FSIE regime draft legislation and guidelines released

10/30/2022

A look at changes to Hong Kong’s foreign source income exemption regime (FSIE), following the gazettal of the draft legislation for implementing the revised regime



The Inland Revenue (Amendment)(Taxation on Specified Foreign-sourced Income) Bill 2022 (Bill) on Hong Kong’s FSIE regime was gazetted on 28 October following prolonged negotiations with the European Union (EU) and a consultation exercise with various stakeholders. The Bill proposes that specified foreign-sourced income would be deemed taxable in Hong Kong unless certain conditions are met. Subject to legislative procedures, the new regime will be effective from 1 January 2023.

The Inland Revenue Department (IRD) also published guidelines on its website to facilitate taxpayers’ understanding of the regime and to provide information on various practical matters.

Key features of the FSIE regime

The key features of the FSIE regime are summarized briefly below.

  • Applicable to entities that carry on business in Hong Kong and are part of a multinational enterprise (MNE).
  • Four types of income are in scope, these are interest, dividends, disposal gains on equity interests and income from intellectual property (IP). Only income that is received in Hong Kong is in scope.
  • The primary method of obtaining an exemption is by satisfying one of the following requirements:
    • The economic substance requirement for interest, dividends and disposal gains.
    • The nexus requirement for IP income.
  • Dividends and disposal gains benefit from a secondary method of obtaining a tax exemption through the participation exemption regime.
  • Where no exemption applies, double taxation relief is available. For dividends, double taxation will be prevented through the use of tax credits under a “look-through” approach.

Covered taxpayer

An entity that is part of an MNE group and carries on a business in Hong Kong will be in-scope irrespective of the quantum of the MNE group’s revenues or assets. An in-scope MNE group is effectively defined as any group that has a taxable presence in Hong Kong and one other location. The precise definition makes reference to the Global Anti-Base Erosion (GloBE) rules promulgated by the Organization for Economic Co-operation and Development (OECD).

The following taxpayers will be excluded from the scope of FSIE regime:

  • Investment funds, pension funds, real estate investment vehicles, government entities, international organizations and non-profit organizations as defined under the GloBE rules.
  • Insurance investment entities.
  • Taxpayers benefitting from the existing preferential tax regimes of Hong Kong.
  • Local companies that do not belong to an MNE group.
  • Non-Hong Kong permanent establishments of a Hong Kong resident.

Covered income

The following four types of foreign-sourced income that are received in Hong Kong will be in-scope. Consistent with the current provisions of the Inland Revenue Ordinance (IRO), there is no definition of dividends or interest.

  • Dividends: In the absence of a definition of dividends, we anticipate the scope of dividend income being legal form dividends.    
  • Interest: While there is no definition of interest, whether income is interest or not will depend on its nature and can be determined based on applicable jurisprudence.
  • IP income: Defined as income derived from the use of IP, such as royalties and licensing fees etc. Notably, the Bill adopts a narrower definition than the OECD 2015 Report on Action 5 harmful tax practices which includes gains on the disposal of IP.
  • Disposal gains: Defined as any gain or profit derived from the sale of equity interests (other than partnership interests) in an entity. The equity interest definition follows the GloBE definition and requires the owner to account for the item as equity. This would appear to exclude preference shares accounted for as financial assets from the definition.

Received in Hong Kong

The relevant income will be regarded as “received in Hong Kong” when the sum is:

  • Remitted to, or is transmitted or brought into, Hong Kong;
  • Used to satisfy any debt incurred in respect of a business carried on in Hong Kong; or
  • Used to buy movable property, and the property is brought into Hong Kong.

If the economic substance requirement, participation exemption or nexus requirement cannot be fulfilled when such foreign-sourced income accrues to the MNE entity (i.e. year of accrual), the relevant income will be deemed subject to tax in the year of assessment when the income is received in Hong Kong (i.e. year of receipt).

Economic substance requirement (for non-IP income)

Foreign-sourced interest, dividends and disposal gains will continue to be exempt from profits tax if the economic substance requirement is met.

Pure equity holding company

A pure equity holding company is subject to a reduced economic substance requirement. The definition of pure equity holding company refers to a company which, as its primary function, only holds equity interests in companies and only earns dividends, disposal gains and income incidental to the acquisition, holding or sale of such equity interests. The receipt of incidental interest income (e.g. interest on the deposit of dividends received) should not affect a taxpayer’s status as a pure equity holding company.

The reduced economic substance requirements are:

  • Complying with every applicable registration and filing requirement under the Companies Ordinance, Limited Partnerships Ordinance and Business Registration Ordinance etc.;
  • Carrying out the specified economic activities (i.e. holding and managing its equity participation) in Hong Kong either by itself or by another entity; and
  • Having adequate human resources and premises for carrying out the specified economic activities.

