Update: the tax position on a cross-border dividend or interest flow

The single question that keeps returning to our desk – from treasury teams, group CFOs and in-house counsel across the corridor – is deceptively simple: is this dividend or interest payment taxable in Hong Kong, and on which side of the border does the liability crystallise? The answer turns entirely on source and substance, not on the headline rate. And two developments in the current cycle have made the analysis more urgent.

Hong Kong taxes profits on a territorial basis under the Inland Revenue Ordinance: income is assessable only where it arises in or is derived from Hong Kong. For a cross-border dividend or interest flow, the operative question is therefore whether the income has a Hong Kong source – a question the Inland Revenue Department resolves by examining the acts that produced the profit, not the residency of the payer or payee. Since the foreign-sourced income exemption (FSIE) regime took effect from 1 January 2023, a further layer applies: passive income that was previously outside the charge may now be brought within it unless the recipient entity satisfies economic-substance conditions or an applicable participation exemption.

This briefing sets out what has changed, who it affects across the Hong Kong–Mainland and Hong Kong–offshore corridors, and the immediate step required.

What has changed – and what is now triggering exposure

Two pressure points are converging. First, the FSIE regime – amended since its initial commencement and now embedded in the Inland Revenue Ordinance – requires any Hong Kong-resident entity receiving specified foreign-sourced passive income (including dividends and interest) to demonstrate genuine economic substance in Hong Kong, or to meet the conditions of the participation exemption, before the income can escape assessment. Entities that initially assumed their dividend flows were simply outside the territorial charge have discovered that the FSIE regime reaches them wherever the paying entity is incorporated.

Second, the Pillar Two minimum top-up tax and income-inclusion rule, effective for fiscal years beginning on or after 1 January 2025, apply to in-scope multinational enterprise groups with consolidated revenue at or above EUR 750 million. For those groups, the interaction between the territorial system, the FSIE conditions and the global minimum tax is a live computational question, not a planning option.

The window-closing element is this: where a group has restructured – or is in the process of restructuring – the holding layer between the Mainland operating entity and the offshore or Hong Kong holding company, the tax characterisation of the dividend or interest flow at each node needs to be resolved before the restructuring is completed. Retrofitting substance or revisiting the source analysis after the payment has been made is materially more difficult.

Who is affected across the corridor

The primary corridor is Mainland China to Hong Kong to the offshore centre – typically a BVI or Cayman holding entity above a Hong Kong intermediate holding company, with the operating profit generated at the Mainland level. Three groups face immediate exposure.

First, Hong Kong intermediate holding companies receiving dividends or interest from Mainland subsidiaries. The source analysis for interest income historically depended on where the loan was negotiated and executed, and where the funds were deployed. That analysis remains live. Where a holding company has thin substance – a common registered-address arrangement – the FSIE conditions will not be satisfied without a substance review.

Second, offshore holding entities that have re-routed income through a Hong Kong company for administrative convenience but have not assessed whether that routing creates a Hong Kong taxable presence. In our cross-border practice, we regularly see structures where the intermediate entity was inserted without a contemporaneous tax analysis of the income flows.

Third, groups approaching a distribution event – a recapitalisation, an exit, or a pre-listing reorganisation – where the accumulated retained earnings at the Hong Kong or offshore level include passive income that was not reviewed under the FSIE conditions when it arose. The distribution does not cure an earlier mischaracterisation.

The immediate action

The first step is a source-and-substance review of each dividend or interest flow within the structure, conducted against the Inland Revenue Ordinance and the FSIE regime conditions as currently in force. That review should produce a written position before the next payment, the next restructuring step, or the next fiscal year-end, whichever comes first.

For in-scope Pillar Two groups, the review must also address how the Hong Kong tax position interacts with the income-inclusion rule applied at the ultimate parent level. A position that produces a nil or low effective rate in Hong Kong without satisfying the FSIE substance conditions may trigger a top-up charge in another jurisdiction.

Where the structure involves a BVI or Cayman holding entity, the pre-distribution tax review for BVI structures is a necessary companion step. The substance and source questions at the Hong Kong layer cannot be resolved in isolation from the offshore layer above it.

For a structured assessment of your cross-border dividend or interest flows and the current FSIE and Pillar Two position, write to us at info@lockhartyip.com.

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Related

• Tax Positions
• Tax Review Before Bvi Exit Or Distribution Bvi 8
• Profits Tax Position Hong Kong Trading Entity Guide 2

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