Balancing certainty and ambiguity – The revamped tax treatment of disposal gains in Hong Kong

As the new year unfolds, Hong Kong implements two tax rules as of 1 January 2024.

The first amendment extends the foreign-sourced income exemption regime ('FSIE Regime') that came into operation on 1 January 2023, by imposing profits tax on all types of non-Hong Kong sourced disposal gains (not limited to gains from equity interest), whilst the second amendment provides for a safe harbour or tax certainty ('Tax Certainty Scheme') such that Hong Kong-sourced disposal gains derived by taxpayers on sale of certain equity interests would be treated as capital in nature and exempt from profits tax.^[1]

A brief recap on the concept of source of profits and taxation of disposal gains in Hong Kong

Hong Kong generally adopts a territorial principle of taxation, i.e. profits tax is only chargeable on Hong Kong-sourced profits derived by a person carrying on a trade, profession or business in Hong Kong. With respect to gains on disposal (i.e. buying and selling of assets), whether the gains are treated as Hong Kong-sourced would depend on matters such as the nature of the asset; where the asset is located and/or where the activities of purchase and sale generating the gains are 'effected'.^[2]

Even if the disposal gains are Hong Kong sourced, they will only become chargeable to profits tax if the relevant asset is disposed of in the course of a trade by the taxpayer (chargeable), but not if the asset was held by the taxpayer as a long-term capital investment (i.e. exempt from profits tax).  However making the 'trading/capital' distinction calls for examination of facts with reference to various 'badges of trade'^[3], which creates uncertainty and burden for taxpayers wishing to satisfy the Inland Revenue Department (IRD) that the asset disposed of was held as capital investment.

The FSIE regime and the 2023 refinements

The FSIE Regime was introduced in 2022 and took effect on 1 Jan 2023, pursuant to which certain taxpayers who are carrying on trade or business in Hong Kong would be subject to additional profits tax liability if they derive certain types of non-Hong Kong sourced profits, including disposal gains of equity interest, provided that such incomes are (i) received in Hong Kong; and the taxpayer is (ii) an 'MNE' entity; unless the taxpayer fulfils the 'substance' or certain 'participation'  exceptions under the regime (please refer to our previous client alerts (part 1 and part 2) on the FSIE Regime). Unlike the tax treatment for Hong Kong-sourced disposal gains (see paragraph above), the FSIE Regime does not distinguish between disposal gains derived from trading or capital assets such that non-Hong Kong sourced gains of equity interest which satisfy the chargeability criteria would be subject to profits tax.
 
We also refer to our client alert part 3 for the changes proposed to the FSIE Regime subsequent to its introduction, which were substantively adopted in the 2023 refinements. The main changes are highlighted below: 

Chargeability under the 2023 refinements

The 'disposal gain' is now expanded from gains arising from disposal of 'equity interest' only to gains from disposal of all types of properties, including immovable and movable properties (which include IP and non-IP properties). ^[4] Gains of both trading and capital nature remain chargeable under the refined FSIE Regime.

Exclusions from the FSIE Regime 

Existing exclusions available to taxpayers benefited from preferential tax regime or engaged in regulated financial entity remain unchanged. In addition, the 2023 refinements provide for a new exclusion for a taxpayer engaged in the business of buying and selling of property that derives 'non-IP disposal gains' in the ordinary course of its business (the 'trader' exception) such that its non-Hong Kong sourced gains from disposal of properties other than IP assets would not be subject to the refined FSIE Regime. 

 Exemptions and reliefs

There is now a new intra-group transfer relief, enabling the deferral of tax charged on disposal gains until the asset is resold to third parties outside the group. The existing economic substance exception will continue to apply to non-IP disposal gains, whereas the existing participation exemption will remain applicable to equity interest disposal gains. IP-disposal gains that satisfy the nexus requirement will continue to be exempt from profits tax under the refined FSIE Regime. 

