules and regulations.

 Why Intertrust Group?

  • Established in Hong Kong for more than 40 years
  • We can help clients review their structure to be effectively aligned with the proposed refinements to FSIE for passive income
  • We can provide corporate, fund, capital markets and private wealth services to help build and fulfil your economic substance case in Hong Kong
  • Intertrust Hong Kong is home to 150-plus specialists with deep professional expertise
  • We can provide access to an international network of colleagues with jurisdictional trading and regulatory knowledge to help you better align your structures in advance of any forthcoming regulatory changes