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Hong Kong To Amend Tax Rules For Foreign-Source Passive Income

Monday, November 1, 2021

The Hong Kong Government has issued a statement committing to amend its tax law with regards the tax exemption for foreign source passive income from 2023, to ensure the territory does not end up placed on the EU's tax blacklist of non-cooperative territories.

Background

In 2017, the EU's Code of Conduct Group (COCG) found that a tax system that fully excludes passive income with a foreign link from taxation, without any conditions, is harmful.

The COCG has said: "Foreign source exemption regimes that are broad enough to include passive income, without any conditions, can result in ring-fencing and a lack of substance. Ring-fencing arises because the receipt of passive income generally requires a transaction with a non-resident. Passive income is generally not coupled with economic substance requirements. The COCG has found that the exemption of passive income without clear conditions (e.g. explicit link to some real activity in the jurisdiction) contravenes the principles of the Code."

On May 20, 2019, the Code of Conduct Group (COCG) agreed on an approach to assess foreign sourced income exemption regimes. It also issued guidelines to provide direction for jurisdictions that have already taken a commitment to amend their foreign source income exemptions, due to harmful features identified by the COCG.

In those guidelines, it said: "Foreign source income exemption regimes, or regimes that charge corporate tax on a territorial basis are not, in themselves, problematic. In fact, exempting foreign profits is acceptable and even recommendable, in certain cases, to prevent double taxation. However, problems arise when such regimes not only prevent double taxation, but also create situations of double-non taxation. This is particularly the case for regimes that have (i) an overly broad definition of the income excluded from taxation, notably foreign source passive income without any conditions or safeguards, and/or (ii) a nexus definition that is non-compliant with the definition of a permanent establishment in the OECD Model Tax Convention."

The COCG has said jurisdictions with harmful foreign income exemption regimes should either:

  • Introduce taxation of passive income; or
  • If they exclude from taxation certain types of passive income:
    • implement adequate substance requirements to the entities concerned, in line with the EU's Code of Conduct (Business Taxation); have robust anti-abuse rules in place; and
    • remove any administrative discretion in determining the income to be excluded from taxation.

Hong Kong's response

The Hong Kong Government issued a statement on October 5, 2021, following the inclusion of Hong Kong in the list of territories that have a harmful tax regime but have committed to address the COCG's concerns. According to the EU, Hong Kong has agreed to make legislative amendments to its tax laws by an agreed deadline of December 31, 2022, which according to Hong Kong will be implemented from 2023.

The Hong Kong Government said: "As an international financial centre, Hong Kong has all along been actively participating in and supportive of international tax co-operation. Over the years, Hong Kong has adopted the territorial source principle of taxation, whereby offshore profits are generally not subject to profits tax in Hong Kong."

"The EU is concerned that corporates with no substantial economic activity in Hong Kong are not subject to tax in respect of certain offshore passive income (such as interest and royalties), hence leading to circumstances of 'double non-taxation'. Under the premise of supporting the combating of cross-border tax evasion, the HKSAR Government agrees to co-operate with and has committed to the EU to amend the Inland Revenue Ordinance (Chapter 112 of the Hong Kong laws) by the end of 2022 and implement relevant measures in 2023."

"Hong Kong will continue to adopt the territorial source principle of taxation. The Government will endeavour to uphold our simple, certain and low-tax regime with a view to maintaining the competitiveness of Hong Kong's business environment."

"The proposed legislative amendments will merely target corporations, particularly those with no substantial economic activity in Hong Kong, that make use of passive income to evade tax across a border. Individual taxpayers will not be affected. As to financial institutions, their offshore interest income is already subject to profits tax under the Inland Revenue Ordinance at present, and hence the legislative amendments will not increase their tax burden."

"We will consult the stakeholders on the specific contents of the legislative amendments and strive to minimise the compliance burden of corporates."

The Government concluded: "Hong Kong enterprises will not be subject to defensive tax measures imposed by the EU as a result of being included in the watchlist on tax co-operation. The HKSAR Government will request the EU to swiftly remove Hong Kong from the watchlist after amending the relevant tax arrangements."