The digital economy is rapidly changing ways of doing business. For tax authorities worldwide, this is creating challenges to implementing or modifying existing tax rules to deal with digital businesses, where physical nexus or tangible presence such as headcount or assets are minimal. It is therefore welcoming that the Hong Kong Inland Revenue Department (IRD) has revised its Departmental Interpretation and Practice Note (DIPN) 39 on the digital economy, first issued in 2001. The revised version, Profits Tax – Digital Economy, Electronic Commerce and Digital Assets, published in March, provides more guidance on its view on taxation of digital businesses.
In a change from its previous position, the IRD indicates that a non-Hong Kong resident enterprise that only maintains a server in Hong Kong, without the involvement of human activities in Hong Kong, is now exposed to tax in Hong Kong.
Revised DIPN 39 also extends the scope of the old DIPN 39 to cover the tax treatment of digital assets, including the tax position of an issuer in an initial coin offering, and what constitutes a permanent establishment (PE) in the context of e-commerce (e.g. the potential application of the anti-fragmentation rule, anti-abuse rule for the specific activities exemption from constituting a PE, and the dependent agent PE).
Revised DIPN 39 also notes that the IRD’s position may change as a result of the conclusion of the current international discussion regarding changing the rules for taxing the digital economy under the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting 2.0 initiatives, with consensus expected to be reached by the end of 2020.
It is therefore worth noting that the IRD’s position is based purely on how the IRD considers the current provisions of the Inland Revenue Ordinance (IRO) would apply to the issues covered by the revised DIPN.
Recent change in the definition of PE in the IRO
The IRO’s definition of PE changed in 2018 to mean “a fixed place of business in Hong Kong through which the business of [a non-Hong Kong resident enterprise] is wholly or partly carried on…” This was from “a branch, management or other place of business… [in Hong Kong].” This current definition is modelled on how the term is defined under the Model Tax Convention on Income and on Capital 2017 (MTC) for tax treaties of the OECD.
IRD’s change of its position as a result of the change in the definition of PE
Under the previous definition of PE, the IRD considered that the words “branch, management or other place of business” implied a physical presence of a “place” and personnel.
Previously therefore, the IRD did not consider the presence of a mere server in Hong Kong, without the involvement of human activities in Hong Kong, of a non-Hong Kong resident enterprise would constitute a PE in Hong Kong. This would generally mean that such an enterprise would not be regarded as carrying on a business in Hong Kong and, therefore, would previously not be exposed to tax in Hong Kong.
However, under the current definition of PE, Revised DIPN 39 indicates that the IRD now follows the OECD’s interpretation that the mere presence of a server in Hong Kong can constitute a PE in Hong Kong.
Only if a server “at the disposal” of an enterprise is “an essential and significant part” of the business would there be a PE
It should be noted that not all servers maintained in Hong Kong by a non-Hong Kong resident enterprise would expose the enterprise to tax in Hong Kong. That is, not all servers create a PE in Hong Kong.
Following the OECD’s position in its commentary on the MTC, the IRD states that (i) it is only where a server is “at the disposal” of an enterprise, and (ii) “an essential and significant part” of the business of the enterprise is conducted through the server that the PE exposure exists. These two conditions are discussed below.
(i) “At the disposal”
Regardless of whether a server is owned or leased by an enterprise, the revised DIPN indicates that if the enterprise can have effective control over the use of, and access to, the server, i.e. it can operate the server on its own, the place where such a server is located can constitute a PE of the enterprise.
However, a website of a non-Hong Kong resident enterprise which is hosted on the Hong Kong server of a third-party Internet service provider may not constitute a PE. This is because, under such a hosting arrangement, the enterprise would typically not have effective control over the use of, and access to, the server.
(ii) “Core operations”
Revised DIPN 39 indicates the core operations of an enterprise are those that “form an essential and significant part of the business,” beyond preparatory or auxiliary activities. What constitutes “core operations” for a particular enterprise however has to be determined on a case-by-case basis considering the fact and circumstances.
While the revised DIPN also tries to be helpful by providing a list of “relevant” factors in considering the source rule, the list is not comprehensive for sophisticated digital businesses which have limited physical operations in Hong Kong.
Regarding e-commerce, revised DIPN 39 nevertheless states that an at-the-disposal “intelligent server” in Hong Kong of a non-Hong Kong resident enterprise, that is a server capable of concluding contracts, processing payments or delivering digital goods, even without the involvement of human activities in Hong Kong, would constitute a PE of the enterprise in Hong Kong. This is because the Hong Kong server represents “an essential and significant part of the business of the enterprise.” The DIPN also gives examples of activities regarded as “preparatory or auxiliary in nature” including advertising, displaying a catalogue of products and providing information to potential customers.
An apparently inconsistent application of the source principles
Profits of a Hong Kong resident enterprise that performs all the core operations in Hong Kong (except a server outside Hong Kong) are fully chargeable to tax in Hong Kong
Similar to the position taken by the IRD in the original version, the revised DIPN states that profits of a Hong Kong resident enterprise derived from its performance of all the core operations in Hong Kong of an e-commerce business would be fully chargeable to tax in Hong Kong under section 14 of the IRO. The IRD has stated this would be the case even if such an enterprise operates an intelligent server that is at its disposal outside Hong Kong.
