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A comparative study of the taxation of business profits
especially online profits

in Australia and the Hong Kong Special Administrative Region
of the Peoples Republic of China

WONG, Antonietta Pui-Kwok
A thesis submitted in total fulfilment of the requirements of the
degree of Doctor of Philosophy

2008
Department of Business Law and Taxation
Faculty of Business and Economics
Monash University

i
TABLE OF CONTENTS

ABSTRACT v
DECLARATION viii
LIST OF ABBREVIATIONS AND ACRONYMS ix
ACKNOWLEDGMENTS xvi
CHAPTER 1: INTRODUCTION 1
1.1 Introduction income and the source principle of taxation 1
1.2 The source of income 5
1.3 Purpose and aims of the thesis 6
1.4 Research questions and research method 8
1.5 What this thesis adds to taxation learning 10
1.6 Outline of thesis chapters 11
CHAPTER 2: THE SOURCE OF INCOME AND AREAS OF CONCERN 15
2.1 Introduction 15
2.2 Meaning of source of income 15
2.3 Literature review and findings 16
2.4 The significance of the concept of source of income (with particular reference to
Australia and Hong Kong) 21
2.5 Conclusion 33
2.6 Source-based taxation areas of concern 35
2.6.1 Tax havens and offshore financial centres 36
2.6.2 Nexus or link to a jurisdiction 38
2.6.3 Permanent establishment 40
2.7 Taxation of business profits alternative approaches 44
CHAPTER 3: THEORETICAL OVERVIEW 49
3.1 Introduction 49
3.1.1 Structure of the chapter 50
3.2 Taxation at source 51
3.3 Origin of taxation at source 53
ii
3.4 Application of taxation at source and the schedules 56
3.5 Taxation at source and tax avoidance 58
3.6 Source taxation and withholding 62
3.7 Source taxation and investment decisions 71
3.8 Some issues relating to the concept of source of income 74
3.9 Some further issues relating to the concept of source of income in an integrated global
economy 78
3.10 Conclusion 84
CHAPTER 4: HONG KONG AND AUSTRALIA BACKGROUND 87
4.1 Introduction 87
4.1.1 Purpose and role of chapter 88
4.1.2 Overview 88
4.2 Hong Kong 89
4.2.1 Statutory framework 92
4.2.2 Structure of tax laws 93
4.2.3 Tax system 95
4.2.4 Conclusion 114
4.3 Australia 115
4.3.1 Development of tax laws 116
4.3.2 Structure of tax laws 120
4.3.3 Tax system 123
CHAPTER 5: DETERMINING THE SOURCE OF PROFITS 146
5.1 Introduction 146
5.1.2 Overview 147
5.2 Income from a business 149
5.3 The guiding principles 156
5.3.1 The general source rule 157
5.3.2 The contract conclusion test 160
5.3.3 The operations test 162
5.3.4 The provision of credit test 163
5.4 From what and where do profits arise? 165
5.4.1 Hong Kong 165
5.4.1.1 Source of manufacturing profits 166
5.4.1.2 Source of trading and other profits 168
5.4.1.3 Source of interest income 187
5.4.2 Australia 189
5.4.2.1 Source of manufacturing profits 191
5.4.2.2 Source of trading profits 197
5.4.2.3 Source of interest income 199
iii
5.5 Source of income and tax avoidance 199
5.6 Nature of the current source issues 211
5.7 Conclusion 224
CHAPTER 6: ELECTRONIC COMMERCE 226
6.1.2 Overview 227
6.2 What is the Internet? 230
6.2.1 How does electronic commerce work? 231
6.3 Electronic commerce security and integrity issues 233
6.3.1 Encryption 233
6.3.2 Digital certificate 235
6.3.3 Electronic money 236
6.4 Tax administration and enforcement issues in electronic commerce 238
6.4.1 Location and identity of the taxpayer 239
6.4.2 Nexus in electronic commerce 242
6.4.3 Migration of business to a web site 244
6.5 Taxation of business profits derived from electronic commerce 247
6.5.1 Characterisation of income 247
6.5.2 Source of online profits 250
6.5.3 Source of services income 252
6.6 Application of source rules to electronic commerce transactions 255
6.7 Conclusion 261
CHAPTER 7: POSSIBLE SOLUTIONS 264
7.1.1 Overview 265
7.2 The Pinto Proposal 267
7.2.1 The refundable withholding model 270
7.2.2 Main characteristics of the Pinto Proposal 274
7.2.3 Practical implications of the Pinto Proposal 289
7.2.4 Pintos comments on the possible criticisms of his proposal 295
7.3 Residence-based taxation 306
7.3.1 Introduction 306
7.3.2 Residency rules 309
7.3.2.1 Place of incorporation test 311
7.3.2.2 Central management and control test 312
7.3.2.3 Voting power control test 316
7.3.3 Dual or multiple residence 319
7.3.4 Practical difficulties in applying the corporate residency rules 323
iv
7.4 General consumption taxes 343
7.4.1 What is a VAT/GST? 344
7.4.2 Is GST suitable for electronic commerce? 347
7.4.3 GST the enforcement challenges 350
7.4.4 A general consumption tax for Hong Kong? 358
7.4.5 Consumption vs income taxation 366
CHAPTER 8: SUMMARY AND CONCLUSION 374
8.1.1 Research questions 374
8.1.2 Overview 376
8.2 Summary of thesis 377
8.3 The source challenge 381
8.4 Addressing the source challenge general observations 388
8.5 Addressing the source challenge specific observations: Australia and Hong Kong 396
8.6 Conclusion 401
8.6.1 The preferred solution 401
8.6.2 Future outlook and further research questions 405
8.6.3 Tackling the taxation of electronic commerce profits today and tomorrow 414
Appendix A Ongoing Research Agenda 422
BIBLIOGRAPHY 426
APPENDIX ONE INCOME OVERVIEW 468
Source of income 468
Class of income 469
Category of income 470
A note on Australian income tax 471

v
ABSTRACT

There are two main principles under which jurisdictions tax income source and
residence. The point of these two principles is to establish a nexus or link between a
taxable transaction, operation or activity and a taxing state. It is this nexus which is
used to justify the imposition of taxation by the jurisdiction on a particular taxpayer.
Where a taxpayer is a resident of a jurisdiction, then that person often becomes
liable to pay tax on income derived from all sources. Where a taxpayer is a non-
resident of a jurisdiction, then that person often becomes liable to pay tax on income
derived from sources within a particular, relevant jurisdiction.

The concept of source of income is fundamentally important to both Australia and
Hong Kong. Australia adopts a worldwide tax system that taxes its residents on
Australian and foreign income and non-residents on Australian income, whilst Hong
Kong adopts a territorial tax system that forgoes taxing foreign income irrespective of
who has derived it. The fundamental basis for taxation under a territorial tax system
is the source of income; while the fundamental basis for taxation under a worldwide
tax system is the concept of residence. In both jurisdictions, the decisions of the
courts on the meaning of source have been crucial in defining the concept of source
of income for tax purposes.

The foundations of source-based taxation are less stable today. There is no universal
set of source rules that can readily be applied to every circumstance to determine the
source or locality of profits. The growth in international trade, supported by the
vi
development of electronic commerce, has substantially increased source-related
revenue risks. Entities are increasingly able to structure their finances and conduct
their affairs without being constrained by geography or national boundaries.
Anticipated profits may be shifted to a related party and from one jurisdiction to
another to arrive at a reduced overall tax burden. It is becoming increasingly difficult
to determine from what and where income originates.

The thesis examines the nature of the current source rules in Australia and Hong Kong
and analyses the fundamental adequacy of the source principle generally when
confronted, especially, with the challenge of rapidly growing Internet-based
commercial activities. Australia and Hong Kong have been chosen for comparative
study for the following reasons:
the two jurisdictions are good examples of small-medium advanced economies;
they are similar in the sense that they are, primarily, knowledge capital-importing
jurisdictions;
their approaches to source differ markedly; and
these approaches tend towards each end of the source spectrum.

The thesis identifies certain principal research questions. The basic responses to these
questions are:
The concept of source of income is, essentially, less clear today in the domestic
tax law of Australia and Hong Kong than before. Determining the source of
income in Australia and Hong Kong can be a very complex issue. The difficulty
related to making such determinations is growing.
vii
Searching for the real source of income has become still more problematic with
the increase in globalisation and the rapid growth of Internet-based commerce.
The traditional concept of source of income has lost traction as a fundamental
basis for effectively imposing income taxation, especially, in todays globalised
economy.
Existing source rules do not deal adequately with certain revenue-leakage issues
confronting us today and, even more, the likely issues of tomorrow.
We need to reconsider how we can better address these issues. The thesis
establishes that this is so for Australia and Hong Kong. It also reasons that this
proposition generally holds true for most developed tax jurisdictions.

The thesis concludes with a detailed review of three of the most prominent optional
approaches for addressing the source challenge: (A) a move to a new refundable
withholding-tax-based method of taxing cross-border electronic commerce; (B) a shift
to far greater reliance on the use of the residence principle of taxation; and (C) a shift
to notably greater reliance on (indirect) consumption taxation. Option C, it is argued,
offers the best prospects for dealing in the least bad way with the identified issues.

viii
DECLARATION

This thesis contains no material that has been accepted for the award of any other
degree or diploma in any university or other institution. To the best of my knowledge,
the thesis contains no material previously published or written by any other person,
except where due reference is made in the text of the thesis, and a list of references is
given in the bibliography.

Signed:

ix
LIST OF ABBREVIATIONS AND ACRONYMS

The following abbreviations and acronyms are used throughout the thesis. When the
term first appears in the text and footnote in each chapter, both the
abbreviation/acronym and the definition are given. Thereafter, only the
abbreviation/acronym is used in the chapter.

A$ Australian dollar

ABLR Australian Business Law Review

ABN Australian Business Number

AC Law Reports, Court of Appeal

ACS Australian Customs Service

AFC Asian Financial Crisis

Agreements Act

International Tax Agreements Act 1953 (Cth)

AIR All India Reporter

AITR The Australian and New Zealand Income Tax Reports

All ER All England Law Reports

ALR Australian Law Reports

ANTS A New Tax System

APTIRC Asian-Pacific Tax and Investment Research Centre

ATC Australian Tax Cases

ATD Australian Tax Decisions

ATM automated teller machine

ATO Australian Taxation Office

ATO ID ATO Interpretative Decision

ATR Australian Tax Reports

AUSTRAC Australian Transaction Reports and Analysis Centre

x
Australia-China
DTT
Agreement Between the Government of Australia and the
Government of the Peoples Republic of China for the Avoidance
of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 28 December
1990)

Australia-UK
DTT
Convention Between the Government of Australia and the
Government of the United Kingdom of Great Britain and
Northern Ireland for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to Taxes on Income
and on Capital Gains (entered into force 17 December 2003)

Australia-US
Protocol
Amending the
DTT
Protocol Amending the Convention Between the Government of
Australia and the Government of the United States of America for
the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income (entered into force
12 May 2003)

B2B business to business

B2C business to consumer

Basic Law Basic Law of the Hong Kong Special Administrative Region of
the Peoples Republic of China

C2C consumer to consumer

CA Certification Authority

CA 2001 Corporations Act 2001 (Cth)

CACV Civil Appeal, Court of Appeal (Hong Kong)

cap chapter of ordinance

CEN capital export neutrality

CFA Court of Final Appeal

CFC controlled foreign company

CFI Court of First Instance

CGT capital gains tax

CIN capital import neutrality

CJ Chief J ustice

CLR Commonwealth Law Reports
xi

CM&C central management and control

CR Class Ruling

Cth Commonwealth

DC digital certificate

DIPN Departmental Interpretation and Practice Note

div division

DTT double tax treaty

e-commerce electronic commerce

ed edition/editor

EFTPOS electronic funds transfer at point of sale

ETP employment termination payment

EU European Union

FACV Civil Appeal, Court of Final Appeal (Hong Kong)

FAR functions, assets and risks

FBT fringe benefits tax

FIF foreign investment fund

FTC foreign tax credit

FTRA 1988 Financial Transaction Reports Act 1988 (Cth)

GST goods and services tax

GST Act 1999 A New Tax System (Goods and Services Tax) Act 1999 (Cth)

HCIA Inland Revenue Appeal, High Court (Hong Kong)

HK$ Hong Kong dollar

HKDNR Hong Kong Domain Name Registration Company Ltd

HKLJ Hong Kong Law J ournal

HKLR Hong Kong Law Reports
xii

HKLRD Hong Kong Law Reports and Digest

HKMA Hong Kong Monetary Authority

HKRC Hong Kong Revenue Cases

HKSAR Hong Kong Special Administrative Region

HKTC Hong Kong Tax Cases

Hong Kong-
Belgium DTT
Agreement Between the Hong Kong Special Administrative
Region of the Peoples Republic of China and the Kingdom of
Belgium for the Avoidance of Double Taxation and the
and on Capital (entered into force 7 October 2004)

Hong Kong-
China Double
Tax Arrangement
Arrangement Between the Mainland of China and the Hong Kong
Special Administrative Region for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with respect to
Taxes on Income (entered into force 8 December 2006)

Second Protocol to Arrangement Between the Mainland of China
and the Hong Kong Special Administrative Region for the
Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income (signed on 30 J anuary
2008)

Hong Kong-
Luxembourg
DTT
Agreement Between the Hong Kong Special Administrative
Region of the Peoples Republic of China and the Grand Duchy
of Luxembourg for the Avoidance of Double Taxation and the
and on Capital (entered into force 1 April 2008)

Hong Kong-
Thailand DTT
Agreement Between the Government of the Hong Kong Special
Administrative Region of the Peoples Republic of China and the
Government of the Kingdom of Thailand for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 7 December 2005)

HWI high-wealth individual

IAP Internet Access Provider

ICT information and communications technology

IP Internet Protocol

IRC Internal Revenue Code (26 USC)

xiii
IRD Inland Revenue Department

IRO 1947 Inland Revenue Ordinance 1947 (Cap 112)

ISP Internet Service Provider

ITAA 1936 Income Tax Assessment Act 1936 (Cth)

ITAA 1997 Income Tax Assessment Act 1997 (Cth)

J ; J J J ustice; J ustices

J HI NV J ames Hardie Industries NV

J HIL J ames Hardie Industries Ltd

J oint Declaration Joint Declaration of the Government of the United Kingdom of
Great Britain and Northern Ireland and the Government of the
Peoples Republic of China on the Question of Hong Kong
(entered into force 27 May 1985)

LC Lord Chief

LJ Lord J ustice

M1 money supply definition 1



MNE multinational enterprise

MRCF Medical Research and Compensation Foundation

MTC Model Tax Convention on Income and on Capital

NANE non-assessable non-exempt

NPJ Non-Permanent J udge of the Court of Final Appeal (Hong Kong)

NSW New South Wales

NSWLR New South Wales Law Reports

NT Northern Territory

OECD Organisation for Economic Co-operation and Development

p; pp page; pages
xiv

para paragraph

PAYE Pay As You Earn

PAYG Pay As You Go

PE permanent establishment

PGBR Product Grants and Benefit Ruling

POP point-of-presence

PPS Prescribed Payments System

PR Product Ruling

PRC Peoples Republic of China

PSI personal services income

pt part

Qld Queensland

RPS Reportable Payments System

s, ss section, sections

SATC South African Tax Cases

sch schedule

SR(NSW) State Reports, New South Wales

STC Simons Tax Cases

TAA 1953 Taxation Administration Act 1953 (Cth)

Tas Tasmania

TC Tax Cases

TCP Transmission Control Protocol

TD Taxation Determination

Tenn App Tennessee Appeals Report

TLIP Tax Law Improvement Project
xv

TR Taxation Ruling

UK United Kingdom

UN United Nations

UN MTC United Nations Model Double Taxation Convention Between
Developed and Developing Countries

URL Uniform Resource Locator

US United States

US$ United States dollar

VAT value added tax

VAT Directive Council Directive No 2006/112/EC of 28 November 2006 on the
Common System of Value Added Tax [2006] OJ L 347 (European
Union)

Vic Victoria

vol volume

VP Vice-President

WA Western Australia

WET wine equalisation tax

WRO 1940 War Revenue Ordinance 1940

WST wholesale sales tax

WTO World Trade Organization

xvi
ACKNOWLEDGMENTS

This thesis could not have been written without the great support of my supervisor,
Professor Richard Cullen. Not only has he encouraged and motivated me throughout
the whole course even during his leave, but also has faith in my ability to accomplish
a research paper on comparative tax law. He and my other supervisors, Professors
Paul von Nessen and Stephen Barkoczy, have provided tremendous insights and
invaluable comments on the thesis. I would like to express my deep gratitude to them
for their advice, guidance, patience and understanding throughout the past five and a
half years.

I would also like to thank Professor Rick Krever for his expert advice and comments
from the development to the successful completion of this research paper.

I am grateful to the Academic Council at the International Bureau of Fiscal
Documentation that provided an opportunity for me to discuss my research topic with
a wide circle of research students and interested researchers.

There are many other people I would like to acknowledge for their support and
encouragement. To Professor Dale Pinto for his best wishes for my research and for
providing me with a copy of his thesis before it was published. To the Library Staff
at Monash University for providing an efficient off-campus service. To Maggie Lai
who is constantly there for me and helps me with the housework while completing the
thesis. To Dr Shu Wang for his care of my family and my health matters. To Alan
Chan who is full of enthusiasm and always available to deliver the drafts to their
destination.

A special note of thanks must go to my sister, Agnes, for doing most of the
housework and looking after our elderly mother to enable the smooth running of the
research project.

I thank them all in making it possible for me to carry out this research as well as to
enjoy such an enlightening experience.

1
CHAPTER 1: INTRODUCTION

1.1 Introduction income and the source principle of taxation

There are two main principles under which jurisdictions tax income residence and
source.
1
The point of these two principles is to establish a nexus or link between a
taxable transaction, operation or activity and a taxing jurisdiction.
2
It is this nexus
which is used to justify the imposition of taxation by the jurisdiction on a particular
taxpayer.
3

1
Some jurisdictions, like the United States (US), impose a different (or additional) test for liability to
taxation such as citizenship.
2
Nexus is a term generally used in the context of a states jurisdiction to tax foreign or non-resident
persons. J urisdiction to tax refers to the extent of a states right to tax and the power of a state to claim
such rights. Tax jurisdiction consists of legislative (legal) jurisdiction and enforcement (practical)
jurisdiction. Legislative (legal) jurisdiction refers to a states competence to legislate. Enforcement
(practical) jurisdiction refers to the actual enforcement of the law. A states tax jurisdiction is limited by
its enforcement ability (the identification of a legal entity on which to impose tax and association with
physical proximity to enforce the tax liability). The concept of (and law relating to) sovereignty
prevents a jurisdiction from pursuing its tax claims in the territory of other jurisdictions, since this
would involve extraterritorial exercise of its powers. See Australian Taxation Office, Tax and the
Internet (1997) vol 1 [7.2.1], [7.2.7]; Martin Dixon, Textbook on International Law (5
th
ed, 2005) 132-4;
Barry Larking (ed), IBFD International Tax Glossary (5
th
ed, 2005) 279; Angharad Miller and Lynne
Oats, Principles of International Taxation (2006) 21 and Asif H Qureshi, The Public International Law
of Taxation: Text, Cases and Materials (1994) 22, 308 on the meaning of the term nexus.
See Part 2.6.2, Chapter 2, for a discussion of nexus or link to a jurisdiction. See, also, Part 6.4.2,
Chapter 6, for a discussion of nexus in electronic commerce.
3
According to the OECD (Organisation for Economic Co-operation and Development), taxes are
compulsory, unrequited payments to general government and are divided into five broad categories:
income and profits taxes;
property taxes;
consumption taxes;
payroll taxes; and
compulsory social security contributions.
See OECD, Consumption Tax Trends: VAT/GST and Excise Rates, Trends and Administration Issues
(2006) 10.
The OECD is an international organisation where the governments of 30 member countries work
together to address the economic, social and governance challenges of globalisation as well as to exploit
its opportunities. All aspects of taxation are examined by the OECD, including international and
domestic tax issues, direct and indirect taxes, and tax policy and administration. See OECD, The
OECD Organisation for Economic Co-operation and Development (2008)
<http://www.oecd.org/dataoecd/15/33/34011915.pdf>at 1 May 2008.
2
Under the residence principle, residents (both individuals and companies) are liable to
be taxed on their worldwide income in the jurisdiction in which they establish their
domicile or residence, regardless of the sources of income.
4
The residence
jurisdictions claim to tax is based on its relationship to the person deriving that
income. Under the source principle, both residents and non-residents are liable to be
taxed on their income having its source within a jurisdiction. The source jurisdictions
claim to tax is based on the transaction, operation or activity which generates the
income by non-residents (and residents) within its territory.

