This article dives into the economic substance requirement introduced in the new section 15K of the Inland Revenue Ordinance (Cap. 112). It is a follow-up to Part 1 in the series of articles on Hong Kong’s new rules on the taxation of passive income.
This is a new area of law with no precedents yet and a complex subject matter. This article does not, and is not intended to, constitute legal advice, and should not be relied upon as such.
The Hong Kong territorial taxation regime was fundamentally changed by the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022, which came into effect on 1 January 2023.
Under the previous regime, overseas income was most likely not taxable in Hong Kong. However, from 1 January 2023, the default assumption for multinational enterprises (MNE) has become that overseas income from interest, dividends, disposal gains or intellectual property (IP) are taxable in Hong Kong. This article focuses on the economic substance requirement that allows MNEs to continue enjoying an exemption from profits tax in respect of foreign-sourced interest, dividends and disposal gains received in Hong Kong.
Are you an MNE?
Simply put, an MNE in Hong Kong is a holding company with at least one permanent establishment or subsidiary overseas. The holding company is also required to prepare consolidated financial statements according to the provisions of Hong Kong law (read our Part 1 article for a more detailed definition).
For the purpose of the economic substance requirement, MNEs are split between the very small category of pure equity-holdings and the very broad category of non-pure equity-holdings.
A pure equity-holding refers to a company that holds shares in others and derives dividend income or disposal gains[1] from those shares. A pure equity-holding does not derive any other income from those shares or have any business other than the holding and management of those shares (the so-called “specified activities”). If a holding company grants a shareholder’s loan to another company in which it holds shares, the holding company is not considered a pure equity-holding, irrespective of whether the loan is interest-free.
Any international group holding company with other activities qualifies as a non-pure equity-holding.
The definitions of pure equity-holding entity and non-pure equity-holding entity in the proposed new section 15K (2) and (3) of the Inland Revenue Ordinance (Cap. 112) are modelled on the Guidance on the Interpretation of the Third Criterion of the Code of Conduct for Business Taxation[2] issued by the Code of Conduct Group (Business Taxation) of the European Union (EU).
One may also refer to the minimum substance requirements related to Base Erosion and Profit Shifting[3] (BEPS) Action 5 of the Organisation for Economic Co-operation and Development (OECD).
What is the economic substance requirement for pure equity-holding MNEs?
For a taxpayer that is a pure equity-holding MNE, economic substance is defined by the holding and management of its shares in other companies, directly or through an adequately monitored service provider.
According to Inland Revenue Department guidance[4], hiring a service provider to deal with registration and filing matters, with only one nominee director in Hong Kong and no resident director, does not meet the threshold of economic substance for a pure equity-holding in the new section 15K (2) of the Inland Revenue Ordinance (Cap. 112). In this scenario, equity investments are considered held and managed outside Hong Kong by the shareholders and directors.
On the other hand, if the pure equity-holding with only one nominee director in Hong Kong and no resident director engages a service provider in Hong Kong to (i) deal with registration and filing matters and (ii) hold and manage equity participations in overseas investee entities on its behalf, it may meet the threshold if these outsourced activities carried out in Hong Kong are adequately monitored[5].
According to further guidance from the Inland Revenue Department, the presence of office premises is only one of the factors that determine whether a taxpayer that is a pure equity-holding MNE has a substantial economic presence in Hong Kong. This factor may not be required[6].
The analysis is likely to differ for MNEs that are non-pure equity-holdings.
What is the economic substance requirement for non-pure equity-holding MNEs?
Considering the narrow definition of pure equity-holding under the new regime, most MNEs will be considered non-pure equity-holdings. Their businesses may fall under any category, from international F&B to financial services through sourcing, retail and other functionalities.
For a taxpayer that is a non-pure equity-holding MNE, economic substance is defined in technical terms as “(i) making necessary strategic decisions in respect of any assets the entity acquires, holds or disposes of; and (ii) managing and bearing principal risks in respects of such assets”[7] according to the EU guidance. The key components of the study carried out by the Code of Conduct Group are the need for a sufficient number of qualified personnel and an appropriate number of operational expenses in relation to the main revenue-generating activities.
To assess whether the threshold of economic substance is met, the Inland Revenue Department will consider relevant factors such as:
- nature of the business;
- scale of operations;
- number of employees;
- operating expenditures; and
- office premises.
As size and mode of operations vary from industry to industry[8], the threshold of economic substance is met if the relevant factors are considered adequate on a case-by-case basis (adequacy test).
To enhance tax certainty, taxpayers may apply for an advance ruling on their compliance with the economic substance requirement[9].
Advance rulings on compliance with the economic substance requirement
The Inland Revenue Department published two advance rulings made on 1 March 2023 on compliance with the economic substance requirements under the new foreign-sourced income exemption regime (FSIE)[10]. In both cases:
- the applicants should not be pure equity-holdings;
- they receive foreign-sourced dividend income from overseas subsidiaries;
- they have several directors and employees in Hong Kong to manage and support their business operations;
- they outsource legal and business support activities to a non-associated service provider in Hong Kong; and
- activities under the FSIE regime are carried out in Hong Kong, directly or outsourced to non-associated service providers in Hong Kong, which they undertake to monitor adequately.
The rulings are valid for five financial years, namely, from 2023/24 to 2027/28.
Advance rulings are provided for in section 88A of the Inland Revenue Ordinance (Cap. 112) for any of the matters specified in Schedule 10. When seeking a ruling, the applicant must disclose all relevant information. Details of the procedures for applying for a tax ruling can be found in the Departmental Interpretation and practice notes No. 31 (revised) on advance rulings of the Inland Revenue Department of Hong Kong.
Useful links
- Advance Ruling on Compliance with the Economic Substance Requirement under the Foreign-sourced Income Exemption (FSIE) Regime
- Departmental Interpretation and Practice Notes No. 31 – Advance Rulings
- Application for Advance Ruling (IR1297)
- Data Form – Economic Substance Requirement of the Foreign-sourced Income Exemption Regime (IR1297B)
- Annex to IR1297B (Group Application) (if applicable)
Takeaway
As a result of the new tax rules in place since 1 January 2023, specified income received by international group holding companies in Hong Kong are taxable, unless the MNEs meet the conditions for an exemption.
MNEs with management or teams in Hong Kong may consider applying for an advance ruling, to ensure they comply with the economic substance requirement and avoid uncertainty as to their tax liabilities for interest, dividend or disposal gains from overseas subsidiaries or permanent establishments.
Specified foreign-sourced income received in Hong Kong will not be taxed if the MNE entity meets the exception requirements that apply to that particular type of income. The economic substance requirement is the first of the three exceptions provided for under the new FSIE regime. Read Part 3 of this article series to examine the nexus requirement, which applies to intellectual property income.
[1] Disposal gain means any gain or profit derived from the sale of equity interests in an entity (new section 15H of the Inland Revenue Ordinance (Cap. 112), interpretation provisions).
[2] Guidance on the Interpretation of the Third Criterion of the Code of Conduct for Business Taxation.
[3] According to the OECD, BEPS refers to tax planning strategies used by MNEs to exploit gaps and mismatches in tax rules to avoid paying tax.
[4] IRD: Illustrative Examples.
[5] IRD: Illustrative Examples.
[6] IRD: Illustrative Examples.
[7] Definition in the new section 15k of the Inland Revenue Ordinance (Cap. 112).
[8] IRD: Foreign-sourced Income Exemption.
[9] Q23 – FAQ on New FSIE Regime.
[10] Advance Ruling Case No. 68 and Advance Ruling Case No. 69.