A literal reading of the DIPN would mean that notwithstanding that the functions performed by such an intelligent server outside Hong Kong can, in a sense, also be regarded as forming an essential and significant part of the business of the enterprise (see the above discussion), the IRD may disregard the server when considering the source of the profits of the Hong Kong resident enterprise if the other core operations performed by the enterprise in Hong Kong are more relevant and are the direct “profit-producing transactions” (the authoritative ING Baring Securities case on the source principles quoted in Revised DIPN 39 refers).
This position is further reinforced by the statement that “[i]rrespective of the e-commerce model adopted, it is usually the case that tasks undertaken through a server are performed according to pre-designed application software since the server cannot function by itself and human functions remain important in the carrying on of the e-commerce as a whole.”
A non-Hong Kong resident enterprise that performs all the core operations outside Hong Kong (except a server PE in Hong Kong) – should none of its profits then be chargeable to tax in Hong Kong?
As far as the source of the profits under section 14 of the IRO is concerned, the position of a non-Hong Kong resident enterprise that performs all the core operations outside Hong Kong (except the location of a server PE in Hong Kong) may be regarded as the reverse position of the previous example.
As such, given the IRD’s view that the profits of the above Hong Kong resident enterprise would be regarded to be fully chargeable to tax in Hong Kong (thereby effectively disregarding the location of the server as being relevant to determining the source of the profits), one may expect that none of the profits of a non-Hong Kong resident enterprise would then be chargeable to tax in Hong Kong.
However, by way of an example regarding a non-Hong Kong resident enterprise conducting business in the provision of online audio, video and web conference services, the DIPN indicates that the IRD takes the position that the functions performed by a data centre or server PE of such non-Hong Kong resident enterprise form an “essential and significant part” of the enterprise’s business. This would be the case despite the enterprise having no service providers, employees or office in Hong Kong, i.e. all the other core operations and all the human functions important to the business are performed outside Hong Kong.
The IRD then takes the position that profits attributable to the PE in Hong Kong of the non-Hong Kong resident enterprise, are ascertained based on the transfer pricing (TP) rules under the authorized OECD approach (AOA), and would be chargeable to tax in Hong Kong.
Under the recently enacted section 50AAK of the IRO, a non-Hong Kong resident enterprise which has a PE in Hong Kong is regarded as carrying on a business in Hong Kong for the purposes of section 14 of the IRO.
However, to be chargeable to tax in Hong Kong under section 14, apart from carrying on a business, the relevant “profit-producing transactions” of such an enterprise must also be undertaken in Hong Kong – the territorial source principles as developed by the courts over the years.
It is true that under the TP rules, certain profits would normally be attributable to such a PE of a non-Hong Kong resident enterprise, generally based on the functions performed, the assets used, and the risks assumed by the PE.
However, DIPN 60 Attribution of Profits to Permanent Establishments in Hong Kong also explicitly acknowledges that the TP rules are only relevant to determining whether the profits as reflected in the accounts are arms’-length or adequate. Once the arms’-length profits are ascertained, Hong Kong’s source principles need to be applied in order to determine whether those profits are chargeable to tax under section 14 of the IRO, based on the extent to which the relevant “profit-producing transactions” are undertaken in Hong Kong.
This process is referred to as the “two-step” approach to determining chargeability to tax under section 14 . Such a process is required given that the TP and the source rules may not converge in many instances.
The IRD has not given detailed elaboration in the revised DIPN on how source of profits would be determined subsequent to adopting the AOA to attribute profits to the Hong Kong PE, or how TP rules would interplay with the established source rules. However, a literal reading of the DIPN in effect appears to indicate that as a result of the recent change in the definition of PE, the IRD considers that the TP and the source rules will converge in the attribution of profits to a server PE.
However, as the example above showed, the profits attributable to the data centre or server PE in Hong Kong of a non-Hong Kong resident enterprise under the TP rules could be irrelevant to determining whether any of the profits of the enterprise can be regarded as being sourced in Hong Kong.
In fact, consistent application of the source principles in reverse would seem to require that if the source of the profits of the above Hong Kong resident enterprise is considered as being only located in Hong Kong, then the source of the profits of the non-Hong Kong resident enterprise should be considered as being located wholly outside Hong Kong. As such, none of the profits of the non-Hong Kong resident enterprise should be chargeable to tax in Hong Kong.
Taxpayers would welcome the IRD’s clarification on the above apparently inconsistent application of the source principles to the two opposite scenarios as illustrated in the revised DIPN.
Organizations engaging in digital economy and e-commerce businesses should keep abreast of the rapid tax development in Hong Kong in light of DIPN 39. The new concept of a “server PE” can expose many non-Hong Kong resident enterprises to Hong Kong profits tax that was not previously applicable under the old DIPN 39. Therefore, it is important to seek professional tax advice where necessary to make sure the tax exposure is addressed appropriately.
This article is contributed by Jo An Yee, International Tax and Transaction Services Partner, Technology, Media and Telecommunications Tax Leader – Hong Kong at EY; Patrick Kwong, Executive Director and Kathy Kun, Senior Manager, of Ernst & Young Tax Services Ltd.