FSIE Regime - Frequently Asked Questions

Hong Kong will continue to adhere to the territorial source principle of taxation, and determination on the source of profits will not be affected by the introduction of the "economic substance requirement" under the FSIE regime. In other words, in-scope taxpayers can still make offshore claims and be tax-exempt so long as they meet the economic substance requirement, with the source of profits and compliance with the economic substance requirement being considered in distinct and separate contexts.

Determination on the source of profits will continue to be based on the existing provisions of the Inland Revenue Ordinance (Cap. 112) ("IRO") and common law principles.

As regards the "economic substance requirement", a taxpayer that is a non-pure equity-holding entity is required to satisfy the adequacy test in terms of the number of qualified employees employed and the amount of operating expenditures incurred for carrying out the "specified economic activities" in Hong Kong.  For a pure equity-holding entity, the specified economic activities are holding and managing its equity participations, and complying with the corporate law filing requirements in Hong Kong ("reduced economic substance requirement").  For a taxpayer that is not a pure equity-holding entity, the specified economic activities are making necessary strategic decisions and managing and bearing principal risks in respect of any assets it acquires, holds or disposes of.  Such specified economic activities are not necessarily directly related to the source of the relevant offshore income received.

In the case where a covered taxpayer sustains a loss from the sale of equity interests outside Hong Kong ("equity interest disposal loss"), the "equity interest disposal loss" can be used to set off against the taxpayer’s assessable profits derived from specified foreign-sourced income that is chargeable to profits tax under the FSIE regime in the year of assessment during the basis period of which the sale proceeds are received in Hong Kong if the taxpayer fails to meet the economic substance requirement and the conditions for participation exemption.  Any amount of loss not so set off can be carried forward and set off against the taxpayer’s assessable profits derived from specified foreign-sourced income in subsequent years of assessment.

The term "dividend" is not defined in the IRO, and the ordinary meaning and common law interpretation of the term has been relied upon in construing the term in the context of the IRO.

In deciding whether an income is in substance a dividend, it is necessary to examine all the facts and circumstances relating to the transaction rather than the mere label of the income.  Generally, dividend refers to a payment of part of the profits for a period in respect of a share in a company.  It does not include distributions from a partnership, unit trust or other non-corporate entities and profit distributions from a branch.

At present, the term "interest" is not defined in the IRO, and the ordinary meaning and common law interpretation of the term has been relied upon in construing the term in the context of the IRO.

In deciding whether an income is in substance interest, it is necessary to examine all the facts and circumstances relating to the transaction rather than the mere label of the income.  Generally, interest is payable for the use of money and is in the nature of compensation for the deprivation of such use.

All disposal gains would fall within the scope of the FSIE regime whether or not they are capital or revenue in nature.

Under the FSIE regime, specified foreign-sourced income does not include any non-IP disposal gain that accrues to a trader and is derived from, or is incidental to, its business as a trader.  Such exclusion resembles that applies to foreign-sourced interest, dividend and non-IP disposal gains derived by regulated financial entities.

Yes.  Under the territorial principle of taxation, it is always possible that a person carries on a business in Hong Kong but derives foreign-sourced profits.  A trader carrying on its business in Hong Kong and undertaking its specified economic activities in Hong Kong would not be prevented from claiming that its non-IP disposal gains were sourced outside Hong Kong.

The sales proceeds from the subsequent disposal of immovable or movable property will still be regarded as the original specified foreign-sourced income and thus have to be tracked.  When the sales proceeds are remitted to Hong Kong, the original specified foreign-sourced income will be regarded as received in Hong Kong and chargeable to profits tax in Hong Kong in case the conditions for tax exemption are not satisfied.

The amount of the original specified foreign-sourced income should not be altered by the subsequent acquisition and disposal of assets no matter whether gains or losses are generated from such reinvestment activities.  Whether the gains or losses from the subsequent disposal of assets are chargeable to profits tax under the FSIE regime will be considered separately, having regard to the facts and circumstances relating to the disposal.

