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New Trend of Japanese Corporates Retreating from China

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In early April 2020, the Japanese Government announced its plan to earmark about USD$2.2 billion as part of its economic stimulus package to help manufacturers to shift their production out of China.  This effort has surfaced following the outbreak of coronavirus in China and its devastating disruptions to supply chains after temporary suspension of production bases in various parts of the country. 

According to latest statistics, there are over 30,000 Japanese entities having establishments and presence in the PRC.  Not surprisingly, most of them structure their investment in China via Hong Kong intermediaries for tax efficiency reasons.  With the rolling out of the stimulus measures, will we be witnessing a new trend of Japanese companies moving out from China?  What are the factors the enterprises should consider on their decision to “exit” China? What is the most tax efficient way to structure the investment post-exit? Should the Japanese enterprises maintain their regional head office in Hong Kong post-exit?

To leave or not to leave?

Targeting at Japanese manufacturers whose production is highly dependent on China (including pharmaceutical products, automobile, electronic components and other computer components), this new funding aims to encourage these manufacturers to build a stronger supply chain by shifting more high-value added productions back to Japan (Total: JPY 220 billion) and diversifying other manufacturing activities to neighbouring ASEAN countries (Total: JPY23.5 billion yen).  Depending on the company size, these subsidies will cover from at least one half (for large corporations) to two-third (for SMEs) and even 75% (for SME groups) of their relocation expenses, including building and equipment acquisition and installation.

Though the proposed domestic return may gain support from export-oriented companies due to the rising labour costs in China and the US-China Trade War while some others may consider strengthening their procurement chain from outside China, there might be hesitation for enterprises with strong domestic market demand in China (notably the automobile industry).  In addition, it is expected that the Mainland authorities, with a very strong desire to attract foreign enterprises to develop its high-technology (e.g. AI and 5G), will continue to provide more incentives to convince them to stay in China.  At present, the tax incentives to such sector include a 15% preferential Corporate Income Tax (“CIT”) rate designated to foreign enterprises which are qualified as new/high technology enterprises, key software enterprises, technology-advanced service providers and those operating in Qianhai Shenzhen-HK Modern Services Industry Cooperation Zone and Zhuhai Hengqin New Area.  Besides, tax reductions and exemptions also apply to specific industries and projects.  For instance, qualified new/high-tech enterprises (established in certain parts of PRC) and software enterprises are entitled to enjoy a “2+3” tax holiday, meaning that they could enjoy first two years of exemption from CIT followed by three years of 50% CIT reduction.

Costs of exiting China – How to shut down a WFOE?

However attractive the stimulus measures might be, if the costs outweigh the benefit one could potentially receive, Japanese enterprises might still have hesitation to exit China. Currently, there are a number of ways to shut down a wholly foreign-invested enterprise (or commonly called “WFOE”) in China, with the most common being a formal dissolution.  After paying up all the salaries and social insurances, taxes and debts, the WFOE must submit dissolution applications with various Chinese authorities one by one (including Commerce Bureau, Industrial and Commercial Administration Bureau, Statistic Bureau, Finance Bureau, Tax Bureau, State Administration of Foreign Exchange, etc.).  The entire process, though complicated and time-consuming (often take around one year), remains the prudent way for management and shareholders as non-compliance by simply walking away and abandoning the WFOE may result in severe repercussions (including penalty, criminal and personal liability and failure to establish a new business in China again).  The likely costs involved shall include administrative and other dissolution expenses, publication of notice and tax clearance prior to dissolution.  Investors should therefore be mindful and seek independent advice for the best course of action before terminating their operation in China.

Whether to Keep Hong Kong Regional Head Office

Historically, Hong Kong is preferred over Singapore as a better option for Japanese enterprises to expand their business, likely because of the vibrant capital market, the more volatile stock market, an independent judiciary and a simple and competitive tax system.  More importantly, Hong Kong’s strategic location in the post-CEPA regime allows Japanese investors to have access to the opportunities in Mainland market. 