When a company expands its business activities to another jurisdiction by establishing
a physical presence there to manage the local market, the company may become liable
to pay tax on the business profits
5
which arise in or are derived from that host (source)
jurisdiction.
6
Thus, the same income may be taxed twice, once by the source
jurisdiction where the income arose, and again by the jurisdiction where the entity
resides. To avoid such double taxation, countries enter into double tax treaties (DTT)

4
The US is one of the rare examples of a country which levies income tax (subject to concession in
certain cases) on the worldwide income of its citizens regardless of their residence.
5
The term profits is not defined in Australias income tax legislation and Hong Kongs Inland
Revenue Ordinance 1947 (IRO 1947). The OECD states it has a broad meaning and includes all
income derived in carrying on an enterprise. See OECD, Model Tax Convention on Income and on
Capital (condensed version, 2005) 129.
In relation to Australias income tax, s 3(2) of the International Tax Agreements Act 1953 (Cth)
provides that the profits of an activity or business, where the context permits, must be read as a
reference to the taxable income derived from that activity or business. In relation to Hong Kongs
profits tax, s 2 of the IRO 1947 provides that profits arising in or derived from Hong Kong includes all
profits from business transacted in Hong Kong, whether directly or through an agent.
6
An entity may incorporate a subsidiary company offshore. A subsidiary company has a legal identity
of its own, irrespective of whether it is controlled by foreign shareholders. It is treated as a resident and
is subject to tax on its worldwide income (and capital gains). On the other hand, an entity may structure
its business activities as a branch and only profits attributable to it are subject to tax in the source
jurisdiction.
The word attributable means capable of being attributed, that is, owing to, produced by or as a
consequence of. You can attribute a quality to a person or thing, you can attribute a product to a source
or an author, or you can attribute an effect to a cause. The essential element is connection of some kind,
and does not require a sole, dominant or proximate cause and effect. A contributory causal connection
is quite sufficient. See Central Asbestos Co Ltd v Dodd [1972] 2 All ER 1135, 1141, 1149-50; Walsh v
Rother District Council [1978] 1 All ER 510, 514.
3
that limit the rights of one of the contracting states to levy tax in a particular situation.
7

A DTT allocates taxing rights over income between the residence and the source
jurisdiction (that are parties to the DTT) and specifies what forms of income are
subject to tax and who may tax it.
8
The aim is to minimise liability to double taxation
on the same income. The relevant purpose of DTTs is to strengthen the ability of
jurisdictions to impose taxes fairly and effectively on taxpayers engaged in cross-
border trade and investment (and, thus, to facilitate cross-border trade and investment).

In principle, business profits shall be taxable only in the residence jurisdiction.
9

However, profits attributable to a permanent establishment (PE) in the source
jurisdiction may be taxed in the source jurisdiction.
10
To avoid double taxation,
relief is normally allowed by the residence jurisdiction for the tax paid in the source
jurisdiction.
11
In this way, only one level of national income tax will be borne by the
enterprise with respect to the business profits. Determining the source of income is,
therefore, crucial when two or more jurisdictions are entitled to tax the same income:
for non-residents source provides the primary connecting factor to determine
whether the income is taxable by the source jurisdiction; and

7
There are two major standard models used in negotiating double tax treaties (DTT) the OECD
Model Tax Convention on Income and on Capital (OECD MTC) and the United Nations Model
Double Taxation Convention Between Developed and Developing Countries (UN MTC). The OECD
MTC, which generally reflects the residence principle of taxation, was designed for treaties between
developed countries whose investment and trade flows over time tend to be in balance among
themselves. The UN MTC, which generally reflects the source principle of taxation, was designed for
situations where investment and trade flows are not in balance. See Commonwealth, Board of Taxation,
International Taxation: A Report to the Treasurer (2003) vol 1 92; Larking, above n 2, 286.
Discussions in this thesis are based on the OECD MTC, unless otherwise stated.
8
The basis for the allocation of taxing rights varies for different types of income. For example, under a
standard DTT, royalty income is taxed only in the country of the recipient (residence) unless attributed
to a PE (source). Withholding taxes on interest, dividends and royalties are levied by the source
jurisdiction. See Appendix One Income Overview for an explanation of the classes and types of
income that may be taxed in the source jurisdiction.
9
Pursuant to a DTT. See art 7 of the OECD MTC on the taxation of business profits derived by non-
residents through the carrying on of business in the source jurisdiction.
10
See Part 2.6.3, Chapter 2, for a discussion of the concept of permanent establishment (PE).
11
Relief from double taxation is only available under the applicable domestic laws of the residence
jurisdiction for the income tax or withholding tax paid to the source jurisdiction.
4
for residents source determines which part of the foreign income
12
qualifies for
double taxation relief (through the exemption, credit or the deduction method) by
the residence jurisdiction.
13

Most jurisdictions, like Australia, impose income tax based on the dual principles of
residence and source. A few jurisdictions, including Hong Kong, use a territorial tax
system based on source alone.
14
Historically, it has normally been of fundamental
importance to establish the geographic source of income and the tax residence of
businesses in order to determine whether a jurisdiction has a right to impose and
enforce a tax claim.

12
In Australia, the term foreign income is defined in s 6AB(1) of the Income Tax Assessment Act 1936
(Cth) and means income derived from sources in a foreign country or foreign countries.
13
Under the exemption method, residents are exempt from tax on their foreign-source income. Under
the credit method, residents are taxed on their foreign-source income but are allowed a credit for the
foreign tax paid on that income. Under the deduction method, residents include their foreign-source
income in their assessable income, and are allowed a deduction for the foreign tax paid. Hong Kong
uses the exemption method and also the deduction method, while Australia uses both the credit and
exemption methods.
14
J urisdictions, apart from Hong Kong, using the territorial tax system to varying degrees include
Bolivia, Costa Rica, El Salvador, Guatemala, Kenya, Malaysia, Nicaragua, Panama, Paraguay,
Singapore and Uruguay. See Victor Thuronyi, Comparative Tax Law (2003) 287.
Malaysia uses a territorial system for taxing income. Tax is imposed on income accruing in or
derived from Malaysia or received in Malaysia from outside Malaysia. However, income remitted by
resident companies investing overseas is exempt from tax except for those carrying on banking,
insurance, air and sea transport operations which are taxed on a worldwide basis. From 1 J anuary 2004,
income remitted from overseas to Malaysia and received in Malaysia by resident individuals is also
exempt from income tax. Non-residents are taxed on income accrued in or derived from Malaysia, but
not on income received in Malaysia from outside sources. See CCH Tax Editors, Malaysia Master Tax
Guide 2006 (23
rd
ed, 2006) [1-100], [12-780].
Singapore operates a source-based tax system whereby income accruing in or derived from
Singapore or received in Singapore from outside Singapore is taxed. But the remittance basis has been
effectively abolished in many situations.
From 1 June 2003, all foreign-source dividends, branch profits and services income received by a
resident company are exempt from tax if the following conditions are met:
the income is received from a foreign jurisdiction with a corporate tax rate of at least 15 per cent in
the year the income is received in Singapore; and
the foreign income has been subject to tax in the jurisdiction from which it was received.
From 1 J anuary 2004, all foreign-source income received by resident individuals is exempt from tax,
except through a partnership in Singapore.
Non-residents are taxed on income accrued in or derived from Singapore.
See Angela Tan and Tan How Teck, Singapore Master Tax Guide 2006/07 (25
th
ed, 2006) [14-330].
See, also, Andrew Halkyard and Stephen Phua Lye Huat, Common Law Heritage and Statutory
Diversion Taxation of Income in Singapore and Hong Kong [July 2007] Singapore Journal of Legal
Studies 1, 1-24, for a discussion of taxation of income in Singapore.
5
1.2 The source of income

The source of income, for taxation purposes, has typically been identified by
reference to the character of moneys received and the geographic origin or location
where the income arises.
15
This thesis discusses the concept of source of income,
based on Australian and Hong Kong tax law,
16
although the concept is widely used in
most if not all other jurisdictions. The thesis concentrates on the meaning of source as
derived, primarily, from decisions of courts, given that it focuses on a comparison
between Australia and Hong Kong. Some influential court cases have concluded that
the concept of source is not a legal concept, but something which a practical man
would regard as a real source of income.
17
Lockhart J commented in the Spotless case
(1993) that there is no universal set of source rules
18
that can readily be applied to
every circumstance to determine the source or locality of profits.
19
It is a matter of
judgment which requires weighing the relative importance of the various factors in
each case in reaching the conclusion as to the source of income.
20
In practice, one
often has to rely on case law or other factors derived from case law such as the
operations test, the contract conclusion test or the provision of credit test in order
to determine the geographic source of income.
21
These tests are subject to different
interpretations. In the final analysis, the source of income is a matter to be determined

15
The concept of source of income is discussed in detail in Chapter 2.
16
Hong Kong became a Special Administrative Region of China on 1 J uly 1997 and is a separate
jurisdiction with its own taxation and legal system, as distinct from the Peoples Republic of China. See
Part 4.2, Chapter 4, for a brief overview of the tax system of Hong Kong.
17
See Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183 and Commissioner of Inland
Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044.
18
Source rules are used to determine the source of income. Source rules may be embodied in the
legislation or case law of a jurisdiction, or in tax treaties. See Larking, above n 2, 373.
19
Spotless Services Ltd & Anor v Federal Commissioner of Taxation (1993) 93 ATC 4397, 4409.
20
Ibid 4409-10.
21
The operations test, the contract conclusion test and the provision of credit test are discussed in
Chapter 5.
6
in all the circumstances and no single legal test can be employed.
22
In some factual
situations, it will be appropriate to describe what the taxpayer has done to earn the
profit in question as the effecting of a transaction.
23
In others, it may be more
appropriate to describe what the taxpayer has done to earn the profit in question as the
performance of an operation.
24
The common factor is that, in every case, one must
look to the nature of the transaction, operation or activity which generates the profit.
25

One must then look to see where that transaction was effected, where that operation
was performed, or where that activity was carried on.
26
Whether what is sought to be
charged to tax is appropriately to be described as the profit from a transaction, an
operation or an activity will vary according to the facts of the particular case.
27

1.3 Purpose and aims of the thesis

This thesis will, primarily, compare the impact of the source rules on the taxation of
profits from international transactions, operations and activities in two jurisdictions
Australia and Hong Kong. This comparative study is designed to draw on the
experience with the widely differing reliance on source-based taxation in these two
jurisdictions (noted above) in order to delineate certain conclusions on the nature of
current source rules, generally, and the adequacy of these rules in the face of major
changes in the way in which business is conducted. The thesis also considers aspects
of the operation of the source principle in other tax jurisdictions, but the key

22
See Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044, 100,422;
Commissioner of Inland Revenue v Orion Caribbean Ltd (in vol liq) (1997) HKRC 90-089, 100,829;
Esquire Nominees Ltd as Trustee of Manolas Trust v Federal Commissioner of Taxation (1973) 73 ATC
4114, 4117.
23
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044, 100,422.
24
Commissioner of Inland Revenue v HK-TVB International Ltd (1992) 1 HKRC 90-064, 100,542.
25
Orion Caribbean Ltd (in vol liq) v Commissioner of Inland Revenue (1996) HKRC 90-077, 100,722.
26
Ibid.
27
Ibid.
7
comparative jurisdictions are Australia and Hong Kong (the reason for using these two
jurisdictions is explained below).

What I aim to do in the thesis is, first, to trace the origins of taxation at source, and
show how it has been applied over the last two hundred years. I then examine the
fundamental nature of the current source issues relating to Australia and Hong Kong
(in a business profits context) including those particularly related to electronic
commerce. I conclude that the foundations of source-based taxation are less stable
today and explain, in detail, why this is so.

In the course of this review of the application of the source principle, some discussion
of residency issues also arises. The operation of these two principles is inevitably
inter-related. The thesis confines itself principally to the taxation of business profits
(by the imposition of income-type taxes) and the source principle. Considerations of
space mean it is prudent to have this focus to enable examination of the issues in some
depth. The thesis does, however, offer some commentary on non-income type taxes
imposed on business in the form of consumption taxes where the transactions being
reviewed clearly raise consumption tax concerns. These other issues of residence and
consumption taxes are outlined in the thesis to place the main concerns of the thesis in
a wider context. Consumption tax is also discussed in the context of reviewing policy
recommendations for greater reliance on consumption tax to help overcome the
increasing difficulties in applying the source principle in the (income) taxation of
business profits. (The thesis does not review the taxation of individual exertion
income remunerated in the form of salary, wages or the like.)

8
1.4 Research questions and research method

The principal research questions which this thesis seeks to answer are:
What is the essence of the concept of source of income as it has been developed in
the domestic tax law of Australia and Hong Kong?
Are the traditional rules governing the source of income, relying on the nature of
income and the geographic origin or location for that particular type of income,
adequate to deal with the taxation of business profits in a changing world
environment, changing technology and changing lifestyles?
If these traditional source rules can be demonstrated to be less adequate than
before, what response options can be suggested and considered?

The primary mode of addressing these questions has been to adopt, in essence, a
bilateral (Australia and Hong Kong) case-study approach using two representative
jurisdictions. These two jurisdictions have been chosen for study for the following
reasons:
both jurisdictions share British heritage, and are good examples of small-medium
advanced economies;
28

they are similar in the sense that they are, primarily, knowledge capital-importing
jurisdictions;
29
and

28
The International Monetary Fund divides the world into two major groups for classification purposes:
advanced economies; and
other emerging markets and developing countries.
Both Australia and Hong Kong are classified as advanced economies. See International Monetary Fund,
World Economic Outlook: Financial Systems and Economic Cycles (World Economic and Financial
Surveys, September 2006) 181-3.
29
Historically, Australia has been a significant capital importer and may remain a net capital importer
for many years to come. See Commonwealth, Board of Taxation, International Taxation: A Report to
the Treasurer (2003) vol 1, 93.
Hong Kong has transformed itself from a manufacturing and trading economy to a knowledge-
based economy over the past decade or so and is now one of the most knowledge-intensive economies
in the world. See Michael J Enright, Globalization, Regionalization, and the Knowledge-Based
9
their approaches to source differ markedly.

This bilateral approach allows for a full, in-depth review of the historical and
contemporary experience (of source-based taxation) of these two both different (in
certain tax fundamentals) and similar (in certain economic focus areas) jurisdictions.
The research questions just noted are primarily addressed using the case-study method.

Hong Kong is unique in the developed world in that it still retains a virtually
unqualified, territorial tax system and the meaning of source is of key importance.
The territorial source principle is simple to state: in the case of profits tax, only profits
which have a source in Hong Kong are subject to tax. However, its application in
particular cases can, at times, be contentious. The meaning of source has been
considered in many cases, from Karsten Larssen (1950)
30
to ING Baring Securities
(2008),
31
and the decisions have not always been consistent.
32
Hong Kong is also
different from most other developed economies in that it does not have a
comprehensive DTT network.
33
Australia is representative of a developed jurisdiction

Economy in Hong Kong in J ohn H Dunning (ed), Regions, Globalization, and the Knowledge-Based
Economy (2002) 388-9.
30
Commissioner of Inland Revenue v Karsten Larssen & Co (HK) Ltd [1950-1] HKLR 323.
31
ING Baring Securities (Hong Kong) Ltd (formerly known as Baring Securities (Hong Kong) Ltd and
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD 412.
32
The cases are discussed in Chapter 5.
33
Due to the fact that Hong Kong has a largely territorial basis of taxation and does not in general seek
to tax the worldwide income or assets of persons or companies residing there, there has not been a
significant incentive for it to enter into general DTTs. Hong Kong has thus far signed three
comprehensive DTTs (Belgium, Thailand and Luxembourg) and a tax arrangement with China covering
business profits, shipping and air transport, capital gains, personal services income as well as passive
income such as dividends, interest and royalties. There are a number of treaties relating specifically to
airline and shipping income. Hong Kong has reached bilateral air services agreements for airline
income with Bangladesh, Canada, Croatia, Denmark, Estonia, Ethiopia, Finland, Germany, Iceland,
Israel, J ordan, Kenya, the Republic of Korea, Kuwait, Macao Special Administrative Region, Mauritius,
Mexico, the Netherlands, New Zealand, Norway, the Russian Federation, Sweden, Switzerland and the
United Kingdom (UK). Hong Kong has also entered into double taxation relief arrangements for
shipping income with Denmark, Germany, the Netherlands, Norway, the UK and the US. Agreements
covering both airline and shipping income have been concluded with Singapore and Sri Lanka. See
Hong Kong, Inland Revenue Department, Taxation Information: Double Taxation Relief:
10
whose income tax system is based on the dual principles of residence and source.
Australia does have a comprehensive DTT network.
34
(Where DTTs are relevant, the
concept of PE is used to determine the right of a contracting state to tax profits of an
enterprise of the other contracting state.) In both cases, the decisions of the courts on
the meaning of source have been crucial in defining the concept of source for tax
purposes.

The two jurisdictions provide a representative example from each end of the source
spectrum. The strongly contrasting experiences are used in the thesis to analyse the
fundamental adequacy of the source principle generally when confronted, especially,
with the challenge of rapidly growing Internet-based commercial activities.

The research on the principal and related aims of the thesis has been undertaken by
conducting a thorough review of the relevant legislation and cases and an extensive
survey of the commenting literature.

1.5 What this thesis adds to taxation learning

The source of income is an important concept in taxation law as it determines
whether a state can assert its jurisdiction to tax a person on a particular item of
income. However, source is not normally discussed in much detail in the tax
literature as compared with residence.
35
It has been pointed out that textbooks on
income tax often discuss residence at considerable length and most do not deal with

Classification of Section 49 Arrangements (Double Taxation) Orders On Income Basis (revised
7 March 2007) <http://www.ird.gov.hk/eng/tax/dta_s49.htm>at 27 April 2008.
34
Australia has concluded DTTs with over 40 countries.
35
Alex Easson, Common Law Approaches to the Determination of the Source of Income: Pragmatism
over Principle (2006) 60 Bulletin for International Taxation 495, 495.
11
source.
36
Where source is considered at all, it tends to be treated simply as part of the
subject of the taxation of non-residents, though determining the source of income can
be a very complex issue and much more problematic than residence.
37
Other writers
have commented that the concept of source, despite the priority given to source
jurisdiction to tax income, is rather poorly developed in the tax literature and in the
domestic tax law.
38
One reason that the source principle has not dominated tax policy
decisions concerning jurisdiction is the difficulty of satisfactorily identifying (and
meaningfully describing in legislative terms) the source of income.
39

A tax literature review shows no similar research has been done using Australia and
Hong Kong for a comparative study like this. This thesis uses these two jurisdictions
to investigate issues related to relying on the source principle to impose taxation,
particularly on business income. The study throws new comparative light on similar
issues faced by knowledge capital-importing jurisdictions.

1.6 Outline of thesis chapters

Chapter 2 discusses the concept of source of income and defines in greater detail the
difficulties of the use of source in a global economy. Source as used in Australia and
Hong Kong is problematic for a number of reasons.

36
Ibid.
37
Ibid.
38
In principle, the jurisdiction where income is located (source) enjoys the primary right to tax that
income that arises within its jurisdiction. The jurisdiction where an entity is incorporated or a business
is managed (residence) retains a residual right to tax such income. See Brian J Arnold and Michael J
McIntyre, International Tax Primer (2
nd
ed, 2002) 21.
39
Richard M Bird and J Scott Wilkie, Source- vs. Residence-Based Taxation in the European Union:
The Wrong Question? in Sijbren Cnossen (ed), Taxing Capital Income in the European Union: Issues
and Options for Reform (2000) 78.
12
Chapter 3 provides a theoretical overview of taxation at source and outlines how the
concept has been developed and applied over the past two hundred years. Originally,
tax was collected at source under a system of schedules (having relation to income
derived from particular sources) and was imposed on the very few citizens who had
relatively high incomes. (Almost all income at that time had a single identifiable
source when looking at source in the sense of the character of the income. Also, it
was typically clear exactly what the geographic or territorial source of the relevant
income was.) Taxation at source worked well in the nineteenth century when labour
and capital were less mobile. It has grown less appropriate to rely on source as the
primary method for calculating tax levels clearly with the passage of time. It is even
less appropriate in todays globalised economy when taxpayers can increasingly
operate internationally at a comparatively low cost, shifting profits from a high-tax to
a low-tax jurisdiction.

In Chapter 4, the general tax systems of Hong Kong and Australia are examined.
Hong Kongs tax system is unusual. A series of separate taxes apply in their own
special way to different sorts of earnings and profits. Only three income-type taxes are
imposed under the schedules being salary, property and profits tax. The residence of
a taxpayer is normally of little practical relevance. Unlike Hong Kongs territorial tax
system that is based purely on source, Australia taxes its residents on their worldwide
income from all sources in or outside of Australia.

