Hong Kong is one of Asia's finest jurisdictions for international corporations managing assets and investments in the area. The city is geographically well-located, tax efficient, hosts one of the world's largest financial centers, has a robust legal framework, and relies on a skilled workforce. 

At the end of 2021, Hong Kong was included on the "grey list" of the European Union, as a non-cooperative jurisdiction for tax purposes, due to the lack of taxation of foreign passive income. Currently, Hong Kong, Malaysia, Uruguay, Costa Rica, Qatar are considered in the “grey list”, save for an adjustment in their local tax regulation. 

From a broad perspective, the European Union (EU) finds that certain aspects of the Hong Kong territorial tax system may facilitate tax avoidance or other tax practices regarded as harmful. In particular, it has been observed that corporations without substantial economic activity in Hong Kong and that are not subject to local tax in respect of certain foreign-sourced passive income could lead to situations of “double non-taxation”.

The EU has deeply monitored the situation and has addressed the need to move Hong Kong to a blacklist should the identified harmful aspects of its tax system be unaltered by the end of 2022. In the case of blacklisting, consequences could be significant for Hong Kong; for instance, non-deductibility of payments made, increase of withholding taxes, taxation of dividends, and administrative sanctions.

• Avoiding EU Blacklist

To remedy such circumstances, the Hong Kong Government has recently released a consultation page under the Inland Revenue Ordinance (Cap. 112) amending the 'Foreign Sourced Income Exemption' regime (FSIE) for passive income. The draft legislation has been introduced to the Legislative Council at the end of October 2022, and the new regime became effective from January 1st, 2023.

Under the new regime, four types of passive income (i.e., dividends, interest, royalties, and capital gains) received in Hong Kong by a Multinational Enterprise (MNE), will be considered taxable and subject to the Hong Kong Profits Tax (with a standard rate of 16.5%).

Under the previous regime, only income sourced from Hong Kong would be subject to profits tax in Hong Kong, while the offshore passive income such as dividends, gains related to shares and equity interest, interest income, and interest from intellectual property exempt from profits tax.

Many foreign multinational groups use intermediate holding companies in Hong Kong as special-purpose vehicles to hold interests in Chinese subsidiaries or other Asian subsidiaries; however, with the implementation of the new FSIE regime, there will certainly be a higher tax rate for Hong Kong based holding companies, with the region also likely to be deemed more cooperative with the tax authorities around the world as a result.

• Cases of Exemption

Following the release of the consultation page under the Inland Revenue Ordinance (Cap. 112) introduced to the Legislative Council at the end of October 2022, the 'Foreign Sourced Income Exemption' regime (FSIE) for passive income has been amended from January 1st, 2023, with the new FSIE applying to Hong Kong corporations that receive passive income from sources other than those derived domestically. Such passive earnings are now routinely taxed unless they fall under one of three major exclusions under the aforementioned amended tax regime: 

• Economic substance exemption for dividends, capital gains, and interest, 

• Participation exemption for dividends and capital gains, and 

• Linkage exemption for royalties.

The new rules on passive income should apply to special regimes such as Qualifying Corporate Treasury Centers. Individual taxpayers, local enterprises with no activities outside of Hong Kong, and local organizations with no foreign entities will all be excluded from the scope of the new regime.

Offshore non-IP (Intellectual Property) income, such as interest, dividends, and disposal gains, shall remain exempted from Hong Kong Profits Tax if the company shows enough “economic substance” in the region. From a broad perspective, this will generally imply:

• Having a physical office, 

• Hiring a certain number of employees, and 

• The presence of a volume of operating expenditures inside Hong Kong.

As no minimum threshold is defined, each situation would need to be assessed on a case-by-case basis, depending on the entity’s relevant activities to derive such passive income. The regulator also allows the outsourcing of certain economic activities to third parties as long as the taxpayer is able to demonstrate the adequate monitoring of such activities conducted in Hong Kong.

Offshore dividends and capital gains shall also be exempted from Hong Kong Profits Tax, where:

a) The investor is a Hong Kong resident or a non-resident with a permanent residence in Hong Kong;

b) The investor holds at least 5% of the shares of the investees from which it derives passive income; 

c) At most, 50% of the income coming from these investees is passive income.

The last type of exemption refers to incomes from patents or other IPs: a nexus requirement is in place to evaluate the extent to which such income would be eligible to be exempt from profits tax. Basically, a specific amount of the revenue obtained from an intellectual property could be excluded from profits tax, and such fraction is referred to as the “excepted portion”. 

The nexus requirement is an approach governed by the Organization for Economic Co-operation and Development (OECD) which is a unique international forum where the governments of 37 democracies collaborate to develop policy standards to promote sustainable economic growth.

As a result, it is critical for all foreign multinational groups having sub-holding companies in Hong Kong to ensure that the requirements are met in order to benefit from the tax exemption on passive income generated outside of Hong Kong's jurisdiction, or else, such income may be taxed at a rate of up to 16.5%.

We suggest clients having intermediate holding companies in Hong Kong to pay attention to the new requirements and review the potential consequences at the local level along with the implementation of the new regime in Hong Kong. 

At PHC Advisory we are always updated on new policies and the most recent changes concerning Asian countries. Send us an email at info@phcadvisory.com to know more about the services that may suit you and your company.