The Hong Kong foreign-sourced income exemption regime

On Jan. 1, 2023, the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance of 2022 went into effect in Hong Kong. Hong Kong’s new foreign-sourced income exemption (FSIE) regime requires that certain foreign-sourced income accrued to (or earned by) a multinational enterprise (MNE) group member (MNE entity) engaged in a trade, profession, or business in Hong Kong be treated as originating in or derived from Hong Kong and subject to profits tax at the time of receipt. The Amendment Ordinance also changed the Inland Revenue Ordinance (IRO) to include provisions for transitional issues and relief from double taxation with regard to certain foreign-sourced income.

U.S. MNEs with Hong Kong subsidiaries should analyze whether they are subject to the new FSIE regime.

Covered taxpayers

Only MNE entities will be subject to the new FSIE regime as it is thought that MNE groups have a greater incentive to adopt aggressive tax planning strategies which may result in higher base erosion and profit-shifting risks.

Covered income

Specified foreign-sourced income means any of the following income arising in or derived from a territory outside Hong Kong:

• Interest
• Dividend
• Disposal gain from the sale of equity interests in an entity (disposal gain)
• Intellectual property (IP) income

However, it does not include any interest, dividend, or disposal gain derived by any of the following entities:

• A regulated financial entity
• An entity the assessable profits of which are chargeable to tax at the rate specified in a concession provision (as defined by section 19CA of the IRO) other than section 14A(1)
• An entity that is exempt from tax chargeable in respect of its assessable profits under section 20AC, 20ACA, 20AN, or 20AO of the IRO
• An entity that is a ship-owner and has any exempt sums excluded under section 23B(4AA) of the IRO from the amount of relevant sums earned by or accrued to the entity

Deeming provisions

If the income is received by the MNE entity in Hong Kong and the MNE entity does not meet the exception requirements in the year of assessment in which the income accrues, the specified foreign-sourced income will be deemed to be Hong Kong sourced (and as not arising from the sale of capital assets even if it does) and chargeable to profits tax in the year of assessment in which it is received.

Exceptions from the deeming provision

If the MNE entity satisfies the exception criteria for the specific types of incomes, the specified foreign-sourced income received in Hong Kong will not be brought into charge. The following criteria apply to exceptions:

Exception requirements

Economic substance requirement

If the economic substance requirement is satisfied for the year of assessment in which the income accrues, foreign-sourced interest, dividends, or disposal gains received in Hong Kong by an MNE entity will continue to be exempt from profits tax.

The Inland Revenue Department (IRD) will consider the totality of facts and circumstances of each case to determine the minimum thresholds for the economic substance requirement. These can include:

• Nature of specified economic activities (e.g., capital or labor-intensive industry)
• Full-time or part-time employees
• Employees’ qualifications
• Quantitative and qualitative aspects of management and administration
• Office premises

Nexus requirement: IP income

For foreign-sourced IP income, the nexus requirement will be in place to determine the extent of such income to be exempt from profits tax. The excepted portion is calculated based on a nexus ratio which is defined as the qualifying research and development (R&D) expenditures as a proportion of the overall expenditures that have been incurred to which the qualifying IP income relates.

A QE does not include interest payments, payments for any land or buildings, or for any alteration, addition, or extension to any building and acquisition of IP. A NE does not include interest payments and payments for any land or buildings, or for any alteration, addition, or extension to any building.

Participation requirement

For an MNE entity that receives a foreign-sourced dividend or disposal gain in Hong Kong, the participation requirement offers an alternative to the economic substance requirement in order to facilitate tax exemption.

The prerequisites for the participation requirement are:

• The MNE entity is a Hong Kong resident person, or where it is a non-Hong Kong resident person, it has a permanent establishment (PE) in Hong Kong to which the foreign-sourced dividend or 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 disposal gain accrues.

The above participation exemption is subject to the following anti-abuse rules:

Switch-over rule (subject to tax condition)

The participation exemption will only apply if the foreign-sourced disposal gains and dividends (or the underlying profits out of which the dividend is paid) is subject to a qualifying similar tax in a foreign jurisdiction of at least 15%. In case the specified foreign-sourced income is a dividend, the total amount of the underlying profits out of which the dividends are paid and subject to tax at 15% or above must be equal to or larger than the amount of the subject dividends. A see-through approach is adopted such that the underlying dividends/profits of up to five tiers of investee entities will be taken into account when assessing whether the condition is met. If the MNE entity fails the subject to tax condition, the tax relief available will be switched over from full exemption to tax credit. In other words, the MNE entity will remain subject to Hong Kong profits tax in respect of the income concerned but with a deduction from the Hong Kong profits tax of the foreign tax paid on the income concerned and underlying profits/income.