Chapter 5 examines how the law in relation to source has developed in Hong Kong
and Australia, and shows the difficulties in determining the source of income where
profits are not necessarily confined to one territorial source. The guiding principles
13
and the different approaches adopted by the courts are discussed. The operation of the
current source rules of Hong Kong and Australia has been placed under significant
strain by the increase in globalisation and access to world markets. Hong Kongs
source rules have become increasingly complex due to certain, in part, inconsistent
case law principles. In Australia, related-party cross-border dealings remain an issue,
and the profits returned often do not reflect the real economic contribution made in
Australia.

Chapter 6 provides an introduction to the Internet and examines the challenges and
opportunities it presents as electronic commerce grows. The Internet has changed the
dimensions of international trading, finance and commerce, and has provided an
environment where the geographic location of the income-generating transaction,
operation or activity can become blurred. Technological development and business
innovation raise the question of where income from electronic commerce will be taxed.
The issues raised by electronic commerce are practical difficulties that were not
foreseeable when taxation at source was introduced in the nineteenth century.

Chapter 7 considers ways to deal with issues arising out of our reliance on the source
principle, as it is currently understood. The chapter considers the proposal to address
cross-border source-related issues by the adoption of a dollar-based threshold test and
a refundable withholding mechanism. The thesis argues that this proposal, with its
reliance on a refundable withholding mechanism, suffers from certain implementation
and enforcement problems. The United States Treasury Department has suggested
abandoning source-based taxation which is tied to geographic location in favour of
residence-based taxation. But the tax residence of a taxpayer can be manipulated
14
because electronic commerce can be conducted anywhere. The chapter also considers
the option of relying less on income tax by placing a greater reliance on a general
consumption tax and various ways in which current application and enforcement
systems related to direct and indirect taxes might be adapted and strengthened.
40

Chapter 8 draws on the discussions in the previous chapters in order to summarise the
key issues which need to be addressed. The chapter also summarises the discussion of
possible solutions to enhance the fair and effective taxation of profits in an era where
electronic commerce is set to continue expanding significantly.

40
A direct tax is levied on a taxpayers engagement with the economic system and applies to receipts
such as wages, rents and profits. It is charged to a person, whether natural or legal, that earned the
income and is paid directly by that person. An indirect tax is levied on what people take out of (or
consume from) the economic system and use. It is assessed on transactions or production of particular
commodities or services before they reach the ultimate consumer, who pays the taxes as part of the
market price of the commodity or service. See J ames Edward Meade, The Structure and Reform of
Direct Taxation (1978) xvi and 31.
Though in theory direct taxes are imposed directly on the person earning the income, the actual
taxes may be collected from the taxpayers employer (for example, Australias Pay As You Go
(PAYG)). Australia started the PAYG system on 1 J uly 2000. PAYG is a single, integrated system,
comprising PAYG Withholding and PAYG Instalment, for withholding amounts at source in respect of
particular kinds of payments or transactions and reporting and paying tax on business and investment
income. For example, payments of salary and wage income to an employee are subject to PAYG
Withholding. The payer must withhold an amount from the payment and then pay that amount to the
Commissioner of Taxation. Entities that have business and investment income are subject to PAYG
Instalment. They have to pay instalments towards their expected tax liability. Under the PAYG system,
the amount of income tax paid to the Commissioner is the taxpayers expected tax liability. The actual
tax liability is determined when the taxpayers income tax return is assessed and the PAYG credits for
the year are applied against the assessment. The PAYG system ensures tax is collected throughout the
year on a regular basis. See s 10-1 in Sch 1 to the Taxation Administration Act 1953 (Cth) (TAA 1953)
which provides an overview of the PAYG withholding system and s 45-1 in Sch 1 to the TAA 1953
which provides the basic rules of the PAYG instalment system.
Prior to 1 J uly 2000, there was a series of five tax payment and reporting systems Pay As You
Earn (PAYE), Prescribed Payments System (PPS), Reportable Payments System (RPS),
Provisional Tax, and Company and Superannuation Fund Instalment System (COIN). PAYE, PPS
and RPS are now replaced by PAYG Withholding, and the provisional tax and COIN by PAYG
Instalment.
Hong Kong does not have a PAYE mechanism of withholding of tax on income from employment,
although it does use a system of collecting provisional taxes in advance.
15
CHAPTER 2: THE SOURCE OF INCOME AND AREAS OF CONCERN

2.1 Introduction

This chapter discusses the concept of source of income and defines in greater detail
the difficulties of the use of source in a globalised economy. The chapter also
provides an overview of the potential risk areas related to taxation based on source
which the thesis addresses. Topics discussed include:
tax havens and offshore financial centres;
nexus or link to a jurisdiction; and
permanent establishment (PE).

2.2 Meaning of source of income

The concept of source of income for income tax purposes has two primary meanings:
(A) the character of income; and (B) the geographic origin or location of income.
1

1
See Commissioner of Taxation (New South Wales) v Meeks (Public Officer of the Sulphide
Corporation Ltd) (1915) 19 CLR 568, 579, ING Baring Securities (Hong Kong) Ltd (formerly known as
Baring Securities (Hong Kong) Ltd and presently known as Macquarie Securities Ltd) v Commissioner
of Inland Revenue [2008] 1 HKLRD 412, [48] and Roger Hamilton, International Aspects of Australian
Income Taxation in Richard E Krever and Gretchen Kewley (ed), Australian Taxation: Principles and
Practice (1987) 276 on the meaning of source. See, also, Appendix One Income Overview on the
concept of source of income.
There are many ways of looking at the meaning of source, depending on which tax system applies
when using the source principle.
Source (meaning A) may mean the origin or production of the income in question all the stages
involved in the creation of wealth. See Klaus Vogel, Worldwide vs Source Taxation of Income A
Review and Re-evaluation of Arguments (Pt I) (1988) 16 Intertax 216, 223.
Source (meaning B) may also be used to refer to the place where a particular item of income is
deemed to originate. See Barry Larking (ed), IBFD International Tax Glossary (5
th
ed, 2005) 373 on
the meaning of source of income.
Others distinguish between source and origin. Origin is the location where income is created by
activities of human beings the location that makes the yield or the acquisition of wealth. The
intellectual input of individuals is the key component for the creation of income, as things in themselves
cannot create income. If income is generated by Company O in State O, but transferred via Company S
in State S as a dividend to a person resident in State R, only State O may tax the income under the origin
principle. See Eric C C M Kemmeren, Principle of Origin in Tax Conventions: A Rethinking of Models
(2001) 35-8 on his meaning of origin.
16
The source of income flows from the nature of the transaction, operation or activity
that generates the moneys received (for example, income from business, income from
property, income from personal exertion). The source of income in a territorial sense
means the geographic location where an item of income is derived, including
classifying into domestic or foreign income. One looks to see what the taxpayer has
done to earn the profit in question and where he or she has done it. The primary
concern in this thesis is with the concept of source according to meaning B. Where
source is discussed with reference to meaning A, this is made clear in the text.

2.3 Literature review and findings

A tax literature review has shown that changes to the structure of business and
globalisation open up cross-border trading opportunities.
2
The effectiveness of the
existing source rules is increasingly challenged by the growth in all forms of

This meaning of origin seems to overlap with the meaning of source discussed in this thesis. For
the purposes of this thesis, source refers to the two meanings stated above (meanings A and B), which
are the most relevant for Australia and Hong Kong.
The origin of taxation at source and how it has been applied in income taxation is discussed in
Chapter 3. How the law on source has developed in Australia and Hong Kong is discussed in Chapter 5.
Other source-related issues are also discussed in subsequent chapters.
2
The list is numerous and includes: Reuven S Avi-Yonah, International Taxation of Electronic
Commerce (1997) 52 Tax Law Review 507; Randolph J Buchanan, The New Millennium E-
Commerce Tax Dilemma (2002) 27 Tax Notes International 1097; J ames D Cigler et al, Cyberspace:
The Final Frontiers for International Tax Concepts? (1996) 7 Journal of International Taxation 340;
William J Craig, Taxation of E-commerce Fiscal Regulation of the Internet (2000); Richard L
Doernberg et al, Electronic Commerce and Multijurisdictional Taxation (2001); Richard L Doernberg,
Electronic Commerce Changing Income Tax Treaty Principles a Bit? (2000) 21 Tax Notes
International 2417; Robert A Green, The Future of Source-Based Taxation of the Income of
Multinational Enterprises (1993) 79 Cornell Law Review 18; David L Forst, The Continuing Vitality
of Source-Based Taxation in the Electronic Age (1997) 15 Tax Notes International 1455; Karl Frieden,
Cybertaxation The Taxation of E-Commerce (2000); J ulian J B Hickey; The Fiscal Challenge of E-
commerce [2000] British Tax Review 91; Luc Hinnekens, The Challenges of Applying VAT and
Income Tax Territoriality Concepts and Rules to International Electronic Commerce (1998) 26 Intertax
52; International Fiscal Association, Taxation of Income Derived From Electronic Commerce, vol 86a
(2001); J inyan Li, International Taxation in the Age of Electronic Commerce: A Comparative Study
(2003); J inyan Li, Rethinking Canadas Source Rules in the Age of Electronic Commerce: Part 1
(1999) 47 Canadian Tax Journal 1077; J effrey Owens, The Tax Man Cometh to Cyberspace (1997)
14 Tax Notes International 1833; J ohn K Sweet, Formulating International Tax Laws in the Age of
Electronic Commerce: The Possible Ascendancy of the Residence-Based Taxation in an Era of Eroding
Traditional Income Tax Principles (1998) 146 University of Pennsylvania Law Review 1949; Bjrn
Westberg, Cross-Border Taxation of E-Commerce (2002); Richard A Westin, International Taxation of
Electronic Commerce (2000).
17
borderless web-based commerce. Too many international trade and investment
activities fall potentially outside of the tax net.

The traditional precepts of source-based taxation were derived from an era where the
factors of production were labour, raw materials, land and capital. At that time,
industrial-based activities were, typically, the only businesses engaged in outside of
the home jurisdiction. Today, knowledge is progressively transforming the traditional
factors of production and is increasingly incorporated into an economic activity to
produce a particular good or service. Knowledge thus plays a role in increasing
productivity and has become an increasingly important source of wealth.
3
The
knowledge economy is emerging from two forces:
the rise in knowledge intensity of economic activities; and
the increasing globalisation of markets and products and services.
4

Companies become more knowledge-intensive, with more geographic locations
available to them to conduct their economic activities.
5
The production of high-
knowledge, value-added goods and services is being rationalised globally, with
companies combining the factors of production, features and skills of various locations
in the process of competing in global markets.
6
Knowledge-based and knowledge-
generating activities are separated from labour-intensive activities in the production of

3
rjan Slvell and J ulian Birkinshaw, Multinational Enterprises and the Knowledge Economy:
Leveraging Global Practices in J ohn H Dunning (ed), Regions, Globalization, and the Knowledge
Economy (2002) 83.
4
Ainsley J olley, Australian Agriculture in the Knowledge Economy in Bhajan S Grewal and
Margarita Kumnick (ed), Engaging the New World: Responses to the Knowledge Economy (2006) 102.
5
J ohn H Dunning (ed), Regions, Globalization, and the Knowledge Economy (2002) 7.
6
J ohn Houghton and Peter Sheehan, A Primer on the Knowledge Economy (Working Paper No 18,
Centre for Strategic Economic Studies, Victoria University of Technology, 2000) 12.
18
goods and services.
7
For example, knowledge-based services such as research and
development may take place in any number of locations separate from the actual
manufacturing facilities.
8
The know-how or technology is then transferred offshore to
the manufacturing facilities without being properly reported and taxed in the location
where the functions are performed. Labour-intensive manufacturing facilities are
relocated in developing countries to take advantage of cheap labour, fewer government
regulations and, in some cases, a large domestic market.
9

The changing patterns of production and investment the absence of knowledge
inputs in the jurisdiction where products are manufactured, the transfer of value-added
functions and assets to low-tax jurisdictions and the payment of royalties at non-arms
length to related parties create new and significant limitations on the taxing powers
of the source jurisdiction.
10
Global collaboration on the sale of goods, provision of
services and the licensing of intellectual property poses a challenge to the traditional
rules for determining the source of income. The nexus or link between the taxing
jurisdiction and the income, entity, property or activity it seeks to tax becomes more
difficult to pinpoint. The growth of profits in the low-tax jurisdictions does not
necessarily correlate with increases in real economic activity performed there
measured by capital accumulation, sales, employment and so on.
11
The return on an
investment can be realised in many different forms such as profits, dividends, interest,
royalties, rents. Globalisation provides greater opportunities for tax planning as the

7
David L Carr et al, Estimating the Knowledge-Capital Model of the Multinational Enterprise (NBER
Working Paper No 6773, 1998) 2.
8
Ibid.
9
Alan Burton-Jones, Knowledge Capitalism: Business, Work, and Learning in the New Economy (1999)
v, 15.
10
International profit-shifting arrangements and related-party dealings are discussed in Part 3.9, Chapter
3.
11
Martin A Sullivan, The Truth About Offshore Outsourcing and Profit Shifting (2004) 102 Tax Notes
1187, 1189.
19
source of income of different types of income can now be planned to maximise an
investors return after tax.

A business can be conducted in cyberspace by placing a dot-com store on a web site,
which makes it present, in effect, everywhere:
For example, one such Web site is a bookseller that allows customers to search
a database of over one million books, searching by either subject or name. It is
open 24 hours a day and has customers in over 60 countries.
12

The web site, though virtual in nature, may advertise its products, collect information
and create databases, solicit business, communicate, receive and confirm orders,
deliver goods digitally, provide services, process and conclude transactions, and
collect payments. Instead of using the traditional paper-based contract system, a
commercial relationship is formed by the transmission of electronic data messages
between two trading parties.
13
It is difficult to determine, precisely, where the
functions are performed and by whom. Although the web site address may indicate
the party responsible for maintaining it, it does not show the location of the business.
Further, the web site can be moved from jurisdiction to jurisdiction to make it even
harder to trace the identity and location of the parties. There is no taxpayer on which
tax may be levied if the parties to the transaction, the taxable transaction and the tax
liability cannot be identified clearly.

The collection of consumption tax poses difficulties as well. A company can avoid the

12
United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of
Global Electronic Commerce (1997) 25 Intertax 148, 152.
13
The problems related to forming enforceable contracts electronically are far from completely solved,
but progress continues in addressing this issue. See Duncan Bentley, The Internet: Taxing Electronic
Transactions (1997) 5 Taxation in Australia 122, 123-8; Yee Fen Lim, Cyberspace Law:
Commentaries and Materials (2002) 62-112; Mark Allen, E-Business, the Law and You: A Guide for
Australian Business (2002) 71-82; Stephen Thompson, E-commerce, E-security and Contracting
(2004) 32 ABLR 132.
20
application of a consumption tax by locating its business in a jurisdiction that does not
impose a comparable tax. It may also consider selling its products to an offshore
company, which then sets up an offshore web site, as export sales are usually exempt
from such a consumption tax. Similarly, a consumer may well have a choice to buy
(at a cheaper price) a like product (to that supplied by a resident supplier) from a
supplier in a jurisdiction that does not impose a consumption tax. Tax collection may
suffer when consumers increasingly buy from offshore online businesses. (Although a
value added tax (VAT) or a goods and services tax (GST) normally applies to
imports, where individuals (rather than businesses) do the importing via (individually)
low-value transactions, it is very difficult to establish an effective tax collection
regime for such transactions.) As a result, the jurisdiction where the consumer resides
often cannot raise taxes on the profits generated by the offshore company through the
sale of its goods or the provision of services.

Globalisation and the advent of electronic commerce have exposed serious
shortcomings in the application of direct and indirect taxation. Entities are becoming
more focused internationally, but tax authorities remain national and generally cannot
go beyond their jurisdiction to enforce and collect international tax claims.
14
The
OECD has released a comprehensive set of reports and technical papers on the tax
policy and tax administration aspects of electronic commerce and the taxation of
business profits in a borderless world.
15
Australia,
16
Canada,
17
the European Union,
18

14
See footnote 2, Chapter 1, for a discussion of a states jurisdiction to tax. See Part 7.2.2, Chapter 7,
for a discussion of the enforcement of international tax claims.
15
See, for example, OECD, Committee on Fiscal Affairs, Clarification on the Application of the
Permanent Establishment Definition in E-Commerce: Changes to the Commentary on the Model Tax
Convention on Article 5 (December 2000) <http://www.oecd.org/dataoecd/46/32/1923380.pdf> at
1 May 2008;
OECD, Report by the Technology Technical Advisory Group (TAG) (December 2000)
<http://www.oecd.org/dataoecd/46/2/1923248.pdf>at 1 May 2008;
21
Hong Kong,
19
New Zealand,
20
the United Kingdom (UK)
21
and the United States
(US)
22
have published policy papers on the tax implications of electronic commerce,
eliciting views on the issues presented as well as suggestions as to a solution on how
to determine the source of profits that works well with the Internet.

2.4 The significance of the concept of source of income (with particular
reference to Australia and Hong Kong)

The concept of source of income is fundamentally important to both Australia and
Hong Kong. Australia adopts a worldwide tax system that taxes its residents on

OECD, Technical Advisory Group, Attribution of Profit to a Permanent Establishment Involved in
Electronic Commerce Transactions (February 2001)
OECD, Forum on Strategic Management, Tax Administration Aspects of Electronic Commerce:
Responding to the Challenges and Opportunities (February 2001)
OECD, Technical Advisory Group, Tax Treaty Characterisation Issues Arising From E-Commerce
(February 2001) <http://www.oecd.org/dataoecd/46/34/1923396.pdf>at 1 May 2008;
OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework Conditions
(2001);
OECD, Centre for Tax Policy and Administration, Report: The Application of Consumption Taxes to
the Trade in International Services and Intangibles (2004)
OECD, E-commerce: Transfer Pricing and Business Profits Taxation (Tax Policy Studies No 10, 2005);
OECD, Centre for Tax Policy and Administration, Report on the Attribution of Profits to Permanent
Establishments Parts I (General Considerations), II (Banks) and III (Global Trading) (December 2006)
16
Australian Taxation Office, Tax and the Internet (1997) vol 1; Australian Taxation Office, Tax and
the Internet (1997) vol 2; Australian Taxation Office, Tax and the Internet: Second Report (1999).
17
Canadian Customs and Revenue Agency, Electronic Commerce and Canadas Tax Administration: A
Report to the Minister of National Revenue from the Ministers Advisory Committee on Electronic
Commerce (April 1998) <http://www.ccra-adrc.gc.ca/tax/business/ecomm/ecomedoc.doc>at 6 October
2003.
18
European Union, A European Initiative in Electronic Commerce (1997)
<ftp://ftp.cordis.europa.eu/pub/esprit/docs/ecomcom.pdf>at 20 April 2008.
Some member states of the European Union have also published discussion papers on the tax
implications of electronic commerce. See, for example, Ireland, Revenue, Electronic Commerce and
the Irish Tax System (1999) <http://www.revenue.ie/pdf/e_commerce/e_commerce.pdf>at 1 May 2008;
Spanish Institute for Foreign Trade, A Guide to Business in Spain: Legal Framework and Tax
Implications of Ecommerce in Spain (2002) <http://www.spainbusiness.com/staticFiles/e-
commerce_in_spain_1085_.pdf>at 21 November 2008.
19
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 39,
Profits Tax: Treatment of Electronic Commerce.
20
New Zealand, Inland Revenue, Guide to Tax Consequences of Trading Over the Internet (May 2002)
<http://www.ird.govt.nz/resources/file/eb80f208498c5a2/internettaxguide.pdf>at 1 May 2008.
21
United Kingdom, Inland Revenue, Electronic Commerce: The UKs Taxation Agenda (1999).
22
Global Economic Commerce, above n 12, 148.
22
Australian and foreign income and foreign residents on Australian income,
23
whilst
Hong Kong adopts a territorial tax system that forgoes taxing foreign income
irrespective of who has derived it. The fundamental basis for taxation under a
territorial tax system is the source of income; while the fundamental basis for taxation
under a worldwide tax system is the concept of residence.