Tax Certainty Scheme

 Application of the Tax Certainty Scheme

 The Tax Certainty Scheme is an optional opt-in scheme that seeks to provide some certainty to the taxpayers without having to enter into the 'badges of trade' analysis. Under this new scheme, Hong Kong-sourced gains derived by a taxpayer that is a corporation from disposal of certain equity interests will be regarded as arising from the sale of capital assets and exempt from profits tax if certain equity holding conditions are met.^[5] The equity holding conditions are two-folds: the taxpayer (alone or together with its closely related entities) must have held at least 15% of the equity interests (i.e. entitlement to at least 15% of the profits, capital or reserves) in the investee entity, and the holding period must be a continuous period of at least 24 months immediately before the date of disposal. The Tax Certainty Scheme builds in some flexibility in the equity holding conditions where the disposal is structured in tranches. ^[6]

Exclusions from the Tax Certainty Scheme

To prevent abuse by businesses attempting to claim their trading gains as non-taxable, the Tax Certainty Scheme has excluded certain gains that are not typically considered as capital in nature and are prone to abuse. Any equity interests disposed of by insurers are excluded, as well as disposal of equity interests that are regarded as 'trading stock' for tax purpose (based on whether the profits, gains or losses (whether unrealised or actual) in respect of such equity interests has been 'brought into account for tax' assessment purpose with respect to the taxpayer disposing of such interests). ^[7]
 
Furthermore, the Tax Certainty Scheme contains important exceptions to gains arising from the disposal of unlisted equity interests in certain 'investee entities' which are engaged in 'property trading', 'property development' and 'property holding'. An investee entity will be regarded as an 'excluded [investee] entity'^[8] if it: 

1. carries on a business of acquisition and sale of immovable properties located in Hong Kong or elsewhere (i.e. property trading); 
2. undertakes the construction and sale of buildings (i.e. property development), unless it (i) has not undertaken property development for at least a continuous period of 60 months; (ii) holds immovable properties for its trade or business (including for its letting business) and (iii) holds immovable properties other than for sale, prior to the disposal of its equity interests by the taxpayer; or 
3. does not carry on 'property trading' nor 'property development', but still holds any immovable properties directly or indirectly (rather than for the purpose of its trade or business including a letting business) and the value of such properties exceeds 50% of its total assets in the basis period when its equity interests is disposed of by the taxpayer (i.e. property holding).

Our reading is therefore if the investee entity has not constructed but has only acquired immovable properties and holds such immovable properties for the purpose of its business (as its office premises for example) or the business of letting, it is not an excluded entity and the disposal of its equity interests by the investor taxpayer may still qualify for the Tax Certainty Scheme. 

 Disposal Gains not within the Tax Certainty Scheme 

 If the criteria from the Tax Certainty Scheme could not be met, chargeability for Hong Kong-sourced  disposal gains (as trading vs capital assets) will continue to be determined based on the 'badges of trade' analysis.
 
It should be noted that any non-Hong Kong sourced gains subject to the FSIE Regime (i.e. gains on disposal of any types of immovable or movable properties (including any equity interests) which are non-Hong Kong sourced) should not qualify for the Tax Certainty Scheme treatment^[9] and the chargeability to profits tax of such gains continue to follow the refined FSIE Regime described above. 

Separately under the family office tax concession regime (see our alert here), any gains from disposal of shares in a family special purpose entity (FSPE) by a qualified family investment holding vehicles (FIHV) is also exempt from profits tax provided conditions specified in that regime are met. The FSPE may hold immovable properties (mainly non-Hong Kong properties) and the conditions applicable to an “excluded entity” in the Tax Certainty Scheme do not apply. 

Move towards Hong Kong sourced gains going forward? 

Overall, these two new tax rules represent advancement toward two ends of a spectrum in the tax treatment of disposal gains, depending on whether the gains are sourced in Hong Kong (exempt from profits tax if capital in nature and may benefit from the Tax Certainty Scheme) or are sourced outside of Hong Kong (may be chargeable to profits tax under the FSIE Regime).  
 
The refined FSIE Regime imposes an increased tax compliance burden on multinational companies receiving any types of non-Hong Kong-sourced gains, whereas the Tax Certainty Scheme works the opposite by providing a safe harbour for Hong Kong-sourced gains from disposal of certain equity interests. 
 
We anticipate taxpayers may adapt to these new changes by reorganising long term equity interest holding structures and bringing the transactions of such interests onshore, such that any disposal gains of equity interests extracted therefrom may be regarded as Hong Kong-sourced and may benefit from the Tax Certainty Scheme provided the conditions could be met. 
 
Should you have any questions, please feel free to reach out to Daniel Tang or Deirdre Fu for a consultation.