Current international tax regulations stipulate that taxpayers receiving special tax benefits in a jurisdiction must possess a significant economic presence there and demonstrate a clear connection between their income and actual business operations within that jurisdiction.
To aid global initiatives aimed at fighting tax evasion across borders and the practice of taxe evasion in multiple jurisdictions, Hong Kong has pledged to revise its tax rules regarding the non-taxation of foreign-sourced passive income. This revision will follow the guidelines set out by the European Union (EU) for such tax exemption systems.
At its core, the FSIE regime is designed to exempt income derived from foreign sources from Hong Kong tax, under specific conditions. This principle supports Hong Kong’s territorial tax system, which only taxes income sourced within the city. Understanding the FSIE’s foundational elements is crucial for grasping the implications of the recent amendments.
The amendment expands the scope of taxable foreign income, introducing nuanced criteria for what constitutes ‘taxable’ under the FSIE regime. This shift requies a deeper analysis by corporations to determine their tax liabilities.
The revised Foreign Source Income Exemption (FSIE) regime in Hong Kong, which was implemented on January 1 2024, has garnered significant attention within the business sector. This updated regime, now in alignment with European Union regulations, will permit eligible multinational enterprise groups to benefit from a tax exemption on specified types of income sourced from abroad.
Changes
Historically, offshore passive income earned by multinational corporations, which lacked a significant economic footprint within the region, was exempt from the profits tax. This exemption allowed certain corporations to benefit from “double non-taxation,” meaning they incurred no tax liabilities either in Hong Kong or in the country where the profits originated. As a result of this practice, Hong Kong was designated as a non-cooperative tax jurisdiction and subsequently added to the European Union’s watchlist in 2021.
Under the newly instituted Foreign Source Income Exemption (FSIE) regime, multinational enterprise (MNE) entities will henceforth be precluded from availing themselves of double non-taxation benefits pertaining to specified categories of foreign-sourced income.
It is important to note that individuals and domestic companies not part of a multinational conglomerate are not subject to the stipulations of the FSIE regime.
The FSIE Exemption Regime
Corporations now face a more rigorous process in proving the foreign source income exemption.
To be eligible for this exemption, taxpayers are required to fulfill specific prerequisites, including the maintenance of an office or similar establishment within Hong Kong, and the stipulation that the income under consideration must not originate from business activities conducted in Hong Kong.
The FSIE scheme encompasses exemptions for four distinct categories of offshore passive income:
- Dividends;
- Gains from the disposal of shares or equity interests;
- Interest income;
- Income derived from Intellectual Property (IP).
The exemptions offered under the Foreign Source Income Exemption (FSIE) regime, require to the following conditions to be met:
Economic Substance Requirement (ESR)
This requires the conduct of significant economic activities within Hong Kong, directly correlated with the generation of income. It mandates that taxpayers establish a tangible business presence and economic substance within the territory.
Participation Requirement
This provision demands substantial involvement in the foreign entity responsible for generating the income. Taxpayers are required to demonstrate a considerable degree of ownership (in excess of 25%) or exert control over the entity producing the foreign-sourced income.
Nexus Requirement
Compliance with the nexus requirement is achieved when the taxpayer can demonstrate a direct and significant linkage between the foreign-sourced income from Intellectual Property (IP) and their operational and research and development (R&D) endeavors conducted in Hong Kong.
Distinction between Pure and Non-Pure Equity-Holding Entities
The primary criteria for pure equity-holding entities centers on the extent of ownership or control exerted over the foreign entity responsible for income generation. Entities based in Hong Kong are required to prove significant ownership or control over their offshore counterparts. This generally entails holding a specified share percentage or possessing considerable influence over decision-making processes.
Conversely, for non-pure equity-holding entities, adherence to Economic Substance Requirements (ESR) assumes greater significance. Such entities are obliged to demonstrate that they engage in substantial economic activities within Hong Kong, which bear a direct relation to their income-producing operations.
To fully leverage the advantages offered by the Foreign Source Income Exemption (FSIE) regime, corporations are advised to reassess their international tax strategies and contemplate reorganizing their operations within Hong Kong to capitalize on the provisions of the scheme. Enterprises aiming to scale their operations may benefit from exploring the potential tax optimization opportunities presented by establishing a presence in Hong Kong under the revised FSIE framework. Engaging the expertise of seasoned accounting and tax professionals could prove pivotal in maximizing the tax incentives provided by the new regime.