The issues with the concept of source of income are:
it depends on the concepts of source and income, both difficult to define and
determine in todays almost infinite variety of commercial arrangements; and
one cannot determine where the source of income is situated unless one knows
what is the source of income.
24

Even once we are able to identify and classify a particular item of income, we still
need to link that income to a particular taxing jurisdiction. Appropriate source rules
are, therefore, essential to make the necessary delineation, for example, between
domestic and foreign income and to determine which jurisdiction may tax that income.
But source rules are not always embodied in the legislation of a jurisdiction.
25
Certain

23
For the purposes of Australias tax legislation, a person is regarded as a foreign resident or a non-
resident if the person is not an Australian resident. The term foreign resident is used in the Income
Tax Assessment Act 1997 (Cth) (ITAA 1997), while the term non-resident is used in the Income Tax
Assessment Act 1936 (Cth) (ITAA 1936). The two terms are used interchangeably.
24
Per Romer LJ in Bennet v Marshall [1938] 1 All ER 93 at 104.
25
Australias tax rules on the question of source are a mixture of general law and statutory provisions.
The income tax legislation contains some source rules that denote the character of the receipt of (and
attribute a source to) certain types of income. For example:
Section 6C of the ITAA 1936 provides that a royalty payment will have a source in Australia where
it is paid or credited to a non-resident by an Australian resident or the Australian permanent
establishment (PE) of a non-resident.
Subsection 44(1)(b) of the ITAA 1936 deems an Australian source for dividends paid to a non-
resident shareholder out of profits derived by the company from sources in Australia.
Source rules are not defined in Hong Kong, but certain amounts are assessable to profits tax
because they are deemed to be receipts arising in or derived from a business carried on in Hong Kong.
For example, certain royalty income, otherwise not chargeable to tax, is treated as a trading receipt
under s 14 of the IRO 1947, even though there is no business carried on in Hong Kong:
s 15(1)(a) includes receipts from the exhibition or use of films, tapes or recordings;
23
jurisdictions attempt to define source statutorily
26
whereas others (such as Australia
and Hong Kong) tend to leave the major definitional role to the courts.
27
The courts
have tended to emphasise particular factors as relevant in determining the source of
particular types of income.
28

s 15(1)(b) includes receipts for the use of or right to use a patent, design, trademark, copyright
material, secret process or formula in Hong Kong; and
s 15(1)(ba) includes sums received for the use of or right to use a patent, design, trademark,
copyright material, secret process or formula outside Hong Kong, if the sum is deductible in
ascertaining the assessable profits of the payer under profits tax.
26
Source rules can be based mainly or entirely on statute. The US has detailed source rules in its
Internal Revenue Code (26 USC) (IRC). These essentially fall into two basic groups:
general source rules that apply for all purposes of the IRC; and
other source rules that apply more narrowly.
For example, tax based on income from sources within or without the US is contained in Subtitle A,
Chapter 1, Subchapter N of the IRC as follows:
Part I source rules and general rules relating to foreign income;
Part II non-resident aliens and foreign corporations;
Part III income from sources without the US;
Part IV domestic international sales corporations; and
Part V international boycott determinations.
See Warren Crowdus, The Interaction of Treaty and Code Source Rules (2002) 13(4) Journal of
International Taxation 28, 30-1 for a discussion of US source rules.
27
In Australia, s 6C of the ITAA 1936 has established a very broad source rule for royalties, defined in
s 6(1). Following a decision adverse to Federal Commissioner of Taxation v Sherritt Gordon Mines Ltd
(1977) 77 ATC 4365, the definition of royalty was amended by the Income Tax Laws Amendment
(Royalties) Act 1976 (Cth) (No 143, 1976) to include know-how payments. Subsection 6(1) now
provides an extremely wide definition of royalties and covers payments for the supply of scientific,
technical, industrial or commercial knowledge or information, some of which would not have been
regarded as royalty at general law.
28
Source rules vary for different types of income and they are subject to different interpretations by the
courts. For example:
The source of profits from the sale of tangible property or goods has been found to be (in the
following cases):
- where the contract is made (Premier Automatic Ticket Issuers Ltd v Federal Commissioner of
Taxation (1933) 50 CLR 268); and
- where the business is carried on (Firestone Tyre & Rubber Co Ltd v Llewellin (Inspector of
Taxes) (1957) 1 All ER 561).
The source of dividend income has been found to be (in the following case):
- where the company earned the profits giving rise to the payment of the dividend (Esquire
Nominees Ltd as Trustee of Manolas Trust v Federal Commissioner of Taxation (1973) 73
ATC 4114)
The source of royalty income has been found to be (in the following cases):
- where the intangible rights are used (Curtis Brown Ltd (as agents for Stella Brown) v Jarvis
(1929) 14 TC 744); and
- where the intangible rights are registered (Federal Commissioner of Taxation v United Aircraft
Corporation (1943) 68 CLR 525).
The source of income from real property has been found to be (in the following cases):
- where the immovable property is physically situated (Liquidator, Rhodesia Metals Ltd (in liq) v
Taxes Commissioner [1940] 3 All ER 422); and
- where an option to purchase is exercised (Benwerrin Developments Pty Ltd v Federal
Commissioner of Taxation (1981) 81 ATC 4524).
24
Most jurisdictions only have sketchy rules for determining the source of income,
especially income derived from business activities.
29
The terms such as arising in,
derived from, having its origin in, accruing in, effectively connected with or
produced or obtained are typically used to describe income having a domestic
source.
30
Determining the source of income typically becomes a matter of establishing
the nature of the transaction, operation or activity surrounding the receipt and making
the appropriate connection with a geographic location. Thus, an item of income
received by a taxpayer has to be characterised and allocated to a source or be given a
deemed source. If a transaction, operation or activity is complex in nature and sourced
in several different jurisdictions, it becomes increasingly difficult to determine from
what and where the income originates. No tax will be due if the source of income
cannot be identified in some legally effective way.

Hong Kong adopts an (operationally separated) schedular tax system under which
income arising in or derived from a source in Hong Kong is divided into three separate
types being income from office, employment or pension;
31
profits derived from
carrying on a trade, profession or business (except profits arising from the sale of
capital assets);
32
and income derived from the use of land and buildings.
33
There is
no concept of total income (based on the taxpayers total income), with the practical

29
Brian J Arnold and Michael J McIntyre, International Tax Primer (2
nd
ed, 2002) 21.
30
Robert J Patrick, J r, General Report Rules for Determining Income and Expenses as Domestic or
Foreign in Cahiers de Droit Fiscal International LXVb (1980) 16, 287, 490.
In Australia, the term Australian source is defined in s 995-1(1) of the ITAA 1997, which states
that the ordinary income or statutory income has an Australian source if, and only if, it is derived from a
source in Australia for the purposes of the ITAA 1936. In Hong Kong, tax is charged on income that
arises in or is derived from a source in Hong Kong and on property situated in Hong Kong.
31
Inland Revenue Ordinance 1947 s 8.
32
33
25
semi-exception of Personal Assessment elected by an individual taxpayer.
34
There is
no definition of income or profits. To be liable to income-type tax, income must
fall within a taxable source. Income which does not fall within a taxable source in one
of the schedules (for example, dividends and foreign income) or income that is exempt
under a provision of the Inland Revenue Ordinance 1947 can escape the tax net.
35

The original income tax systems introduced in Australia by the colonies/states were,
like Hong Kong, also founded on the (territorial) source principle, except in
Tasmania.
36
Tax was imposed on income derived from a source within the geographic
area controlled by the taxing authority.
37
The residence principle of extending the tax
base
38
to income derived from sources outside Australia was adopted in 1930 by the

34
Under Personal Assessment, income of the individual taxpayer chargeable to salaries tax, profits tax
and property tax is aggregated and, from this total, the following may be deducted:
interest payable on money borrowed for the acquisition of the property let (the amount deductible
for each property would not exceed the assessed income from that property);
approved charitable donations;
elderly residential care expenses;
home loan interest;
mandatory contributions paid to a Mandatory Provident Fund Scheme as an employee;
contributions paid to a Recognised Occupational Retirement Scheme;
business losses incurred in the year of assessment;
losses brought forward from previous years under Personal Assessment; and
personal allowances.
The balance, if any, will then be taxed at the same progressive rates as those used for salaries tax.
Credit will be given for any tax already paid on the income included in the assessment. If the total of
the (provisional) tax already paid exceeds the tax chargeable under Personal Assessment, a refund will
be made. See Hong Kong, Inland Revenue Department, Tax Information: Individuals: Personal
Assessment (revised 19 J anuary 2008) <http://www.ird.gov.hk/eng/tax/ind_per.htm>at 27 April 2008.
This still does not produce taxation of total income as income not assessable under the profits tax,
salaries tax and property tax schedules (for example, interest or dividend income) will normally remain
completely free of tax.
35
In principle, a Hong Kong business will be chargeable to profits tax under s 14 of the IRO 1947 in
respect of profits arising in or derived from that business from Hong Kong unless specifically exempt
(for example, s 26A(1A) which exempts from profits tax certain profits derived by specified investment
schemes such as mutual funds and unit trusts).
36
Tasmania was the first Australian colony to introduce a limited income tax based on the worldwide
basis of taxation. See Michael Dirkis, Ripe for Reform: Australias Domestic Source Rules (2007) 61
Bulletin for International Taxation 168, 168.
The development of tax laws in Australia is discussed in Part 4.3.1, Chapter 4.
37
Michael Dirkis, Where We Were; Where We Are; Where We Want to Be (2001) 5 The Tax
Specialist 66, 67.
38
The term tax base or taxable base has two meanings the thing or amount on which the tax rate is
applied. In a broad sense, the taxable base refers to the taxable object (that is, the nature of the thing
26
Commonwealth and in some states, shortly thereafter.
39
Australia moved (at least in
form) to a worldwide (extraterritorial) basis of taxation in 1936, with the introduction
of uniform income tax legislation by the Commonwealth and the states.
40
Under this
regime, the liability to income tax was based upon the residency of a taxpayer and

which is taxed such as income or capital). In a narrower sense, the term refers to the amount or
composition of the taxable object (that is, what items are included in or excluded from the computation
such as deductions or losses). See Larking, above n 1, 394.
39
Prior to the income year 1929-30, the Commonwealth income tax was levied on income derived from
Australian sources only. A definition of resident was inserted in the Income Tax Assessment Act 1930
(Cth) in 1930. The residency basis of taxation was introduced in South Australia and Victoria in 1931.
However, ex-Australian income was partially taxed in New South Wales (income from non-investment
trade or business) and Western Australia (export income), and fully exempt in Queensland. See A J
Baldwin and J A L Gunn, The Income Tax Laws of Australia (1937) 134; Dirkis, above n 36, 82.
40
Between 1915 and 1942, most Australian residents were subject to two income taxes as both the
Commonwealth and the states imposed an income tax. Uniform tax legislation was introduced by the
Commonwealth and the states between 1936 and 1937 as follows:
Income Tax Assessment Act 1936 (Cth);
Income Tax (Management) Act 1936 (NSW);
Income Tax (Assessment) Act 1936 (Vic);
Income Tax Assessment Act 1936 (Qld);
Income Tax Assessment Act 1936 (SA);
Income Tax Assessment Act 1937 (WA); and
Land and Income Taxation Act 1910 (Tas) as amended by the Land and Income Taxation Act 1935
(Tas).
This attempt at introducing a uniform income tax system in Australia did not achieve its full aims,
however. In 1942, the Commonwealth Parliament passed four acts whose effect was to take over the
income tax collections of the states as a wartime measure and to provide grants to the states for the
revenue forgone:
Income Tax Act 1942 (Cth) which set an income tax rate higher than the combined existing state
and Commonwealth rates;
Income Tax Assessment Act 1942 (Cth) which gave priority to payment of the Commonwealth
income tax over state income tax;
States Grant (Income Tax Reimbursement) Act 1942 (Cth) which provided for Commonwealth
financial assistance to those states which did not impose their own state income tax; and
Income Tax (War Time Arrangement) Act 1942 (Cth) which allowed for the Commonwealth to take
over state income tax officers, premises, equipment and records.
These four acts, which were to continue until the end of the war, prevented state governments
(politically) from levying an income tax due to the high rates imposed by the Commonwealth. South
Australia, Victoria, Queensland and Western Australia went to the High Court to challenge the validity
of these four acts, which the High Court found was valid (State of South Australia & Anor v
Commonwealth (1942) 65 CLR 373). After the war, the State Grants (Income Tax Reimbursement) Act
1942 (Cth) and the Income Tax Assessment Act 1942 (Cth) were replaced by the State Grants (Tax
Reimbursement) Act 1946-1948 (Cth) and the Income Tax and Social Services Contribution Assessment
Act 1936-1956 (Cth) with unlimited duration. Victoria and New South Wales returned to the High
Court to challenge the validity of these acts (State of Victoria & Anor v Commonwealth (1957) 99 CLR
575). These states argued that the operation of the enactments effectively converted taxation into an
exclusive Commonwealth power. The High Court found the acts to be a valid exercise of
Commonwealth power, and that the whole plan of uniform taxation has thus become very much a
recognised part of the Australian fiscal system (State of Victoria & Anor v Commonwealth (1957) 99
CLR 575, 601). See Rodney Fisher and J acqueline McManus, The Long and Winding Road: A
Century of Centralisation in Australian Tax in J ohn Tiley (ed), Studies in the History of Tax Law (2004)
321-7; Peter Hanks, Constitutional Issues of Australian Taxation in Richard E Krever and Gretchen
Kewley (ed), Australian Taxation: Principles and Practice (1987) 51.
27
residents began to be taxed on their foreign as well as domestic income. But the
foreign income of Australian residents that was taxed in another jurisdiction was
usually exempt from income tax.
41
The foreign tax credit system was introduced on
1 J uly 1987 to cover most foreign income.
42
Briefly, under this system, Australian
resident taxpayers are granted double tax relief on their foreign income according to
the amount of the foreign taxes they paid on that income.
43

At its inception, Australias income tax was levied on a broad base of income from all
sources.
44
Income tax was levied upon a taxpayers taxable income, calculated by

41
At the time when Australia moved to residence-based taxation, the UK had requested Australia to
exempt income derived from the UK where it had already been taxed. A subsequent request was
received from the US for similar treatment. In 1947, all foreign-source income that was taxed abroad
was exempt from income tax in Australia. See Sam Reinhardt and Lee Steel, A Brief History of
Australias Tax System (Paper presented to the 22
nd
APEC Finance Ministers Technical Working
Group Meeting in Khanh Hoa, Vietnam, 15 June 2006) [13] in Commonwealth, Treasury, Economic
Roundup Winter 2006 <http://treasury.gov.au/documents/1156/PDF/01_Brief_History.pdf>at 27 April
2008.
42
Some direct income (such as the foreign employment income that met the time requirements) is
exempt. See s 23AG of the ITAA 1936.
43
The operation of Australias foreign tax credit (FTC) system will be replaced by foreign income tax
offset rules from 1 J uly 2008.
Under the FTC system, foreign income is divided into the following classes for the purpose of
allowing a FTC:
passive foreign income (such as foreign dividends, interest, rental income, royalties, foreign capital
gains and passive commodity gains);
offshore banking income (such as interest, fees and commission derived from offshore banking
transfers);
lump sum payments from non-resident superannuation funds that are taxed under section 27CAA of
the ITAA 1936; and
other foreign income.
A credit is allowed for foreign income tax paid in the source country, up to the amount of Australian tax
payable in respect of that foreign income. If the amount of foreign tax paid in respect of a class of
foreign income exceeds the Australian tax payable on that class of foreign income, a taxpayer may carry
forward the excess foreign tax credit for the five years immediately following the income year when it
arose. The excess credit for a class of foreign income can be used if there is a credit shortfall for the
same class of income in a later year. A credit shortfall occurs if the credit allowed for a class of income
is less than the Australian tax payable on that class of income. See Australian Taxation Office, How to
Claim a Foreign Tax Credit (2007).
Under the foreign income tax offset rules, the carry forward of excess foreign income tax is
removed. Taxpayers are entitled to a non-refundable tax offset for foreign income tax paid on an
amount included in assessable income, capped at the lesser of the Australian tax that would be payable
on the foreign income or the actual foreign tax paid. Taxpayers will no longer be required to quarantine
assessable foreign income amounts, but they can combine all assessable foreign income amounts when
working out a tax offset entitlement, thus minimising the amount of foreign income tax that goes
unrelieved. See Div 770 of the ITAA 1997 on the foreign income tax offset rules.
44
Reinhardt and Steel, above n 41, 10.
28
subtracting a taxpayers allowable deductions from assessable income
45
which
included ordinary income, but did not include capital receipts.
46
The terms income,
ordinary income and income according to ordinary concepts were not and still are
not defined in the Income Tax Assessment Act 1936 (Cth) or the Income Tax
Assessment Act 1997 (Cth). So it is necessary, from the outset, to use the guidance
developed by the courts on the concept of ordinary income and to determine what
amounts were income from a given source.

Without a definition of income, different views can be taken on what income is and,
hence, on how to determine where the source of income is situated. Some receipts
(business profits, interest, rent, salaries) are accepted as income (and are, thus,
included in the income tax base) while others (capital gains,
47

beneficial receipts
48
and
windfall gains
49
) are not accepted as income according to ordinary concepts in
numbers of jurisdictions, including Australia and Hong Kong, and are typically
excluded from the income tax base. Income from the carrying on of a business is
generally assessable, but gains from casual, infrequent, sporadic or haphazard sales are
not generally liable to tax (although businesses can be carried out with a very low level

45
R D Fayle, An Historical Review of the Development of Income Tax in Australia (1984) 18
Taxation in Australia 666, 675.
46
Prior to 1985, Australia did not impose a general tax on capital gains. A capital gains tax was
introduced in 1985 and applied to realised gains and losses on assets acquired after 19 September 1985.
See Appendix One Income Overview for an explanation of Australian income tax and the meaning of
ordinary income, statutory income, assessable income and taxable income.
47
In Australia, capital receipts are included in assessable income due to the statutory provisions under
s 6-10 of the ITAA 1997.
In Hong Kong, profits arising from the sale of capital assets are excluded from profits tax under
s 14 of the IRO 1947.
48
A benefit which is not convertible into money or moneys worth is not income. A person has not
received any income if he/she receives a benefit which cannot be cashed in. In Federal Commissioner
of Taxation v Cooke & Sherden (1980) 80 ATC 4140, it was held (at 4149) that if the receipt of an item
saves a taxpayer from incurring expenditure, the saving is not income: income is what comes in, it is
not what is saved from going out. A non-pecuniary receipt can be income if it can be converted into
money; but if it be inconvertible, it does not become income merely because it saves expenditure.
49
A windfall gain such as a lottery win does not constitute income. However, in Federal Commissioner
of Taxation v Stone (2005) 59 ATR 50, grants, prize money and appearance fees received by an athlete
were held to be receipts from the conduct of carrying on a business and are assessable income.
29
of activity).
50
On the other hand, profits from a single transaction may amount to a
business profit rather than something in the nature of a capital gain even if it does not
involve the carrying on of a business.
51
Income may be regarded as receipts from
salaries, rents, profits of a business or as a return from investments such as
dividends.
52
The economist views income as the measure of a persons economic gain
over a set period,
53
similar to the accounting concept.
54
The judicial concept of
income sees income as a flow.
55
Income is what comes in, but frequently does not
include (according to some courts) a capital gain (for example, in Australia and Hong
Kong). As a consequence
it taxes some apparent flows that do not entail gains it omits gains that we
call capital gains it relies on legal transactions rather than on underlying
economic movements.
56

Clearly, income tax is a tax on income and the distinction between income and capital
is a fundamental issue due to the different tax treatment of a capital gain.
57
Profits or

50
See Commissioner of Inland Revenue v Bartica Investment Ltd (1996) HKRC 90-080. The placing
and rolling over deposits as security for loans in Australia by a shelf company incorporated in Hong
Kong constituted the carrying on of a business.
51
See Thiel v Federal Commissioner of Taxation (1990) 90 ATC 4717 discussed in footnote 24,
Chapter 5.
52
For an in-depth analysis of the concept of income and its development for tax purposes, see Kevin
Holmes, The Concept of Income A Multi-Disciplinary Analysis (2001).
53
Richard J Vann, Income as a Tax Base in Richard E Krever and Gretchen Kewley (ed), Australian
Taxation: Principles and Practice (1987) 62.
54
Frank Gilders et al, Understanding Taxation Law An Interactive Approach (2
nd
ed, 2004) [2.6].
55
The judicial concept of income (analysed in this thesis) is based primarily on UK trust law. Profits
and gains derived by a trustee have to be distinguished between income of the trust or trust property or
capital before distributing them to specified beneficiaries. Receipts with an income character are
distributed to the trusts income beneficiaries and receipts with a capital character are distributed to the
trusts competing capital beneficiaries. The test that distinguishes between income and capital receipts
is the close nexus of the former with an identifiable source that generated the gain, such as the direct
provision of personal services or business activities, or a return paid on an investment. See Richard
Krever, Court Decision Reflects Australias Peculiar Notion of Income (2005) 38 Tax Notes
International 477, 477.
56
J ohn Prebble, Income Taxation: A Structure Built on Sand (2002) 24 Sydney Law Review 301, 301.
57
Hong Kong does not normally tax capital gains. Section 14 of the IRO 1947 excludes profits arising
from the sale of capital assets. However, Hong Kong has a minimal, de facto capital gains tax regime.
Profits tax has been applied to certain speculative gains related to real estate, especially. See Richard
Cullen, Hong Kong Revenue Law The Present, 1997, and Beyond (1993) 7 Tax Notes International
1109, 1122.
In Australia, assets acquired prior to 20 September 1985 are generally exempt from capital gains
tax (CGT), except certain gains on the disposal of pre-CGT shares in a company or an interest in a
30
gains derived by an entity in its ordinary course of trading are income according to
ordinary concepts, but capital receipts do not constitute income according to ordinary
concepts.
58