The definitions of "MNE group" and other related terms adopted for the purposes of the FSIE regime are modelled on those in the Global Anti-base Erosion Rules ("GloBE Rules") published by the Organisation for Economic Co-operation and Development under the Two-Pillar Solution to address the tax challenges arising from the digitalisation of the economy.  Under the GloBE Rules, the governing principle to determine whether an entity is a part of an MNE group is to follow the accounting consolidation rules.  If the accounting rules do not require the financial results of an entity to be included in the consolidated financial statements of its ultimate parent entity on a line-by-line basis (except that its exclusion is solely on size or materiality grounds or on the grounds that it is held for sale), the entity will not form part of a group and the FSIE regime will not be applicable to it.

No.  Since the reason for the Hong Kong SME not preparing consolidated financial statements to include the overseas subsidiary’s assets, liabilities, income, expenses and cash flows on a line-by-line basis is not solely on materiality grounds, nor on the grounds that the overseas subsidiary is held for sale, the Hong Kong SME is not regarded as a group and hence not an MNE entity.

An investment entity that is an ultimate parent or intermediate parent entity is generally exempted from preparing consolidated financial statements and measures its subsidiaries at fair value in accordance with the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board and the Hong Kong Financial Reporting Standards (HKFRS) issued by the Hong Kong Institute of Certified Public Accountants.  The term "investment entity" as defined under the IFRS and the HKFRS includes an investment fund.  Under such circumstances, an investment entity that is not required under applicable accounting principles (including the IFRS and the HKFRS) to be included in the consolidated financial statements of the ultimate parent entity of the collection will not be regarded as part of a group and hence not an MNE entity.  The FSIE regime will not be applicable to it.

However, an investment entity may be required to consolidate the assets, liabilities, income and expenses of its subsidiaries on a line-by-line basis if the subsidiaries themselves are not investment entities and the subsidiaries’ main purposes are to provide services and carry out activities that are related to the investment activities of the investment entity parent.  In such case, a collection of the investment entity and its subsidiaries will be regarded as a group.  If the group includes at least one entity or permanent establishment that is not located or established in the jurisdiction of the ultimate parent entity of the group, the investment entity will be regarded as an MNE entity.

As Fund A is authorized as a collective investment scheme under section 104 of Cap. 571, it qualifies for tax exemption under section 26A(1A)(a)(i) of the IRO.  Even though Fund A falls within the definition of "MNE entity" under the FSIE regime, its foreign-sourced dividends from its investment activities can still be exempt from profits tax under section 26A(1A).

No.  Company B can continue to enjoy its exemption status under section 88 of the IRO.  Its foreign-sourced interest income will be exempt from profits tax, provided that the conditions under the proviso to section 88 are fulfilled if such interest income is derived from a trade or business carried on by Company B.

No.  Since Mr. C is a natural person, which is excluded from the definition of entity, he will not fall within the scope of the FSIE regime.  His dividends received in Hong Kong from Company X and Company Y would not be brought into charge by the operation of the FSIE regime.

The definition of "MNE entity" is formulated to ensure that a person (e.g. a trustee) who acts for an arrangement (e.g. a trust) that is an entity included in an MNE group or an MNE group can be chargeable to profits tax under the FSIE regime.  Such an arrangement may take many forms and is not limited to trust and arrangements similar to trust (e.g. unlimited liability joint venture).

According to the ordinary meaning of the term "act for", it means "to serve as an authorized or official representative".  Hence, if service providers merely provide services to MNE groups, this alone does not count as "act for".  An independent service provider who only serves an MNE group or an entity included in an MNE group in the course of providing services to the group or entity will generally not be brought within the scope of the FSIE regime.

