Tax advisors are advising corporations that significant changes to Hong Kong's foreign-sourced passive income taxation regime are likely be introduced in January 2023.

The draft legislation is set to be introduced to the Legislative Council of Kong Hong in October 2022, in response to the European Union'sconcerns over potential double non-taxation arising from Hong Kong's foreign source income exemption (FSIE) regime for certain passive income. Hong Kong has therefore conducted a consultation on a proposed refinement to the FSIE regime.

If enacted, the amendments will tax constituent entities of multinational enterprise (MNE) groups on their foreign-sourced passive income received in Hong Kong, wherever headquartered and irrespective of group asset size and revenue. Hong Kong will continue to adhere to the territorial source principle of taxation, in that active income such as trading profits and service income will continue to be exempt from profits tax if it is regarded as offshore-sourced based on Hong Kong's existing source rules.

The new FSIE regime in respect of in-scope offshore passive income received in Hong Kong will apply to interest, income from intellectual property, dividends and disposal gains in relation to shares or equity interest. Entities satisfying the economic substance or nexus approach requirements will be exempt. The economic substance tests will look at whether the company employs a sufficient number of qualifying employees and incurs sufficient operating expenditure, the details of which are still to be issued. Pure equity-holding companies will be subject to a reduced economic substance requirement.

No grandfathering arrangements were proposed in the consultation. However, the new regime proposes to introduce a 5 per cent participation exemption in respect of offshore dividends and disposal gains in relation to shares or equity interest, which will apply whether or not the economic substance requirement is met, subject to specific anti-abuse rules.

For the participation exemption to apply, the dividend or underlying profits must be...