An often cited passage on the difference between income and capital is the judgment
by Pitney J in Eisner v Macomber (1919),
59
an American case:
The fundamental relation of capital to income has been much discussed by
economists, the former being likened to the tree on the land, the latter to the
fruit or the crop; the former depicted as a reservoir supplied from springs, the
latter as the outlet stream, to be measured by its flow during a period of time.
60

The Eisner v Macomber case was heard before the US Supreme Court as a
constitutional law matter. The case related to the issuance of stock certificates and the
question whether Congress had the power to tax as income of the stockholder and
without apportionment, a stock dividend made against profits accumulated by the
company. Pitney J defined income as a gain derived from capital, from labour, or
from both combined.
61
Income was essentially:
a gain, a profit, something of exchangeable value proceeding from the property,
severed from the capital however invested or employed, and coming in, being
derived, that is, received or drawn by the recipient (the taxpayer) for his
separate use, benefit and disposal; that is income derived from property
(emphasis in original).
62

trust (see CGT event K6 in s 104-5 of the ITAA 1997). Capital gains are now included in a taxpayers
assessable income as statutory income under s 102-5 of the ITAA 1997, but the method of calculating
the capital gain is different. For assets purchased before 21 September 1999, indexation of the cost base
(up to 30 September 1999) is available to offset the effect of inflation. This means that any gain from
the asset due to inflation would not be taxed. After 21 September 1999, an individual taxpayer
(including a small business owner) will get a CGT discount of 50 per cent on the capital gains realised
(33.3 per cent for superannuation funds), provided the other requirements are met. For individuals, the
gain is taxed at the taxpayers marginal rate of tax, ranging from 15 to 45 per cent excluding Medicare
levy (based on the 2007-08 general rates applicable to residents). This concession is not available to
companies, and all of their gains are subject to CGT at the company tax rate of 30 per cent.
58
See Commissioner of Taxation of the Commonwealth of Australia v Myer Emporium Ltd (1987) 163
CLR 199, 209 and Westfield Ltd v Federal Commissioner of Taxation (1991) 21 ATR 1398, 1408.
59
Eisner, as Collector of United States Internal Revenue for the Third District of the State of New York
v Macomber, 252 US 189 (1919).
60
Ibid 206.
61
Ibid 207.
62
Ibid.
31

It was held the mere growth or increment of value in a capital investment was not
income.
63
Hence, the new shares acquired in the stock dividend did not answer the
definition of income within the meaning of the Sixteenth Amendment as the
stockholder had received nothing out of the companys assets for her separate use and
benefit.
64
The real issue was one of timing. If the stockholder had sold the new shares
acquired in the stock dividend and realised a profit, such profit would be income.
65

Similarly, if the stockholder had sold her original shares or dividend stock at a profit,
such profit would be income.
66
It has been argued that Pitney J s definition of income
in Eisner v Macomber lacks any convincing supporting argument.
67
In Australia, a
realisation upon sale of appreciated property has been considered (as a matter of legal
interpretation using court-derived principles) a mere enlargement of capital and not a
revenue receipt.
68
Even if the realisation produced a profit, the profit would only be
separated and treated as income if it otherwise displayed characteristics the courts
commonly attributed to income from business or income from property.
69
(That is,

63
Ibid.
64
A stock dividend showed that the companys accumulated profits had been capitalised, instead of
being distributed to the stockholders or retained as surplus available for distribution in money. A stock
dividend really took nothing from the property of the company and was not a realisation of income.
Ibid 211-2.
It is argued the definition of income for Australian constitutional law purposes is much broader.
Virtually any gain realised by or accruing to the benefit of a taxpayer is included in the income tax.
See Rick Krever, The Ironic Australian Legacy of Eisner v Macomber (1990) 7 Australian Tax Forum
191, 198.
65
Eisner, as Collector of United States Internal Revenue for the Third District of the State of New York
v Macomber, 252 US 189, 212 (1919).
66
Ibid.
67
R Magill, Taxable Income (revised ed, 1945) 18 cited in Richard D Fayle, A Commentary on the
s. 25 Income/Capital Distinction for Australian Taxation Purposes in Queensland Division of the
Taxation Institute of Australia, State Convention Papers (27-29 May 1983) 18, 23.
68
Krever, The Ironic Australian Legacy of Eisner v Macomber, above n 64, 195.
69
Ibid.
In Australia, the factors which determine whether a receipt is income or capital are set out in G P
International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124, 138:
periodicity, regularity or recurrence;
the character of a right or thing disposed;
the scope of the transaction, venture or business; and
the purpose in engaging in the transaction, venture or business.
32
under ordinary principles, as developed by the courts, the concept of income was
confined so as to exclude capital receipts.) Therefore, if a taxpayer sold the tree
before the fruit was picked, the sum received for selling the tree with the fruit attached
was, normally, wholly capital.
70
For example
where a taxpayer who holds shares as an investment sells them cum dividend.
The part of the sale price attributable to the dividend payable is not regarded as
income.
71

The concept of income and the distinction between income and capital become blurred
due to the lack of a definition of income.
72
(Indeed, it is this blurring of the
definition of income which led to the introduction of a statutory capital gains tax in
Australia.
73
) The blurring is aggravated by taxpayers planning to have particular gains
characterised as capital gains so as to lower (or eliminate) the taxation which might
otherwise apply. Determining where the source of income is situated is even more
significant due to the different tax treatment of income derived within a jurisdiction
and outside a jurisdiction by a resident and a non-resident.

The court has emphasised that the factors relevant to the ascertainment of the character of a receipt of
money are not necessarily the same as the factors relevant to the ascertainment of the character of its
payment.
70
Michael Flynn, Distinguishing Between Income and Capital Receipts A Search for Principle
(1999) 2 Journal of Australian Taxation 155, 160.
71
Ibid.
The distinction between income and capital may not, at times, be quite so clear. If the taxpayer is in
the business of trading in trees, for example, then sale of the trees may be regarded as income according
to ordinary concepts.
In Commissioner of Inland Revenue v British Salmson Aero Engines Ltd (1938) 22 TC 29, Lord
Greene said (at 43) that there have been many cases that fall on the borderline: indeed, in many cases it
is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt
to find reasons. The issue in British Salmson was whether a lump sum (payable in instalments) for the
sole licence to manufacture and sell in the UK and within British territories the aeroplane engines
originally designed and made by a French company was of a capital nature. Income tax was attracted
by that part of the payment which was a royalty and the payer was bound to deduct a sum representing
the amount of tax and to account for it to the revenue authority (a form of withholding tax). No income
(withholding) tax was attracted if the payment was of a capital nature.
72
Though the term income is not defined in Australia, income from personal exertion or income
derived from personal exertion is defined to consist of earnings, salaries, wages, commissions, fees etc
in Australia. All income not being income from personal exertion is treated as income from property
or income derived from property. See the definition of income from property or income derived
from property in s 6(1) of the ITAA 1936.
73
See above footnote 46.
33
2.5 Conclusion

The operation of the current source rules in Australia and Hong Kong (which rules are
based on legislation, case law and double tax treaties (DTT)) have been placed under
significant strain by globalisation and the increasing conduct of commerce on the
Internet.
74
Hong Kongs income tax system is widely seen as outdated.
75
Australias
source rules have been described as antiquated.
76
The rules, developed by the courts
in another age when life was simpler and moved more slowly, have been left behind
by the electronic communications revolution and are quite inadequate and, in some
instances, even ludicrous in todays environment.
77

Hong Kong has experienced dynamic growth during the past several decades and is
now an international financial centre as well as an attractive base for multinational
operations in part because of its simple, low-tax structure. The source-based system of
profits tax means that many income-generating transactions, operations or activities
related to Hong Kong fall outside of the Hong Kong profits tax net. This is because
Hong Kong entities, whether locally owned or controlled by non-residents, are only
taxed on their business profits arising within the jurisdiction of Hong Kong.
78
A

74
Some areas considered by the Australian Taxation Office to be difficult areas in applying and
enforcing the law are:
source rules relating to sales of goods/provision of services on the Internet;
share trading income on the Internet;
withholding tax;
central management and control;
controlled foreign corporations; and
transfer pricing.
See Australian Taxation Office, Tax and the Internet, vol 1, above n 16, [9.24.5].
75
Richard Cullen and Tor Krever, Will Tax Reform Drive Political Reform in Hong Kong? (2006) 41
Tax Notes International 197, 197.
76
Tom Magney, Commentary: Our Antiquated Rules of Source Have Been Left Behind by the
Electronic Communications Revolution (1995) 3 Taxation in Australia (red ed) 175, 175.
77
Ibid. See, also, Dirkis, Ripe for Reform: Australias Domestic Source Rules, above n 36, on his
evaluation on the effectiveness of Australias source rules in terms of equity, efficiency (neutrality) and
simplicity in their practical application.
78
34
resident business may be able to place certain income-producing transactions,
operations or activities in an offshore company that it controls. If that resident
company can show that the profits of the offshore company do not arise in or derive
from Hong Kong, then those profits will not be subject to any tax in Hong Kong, even
if the profits are remitted to Hong Kong. Thus, disputes regularly arise as to what
constitutes the source of business profits. This is especially so in re-invoicing
activities when purchases and sales are booked through an offshore company so as to
shift the source of profits into a foreign jurisdiction.
79

In Australia, residents are assessed on income from all sources whether in or out of
Australia,
80
and foreign residents are assessed on income that has an Australian
source.
81
The comprehensive coverage of all tax aspects of inbound, outbound and
conduit investment does reduce opportunities for tax planning, compared to Hong
Kong. But, with the ongoing globalisation of the Australian economy, more taxpayers
are becoming involved in cross-border trade and investment. Shifting profits out of
Australia to low-tax jurisdictions is an issue.
82
Some common techniques used by
Australian businesses to shift income out of Australia have been identified as follows:
using transfer pricing arrangements between related Australian and offshore
entities to shift income to low-tax jurisdictions and expenses to high-tax
jurisdictions;
83

79
See Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074 and
Commissioner of Inland Revenue v Magna Industrial Co Ltd (1997) HKRC 90-082 discussed in Part
5.5, Chapter 5.
80
Income Tax Assessment Act 1997 (Cth) ss 6-5(2), 6-10(4).
81
82
Michael J enkins, Profit Shifting in Australia: The State of Play in 2006 (2006) 15(9) Tax
Management Transfer Pricing Report 365.
83
Transfer pricing encompasses such things as goods, intangibles, management fees and funding
arrangements. See Michael DAscenzo, International Profit Shifting The ATO Perspective (Speech
delivered at the Corporate Tax Summit, 20 J une 1989) Australian Taxation Office
<http://www.ato.gov.au/print.asp?doc=/content/75026.htm>at 2 May 2008.
35
using service fees or commissions paid to related-party intermediaries to reduce
taxable income in Australia;
providing interest-free loans to offshore associates which earn returns in low-tax
jurisdictions; and
sending Australian-generated intangibles and other payments offshore.
84

The difficulty with respect to the taxation of business income is to determine the true
profits where the transactions, operations or activities are carried on through related
parties and not dealt with at arms length.
85
There are general anti-avoidance
provisions in the tax legislation of both Australia and Hong Kong, but they have been
applied in a fairly limited number of cases.
86
Though the general anti-avoidance rules
have a role to play to encourage compliance with any tax regime, they do not
specifically address the issues discussed in this thesis and do not provide a solution to
the question of source.

2.6 Source-based taxation areas of concern

Below is an outline of the extent to which source-based taxation presents a revenue
risk, especially in the case of cross-border trade and investment. Some key options for
reducing this revenue risk are also canvassed in brief. This discussion raises general

84
Australian Taxation Office, 2006 Large Business and Tax Compliance (2006) 27.
85
In the 2004-05 financial year, more than 60 per cent of large businesses had international dealings,
and most of these were with related parties. About 50 per cent of imports into Australia and 30 per cent
of exports out of Australia were through related-party dealings. See Australian Taxation Office,
Commissioner of Taxation Annual Report 2004-05 (2005) 179.
International profit shifting and related party dealings are discussed in Part 3.9, Chapter 3.
86
In Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775, Pt IVA
was invoked due to the contrivance of sourcing the interest offshore. See Australian Taxation Office,
Part IVA: The General Anti-Avoidance Rule for Income Tax (2005) for a discussion of the basic
principles about how and when Pt IVA applies.
In Hong Kong, the general anti-avoidance provisions are contained in ss 61 and 61A of the IRO
1947 (modelled on Australias Pt IVA), explained in footnotes 26-27, Chapter 4.
36
issues, that is, issues which apply not just to Australia and Hong Kong, but beyond.
The headings below identify well-recognised areas of taxation difficulty. Particular
problematic tax topics will rarely be confined to a single heading but will usually give
rise to difficulties under several headings. The areas of concern noted directly below
are addressed in further detail in later chapters.

2.6.1 Tax havens and offshore financial centres

Not all residents declare their worldwide income. Some may hide their taxable
income or assets or structure their cross-border dealings and financial arrangements in
tax havens and offshore financial centres in an attempt to minimise tax. Previously
these mechanisms were only available to the rich and large corporations. Today, they
are far more widely available to a much larger range of taxpayers due to the rapid
growth of the Internet and the very low, per transaction cost of using it.
87

A tax haven generally refers to a country which is used to avoid tax that would
otherwise be payable in a high-tax country.
88
An entity can form a company or a
trust
89
in a tax haven and arrange for the company or trust to derive income from third

87
Allesandra Fabro, ATO Tax Haven Unit Claws Back $5m, The Australian Financial Review
(Sydney), 7 March 2005, 7.
88
Some examples of tax havens include British Virgin Islands, Cook Islands, J ersey, Liberia, Panama,
Samoa and Vanuatu. See Australian Taxation Office, Tax Havens and Tax Administration (2007) 8.
89
A trust is not a legal entity. It is a relationship under which a person (the trustee) is obliged, as the
owner of specific property, to deal with that property for the benefit of another person (the beneficiary)
or for the advancement of certain purposes. The beneficiaries of a trust have an individual beneficial
interest in all of the trusts underlying assets and income. Income generated by the trust is generally
taxable in the hands of the beneficiaries. Tax is saved by directing distributions to family members
with little or no other income. It is the discretionary power to distribute income and capital to family
members with the lowest rate of tax that makes a trust a desirable tax planning structure. See Michael
Butler, Taxation of Trusts in Australia: A Practical Update (2002) 8 Asia-Pacific Tax Bulletin 233,
233-5; Max Newnham, In Defence of Trusts: Not a Tax Dodge, But a Legitimate, Historical
Investment Structure for Families, The Age (Melbourne), 19 J uly 2004, B10.
37
countries to shelter income from taxation both at the source and in its residence
jurisdiction.
90

Offshore financial centres offer currencies, loans, bonds and many other financial
instruments (which exist beyond the reach of regulation by the originating national
economy) to minimise income tax.
91
The Internet can also provide easier access to
credit and debit cards issued by financial institutions in the tax haven countries, which
cards can be used to hide taxable activity.
92

Perhaps the most significant change brought about by electronic commerce is the
ability to produce income with little or no traceable record. Most business transactions
conducted on the Internet make use of electronic funds transfer facilities such as the
credit card or electronic cash. If electronic cash is used, then the income flows out of
the jurisdiction of the buyer to another jurisdiction without leaving any easy audit trail
to follow. Unlike a credit card transaction, electronic cash is anonymous and reusable
like cash. If a buyer pays for goods or services by electronic cash, that person is only
transmitting a number directly from one computer to another. No third party (credit
card company) is involved as with a credit card transaction. Some transactions may
pass through several jurisdictions including tax havens and offshore financial centres
and the electronic cash may be deposited in a secret bank account.

90
United Nations, Department of Economic and Social Affairs, Manual for the Negotiation of
Bilateral Tax Treaties Between Developed and Developing Countries (2003) 37.
Non-common law entities such as anstalts and stiftings may also be used to avoid tax. See
Australian Taxation Office, Tax Havens and Tax Administration, above n 88, 41 for the
characteristics/features of offshore structures such as anstalt and stifting.
91
Susan Roberts, Fictitious Capital, Fictitious Spaces: the Geography of Offshore Financial Flows in
Stuart Corbridge et al (ed), Money, Power and Space (1994) 93.
92
Offshore credit and debit cards are actively marketed on the Internet and can be used to access income
or wealth that is hidden offshore in tax havens so as to try to avoid tax. See Australian Taxation Office,
Tax Havens and Tax Administration, above n 88, 32, on how the Australian Taxation Office identifies
tax haven arrangements.
38

The use of offshore accounts or offshore entities to conduct international operations to
minimise tax is a significant and growing concern for the tax authorities.
93
A key
issue in dealing with international non-compliance is the lack of cooperation between
relevant tax authorities. The combination of flexible commercial activities, innovative
financial arrangements, bank secrecy and a cashless society present a major threat to
the tax base for many jurisdictions.
94

2.6.2 Nexus or link to a jurisdiction

Typically, income tax law assumes that all income can be located in one jurisdiction or
another as a matter of physical fact,
95
either in the geographic location where the
wealth or the income is physically or economically produced or paid (source), or in
the geographic location of the entity earning the income (residence). However, a
jurisdiction can exercise its taxing right over an item of income only if there is a
nexus or link to the jurisdiction. It is this nexus which is used to justify the

93
For example, the use of offshore trusts to disguise offshore accounts is a concern in Australia.
Investigations by the Australian Taxation Office and the Australian Crime Commission into the abuse of
tax havens have exposed hundreds of secret offshore trusts, or blind trusts, which are presumably used
for tax planning purposes. Blind trusts are vehicles used to hide the true identity of the controllers and
beneficiaries, and the information would not be revealed to authorities or named on trust documents.
See J ohn Garnaut, Offshore Trusts Used As Veil: ASIC Worried About Secret Transactions, Sydney
Morning Herald, 29 August 2005, 23; J ohn Garnaut, Banks Singled Out in Drive to Track Down
Offshore Tax Cheats, Sydney Morning Herald, 21 September 2006, 2.
94
Bank secrecy can be a factor in blocking effective information exchange. There are Australian
residents who try to exploit the secrecy of tax havens to conceal their income and assets so as to avoid
paying the amount of tax properly payable under the law. See Australian Taxation Office, Tax Havens
and Tax Administration, above n 88, 6.
To reduce offshore tax evasion and improve transparency, Australia has entered into a network of
tax information exchange agreements with Bermuda (Agreement Between the Government of Australia
and the Government of Bermuda [as authorised by] the Government of the United Kingdom of Great
Britain and Northern Ireland on the Exchange of Information with respect to Taxes (entered into force
20 September 2007)), Antigua and Barbuda (Agreement between the Government of Australia and the
Government of Antigua and Barbuda on the Exchange of Information with respect to Taxes (signed on
30 J anuary 2007)) and the Netherlands Antilles (Agreement between the Government of Australia and
the Government of the Kingdom of the Netherlands in respect of the Netherlands Antilles for the
Exchange of Information with respect to Taxes (entered into force 4 April 2008)).
95
Prebble, above n 56, 306.
39
imposition of taxation by the jurisdiction on a particular taxpayer. The nexus or link
creates a tax liability due to the relationship between a taxpayer (tax subject) and an
item of income (tax object) and a tax jurisdiction. The primary link with a jurisdiction
is the residence of the taxpayer (tax subject) or source of income (tax object). Other
factors that can create a nexus or link include the site or location of the transaction or
asset, the nature of the transaction, activity or business operation, or the character of
the payment. These factors help link the taxpayer personally to a particular tax
jurisdiction and can give a jurisdiction the right to tax.

The jurisdiction to impose income tax on the basis of residence arises from the
relationship of the taxpayer (tax subject) to the taxing jurisdiction. On the other hand,
the jurisdiction to impose income tax on the basis of source derives this entitlement
from the relationship of the income (tax object) to the taxing jurisdiction. The
residence and source factors form the basis of the rules governing a countrys
jurisdiction to tax.

