How Hong Kong’s Territorial Tax System Aligns with Global Compliance Standards

Core Principles of Hong Kong’s Territorial Taxation

Hong Kong distinguishes itself with a territorial tax system, a foundational principle that contrasts with jurisdictions applying worldwide taxation. Under this framework, administered by the Inland Revenue Department (IRD), only income and profits arising in or derived from Hong Kong are subject to profits tax.

The Territorial Source Principle

The territorial source principle has been a cornerstone of Hong Kong’s tax system since the enactment of the Inland Revenue Ordinance on May 3, 1947. This principle operates on the fundamental premise that taxation is based solely on the geographic source of income, not on the residence or nationality of the taxpayer.

According to the IRD’s official guidance, three basic requirements must be met for profits to be taxable in Hong Kong:

1. The person must carry on a trade, profession, or business in Hong Kong
2. The profits must come from the trade, profession, or business carried on in Hong Kong
3. The profits must arise in or be derived from Hong Kong

The Operations Test

The IRD applies the “Operations Test” as the broad guiding principle for determining source of profits. This test examines what the taxpayer has done to earn the profits and where those operations took place. The determination is a practical matter of fact, with no universal rule applicable to every scenario. Courts and the IRD also consider the “Totality of Facts” principle, which requires looking beyond the formal appearance of business structures.

Distinguishing Features from Worldwide Tax Systems

Unlike most tax systems that apply both residential and territorial jurisdiction, Hong Kong’s system disregards the concept of residence entirely for profits tax purposes. This creates a unique advantage: profits sourced entirely outside Hong Kong may qualify for exemption, regardless of where the company is incorporated or managed.

Hong Kong’s Current Tax Rates and Structure (2025)

Two-Tier Profits Tax Rates Regime

Hong Kong maintains competitive tax rates through its two-tiered profits tax regime, which has been confirmed for the 2025 tax year:

Important Note: For groups of connected entities, only one entity may be nominated to enjoy the two-tiered rates. This measure prevents artificial splitting of businesses solely for tax benefits.

What Hong Kong Does Not Tax

• Capital gains (unless characterized as trading profits)
• Withholding tax on dividends
• Interest income (for non-financial institutions)
• Sales tax or Value Added Tax (VAT)
• Offshore-sourced profits (subject to FSIE regime requirements)

The Foreign-Sourced Income Exemption (FSIE) Regime

Evolution and Implementation Timeline

The FSIE regime represents Hong Kong’s response to international concerns about potential double non-taxation scenarios. The regime has evolved through two major phases:

Types of Covered Income

The FSIE regime applies to foreign-sourced income that is accrued to and received in Hong Kong by members of multinational enterprise (MNE) groups. The covered income types include:

• Dividends: Foreign-sourced dividend income received in Hong Kong
• Interest: Interest income from foreign sources
• IP Income: Income derived from the use, sale, or licensing of intellectual property
• Equity Disposal Gains: Gains from disposal of shares or equity interests
• Asset Disposal Gains (FSIE 2.0): Gains from disposal of all other types of property, both movable and immovable

Exemption Requirements

Specified foreign-sourced income will be exempt from profits tax if one of the following requirements is satisfied:

• Economic Substance Requirement: The MNE entity conducts adequate economic activities in Hong Kong in relation to the income
• Participation Requirement: For dividends and equity disposal gains, the entity holds sufficient participation in the investee company
• Nexus Requirement: For IP income, there is a sufficient nexus between the R&D activities and the IP income

If an MNE entity fails to meet all these requirements, the specified foreign-sourced income will be subject to profits tax in the year of receipt.

Compliance and Reporting

The FSIE regime operates as a self-reporting regime. MNE entities in Hong Kong must:

• Report specified foreign-sourced income in their profits tax returns
• Calculate the amount of chargeable specified foreign-sourced income
• Retain transaction and business records for at least seven years after the income is received or the transaction is completed, whichever is later
• Apply for advance rulings from the IRD if greater tax certainty is desired

BEPS Alignment and International Compliance

Hong Kong’s Commitment to BEPS 2.0

In July 2021, Hong Kong joined more than 130 jurisdictions in accepting the OECD’s Base Erosion and Profit Shifting (BEPS) 2.0 international tax reform framework. This commitment demonstrates Hong Kong’s dedication to maintaining its status as a responsible international financial center while combating cross-border tax evasion.

