Update: substance requirements for a tax position to hold

Substance requirements for cross-border tax positions are tightening across every corridor that runs through Hong Kong. Under Hong Kong's territorial system, whether income is treated as sourced outside the jurisdiction – and therefore outside the charge to profits tax – depends on where the income-generating activities actually take place. Since the foreign-sourced income exemption (FSIE) regime took effect on 1 January 2023, that question now carries a second layer: even income that is genuinely offshore can lose exempt status unless the recipient entity meets defined economic-substance conditions. The pressure on substance is not easing.

This briefing sets out what the current position requires, who it affects across the Greater China corridor, and the immediate steps that principals and their in-house teams should take now.

What changed and why it matters now

Hong Kong's territorial basis of taxation has always focused on source. Profits arising offshore were, in principle, outside the charge. That position has not changed in structure. What changed is the standard of proof required to maintain it.

The FSIE regime (foreign-sourced income exemption regime, the set of rules governing when offshore passive income remains exempt from Hong Kong profits tax) introduced a substance gate. Dividends, interest, royalties, and gains on disposal of equity interests received in Hong Kong from an offshore source are now subject to a charge unless the recipient entity demonstrates adequate economic substance in Hong Kong – or meets an alternative condition such as the participation exemption or the related-company interest test. The governing instrument is the Inland Revenue Ordinance, as amended to give effect to the FSIE regime.

Alongside the FSIE changes, the Hong Kong minimum top-up tax – introduced as part of the Pillar Two global minimum tax framework – applies to in-scope multinational enterprise groups for fiscal years beginning on or after 1 January 2025. In-scope groups are those with consolidated annual revenue of at least EUR 750 million. For those groups, substance now also feeds into the qualified refundable tax credit and substance-based income exclusion calculations. Even entities that previously regarded substance as a compliance formality are now running the numbers again.

The combined effect is that "offshore" is no longer a status that a structure inherits at formation. It is a position that each relevant entity must earn and maintain, and that a tax authority in any of the relevant jurisdictions may challenge on the facts.

Who is affected across the corridor

The trigger is widest for holding and intermediate structures sitting between a Mainland China operating group and its offshore parents or investors. A BVI or Cayman holding vehicle is a common feature in that corridor. If that vehicle is managed or controlled from Hong Kong – or receives income in Hong Kong – the substance question bites.

Several categories of principal should review their position now.

• Hong Kong intermediate holding companies receiving dividends or disposal proceeds from Mainland or regional operations, where the income is claimed as offshore and outside profits tax.
• In-scope MNE groups using Hong Kong treasury or IP-holding entities, where the Pillar Two substance-based income exclusion is a live variable in the group's effective-tax-rate calculation.
• Regional headquarters that have relocated to Hong Kong and now consolidate income streams across the Greater Bay Area and the wider Asia-Pacific region.
• Family-office holding structures with mixed Hong Kong and offshore assets, where the treatment of inter-entity payments is based on a source analysis that has not been revisited since the FSIE amendments.

In each case, the risk is the same: a tax position that appeared sound under the pre-FSIE or pre-Pillar Two position may no longer hold on current facts. The Inland Revenue Department has the tools to look through structures that lack genuine activity, and cross-border audit coordination between Mainland and Hong Kong authorities continues to develop. A position that was defensible two years ago should not be assumed defensible today without a current-year review. Parties should verify the current administrative guidance before acting.

For cross-border matters, we regularly advise groups where the substance question in Hong Kong connects to a parallel analysis in the Mainland, Singapore, or the UAE – jurisdictions that each impose their own substance or beneficial-ownership conditions for treaty access or domestic-exemption claims. A holding structure that satisfies the Hong Kong FSIE conditions may still fail the Mainland's beneficial owner test (the requirement that the treaty claimant have genuine economic ownership and not be a mere conduit) if the entity lacks adequate decision-making presence.

The sequence in which the positions are built and documented across the corridor is where the outcome is decided.

The sequence above describes the standard position. Your matter turns on the specific entities involved, the income types in scope, and the documentation actually held – which is where the position is won or lost. If you are unsure whether your current structure satisfies the FSIE conditions or the Pillar Two substance-based exclusion, the time to assess that is before a filing or a challenge, not after.

To discuss how the FSIE regime and substance requirements apply to your cross-border holding structure, contact info@lockhartyip.com.

What to do immediately

Three steps are relevant for most affected principals.

First, audit the income flows and entities in scope. Map each entity in the group that receives passive income in or through Hong Kong and identify whether it has historically relied on an offshore source claim or an exemption under the FSIE regime. For in-scope MNE groups, identify which entities contribute to the substance-based income exclusion calculation.

Second, review the substance file for each relevant entity. Substance under the FSIE regime requires genuine economic activity: qualified employees carrying out core income-generating activities in Hong Kong, adequate operating expenditure incurred locally, and management and control exercised in Hong Kong. A registered address and a nominee director are not sufficient. The file should document the activity, not simply assert it.

Third, consider the cross-border documentation chain. Where the tax position in Hong Kong interacts with a treaty claim or a domestic exemption in another jurisdiction – most commonly the Mainland, Singapore, or a jurisdiction in the Gulf – the documentation should be consistent across both ends of the transaction. Inconsistencies between what is filed in Hong Kong and what is filed or asserted elsewhere are an audit trigger in both directions.

Our desk works with groups on the substance review, the documentation file, and the cross-border position across the corridor. For more on how we approach tax-position work, see our Tax Positions practice. Groups with structures involving collective investment vehicles may also find our tax review guide for CIS exit and distribution relevant. For the withholding-tax dimension of cross-border structure, see our briefing on withholding tax planning across Greater China.

If an existing structure was built on a substance analysis that has not been updated since the FSIE amendments or the commencement of Pillar Two obligations, a second read now can identify the gap before a filing or an enquiry opens it. To map the substance and FSIE position across your group's relevant entities, write to us at info@lockhartyip.com.

Speak with Lockhart & Yip

For a scoped view of your matter, contact info@lockhartyip.com. Discuss your matter →

Related

• Tax Positions
• Tax Review Before Cis Exit Or Distribution Cis 5
• Withholding Tax Planning Across Greater China Structure Briefing

This publication is general information and does not constitute legal advice. For advice on your situation, contact info@lockhartyip.com.