Thus, to assert the right to impose tax on the income derived by a person, there must
be a nexus or link to a jurisdiction. Where is the nexus in electronic commerce?
is it between the seller and his home state, the seller and the state of the
customer, the customer and the state of the seller, the customer and his/her
state of residence, the internet service provider and their resident state, the
internet service provider and the home state of the customer, or the internet
service provider and the state of the seller?
96

For entities existing and doing business via a web site, an online transaction is
essentially electrons floating over wire in cyberspace, with no border or geographic

96
S Peter Horn, Taxation of E-Commerce (2003) 2 Journal of American Academy of Business 329,
331.
40
place.
97
It is difficult to establish a nexus or link to a jurisdiction because all
transactions occur instantaneously in the nebulous world of cyberspace, which is
radically distinct from the physical world.
98
The challenge for tax administrators is to
determine how to apply the currently formulated residency and source rules to
electronic commerce and enforce the collection of tax on income earned by entities
residing in cyberspace.

2.6.3 Permanent establishment

Electronic commerce requires a rethinking of the concept of PE, which currently is
normally crucial in determining whether a source country can tax business profits
(where a DTT applies). Virtually all DTTs use the PE concept as the main instrument
to establish taxing jurisdiction over a resident carrying on business overseas or a non-
resident carrying on business in the host jurisdiction.
99
A contracting state cannot tax
the profits of an enterprise of the other contracting state unless it carries on its business
through a PE situated therein and profits are attributable to the PE.
100
The existing
treaty rules that determine when a source country may tax business profits (based on
the PE concept) did not emerge from economic principles, but from a negotiation
process which took place in the 1920s in which one of the primary factors was

97
Kyrie E Thorpe, International Taxation of Electronic Commerce: Is the Internet Age Rendering the
Concept of Permanent Establishment Obsolete? (1997) 11 Emory International Law Review 633, 652.
98
99
Arvid A Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle (1991) 1.
100
Before the concept of PE was developed, double taxation could arise when different tax systems
were used by different countries to tax the same income. Take the case of British India. Income tax
was introduced in British India in 1860 upon income and profits arising in India. As the United
Kingdom (UK) taxed its residents on income from all sources, UK residents in India became liable to
income tax both in the UK and in India (without relief for double taxation). Though it was recognised
that there was a problem of double taxation, no further investigation was made into the matter by the
Chancellor of the Exchequer of the day. See Robert Willis, Great Britains Part in the Development of
Double Taxation Relief [1965] British Tax Review 270, 270.
41
enforcement considerations the territorial limitations to the jurisdictions capacity to
determine, verify and collect tax from foreign enterprises.
101

The concept of PE is used to define the contact required to justify source-based
taxation of a non-residents business presence in a particular jurisdiction in general. It
requires:
a definitive, organized contact or presence so that casual business connections
or even a steady stream of exports without a business presence of the foreign
exporter will not trigger source taxation.
102

There are three conditions to be satisfied:
physical presence the existence of a place of business (that is, a facility such as
premises or, in certain instances, machinery or equipment);
fixed place of business it must be established at a distinct place with a certain
degree of permanence; and
level of business activity the carrying on of the business of the enterprise through
this fixed place of business. This means that there are persons who, in one way or

101
The original PE concept was developed under Prussian law and the law of the German Empire. For
tax purposes, the PE concept emerged as the necessity of preventing double taxation among Prussian
municipalities in the middle of the 19
th
century.
In 1919-20, the League of Nations was called upon by the International Chamber of Commerce to
examine the problem of international double taxation which was a major obstacle to the reconstruction
of the public finance of the world. From 1928 to 1946, the League of Nations presented three draft tax
treaties that provided different variations of the PE concept, and arrived at three important decisions
which formed the basis of the rules governing a countrys jurisdiction to tax today:
profits of a PE of a non-resident entity (such as a foreign branch) could be taxed by the host country;
tax residence depended on the place of centre of management; and
subsidiaries were to be treated as separate entities for tax purposes.
Today, the League of Nations model tax treaty still serves as the basis for the model used in the
OECD and the United Nations.
See Michael J Graetz and Michael M OHear, The Original Intent of U.S. International
Taxation (1997) 46 Duke Law Journal 1021, 1066-89; Angharad Miller and Lynne Oats, Principles of
International Taxation (2006) 94; OECD, E-commerce: Transfer Pricing and Business Profits Taxation,
above n 15, 83, 87; Judd A Sher, A Band-Aid or Surgery: It is Time to Evaluate the Health of the
Permanent Establishment Concept (1999) 28 Tax Management International Journal 415, 416; Skaar,
above n 99, 71-101.
102
Thorpe, above n 97, 658.
42
another, are dependent on the enterprise (personnel) conducting the business of the
enterprise in the state in which the fixed place is situated.
103

If the three conditions are met, business profits are allocated to the jurisdiction in
which the profits are earned (source jurisdiction) and then these profits are taxed on a
net basis. Thus, the requirement for a PE is a minimum threshold that must be
satisfied before a jurisdiction can tax residents of other treaty jurisdictions on their
business profits derived from the jurisdiction.
104

In Australia, the PE concept was first used in the Australia-UK DTT signed in 1946
and in Australias domestic tax law outside the tax treaty context in 1959.
105
A
permanent establishment, in relation to a non-residents business presence in a
particular jurisdiction, means:
a place at or through which the person carries on any business and, without
limiting the generality of the foregoing, includes:

(a) a place where the person is carrying on business through an agent;

(b) a place where the person has, is using or is installing substantial
equipment or substantial machinery;

(c) a place where the person is engaged in a construction project; and

(d) where the person is engaged in selling goods manufactured, assembled,
processed, packed or distributed by another person for, or at or to the
order of, the first-mentioned person and either of those persons
participates in the management, control or capital of the other person or
another person participates in the management, control or capital of

103
OECD, Model Tax Convention on Income and on Capital (condensed version, 2005) 85.
104
Brian J Arnold, Threshold Requirements for Taxing Business Profits under Tax Treaties (2003) 57
Bulletin for International Fiscal Documentation 476, 476.
See, also, OECD, E-commerce: Transfer Pricing and Business Profits Taxation, above n 15, on PE
issues relating to electronic commerce.
105
See Australian Taxation Office, Taxation Ruling TR 2002/5, Income Tax: Permanent
Establishment What is a Place at or through which [a] Person Carries on any Business in the
Definition of Permanent Establishment in Subsection 6(1) of the Income Tax Assessment Act 1936? [16].
43
both of those persons the place where the goods are manufactured,
assembled, processed, packed or distributed;

but does not include:

(e) a place where the person is engaged in business dealings through a
bona fide commission agent or broker who, in relation to those dealings,
acts in the ordinary course of his business as a commission agent or
broker and does not receive remuneration otherwise than at a rate
customary in relation to dealings of that kind, not being a place where
the person otherwise carries on business;

(f) a place where the person is carrying on business through an agent:

(i) who does not have, or does not habitually exercise, a general
authority to negotiate and conclude contracts on behalf of the
person; or

(ii) whose authority extends to filling orders on behalf of the person
from a stock of goods or merchandise situated in the country
where the place is located, but who does not regularly exercise
that authority,

not being a place where the person otherwise carries on business; or

(g) a place of business maintained by the person solely for the purpose of
purchasing goods or merchandise.
106

The phrase a place at or through which [a] person carries on any business is a
reference to a place used for carrying on that persons business activities.
107
That place
must have an element of permanence, both geographic and temporal.
108
But these
elements may not be present in electronic commerce. The issue raised by electronic
commerce is that a non-resident company can trade with the source country via a web
site without establishing a local presence. This means a country where goods or
services are sold has no jurisdiction to tax the resulting profits in the absence of a PE.

106
Income Tax Assessment Act 1936 (Cth) s 6(1).
107
Australian Taxation Office, Taxation Ruling TR 2002/5, above n 105, [9].
108
In the context of Australias definition of PE, a place at or through which a person carries on any
business must be geographically permanent. The business presence must not be of a purely temporary
nature. An entity must operate at that place for a period of time. Ibid [29]-[30].
44
Though the liability to tax in Hong Kong is based on the source of income, the PE
concept is relevant in determining if a non-resident has a business in Hong Kong. A
PE is defined in r 5(1) of the Inland Revenue Rules and means:
a branch, management or other place of business, but does not include an
agency unless the agent has, and habitually exercises, a general authority to
negotiate and conclude contracts on behalf of his principal or has a stock of
merchandise from which he regularly fills orders on his behalf.

The comprehensive DTT concluded with Belgium, Thailand and Luxembourg each
contains a definition of PE.
109
The Hong Kong profits of a person having a PE in
Hong Kong are assessable to profits tax. The threshold question is whether the foreign
company is carrying on a business in Hong Kong and Hong Kong profits are derived
from that business. Where a foreign company is merely selling products to customers
in Hong Kong without a local presence, the Hong Kong profits of the foreign company
would not be subject to profits tax.

2.7 Taxation of business profits alternative approaches

How should business profits be taxed in this digital age when more and more
companies are engaged in cross-border trade and investment activities facilitated by
developments in electronic commerce? The absence of geographic place in
cyberspace undermines the source rules. Should taxation be based on the residence
principle in which the worldwide income of the entity is included in the taxable

109
See art 5 of the Agreement Between the Hong Kong Special Administrative Region of the Peoples
Republic of China and the Kingdom of Belgium for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (entered into force
7 October 2004); Agreement Between the Government of the Hong Kong Special Administrative Region
of the Peoples Republic of China and the Government of the Kingdom of Thailand for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (entered into
force 7 December 2005); Agreement Between the Hong Kong Special Administrative Region of the
Peoples Republic of China and the Grand Duchy of Luxembourg for the Avoidance of Double Taxation
and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (entered into
force 1 April 2008).
45
income without the need to find the origin or source of income or profits? The US
Treasury Department has suggested that shifting to residence-based taxation is
necessary because electronic commerce raises special difficulties in sourcing income:
In the world of cyberspace, it is often difficult, if not impossible, to apply
traditional source concepts to link an item of income with a specific
geographical location. Therefore, source based taxation could lose its rationale
and be rendered obsolete by electronic commerce In situations where
traditional source concepts have already been rendered too difficult to apply
effectively, the residence of the taxpayer has been the most likely means to
identify the jurisdiction where the economic activities that created the income
took place, and thus the jurisdiction that should have the primary right to tax
such income.
110

Advances in computer and telecommunications technology often blur the geographic
site or location of economic activity to such an extent that the traditional economic
underpinnings of the US source rules may no longer be valid.
111
Almost all taxpayers
are resident somewhere and, it is argued, each relevant entity may be made liable to
pay tax on its worldwide income.

But taxation based on residence may tend to lose its meaning, too. That is, not unlike
with source, determining residence also may grow to be more difficult because there
is no single concept of residence. The tax residence of a taxpayer can be
manipulated not least because electronic commerce can be conducted anywhere.
Companies can choose where to organise themselves they can choose their residence

110
111
The US source rules are based on the following principles:
the rules reflect the location of the economic activity generating the income and the source of legal
protections facilitating the earning of that income;
the rules are neutral in the sense that the US would have no ground for objection if its source of
income rules were applied by other countries;
the rules do not allow erosion of the legitimate US tax base through taxpayer manipulation of the
source rules or of the FTC limitation; and
the rules operate clearly and do not require difficult factual determinations on a transaction by
transaction basis.
See J oseph L Andrus, Determining the Source of Income in a Changing World (1997) 75 Taxes 839, 840.
46
by the place of incorporation and the place to hold their shareholders and directors
meetings without regard to where the companys real business operates.
112

Even if residence-based taxation may lower the revenue loss risk, there is a need to
note another difficulty with any move to a greater reliance on residence as a basis for
taxation. A shift to residence-based taxation would clearly benefit exporting
jurisdictions of goods, services, capital and technology, while importing jurisdictions
would suffer significant revenue loss as a result. Under residence-based taxation,
exporting jurisdictions grow richer as their residents make and earn income from
commerce, capital, investment and technology. It is highly unlikely that net-importing
jurisdictions would agree to residence-only taxation (as a mechanism to try and
overcome difficulties with the application of source rules) in view of these potential-
adverse revenue consequences.
113

It has been argued that source-based taxation should continue as it is theoretically
justifiable for income that arises from international transactions which are conducted

112
Residency rules are discussed in Part 7.3.2, Chapter 7.
113
A jurisdiction has the power to design its own tax system, including developing a network of DTTs
with other jurisdictions, to reduce tax impediments to both international trade and investment. Investors
may be concerned about becoming subject to another jurisdictions income tax or withholding tax,
which can significantly increase the cost of investments. Where a DTT applies, the taxation of cross-
border trade and investment is governed by the terms of the DTT. The main structural mechanism by
which a DTT avoids double taxation is to distribute or allocate taxing rights over income between
the contracting states and to require the residence state to relieve double taxation for any tax paid at
source. The basis for the allocation of taxing rights varies for different types of income. For example,
Australias more recent DTTs provide for exclusive residence state taxation of inter-company dividends,
limiting the source state the right to levy dividend withholding tax to zero. In the case of business
profits, though the right to tax is given to the residence state, the source state may also tax income
derived from a business located in its territory if attributable to a PE. This means shifting to an
exclusive residence taxation of business profits, as proposed by the United States Treasury Department,
would be hard to achieve unless all DTTs were re-negotiated. On the other hand, contracting parties to
a DTT can negotiate their DTTs to reflect their position in the global economy as both a significant
exporter of, and a significant importer of, capital and technology. See Australian Taxation Office,
Taxation Ruling TR 2001/13, Income Tax: Interpreting Australias Double Tax Agreements [9-11]
addressing the methods utilised in DTTs to avoid double taxation and how taxing rights are allocated
between the two contracting states that have concluded a DTT.
47
in an electronic commerce environment.
114
However, the way in which source is
defined under the PE threshold for active business profits may need to be
reconceptualised to adequately accommodate electronic commerce transactions.
Physical presence could become more elusive (or even absent) in an electronic
commerce context. Under this particular proposal (the Pinto Proposal),
115
the
requirement for a physical presence for source tax nexus is to be replaced by a dollar-
based threshold test. The Pinto Proposal argues for a system of withholding to be
applied by source countries at a uniform rate to all international electronic commerce
transactions, which will be refundable if the total gross sales of a foreign seller for a
relevant period remain below a de minimis threshold.

The Pinto Proposal arguably poses certain fundamental implementation challenges
(which are discussed in greater detail in Chapter 7). On the administrative side, it
requires the use of a third-party intermediary to collect the tax and the provision of a
digital certificate to prove the taxpayers identity. Thus far, digital certificates are not
normally issued by a central governing body, but are issued by different certification
authorities with no uniform standards governing them. They typically do not state the
tax residence of the holder, however. The Pinto Proposal also requires a substantial
reform of the tax system of many if not most jurisdictions around the world to
introduce such a system. A withholding tax is a barrier to the use of cross-border
goods and services. This could lead to entities relocating their businesses to low-tax
jurisdictions.

114
The argument that source-based taxation of electronic commerce transactions is theoretically
justifiable is based on the principles of benefit theory, neutrality considerations (for example, capital
import neutrality), equity (for example, inter-nation equity), the concept of entitlement, and pragmatic
considerations including the prospect of double taxation and likely impediments to international trade.
See Dale Pinto, E-Commerce and Source-Based Income Taxation (2003) 44-5.
115
The proposal outlined in Pinto, ibid. The Pinto Proposal is discussed in detail in Chapter 7.
48

Finally, should most or all income taxes be replaced with consumption taxes? It has
been argued that a consumption tax could provide a more stable tax base in the face of
increasing global tax competition, as consumption is less mobile than flows of
investment capital.
116

These topics are discussed in Chapter 7 (and also in Chapter 8), when the ways to deal
with issues arising out of our reliance on source-based taxation are considered in detail.

116
Chris Edwards and Veronique de Rugy, International Tax Competition: A 21
st
-Century Restraint on
Government (2002) 27 Tax Notes International 63, 107.
49
CHAPTER 3: THEORETICAL OVERVIEW

3.1 Introduction

Taxation at source and the schedular tax system were introduced in the United
Kingdom (UK) in the early nineteenth century.
1
At that time, all items of income
could be classified by description under the schedules, each of which implied income
from a particular activity or source (meaning A). One could usually and readily point
to the location where the income first arose (meaning B).

This chapter provides a theoretical overview of taxation at source and how source was
determined under the schedules in the UK. It is necessary to have a thorough grasp of
where source came from in order to fully understand why the application of source
is not easy today.

1
United Kingdom (UK) means Great Britain and Northern Ireland. Great Britain means England,
Wales and Scotland.
England and Wales became a single state in 1295. Great Britain was formed in 1707 by the union
of England and Wales with Scotland. This entity united with Ireland in 1801 to form the United
Kingdom of Great Britain and Ireland.
In 1921, Ireland had to be divided into Northern Ireland and the Irish Free State (later Eire or the
Republic of Ireland) for political purposes. But Northern Ireland remained part of the UK. In every Act
and public document passed and issued after 12 April 1927, the United Kingdom means Great Britain
and Northern Ireland.
See David M Walker, The Oxford Companion to Law (1980) 153, 648, 1250; Butterworths,
Halsburys Laws of England, vol 8(2) (4
th
ed reissue, 1996), Constitutional Law and Human Rights,
1 Introduction: Basic Principles of the Constitution [3]; Butterworths, Halsburys Laws of England,
vol 23(1) (4
th
ed reissue, 2002), Income Taxation, 1 Introduction [1].
The income tax introduced in the UK in 1803 applied to Great Britain only England, Wales and
Scotland. Ireland was integrated into the UK tax system in 1853. See J ohn F Avery J ones, Taxing
Foreign Income From Pitt to Tax Law Rewrite The Decline of the Remittance Basis in J ohn Tiley
(ed), Studies in the History of Tax Law (2004) 19; Edwin R A Seligman, The Income Tax A Study of
the History, Theory, and Practice of Income Taxation at Home and Abroad (2
nd
ed, 1914) 154.
50
3.1.1 Structure of the chapter

This chapter is divided into 10 parts. The next part discusses the methods of collecting
taxes at source, and explains why withholding the tax at source also reduces
opportunities for evasion. Part 3 traces the origin of taxation at source and the
schedular tax system. Historically, tax used to be collected by a disinterested third
party based on the income classified under the schedules. This method of taxation
largely avoided any need to look at a taxpayer and his tax return, for example. Part 4
discusses the concept of source of income under the schedules, and examines how
taxation at source had been applied over the past two hundred years. Part 5 identifies
the techniques used to avoid tax and explains why taxation at source generally proved
to be a practical way of raising revenue in days gone by. Part 6 shows how the
withholding principle has been extended and used in Australia and Hong Kong.
Withholding is the most direct way of collecting tax at source, especially from non-
residents engaged in cross-border transactions, operations and activities. Part 7
illustrates how investment decisions can be driven by tax (and source). The source-
based approach ensures that residents and non-residents can compete on an equal
footing based on where the income was earned. Part 8 examines the issues relating to
the concept of source of income. The source issue is further complicated with the
global integration of business operations, discussed in Part 9. Globalisation has
substantially increased source-related revenue risks as well as provided greater
opportunities for tax planning enjoyed by international businesses. Part 10 concludes
that the traditional concept of source of income is no longer applicable as readily, in
the way it once was, to resolve taxation issues.