Implementation of Global Minimum Tax (Pillar Two)

On June 6, 2025, Hong Kong enacted the Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance 2025, implementing the OECD Pillar Two GloBE (Global Anti-Base Erosion) rules. The legislation was approved by the Legislative Council on May 28, 2025.

Key Components of Hong Kong’s Global Minimum Tax Framework

Scope and Thresholds

The global minimum tax applies only to large multinational enterprise groups meeting the following criteria:

• Consolidated annual revenue of EUR 750 million or more
• Revenue threshold must be met in at least two of the previous four fiscal years
• Excluded entities: government entities, international organizations, non-profit organizations, pension funds, and certain investment/real estate funds

Importantly, smaller MNE groups and purely domestic groups are excluded from the global minimum tax requirements and continue to benefit from Hong Kong’s traditional low tax rates.

Filing and Compliance Requirements

For reporting fiscal years starting on or after January 1, 2025:

• Annual Notification: Must be filed electronically within six months after the end of the fiscal year
• Top-up Tax Return: Must be filed electronically no later than 15 months after the last day of the reporting fiscal year (extended to 18 months in the transition year)
• Safe Harbour Provisions: Hong Kong has implemented various safe harbours to reduce compliance burden, including:
  • Transitional Country-by-Country Reporting Safe Harbour
  • Transitional UTPR Safe Harbour
  • QDMTT Safe Harbour
  • Simplified Calculations Safe Harbour for non-material constituent entities

EU Tax Compliance and Watchlist Removal

Background and EU Concerns

On October 5, 2021, the European Union added Hong Kong to its watchlist (grey list) of non-cooperative tax jurisdictions. The EU’s primary concern centered on the potential for “double non-taxation” of passive income—situations where companies could avoid paying taxes on offshore passive income both in the jurisdiction where it was generated and in Hong Kong.

Hong Kong’s Response and Legislative Actions

To address the EU’s concerns, Hong Kong took decisive action:

1. December 2022: Enacted the Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022, implementing FSIE 1.0
2. January 1, 2023: FSIE 1.0 took effect, covering four types of passive income
3. December 2023: Updated EU guidance required expansion to cover all types of passive income and disposal gains
4. December 8, 2023: Enacted the Inland Revenue (Amendment) (Taxation on Foreign-sourced Disposal Gains) Ordinance 2023
5. January 1, 2024: FSIE 2.0 took effect, expanding coverage to disposal gains on all types of assets

Successful Removal from EU Watchlist

On February 20, 2024, the European Union formally removed Hong Kong from its tax watchlist, recognizing Hong Kong’s fulfillment of its commitments to strengthening tax good governance standards. Hong Kong was moved to the EU’s “white list” of compliant jurisdictions.

This removal, alongside five other jurisdictions (Albania, Aruba, Botswana, Dominica, and Israel), signified international recognition of Hong Kong’s enhanced tax framework and its commitment to preventing harmful tax practices.

Impact on Hong Kong’s International Standing

The removal from the EU watchlist has several significant implications:

• Consolidates Hong Kong’s status as a responsible international financial center
• Enhances investor confidence in Hong Kong’s regulatory framework
• Demonstrates successful alignment with international tax standards
• Maintains Hong Kong’s attractiveness as a sustainable market for investment
• Validates the effectiveness of the FSIE regime in addressing international concerns

Balancing Competitiveness with Global Standards

Hong Kong’s Strategic Positioning

Hong Kong has successfully navigated the challenging balance between maintaining its competitive tax advantages and meeting evolving international compliance standards. The jurisdiction’s approach demonstrates that territorial tax systems can coexist with global transparency and anti-avoidance initiatives.

