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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- 知識產權團隊

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 假期通信

由於公眾假期，我們的中國和香港辦事處將在以下日期關閉。請注意，2020年4月26日星期日和2020年5月9日星期六在中國是工作日。在這兩天內，有關中國商標事項的截止日期不能推遲。

辦事處辦事處關閉恢復工作日期特別工作天
由至
中國辦事處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
香港辦事處2020年4月30日2020年5月3日2020年5月4日N/A

高李严律师事务所知识产权团队祝劳动节快乐！

合約受挫失效原則：冠狀病毒大流行（Covid-19）是否為商業租戶不支付租金提供了法律依據？

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作者：陳韻祺, 謝昇餘及何樂為

與世界其他地區一樣，香港正竭力應對冠狀病毒在不同方面造成的影響。冠狀病毒大流行不僅奪走了無數生命，而且大肆破壞了經濟。您是否租用了你以為就能負擔得起的房屋，直至冠狀病毒改變一切之前？您是否打算以冠狀病毒為由而退出已經簽署了的租賃協議？在本文中，我們將列出一些常見問題並為您提供答案，以便您可以了解公共衛生突發事件（例如冠狀病毒）可能對房東和房客的權利和義務產生什麼影響。

問題1：是否有人曾因病毒爆發而提起訴訟以終止租賃協議/擺脫租賃義務？↓

問題2：Li Chun Wing的判決是否使未來的租戶不再因Covid-19大流行而依賴合約受挫失效原則？↓

問題3：那麼，租戶如何才能立即終止租約並要求退還預付了的租金/押金？↓

問題4：鑑於上述情況，房東應採取什麼行動？↓

問題5：如果我打算簽訂新的租賃協議，應該注意什麼？↓

問題1：是否有人曾因病毒爆發而提起訴訟以終止租賃協議/擺脫租賃義務？

回答:

是的，但是相關案例是關於家庭租賃的情況。

2003年，香港因嚴重急性呼吸系統綜合症（SARS）爆發而遭受重創。該綜合症在全球感染了8,096人，造成744人死亡。香港的私人住宅淘大花園E座不幸有共107人被感染。鑑於形勢嚴峻，政府對該處施加了10天的隔離令，強行撤離其中的所有居民。隨後，科學研究發現污水處理系統中的U型渠乾涸，導致病毒從建築污水處理系統傳播回公寓。

不幸的淘大花園E座租戶面臨兩難困境：在這種情況下，他們是否有法律根據終止租約？還是應該在隔離令期滿後繼續留在這個對許多人來說並不安全的場所？

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的另一種論點是，租賃協議中應該有一個隱含的約定使該場所適合租客居住。法院同樣駁回了這個論點，因為法院通常不會在租賃協議中加入這種隱含的約定，而且無論如何，在該案件中並沒有證據表明在隔離令期滿後該棟大廈仍然是不安全的。

問題2：Li Chun Wing的判決是否使未來的租戶不再因Covid-19大流行而依賴合約受挫失效原則？

回答：

不一定。

法院在Li Chun Wing的判詞中強調：導致承租人對房屋的預期使用中斷的事件不會使租賃受挫失效，除非該中斷預計會持續至租賃的完結，或至少會持續在未到期的期限內很長一段時間。

這就是說，流行病的持續時間，或更確切地說，與租期相比流行病的相對持續時間，是決定租約是否受挫的重要因素。正如傳染病專家指出的那樣，Covid-19可能不會迅速消失，我們可能不得不與之展開長期戰爭。這可能與SARS疫情形成鮮明對比。SARS疫情最初對香港造成了沉重打擊，但在數週內迅速得到緩解。

因此，對於租期短的租戶來說，他們可能更容易依賴合約受挫失效原則。但是，這並不意味著長租約永遠都不能同樣地依賴挫敗原則，因為Li Chun Wing只是區域法院的裁決。另一方面，在最近的英國高等法院Canary Wharf (BP4) T1 Limited & ors v European Medicines Agency [2019] EWHC 335 (Ch)一案中，有人提出這不僅僅是租約時長的問題，而取而代之的是，法院應通過綜合考慮所有情況來決定合同的“共同目標”是否受到挫敗。這將要求我們超越租賃本身並考慮以下的因素：

