Reform of Hong Kong’s Offshore Tax System

Hong Kong’s Offshore Tax System

The legislation on FSIE has been enacted and became effective on January 1, 2023.

Further to the introduction of the proposed Hong Kong’s new Foreign-Source Income Exemption (FSIE) regime as discussed in our article A Challenge to Hong Kong’s Long-Established Offshore Tax System in October 2022, the relevant legislation has been enacted and became effective on January 1, 2023.  

Such a reform was initiated by the European Union (EU)’s review and Hong Kong being put on the EU’s watch list of non-cooperative tax jurisdictions. To recap, under the FSIE regime, specified foreign-source income (i.e. interest, dividends, disposal gains on equity interest and income from intellectual property (IP)) received by an entity of a multinational enterprise group carrying on a business in Hong Kong are deemed taxable, unless certain conditions are met.

Foreign-source interest, dividends and disposal gains on equity interest are exempt from tax, provided the economic substance requirement is met. Participation exemption provides an additional pathway for foreign-source dividends and disposal gains on equity interest to be exempt from tax. Foreign-source IP income is exempt from tax with reference to the level of research and development activities concerning the IP. Where no exemption applies, double taxation relief is available. 

The new FSIE regime applies to the specified income received and accrued on or after January 1, 2023. There is no grandfathering rule.  

Hong Kong government’s effort

The Hong Kong government actively negotiated with the EU and engaged with stakeholders during the legislative procedures to seek a balance between the EU’s concerns and the impact on taxpayers. This helped speed up the legislative procedures within a tight timeline. 

To improve taxpayers’ certainty and reduce their tax reporting burden, the Hong Kong Inland Revenue Department (IRD) welcomes taxpayers to apply for an advance ruling to confirm their tax position under the new FSIE regime. The IRD has also provided guidelines and examples on its website.  

The impact on taxpayers

With a degree of forethought, it should be possible for the majority of taxpayers to continue their operations with relatively little financial or operational impact as a result of the implementation of the FSIE. Most likely, they will only be subject to additional tax compliance requirements.

To uphold their tax-exempt status, multinational enterprise (MNE) groups with in-scope income should review their existing investment holding structures and operating models and consider making the necessary adjustments. Taxpayers should also understand the associated compliance requirements and retain relevant information and documents. 

Upholding Hong Kong’s competitiveness 

Hong Kong is required to refine its FSIE regime to demonstrate that it is a cooperative jurisdiction within the international tax community. With the implementation of the FSIE regime, Hong Kong’s tax landscape will inevitably change. Therefore, it is important to uphold Hong Kong’s competitiveness. 

The government will explore the introduction of a preferential tax regime for Hong Kong-sourced IP income to encourage more research and development activities in Hong Kong. Some enterprises may be prompted by the FSIE regime to consider bringing transactions in respect of the disposal of equity interests onshore to get tax exemption through the capital argument route. The government will look into appropriate measures to enhance tax certainty for such kinds of transactions with a view to facilitating corporate restructuring and minimizing compliance costs.

Our observations

The government has been transparent throughout the consultation and has responded to the industry and practitioners’ feedback in respect of the FSIE regime. Some of the exemption conditions have been refined so that the exemptions are more likely to apply to taxpayers. The tax credit regime has also been enhanced to avoid double taxation to a large extent. We hope that the refined FSIE regime will pass the EU’s review and look forward to Hong Kong being removed from the EU’s watch list in February 2023.

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Header Image Courtesy of the Hong Kong Inland Revenue Centre

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