Advantages Retained Despite Enhanced Compliance

Impact on Different Business Categories

Small and Medium Enterprises (SMEs):

• Minimal impact from FSIE and global minimum tax
• Continue to benefit from two-tier tax rates
• Traditional territorial source principle applies

Domestic Groups:

• Not subject to FSIE regime (applies only to MNE groups)
• Global minimum tax does not apply
• Retain full advantages of Hong Kong’s low-tax environment

Large Multinational Enterprises (Revenue ≥ EUR 750M):

• Subject to FSIE regime for specified foreign-sourced income
• Must comply with global minimum tax (15% effective rate)
• Enhanced compliance and reporting requirements
• Need to maintain adequate economic substance for exemptions
• May benefit from safe harbour provisions and advance rulings

Future Outlook and Anticipated Developments

Ongoing IRD Guidance Updates

The IRD continues to refine its guidance on both the FSIE regime and the global minimum tax implementation. As recently as July 24, 2025, the IRD posted four new FAQs on the FSIE regime, demonstrating its commitment to providing clarity for taxpayers.

UTPR Implementation Timeline

While the Income Inclusion Rule and Hong Kong Minimum Top-up Tax are effective for fiscal years beginning January 1, 2025, the Undertaxed Profits Rule (UTPR) implementation has been deferred to a date to be announced. This staged approach allows businesses and the IRD to adapt to the new framework progressively.

Revenue Projections

Hong Kong’s Financial Secretary has estimated that the global minimum tax implementation will generate approximately HK$15 billion per year in tax revenue for the government, representing a significant addition to public finances while affecting only the largest multinational groups.

Continued International Cooperation

Hong Kong remains committed to:

• Maintaining alignment with OECD standards and updates to GloBE rules
• Participating in international tax transparency initiatives
• Updating its FSIE regime in response to evolving international requirements
• Providing clear, accessible guidance for taxpayers navigating new requirements

Practical Considerations for Taxpayers

For MNE Groups Operating in Hong Kong

Multinational enterprises with operations in Hong Kong should:

1. Assess Economic Substance: Review current operations to ensure adequate economic substance for foreign-sourced income exemptions
2. Review Corporate Structures: Evaluate group structures in light of FSIE requirements and global minimum tax implications
3. Enhance Record Keeping: Implement robust systems to track and document specified foreign-sourced income and related activities
4. Consider Advance Rulings: Apply for IRD advance rulings when seeking greater certainty on tax treatment
5. Prepare for Increased Compliance: Budget for enhanced reporting requirements and potential professional advisory costs
6. Monitor Safe Harbour Eligibility: Assess whether operations qualify for available safe harbour provisions to reduce compliance burden
7. Calculate Effective Tax Rates: Conduct jurisdiction-by-jurisdiction ETR calculations to determine global minimum tax exposure

For Domestic and Smaller Businesses

Businesses not within the scope of FSIE or global minimum tax should:

• Continue to leverage Hong Kong’s competitive two-tier tax rates
• Maintain proper documentation for source of profits determinations
• Stay informed about thresholds to anticipate if/when new regimes might apply
• Focus on traditional territorial source principles for tax planning

Documentation and Compliance Best Practices

All businesses should maintain:

• Clear records of where profit-generating activities occur
• Documentation supporting the source of all income streams
• Minutes of board meetings and management decisions
• Contracts and agreements demonstrating the nature of transactions
• For MNE groups: evidence of economic activities in relation to foreign-sourced income
• Retention of records for at least seven years as required

Note: This article is based on information available as of December 2025. Tax laws and regulations are subject to change. Businesses should consult with qualified tax professionals and refer to official IRD guidance for specific situations and the most current information.

Official Resources:

• Hong Kong Inland Revenue Department: www.ird.gov.hk
• IRD – Foreign-sourced Income Exemption: www.ird.gov.hk/eng/tax/bus_fsie.htm
• IRD – Global Minimum Tax: www.ird.gov.hk/eng/tax/bus_beps.htm
• IRD – Territorial Source Principle: www.ird.gov.hk/eng/paf/bus_pft_tsp.htm