Hong Kong’s Foreign-Sourced Income Exemption (FSIE) Regime

On October 5, 2021, the European Union added Hong Kong to its tax grey list, citing concerns that Hong Kong’s exemption for foreign-sourced income (FSI) might constitute a harmful tax practice. Specifically, the EU suspected that Hong Kong’s policies could facilitate multinational corporations in using Hong Kong entities for cross-border tax avoidance or other harmful tax behavior.

To ensure Hong Kong’s removal from the EU’s grey list, the Hong Kong SAR government committed to introducing tax reforms by the end of 2022 to meet the EU’s requirements and prevent corporations from exploiting Hong Kong for harmful tax practices.

On December 22, 2022, the Hong Kong government officially gazetted the 2022 Inland Revenue (Amendment) (Taxation on Specified Foreign-Sourced Income) Ordinance (commonly referred to as FSIE) and implemented it on January 1, 2023. Unfortunately, the EU did not remove Hong Kong from the grey list as promised. This was mainly because the EU introduced new requirements concerning Hong Kong’s treatment of disposal gains (or capital gains). As a result, further tax reforms are expected by the end of 2023.

Key Features of the FSIE Regime

1. Affected Taxpayers: The FSIE regime only applies to certain qualifying taxpayers.
2. Foreign Income Deemed as Domestic: Certain foreign-sourced income, such as interest, dividends, capital gains, and intellectual property (IP) income, will be deemed as Hong Kong-sourced income if specific conditions are met.
3. Taxation on Domestic Income: Once foreign income is deemed as Hong Kong-sourced, it will be subject to tax in Hong Kong, even if it would otherwise be exempt (e.g., dividends and capital gains), unless specific exemption conditions are satisfied.
4. Exemption Conditions: The FSIE regime provides three exemption criteria—economic substance requirement (applicable to interest, dividends, and capital gains), nexus requirement (applicable to IP income), and participation exemption (applicable to dividends and capital gains).
5. Tax Credits: Taxpayers required to pay tax under the FSIE regime may still qualify for tax credits under certain conditions.

The core takeaway is simple: as long as a Hong Kong company has sufficient personnel and incurs adequate operating expenses in Hong Kong, it can continue to enjoy tax exemptions for foreign-sourced income (except for IP income, which is less common). However, if a Hong Kong company is merely a shell company (i.e., without employees and registered at a company secretary’s address) and falls under the affected taxpayer category, it will likely lose its tax exemption for specified foreign-sourced income.

In the past, Hong Kong shell companies were only ineligible for benefits under Hong Kong’s tax treaties with other jurisdictions. Now, they are also disqualified from Hong Kong’s own tax exemptions. In this article, we will provide a detailed overview of the FSIE regime.