In July 2001, the Hong Kong Inland Revenue Department (IRD) issued the Departmental Interpretation and Practice Notes (DIPN) No. 39. The DIPN outlines the assessing practice that will be applied by the IRD in relation to profits derived from electronic commerce (ecommerce).
The impact of the DIPN is broadly favourable to the conduct of ecommerce in Hong Kong and is consistent with the approach being taken by Hong Kongs main trading partners. The increased level of certainty provided by the IRDs first formal guidance on the issue is to be welcomed.
Nevertheless, some caution is required. The DIPN is expressed in fairly general terms and the rather basic examples provided contrast sharply with both the complex situations already arising in practice and with the 28 detailed scenarios examined by the OECD in their work on ecommerce taxation. The IRD states that with rapid change in ecommerce, there would be little point to describe in detail how the existing tax law applies to particular forms of ecommerce. It has instead opted to focus on broad principles and note that the DIPNs contents will be reviewed in light of new developments.
It remains to be seen how responsive the IRD will be in dealing with future commercial and technological changes. In essence, the IRD appears to have approached the subject from an 'old economy' perspective. Given the rapid development and change in ecommerce, this is perhaps not an unreasonable approach. Having said this, from the perspective of taxpayers looking for greater certainty, an approach that took better account of the technological changes now in process may have been more helpful.
The DIPN states that the maintenance of a website operated or replicated on a server in Hong Kong of an overseas business will not, by itself, either constitute carrying on business, or create a Permanent Establishment (PE) in Hong Kong. In determining whether such a potentially taxable presence is created, the IRD will examine the extent of other operations being carried on by the overseas business in Hong Kong.
Assuming that other operations are being carried on in Hong Kong to the extent that a Hong Kong business or PE presence arises, the next question in determining whether the overseas business will ultimately have a liability to pay Hong Kong tax, is whether the attributable profits have a Hong Kong source. According to the DIPN, it is the location of physical operations, including personnel and office premises which will carry most weight and the location of the website, possibly even when it is capable of performing 'intelligent' operations, will generally not determine the locality of source.
Thus, according to the view of the IRD, most Hong Kong-based ecommerce businesses will be subject to Hong Kong tax, irrespective of the location of a website. On the other hand, for overseas ecommerce businesses, it is generally physical presence in Hong Kong which determines liability, not the location of the website.
The other key issue covered by the DIPN is the characterization of certain types of income. This is important as where payments are made to a non-Hong Kong resident for the "use of or right to use in Hong Kong copyright material"; they are deemed to be Hong Kong sourced. Most digital products are copyrighted material. Accordingly, where there are payments made to a non-resident for the "use of" digital products, the payer is required to withhold tax, typically at an effective rate of 1.6%.
According to the DIPN however, payments for digital products purchased from an overseas vendor will only be subject to this "withholding tax" if the payment is for the right to commercially exploit the digital product, for example by selling it on to third parties. If the payment is, in substance, in return for a product or service, no tax needs to be withheld. As a result, the Hong Kong tax consequences are the same irrespective of the medium of delivery, for example, purchase of software by way of "shrink wrap" packaging or downloaded through a modem. This is a clear example of the IRDs stated principle of neutrality in the treatment of taxation of traditional and electronic commerce.
By stating that the term "use of" only applies to the commercial exploitation of a copyright, the IRD appears to have introduced a significant restriction to the meaning of the term. This restrictive interpretation greatly simplifies the application of the section in relation to ecommerce, and is one that should be welcomed by taxpayers and practitioners alike.
In conclusion, as many businesses are already undertaking, or at least considering undertaking, ecommerce and other transactions via the Internet, the impact of DIPN 39 needs to be considered:
+ Any overseas company looking to operate or replicate a website on a Hong Kong server should carefully consider the contents of DIPN 39, especially if planning to establish or maintain a physical presence in Hong Kong at the same time.
+ Any Hong Kong company which intends to operate a server in an overseas jurisdiction should note the following. Where there is no physical presence in the overseas jurisdiction any profits attributable to the web site would remain subject to tax in Hong Kong. The website may also create a taxable presence in that country and in the general absence of double tax agreements, this means that double taxation can arise.
+ Any company which already has operations in Hong Kong and is making payments to an overseas entity for the use of information of data or for any form of computer program or other digital product, should review their withholding tax obligations in respect of these payments.
Failure to take into account the guidance contained in DIPN 39 could ultimately result in substantial financial cost to a company undertaking transactions through the medium of the Internet.
Nick Dignan is a tax partner in PricewaterhouseCoopers Hong Kong with responsibility for ebusiness taxation matters.
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