Hong Kong’s new taxation regime for foreign-sourced income (Part 3)

This article dives into the impact of the new foreign-sourced income exemption (FSIE), introduced by the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance of December 2022, on the taxation of intellectual property (IP) income. It is a follow-up to Part 2 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.

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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.

Although the taxation in Hong Kong of IP income generated overseas is not new, the FSIE regime introduces a new notion: the nexus requirement. It is one of the three exceptions justifying tax exemption for an income subject to the new regime.

The nexus requirement derives from the nexus approach of the Organisation for Economic Co-operation and Development (OECD). The exemption is only applicable to income derived from qualifying IP income received by a multinational enterprise (MNE).

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).

What constitutes qualifying IP income?

Under the new FSIE regime, only income derived from the use of patents and copyrighted software may be excluded and thus, non-taxable. Income from marketing-related IP assets such as trademarks and copyrights does not qualify for the exemption.

What is the nexus requirement?

A certain portion of the income derived from qualifying IP income can be exempt from profits tax. That portion is referred to as the excepted portion. The excepted portion is calculated based on a nexus ratio, which is defined as qualifying expenditures as a proportion of overall expenditures that the taxpayer incurred to develop the IP asset (new section 15L and Schedule 17FC of the Inland Revenue Ordinance (Cap. 112)).

In other words, the nexus approach ensures that there is a direct nexus between the IP income that is receiving tax benefits and the research and development (R&D) expenditures that contributed to generating that income.

What is the R&D fraction?

Qualifying IP income will be excluded based on a percentage that accounts for R&D expenses. This percentage is the “R&D fraction”.

The R&D fraction is calculated according to the following formula, and is capped at 100%:

F = (QE × 130%) / (QE + NE) where F means the R&D fraction; QE means the qualifying R&D expenditures connected to the qualifying IP to which the income relates; and NE means the non-qualifying expenditures connected to the same qualifying IP.

 

Qualifying IP income	Qualifying expenditures (QE)	Non-qualifying expenditures (NE)
✓ Patents and other IP assets functionally equivalent to patents (copyrighted software)	✓ R&D expenditures directly connected to a qualifying IP: R&D activities undertaken by the taxpayer inside or outside Hong Kong R&D activities outsourced to unrelated parties, whether they are undertaken inside or outside Hong Kong R&D activities outsourced to a related resident party, and undertaken in Hong Kong	✓ R&D expenditures directly connected to a qualifying IP income: Expenditures for acquiring the subject IP R&D activities outsourced to related non-resident parties R&D activities outsourced to related resident parties, but undertaken outside Hong Kong
✗ Marketing-related IP assets (trademark and copyright) are NOT qualifying IP income	✗ QE does not include interest payments, payments for any land or buildings or for any alteration, addition or extension to any building, or the acquisition of intellectual property	✗ NE does not include interest payments or payments for any land or buildings or for any alteration, addition or extension to any building

 

The R&D fraction is used to calculate the excepted portion of qualifying IP income received by an MNE entity. The excepted portion is calculated according to the following formula:

P = I × F where P means the excepted portion; I means the qualifying IP income; and F means the R&D fraction applicable to the qualifying IP income.

 

Takeaway

• Only income that meets the definition of qualifying IP income are eligible for tax exemption. Income derived from the use of patents and copyrighted software may be exempt from taxation, whereas income from marketing-related IP assets (such as trademark and copyright) does not qualify for the exemption.
• The extent of offshore IP income that is exempt from taxation is based on a nexus ratio, which takes into consideration qualifying expenditures as a proportion of overall expenditures that the taxpayer incurred to develop the IP asset.
• Qualifying expenditures only include R&D expenditures that are directly connected to the IP asset, while excluding acquisition costs of the IP asset.
• No other tax exemption applies to foreign-sourced IP income; the economic substance requirement and the participation requirement are not applicable.

The nexus requirement is the second of the three exceptions that allow tax exemption for income subject to the new FSIE regime. Read Part 4 of this article series to examine the participation requirement, which is subject to tax anti-abuse rules.