Overview of HK’s Foreign Sourced Income Exemption (FSIE)

Overview of HK’s Foreign Sourced Income Exemption (FSIE)

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Hong Kong has rolled out a Foreign Sourced Income Exemption (FSIE) regime in 2022. The change took place from 1 January 2023, and no grandfathering provisions were envisaged.

We can see that the Hong Kong’s tax system is moving in international directions, following OECD norms on the taxation of passive income (i.e. dividends, interests, royalties and capital gains taxation). This was particularly required when the European Union added Hong Kong to the “Grey List of The Uncooperative Tax Jurisdictions” in October 2021 due to concerns about double non-taxation of certain foreign-sourced passive income under the territorial source regime of Hong Kong.

Who is subject to the Foreign Sourced Income Exemption (FSIE) regime?

The new FSIE regime applies to members of Multinational Enterprise Entity (MNE) groups (i.e. MNE entities) carrying on a trade, profession or business in Hong Kong unless they qualify for the exemption conditions.

The FSIE regime does not apply to:

  • Local companies without foreign operation
  • Local group based companies (without overseas constituent entities)
  • Individual taxpayers

Moreover, regulated financial entities and MNEs beneficials from the current preferential tax regimes of Hong Kong are generally spared from the new FSIE regulation, if certain requirements can be complied with.

What is included in the FSIE scope?

The current territorial source regime in Hong Kong will continue to exist. Nevertheless, under the FSIE regime, certain foreign-sourced passive income, also referred to as “covered income”, received by a covered taxpayer in Hong Kong is considered as income derived in Hong Kong and is subject to tax at the standard rate of 15% or 16.5% or the reduced rate of 7.5% or 8.25% respectively under the two tier profits tax rate system, unless there are applicable exemptions. There are 4 types of covered income:

  • Dividends
  • Interests
  • Share disposal gains
  • Income from intellectual property (IP), such as royalties

Foreign-sourced passive income will be treated as received in Hong Kong:

  • When it is remitted to, transmitted, or brought into Hong Kong.
  • When it is used to settle any debt arising from a trade, profession, or business in Hong Kong.
  • When it is used to purchase movable property that is subsequently brought into Hong Kong.

FSIE Exemption conditions

The four types of foreign-sourced passive income could be excluded from Hong Kong Profits Tax under the FSIE regime if the conditions under the economic substance requirement (ESR), participation exemption or nexus exemption can be met, which are summarised as follows:

FSIE Exemption conditions HK

The economic substance requirement covers interests, dividends, and share disposal gains while the participation exemption covers only the latter two.

On the foreign-sourced income from IP, only the nexus exemption is applicable.

The Economic Substance Requirement (ESR)

Non-IP income, such as dividends, interests and share disposal gains won’t be subject to Hong Kong Profits Tax if a covered taxpayer is sufficiently substance in Hong Kong.

Holding vehicles whose assets are entirely comprised of equity are not subject to the economic substance test. More specifically, they are only required to perform every registration and filing obligation applicable in Hong Kong and have the human resources and premises to carry out the “specified economic activities” (the holding and management of equity participations in other entities) in Hong Kong.

Regarding to non-pure equity-holding entities, they shall incur more economic substance requirement in Hong Kong, such as employing sufficient numbers of adequately qualified employees with the necessary qualifications and incurring adequate operating expenditure to perform the specified economic activities (i.e. making necessary strategic decisions in respect of assets acquired, held or disposed as well as managing and bearing the principal risks in respect of such assets)

The Inland Revenue Department (“IRD”) does not have any threshold limits which would be used for the purpose of deciding whether the economic substance requirement is met. The considerations will be made on a case-by-case basis, depending on the facts and circumstances of each case.

Outsourcing economic activities for the purpose of meeting the economic substance requirement is allowed. Outsourcing is done by contracting an external provider or a group entity (e.g., subsidiary). In any of the cases, the covered taxpayer is required to prove the provision of an appropriate level of supervision of the outsourced activities and to keep appropriate documentation.

Finally, it is important to say that companies that perform investment activities, for example securities investments, will be exempt from the FSIE regime as long as they meet the economic substance requirement.

Participation Exemption

Moreover, profit tax exemption can be granted for foreign source dividends and capital gains from the disposal of shares (excepting interests) under the FSIE regime if the requirements for the participation exemption are fulfilled. These conditions include:

  • The covered person should be a Hong Kong tax resident or a non-resident with a permanent establishment in Hong Kong. 
  • The taxpayer must have owned at least 5% of shares or equity interests of the investee entity for at least 12 months, before the foreign-sourced dividend arises or the share disposal gain comes up.

There are anti-abuse rules which cover the participation exemption, such as the subject to tax condition, anti-hybrid mismatch rule, and main purpose rule, all of which are to be considered cautiously.

Nexus exemption

The nexus approach will, however, deny companies from paying tax on intellectual property on passive income sourced offshore from the qualifying IP assets (patents or copyright subsisting in software). But, marketing-based IP assets, such as trademarks, rather not qualifying IP assets, so their earnings do not fit for tax exemption.

The IP income in the form of tax exemption, earned from the qualifying IP assets, is calculated by using a formula that evaluates the part of the qualifying R&D expenditure spent on qualifying IP assets relative to the overall expenditure. Relevant R&D activities should be carried out by the covered taxpayer itself, by its related parties resident in Hong Kong, or by outsourced unrelated parties, in or outside, Hong Kong.

Advance ruling & the FSIE

To determine if the economic substance requirement (ESR) will be met or not and whether the income is subject to profits tax under the FSIE regime and to ease the compliance burden of the taxpayers, they can seek an advance ruling from the IRD.

A ruling is in force for 5 years and it is legally binding. An application can be lodged as an individual or as a group, that is either (1) as the entity itself or (2) as the entity and other entities of the same MNE group in Hong Kong. The conditions for a group application are:

  • Contractual arrangements are defined in the service agreement made with the applicant and other MNE entities of the specified economic activities concerned in the form of outsourcing to one entity.
  • The applicant and/or its representative must have written consent of the other entities of the MNE group to authorize the group application (and must supply the Commissioner with the written consent on request).
  • The service agreement duly copied should be submitted along with the application.

When to apply?

The advance ruling normally takes about 21 working days for the IRD to process the application and can be applied at any time.

Taxpayers can enjoy the profits tax exemption under the FSIE when a positive ruling is obtained from the IRD. Or, taxpayers can explore the possibilities of tax management, under the advice of a tax lawyer, such as business restructuring with a view to maintain/obtain the tax efficiencies.

Related Article: 2024 Tax Filing Season: Tax Deadline 2024 in Hong Kong You Need To Know About

How FastLane Group can Help?

Does FSIE regime have any effect on the tax liability of passive income of your company? Do you think about developing your economical substance in Hong Kong? Is restructuring of your current business and investment structure viable?

FastLane Group are available to respond to your questions, provide personalized tax advice, and deal with the consequences of tax reforms.

The range of services that we provide includes the application for an advance ruling on ESR compliance and the FSIE regime income taxability, a deep analysis of the impact of the FSIE regime on your company, as well as expert advice on maintaining your tax efficiency. 

For a tax health check, we recommend a preliminary meeting to establish your tax position, mitigate risks and preserve financial health. Trust in our ability and knowledge to protect your company’s future. Contact us today for a consultation.