FSIE Regime: Hong Kong Foreign-Sourced Income Exemption for Multinational Groups

FSIE Hong Kong Foreign Sourced Income Exemption Regime

The FSIE regime is a targeted anti-avoidance measure. It took effect on 1 January 2023. From 1 January 2024, the regime expanded to include disposal gains. It applies to specified foreign-sourced income received in Hong Kong by a member of a multinational group. The regime responds to the OECD’s Pillar Two initiative, which requires jurisdictions to address the risk that passive income can be shifted out of a jurisdiction without being taxed elsewhere. Under the FSIE regime, such income is deemed chargeable to profits tax unless one of the statutory exceptions is satisfied.

Scope of the FSIE Regime

The FSIE regime covers four categories of foreign-sourced income: interest, dividends, disposal gains (added from 1 January 2024), and intellectual property (IP) income. It applies only to a taxpayer that is a member of a multinational group - broadly, a group that includes at least one entity or permanent establishment not resident in Hong Kong. The income must be received in Hong Kong. This means it is brought into the territory by the taxpayer, or is used to discharge a debt incurred in the course of the taxpayer’s trade or business in Hong Kong.

The regime does not replace the traditional territorial source principle. A taxpayer that is not a member of a multinational group continues to rely on the offshore claim under the territorial source principle to argue that its foreign-sourced income is not chargeable. For multinational group members, the FSIE regime reverses the burden: the income is chargeable unless an exception applies.

Hong Kong Foreign Sourced Income Exemption: The Core Exceptions

For a multinational group member, the central question is whether it can satisfy one of the statutory exceptions to the charge. Three main exceptions exist: the economic substance requirement, the nexus requirement for IP income, and the participation exemption for dividends and disposal gains.

The economic substance requirement is the default exception for non-IP income. To qualify, the taxpayer must demonstrate adequate economic substance in Hong Kong in relation to the income. This means a sufficient number of qualified employees and a sufficient amount of operating expenditure in Hong Kong to carry out the relevant income-generating activities. The Inland Revenue Department (IRD) examines the facts of each case. The requirement is applied on a category-by-category basis - a taxpayer may satisfy it for interest income but not for dividend income.

For IP income, the exception is the nexus requirement, which aligns with the OECD’s modified nexus approach. The taxpayer must calculate the qualifying expenditure on research and development that gave rise to the IP asset. Only the proportion of IP income that corresponds to that qualifying expenditure is exempt. The nexus ratio is the qualifying expenditure divided by the overall expenditure on the IP asset, subject to an uplift of 30% (capped at the overall expenditure).

FSIE Regime Hong Kong 2023: The Original Framework

When the FSIE regime first took effect on 1 January 2023, it covered interest, dividends, and IP income. Disposal gains were added from 1 January 2024. The 2023 framework established the core structure: the charge on foreign-sourced income received in Hong Kong, the economic substance requirement as the primary exception, and the participation exemption for dividends.

The participation exemption for dividends allows a taxpayer to claim exemption on foreign-sourced dividends if the dividend-paying entity is a company, the taxpayer holds at least 5% of the shares in that company, and the taxpayer is a Hong Kong resident or has a permanent establishment in Hong Kong. The dividend-paying entity must also be subject to tax in its jurisdiction of residence at a rate of at least 15%.

Hong Kong FSIE Economic Substance Requirement

The economic substance requirement is the most commonly relied-upon exception for non-IP income. To satisfy it, the taxpayer must demonstrate adequate economic substance in Hong Kong. The IRD looks at the number of qualified employees, their qualifications and experience, the amount of operating expenditure incurred in Hong Kong, and whether the taxpayer’s premises are adequate for the activities.

The requirement is applied on a category-by-category basis. A taxpayer that receives both interest and dividends must satisfy the economic substance requirement separately for each category. The IRD has indicated that it will consider the nature and complexity of the activities. Outsourcing to a related party does not automatically disqualify the taxpayer, but the taxpayer must retain sufficient oversight and control.

Hong Kong FSIE Participation Exemption

The participation exemption applies to dividends and disposal gains. For dividends, the conditions are: the dividend-paying entity is a company; the taxpayer holds at least 5% of the shares; the taxpayer is a Hong Kong resident or has a permanent establishment in Hong Kong; and the dividend-paying entity is subject to tax in its jurisdiction of residence at a rate of at least 15%. For disposal gains, the conditions are similar: the taxpayer must have held at least 5% of the shares in the investee company for at least 12 months; the taxpayer must be a Hong Kong resident or have a permanent establishment in Hong Kong; and the investee company must be subject to tax at a rate of at least 15%.

The participation exemption is an alternative to the economic substance requirement. A taxpayer that meets the participation exemption conditions does not need to demonstrate economic substance for that income. File a profits tax return and claim the exemption.

Distinction From the Traditional Offshore Claim

The FSIE regime operates alongside the traditional territorial source principle. A taxpayer that is not a member of a multinational group can still make an offshore claim under the territorial source principle, arguing that the profits were not arising in or derived from Hong Kong. The IRD’s guidance on the locality of profits is set out in Departmental Interpretation and Practice Note 21 (DIPN 21).

For multinational group members, the FSIE regime applies first. If the taxpayer satisfies one of the statutory exceptions, the income is exempt. If it does not, the income is chargeable to profits tax. The taxpayer cannot fall back on the offshore claim. The FSIE regime overrides the territorial source principle for in-scope taxpayers.

Filing and Compliance

A taxpayer that receives foreign-sourced income covered by the FSIE regime must report it on its profits tax return, Form BIR51 for corporations. The taxpayer must also complete the relevant supplementary form, which requires details of the income, the exception relied upon, and supporting evidence. The year of assessment is the basis period in which the income is received in Hong Kong.

The IRD may request additional information to verify the claim. Maintain records demonstrating compliance with the economic substance requirement, the nexus requirement, or the participation exemption. The IRD has published guidance on the evidence required: employment records, expenditure records, and documentation of the shareholding and tax status of the investee company.

Alignment with OECD Pillar Two

The FSIE regime is part of Hong Kong’s response to the OECD’s Pillar Two initiative, which introduces a global minimum tax of 15% for multinational enterprise groups with consolidated revenue of EUR 750 million or more. The FSIE regime ensures that Hong Kong does not become a jurisdiction where passive income can be shifted without being taxed. The regime is designed to be consistent with the OECD’s requirements. The IRD has stated that it will continue to monitor developments and make adjustments as necessary.

For multinational groups within the scope of Pillar Two, the FSIE regime interacts with the income inclusion rule and the undertaxed profits rule. A taxpayer that pays tax in Hong Kong under the FSIE regime may credit that tax against its top-up tax liability in another jurisdiction. Seek advice on the interaction between the FSIE regime and your Pillar Two obligations.