Anti-hybrid mismatch rule

If the income concerned is a dividend, the participation exemption will not apply to the extent that the dividend is allowable for deduction when computing the amount of tax of the investee entity.

Main purpose rule

If the arrangement (or series of arrangements) has been put into place for the main purpose (or one of the main purposes) of obtaining a tax advantage that defeats the object or purpose of the exemption, the arrangement will be regarded as non-genuine and be ignored (i.e., participation exemption will not apply).

Setting off losses

Foreign-sourced qualifying IP income

If an MNE entity receives a foreign-sourced qualifying IP income and sustains a loss in respect of the qualifying IP to which the income relates, the qualifying portion of the loss (i.e., the portion of the loss that is not attributable to the excepted portion of the qualifying IP income) may be set off against the assessable profits of the MNE entity for that year of assessment. Any portion of loss not so set off may be carried forward to subsequent years of assessment.

Sale of offshore equity interests

In case an MNE entity sustains a loss from a sale of offshore equity interests (disposal loss), the disposal loss can be used to set off against the taxpayer’s assessable profits derived from specified foreign-sourced income that is chargeable to profits tax under the FSIE regime in the year of assessment the sale proceeds are received in Hong Kong if the taxpayer fails to meet the economic substance requirement and the conditions for participation exemption. Any amount of loss not so set off can be carried forward and set off against the taxpayer’s assessable profits derived from specified foreign-sourced income in subsequent years of assessment.

Double taxation relief

Whether or not the foreign jurisdiction has entered into a comprehensive avoidance of double taxation agreement (CDTA) with Hong Kong, double taxation relief will be available on the similar tax payable on the specified foreign-sourced income in the event that the MNE entity is a Hong Kong resident but is unable to qualify for an exemption under the FSIE regime. The tax credit amount is limited to the lesser of the foreign tax paid and the profits tax that would have been due on the same income.

When a dividend is the specified foreign-sourced income, tax credits will be granted for both the foreign tax paid on the dividend and the underlying profits of the investee entity from which the dividend is paid, as long as the MNE entity had at least a 10% equity stake in the investee entity at the time the dividend was distributed.

If the MNE entity is not a resident of Hong Kong, section 16(1)(ca) of IRO may allow the foreign tax paid on the specified foreign-sourced income that is subject to profits tax in Hong Kong to be deducted.

Tax implications to the U.S.MNES with a Hong Kong holding company and Chinese subsidiary

For a variety of reasons, many U.S. MNEs establish Hong Kong holding companies solely for the purpose of holding equity interest in Chinese investments. The new Hong Kong FSIE regime offers good news to U.S. MNEs in this type of structure (or similar structure). In this scenario, U.S. MNEs will likely continue to remain exempt from profits tax on certain types of specified foreign-sourced income.

• Dividend: Chinese subsidiary distributions to their parent Hong Kong holding company are likely exempt from profits tax under the participation exemption since China’s corporate tax rate is 25% (i.e., a qualifying similar tax), which is greater than 15%. However, U.S. MNEs must meet the 12-month holding period requirement to qualify for the participation exemption.
  
• Disposal gain: Similar to dividends, disposal gain is exempt from profits tax under the participation exemption if the disposal gain is subject to a tax that is of substantially the same nature as profits tax in the jurisdiction outside of Hong Kong, and the applicable tax rate is at least 15%. 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. China’s corporate income tax rate is 25%, and disposal gain is subject to a 10% withholding tax rate in China. For purposes of qualifying for the participation exemption, the headline tax rate for disposal gain would be 25%, which is greater than 15%. As such, the majority of U.S. MNEs with a Hong Kong holding company are likely exempt from profits tax with regards to disposal gain from the sale of equity interests in their Chinese subsidiary.
• Interest: Due to the stringent currency control regime of China, it is not common for U.S. MNEs with a Hong Kong holding company to provide loans to their Chinese subsidiary and as such, receive interest. If a Hong Kong-based company receives foreign-sourced interest payments, such interest payments could be exempt from profits tax if the economic substance requirement is met. Satisfying the economic substance requirement requires additional analysis.
  
• IP income: A nexus requirement is in place to determine the extent that foreign-sourced IP income is exempt from the profits tax. Nevertheless, it is not common for Hong Kong holding companies to receive royalty income from their Chinese subsidiaries.