A Challenge to Hong Kong’s Long-Established Offshore Tax System
Updated: Dec 1, 2022
Once enacted into law, the new FSIE regime will apply as from January 1, 2023, in Hong Kong.
Hong Kong is well-known for its simple and low tax system. It adopts a territorial taxation system, which only taxes income earned in Hong Kong. Suppose a company derives onshore income by providing services locally and offshore income by sending its staff overseas to deliver the services. In this case, only the onshore income will be chargeable to Hong Kong tax. The offshore income will not be taxable in Hong Kong, although it may be subject to tax in other jurisdictions depending on local tax law. Such a tax system is known internationally as the “foreign-source income exemption (FSIE)” regime.
Challenge from the European Union (EU)
In recent years, the EU has conducted an exercise to review the FSIE regimes of various jurisdictions, including Hong Kong. The EU had a particular concern that Hong Kong allows tax exemptions for passive income derived by companies that may not have any economic activities in Hong Kong. Passive income generally refers to dividends, interest income, royalties etc. The EU considered this feature harmful because it may create a situation where multinational enterprise (MNE) groups use shell companies to book passive income in Hong Kong to obtain certain tax benefits. As a result, the EU put Hong Kong on its watch list of non-cooperative tax jurisdictions in 2021.
As an immediate response, Hong Kong announced its commitment to amend its tax law by December 31, 2022. To minimize the impact on most of the businesses in Hong Kong, the amendments would only target corporations that have no substantial economic activity in Hong Kong but are receiving non-taxable passive income. Hong Kong will continue to adopt the territorial source principle of taxation.
In July 2022, the Hong Kong government released its proposed plan for the amendments to its FSIE regime for passive income. Meant to address the EU’s concerns, the proposed FSIE regime is a refinement to Hong Kong’s long-established offshore tax system.
Key features of the proposed FSIE regime
Under the refined regime, taxpayers need to satisfy certain additional conditions to enjoy a tax exemption for offshore passive income. The in-scope passive income includes interest, income from intellectual property (IP), dividends and gains from the disposal of shares that are received in Hong Kong. The new regime applies to MNE groups only.
In-scope offshore interest, dividends and disposal gains received in Hong Kong are eligible for tax exemption if substantial economic activities are conducted in Hong Kong. This will be tested in terms of the number of qualified employees in Hong Kong and the amount of operating expenditures incurred in Hong Kong.
If the taxpayer fails to meet the economic substance requirement, participation exemption is an alternative way to get the tax exemption for dividends and disposal gains. Certain conditions must be met for the participation exemption, such as holding at least 5% of the shares in the invested company.
The exemption requirements for offshore IP income are different from other passive income. Instead of imposing the economic substance requirements, the exemption will be granted with reference to the level of research and development activities concerning the IP. This approach is in line with international standards.
Foreign tax credit
To further mitigate the impact, Hong Kong plans to introduce a new unilateral tax credit system for these passive incomes. If a taxpayer fails to get an exemption under the FSIE regime and happens to pay foreign taxes on the same income, a foreign tax credit would be granted to provide double taxation relief. In most cases, if the income has been subject to tax in a foreign jurisdiction, it would only need to pay a minimal or even no tax in Hong Kong due to the relatively low tax rate in Hong Kong.
The Hong Kong government targets to introduce the draft legislation in late October or early November 2022. Once enacted into law, the new regime will apply as from January 1, 2023.
The new regime will mainly affect shell companies set up by MNE groups. The tax impact on companies with existing operations in Hong Kong would not be significant. Most likely, they will only be subject to additional tax compliance requirements.
Meanwhile, with the amendments to the FSIE regime, there is no doubt that Hong Kong’s territorial system of taxation will no longer be as “simple” as it used to be. MNE groups with in-scope offshore passive income should review their existing investment holding structures and operating models and consider making the necessary adjustments to preserve their tax-exempt status. Taxpayers should also understand the associated compliance requirements and maintain relevant information and documents.
While it is a challenge, it is also an opportunity for Hong Kong to enhance its tax system to align with international standards. The Hong Kong government has made its very best effort to be friendly to businesses and maintain Hong Kong’s status as an international financial center.