The Inland Revenue Department (the “IRD”) has recently revised and reissued Departmental Interpretation and Practice Notes 39 (the “DIPN 39 (Revised)”) since it was first published in July 2001. Amongst others, the IRD has now provide some guidance on how it is going to assess digital assets (including but not limited to cryptocurrencies, cryptoassets or digital tokens). The article aims to discuss the tax treatment of the digital assets under the DIPN 39 (Revised).

1. No Specific Legal Legislation for Digital Assets

Currently, there is no specific provision in the Securities and Futures Ordinance (Cap. 571) (the “SFO”) or other legislation which governs the digital assets or tokens. In general, if a digital token has terms and features that may qualify as “securities” as defined in the SFO, it will be subject to the regulation and scrutiny of the Securities and Futures Commission. For instance:-

1. Where a digital token offered in an initial coin offering (the “ICO”) represents equity or ownership interest in a corporation such as shareholders’ rights, i.e. the right to receive dividends and the right to participate in the distribution of the corporation’s surplus assets upon winding up, etc., such token may be regarded as “shares”;

2. Where a digital token is used to create or to acknowledge a debt or liability owed by the issuer, for example, an issuer may repay a token holder the principal of their investment on a fixed date or upon redemption, with interest paid to the token holder, such the digital tokens may be considered as a “debenture”; or

3. Where token proceeds are managed collectively by the ICO scheme operator to invest in projects with an aim to enable a token holder to participate in a share of the returns provided by the project, the digital tokens may be regarded as an interest in a “collective investment scheme”.

Payment tokens or utility tokens, however, are not subject to the regulation of the SFC.

2. Tax Treatment of the Digital Tokens and Cryptocurrency Business

As explained in the DIPN 39 (Revised), the nature of the digital tokens issued in an ICO (i.e. the rights and obligations associated with the digital tokens) will determine the taxability of the proceeds from the ICO. If “security” tokens are offered in an ICO, the proceeds thereof will be capital in nature and hence not taxable from the perspective of the issuer.  On the other hand, if utility tokens are offered in an ICO, the IRD is of the view that such proceeds could be taxable under section 14 of the Inland Revenue Ordinance (Cap. 622) as the proceeds represent prepayment by the token holders for future benefits or services.

As for digital token holders, if it can be established that the tokens are capital assets rather than trading stock, any profits from the disposal of the tokens will not be chargeable to profits tax. The well-established 6 badges of trade will be relied on by the IRD in determining whether a digital token is a capital asset or a trading stock. The IRD has also made it clear that it will apply the broad guiding principle in determining the source of profits arising from cryptocurrency transactions, i.e. the nature of the profits in question, the relevant operations that produced the profits in question and the place where those profit-generating operations were carried out.

3. Our Observations

Notwithstanding the inclusion of a new section for the taxation of digital assets and cryptocurrency businesses under the DIPN 39 (Revised), little concrete or additional guidance (save and except for the part on security tokens) has been provided when it comes to the determining of the nature of a digital asset and the source of profits for cryptocurrency businesses.  The over-reliance on the 6 badges of trade and the basic charge under the IRO to tax an emerging industry which involves blockchain technology is likely to cause many ICO issuers and cryptocurrency businesses to be subject to tax review by the IRD and give rise to tax disputes. It is high time for the blockchain businesses to get prepared for the IRD’s stricter scrutiny for a tax perspective.

If you have any questions on the above, please contact one of the members of our Tax Advisory Team.

Shall you be interested to download this article as a brochure, please click on the following link: Revised Departmental Interpretation and Practice Notes on E-commerce and Digital Assets – Part 2

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.

Technological advancement and shifting consumer patterns have contributed to the increasing trend of businesses or exchange done virtually. The current form of Inland Revenue Ordinance (Cap. 112) (the “IRO”), however, contain no specific provisions to deal with the taxation of e-commerce and / or digital assets businesses. To cope with such change of circumstances and to fill the gap, the Inland Revenue Department (the “IRD”) issued the Departmental Interpretation and Practice Notes 39 in July 2001 to provide clarity on its taxation of e-commerce businesses. Such Departmental Interpretation and Practice Notes was recently revised and issued by the IRD in late March 2020 (the “DIPN 39 (Revised)”). In gist, it adopts the general approach (as provided for under section 14[1] of the IRO and at common law) in determining whether a person is chargeable to Hong Kong Profits Tax for those businesses. The sharp difference between e-commerce businesses and traditional trading and manufacturing businesses prompted the IRD to revisit the relevant tax position and issue additional guidelines thereon. The article aims to discuss the notable changes under the DIPN 39 (Revised).

