Hong Kong’s new taxation regime for foreign-sourced income (Part 4)

This article dives into the participation requirement introduced in the new section 15M of the Inland Revenue Ordinance (Cap. 112). It is a follow-up to Part 3 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.

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) is taxable 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).

Since 1 January 2023, if an MNE receives dividends from shareholdings in companies outside Hong Kong or consideration from the sale of assets overseas, that income is taxable in Hong Kong unless the economic substance requirement is met (see our Part 2 article for more details) or the participation exemption applies.

What are the conditions for the participation exemption?

A taxpayer (a company incorporated in Hong Kong or a company incorporated outside Hong Kong with a permanent establishment in Hong Kong) may be exempt from paying tax on foreign-sourced dividends and disposal gains if:

• relating to dividends: the taxpayer continuously held at least 5% shareholding in the overseas company paying the dividend[1] for at least 12 months immediately before the distribution of the dividend; or
• relating to capital gains: the taxpayer continuously held at least 5% shareholding in the overseas asset sold[2] for at least 12 months immediately before the sale.

However, a taxpayer caught by new specific anti-abuse rules will not be able to benefit from the exemption under the participation requirement.

What are the new specific anti-abuse rules?

1	The “subject to tax” condition For the taxpayer to benefit from the exemption, the dividend income or disposal gains, or underlying profits from which dividends are paid, must be subject to a similar tax in a foreign jurisdiction. A sum is subject to a similar tax in a foreign jurisdiction if: it is subject to a tax that is substantially of the same nature as profits tax in the foreign jurisdiction; and the highest applicable rate is at least 15%. Understanding the applicable rate: The highest applicable corporate tax rate does not need to be the actual tax rate applied. If income or profits are taxable under a special tax legislation at a lower rate than in the main legislation of the jurisdiction and the lower rate is not a tax incentive for carrying out substantive activities, the highest applicable corporate tax rate should be the highest stipulated tax rate in the special legislation. If income or profits are subject to the foreign tax at progressive corporate tax rates, the applicable rate will be the highest corporate tax rate applied to that income. If an MNE satisfies the participation requirement but fails the “subject to tax” condition[3], the tax relief available will switch from full exemption to tax credit. The MNE will remain subject to profits tax on the relevant income, but with a deduction of the foreign tax paid on the income and underlying profits.
2	Anti-hybrid mismatch rule Dividends paid by a company outside Hong Kong to an MNE in Hong Kong are disqualified for the participation requirement if the company making the payment is granted a tax deduction for the dividend paid (see for instance the French credit d’impôt mechanism). This rule aims to prevent taxpayers from exploiting “mismatch outcomes” by taking advantage of differences in tax systems in other countries, whether by obtaining a double deduction for the same expense, or by avoiding tax on income that has been deducted for tax purposes elsewhere.
3	Main purpose rule If the Commissioner of Inland Revenue is of the opinion that the main purpose or one of the main purposes of entering into an arrangement is to obtain a tax benefit for a profits tax liability, the participation exemption does not apply. In other words, if the main purpose or one of the main purposes of an arrangement is to obtain a tax advantage, then the exemption is not applicable. An arrangement will be regarded as non-genuine when it is not motivated by valid commercial reasons that reflect the economic reality. The term “one of the main purposes” means that obtaining a tax benefit does not need to be the sole or dominant purpose of a particular arrangement. It is sufficient that at least one of the principal purposes of an arrangement is to obtain a tax benefit, even if it’s not the dominant purpose. All relevant facts and circumstances have to be considered, including: the manner in which the arrangement was structured; the terms of the arrangement; the ways of implementing the arrangement; the result which the arrangement intended to achieve or had achieved; the non-tax purposes of the arrangement and any alternative way that the non-tax purposes could be achieved; the form (i.e., contractual rights and obligations created) and substance (i.e., practical or commercial end result) of the arrangement; the functions, assets and risks of each entity in the arrangement; and the contractual rights and obligations normally created, and the commercial and financial relationships normally entered into, between independent persons under an arrangement of the kind in question.

 

Takeaway

For foreign-sourced dividends and disposal gains, the participation exemption provides an additional pathway for Hong Kong MNEs to obtain an exemption from Hong Kong profits tax.

The exemption applies to the taxpayer if the following conditions are satisfied:

• Dividends: the taxpayer continuously held at least 5% shareholding in the overseas company paying the dividend[4] for at least 12 months immediately before the distribution of the dividend
• Capital gains: the taxpayer continuously held at least 5% shareholding in the overseas asset sold[5] for at least 12 months immediately before the sale

The participation exemption is subject to specific anti-abuse rules (“subject to tax” condition, anti-hybrid mismatch rule and main purpose rule).

 

With its new FSIE regime, Hong Kong is moving closer to the approach adopted by Singapore 20 years ago. Read Part 5 of this article series (available soon) for a comparison of the Hong Kong and Singapore regimes.

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[1] In relation to an MNE entity that receives a dividend, the entity that distributes the dividend (Section 15M of the Inland Revenue Ordinance (Cap. 112), Exception 3: dividend or disposal gain subject to participation requirement being met).

[2] In relation to an MNE entity that receives a disposal gain, the entity the equity interests in which are sold (Section 15M of the Inland Revenue Ordinance (Cap. 112), Exception 3: dividend or disposal gain subject to participation requirement being met).

[3] The Inland Revenue Department gives a few examples to illustrate how the “subject to tax” condition applies on its website: https://www.ird.gov.hk/eng/tax/bus_fsie.htm.

[4] In relation to an MNE entity that receives a dividend, the entity that distributes the dividend (Section 15M of the Inland Revenue Ordinance (Cap. 112), Exception 3: dividend or disposal gain subject to participation requirement being met).

[5] In relation to an MNE entity that receives a disposal gain, the entity the equity interests in which are sold (Section 15M of the Inland Revenue Ordinance (Cap. 112), Exception 3: dividend or disposal gain subject to participation requirement being met).