– 租約簽署時的背景或上下文

– 租約訂立時雙方(特別是關於風險)的知識，期望，假設和考慮

– 重大事件的性質；和

– 各方對在新情況下對能否履行合同未來表現的可能性進行的合理和客觀推測

問題3：那麼，租戶如何才能立即終止租約並要求退還預付了的租金/押金？

回答：

除非合同另有規定，否則房東和租戶通常無權在合同規定的期限屆滿之前隨時終止租約。在大多數情況下，即使使了用不可抗力條款，它們也僅允許暫停租金或減租，而不允許終止租賃。但是，除了上述可能引起合約挫敗失效的情況外，在某些情況下，如果發生了毀約性違約，則非違約方有權終止租賃。

通常，只有在違反合同的程度足以使非違約方被剝奪合同“實質上所有利益”的情況下，才產生毀約性違約。如果房東單方面決定關閉租賃地點，除非雙方另有同意，房東有可能會違反了默示的隱含的安靜享受條款。但是，在政府強制關閉的情況下，會比較難將錯誤歸咎於房東並聲稱房東違反了租約。

就租戶預付的租金或預付款（例如兩個月的租金）而言，首先，必須轉向實際的租賃協議，並檢查雙方方是否就如何處理定金達成協議。如果合同在此問題上不清楚或沉默，則需要對租賃協議和情況進行逐案分析。在簡單直接的情況下，即房東違反了租賃協議以致引起毀約性違約，則租戶幾乎可以確定終止租賃並要求退還押金。相反，如果承租人是違約方，則房東可能會將押金用於支付因承租人違約造成的損失。

但是，如上所述，很多時候承租人可能不能夠客易地確定他/她是否有權以其他理由（例如沮喪）撤銷合同或終止合同（請參閱上文問題2的答案）。這是房客必須格外謹慎的地方，因為如果後來裁定該違規行為不是毀約性的違規行為，則他們可能有責任向房東賠償未付的租金，間接損失和法律費用。

問題4：鑑於上述情況，房東應採取什麼行動？

回答：

對於房東，在開始任何法律收取租金之前，請務必考慮您收取租金的權利是否受到Covid-19的影響。如下所述，您的租賃協議中可能包含合同條款（例如不可抗力條款和“重大不利變化”條款），這些條款已經考慮到了流行病/大流行的情況，並使當事方在特定情況下不必履行合同。當然，答案將在很大程度上取決於當事方的意圖和其他環境因素。

問題5：如果我打算簽訂新的租賃協議，應該注意什麼？

回答：

除了明確的合同終止條款外，各方還必須注意不可抗力條款和“重大不利變化”（MAC）條款。

有關不可抗力條款的討論，請參閱我們的高級合夥人Gordon Oldham撰寫的文章：https://oln-law.com/are-you-frustrated-by-your-force-majeure-clause。締約方可考慮提供明確明確的不可抗力條款，以包括流行病/大流行事件。

此外，合同中通常會包含MAC條款，其中明確規定，某些重大改變一方當事人的業務、營運、資產、負債、狀況（例如財務狀況）的事件可能會產生終止協議的權利。同樣，與不可抗力條款一樣，如果各方希望依靠MAC條款，該條款必須明確地包括流行/大流行事件。如果以一般方式起草MAC條款，則法院傾向於狹義地解釋該條款並將Covid-19排除為MAC事件。在確定是否觸發MAC子句時，還必須針對以下情況進行案例分析：

– 雙方的意圖

– 雙方對處理Covid-19情況的討論；

– 該方業務的市場可比性；和

– 將該方的業務績效與可比市場的績效進行比較。

結語

隨著Covid-19形勢的不確定性發展，我們認為可能會出現一些案例，測試合約受挫失效原則是否可以將租戶從租約中解僱，以及在什麼情況下會發生這種情況。在有明確的指導方針之前，我們建議房東和租戶都留意情況並審查關鍵的租賃協議條款，以評估Covid-19對他們造成的具體影響。與大多數其他爭端類似，最好的解決辦法是始終考慮各種商業現實和實用性來嘗試友好的談判和討論。如果租戶發現不可避免地要放棄租金，我們建議他/她與房東進行討論，並嘗試在採取任何法律行動之前理清租金減免是否可行。

如果您希望獲得法律意見以評估您的當前狀況，請隨時與我們聯繫（anna.chan@oln-law.com或martin.tse@oln-law.com），我們很樂意為您提供解答和幫助。

免責聲明：本文僅供參考。本文中的任何內容均不得解釋為對任何人的香港法律意見或任何與此有關的法律意見。高李嚴律師樓對因本條所載材料所造成的任何行為所造成的任何損失和/或損害不承擔任何責任。

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.