As alternative to the manufacturing bases in China, Japanese enterprises have found vigour by establishing more than 10,000 bases (2019) in other Southeast Asian countries, such as Thailand (3,925 bases, representing 5.2%), Indonesia (1,911, 2.5%), Vietnam (1,816, 2.4%), the Philippines (1,502, 2.0%) and Malaysia (1,295, 1.7%).  Despite the similarity between the tax system in Hong Kong and Singapore, in determining whether Hong Kong or Singapore is more appropriate to set up their regional head office, enterprises should also consider the following factors:-

  1. The relevant Double Taxation Agreements (“DTAs”) that HK and Singapore have each signed with these ASEAN countries —  While business profits are not generally at issue because they are taxed in the country where they are derived (and not in Hong Kong or Singapore on the basis of territorial source concept), attention should be paid to the reduction of withholding tax levied on incomes (e.g., dividends, interest and royalty) to be received by the Hong Kong or Singaporean head office.  The relevant applicable withholding tax rates under the DTAs with the eight ASEAN countries are summarised in the table below.

Financing Needs and Future Investors’ Pitching — Hong Kong remains the market leader in equity and debt capital raisings in Asia possessing US$2.4 trillion worth of bank assets (triple of its keen competitor Singapore).  With strong physical and technological infrastructure, Hong Kong has edge over Singapore to meet corporate financing needs with a domestic market capitalisation of US$4 trillion (as compared to US$0.8 trillion in Singapore) and its corporate bond issuance stands at US$33 million (more than double of Singapore).  Coupled with Hong Kong’s proximity to their underlying businesses in Japan, better access to strong equity and debt capital raising markets in Hong Kong will continue to attract Japanese corporations seeking a stronger presence or expansion in the region.

  1. While two cities appear to be on par in terms of various tax incentives, regard must be made to other non-tax factors, e.g. availability of talent pool, corporate structure, etc.

If you have any question regarding the topic discussed above, please contact our partner Ms. Anna Chan at anna.chan@oln-law.com for further assistance.

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.

Constructive dismissal in a nutshell in the time of COVID-19 pandemic

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Prelude
With the worldwide economy being hit hard with the COVID-19 pandemic, employers, irrespective of the scale of the business, have been forced to reduce costs to survive this economic ice age. With the diminished demand for labour force due to the stagnant economy, it is always tempting for employers to start cutting costs by downsizing the labour force or making alternative working arrangements with their employees (including requesting the employees to take no pay leave or to have a pay cut). Employers should, however, beware of constructive dismissal in the course of implementing such downsizing plan or alternative working arrangements; otherwise the additional costs incurred thereof might outweigh the costs saved by these costs-cutting measures. 

Constructive dismissal – General legal position
Subject to the factual matrix of each particular case, common circumstances which give rise to a claim for constructive dismissal include but not limited to unilateral variation of the contract of employment (for example, reduction in wages or substantial reduction in working hours), failure to pay wages, failure to provide reasonable amount of work, failure to pay statutory entitlements and discriminatory conduct at workplace etc.
In the event of constructive dismissal, an employee may terminate his employment contract without notice or payment in lieu of notice. In such case, although the employee is the party who terminates the employment contract, such dismissal is referred to as a “constructive dismissal” because the laws construe the employee’s termination of employment as a de facto dismissal by his employer. That being said, such finding might be rebutted by acts of the employee pointing to the otherwise.

