On 28 October 2022, Hong Kong introduced into the Legislative Council for review the proposed Inland Revenue (Amendment) Taxation of Specified Foreign-sourced Income Bill 2022 (the Foreign-sourced Income Amendment Bill), which will render certain specified categories of foreign-sourced income subject to Hong Kong profits tax liability. When passed, the Foreign-sourced Income Amendment Bill will bring about one of the most significant changes to Hong Kong’s long-standing territorial source basis of taxation, potentially applying tax on income received in Hong Kong with the stated objective of addressing “double non-taxation”.
Background
Hong Kong’s existing territorial basis of taxation imposes profits tax on assessable income or profits arising in or derived from Hong Kong by persons carrying on a trade, profession or business in Hong Kong, unless specifically exempted from tax under the Inland Revenue Ordinance (IRO). Under such territorial basis of taxation, the chargeability to tax is determined on the source of income as opposed to the residence status. As such, a person may be liable to tax in Hong Kong in respect of assessable profits which are attributable to a trade or business carried on in Hong Kong and which have a Hong Kong source. Whether a trade or business is carried on in Hong Kong and whether profits are sourced in or derived from Hong Kong is a question of fact and subject to application of law and principles for which case law provides some guidance. The Hong Kong Inland Revenue Department (IRD) has clarified that the concept of carrying on business in Hong Kong is generally broader than the definition of permanent establishment in the IRO and in double tax agreements concluded by Hong Kong. Conversely, at present, tax is not levied based on remittance or receipt in Hong Kong, therefore foreign-sourced income falls outside the charge to tax in Hong Kong.
In October 2021, the European Union (EU) included Hong Kong in its watchlist for tax cooperation, as the EU is concerned that corporations with no substantial economic activity in Hong Kong are not subject to tax in respect of certain offshore passive income (such as interest and royalties), hence leading to circumstances of “double non-taxation”. In response, the Hong Kong government has emphasised its support for international tax cooperation and combatting cross-border tax evasion, with the intention to amend the IRO by the end of 2022 and implement relevant measures in 2023, with a view to having Hong Kong removed from the EU watchlist. Hong Kong has expressed the intention to continue its territorial source principle of taxation as a simple and low-tax regime with a view to maintaining the competitiveness of Hong Kong’s business environment, while proposed legislative amendments will in particular target corporations with no substantial economic activity in Hong Kong that make use of passive income to evade tax cross-border.
Proposed changes
The Foreign-sourced Income Amendment Bill is expected to apply from 1 January 2023, subject to legislative process, amending the IRO to regard certain foreign-sourced income as arising in or derived from Hong Kong and thus chargeable to profits tax, subject however to prescribed exceptions and to relief against double taxation in respect of certain foreign-sourced income. “Received in Hong Kong” is proposed to cover or deem as received in Hong Kong: (a) sums remitted to or transmitted or brought into Hong Kong; (b) sums used to satisfy any debt incurred in respect of a trade, profession or business carried on in Hong Kong; or (c) sums used to buy movable property and the property is brought into Hong Kong.
Foreign-sourced income in the nature of interest, dividend, disposal gain from sale of equity interest in an entity or specified “intellectual property income” will be caught under current proposed changes. Remarkably, specified foreign-sourced income is to be regarded as not arising from the sale of capital assets even if it so arises, applying profits tax on what may otherwise be a gain capital in nature.
Under the Foreign-sourced Income Amendment Bill, “MNE entity” is defined as a person that is, or acts for, an MNE group or an entity included in an MNE group, and is not an excluded entity; “entity” refers to a legal person (other than a natural person), or an arrangement that prepares separate financial accounts, such as a partnership and a trust; and “MNE group” means a group that includes at least one entity or permanent establishment that is not located or established in the jurisdiction of the ultimate parent entity of the group. “Group” is defined to mean: (a) a collection of entities that are related through ownership or control such that the assets, liabilities, income, expenses and cash flows of those entities: (i) are required under applicable accounting principles to be included in the consolidated financial statements of the ultimate parent entity of the collection; or (ii) are excluded from the consolidated financial statements of the ultimate parent entity solely on size or materiality grounds or on the grounds that the entities are held for sale (i.e. as would otherwise be included); or (b) a stand-alone MNE entity.
A “stand-alone MNE entity” is one located in one jurisdiction and has one or more permanent establishments in other jurisdictions, and is not part of a “group”. While that is straightforward, the complexity lies where “MNE entity” and “MNE group” as defined would cover a group or collection of entities, including any partnership or trust structures within such group, that may be subject to potential chargeability to Hong Kong profits tax on foreign-sourced income if received by a person carrying on trade, profession or business in Hong Kong and which is an entity within the group or acting for the group.
Entities or groups having presence or activities in Hong Kong should consider whether there may be potential chargeability to profits tax going forward, through a group entity carrying on a trade or business in Hong Kong and receiving or deemed as receiving specified foreign-sourced income in Hong Kong. An MNE entity that will become chargeable to profits tax in respect of any specified foreign-sourced income under the new rules must notify the Commissioner of Inland Revenue in writing of its chargeability within four months after the end of the basis period of the year of assessment during which the income is received in Hong Kong.
The Foreign-sourced Income Amendment Bill proposes to apply the definition of “permanent establishment” in Hong Kong according to Schedule 17G of the IRO and “Hong Kong resident person” under section 50AAC(1) of the IRO, as are relevant for determining liability for property tax, salaries tax or profits tax in Hong Kong in the context of double taxation arrangements and transfer pricing rules. The proposed new provisions under the Foreign-sourced Income Amendment Bill will need to be considered together with those existing provisions.