A COR is a document issued by the Hong Kong competent authority to a Hong Kong resident person who requires proof of resident status for the purpose of claiming tax benefits under a Comprehensive Double Taxation Agreement ("CDTA").  Therefore, it only serves as a proof that the entity is a Hong Kong tax resident for the purposes of the CDTA.  Since an entity’s tax resident status and its compliance with the "economic substance requirement" under the FSIE regime are considered in different contexts, COR cannot be used to demonstrate sufficient economic substance for the purposes of the FSIE regime.

For interest income from loans, the relevant economic activities are making necessary strategic decisions, managing and bearing principal risks in respect of such loans.  Such activities can be carried out through the holding of board meetings, strategic planning made by the finance department, etc.

In order to comply with the economic substance requirement through outsourcing, the taxpayer has to demonstrate adequate monitoring of the specified economic activities carried out by the outsourced entity.  It is expected that such a monitoring mechanism would be documented in an appropriate manner, say in the outsourcing agreement or any internal policies of the MNE group.

A receipt of incidental interest income (e.g. interest on deposit of dividends received) would not affect a taxpayer’s status as a pure equity-holding entity.

"Pure equity-holding entity" means an entity that only holds equity interests in other entities and only earns dividends, equity interest disposal gains and income incidental to the acquisition, holding or sale of such equity interests.  This definition is modelled on the Guidance on the interpretation of the third criterion of the Code of Conduct (Business Taxation) promulgated by the European Union.

Given the restriction on assets held in the above definition, the existence of the shareholder’s loan, whether interest-free or not, will taint the taxpayer’s status as a "pure equity-holding entity".  This practice is consistent with that adopted by no or only nominal tax jurisdictions in the application of their economic substance laws.

No.  Borrowing money for financing its equity investment and earning incidental income (e.g. exchange gains) from such borrowing does not disqualify the taxpayer from being a pure equity-holding entity.

To prove that the outsourcing and a taxpayer’s monitoring have taken place, it would be sufficient for a taxpayer to have an internal master service agreement or other proper documentation provided that the relevant details of the outsourcing arrangement (e.g. identities of the outsourcing entity and outsourced entity, nature of specified economic activities outsourced, fees charged, monitoring mechanism, etc.) are set out in the document.

It is not practicable to specify the exact level of human resources that is considered adequate for a pure equity-holding entity to meet the reduced economic substance requirement as such level would depend on the extent and complexity of activities that the outsourced entity needs to undertake for holding and managing the pure equity-holding entity’s equity participations in other entities, the number of pure equity-holding entities to which the outsourced entity provides services, etc.

In assessing whether a pure equity-holding entity has satisfied the reduced economic substance requirement, IRD will take into account the commercial reality of the taxpayer, having regard to its entire operation.  In general, activities for holding and managing equity participations include taking decisions on the holding and selling of equity interests, calculating risks, and reviewing or revising financing arrangement for acquiring the equity interests.

The contingent disposal gain which accrued to Company A on or after 1 January 2023 falls within the scope of specified foreign-sourced income under the FSIE regime.  The wording of section 15K(2) of the IRO is clear.  The reference period for considering whether the economic substance requirement is met is the basis period of the year of assessment in which the specified foreign-sourced income accrues to an MNE entity.  If Company A did not have any economic substance in Hong Kong during the year of assessment in which the contingent disposal gain accrued to it, the economic substance requirement would not be regarded as satisfied.

Section 15K(2) of the IRO provides different sets of conditions for pure equity-holding entities and non-pure equity-holding entities respectively in determining whether an entity satisfies the economic substance requirement during the basis period of the year of assessment in which the income accrues to the entity.  For a pure equity-holding entity, the reduced economic substance requirement is applicable.  Since Company A had held certain debts during the basis period of the year of assessment 2023/24 in which the dividends accrued to it, Company A could not be regarded as a pure equity-holding entity during the year even though all the debts were disposed of on 1 June 2023.  Thus, the reduced economic substance requirement would not be applicable to it.