Unilateral variation of the terms of employment
The relevant general legal position in Hong Kong is that an employer may not unilaterally vary the terms of employment (including imposing a substantial reduction in working hours (thus a reduction in pay) and requesting its employees to take on no pay leave), unless the relevant employment contract contains an express provision allowing the employer to do so. In the absence of any express provision to that effect, any unilateral variation of the terms of employment can therefore amount to constructive dismissal. This allows the employee to terminate their employment contracts without the need to give notice or payment in lieu of notice to the employer, and to bring common law claims for damages against the employer for any loss suffered by them as a result of the constructive dismissal. Damages which can be recovered by the employees might include:- (a) the amount which the employees would have earned has their employment been terminated with proper notice (including any outstanding wages, payment in lieu of notice, end of year payment, annual leave pay, holiday pay, bonus payment and other benefits and other payments due under the employment contract); (b) damages for breach of implied term of trust and confidence which the Court may assess the same by considering the potential loss of salary and contractual benefits on the employees’ part caused by the constructive dismissal; and (c) the legal costs of the claims.

In addition, section 32A(1)(b) of the Employment Ordinance (Cap. 57 of the laws of Hong Kong) (“EO”) confers upon an employee who has been employed under a continuous contract the right to claim remedies for “unreasonable dismissal” in the circumstances where his employer unilaterally varies the terms of his employment contract by the reason that his employer intends to extinguish or reduce any statutory right or benefit conferred upon such employee by the EO. 

Section 32A(3) of the EO further presumes that “the variation of the terms of the contract of employment by the employer as referred to in that subsection [i.e. section 32A(1)(b) of the EO] shall, unless a valid reason is shown for that variation within the meaning of section 32K, be taken to be a variation of the terms of the contract of employment by the employer by reason that the employer intends to extinguish or reduce any right, benefit or protection conferred or to be conferred upon the employee by this Ordinance [i.e. the EO]”.

Given that section 32K(c) of the EO specifically sets out that a dismissal, or the variation of an  employment contract, may be regarded as valid in the circumstances where the same is resulting from the redundancy of the employee or other genuine operational requirements of the business of the employer, it is therefore arguable that the COVID-19 pandemic triggers the application of section 32K and protects the employer from the statutory claim of “unreasonable dismissal”.

Notwithstanding the foregoing, the provisions under section 32K of the EO may only protect employers from the statutory claim of “unreasonable dismissal”. The general legal position remains that employers may not unilaterally vary the terms of employment on their employees in Hong Kong, unless the relevant employment contracts contain an express provision to allow the employers to do so. 

Requesting for voluntary resignation by the employees
It is commonly seen that an employer would ask an employee to resign “voluntarily” for face saving or in return for a favourable reference letter; otherwise the employment would still be terminated by the employer by way of dismissal.

 If an employer gives notice to an employee requiring him to resign, or giving him the option to resign or be dismissed, and subsequently the employee tenders his resignation, the Court is likely to characterize such termination as constructive dismissal rather than a resignation. That being said, the situation could be quite different in circumstances where an employer wishes to give an employee the genuine option of being able to resign rather than being dismissed by way of summary dismissal. 

Discriminatory conduct at workplace
Under the anti-discrimination laws in Hong Kong, an employer is prohibited from treating an employee less favourably in relation to employment on the grounds of an employee’s sex, disability, family status, or race. An employee may treat himself as constructively dismissed if he is subjected to discrimination or victimization conduct by his employer under the Sex Discrimination Ordinance (Cap. 480 of the laws of Hong Kong), the Disability Discrimination Ordinance (Cap. 487 of the laws of Hong Kong), the Race Discrimination Ordinance (Cap. 602 of the laws of Hong Kong), or the Family Status Discrimination Ordinance (Cap. 527 of the laws of Hong Kong), if it can be shown that the conduct complained about is initiated, encouraged or tolerated by the employer.

It is not unusual for an employer to consider (subject to the employee’s consent, if the circumstances may require):- (a) requesting some or all employees to take no pay leave; (b) requesting some or all employees to lower their working hours thus the salary on a pro-rata basis; or (c) implementing lay-off, in order to manage its costs in the time of COVID-19 pandemic. However, when implementing any of these costs-cutting measures, an employer is prohibited from selecting the employees pertaining on the employees’ sex, disability, family status, or race; otherwise, that could amount to constructive dismissal. 

