Proposal to refine Hong Kong’s foreign source income exemption regime for passive income

As reported in our earlier tax alert, the European Union (EU) has included Hong Kong in its watchlist of non-cooperative jurisdictions for tax purposes. This was because the EU considered that Hong Kong’s exemption for offshore passive income in the absence of any requirement for recipient companies to have a substantial economic presence in Hong Kong would pose the possible risks of double non-taxation.

After months of anticipation, a consultation paper for the amendments that need to be made to Hong Kong’s foreign source income exemption (FSIE) regime to enable Hong Kong being removed from the watchlist has been released.  

Under the proposal, while Hong Kong will continue to adhere to the territorial source principle of taxation, Hong Kong constituent entities of a multinational enterprise (MNE) group, wherever headquartered and irrespective of group asset and revenue, will be subject to a refined FSIE regime in respect of in-scope offshore passive income received in Hong Kong. 

Such passive income will continue to be exempt from profits tax in Hong Kong under the FSIE regime if the entity concerned satisfies the economic substance or nexus approach requirements. Pure equity holding companies will be subject a reduced economic substance requirement.

In addition, a participation exemption will be introduced for offshore dividends and disposal gains in relation to shares or equity interest such that the relevant income will continue to be tax-exempt in Hong Kong if the conditions for the participation exemption are satisfied, regardless of whether the economic substance requirement is met. 

Furthermore, a unilateral tax credit will also be introduced such that overseas taxes paid in respect of in-scope offshore passive income received from jurisdictions that have not concluded comprehensive double taxation agreements (CDTAs) with Hong Kong will be creditable against the Hong Kong tax payable on the same under the FSIE regime.  

The Government indicates that it plans to introduce a legislative bill to implement the proposed amendments in the last quarter of 2022 so as to bring the refined FSIE regime into force from 1 January 2023.  

This alert summarizes the key features of the refined FSIE regime and implications thereof. 

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