Refined foreign source income tax impacts Hong Kong’s multi-national corporations (“MNC”)
As a result of the pressure from the European Union over non-taxation on offshore passive income received by a Hong Kong company with no substantial operation, the Hong Kong SAR government has recently launched a consultation to refine the foreign source income exemption regime in respect of passive income. The proposed refine regime is expected to impact Hong Kong resident companies from overseas affiliates. Passive income subject to refinement are 1) interest, 2) income from intellectual properties (“IP”), 3) dividends, and 4) disposal gain in relation to shares or equity interest.
Home to over 1,400 regional headquarters in Hong Kong, the presence of MNC in Hong Kong is substantial and is a vital part of the Hong Kong’s economic system. Intra-group’s arrangement, in terms of interest-bearing recharge, dividend, disposal of overseas subsidiaries, and even IP income recharge, between the Hong Kong office and the overseas affiliates are not uncommon. Therefore, the new refinement is expected to have certain impact on these MNCs. Private equity or venture capital holding companies might also be affected if they have established intermediate holding company between the Hong Kong entity and the entities that directly held the investment projects. The effective date of this refined regime is 1 January 2023 and MNCs are advised to get a head-start on their preparation.
Some of the more common passive income of an MNC are interest, dividends and disposal gain. This income will be deemed as sourced from Hong Kong and chargeable to Profits tax if the MNC a) failed the economic substance test and b) failed the participation exemptions (for dividends and disposal gain only).
The economic substance test is split between “pure equity holding company” and “non-pure equity holding company”. In broad, the economic substance test looks into the relevant activities, decision making, employing adequate number of qualified employees, incurring adequate amount of operating expenditures in Hong Kong, etc.
On the other hand, the participating exemptions (applicable for dividends and disposal gain only) apply when i) the investor company is a Hong Kong tax-resident person; ii) the investor company holds at least 5% of the shares of equity interest in the investee company; and iii) no more than 50% of the income is derived by the investee company is passive income.
Offshore IP income are also affected by the refinement. The nexus approach will apply in determining the extent of offshore IP income to be excluded from the deeming provision. Only income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio which is defined as the qualifying expenditures as a proportion of the overall expenditures that have been incurred by the covered taxpayer to develop the IP asset. Qualifying expenditures only include research and development expenditures that are directly connected to the IP asset. Acquisition costs of the IP asset are excluded. Nonetheless, taxpayers are allowed to uplift their qualifying expenditures by 30%, subject to a cap equal to the taxpayer’s overall expenditures.
While the proposal is still under discussion and an amendment bill is expected to be introduced in October 2022, there are further clarifications to be made to the public by the Hong Kong SAR Government. Meanwhile, MNCs who have been lodging offshore claims for the in-scope passive income should closely monitor the development and re-evaluate the group arrangement accordingly.