How can OLN helps?
As can be seen, the downsizing of labour force by an employer in the time of the COVID-19 pandemic could easily give rise to constructive dismissal. We have practical experience in helping an employer with the implementation of temporary employment measures during the time of the COVID-19 pandemic and the review relevant documentation to ensure the same complies with the employment law regime in Hong Kong and to protect the employer from any potential claims. 

On the other hand, we also assist, from time to time, an employee on the review of the employment measures implemented by employers and advise the employee to take appropriate legal actions against the employer if any of the employment measures are in contravention of the employment laws.

If you have any question regarding the topic discussed or other employment issues, please contact our senior associate Mr. Victor Ng at victor.ng@oln-law.com or our associate Ms. Barbara Kwong at barbara.kwong@oln-law.com for further assistance.

Shall you be interested to download this article as a brochure, please click on the following link: Constructive dismissal in a nutshell in the time of COVID-19 pandemic


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.

假期通信- 知识产权团队

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假期通信

由于公众假期，我们的中国和香港办事处将在以下日期关闭。请注意，2020年4月26日星期日和2020年5月9日星期六在中国是工作日。在这两天内，有关中国商标事项的截止日期不能推迟。

办事处办事处关闭恢复工作日期特別工作天
由至
中国辦事處2020年5月1日2020年5月5日2020年5月6日星期日, 2020年4月26日星期六, 2020年5月9日
香港办事处2020年4月30日2020年5月3日2020年5月4日N/A

合约受挫失效原则：冠状病毒大流行（Covid-19）是否为商业租户不支付租金提供了法律依据？

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作者：陈韵祺, 谢升余及何乐为

与世界其他地区一样，香港正竭力应对冠状病毒在不同方面造成的影响。冠状病毒大流行不仅夺走了无数生命，而且大肆破坏了经济。您是否租用了你以为就能负担得起的房屋，直至冠状病毒改变一切之前？您是否打算以冠状病毒为由而退出已经签署了的租赁协议？在本文中，我们将列出一些常见问题并为您提供答案，以便您可以了解公共卫生突发事件（例如冠状病毒）可能对房东和房客的权利和义务产生什么影响。

问题1：是否有人曾因病毒爆发而提起诉讼以终止租赁协议/摆脱租赁义务 ↓

问题2：Li Chun Wing的判决是否使未来的租户不再因Covid-19大流行而依赖合约受挫失效原则？↓

问题3：那么，租户如何才能立即终止租约并要求退还预付了的租金/押金？↓

问题4：鉴于上述情况，房东应采取什么行动？↓

问题5：如果我打算签订新的租赁协议，应该注意什么？↓

问题1：是否有人曾因病毒爆发而提起诉讼以终止租赁协议/摆脱租赁义务？

回答:

是的，但是相关案例是关于家庭租赁的情况。

2003年，香港因严重急性呼吸系统综合症（SARS）爆发而遭受重创。该综合症在全球感染了8,096人，造成744人死亡。香港的私人住宅淘大花园E座不幸有共107人被感染。鉴于形势严峻，政府对该处施加了10天的隔离令，强行撤离其中的所有居民。随后，科学研究发现污水处理系统中的U型渠干涸，导致病毒从建筑污水处理系统传播回公寓。

不幸的淘大花园E座租户面临两难困境：在这种情况下，他们是否有法律根据终止租约？还是应该在隔离令期满后继续留在这个对许多人来说并不安全的场所？

該問題在香港區域法院Li Chun Wing v Xuan Yi Xiong [2004] 1 HKLRD 754一案中得到了法庭的指引。在此案中，E座的租戶（“ T”）在隔離令失效後終止了他的兩年租約，而房東（“ L”）針對T向法庭申請簡易判決，對T索取應計租金和因據稱拒絕租賃協議而造成的損失。因此，在該案中法院要考慮的是，T是否有權終止租賃協議。

