The HKSAR Government will be introducing a Foreign-Sourced Income Exemption (FSIE) regime, with a target enforcement date of 1 January 2023. The new FSIE regime will have a significant impact on the source concept of Hong Kong's taxation system. Hong Kong has long been famous for its territorial-based principle of taxation, in which non–Hong Kong sourced income is not subject to Hong Kong Profits Tax. However, as this could give rise to double non-taxation on a project, such a tax treatment principle is deemed to be harmful to international tax standards and has recently aroused great concern from the European Union (EU). To address the EU concerns, the HKSAR Government has issued a consultation paper to introduce the FSIE regime, which imposes additional rules on the offshore claims of the following four types of income:

• Interest income
• Dividend income
• Disposal gains (equity interest)
• Intellectual property (IP) income

Active income, such as trading profits and service income, are not covered under the FSIE regime. Base rules under the proposed FSIE regime The refined FSIE regime only targets the Hong Kong constituent entities of multinational enterprise (MNE) groups. It also specifically targets passive income that is received in Hong Kong. By following the approach adopted in Singapore, an income is regarded as received in Hong Kong if:

• It is remitted to Hong Kong (e.g., remitted to a Hong Kong bank account);
• It is used to settle debt incurred in respect of a business carried on in Hong Kong; or
• It is used to buy movable property, which is subsequently brought into Hong Kong.

Protection from double-taxation under the FSIE regime Under normal circumstances, a tax credit is generally available in Hong Kong in the case of double-taxation issues for Hong Kong's Comprehensive Double Taxation Agreement (DTA) partners. In other words, no tax credit is available to non-DTA partners. However, if a non–Hong Kong sourced passive income becomes subject to Hong Kong Profits Tax under the FSIE regime, a tax credit will be available in Hong Kong if the concerned income is also subject to tax of a similar nature in other tax jurisdictions, no matter whether the counterparty is a DTA partner or not. The rationale is that the FSIE regime is being enacted solely in response to pressures from the EU, rather than to raise tax revenues in Hong Kong. As a result, taxpayers who have already paid foreign tax on their passive income should be more relaxed under the proposed FSIE regime. Recap of Hong Kong's source rule on passive income The basic principle of determining the source of the four types of concerned passive income under Hong Kong Profits Tax is shown below.

Affected income	Source rule
Interest income	Provision of credit test/operation test
Dividend income	Tax residency of the investment (100% non-taxable under all scenarios)
Disposal gains (equity interest)	Listed shares: location of stock exchange Unlisted shares: place where the sales contracts are effected
IP royalty income	Contract effected test Intellectual property DEMPE functions location

Interest income: For simple loan arrangements, provision of the credit test applies where the source depends on the location in which the loan funds were first made available to the borrower. For moneylenders, corporate treasury centres and more complicated situations, the operation test applies. It is worthwhile noting that the Hong Kong Inland Revenue Department increasingly uses the operation test to determine the source of interest income. Dividend income: As Hong Kong–sourced income is also exempt from Hong Kong Profits Tax, dividend income was 100% non-taxable in Hong Kong before the introduction of the FSIE regime. Disposal gains: Long-term investmentcapital gains are non-taxable in Hong Kong, which is the cornerstone of Hong Kong's taxation system. What is uncertain at the moment is whether the FSIE regime will override the capital gains claim benefits of the Hong Kong tax system. IP income: The contract effected test and the place of usage of the IP are the two traditional criteria for determining the source of royalty fees....

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