Hong Kong’s Foreign Income Tax Reform
Due to pressure from the European Union, the Hong Kong government is proposing to change the offshore tax regime for the taxation of foreign dividends, interest income, royalty income and gains on the sale of shares or similar interests. This change will have a profound effect on the taxation of such income in Hong Kong and we recommend that timely action be taken to prepare for the tax changes. The government is planning to submit a draft of the new tax provisions to Legislative Council in October 2022. The proposed changes are due to take effect on 1 January 2023 (which is the deadline imposed on Hong Kong by the European Union).
Foreign Dividends and Interest Income
It is proposed that with effect from 1 January 2023, foreign dividends and interest income received by Hong Kong resident companies from overseas affiliates* will qualify as offshore sourced income only provided that either (i) the income has not been received in Hong Kong or (ii) the Hong Kong resident company satisfies the economic substance tests. The economic substance tests will look at whether the company employs a sufficient number of qualifying employees and incurs sufficient operating expenditure, the details of which are still to be issued. The question whether the company has ‘received’ the income in Hong Kong will depend on whether the income was remitted to Hong Kong or whether it will be deemed to have received the income, e.g., if the company uses the offshore funds to service intercompany debt. If the foreign dividends or interest would not be received in Hong Kong, then these items of income will in principle continue to be offshore sourced income and not taxable in Hong Kong. With the introduction of the ‘receipt’ rule, Hong Kong seems to be following Singapore’s and Malaysia’s direction.
In the event the economic substance tests are not met, foreign dividends received in Hong Kong will not be taxable if the new participation exemption rule applies, which requires the Hong Kong resident company to own at least 5 percent of the shares of the foreign entity, the latter’s income must for less than 50 percent consist of passive investment income and the dividend or underlying profits must be subject to tax at a headline tax rate of at least 15 percent. This should generally not be a problem where the Hong Kong resident company owns shares of a company in the PRC, but it may be problematic for private equity or venture capital holding companies if there is an intermediary holding company between the Hong Kong entity and the active subsidiary.
Sale of Shares or Similar Equities in Foreign Companies
A sale of shares or similar equity interests will no longer be eligible for the offshore source claim even if the sale would have been negotiated and concluded outside Hong Kong, unless the Hong Kong resident company meets the economic substance rules or if the new participation exemption rule applies (discussed above).
Foreign Royalty Income
Foreign royalty income will be exempt in respect of royalties which are paid for patents and similar rights developed in Hong Kong and computed in accordance with the modified nexus rules developed by the OECD. ‘Developed’ in Hong Kong means that R&D is conducted in Hong Kong, either by the Hong Kong company itself or through outsourcing to an affiliate in Hong Kong or an external party in or outside Hong Kong. It seems that the taxation of foreign royalties paid for IP other than patents or similar rights will be deemed to be onshore sourced income, and therefore taxable for profits tax, under the new law.
To avoid double taxation if, as a result of the new tax law, both Hong Kong and a foreign jurisdiction tax the same income and in the event there is no double tax treaty between the two jurisdictions, the new tax law will include a unilateral tax credit for foreign tax incurred on the income taxed in Hong Kong. This marks a new step forward, as Hong Kong currently gives tax credits only under double tax treaties.
Details are still awaited about the economic substance requirements. We are also expecting more information about the consequences of not meeting the economic substance rules for the sale of shares of foreign companies where the economic substance conditions or the new participation exemption rule are not met, as it seems that the new law intends to abolish the ‘capital’ argument which has been one of the fundamental principles of Hong Kong’s income tax system (income of a capital nature is not taxable). The proposed tax reform will change the tax position for companies resident in Hong Kong engaged in investment holding activities, lending or IP exploitation. It will likely have an impact on holding companies for private equity and venture capital investors, who should revisit their existing holding structures in order to either meet the economic substance requirements, make arrangements to avoid receiving foreign dividends in Hong Kong or adapt their holding structure to the new participation exemption rule.
*An affiliate is an entity which is included in the consolidated financial accounts of the same group as the Hong Kong entity earning the income.