Doris Chik is a tax partner and Carmen Cheung is a tax manager at Deloitte China

In late October, the Hong Kong government released draft legislation on the foreign-source income exemption (FSIE) regime that is meant to address the EU’s concerns. Back in 2021, the EU included the Special Administrative Region on its watchlist of non-cooperative tax jurisdictions following a review of FSIE regimes. In particular, the EU was concerned with the non-taxation of passive income where the income recipient has no substantial economic activity. Hong Kong committed to amend its tax law by 31 December 2022.

Subject to legislative procedures, the new FSIE regime will apply as from 1 January 2023. The proposed regime described in this article is based on the draft legislation to be enacted.

Key features

Under the proposed FSIE regime, four types of foreign-source income – including interest, dividends, gains from the disposal of equity interests, and income from the use of intellectual property (IP) – would be deemed to be sourced from Hong Kong and chargeable to profits tax in the year of receipt if both of the following two conditions apply:

  • the income is received in Hong Kong by an entity that carries on a business in Hong Kong and is part of a multinational enterprise (MNE) group; and
  • the recipient entity fails to meet the economic substance requirement (for non-IP income) or fails to comply with the nexus requirement (for IP income) in the year of accrual.

In other words, specified foreign-sourced income would continue to be exempt from tax if certain conditions in the amended FSIE rules are met.

Foreign-sourced interest, dividends, and disposal gains are tax-exempt if economic substance requirements are met


Foreign-sourced interest income, dividends, and disposal gains received in Hong Kong can enjoy tax exemption if the entity has sufficient economic substance in Hong Kong. In particular, an adequacy test has to be fulfilled in terms of the number of qualified employees and the amount of operating expenditures incurred for carrying out economic activities in Hong Kong.

If an entity primarily derives dividends and disposal gains, it is regarded as a pure equity holding company and a reduced substantial activities test can be applied.  The relevant activities only include holding and managing the company’s equity participation and complying with the applicable registration and filing requirements.

Participation exemption

For foreign-sourced dividends and disposal gains, if the entity fails to meet the economic substance requirements, it could still qualify for the exemption through an alternative pathway – participation exemption, if certain conditions are met – e.g. holding of at least 5% of equity interest in the investee company for a period of not less than 12 months immediately before income accrues. A few anti-abuse rules are included in the participation exemption regime.

Exemption for IP income

The exemption requirements for IP income are different from those for interest, dividends, and disposal gains. Instead of imposing the economic substance requirements, the nexus requirement similar to that of the OECD BEPS (tax base erosion and profit shifting) Project Action 5 would be applied in determining the extent of IP income to be exempted.

Foreign-sourced qualifying IP income is tax-exempt based on an R&D fraction

Only income from the use of patents and copyrighted software can qualify for the tax exemption. Income from use of other IP assets, such as trademarks or copyrights, does not qualify for the tax exemption.

Foreign-sourced qualifying IP income is tax-exempt based on an R&D fraction, defined as qualifying expenditures as a proportion of the overall expenditures incurred by the taxpayer during a specified period to develop the IP asset. Qualifying expenditures include only research and development (R&D) expenditures that are directly connected to the IP asset where the relevant R&D activities should be undertaken by the taxpayer or outsourced to unrelated parties to take place in or outside Hong Kong, or outsourced to resident related parties to take place in Hong Kong.

Double taxation relief

If a Hong Kong resident person fails to get an exemption under the FSIE regime or the participation exemption (for dividends and disposal gains) and foreign tax is paid in respect of that income, double taxation can be relieved by the existing bilateral tax credits or the newly introduced unilateral tax credits for a jurisdiction with or without an applicable comprehensive double taxation agreement with Hong Kong respectively.


Hong Kong is required to refine its FSIE regime in order to demonstrate that it is a co-operative jurisdiction within the international tax community.  The Special Administrative Region government has been transparent throughout the consultation and has responded to industry and practitioner feedback in respect of the FSIE regime.

The government will explore measures to uphold Hong Kong’s competitiveness

With the new FSIE regime, it is clear that Hong Kong’s territorial system of taxation would no longer be as ‘simple’ as it used to be. New concepts such as a nexus requirement for IP income, a participation exemption and a unilateral foreign tax credit are introduced.

MNE groups with the above specified foreign-sourced income should review their existing investment holding structures and operating models in order to assess the implications of the new FSIE regime on their businesses before the legislation becomes effective on 1 January 2023.  They may also consider applying for ruling from the Inland Revenue Department on their economic substance levels in order to obtain certainty.

In order to uphold Hong Kong’s competitiveness, the government will explore a new preferential tax regime for Hong Kong-sourced IP income in order to encourage more R&D activities in Hong Kong. In addition, the government will look into appropriate measures to enhance tax certainty for onshore disposal gains on equity interests that are capital in nature.