To satisfy the European Union in terms of non-taxation of offshore income, Hong Kong has agreed to review its tax system and to tax foreign passive income from January 1, 2023. The Hong Kong government wishes to minimize the impact for local businesses linked to this change in regulations, by applying international standards in the fight against international tax evasion, while maintaining the principle of territoriality.
Companies affected by the new tax regime
The New Tax Regime only concerns the taxation of passive income of International Groups. Are concerned the entities (companies and permanent establishments) member of an International Group or acting on behalf of the latter (the “Targeted Entities”), but excludes natural persons as well as companies not holding entities outside Hong Kong.
Foreign passive income covered by the New Tax Regime
Passive income such as dividends, capital gains, interest and income from intellectual property rights (“Controlled Passive Income”) received in Hong Kong by a Covered Entity will now be subject to corporation tax at the rate of 16.5%, except to be able to take advantage of one of the three exemptions provided for. This Controlled Passive Income is deemed to be received in Hong Kong when one of the following three conditions is met:
- this income was received in Hong Kong,
- this income was used to settle a debt incurred in connection with an activity carried out in Hong Kong,
- this income has been used to acquire an asset which has been sent to Hong Kong, it being specified that in this case the income is deemed to be received when the asset is sent to Hong Kong.
The collection in Hong Kong by a Covered Entity of Controlled Passive Income implies a reporting obligation: it must declare to the tax authorities the Controlled Passive Income collected in Hong Kong. In the event that the Targeted Entity has not received a tax declaration for the fiscal year during which it received taxable Controlled Passive Income, it must inform the tax authorities of the collection of this taxable income within 4 months following the end of the fiscal year during which this income was received.
The three exemptions allow you to continue paying no tax in Hong Kong. Targeted Entities may claim exemptions based on economic, capital and investment criteria to escape taxation under the New Tax Regime:
- Economic substance test – Interest, dividends and capital gains – Interest, dividends and capital gains may be exempt from tax if it is established that the Covered Entity carries on an effective economic activity in Hong Kong with personnel in dedicated premises where strategic decisions are made in relation to the entity from which the Controlled Passive Income originates.
If the Covered Entity is a holding company whose sole activity is to be a holding company (“Holding Pure”), the requirement to employ staff in dedicated premises is reduced and proportional to the limited function of Holding Pure and there is no requirement that strategic decisions be made with respect to the entity from which the Controlled Passive Income originates.
- Capital criteria – Dividends and capital gains on securities – Dividends and capital gains on securities received from a company held at more than 5% for more than 12 months by a Targeted Entity may be exempted as long as the company from which the dividends come and/or the capital gain is itself subject to corporation tax greater than or equal to 15%. This tax shall be applied to amounts which have become Controlled Passive Income. However, care must be taken to verify that the International Group was not formed with the aim of obtaining a tax advantage, its establishment having to be explained by commercial reasons supported by economic reality.
- R&D investment criteria – Income from the exploitation of patents and software – Income from the exploitation of patents and software may be exempted in proportion to the research and development expenses incurred by the Covered Entity according to a formula defined by the text. Are excluded from this exemption and therefore now subject to Hong Kong corporation tax at the rate of 16.5%, foreign income from the exploitation of trademarks and copyrights received by the Covered Entities.
Hong Kong still remains a jurisdiction with an attractive tax system for a regional holding company for the following reasons:
- The Covered Entities will be able to claim easily the exemption based on the capital criterion with regard to dividends and capital gains received from abroad which constitute the usual Controlled Passive Income of holding companies,
- The loss resulting from a capital loss realized by a Targeted Entity may be deductible from its taxes due under the New Tax Regime as soon as it can be reported that this activity falls within the category of Passive Income.
- To eliminate the risk of double taxation under the New Tax Regime, a mechanism for granting a tax credit has been put in place in Hong Kong, from which the Covered Entities concerned will be able to benefit even in the absence of a tax treaty between the two territories concerned by the Controlled Passive Income taxed in Hong Kong. Finally, it will be possible to request a tax ruling from the Hong Kong tax administration: they can describe to the tax administration their situation with respect to the Controlled Passive Income they will receive, to find out whether the latter will be taxed or exempted under the New Tax Regime. The response from the tax authorities will provide legal certainty as to how the situation described will be treated for tax purposes.
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