T主要依賴的法律原則是合約受挫失效。這個原則所指的是，當發生重大事件（沒有任何一方違約且合同未提供清楚足夠的條款）時，從而大大改變了當事方可以合理考慮的未履行的合同權利和/或義務在執行時，法庭可以決定各方毋須進一步執行合同。但是，該重大而突發的事件不僅必須增加簽約方的負擔，而且必須要如此重要以至於要完全從合同中解除當事人，否則會造成不公平的情況。在考慮合約受挫失效的論點時，區域法院指出，此案的10天隔離令就房舍的整體使用而言是微不足道的，因為有關租賃協議的期限為2年。因此，法院駁回了關於合約受挫失效的論點，並裁定租賃令不受隔離令的影響。

T的另一种论点是，租赁协议中应该有一个隐含的约定使该场所适合租客居住。法院同样驳回了这个论点，因为法院通常不会在租赁协议中加入这种隐含的约定，而且无论如何，在该案件中并没有证据表明在隔离令期满后该栋大厦仍然是不安全的。

问题2：Li Chun Wing的判决是否使未来的租户不再因Covid-19大流行而依赖合约受挫失效原则

回答：不一定。法院在Li Chun Wing的判词中强调：导致承租人对房屋的预期使用中断的事件不会使租赁受挫失效，除非该中断预计会持续至租赁的完结，或至少会持续在未到期的期限内很长一段时间。这就是说，流行病的持续时间，或更确切地说，与租期相比流行病的相对持续时间，是决定租约是否受挫的重要因素。正如传染病专家指出的那样，Covid-19可能不会迅速消失，我们可能不得不与之展开长期战争。这可能与SARS疫情形成鲜明对比。 SARS疫情最初对香港造成了沉重打击，但在数周内迅速得到缓解。因此，对于租期短的租户来说，他们可能更容易依赖合约受挫失效原则。但是，这并不意味着长租约永远都不能同样地依赖挫败原则，因为Li Chun Wing只是区域法院的裁决。另一方面，在最近的英国高等法院Canary Wharf (BP4) T1 Limited & ors v European Medicines Agency [2019] EWHC 335 (Ch)一案中，有人提出这不仅仅是租约时长的问题，而取而代之的是，法院应通过综合考虑所有情况来决定合同的“共同目标”是否受到挫败。这将要求我们超越租赁本身并考虑以下的因素：- 租约签署时的背景或上下文- 租约订立时双方(特别是关于风险)的知识，期望，假设和考虑- 重大事件的性质；和- 各方对在新情况下对能否履行合同未来表现的可能性进行的合理和客观推测 问题3：那么，租户如何才能立即终止租约并要求退还预付了的租金/押金？回答：除非合同另有规定，否则房东和租户通常无权在合同规定的期限届满之前随时终止租约。在大多数情况下，即使使了用不可抗力条款，它们也仅允许暂停租金或减租，而不允许终止租赁。但是，除了上述可能引起合约挫败失效的情况外，在某些情况下，如果发生了毁约性违约，则非违约方有权终止租赁。通常，只有在违反合同的程度足以使非违约方被剥夺合同“实质上所有利益”的情况下，才产生毁约性违约。如果房东单方面决定关闭租赁地点，除非双方另有同意，房东有可能会违反了默示的隐含的安静享受条款。但是，在政府强制关闭的情况下，会比较难将错误归咎于房东并声称房东违反了租约。租户预付的租金或预付款（例如两个月的租金）而言，首先，必须转向实际的租赁协议，并检查双方方是否就如何处理定金达成协议。如果合同在此问题上不清楚或沉默，则需要对租赁协议和情况进行逐案分析。在简单直接的情况下，即房东违反了租赁协议以致引起毁约性违约，则租户几乎可以确定终止租赁并要求退还押金。相反，如果承租人是违约方，则房东可能会将押金用于支付因承租人违约造成的损失。但是，如上所述，很多时候承租人可能不能够客易地确定他/她是否有权以其他理由（例如沮丧）撤销合同或终止合同（请参阅上文问题2的答案）。这是房客必须格外谨慎的地方，因为如果后来裁定该违规行为不是毁约性的违规行为，则他们可能有责任向房东赔偿未付的租金，间接损失和法律费用。 问题4：鉴于上述情况，房东应采取什么行动？回答：对于房东，在开始任何法律收取租金之前，请务必考虑您收取租金的权利是否受到Covid-19的影响。如下所述，您的租赁协议中可能包含合同条款（例如不可抗力条款和“重大不利变化”条款），这些条款已经考虑到了流行病/大流行的情况，并使当事方在特定情况下不必履行合同。当然，答案将在很大程度上取决于当事方的意图和其他环境因素。 问题5：如果我打算签订新的租赁协议，应该注意什么？回答：除了明确的合同终止条款外，各方还必须注意不可抗力条款和“重大不利变化”（MAC）条款。有关不可抗力条款的讨论，请参阅我们的高级合伙人Gordon Oldham撰写的文章：https://oln-law.com/are-you-frustrated-by-your-force-majeure-clause。缔约方可考虑提供明确明确的不可抗力条款，以包括流行病/大流行事件。此外，合同中通常会包含MAC条款，其中明确规定，某些重大改变一方当事人的业务、营运、资产、负债、状况（例如财务状况）的事件可能会产生终止协议的权利。