Hong Kong to introduce new substance requirements following EU ‘grey listing’

The Hong Kong government committed, on 6 October, to amend the Inland Revenue Ordinance to prevent companies with no significant economic activity in Hong Kong from being able to avoid paying tax on passive income by diverting it through Hong Kong.

The move followed Hong Kong’s inclusion on the European Union’s ‘grey list’ of non-cooperative jurisdictions for tax purposes following a review of the foreign-source income exemption regimes. The EU concluded that certain aspects of Hong Kong SAR’s territorial tax system could facilitate tax avoidance or other tax practices that it regards as ‘harmful’.

In particular, the EU considered that corporations without substantial economic activity in Hong Kong SAR and that were not subject to Hong Kong SAR tax in respect of certain foreign sourced passive income – such as interest and royalties – could lead to situations of ‘double non-taxation’.

In a statement, the Hong Kong government said: “Hong Kong will continue to adopt the territorial source principle of taxation. The government will endeavour to uphold our simple, certain, and low-tax regime with a view to maintaining the competitiveness of Hong Kong’s business environment.

“The proposed legislative amendments will merely target corporations, particularly those with no substantial economic activity in Hong Kong, that make use of passive income to evade tax across a border. Individual taxpayers will not be affected. As to financial institutions, their offshore interest income is already subject to profits tax under the Inland Revenue Ordinance at present, and hence the legislative amendments will not increase their tax burden.

“We will consult the stakeholders on the specific contents of the legislative amendments and strive to minimise the compliance burden of corporates,” it said.

The EU published the guidance on the foreign-sourced income exemption regime in October 2019 and began assessing the tax arrangements of a number of jurisdictions, including Hong Kong. The focus of the assessment was to address situations where offshore shell companies obtain tax benefits through ‘double non-taxation’.

The Hong Kong government said it had been in contact with the EU on its assessment and had been actively engaging with the EU on the follow-up work. To support the combating of cross-border tax evasion, the government had agreed to co-operate with and had committed to the EU to amend the Inland Revenue by the end of 2022 and implement relevant measures in 2023.

The EU will further monitor the situation and consider moving Hong Kong SAR to a blacklist if the identified harmful aspect of its tax system does not change. Punitive measures against blacklisted jurisdictions include denial of deduction of payments made, increased withholding taxes, application of controlled foreign company rules, taxation of dividends and administrative measures.

“Hong Kong enterprises will not be subject to defensive tax measures imposed by the EU as a result of being included in the watchlist on tax co-operation,” said a spokesman. “The HKSAR government will request the EU to swiftly remove Hong Kong from the watchlist after amending the relevant tax arrangements.”