What Counts as ‘Substance' for Offshore Tax Claims in Hong Kong?

Since 1 January 2023, Hong Kong’s Foreign-Sourced Income Exemption (FSIE) regime has tightened how multinational group companies treat certain foreign-sourced income when it is received in Hong Kong. To keep items like dividends, interest, disposal gains and certain IP income exempt, the Hong Kong entity must show adequate economic substance in Hong Kong, i.e., real people, premises, and decision-making proportionate to the business.

Two tests now sit side-by-side. First, Hong Kong applies the territorial source principle to decide where profits are actually earned. Only if income is genuinely foreign-sourced does FSIE ask a second question: Does your Hong Kong entity have enough local substance to sustain the exemption? In practice, shortcuts such as “our customers are overseas” or “we’ll just leave the money offshore” no longer work for in-scope entities.

This article clarifies what “economic substance in Hong Kong” really means, how the IRD evaluates adequacy (including when functions are outsourced locally), where businesses commonly go wrong, and what evidence you’ll need if you intend to claim an offshore position under today’s rules.

In Hong Kong tax rules, economic substance means a company is actually operating, not just incorporated on paper. Substance is shown through people, premises, and decision-making processes that match the company’s activities.

• People – Employees or decision-makers who carry out the work.
• Premises – Office space suitable for the scale of operations.
• Processes – Evidence of where and how decisions are made, such as board minutes, contracts, and management records.

Think of substance as the business activity itself, while the documents are the proof that those activities genuinely happen in Hong Kong.

Hong Kong only taxes profits sourced in Hong Kong, but since 2023, certain foreign-sourced income received in Hong Kong (e.g. dividends, interest, disposal gains, and some IP income) is not automatically exempt. Under the FSIE regime, exemptions now depend on whether the Hong Kong entity can show adequate substance.

Here’s how it works in practice:

• FSIE only applies to multinational enterprise (MNE) entities – Companies that are part of a group operating in more than one jurisdiction. If you’re an MNE, you must meet substance requirements to keep specified foreign-sourced income exempt.
• Requirements differ by entity type – Pure equity-holding entities (those that only hold shares) face lighter obligations: mainly holding/managing equity and meeting compliance filings. Non-pure equity entities (carrying out wider activities) must demonstrate more: strategic decisions, local staff, and real operating expenses in Hong Kong.
• Source and substance are separate – First, the Inland Revenue Department (IRD) decides where profits are sourced. Only if they are foreign-sourced does substance under FSIE become relevant. One test never replaces the other.
• Failing substance = no exemption – If the substance cannot be shown, the specified income is treated as taxable in Hong Kong.
• Beyond tax liability – Missing substance can trigger back taxes, interest, and deeper IRD scrutiny of your whole structure.

The IRD does not follow a fixed checklist for substance. Instead, it applies an “adequacy test”, which asks whether the people, premises, and activities in Hong Kong are sufficient and proportionate to the nature and scale of your business. 

There are no numerical thresholds (e.g. headcount, office size). Each case is assessed on its facts. Key factors the IRD examines include:

• Entity type – Pure equity-holding entities face lighter obligations (mainly holding/managing shares and meeting filing requirements). Non-pure equity entities must demonstrate broader operations, including strategic decision-making and real operating expenses in Hong Kong.
• Employees and expertise – Whether you employ enough people in Hong Kong, and whether their skills match the company’s business activities.
• Management and control – Whether day-to-day decisions, administration, and oversight are genuinely exercised in Hong Kong.
• Premises – Whether the physical office space is adequate for the type and size of operations.

The IRD recognises that some multinational groups outsource functions. Outsourcing can still support substance, but only if:

• The outsourced work is performed in Hong Kong,
• The company maintains active monitoring and control,
• The service provider has sufficient staff and incurs meaningful operating expenses in Hong Kong, and
• Resources are not double-counted if the provider serves multiple group entities.

In other words, outsourcing is not a loophole. It must look and feel like real local activity, with genuine cost and oversight behind it.

Many business owners confuse economic substance with unrelated factors. The IRD has clarified that shortcuts do not work. Below are some of the most frequent misconceptions.

Having substance in Hong Kong does not automatically make profits offshore. The IRD applies two separate tests:

1. Source test (territorial principle): First, it decides where the profit-generating activities occur.
2. Substance test (FSIE): Only if the profits are foreign-sourced does FSIE ask whether the Hong Kong entity has enough local substance to keep the exemption.

Substance is necessary, but it never replaces the source test.

Simply serving overseas customers does not mean your trading profits are offshore. For trading businesses, the IRD applies the operations test, focusing on where contracts are negotiated and concluded, not just signed.

If negotiations and agreements are made by staff in Hong Kong, the profits may still be taxable here, regardless of where your customers are.

To support an offshore claim, you need clear evidence that profit-generating steps occurred outside Hong Kong, such as:

• Who negotiated the contracts and where?
• Whether an overseas agent had the authority to conclude deals.
• Where acceptance of orders and transfer of title took place.

Leaving money offshore does not secure an exemption. Under FSIE, certain foreign-sourced income is still deemed taxable once it is received in Hong Kong, which includes cases where:

• Funds are remitted or transmitted into Hong Kong.
• Funds are used to settle a Hong Kong business debt.
• Funds are used to buy movable property, which is later brought into Hong Kong.

For in-scope income (dividends, interest, disposal gains, and some IP income), exemption is only available if you meet one of the prescribed exceptions. In most cases, this means showing adequate local substance, such as staff, premises, and decision-making in Hong Kong.

Without this, the IRD may tax the income even if it never touches a Hong Kong bank account.

In short, here are the key takeaways from this article: 

• Economic substance is decisive. Without it, foreign-sourced income covered by FSIE may be taxed in Hong Kong.
• No shortcuts work. Overseas incorporation, foreign customers, or keeping money abroad do not replace substance.
• Two tests apply separately. Source first, then substance. Both must be satisfied.
• Requirements vary by entity. Pure equity-holding entities face lighter rules than operating companies.

The real challenge is that substance is not a box-ticking exercise. The IRD looks at your business holistically, and if you miss the mark, your exemption claim can fail.

That’s where Statrys makes the difference. We don’t just help you set up a company, but we help you start with a solid foundation:

✅ Seamless company incorporation in Hong Kong
✅ Dedicated company secretary to keep you compliant
✅ A multi-currency business account that works
✅ Expert accounting services 

Everything is handled in-house by Statrys, so you don’t have to find multiple providers for each service, which adds complexity.