1. What does that mean by carrying on an e-commerce business in Hong Kong?

Previously, the IRD was of the view that the mere presence of a server in Hong Kong (even if the server was capable of concluding contracts, processing payments or delivering digital goods without the involvement of human activities) would not generally be considered as carrying on a business in Hong Kong.  The IRD would adopt a totality of fact approach to consider a basket of factors (including but not limited to where the goods are stored, where services were rendered, where contracts were made and where payments were made, etc.) in concluding whether or not a person was carrying on an e-commerce business in Hong Kong. 

Further, given that the server did not fall within the scope of “a branch, management or other place of business”, the mere presence of a server in Hong Kong did not constitute a permanent establishment (the “PE”) for non-resident persons and hence, those non-resident persons would not be considered as carrying on an e-commerce business in Hong Kong solely by that reason. Such position taken by the IRD was contrary to the view of the Organization for Economic Cooperation and Development (the “OECD”).

The IRD has now adopted a substantially different position as stated in the DIPN 39 (Revised). The DIPN 39 (Revised) clearly provides that if the core operations and support activities atypically seen in an e-commerce model (see paragraph 7 of the DIPN 39 (Revised)) are performed in Hong Kong, the person concerned will be considered as carrying on an e-commerce business in Hong Kong.

The IRD’s position on “server” has also been aligned with that of the OECD. The IRD’s current view is that the server may constitute a fixed place of business (and hence a PE) if an essential and significant part of the e-commerce business (as distinguished from preparatory or auxiliary activities) is conducted via the server. This literally means that a non-resident person, who owns or rents a server in Hong Kong which is capable of concluding contracts, processing payments or delivering digital goods in Hong Kong even without the involvement of human activities in Hong Kong, might be considered as having a PE in Hong Kong for Profits Tax purposes. While the IRD clarifies that that the sub-contracting to a HK service provider which so happens hosts the non-resident’s website via a server located in HK would not constitute an establishment of PE by that non-resident per se (as long as the server is not at the disposal of the non-resident), it is noteworthy that a non-resident without a PE in HK might still be subject to the Hong Kong Profits Tax if it is regarded as carrying on a business in Hong Kong. All relevant facts and circumstances would be examined before any conclusion could be made.

2. Is the profit of the e-commerce sourced in Hong Kong?

Instead of merely looking at the location of the server, the IRD makes it clear that the correct approach in determining the source of profits of an e-commerce business should be identifying the core operations of the e-commerce business generating the profits and determining where those core operations take place.  In that respect, the IRD has provide 2 illustrations in the DIPN 39 (Revised):-

The logical conclusions to be drawn from the illustrations are that (1) if all the core operations and support activities of an e-commerce business are performed in Hong Kong, the profits generated therefrom will be subject to Profits Tax, irrespectively of the residency of the person, the location of the server and whether or not the server is at the disposal of the person; and (2) a server in Hong Kong at the disposal of a non-resident person might constitute a PE of that non-resident person, giving rise to chargeable profits attributable to that server “activities” in Hong Kong.

3. Our Observations

The IRD’s initiative to revise the rules on the taxation of e-commerce business to be aligned with international tax rules and standards is certainly welcome. The changes as contained in the DIPN 39 (revised) do provide more clarity on how the IRD is going to assess e-commerce businesses. 

Having said that, from a practical point of view, given the fast pace in the development of e-commerce businesses (e.g. crowdfunding, dashboard solutions, drop shipping, online marketplace or flexible payment solutions) and their ever-changing models, it is believed that more e-commerce businesses (whether Hong Kong resident entities or non-Hong Kong resident entities) will be subject to the review by the IRD in terms of chargeability or offshore claims for the following reasons:-

(a) it is of utmost difficulty in determining (1) whether the business activities carried out by a person engaged in an e-commerce represent core operations and support activities of a business or merely constitute preparatory activities; and (2) whether or not the activities conducted via a sever represents an essential and significant activities of the relevant e-commerce business, as all of these are judgmental and might vary between different e-commerce businesses; and

(b) it is never easy to fully comprehend an innovative e-commerce business or its model (e.g. when blockchain business first emerged) and it seems to us that the IRD and the assessors are still analyzing such business and its model in a conventional way.             

In light of the changes under DIPN 39 (Revised) which is likely to be further revised by the end of 2020 upon the finalization of the report on digitalization by the OECD, clients should review their e-commerce businesses and make changes to the models to reduce any adverse tax implication or bearing thereof or better prepare themselves for the IRD’s enquiries on the e-commerce business. If you have any questions on the above, please contact one of the members of our Tax Advisory Team.

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.

[1] Section 14 of the IRO provides that a charge to Profits Tax will arise when the following three conditions are satisfied: (a) the person must carry on a trade, profession or business in Hong Kong; (b) the profits to be charged must be from such trade, professional or business carried on by the person in Hong Kong; and (c) the profits must be “profits arising in or derived from” Hong Kong.