Non-pure equity holding company

The economic substance requirements are:

  • Carrying out the specified economic activities (i.e. making necessary strategic decisions, and managing and bearing principal risks in respect of any assets it acquires, holds, or disposes of) either by itself or by another entity in Hong Kong;
  • Employing an adequate number of qualified employees to carry out the specified economic activities in Hong Kong; and
  • Incurring an adequate amount of operating expenditure in Hong Kong.

The IRD indicates that the relevant activities for interest income from loans can be carried out through the holding of board meetings and strategic planning made by the finance department etc. The IRD considers that a Certificate of Resident Status cannot be used to demonstrate sufficient economic substance for the purpose of the FSIE because tax resident status is considered in a different context.

Source of profits vs. economic substance

The government emphasizes that the source of profits and the economic substance requirement will be considered in separate contexts, with the former not to be affected by the latter.  The source of profits will continue to be determined based on the prevailing principles established by case law. Taxpayers can still make offshore claims and obtain an exemption if they can satisfy the economic substance requirement.

The IRD provides an example where a company carries on an investment business other than a money lending and intra-group financing business in Hong Kong. It receives interest from loans to overseas associates.  The activities in relation to the loans (e.g. negotiation of terms, provision of funds etc.) are carried on outside of Hong Kong.  The company makes strategic decisions in relation to its investments in Hong Kong.  The example explains that the company can meet the economic substance requirement while the interest income from loans can be regarded as offshore sourced.

Taxpayers need to be careful in arranging the specified economic activities so that they will not taint the offshore claim.

Participation exemption

For foreign-sourced dividends and disposal gains, the participation exemption provides an additional pathway for taxpayers to obtain an exemption. The conditions for the participation exemption are as follows:

  • The investor company (i.e. the taxpayer) is a Hong Kong resident person or a non-Hong Kong resident person that has a permanent establishment in Hong Kong; and
  • The investor company has continuously held not less than 5 percent of equity interests in the investee entity for a period of not less than 12 months immediately before the income accrues.

The condition that the investee company should not earn more than 50 percent of its income as passive income, as proposed in the consultation stage, has been removed and replaced with a 12-month holding period requirement. This will generally be helpful and in particular will ease concerns with multi-layer holding structures.

Nexus requirement (for IP income)

The exemption requirements for IP income are different to those for interest, dividends and disposal gains. Instead of imposing an economic substance requirement, the nexus approach adopted by the OECD will apply in determining the extent of foreign-sourced IP income to be exempted.

Only income from the use of patents and copyrighted software may qualify for exemption under FSIE regime. Income from marketing-related IP assets (e.g. trademark and copyright) will not qualify for the exemption.

The relevant IP income will be exempt based on a fraction that references research and development (R&D) spend. The fraction is computed by dividing the qualifying expenditure on R&D by the total expenditure on R&D that has been incurred by the taxpayer or original owner during the specified period to develop the IP asset. In performing the computation, certain adjustments should be made. For example, interest payments and payments for land or buildings should be excluded. Qualifying expenditure is also provided with a 30 percent uplift.

Qualifying expenditure only includes R&D expenditure that is directly connected to the IP asset where the relevant R&D activities are undertaken by the taxpayer or outsourced to unrelated parties to take place in or outside Hong Kong or outsourced to related parties that are residents in Hong Kong to take place in Hong Kong.


Hong Kong’s tax policy environment

With the introduction of the proposed FSIE regime, Hong Kong’s tax landscape will inevitably change. The Hong Kong government has actively negotiated with the EU and engaged with stakeholders in formulating measures to minimize the impact to taxpayers and the associated compliance burden of the FSIE regime.  While there will be very limited time between the passing of the Bill and its provisions becoming effective, the various avenues through which a taxpayer may either fall outside of the FSIE altogether or obtain an exemption under the FSIE are fairly well understood. With a degree of forethought it should be possible for the majority of taxpayers to continue their operations with relatively little financial or operational impact as a result of the introduction of the FSIE. This view appears consistent with the government’s policy objective that the FSIE is not a fiscal revenue generation measure.

Hong Kong is required to refine its FSIE regime in order to demonstrate that it is a co-operative jurisdiction within the international tax community. We hope that the refined FSIE regime will pass the EU’s review and look forward to Hong Kong being removed from the EU’s watch-list in February 2023.


With the draft legislation introduced, as well as the IRD’s guidance, taxpayers should assess the implications of the new FSIE regime on their businesses before the legislation becomes effective. They may also consider applying for an opinion from the Commissioner of Inland Revenue or an advance ruling on their economic substance levels in order to obtain certainty and reduce their tax compliance burden.


This article was contributed by Doris Chik CPA and Jonathan Culver, Tax Partners at Deloitte China