Hong Kong’s territorial tax system has been a cornerstone of its economic success for nearly eight decades. As global tax transparency initiatives and international pressure mount, businesses and tax professionals are questioning whether Hong Kong’s distinctive tax framework can survive in its current form. This article examines recent policy developments and analyzes what the future holds for Hong Kong’s territorial taxation principle.

Understanding Hong Kong’s Territorial Tax System

Hong Kong adopts a territorial-source principle of taxation, meaning only profits that have a source in Hong Kong are subject to profits tax. Unlike most countries that apply both residential and territorial jurisdiction, Hong Kong taxes income solely based on its source, regardless of where the taxpayer resides or is incorporated.

Core Principles

The fundamental principle is straightforward: if income arises in or is derived from Hong Kong, it is taxable. Conversely, income sourced elsewhere—regardless of where it is received or by whom—generally falls outside Hong Kong’s tax net. This territorial approach has made Hong Kong an attractive jurisdiction for international businesses, holding companies, and regional headquarters.

Historical Context

Hong Kong has maintained this territorial system since 1947. The model has survived multiple economic cycles, political transitions, and changing international tax landscapes. However, the past five years have witnessed unprecedented international pressure for jurisdictions to modify traditional tax structures in line with global tax governance initiatives.

Recent Policy Shifts: The FSIE Regime

The most significant modification to Hong Kong’s territorial tax system came with the implementation of the Foreign-Sourced Income Exemption (FSIE) regime, representing Hong Kong’s response to international tax transparency requirements.

FSIE 1.0: Initial Implementation (2023)

The Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income) Ordinance 2022 was enacted on 23 December 2022, establishing the FSIE regime with effect from 1 January 2023. This legislation targeted four specific types of foreign-sourced passive income received in Hong Kong by members of multinational enterprise (MNE) groups:

• Dividends
• Interest
• Intellectual property (IP) income
• Equity interest disposal gains

Under the FSIE regime, these types of foreign-sourced income are deemed to be sourced from Hong Kong and thus become chargeable to profits tax. However, exemptions apply if taxpayers satisfy certain requirements.

Exemption Requirements

Specified foreign-sourced income can be exempted from profits tax if one of the following requirements is met:

FSIE 2.0: Expansion (2024)

Following updated guidance from the European Union, Hong Kong expanded the FSIE regime through the Inland Revenue (Amendment) (Taxation on Foreign-sourced Disposal Gains) Ordinance 2023, enacted on 8 December 2023 and effective from 1 January 2024.

The key enhancement was expanding the scope of covered disposal gains to include foreign-sourced gains from the disposal of all types of assets—both movable and immovable property, whether capital or revenue in nature, and whether financial or non-financial assets. The expanded regime also introduced intra-group transfer relief to defer tax charges when property is transferred between associated entities, subject to anti-abuse provisions.

After these amendments, the European Union moved Hong Kong from its tax haven watchlist to the “white” list on 20 February 2024, acknowledging compliance with international tax transparency standards.

2025 Clarifications

On 24 July 2025, the Inland Revenue Department released additional guidance through expanded Frequently Asked Questions (FAQs), providing important clarifications:

• Redemption of bonds: Bond redemptions constitute repayment of principal, not a disposal, and therefore are not regarded as disposal gains under the FSIE regime
• Associate dividends: Adjustments under the equity method of accounting are not considered dividends, as they merely reflect changes in investment value rather than actual profit distributions
• In-kind dividends: Foreign-sourced dividends received as shares in an overseas entity are not regarded as “received in Hong Kong” under the FSIE regime

BEPS 2.0 Pillar Two: The Global Minimum Tax

The most substantial recent development affecting Hong Kong’s tax landscape is the implementation of the OECD’s Base Erosion and Profit Shifting (BEPS) 2.0 Pillar Two framework.

