In July 2001 the Inland Revenue Department of the Hong Kong Government ("the Department") issued a Departmental Interpretation and Practice Note No. 39 "Profits Tax, Treatment of Electronic Commerce ("the Electronic Commerce Note").
As is the case with other departmental interpretation notes, the Electronic Commerce Note has been issued for guidance only and does not have binding force. However, the Electronic Commerce Note is to be welcomed as it clarifies the stance that the Department is likely to take when it comes to assess the profits tax of companies engaged in electronic commerce activities.
Currently, there are no provisions in the Inland Revenue Ordinance (the "Ordinance") which deal with the taxation of electronic commerce. The Department has clarified that it will adopt a principle of neutrality of treatment in relation to the taxation of electronic commerce and that any taxation in respect of electronic commerce will be determined by reference to the relevant profits tax provisions of the Ordinance.
Profits Tax - The Three Requirements
According to Section 14 of the Ordinance, profits tax is chargeable if the following three conditions are satisfied, namely: (i) the person concerned carries on a trade, profession or business in Hong Kong, (ii) the profits to be charged come from the trade, profession or business carried on by the person in Hong Kong, and (iii) the profits are "profits arising in or derived from Hong Kong.
The Ordinance also contains a deeming provision in Section 15(1) according to which, certain sums otherwise not chargeable to tax are deemed to be receipts arising in or derived from Hong Kong from a trade, profession or business carried on in Hong Kong and are chargeable to profits tax. These include sums received for the use or right to use in Hong Kong a patent, design, trademark, copyright material or secret process or formula or other property of a similar nature, even where the owner of the respective intellectual property right is not located in Hong Kong. Given the wide availability on-line of digital products in which intellectual property rights subsist, this deeming provision is of particular relevance to electronic commerce businesses.
A. Trade, Profession Or Business Carried On In Hong Kong
As far as the first and second requirement for profits tax are concerned, the Department's view is that extensive activities are not necessarily required before it can be said that a person is carrying on a trade or business in Hong Kong
In the electronic commerce context, many factors may be relevant in determining whether this first requirement is satisfied. These may be factors such as the place where goods are stored and delivered, where services are provided, where payments are made and received, where purchases and sales are made, where bank accounts are maintained, and where business back-up services are provided.
However, the Department has clarified in the Electronic Commerce Note that in its view the mere presence of a server in Hong Kong without the involvement of human activities in the jurisdiction would not generally amount to the carrying on of a business in Hong Kong for the purposes of Section 14 of the Ordinance. In other words, in trying to determine whether profits tax should be charged for certain electronic commerce activities, the Department would look beyond the server and examine the extent of the person’s other operations in Hong Kong. The Department would not consider the mere presence of a server in Hong Kong as constituting a permanent establishment for the purposes of Section 14 of the Ordinance.
By contrast, the position taken by the Organisation for Economic Co-operation and Development (OECD) is that a server at the disposal of a business (owned or rented by it) can be regarded as a permanent establishment of the business if an essential and significant part of its business activities are conducted through that server. This is the case even if no personnel of the business are required at the server’s location for the operation of the server.
Locality Of Profits
The third requirement for profits tax in Section 14 of the Ordinance, is 'locality of profits'. The Department's view is that in the context of electronic commerce physical activities are reduced and that one needs to look at automated, server-based activities as well.
However, the place where automated server-based activities are carried out does not of itself determine the locality of profits. Automated activities have to be weighed against the core business operations required to conduct the respective electronic commerce business and these are normally carried out within a physical office. The Department's view therefore is that it is generally the location of the physical business operations, rather than the location of the server alone, that determines the locality of the profits.
A further issue with regard to locality of profits is that the actions of 'agents' may also be relevant. However, the Electronic Commerce Note clarifies that the term 'agent' does not include software or a server, or an Internet Service Provider who merely operates a server under a web-site hosting arrangement.
A general conclusion therefore is that a company engaged in electronic commerce activities in Hong Kong, will be liable to Hong Kong profits tax if its principal place of business is in Hong Kong or if it has a permanent establishment in Hong Kong. By contrast, companies engaged in electronic commerce activities which only have a server in Hong Kong but whose business operations are outside Hong Kong will not be liable for profits tax under the Ordinance.
As mentioned above, Section 15(1) of the Ordinance contains a deeming provision which is of particular relevance in the Internet context. In particular, Section 15(1)(b) provides that sums not otherwise chargeable to tax, which are received for the use of the right to use intellectual property rights such as patents, designs, trademarks, copyright material or secret processes or formula are deemed taxable receipts.
The Electronic Commerce Note clarifies that if the payment is in truth a payment for a product or service, it will not come within the scope of Section 15(1)(b) but if it is a payment for the use of, or the right to use, material in which intellectual property rights subsist, such as copyright material, it is deemed to be a taxable receipt under Section 15(1)(b).
As far as the acquisition or use of computer software or other digital products are concerned, the Electronic Commerce Note states that if the payment made is for the use of or the right to use the copyright which subsists in the software program or the digital products concerned then Section 15(1)(b) would be applicable. However, if the payment is made for the use of or right to use only the actual software program then Section 15(1)(b) would not be applicable.
The former scenario would include re-seller and agency arrangements where there will be a right to make copes for distribution to customers (the public); the right to prepare derivative programs; the right to make a public performance of the program and the right to publicly display the program.
The latter scenario would cover the distribution of shrink-wrapped software or digital software that is downloadable from the Internet. In these cases the seller permits the customer to download (electronically or otherwise) the software on to the latter’s hard disc or other non-temporary media for payment, for his own use only. The downloading may, strictly, constitute the use of the copyright in the software; however, the use of this copyright is merely incidental to the process of acquiring, capturing and storing the digital signals, for which the payment is in fact made. The Department has clarified in the Electronic Commerce Note that this broad principle is also applicable to other types of digital products, such as those containing images, sounds or text.
In conclusion, it is only in cases where the use of the copyright in software or digital products constitutes an essential part of the consideration that the payment by a customer will be regarded as royalty for the purposes of Section 15(1)(b).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.