Generally, in determining whether the "subject to tax" condition is met in relation to underlying profits, IRD will consider the tax position of the underlying profits for the taxable period in which or immediately prior to that in which the subject dividend is declared ("relevant period").  If the investee entity sustains a loss and has no profits chargeable to tax for the relevant period, the "subject to tax" condition cannot be met.

Having said that, IRD may consider otherwise if there is sufficient evidence showing that the underlying profits out of which the subject dividend is distributed have been taxed for a taxable period or periods prior to the relevant period at a rate of at least 15%.  In this regard, the taxpayer should put in place a mechanism (with documentary records) to track: (a) the total dividends paid by investee entities; and (b) the total profits of the entities that are taxed at a rate of at least 15%, for each taxable period. Such a tracking mechanism has to be applied consistently.  In such cases, the "subject to tax" condition can generally be met if the amount of (b) is equal or greater than that of (a).

If the specified foreign-sourced income is a gain derived from disposal of equity interests in an investee entity, the participation exemption only applies if the disposal gain is subject to a qualifying similar tax in a territory outside Hong Kong (foreign jurisdiction).  The foreign jurisdiction may not necessarily be the jurisdiction in which the investee entity is located.

If the gain from disposal of the equity interests in Company X is subject to corporate income tax in Jurisdiction Y on the indirect transfer of Subsidiary Y, such tax would be taken into account in determining whether the “subject to tax” condition is satisfied in respect of the equity interest disposal gain.  As the headline tax rate in Jurisdiction Y is higher than the reference rate of 15%, the “subject to tax” condition would be regarded as satisfied.

If no tax is charged on the gains derived by Company HK from the disposal of its subsidiaries, such disposal gains will not be regarded as subject to a qualifying similar tax in Jurisdiction F.

For dividend income, the "subject to tax" condition will only be met if one of the following conditions is satisfied:

In the given scenario, (i) the subject dividend was not subject to tax in Jurisdiction X; (ii) the amount of the underlying profits (i.e. the profits of Company X) of the subject dividend which had been subject to a qualifying similar tax (i.e. $80) is smaller than that of the subject dividend; and (iii) there is no information showing that any related downstream income of the underlying profits had been subject to tax.  In such circumstance, the "subject to tax" condition in respect of the subject dividend would not be regarded as met since none of the conditions provided in section 15N(2) of the IRO is satisfied.

Section 15N(2) of the IRO clearly provides that where the "subject to tax" condition is to be met in relation to a dividend for the reason that the underlying profits or related downstream income of the profits is subject to a qualifying similar tax, the amount or aggregate amount of such profits or income must be equal to or larger than the amount of the dividend.  There is no room for the adoption of the apportionment approach when ascertaining whether the "subject to tax" condition is met.

A covered taxpayer who receives in Hong Kong any specified foreign-sourced income to which no tax exemption is applicable will have to inform its chargeability to tax within 4 months after the end of the basis period of the year of assessment during which the income is received in Hong Kong ("year of receipt").  In the case where a profits tax return for the year of receipt has been issued, the taxpayer is required to provide details of the income received in the tax return and no separate written notification is required.

A taxpayer can apply for an advance ruling under section 88A of the IRO on whether its covered income is exempt from tax under the FSIE regime.

To obtain tax certainty and reduce compliance burden, taxpayers are encouraged to apply to the Commissioner for advance rulings on their compliance with the economic substance requirement of the FSIE regime specified in section 15K of the IRO.  The application may cover a maximum of 5 years of assessment.  For more information on advance ruling, please click here.

The economic substance requirement, if relied upon, needs to be complied with during the basis period of the year of assessment in which the relevant income accrues to the taxpayer.

To minimise the compliance burden, a taxpayer may consider applying for the Commissioner’s opinion or an advance ruling, as the case may be, on its compliance with the economic substance requirement which, if granted, can be applicable for up to 5 years of assessment.  With the Commissioner’s opinion or an advance ruling, the taxpayer will be relieved from tracking the receipt of the offshore non-IP covered income accrued in the relevant years of assessment.