Legislative Enactment

On 6 June 2025, Hong Kong gazetted the Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance 2025, implementing the global anti-base erosion (GloBE) rules. The legislation includes:

• Hong Kong Minimum Top-up Tax (HKMTT): Effective from fiscal years beginning on or after 1 January 2025
• Income Inclusion Rule (IIR): Effective from fiscal years beginning on or after 1 January 2025
• Undertaxed Profits Rule (UTPR): To be implemented at a later stage

Scope and Application

The Pillar Two rules apply to multinational enterprise groups with consolidated revenues of EUR 750 million or more in at least two of the four fiscal years preceding the relevant fiscal year. The framework establishes a 15% global minimum effective tax rate.

New Residency Definition

With retrospective effect from 1 January 2024, Hong Kong introduced a new definition of “Hong Kong-resident entity” for Pillar Two purposes. An entity is considered Hong Kong-resident if it is:

• Incorporated or constituted in Hong Kong, or
• Normally managed or controlled in Hong Kong

Importantly, this definition applies only within the Pillar Two framework and does not affect tax liabilities or obligations under Hong Kong’s existing territorial tax system.

Compliance Requirements

In-scope MNE groups face new filing obligations:

• Top-up tax notification: Due within six months after the end of the fiscal year (e.g., 30 June 2026 for calendar year-end groups)
• Top-up tax return: Due within 15 months after the fiscal year end (extended to 18 months for transitional years)
• Electronic filing: Mandatory for all profits tax returns from year of assessment 2025/26 onwards for entities within scope of Pillar Two

Safe Harbours

To reduce compliance burdens, Hong Kong has adopted several safe harbour provisions aligned with OECD guidance:

• Transitional Country-by-Country Reporting Safe Harbour
• Transitional UTPR Safe Harbour
• Qualified Domestic Minimum Top-up Tax (QDMTT) Safe Harbour
• Simplified Calculations Safe Harbour for non-material constituent entities

Preservation of the Territorial Principle

Despite these significant changes, Hong Kong authorities have repeatedly emphasized that the territorial-source principle of taxation will continue to apply outside the Pillar Two context. The government has made clear that:

• The territorial tax system remains unchanged for businesses not subject to Pillar Two (i.e., those below the EUR 750 million revenue threshold)
• Source determination principles under existing tax law are unaffected by the FSIE regime
• The new residency definition serves only Pillar Two purposes and does not shift Hong Kong toward residence-based taxation

Hong Kong’s Distinctive Position: No CFC Rules

Hong Kong remains one of the few major jurisdictions without Controlled Foreign Corporation (CFC) rules. CFC rules, common in many developed economies, attribute income from foreign subsidiaries to domestic parent companies, effectively preventing profit shifting to low-tax jurisdictions.

Comparative Landscape

Hong Kong’s absence of CFC rules distinguishes it from most OECD countries and many Asian jurisdictions:

This absence of CFC rules makes Hong Kong attractive for holding company structures, as there are no limitations on owning foreign corporations whose income might otherwise be attributed back to Hong Kong parent entities.

Policy Outlook: What’s on the Horizon?

Likely Continuity

Several factors suggest Hong Kong will maintain its territorial tax system for the foreseeable future:

• Economic competitiveness: The territorial system is integral to Hong Kong’s competitive position as an international financial center and regional business hub
• Government commitment: Authorities have explicitly reaffirmed the continuation of territorial taxation principles
• Compliance achieved: The FSIE regime and Pillar Two implementation demonstrate Hong Kong’s ability to satisfy international requirements while preserving core tax principles
• Limited scope of changes: Recent reforms affect primarily large MNEs and specific passive income categories, leaving the vast majority of businesses under traditional territorial rules

Potential Pressure Points

However, several developments could create pressure for further modifications:

• OECD initiatives: Future phases of BEPS or new international tax frameworks may require additional adjustments
• EU monitoring: Continued EU scrutiny of tax transparency could necessitate further regime refinements
• Mainland China alignment: Greater integration with Mainland China’s tax system could influence Hong Kong’s approach
• Revenue considerations: Government fiscal needs could prompt examination of revenue-raising opportunities

Unlikely Scenarios

Despite these pressures, certain fundamental changes appear improbable:

• Worldwide taxation: A shift to residence-based worldwide taxation would undermine Hong Kong’s core competitive advantage and is not under serious consideration
• CFC rules: Implementation of CFC rules would represent a dramatic departure from established policy and shows no signs of being contemplated
• Broad-based minimum tax: Extension of Pillar Two-style minimum tax beyond large MNEs would contradict Hong Kong’s low-tax competitive strategy

Practical Implications for Businesses

Large MNE Groups (EUR 750M+ Revenue)

For multinational enterprises within the Pillar Two scope:

• Assess effective tax rate calculations across all jurisdictions
• Evaluate whether Hong Kong entities will trigger top-up tax obligations
• Implement systems for GloBE calculations and reporting
• Consider restructuring to optimize under the 15% minimum tax framework
• Ensure compliance with new electronic filing requirements

Medium and Small Enterprises

For businesses below the Pillar Two threshold:

• Territorial tax principles remain fully applicable
• FSIE regime may apply if receiving foreign-sourced passive income
• Focus on demonstrating economic substance for exemptions
• Monitor revenue growth approaching EUR 750 million threshold

Holding Companies

For entities primarily receiving dividends, interest, or IP income:

• Ensure compliance with participation exemption requirements (5% ownership, holding period)
• Maintain adequate economic substance in Hong Kong
• Document activities supporting exemption claims
• Consider timing of income receipt and exemption qualification

Strategic Considerations

Substance Requirements

The FSIE regime has elevated the importance of economic substance in Hong Kong. Businesses should:

• Maintain adequate employees with appropriate qualifications
• Incur operating expenditures in Hong Kong proportionate to activities
• Demonstrate genuine decision-making and management in Hong Kong
• Keep comprehensive documentation supporting substance claims

Planning Under Uncertainty

Given the evolving international tax landscape:

• Monitor OECD developments and potential new initiatives
• Build flexibility into corporate structures to adapt to future changes
• Maintain open dialogue with tax advisors on emerging risks
• Engage with IRD through advance ruling procedures when appropriate

Documentation and Compliance

Robust documentation has become increasingly critical:

• Prepare detailed source of profits analyses
• Maintain records demonstrating satisfaction of FSIE exemption requirements
• Implement systems for Pillar Two calculations if applicable
• Ensure timely filing of all required notifications and returns

Conclusion

Hong Kong’s territorial tax system faces its most significant period of evolution since its establishment in 1947. The introduction of the FSIE regime and implementation of BEPS 2.0 Pillar Two represent meaningful modifications to the pure territorial principle that has long characterized Hong Kong taxation.

However, these changes are best understood as adaptations to international requirements rather than fundamental abandonment of territorial taxation. The territorial principle continues to apply to the vast majority of Hong Kong businesses, and the government has clearly committed to maintaining this core feature of the tax system.

For large multinational enterprises, the new landscape requires careful navigation of FSIE exemptions, economic substance requirements, and Pillar Two obligations. For smaller businesses and those not receiving significant foreign-sourced passive income, traditional territorial principles remain largely intact.

While future international tax developments may necessitate further adjustments, a wholesale shift to worldwide taxation or introduction of CFC rules appears highly unlikely. Hong Kong’s tax system will continue evolving in response to global standards while preserving the territorial foundation that has underpinned its economic success.

Businesses operating in or through Hong Kong should focus on ensuring compliance with current requirements, maintaining robust economic substance, and building flexibility to adapt to future developments in this dynamic international tax environment.

Sources

• IRD: Foreign-sourced Income Exemption
• FAQ on FSIE Regime – Frequently Asked Questions
• IRD: Global minimum tax and Hong Kong minimum top-up tax for multinational enterprise groups
• Hong Kong enacts law on BEPS 2.0 Pillar Two | EY
• BEPS Pillar Two legislation came into effect in Hong Kong | DLA Piper
• Pillar Two developments in Hong Kong – KPMG China
• PwC Hong Kong: IRD releases further guidance on FSIE regime (July 2025)
• Hong Kong’s Foreign-Sourced Income Exemption Regime (FSIE) Refined | Seyfarth Shaw
• Hong Kong SAR – Corporate – Significant developments | PwC
• Hong Kong SAR – Individual – Residence | PwC