Regulated financial entities and excluded entities
Having said that, it would be welcomed by financial institutions and financial intermediaries in Hong Kong that the proposed changes will not affect the income of regulated financial entities carrying on trade or business in Hong Kong and receiving foreign-sourced income in Hong Kong – an insurer authorised under the Insurance Ordinance, an authorised institution under the Banking Ordinance, or an entity licensed under the Securities & Futures Ordinance to carry on any regulated activity are all proposed to be out of scope and need not be concerned with chargeability on foreign-sourced income.
The Foreign-sourced Income Amendment Bill also proposes to exclude a government investment entity, an insurance investment entity, international organisation, a pension fund entity or pension services entity, a non-profit entity or a non-profit organisation, an investment fund that is an ultimate parent entity, or a real estate investment vehicle that is an ultimate parent entity (all of the above as defined in each case) from becoming subject to Hong Kong profits tax on foreign-sourced income received in Hong Kong.
In this context, we further outline the key proposed exclusions, as well as the exceptions based on economic substance requirement where the foreign-sourced income is interest, dividend or disposal gain, or the participation requirement where the foreign-sourced income is a dividend or disposal gain. It is outside the intended scope of this update to cover the potential treatment of intellectual property income and the related exception under the Foreign-sourced Income Amendment Bill – if of interest, please contact the author to discuss the topic separately.
The following key categories of investment structures are exclusions proposed not to be subject to profits tax charge on foreign-sourced income under the Foreign-sourced Income Amendment Bill:
Government investment entity
- A governmental entity having the principal purpose of fulfilling a government function or managing or investing government assets through the making and holding of investments, asset management and investment activities related to the government assets and which does not carry on a trade or business other than such investment business, among other criteria;
Insurance investment entity
- An insurance investment entity which may be the equivalent of an investment fund or a real estate investment vehicle, established in relation to liabilities under an insurance or annuity contract, and is wholly owned by an entity which is a regulated insurance company in its local jurisdiction;
Investment fund or real estate investment vehicle
- An investment fund or a real estate investment vehicle which is an ultimate parent entity, where “investment fund” is defined to cover fund entities exempted from profits tax under certain existing provisions of the IRO, an authorised retail fund under the Securities & Futures Ordinance or a bona fide widely held investment scheme in an acceptable regulatory regime, and also, more broadly, entities that meet designated elements of being an investment fund structure or real estate investment vehicle, respectively;
- Given that the exclusion only applies to an investment fund or real estate investment vehicle which is an ultimate parent entity, it should be noted this refers to a stand-alone MNE entity or an entity that owns directly or indirectly a controlling interest in any other entity and is not owned with a controlling interest directly or indirectly by another entity – structures having underlying investment holding companies or trading entities should be reviewed for potential tax liability under the proposed new rules;
Pension fund entity or pension fund services entity
- A pension fund entity that meets the prescribed definition as a pooled fund established and operated exclusively or almost exclusively to administer or provide retirement benefits and ancillary or incidental benefits which is regulated or protected in its jurisdiction, or a pension services entity established and operated exclusively or almost exclusively to invest funds for the pension fund entity or carry out activities ancillary to the regulated activities of a pension fund entity of the group;
Non-profit organisation
- a non-profit organisation which refers to an entity established and operated in its jurisdiction of residence exclusively for non-profit purpose or as a non-profit entity (the latter referring to organisations such as chamber of commerce, industry organisation, social welfare organisation, labour organisation, professional organisation) where its income from its exclusive non-profit purpose or as a non-profit entity is substantially exempt from income tax in its jurisdiction of residence, and such entity has no shareholders or members having proprietary interest in its income or assets or any private person or non-charitable entity which may receive distributions or benefit of the entity’s income of assets other than on a restricted and limited basis as stipulated in the provisions.
These exclusions are in line with the government’s intention to retain Hong Kong’s attractiveness as a business environment, including its role as a competitive asset management centre and investment hub, while the proposed changes shall target corporations with no substantial economic activity in Hong Kong that make use of passive income to evade tax cross-border. If an MNE entity is a pure equity holding entity, exception from profits tax applies if it meets minimal specified economic substance requirements and, in the opinion of the Commissioner of Inland Revenue, has adequate human resources and premises for carrying out its relevant economic activities in Hong Kong. Otherwise, an MNE entity will need to have such number of employees in Hong Kong with the necessary qualifications to carry out specified economic activities and such total operating expenditure incurred in Hong Kong for carrying out specified economic activities, in each case as considered adequate in the Commissioner’s opinion. “Specified economic activities” refers to the making of strategic decisions in respect of the acquisition, holding or disposal of assets of the entity, managing and bearing principal risks in respect of such assets.
Separately, an MNE entity may qualify for participation exception if it is a Hong Kong resident person or a non-Hong Kong resident person with permanent establishment in Hong Kong and meets the specified participation requirement of having continuously held not less than 5% equity interest in the investee entity for a period of not less than 12 months immediately before accrual of the dividend income or disposal gain, provided the investee entity is subject to a minimum reference tax rate of 15% and also subject to other anti-abuse provisions.
In view of Hong Kong’s position as a financial centre for asset management, investment funds and wealth management hubs, through which investment entities may be commonly established or operated, engaging in the conduct of investment activities, investment entities or structures (including partnership or trust) receiving foreign-sourced income in Hong Kong should consider the relevance and potential implications of the proposed changes, to comply with additional chargeability to tax on foreign-sourced income or whether tax mitigation measures are available.