51
3.2 Taxation at source

Taxation at source was a simple and efficient way to catch as catch can and collect
the tax before the income reached the ultimate recipient.
2
Tax was withheld and
collected either by deducting and retaining it or deducting and remitting it at the
location where the income first arose. Therefore, under taxation at source, tax is
assessed, wherever possible, on the payer of the income rather than its destination
(recipient of income).
3

When tax is collected under the deduct and retain method, the payer is (effectively
see illustration below) levied and charged with the tax as part of the payers own tax
liability. But the payer is entitled to recover the tax from the payee (recipient of
income) by deducting and retaining it when making payment to the payee.
4

The deduct and remit method is based on the agency principle.
5
The payer is
designated a withholding agent. That person must deduct tax from certain income at
the time of payment to the payee (recipient of income) and must remit the tax to the
taxing authority.
6
Unlike the deduct and retain method, there is no recovery by the
payer, since the withholding agent is obliged to remit only the tax that he has already
withheld.
7
The payer is accountable to the government separately for the tax withheld
and for the tax due on his own income.
8

2
Frans J Vanistendael, Reinventing Source Taxation (1997) 6(3) EC Tax Review 152, 152.
3
Piroska E Soos, Taxation at the Source and Withholding in England, 1512 to 1640 [1995] British Tax
Review 49, 49.
4
Piroska E Soos, The Origins of Taxation at Source in England (1997) 11.
5
Soos, Taxation at the Source and Withholding in England, 1512 to 1640, above n 3, 51.
6
Ibid.
7
Ibid.
8
Ibid.
52
The main difference between deduct and retain and deduct and remit is what the
payer does with the tax that he deducted,
9
and this is illustrated by the following
example:
10

9
Ibid 51-2.
10
Based on an example in Soos, The Origins of Taxation at Source in England, above n 4, 14.
An entrepreneur whose taxable profits for the year are $1000 has an interest liability of $100.
The liability is, in principle, deductible in determining taxable profits, but it has not been deducted from
the $1000 profits.
If the deduct and retain method applies to the interest, the entrepreneur (payer) is denied a
deduction for the interest. His or her taxable profits remain $1000 and, assuming a flat rate of tax of 20
per cent, his or her tax liability is $200. When the entrepreneur pays the interest, he or she may deduct
and retain $20 (20 per cent x $100), thus reducing his or her tax liability to $180. This deduction and
retention is in lieu of a deduction from income.
If the deduct and remit method applies to the interest, the entrepreneur, as a withholding agent,
must withhold tax of $20 (20 per cent x $100) from the interest at the time of payment and remit the tax
to the government. As a separate matter, the entrepreneur computes his or her taxable profits and, in
doing so, deducts the interest, making his or her taxable profits $900. His or her tax liability is $180 (20
per cent of $900) the same as under taxation at source after recoupment.
Under both methods, the government collects $20 tax on the interest from the payer (entrepreneur),
and the recipient (lender) receives the interest ($80) net of tax.
Payers income tax data:
Profits $1000
Taxable income $1000
Total tax
actually paid (20%) $ 200
Less recovery of tax
from payee under
deduct and retain $ 20
No deduction for the interest payment
from payers profits.
Payer made an interest payment
of $100.
Payers ultimate
tax liability $ 180
Deduct and Retain
Payer may deduct and retain $20
(20 per cent of $100) from the payee to
recover the tax (in lieu of a deduction
from payers profits).
Payer is levied and charged with tax as
part of his own tax liability.
53

Tax withholding is a central feature of modern income tax systems and a principal
means of collecting many income taxes throughout the world.
11
Tax withholding is
most commonly applied to wages and salaries. It is also frequently used in connection
with non-portfolio investment income such as interest, dividends and royalty payments
to non-residents. Taxation at source enables a government to collect the tax on income
currently as the income arises.
12
Withholding the tax at source also reduces evasion as
tax is collected from persons not directly interested in its payment.

3.3 Origin of taxation at source

In England, the application of taxation at source to the direct tax area can be traced
back to the sixteenth century with the lay subsidies from 1512 to 1523.
13
For example,

11
Ibid 1.
12
See footnote 40, Chapter 1, on Australias Pay As You Go (PAYG) system for withholding amounts
at source in respect of particular kinds of payments and transactions.
The deduct and remit method of tax withholding has also been extended to the collection of
consumption taxes (for example, Australias goods and services tax).
13
Though the Tudor subsidy levied tax with respect to lands and goods, the subsidies from 1512 to 1523
also provided for wages as a taxable category. Ibid 12-22.
Payers income tax data:
Profits $1000
Deduction for interest $ 100
Taxable income $ 900
Tax payable (20%) $ 180
Payers tax liability $ 180
Payer may deduct the interest payment
from his taxable income.

Payer must deduct $20 (20 per cent of
$100) at the time of payment to the
payee and must remit the tax to the
taxing authority.

No recovery of tax by the payer.
Payer made an interest payment
of $100.
Deduct and Remit
Payer is accountable to the government
separately for the tax withheld and for
the tax due on his own income.
54
the tax on the servants wages (income) was first assessed in the hands of the servant
(recipient of income) according to the normal rules of assessment, and the tax so
determined was shifted and charged to the master (payer of income) who was liable
for the tax. However, the master could deduct it from the servants wages (income).
14

Taxation at source was again applied from 1535 in the annual tenth
15
levied on the
clergy with respect to pensions (income) paid out of clerical revenues.
16
The retired
ecclesiastic (recipient of income) was not assessed to tax on the pension he received
from his successor. Instead, his pension was included in the taxable profits of the
payer and taxed in the payers hands. The payer was not allowed a deduction against
the payers profits, but he could recover the tax by deducting it from the pension at the
time of payment.
17
This form of taxation and withholding was used in the clerical
subsidies from 1542 to 1627 and again in 1663, and applied to any pension paid out of
taxable profits.
18
Taxes levied after 1640 contained one or both of these methods for
collecting tax at the source.
19

In 1803, Henry Addington, the Prime Minister, introduced the Property and Income
Tax Act for a contribution of the profits arising from property, professions, trades and
offices as a means of financing the war against the French forces under Napoleon.
There were two significant changes in Addingtons 1803 Act. First, he replaced the
general return of income demanded in the earlier Property and Income Tax Act of
1799 under which income from all sources was aggregated with a new schedular tax

14
15
A perpetual tax payable annually, consisting of one tenth of the yearly revenues of an ecclesiastical
office. Soos, The Origins of Taxation at Source in England, above n 4, 45.
16
Ibid 49-50.
17
Soos, Taxation at the Source and Withholding in England, 1512 to 1640, above n 3, 90-1.
18
Ibid 90.
19
Ibid 91.
55
system.
20
His tax required separate returns of income from particular sources. The
word income was not defined, but income was divided into five Schedules, being A,
B, C, D and E (see Part 3.4 below), each of which implied income from a particular
source (meaning A).
21
The second requirement was the principle of deduction of tax
at source or stoppage at the location where the income first arose (meaning B) by a
disinterested third party. Addingtons aim in introducing taxation at source was
to impose the income tax on profits from all kinds of property, and to do so at
their first source. Wherever possible the tax was to be collected at the source
by deduction before the income reached the ultimate recipient. The idea was to
charge the income with tax in the hands of just one person, who would thus
pay income tax on the whole of his profits. If part of those profits were then
paid to someone else the payer could recoup himself by deducting and
retaining a proportion of the tax he had initially paid, thus spreading the burden
of the income tax amongst recipients of the income.
22

Addingtons schedular tax system remained in place until after the Battle of Waterloo
in 1815, when the war against Napoleon came to an end, and so did the 1803 Act. In
1842, due to a growing deficit at a time of great commercial depression and social
unrest, the schedular tax system was re-introduced by Sir Robert Peel, the Prime
Minister, to replace in a large part the revenue previously derived from indirect taxes
such as tariffs.
23
Although the income tax was stated to be temporary, it became a
permanent feature of the UK tax system from 1842 as the government could not afford
to do without it.
24

20
It has been pointed out that Addingtons schedular tax system was not new, but an elaboration of the
schedular system found in Louis XIVs dixime, imposed in 1710 at a rate of 10 per cent on all incomes
under four schedules real estate, salaries, securities and businesses. See Basil E V Sabine, A Short
History of Taxation (1980) 113, 118; William Phillips, The Origin of Income Tax [1967] British Tax
Review 113, 117-8.
21
Martin Daunton, What is Income? in J ohn Tiley (ed), Studies in the History of Tax Law (2004) 3.
22
Chantal Stebbings, The Taxation of Mortgage Interest at Source in the Nineteenth Century [1989]
British Tax Review 348, 348-9.
23
J ohn A Kay and Mervyn A King, The British Tax System (4
th
ed, 1986) 20.
24
Income tax was a proportional tax until 1911 and everyone paid a fixed rate of tax. A distinction was
made between earned (for example, income from employment) and unearned (for example, income
from investments) income in 1907 so that larger incomes were taxed at a higher rate, but graduation
took the form of an additional supertax in 1909. In 1927, the supertax was turned into a surtax and a
56

3.4 Application of taxation at source and the schedules

Under the schedular tax system introduced by Addington, a taxpayer was no longer
assessed directly on his total income (which was regarded as a lump sum), but his
income was divided into a number of schedules, each with its own method of
assessment and collection. In 1803, income tax was divided into five schedules,
having relation to income derived from particular sources (meaning A):
Schedule A: Tax on the owners of land and houses.

Schedule B: Tax on farmers, including owners of land in occupation
thereof, in respect of their additional profits from such
occupation.

Schedule C: Tax on the fundholders in receipt of annuities, dividends and
shares of annuities payable out of any public revenue.
Persons not being British subjects and not resident in Great
Britain were exempt from this tax.

Schedule D: The schedule was divided into two branches:
1 Residents were charged upon income from property in
Great Britain or elsewhere, and all profits and gains from
any profession, trade, employment, or vocation carried
on in Great Britain or elsewhere.
2 Non-residents were only charged in respect of all profits
and gains from property in Great Britain, and all profits
and gains from any profession, trade, employment, or
vocation exercised in Great Britain.

It also contained the sweeping clause: income not specifically
charged under the other Schedules.

Schedule E: Tax on persons with income from any public office or
employment of profit; also any annuity, pension or stipend
payable by the Crown or out of the public revenue.
25

taxpayer could be subjected to both an income tax and a surtax. The two taxes were finally
amalgamated in the unified system in 1973. See Adrian Shipwright and Elizabeth Keeling, Textbook
on Revenue Law (2
nd
ed, 1997) 137-8.
25
Stephen Dowell, The Acts Relating to the Income Tax (9
th
ed, 1926) cxix-cxxi.
57
There were no gaps between the schedules as Schedule D provided the sweeping
clause on income not specifically charged under the other Schedules. The source of
income determined the type to which the income belonged, as enumerated in the
schedules.
26

The collection of tax was effected by imposing certain tax collecting obligations on
particular payers. This was done in three principal ways:
1 In the case of incomes from real property, the tenant was responsible for the
deduction and payment of the tax. The tenant paid the tax on his rent and then
deducted that tax on making payment of the rent to the landlord. The landlord was
taxed whether he made a return of his rent or not.
27

2 In the case of profits arising from annuities, dividends and shares of annuities
payable out of any public revenue, it was the responsibility of the payer to pay the
tax. The payer acted as a collecting agent and he himself was liable to be assessed
for the tax he deducted from the payee.
3 In the case of incomes from employment or offices, the employer was responsible
for the tax. Tax was assessed to those who paid the income, and the payer
deducted it from the sums receivable by those entitled to the income.
28

But taxation at source could not be applied to the following income and tax was
assessed upon taxpayers making returns of net income to assessors:
1 In the case of income from the occupation of land, a farmers income could not be

26
The schedules were, in turn, sub-divided into 19 cases, a word adopted from Pitts Act of 1799. The
schedules and cases were a list of types of sources. See J ohn F Avery Jones, Does the UK Give Credit
for Tax on a Permanent Establishment Abroad? (1994) 12 APTIRC Bulletin 221, 221.
27
J ames Coffield, A Popular History of Taxation From Ancient to Modern Times (1970) 99.
28
This principle was extended by PAYE (Pay As You Earn) in 1944. See below footnote 46 on the
PAYE mechanism for withholding tax from salaries and wages.
58
measured as it depended on receipts from crops over the year, and the amount
spent on seeds, animals, wages and other inputs.
29

2 In the case of profits from trade, commerce and the professions, there was no
feasible indicator of profits. Schedule D covered the annual profits or gains from
trade, commerce and the professions, and the phrase was not taken to cover casual
profits or one-off sums:
The implication was that a trader who made his living from buying and selling
commodities would pay tax on the profits. However, if an individual made an
occasional profit from selling shares or a stockpile of goods, the income was
not an annual profit and it was not taxed.
30

The measurement of annual profits or gains was further complicated by the
difficulty of distinguishing a capital payment from income, as capital gains were
not specifically made the subject of taxation.
31

3.5 Taxation at source and tax avoidance

Before the introduction of the principle of taxation at source, the attitude of taxpayers
towards taxation was that it was a voluntary payment to government. One could
avoid paying tax in a number of ways by either omitting assessable items altogether
or scaling down their amounts.
32
Under the Assessed Taxes which were based on
wealth,
33
there was no universal agreement as to what were luxuries. Anyone who had

29
Daunton, above n 21, 5.
30
Ibid 7.
31
For a discussion of the British tax regime and the measurement of income under the schedules, see
Daunton, above n 21, 3-14. For a discussion about the distinction between income and capital, see
Part 2.4, Chapter 2.
32
Basil E V Sabine, A History of Income Tax: The Development of Income Tax From Its Beginning in
1799 to the Present Day Related to the Social, Economic and Political History of the Period (2006) 178.
33
Assessed taxes were a form of indirect tax directed at persons living in a certain style and displaying
visible signs of wealth and measures on presumptions. For example, the hearth tax of 1662 was
imposed on the basis of the numbers of fireplaces in peoples houses. See J ohn Prebble, Income
Taxation: A Structure Built on Sand (2002) 24 Sydney Law Review 301, 303; Soos, The Origins of
Taxation at Source in England, above n 4, 11.
59
a servant could dismiss the servant the year before, anyone who possessed a carriage
or coach could sell it in the previous year and so on, and then re-hire the servant,
repurchase or re-use items like hair powder, clocks and watches, and dogs.
34

The earlier Property and Income Tax Act of 1799 also contained a flaw. Tax was
assessed at a rate of 10 per cent on the total income from all sources above 60, with
reductions on income up to 200, and a deduction on outgoings like annual interest
and annuities. This meant that a taxpayer could avoid tax by transferring assets to
others within the family, granting annuities to them or creating trusts
35
for their
benefit.
36
In addition, there were no means of checking the tax returns as what the
taxpayer stated was a lump sum of net income on which he was prepared to pay the
tax.
37

The income tax introduced by Addington in 1803 was much more difficult to evade
because tax was stopped and collected at the time of payment. The tax covered
different sources of income and profits (meaning A): (1) income from land and houses;
(2) income from occupation of land; (3) income from government stock and dividends;
and (4) profits from trade, commerce and the professions. In every case, one could
point to where the income first arose (meaning B).

34
Phillips, above n 20, 119; Sabine, A History of Income Tax, above n 32, 24.
35
A trust is created for a number of reasons estate planning, reducing the burden of taxation on
property and the income therefrom and carrying out business ventures etc. See Barry Larking (ed),
IBFD International Tax Glossary (2005, 5
th
ed) 428-9. See, also, footnote 89, Chapter 2, on the use of
trusts for tax planning purposes.
36
David Stopforth, Settlements and the Avoidance of Tax on Income the Period to 1920 [1990]
British Tax Review 225, 225.
37
Coffield, above n 27, 99.
60
Addingtons Act was aimed at reducing the opportunities for tax avoidance. It proved
effective. Take the case of the fundholders under Schedule C. Schedule C applied to
profits arising from annuities and dividends payable out of public revenues, and it was
directed at the annuities and dividends paid on government securities (the public
fund).
38
At the time of introduction of the 1803 Act, a fundholder could have his tax
assessed in two ways:
39

based on the statement delivered to the commissioner indicating the amounts of his
annual profits from government securities; or
based on an estimate by the commissioner on the persons profits twice a year
(before the half-yearly dividends were payable), in the case where a statement was
not delivered.
40

The assessments on the returned dividends for the 1803-04 year were just under 12
million because not all fundholders declared the full dividends in their tax returns for
assessment.
41
In 1806, withholding at source applied to Schedule C. The obligation
was then placed on the Bank of England to deduct tax on making payment of
dividends on the public funds to the fundholders and furnish an annual statement,
although the tax itself was to be payable by the fundholders or their agents.
42
The
dividend revenue for the 1806-07 year, the first year withholding at source was applied,
exceeded 22 million.
43

38
Soos, The Origins of Taxation at Source in England, above n 4, 162.
39
Schedule C did not provide for either taxation at source or withholding at source as the Acts of 1720
and 1757 were still in effect for withholding tax from payments made out of public revenues. See above
Part 3.3 Origin of taxation at source.
40
Soos, The Origins of Taxation at Source in England, above n 4, 163.
41
Coffield, above n 27, 99-100.
42
Ibid 99.
43
Ibid 99-100.
61
Taxation at source and withholding at source proved a practical way of raising revenue
in the early nineteenth century:
Instead of looking in the first place at the taxpayer, they looked at the source of
income, classified incomes according to their kind under the Schedules A, B, C,
D and E, and levied the tax so far as they could at the point where the income
first emerged and became visible, leaving the first possessors of the income to
deduct a proportion of the tax when distributing any part of the income among
those who had charges upon it.
44

This method of taxation at source proved to be a more certain way of collecting tax:
the revenue is secured from loss, the expense is diminished, a degree of secresy
[sic] is preserved, and the tax collector encounters fewer obstacles and less
resistance than he might meet with in collecting the tax directly ...
45

In 1944, the PAYE (Pay As You Earn)
46
system was used to withhold taxes applicable
to wages and salaries.
47
This has remained the principal means of collecting income
tax from individuals in the UK.

The 1803 Act set the pattern for the income tax that remains in existence (in modified
forms) today in the UK and in numerous other jurisdictions. A minority of countries
today still adopt a schedular tax system that identifies income using a combination of
its character (meaning A) and geographic location where an item of income is derived
(meaning B). J urisdictions then impose tax separately on the total income derived in
each source classification (applying both meaning A and meaning B). Examples
include Hong Kong, Belarus and Sudan.
48
Most jurisdictions including Australia have
adopted an all-inclusive approach that taxes their residents on income aggregated from

44
45
Stebbings, above n 22, 349.
46
The PAYE (Pay As You Earn) is a mechanism for withholding tax from salaries and wages. The
liability is imposed on employers to deduct tax at source on all emoluments assessable to income tax.
See Sarah Laing, British Master Tax Guide 2006-07 (2006) [2784], [11400].
47
PAYE was introduced in an attempt to overcome the difficulties of assessment and collection of tax
that arose during the Second World War. For a history of PAYE, see Simon J ames and Christopher
Nobes, The Economics of Taxation: Principles, Policy and Practice (1997/98 ed, 1998) 167-8.
48
Kevin Holmes, The Concept of Income A Multi-Disciplinary Analysis (2001) 28.
62
all sources (both onshore and offshore that is in the sense of both meaning A and
meaning B).
49

The United States (US) taxes its citizens wherever they reside. The worldwide
income of its citizens, resident aliens and domestic corporations are taxed, whether
derived in the US or elsewhere. However, a concession is given to a qualifying
individual who works abroad and receives earned income from foreign sources.
50

3.6 Source taxation and withholding
51

Withholding is integral to taxation at source. A jurisdiction relies on the withholding
system to collect tax from non-residents on certain income from labour (eg
entertainers and sportsmen)
52
and certain income from capital (eg interests, dividends
and royalties) before the income leaves its jurisdiction.
53
Therefore, withholding is
still employed by a number of jurisdictions today as it is:

49
Countries like Belgium, Colombia, Croatia and Mexico have moved from a schedular to a worldwide
tax system to widen the tax base. Ibid 29.
50
A United States (US) citizen working abroad must make a tax home in a foreign country and meet
either the bona fide residence test or the physical presence test to qualify for the concession. The
maximum exclusion amount for foreign earned income is indexed each year for inflation. For 2008, a
person may elect to exclude up to US$87 600 (United States dollars) of foreign earned income
attributable to the period of residence in a foreign country as well as certain employer-provided housing
costs.
51
Withholding is used here to mean a method of assessing and collecting tax at source by deduction in
respect of dividends, interest, royalties and similar payments to non-residents rather than withholding
for domestic purposes (such as the PAYE system of periodic tax payments for salary and wage earners).
52
The taxation of entertainers and sportsmen is not covered in this thesis.
53
In Australia, additional withholding tax provisions apply to certain payments made to foreign
residents, from 1 July 2004, for:
payments for promoting or organising casino gaming junket arrangements to Australia (3 per cent
rate);
payments for entertainment and sports activities by artists and sportspersons including their
supporting staff (a 30 per cent rate applies where the payee is a company and the marginal rate
applies where the payee is an individual); and
payments under contracts for the construction, installation and upgrading of buildings, plant and
fixtures and for associated activities (5 per cent rate).
The amounts required to be withheld are specified in Regulations 44A, 44B and 44C of the Taxation
Administration Regulations 1976. The amount subject to withholding under the foreign resident
withholding provisions is not a final tax, but is a credit against the foreign residents income tax
assessment.
63
administratively simple in its implementation;
effective in capturing passive (investment) income flows crossing national borders;
and
the most direct means of combating the tax evasion problems associated with
passive income as tax is withheld by easily identifiable entities making the
payment, such as governments, financial institutions and companies.
54

Revenue is collected at source through withholding for two reasons:
the source jurisdiction would have great difficulty in collecting taxes on an
assessment basis from a non-resident who does not have a physical presence (in
the source jurisdiction); and
it is not feasible to verify the non-resident taxpayers deduction claims in an
international context to work out the net income.

