In choosing the form of doing business, the goals of the entrepreneurs will be important: do they want to limit their liability or retain control; do they want to float the company on the stock market; and do (foreign) tax elements play a role? All these aspects impact on the choice amongst a public limited liability company, a private limited liability company or a partnership limited by shares.
A separate company?
If you have an existing firm, then you have to look into whether a separate company is in fact necessary. With a very risky business, it is sometimes better to set limits to the participants liability within a new, separate company. This choice also has consequences under employment law. Are you going to transfer the workforce involved in current activities over to the e-business project? Will their rights be protected? Sometimes, from a tax point of view, a new, separate company is not desirable because there is no tax consolidation, such as in Hong Kong. Thus, if you have existing profitable business activities alongside a loss-making, e-business project in its start-up phase, then by opting for two companies, you will potentially pay tax on the existing activities, whereas within the new company the tax losses will be carried forward and cannot be immediately utilized until such time as there is a profit.
A number of mercantile law aspects are also of importance. For instance, with Internet technology, you can house sales activities in a single, central company, instead of continuing to work via a number of local distribution companies. If so, check whether you might be in breach of any existing exclusive agreements (both within the group and vis-a-vis third parties). You can also set up a market place together with third parties (an e-market or exchange). Here as well, the choice of structure is important from mercantile law and tax viewpoints. Just think of the rules on free competition in the EU and also in the US, for example, which are important where various businesses are able to exercise a decisive influence on such market places.
Your e-business projects structure will also determine what tax rate ultimately applies to your results. Even in an international context, there is no tax consolidation. Thus, the losses of a company in Singapore cannot be off-set against Hong Kong profits. Outside the Hong Kong source-based tax system, one possible solution is to set up a branch of the home company in the other jurisdiction. Furthermore, the tax rates vary greatly as between different countries globally. Thus, to take a European rather than Asia-Pacific example, in Belgium the rate is usually 40.17 per cent, whilst Ireland currently has a rate of 20 per cent (and as from 2003 will have a rate of only 12.5 per cent).
Of course the rate alone is not the be all and end all, since account also has to be taken of other facets that affect the effective tax rate, such as recovery of losses, the treaty network (a noticeable lack in Hong Kong), exemptions for capital gains on shares, and participation exemptions. The tax levied on the employees (stock options, for instance) and the founders is also important. On the other hand, continuing that same European example, a lower rate can mean that, of every 1,000 dollars of after-tax profits you will retain $875 (in Ireland after 2003) instead of $600 (in Belgium). So, in that example, it is certainly worth selecting a location outside Belgium for at least (a part of) your e-business activities.
It is not necessarily enough to set up a company in a given country, however, since, staying with the same example, if you manage the company from Belgium, then the tax authorities can still deem that you are taxable on your worldwide income as a Belgian resident. The true nature of your foreign activities will have to be proved to the Belgian revenue. Nor should you forget to check whether you can tax-efficiently repatriate the profits from the foreign location back to the location of the ultimate holding company. This is especially so in the case of true tax havens, like Bermuda, since this is not always possible, so that your initial advantage may eventually be forfeited.
The Snakes in the fiscal grass
In addition to having an infrastructure when working with foreign companies, you also have to check that no tax liability arises outside the country where the company is established. This can be the case if a permanent establishment is deemed to exist for tax purposes in a certain location, for instance if you have computer equipment outside the country where your company is situated.
With e-business, we are thinking for example of a server on which (a replica of) the web site or digital content is hosted in order to offer faster access to customers in the local foreign market. This point of contention is relevant because the Organization of Economic Corporation and Development (OECD) has laid down the model as a basis for the double taxation treaties that have been or are concluded amongst the OECDs member states. In particular, article 5 of the model deals with the tax concept of a permanent establishment. The OECD has prepared additional comments on this provision regarding the use of servers for e-business. On 22 December 2000, a final position was taken on the subject.
In short, what the situation amounts to is that a server owned by a company, or that is used under a capital lease agreement outside the country of residence, can in principle create a permanent establishment. If only part of the server is hired from an Internet service provider (ISP) or if only software is involved, without any hardware component, then there is no permanent establishment, just as where the server is only used for preparatory or ancillary activities (for example, advertising).
Right up to the last minute, there was still controversy as to whether or not it is a requirement that the server should be operated locally by members of the workforce. The final position on this is that a permanent establishment can indeed arise even if no employees operate the equipment (as is the case with other automated machines).
Readers who would like further information can find the OECDs full report on its Web site (www.oecd.org). This discussion is of importance both for situations where a double taxation treaty applies and for situations where this is not so, in which case resort is taken to the national law of the country concerned. In this regard, relatively few individual territories have yet assumed any clear position, contrary to (say) China, where the view seems to be that a server does perhaps create a permanent establishment.
Finally, we would further point out that in the creation of a permanent establishment, the question also arises as to what portion of profits (profit allocation) is subject to taxation in the country where the permanent establishment is located (a topic for a later article).
Thus, pay sufficient attention to the legal and tax structure of your e-business project, and that way you will not only avoid unpleasant surprises but also achieve an optimal tax situation.
Colin Farrell, leader, Asia-Pacific e-business tax services, PricewaterhouseCoopers. Email: [email protected]