Under 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 shares. similar interests. This change will have a profound effect on the taxation of such income in Hong Kong and we recommend that timely steps be taken to prepare for the tax changes. The government plans to submit draft new tax provisions to the Legislative Council in October 2022. The proposed changes are due to enter into force on January 1, 2023 (a deadline imposed on Hong Kong by the European Union).
Foreign dividends and interest income
It is proposed that from 1 January 2023, dividends and foreign interest income received by Hong Kong resident companies from overseas affiliates* will be treated as offshore source income only provided that ( i) the income was not received in Hong Kong Where (ii) the Hong Kong resident company meets the economic substance test. The economic substance tests will examine whether the company employs a sufficient number of qualified workers and incurs sufficient operating expenses, the details of which have yet to be published. Whether the company “received” the income in Hong Kong will depend on whether the income was transferred to Hong Kong or whether it will be deemed to have received the income, for example, if the company uses the offshore funds to insure intercompany debt service. If the foreign dividends or interest are not received in Hong Kong, such items of income will in principle continue to be foreign source income and not taxable in Hong Kong. With the introduction of the “receipt” rule, Hong Kong seems to be following the lead of Singapore and Malaysia.
If the economic substance test is 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 hold at least 5% of shares of the foreign entity, the latter’s income must consist of less than 50% passive investment income and the dividend or underlying profits must be subject to tax at an overall tax rate of at least 15%. 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 companies if there is a holding company intermediary between the Hong Kong entity and the active entity. subsidiary company.
Sale of shares or similar shares in foreign companies
A sale of shares or similar holdings will no longer qualify for the offshore source application even if the sale would have been negotiated and concluded outside of Hong Kong, unless the Hong Kong resident company complies with the rules of economic substance or if the new participation exemption rule applies (discussed above).
Foreign royalty income
Foreign royalty income will be exempt in respect of royalties paid for patents and similar rights developed in Hong Kong and calculated in accordance with amended nexus rules developed by the OECD. “Developed” in Hong Kong means that the R&D is conducted in Hong Kong, either by the Hong Kong company itself or by subcontracting to a subsidiary in Hong Kong or to a party external to Hong Kong or outside. It appears that the taxation of foreign royalties paid for intellectual property other than patents or similar rights will be considered as onshore-source income, and therefore subject to profit tax, under the new law.
To avoid double taxation if, due to the new tax law, Hong Kong and a foreign jurisdiction tax the same income and if there is no double tax treaty between the two jurisdictions, the new tax law will include a unilateral tax regime foreign tax credit incurred on income taxed in Hong Kong. This marks a further step forward, as Hong Kong currently only grants tax credits under double tax treaties.
Clarifications are still awaited on the requirements of economic substance. We are also awaiting more information on the consequences of non-compliance with the rules of economic substance for the sale of shares of foreign companies when the conditions of economic substance or the new participation exemption rule are not met, because it seems that the new law aims to abolish the “capital” argument which has been one of the main tenets of the Hong Kong income tax system (capital income is not taxable). The proposed tax reform will change the tax position of Hong Kong resident companies engaged in the business of investment holding, lending or exploitation of intellectual property. This will likely impact holding companies for private equity and venture capitalists, who should review their existing holding structures to meet economic substance requirements, make arrangements to avoid receiving foreign dividends in Hong Kong or adapt their ownership structure to the new participation exemption rule.
*An affiliate is an entity that is included in the consolidated financial accounts of the same group as the Hong Kong entity earning the revenue.