Step 1 

Can the covered income fulfill these requirements?

1a. If yes, the income would not be deemed taxable.

1b. If no:

For interest and IP income, check if the income is qualified for foreign tax credit or unilateral tax credit (see Step 3 below).

For dividends and disposal gains, check if the income is qualified for participation exemption (see Step 2 below).

Economic substance requirements

• The Covered Taxpayer has to conduct substantial economic activities (“Relevant Activities”) with respect to the relevant passive income in Hong Kong:
• for a non-pure equity holding company, the Relevant Activities will include (i) making necessary strategic decision, and (ii) managing and assuming principal risks in respect of any assets it acquires, holds or disposes of.
• for a pure equity holding company (i.e. a company which, as its primary function, acquires and holds shares or equitable interests in companies and only earns dividends and disposal gains in relation to shares or equity interest), a reduced substantial activities test applies and the Relevant Activities will only include (i) holding and managing its equity participation, and (ii) complying with the corporate law filing requirements in Hong Kong.
• It is possible for the Covered Taxpayer to outsource the Relevant Activities if it is able to demonstrate (i) adequate monitoring of the outsourced activities, and (ii) that the Relevant Activities are conducted in Hong Kong.

How is “substance” being measured?

• Non-pure equity holding companies have to meet the adequacy test in terms of:
• (i) employing an adequate number of qualified employees; and
• (ii) incurring an adequate amount of operating expenditures in Hong Kong in relation to the Relevant Activities.
• The Inland Revenue Department (“IRD”) will consider whether a taxpayer has met the adequacy test after taking into account a list of factors, including:
• (i) nature of business;
• (ii) scale of operation;
• (iii) profitability;
• (iv) details of employees employed;
• (v) the amount and types of operating expenditures incurred, etc.
• As the adequacy test will be determined based on a totality of facts, there will be no minimum objective threshold in terms of number of employees or operating expenditure.
• Pure equity holding companies have to meet the reduced substantial activities test, which may be satisfied by:
• (i) having a director who is a Hong Kong tax resident;
• (ii) holding annual board meetings;
• (iii) fulfilling annual filing requirements under the Companies Ordinance, etc.
• subject to further guidance from the IRD and the draft legislation.

Nexus approach requirements

• Income from a qualifying IP asset can qualify for preferential tax treatment based on a nexus ratio
• Nexus ratio = Qualifying expenditures incurred by the taxpayer to develop the IP asset / Overall expenditures incurred by the taxpayer to develop the IP asset
• This proportion of research and development (“R&D”) expenditures is a proxy for substantial economic activities.

Qualifying IP asset

• Only covers (i) patents and (ii) other IP assets which are functionally equivalent to patents if those IP assets are both legally protected and subject to similar approval and registration processes (e.g. copyrighted software)
• Marketing-related IP assets (e.g. trademark and copyright) are excluded from the preferential tax treatment

Qualifying expenditures

• Only include R&D expenditures that are directly connected to the IP asset
• Acquisition costs of the IP asset are excluded
• Only cover expenditures on R&D activities (i) undertaken by the taxpayer within the jurisdiction providing the IP regime (“IP Regime Jurisdiction”); (ii) outsourced to unrelated parties to take place inside or outside the IP Regime Jurisdiction; and (iii) outsourced to resident related parties to take place within the IP regime jurisdiction

Taxpayers may be permitted to apply a 30% uplift on the qualifying expenditures, subject to a cap equal to the overall expenditures incurred by the taxpayer

Step 2

For dividends and disposal gains that are already deemed taxable, can the participation exemption requirements be fulfilled?

2a. If yes, the income can be exempt.

2b. If no, check if the income is qualified for foreign tax credit or unilateral tax credit (see Step 3 below).

Participation exemption

• The income concerned will continue to be tax-exempt if:
• (i) the investor company is a Hong Kong resident person (i.e. a company incorporated in Hong Kong, or if incorporated outside Hong Kong, normally managed or controlled in Hong Kong) or a non-Hong Kong resident person that has a permanent establishment in Hong Kong;
• (ii) the investor company holds at least 5% of the shares or equity interest in the investee company; and
• (iii) no more than 50% of the income derived by the investee company is passive income.
• In terms of the requirement of “Hong Kong resident person”, it may not be necessary for companies to apply for a Hong Kong Tax Resident Certificate. The company should be able to fulfill this requirement by demonstrating control of the company in Hong Kong, having a majority of directors who are Hong Kong residents, conducting business activities in Hong Kong, having meetings in Hong Kong etc.

Anti-abuse rules

• (i) Switch-over rule
• If the income concerned or the profits of the investee company is or are subject to tax in a foreign jurisdiction the headline tax rate of which is below 15%, the tax relief available to the investor company will switch over from participation exemption to foreign tax credit.
• (ii) Main purpose rule
• If there is any arrangement or series of arrangements undertaken by the investor company with a main purpose (or one of the main purposes) of obtaining a tax advantage that defeats the object or purpose of the exemption, the participation exemption will not be available.
• (iii) Anti-hybrid mismatch rule
• Where the income concerned is dividends, the participation exemption will not apply to the extent that the dividend payment is deductible by the investee company.