The FSIE Regime in Hong Kong: Everything You Need To Know

Hong Kong has reshaped its tax treatment of foreign-sourced income with the Foreign Source Income Exemption (FSIE) regime. The change addresses the EU’s October 2021 decision to add Hong Kong to its grey list of non-cooperative jurisdictions for tax purposes.

The reforms show Hong Kong’s commitment to align with global tax standards. Prior rules allowed companies to claim tax benefits without substantial business activity in Hong Kong – a practice now viewed as potentially enabling tax avoidance.

The changes were rolled out in two phases. FSIE 1.0 began on January 1, 2023, covering foreign-sourced dividends, interest, intellectual property income, and equity disposal gains. Following updated EU guidance, Hong Kong enacted FSIE 2.0 on December 8, 2023, effective January 1, 2024, expanding coverage to include gains from disposal of all asset types.

These rules establish new compliance benchmarks for companies with cross-border operations and foreign-sourced passive income. The updates require clear evidence of economic substance and direct links between income and real business activities in Hong Kong.

Tax professionals and business leaders need accurate guidance on the FSIE regime in Hong Kong to protect their tax positions and adapt their strategies.

This article provides a clear analysis of the rules, requirements, and practical steps for compliance.

Why The FSIE Regime In Hong Kong Was Updated

The EU’s placement of Hong Kong on its tax watchlist in 2021 prompted swift action. The previous tax framework permitted multinational corporations to benefit from tax exemptions on foreign-sourced income without proving substantial business presence in Hong Kong. This gap raised concerns about potential tax avoidance practices.

To keep Hong Kong off the EU’s blacklist and preserve its position as a premier financial hub, the tax authorities introduced new requirements. Companies must now show real economic substance – actual business operations and employees in Hong Kong – to qualify for tax benefits. These changes match the EU’s requirements that tax benefits link directly to genuine economic activities.

The EU’s Code of Conduct Group later updated its guidance on foreign-sourced capital gains, mandating broader coverage of asset disposals. Hong Kong responded with FSIE 2.0, expanding the rules to all asset types. This proactive response shows Hong Kong’s dedication to meeting international tax standards while maintaining its appeal to global businesses.

What is Covered Under FSIE

The FSIE regime applies to four main categories of foreign-sourced income. These include interest, dividends, income from intellectual property (IP), and disposal gains received in Hong Kong by multinational enterprise (MNE) groups.

Foreign-Sourced Income Categories

1. Interest earned outside Hong Kong
2. Dividends from overseas investments
3. IP income, such as royalties from patents and software copyrights
4. Disposal gains, which from January 2024 include:
   • Gains from the sale of all property types (movable and immovable)
   • Both capital and revenue gains
   • Financial and non-financial assets

Key Exclusions 

The rules exclude certain types of income:

• Interest, dividends, and non-IP disposal gains from regulated financial entities’ core business
• Income from entities benefiting from Hong Kong’s unified fund exemption
• Income from entities under preferential tax regimes
• Income from tax-exempt shipping companies
• Non-IP disposal gains (including equity interests) derived from a trader’s ordinary business activities

Receipt in Hong Kong 

Income falls under FSIE rules when:

• Money transfers into Hong Kong
• Funds pay debts related to Hong Kong business operations
• Proceeds buy movable property brought into Hong Kong

For businesses receiving foreign income, tracking these receipt criteria proves essential for tax planning. The rules apply regardless of the income amount or the size of the business receiving it.

Who Must Comply With FSIE

The FSIE regime applies to members of multinational enterprise (MNE) groups and creates new tax obligations for specific business structures operating through Hong Kong.

Defining MNE Groups 

An MNE group exists when:

• Assets, liabilities, income, expenses and cash flows must be included in the ultimate parent’s consolidated financial statements
• At least one entity or permanent establishment operates outside the parent entity’s jurisdiction
• Entities link through ownership or control

Entity Types 

The rules apply to:

• Legal persons (except natural persons)
• Arrangements that prepare separate financial accounts
• Partnerships and trusts that meet MNE criteria

Special Cases and Exemptions 

Several types of entities receive special treatment:

• Investment entities exempt from consolidated financial statements
• Small and medium-sized entities (SMEs) exempt from preparing consolidated statements
• Charitable institutions under section 88 of the IRO
• Entities with tax exemption under section 26A(1A)

Tax Exemption and Relief Options

The FSIE regime provides four paths for businesses to obtain tax exemption or relief: economic substance requirements, participation requirements, nexus requirements, and intra-group transfer relief.