同样，与不可抗力条款一样，如果各方希望依靠MAC条款，该条款必须明确地包括流行/大流行事件。如果以一般方式起草MAC条款，则法院倾向于狭义地解释该条款并将Covid-19排除为MAC事件。在确定是否触发MAC子句时，还必须针对以下情况进行案例分析：- 双方的意图- 双方对处理Covid-19情况的讨论；- 该方业务的市场可比性；和- 将该方的业务绩效与可比市场的绩效进行比较。 结语随着Covid-19形势的不确定性发展，我们认为可能会出现一些案例，测试合约受挫失效原则是否可以将租户从租约中解雇，以及在什么情况下会发生这种情况。在有明确的指导方针之前，我们建议房东和租户都留意情况并审查关键的租赁协议条款，以评估Covid-19对他们造成的具体影响。与大多数其他争端类似，最好的解决办法是始终考虑各种商业现实和实用性来尝试友好的谈判和讨论。如果租户发现不可避免地要放弃租金，我们建议他/她与房东进行讨论，并尝试在采取任何法律行动之前理清租金减免是否可行。 如果您希望获得法律意见以评估您的当前状况，请随时与我们联系（anna.chan@oln-law.com或martin.tse@oln-law.com），我们很乐意为您提供解答和帮助。免责声明：本文仅供参考。本文中的任何内容均不得解释为对任何人的香港法律意见或任何与此有关的法律意见。高李严律师楼对因本条所载材料所造成的任何行为所造成的任何损失和/或损害不承担任何责任。

Revised Departmental Interpretation and Practice Notes on E-commerce and Digital Assets – Part 2

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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.

Hong Kong’s Tax Treatment on the Emerging E-commerce Business and Digital Assets – Part 1

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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):-

Illustration 1:If a person, resident in Hong Kong, performs all the core operations and support activities of an e-commerce business in Hong Kong apart from operating a server, intelligent or otherwise, which is at the person’s disposal and located outside Hong Kong for e-commerce purposes, the profits from the person’s e-commerce transactions will be fully charged to profits tax as profits derived from Hong Kong.
  
Illustration 2:If a person, resident in a territory which has concluded a double tax agreement with Hong Kong, performs most of the operations and support activities of an e-commerce business outside Hong Kong apart from operating merely a server with essential and significant activities which is at the person’s disposal and located in Hong Kong (i.e. the server constitutes a permanent establishment in Hong Kong), profits attributable to the server permanent establishment having regard to the functions the server performs in Hong Kong will be charged to profits tax in accordance with the general principles in section 14.

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.