Proposed changes to Hong Kong’s offshore regime for passive income
Lewis Lu and John Timpany of KPMG China discuss the implications of a proposed refined foreign source income regime in Hong Kong for constituent entities of multinational enterprises.
The Hong Kong SAR government recently proposed a refined foreign source income exemption regime as a response to the EU’s concerns about Hong Kong’s offshore regime for passive income. For further details, see this publication by KPMG in September 2021, and an update in March 2022.
Subject to the completion of the legislative process, the changes will take effect from January 1 2023 with no grandfathering arrangement and apply to multinational enterprise groups only.
Covered taxpayers and covered income
Only a constituent entity (CE) of a multinational enterprise (MNE) group, irrespective of the group’s revenue or asset size, will be in scope. The definitions of a CE and an MNE are the same as those under the Global Anti-Base Erosion (GloBE) model rules.
An MNE group means any group that includes at least one entity or permanent establishment that is not located in the jurisdiction of the ultimate parent entity. A CE effectively means an entity with financial results that are consolidated on a line-by-line basis in the group’s consolidated financial statements. As such, associates and joint venture entities within an MNE group that are not included in the group’s consolidated financial statements, standalone local companies and purely domestic groups without any offshore operations would not be affected.
Dividends, gains from the disposal of shares or an equity interest (equity disposal gains), interest and income from intellectual property with an offshore source will be classed as in-scope offshore passive income.
Offshore passive income
Under the proposed regime, a CE of an MNE group will need to determine whether the in-scope passive income is with an offshore source and then whether the income “is received in Hong Kong”.
In-scope offshore passive income that is “received in Hong Kong” by a CE of an MNE group will be deemed to be sourced from Hong Kong and taxable unless the economic substance requirement (for non-IP income), the nexus approach requirement (for IP income) or the participation exemption conditions (for dividends and equity disposal gains) are met.
Unilateral tax credit
A unilateral tax credit will provide double tax relief for in-scope offshore passive income that is subject to tax in Hong Kong and a foreign jurisdiction that does not have a double taxation agreement with Hong Kong.
Unilateral tax credit is only applicable to in-scope passive income and will not be available for other income, even though it may be subject to tax in Hong Kong and overseas.
The Hong Kong SAR government plans to introduce a tax bill on the proposed foreign source income exemption (FSIE) regime in October 2022 and the regime will take effect from January 1 2023, subject to the completion of the legislative process.
The Inland Revenue Department will issue administrative guidance on the FSIE regime, including the factors that will be considered in determining whether the substance requirement is met, the rules relating to participating exemption regime and the application of the nexus approach.
The refined FSIE regime for passive income represents a significant change to the long-established offshore regime in Hong Kong. In-scope companies that have been relying on an offshore claim for non-taxation of offshore passive income should monitor the developments in this area, particularly the detailed rules to be set out in the forthcoming tax bill.
They will also need to revisit their Hong Kong profits tax positions and consider if any changes to their holding structures or operating models are desirable.
For more comments on the proposed regime, and the critical points that in-scope taxpayers should consider when performing their assessment, please see KPMG’s publication here.