Hong Kong’s government has gazetted the most significant change in its tax laws in over four decades, imposing profits tax on multinational enterprises’ foreign-sourced income that is currently exempt.
The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Bill 2022 is in response to pressure from the European Union, which has concerns that multinational enterprises (MNEs) can use Hong Kong’s territorial taxation principle to achieve ‘double non-taxation’ of certain passive income. The EU regards this territorial system as facilitating the erosion of the tax base of certain EU Member States and the Hong Kong government has negotiated with the EU to avoid blacklisting. The new Bill is the result of this process.
According to law firm Deacons, the law will change the way MNEs do business in Hong Kong and vary principles that have been seen as cornerstone features of its tax code. Most importantly, dividends and capital gains arising from the disposal of equity interests will be taxable when received in Hong Kong by a Hong Kong component of a MNE, as will interest and royalties.
‘This is a paradigm shift from the longstanding features of Hong Kong revenue law and will necessitate a careful review and, if necessary, restructuring of the Hong Kong operations of groups and business operating across multiple jurisdictions’, commented Stefano Mariani TEP, Partner at Deacons.
The new regime does not apply to foreign-sourced dividends and disposal gains if the receiving MNE satisfies the ‘economic substance’ requirement. This would be the case if the entity is a pure equity-holding company whose only activity is the holding of equity interests and earns only dividends and disposal gains, so that it needs only a bare minimum of staff and premises in Hong Kong.
However, the entity is not a pure equity-holding company if its activities include the making of strategic decisions when dealing with its assets and the assumption of corresponding risks. In that case, in order to meet the economic substance requirement, it will have to employ an adequate number of qualified employees and incur an adequate amount of operating expenditure in Hong Kong for its specified economic activities. The Hong Kong Inland Revenue Department will issue legally binding opinions, free of charge, on whether the economic substance requirement is met in any particular case.
Exemption from the new regime is also granted to purely domestic companies and groups that are resident only in Hong Kong and have no components or permanent establishments elsewhere. Banks, charities, non-profit organisations, pension schemes, widely held collective investment schemes and investment funds and real estate investment vehicles that are ultimate parent entities of an MNE are also exempt.
The Bill is now under scrutiny by the Legislative Council of Hong Kong and is expected to come into effect in 2023 for trust structures as well as companies. If a trust holds a private investment holding company carrying on trade or business in Hong Kong, and the trust and the investment holding company are established in different jurisdictions, the structure will be treated as an MNE, says law firm Withersworldwide. ‘In such a case, the non-Hong Kong sourced income of the investment holding company which is received in Hong Kong would prima facie be subject to profits tax under the new regime’, it said.