1. Economic Substance Requirement 

For pure equity-holding entities:

• Must maintain adequate human resources and premises in Hong Kong
• Required to manage and hold equity stakes in other entities
• Must meet all registration and filing obligations

For non-pure equity-holding entities:

• Need qualified employees in sufficient numbers
• Must incur adequate operating costs in Hong Kong
• Must make strategic decisions about assets
• Required to manage and bear principal risks

2. Participation Requirement 

To qualify, entities must:

• Hold at least 5% of equity interests in the investee entity
• Maintain this holding for 12 months before income accrual
• Be subject to a minimum 15% tax rate in foreign jurisdictions
• Meet anti-abuse rules

3. Nexus Requirement for IP Income 

This applies to:

• Patents granted under Hong Kong law
• Patent applications
• Copyright in software
• Similar IP rights in other jurisdictions

4. Intra-group Transfer Relief 

Available when:

• Both selling and acquiring entities pay Hong Kong profits tax
• Entities maintain 75% ownership association
• Transfer occurs between associated entities
• Relief can be withdrawn if conditions change within two years

FSIE Compliance and Implementation

The FSIE regime creates specific reporting and record-keeping duties for MNE entities.

Tax Return and Filing Requirements 

MNE entities must:

• Report foreign-sourced income in profits tax returns for the year income accrues
• Report chargeable amounts in tax returns for the year income is received in Hong Kong
• File written notice within 4 months after year-end if income is received but no tax return issued

Record Keeping 

MNE entities must retain records of:

• Transactions related to foreign-sourced income
• Acts or operations affecting foreign-sourced income Records must be kept for:
• 7 years after transactions complete, or
• 7 years after income receipt in Hong Kong (whichever is later)

Advance Tax Rulings 

MNE entities can:

• Apply for advance rulings on economic substance requirements
• Obtain tax certainty on compliance status
• Receive rulings valid for up to 5 years
• Reduce compliance burden through early clarity

These compliance measures help businesses maintain proper documentation and obtain tax clarity.

Practical Considerations for Businesses

Adhering to Hong Kong’s FSIE regime requires focused effort on compliance. Businesses need to plan effectively, adapt operations, and maintain thorough records. Partnering with a trusted tax advisor like InCorp ensures these steps are not only manageable but also more efficient, saving time and resources.

Tax Planning Methods

Businesses must take several actions to align with FSIE requirements, including:

• Income Receipt Tracking: Carefully monitor when foreign income is received in Hong Kong to clarify tax obligations.
• Asset Holding Reviews: Ensure asset holding periods meet the necessary conditions for participation exemptions.
• Substance Documentation: Maintain detailed records of employees, operations, and expenses based in Hong Kong to demonstrate economic substance.
• Group Structure Analysis: Evaluate whether current ownership and operational structures align with FSIE requirements.
• Tracking Systems: Develop reliable systems to monitor disposal gains and historical acquisition details.

InCorp’s Support: InCorp provides clear strategies, tailored solutions, and advanced tools to simplify these tasks and minimise the risk of oversight.

Business Structure Impact

The FSIE rules directly influence how businesses should arrange and operate their structures. Key considerations include:

• Equity Holding Entities: Different standards for substance requirements may apply based on entity type.
• Ownership Frameworks: Participation exemptions depend on ownership arrangements and business activities.
• Asset Location Decisions: Income from asset disposals may be impacted by where assets are held.
• Operational Adjustments: Changes in operations or business models may be required to meet compliance benchmarks.

InCorp’s Expertise: InCorp evaluates structures and offers practical recommendations to ensure they meet the necessary standards while maintaining operational goals.

Strategic Options

Implementing effective measures can reduce potential risks and help businesses remain compliant. These include:

• Claiming Foreign Tax Credits: Minimise exposure to additional taxes by claiming credits for taxes paid abroad.
• Securing Advance Rulings: Obtain upfront clarity about compliance requirements to simplify ongoing operations.
• Reassessing Trader Status: Analyse how classifications may affect tax treatment for income from disposals.
• Planning Group Transfers: Structure asset transfers within the group to satisfy FSIE criteria.
• Optimising Equity Holdings: Arrange shareholding structures to comply with participation exemption rules.

InCorp’s Role: With a deep understanding of Hong Kong’s tax environment, InCorp offers solutions tailored to specific business needs, helping clients make informed decisions.

Action Steps

Achieving compliance requires taking deliberate and consistent steps:

• Implement monitoring systems to track relevant income and transactions.
• Maintain comprehensive records for all foreign-sourced income.
• Regularly review tax positions to address any gaps or inconsistencies.
• Build detailed evidence of economic activities and substance in Hong Kong.
• Plan shareholding arrangements and asset timelines to meet criteria.

How InCorp Makes it Easier: InCorp’s guidance simplifies the process, from monitoring systems to strategic planning, ensuring compliance is handled smoothly and effectively.

By working with InCorp, businesses can manage FSIE requirements with greater clarity and confidence, ensuring all obligations are met while focusing on long-term goals.

Where to Next With InCorp

Complying with Hong Kong’s FSIE regime can be complex, but it doesn’t have to disrupt your business. With the right approach, businesses can align their operations and safeguard their tax positions.

Partnering with InCorp ensures you receive expert guidance tailored to your unique needs, saving time and reducing risks. Contact InCorp today to simplify your FSIE compliance journey and unlock the benefits of a trusted advisor by your side.