Passive income is usually subject to a flat withholding tax on a gross basis in the
source jurisdiction, while active business income (including independent personal
services) attributable to a permanent establishment (PE) in the source jurisdiction is
taxed on a net basis by assessment in the source jurisdiction. Generally, non-residents
are taxed on their passive income on a withholding basis by the source jurisdiction at a
flat rate usually significantly below the corporate income tax rate.
55
Therefore,
passive income is taxed at a lower tax rate than active business income. If a

54
Howell H Zee, Taxation of Financial Capital in a Globalized Environment: The Role of Withholding
Taxes (1998) 51 National Tax Journal 587, 592-3, 596.
55
If there is a double tax treaty (DTT) between the residence and the source jurisdiction, the DTT
typically will provide that the source jurisdiction must limit its rate of withholding tax on certain types
of investment income, with residence jurisdiction relief on the tax paid at source. See, for example,
art 10 (dividends), art 11 (interest) and art 12 (royalties) of the OECD Model Tax Convention on
Income and on Capital.
Although the corporate income tax rate is significantly higher than the withholding tax rate, less tax
may be paid under a net tax as deductions are allowed and the taxpayer is assessed on the net income.
64
jurisdiction imposes withholding tax on passive income paid to non-residents at a high
rate, it is likely to discourage them from investing in that jurisdiction. The distribution
of tax revenue between the residence and the source jurisdiction is determined by the
decision of the investor who, in turn, is influenced by the tax systems of the respective
residence and source jurisdictions. It is argued that capital income can flow more
freely from one jurisdiction to another without withholding taxes.
56
Withholding taxes
thus have an impact on the distribution of tax revenue between the residence and the
source jurisdiction.
57

Interest withholding taxes are a concern when making cross-border investments, and
tax planners generally choose countries with a low or nil withholding tax or attempt to
reduce them through the use of intermediary entities.
58
High rates of interest
withholding taxes seem to have detrimental effects on attracting foreign savings and
on the development of domestic financial markets and, in an era of increased capital
mobility and tax competition, the risk as well of driving domestic credit market
operations offshore.
59
Financial institutions face the same concern because
such taxes would effectively subject the bulk of their income to tax on a gross
basis in the first instance. High rates of interest-withholding taxes are thus
likely to render their cross-border loan operations unprofitable if they face
foreign tax credit limitations in their home countries.
60

Withholding taxes have been criticised as creating an investment disincentive by
placing an exit fee on repatriated earnings.
61
For example, businesses are dissuaded

56
Vanistendael, above n 2, 153.
57
Source taxation and investment decisions are discussed in Part 3.7 below.
58
Roy Rohatgi, Basic International Taxation (2
nd
ed, 2005) vol 1, 250.
59
Zee, above n 54, 595.
60
Ibid 598, at footnote 16.
61
st
Government (2002) 27 Tax Notes Internationals 63, 80.
The incidence of withholding tax can be passed back to the domestic borrower so that it becomes a
cost of finance.
65
from building factories in jurisdictions that place a high tax on repatriated dividends.
62

Australia

In Australia, interest income, unfranked dividends
63
and royalties paid to non-residents
are subject to withholding tax on a gross basis. If the non-resident does not have any
other Australian income, this withholding tax is normally a final tax.
64
If the non-
resident has other Australian income, that person does not have to include the interest
income, unfranked dividends or royalties which have had the tax withheld by the payer.
If the investment income is derived by a non-resident who also carries on business in
Australia through a PE, then the non-resident is taxed on a net basis by assessment
under the ordinary provisions of the Income Tax Assessment Act 1936 (Cth) (ITAA
1936) and the Income Tax Assessment Act 1997 (Cth).

The withholding system of collecting tax does not promote fairness to residents of the
source jurisdiction as different tax rates apply to residents and non-residents. If an
Australian resident chooses to deposit his or her savings onshore, the interest income
received by that person is subject to tax by assessment at the marginal tax rate, which

62
Ibid.
63
Australia moved from a classical system of company taxation to an imputation system of company
taxation in 1987. Under the imputation system, a company may attach a franking credit to the dividend
payment when the dividend is distributed to a shareholder. The tax treatment of a dividend received by
a non-resident depends on whether it has been franked. A franked dividend is paid out of fully taxed
income before it is paid to a shareholder and there is an imputation credit associated with the franked
dividend. The credit is for the tax already paid on the profits that were distributed as dividends.
Therefore, no further tax has to be paid on it. An unfranked or partly franked dividend has not been
subject to a full rate of tax. There is no imputation credit associated with an unfranked dividend and the
payer must withhold tax from the unfranked amount before paying the dividend to the non-resident
shareholder.
64
Today, withholding tax on interest, dividends and royalties are also final taxes if the correct amount
has been withheld (by virtue of s 128D of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
There is no further liability to tax on the non-resident once the withholding tax is paid. For example, if
the correct withholding tax on the royalty payment has not been withheld by the payer, the non-resident
receiving the royalty must lodge an Australian income tax return with a note providing all the details,
such as the type of income and their country of residence.
66
ranges from 15 to 45 per cent.
65
If a non-resident invests the same amount of money
in Australia, that person is subject to an interest withholding tax of 10 per cent on the
gross amount of interest income.
66
Dividend income and royalties are also subject to
non-resident withholding tax at lower than marginal tax rates.
67
If both resident and
non-resident taxpayers are to be treated equally, then either the non-resident taxpayer
should be subject to tax on a net basis by assessment or the tax rate should be the same
for both types of taxpayers.

The difference in taxation and withholding for residents and non-residents has
promoted the development of tax avoidance arrangements, for example, by the use of
back-to-back loans:
a resident invests funds in an overseas financial institution, generally located in
a low-tax jurisdiction. The financial institution subsequently makes a loan to
the resident of an amount equivalent to the funds invested. The loan is for use
in an income-generating venture. The funds invested by the resident are used
as security for the loan. As the funds are located in a low-tax jurisdiction,
interest on the invested funds accrues tax free or is subject to only low tax.
Interest on the loan is paid to the overseas financial institution, less 10 per cent
withholding tax. The resident offsets the loan interest against other income.
The net effect of the arrangement is that the resident gains a financial benefit
by creating a tax deduction for interest paid on the loan, while gaining a

65
Based on the 2007-08 general rates applicable to resident individuals excluding the Medicare levy.
66
Payers of interest are required to withhold tax from gross interest paid (or deemed to be paid) to non-
residents. The withholding tax rate is 10 per cent. However, some DTTs concluded by Australia
provide an exemption from interest withholding tax in certain circumstances. For example, under the
Convention Between the Government of Australia and the Government of the United Kingdom of Great
Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income and on Capital Gains (Australia-UK DTT) (entered into
force 17 December 2003), no tax will be chargeable in the source country on interest derived by:
a government body of the other country (including a body exercising governmental functions or a
bank performing central banking functions), or
a financial institution resident in the other country (subject to certain safeguards).
67
The withholding tax rate is 30 per cent for royalties and the unfranked portion of dividends. The
withholding tax rates for both royalties and unfranked dividends are reduced if the non-resident is a
resident of a jurisdiction that has a DTT with Australia. See, for example, the Protocol Amending the
Convention Between the Government of Australia and the Government of the United States of America
for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on
Income (Australia-US Protocol Amending the DTT) (entered into force 12 May 2003) and the
Australia-UK DTT that provide a complete exemption of dividend withholding tax in some cases.
67
reimbursement of the interest paid through the accrual of interest earned on the
invested funds.
68

This type of round robin financing is commonly used by taxpayers by establishing a
company and a bank account in a tax haven.
69
It is for the Australian Taxation Office
to identify schemes and arrangements where taxpayers exploit the secrecy laws of tax
havens in an attempt to conceal assets and income that are subject to Australian tax
and those operating outside the tax system, though there are legitimate dealings with
tax havens.
70

The withholding tax system can motivate some resident taxpayers to seek to appear to
be non-residents to take advantage of the lower tax rate.
71
Part IVA, the general anti-
avoidance provisions, is now extended to withholding tax.
72

Though withholding taxes are an effective way of collecting tax from non-residents on
cross-border transactions and arrangements, they are considered a barrier to free trade

68
Commonwealth, House of Representatives Standing Committee on Finance and Public
Administration, Follow the Yellow Brick Road: The Final Report on an Efficiency Audit of the
Australian Taxation Office: International Profit Shifting (1991) [2.22].
69
Australian Taxation Office, Tax Havens and Tax Administration (2007) 11.
70
In a global economy it is to be expected that tax havens can provide legitimate dealings in finance,
insurance, broking, holding company and head office services that are facilitated by modern
communications. For example, tax havens are particularly attractive to international businesses
involved in portfolio management, such as insurance companies, self-insurers, hedge and mutual funds,
and offshore investment funds. These international businesses require access to the huge international
foreign exchange markets and 24-hour management. Ibid 11.
See Part 4.3.3, Chapter 4, for a discussion of aggressive tax planning and tax avoidance and evasion
using offshore structures established in tax havens.
71
As non-residents are generally subject to an interest withholding rate of 10 per cent (compared with
rates between 15 and 45 per cent for residents excluding Medicare levy), a few residents placed some of
their funds in bank accounts in the name of overseas relatives to earn interest income and obtain the
benefit of more favourable withholding tax rate. See Commonwealth, House of Representatives
Standing Committee on Finance and Public Administration, Follow the Yellow Brick Road: The Final
Report on an Efficiency Audit of the Australian Taxation Office: International Profit Shifting, above
n 68, [2.23].
72
See s 177CA of the ITAA 1936, inserted by Taxation Laws Amendment Act (No 2) 1997 (Cth) (No 95,
1997).
68
and free investment.
73
The source-based DTT policy has detrimental impacts on
Australian firms investing offshore, because it exposes them to high taxes in tax treaty
partner countries.
74
Australia is moving towards a more residence-based treaty policy
in substitution for the treaty model based on the source taxation of income,
75
and
withholding taxes on certain dividend, interest and royalty payments have been
reduced.
76

Hong Kong

Hong Kong does not have a general withholding tax regime. Dividend payments to
non-financial institutions as well as banks are not subject to tax in Hong Kong by
virtue of s 26 of the Inland Revenue Ordinance 1947 (IRO 1947) and, therefore, no
withholding tax applies to such payments. But interest payments received by or
accrued to a person through the carrying on of a business in Hong Kong are deemed
Hong Kong-sourced trading receipts.
77

Under s 15(1) of the IRO 1947, certain amounts are assessable to profits tax because
they are deemed to be receipts arising in or derived from Hong Kong from a trade,
profession or business carried on in Hong Kong. Section 15(1)(a) includes receipts

73
Vanistendael, above n 2, 152.
74
Commonwealth, Board of Taxation, International Taxation: A Report to the Treasurer (2003) vol 1,
90.
75
Ibid 94.
76
See above n 66 and 67 on the reduction of withholding tax rates under the Australia-UK DTT and the
Australia-US Protocol Amending the DTT.
77
Though interest tax was repealed with effect from the year of assessment commencing on 1 April 1989,
interest received by or accrued to a person carrying a trade, profession or business in Hong Kong is
chargeable to tax under profits tax. Section 15(1)(g) deems interest received in respect of the funds of a
business carried on in Hong Kong by a person, other than a corporation, to be receipts arising in Hong
Kong from a business carried on in Hong Kong and chargeable to profits tax. Section 15(1)(i) deems
interest income received by financial institutions from their businesses in Hong Kong to arise in or be
derived from a trade, profession or business carried on in Hong Kong notwithstanding that the provision
of credit may have been outside of Hong Kong. The deeming provision applies only to interest income
not otherwise chargeable to profits tax. See Hong Kong, Inland Revenue Department, Departmental
Interpretation and Practice Note No 13 (revised), Profits Tax: Taxation of Interest Received, [8].
69
from the exhibition or use of films, tapes or recordings. Section 15(1)(b) includes
receipts for the use of or right to use a patent, trademark or copyright in Hong Kong.
Section 15(1)(ba) includes sums received for the use of, or right to use, such property
outside Hong Kong, if the sum is deductible in ascertaining the assessable profits of the
payer under profits tax. This means that royalty income, otherwise not chargeable to
tax, is treated as a trading receipt under s 14 of the IRO 1947 (as arising in or derived
from Hong Kong), even though there is no business carried on in Hong Kong.

When royalty income is deemed to be a trading receipt under s 15(1)(a), (b) or (ba),
s 21A(1) operates to apply profits tax to 30 per cent of the gross amount of the
assessable profits on a withholding basis, or to 100 per cent of the sum if it is derived
from an associate. The 100 per cent rate applies to prevent taxpayers from minimising
their tax liabilities through arrangements entered into with associated companies or
individuals.
78

Section 20A of the IRO 1947 provides that a non-resident person may be assessed
directly or in the name of his agent in respect of his profits arising in or derived from
Hong Kong from any trade, profession or business carried on in Hong Kong. The
section further provides that the tax so charged shall be recoverable from the assets of
the non-resident or his agent. Section 20B applies to situations where persons in Hong
Kong, who are not agents, deal with non-residents in receipt of royalties and licence
fees from Hong Kong. A Hong Kong payer has to deduct and retain a withholding tax
on payments of royalties and licence fees to non-residents who have no permanent
business presence in Hong Kong, until a demand note calling for payment is issued by

78
CCH, Hong Kong Master Tax Guide 2006/07 (15
th
ed, 2006) [6-2260].
70
the Inland Revenue Department.
79
The Hong Kong payer is chargeable on behalf of
the non-resident.

The double tax treaty (DTT) with Belgium is the first comprehensive agreement
which Hong Kong has entered into with another jurisdiction for the avoidance of
double taxation and the prevention of fiscal evasion with respect to taxes on income
and on capital.
80
Under the Hong Kong-Belgium DTT, withholding tax applies to
dividends, interest income and royalties. Such income will be taxable in the
jurisdiction in which it is received.
81
Due to Hong Kongs territorial tax system,
withholding tax does not apply to dividends and interest income paid to a Belgian
company by a Hong Kong company. However, royalties paid by a Hong Kong
company to a Belgian company (and vice versa) are subject to withholding tax, but the
tax rate is capped at 5 per cent.
82
A feature of the Hong Kong-Belgium DTT is that it
provides a withholding tax exemption on dividends paid by a company in Belgium to a
Hong Kong resident, if at least 25 per cent of the capital of the Belgian company is
held by a Hong Kong resident company.
83
The treaty offers investors the opportunity
to receive tax-free repatriation of profits from Belgium. It has been noted that the
Hong Kong-Belgium DTT contains a number of unique features that enable Hong

79
Inland Revenue Ordinance 1947 s 20B(3). See, also, Hong Kong, Inland Revenue Department,
Departmental Interpretation and Practice Note No 17 (revised), The Taxation of Persons Chargeable to
Profits Tax on Behalf of Non-Residents [12].
80
See footnote 33, Chapter 1, for a brief discussion of Hong Kongs very limited involvement with tax
treaties.
81
See art 10 (dividends), art 11 (interest) and art 12 (royalties) of the Agreement Between the Hong
Kong Special Administrative Region of the Peoples Republic of China and the Kingdom of Belgium for
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on
Income and on Capital (entered into force 7 October 2004) (Hong Kong-Belgium DTT).
82
The normal withholding tax rate for royalties is 5.25 per cent in Hong Kong and 15 per cent in
Belgium. Under the Hong Kong-Belgium DTT, withholding tax on royalties is limited to 5 per cent of
the gross amount. See art 12 of the Hong Kong-Belgium DTT on the taxation of royalties.
83
The normal withholding tax rate for dividends is either 15 or 25 per cent in Belgium. Under art 10 of
the Hong Kong-Belgium DTT, no dividend withholding tax is levied if the recipient is a company that
holds at least 25 per cent of the share capital of the company paying the dividends. If the recipient is a
company that holds 10 per cent of the share capital, the rate is capped at 5 per cent. In all other cases,
the upper limit of the withholding tax is 15 per cent of the gross dividend.
71
Kong investors to structure their overseas investments through a Belgian holding
company, so as to minimise the overseas income and withholding tax on their overseas
earnings.
84

3.7 Source taxation and investment decisions

This discussion considers the traditional position in relation to source-based taxation
and investment decisions. That is, it looks at the general position prior to the growth
of Internet-based commerce.

When a jurisdiction uses source-based taxation, it can increase its tax revenue through
policies that reduce outbound investment by its residents and encourage inbound
investment by non-residents as both residents and non-residents are taxed on income
derived within its border. If tax rates are not equal across jurisdictions, taxes have the
potential not only to re-distribute income across jurisdictions, but also to distort
investment decisions in favour of a low-tax location.
85
For this reason, it is commonly
believed that source-based taxation tends to encourage excessive tax competition:
86

84
For example, the withholding tax rate of interest is capped at 10 per cent or exempt if specified
conditions under art 11 are satisfied (the normal withholding tax rate for interest is 15 per cent).
See Pieter de Ridder and J an van Gompel, Hong Kongs International Gateway: Belgium (2005)
11 Asia-Pacific Tax Bulletin 120, for a discussion of the Hong Kong-Belgium DTT.
85
United States, House of Representatives, J oint Committee on Taxation, Overview of Present-Law
Rules and Economic Issues in International Taxation (9 March 1999) <http://www.house.gov/jct/x-13-
99.htm>at 1 May 2008.
International investment flows are generally governed by two competing principles capital export
neutrality (CEN) and capital import neutrality (CIN). CEN encourages domestic investors to locate
investment anywhere in the world as foreign investment income is subject to the domestic rate of tax of
the investor regardless of where income is earned. CIN promotes investment activities within the
borders of a jurisdiction as both domestic and foreign investors are subject to the same rate of tax
regardless of the residence of the investor. See Larking, above n 35, 57-58.
86
Zee, above n 54, 591.
Tax competition may be defined as the attempt to attract investment that might otherwise go
elsewhere by offering a relatively attractive tax environment to investors. The attraction may lie in
generally low tax rates, in special incentives, or in other favourable tax provisions or practices that
reduce the effective burden of taxation on the investor. See Alex Easson, Harmful Tax Competition:
An Evaluation of the OECD Initiative (2004) 34 Tax Notes International 1037, 1037.
72
If investment income is taxed only at the source, substantial amounts of capital
could be diverted to jurisdictions with the lowest tax rates instead of flowing to
investment projects with the highest pre-tax rate of return. If a system of
residence taxation is the worldwide norm, enterprises resident in low-tax
countries might be able to attract more investment capital or perhaps increase
their market share through lower prices to the detriment of enterprises resident
in high-tax jurisdictions, even though the latter are more efficient. In either
case, capital is diverted from its more productive uses, and worldwide income
and efficiency suffer.
87

As the source jurisdiction is regarded as having the primary right to tax income from
direct investments located within its border and the residence jurisdiction the residual
right to tax,
88
taxation based on source may influence the location of investment with
unequal tax rates, as illustrated by the following example:
89

Assume that the rate of return in both Australia and Hong Kong is 10 per cent,
but the tax rate imposed is 17.5 per cent in Hong Kong and 30 per cent in
Australia. By relocating a $100 investment from Australia to Hong Kong,
Australian investors in Hong Kong would receive $8.25 (investment income of
$10 less tax of $1.75), where they would only receive $7 (investment income
of $10 less tax of $3) in Australia. If effective tax rates are equal around the
world, the Australian investor is indifferent to whether government imposes
source or residence taxation. However, those governments are not indifferent.
Whether source or residence taxation prevails is of major importance to the
distribution of income across nations. Following the relocation of $100 to
Hong Kong, Australia now only receives $8.25 investment income (investment
income of $10 less tax of $1.75) while Australia as a whole should have
received $10 ($7 of after-tax return plus $3 of Australian tax) for investment
located in Australia. The national income of Australia is reduced by $1.75

87
United States, Overview of Present-Law rules and Economic Issues in International Taxation, above
n 85.
88
For example, under a standard DTT, the right to tax profits from a business not attributable to a PE is
given to the residence country. Royalty income is taxed only in the country of the recipient (residence)
unless attributed to a PE (source). The right to tax interest income is shared between the country of the
debtor (source) and that of the creditor (residence). Withholding taxes on interest, dividends and
royalties are levied by the source jurisdiction. Relief from double taxation is only available under the
applicable domestic laws of the residence country for the income tax or withholding taxes paid to source
countries.
89
It has been noted that tax is usually not a primary or overriding factor in the decisions to engage in
overseas business activities or to invest abroad. The very great majority of business transactions in Hong
Kong, both in the past and today, are not driven by taxation considerations. See Andrew Halkyard and
Stephen Phua Lye Huat, Common Law Heritage and Statutory Diversion Taxation of Income in
Singapore and Hong Kong [J uly 2007] Singapore Journal of Legal Studies 1, 16.
But it is recognised that tax arrangements can affect the level and country location of foreign direct
investment. See Commonwealth, Treasury, Review of International Taxation Arrangements: A
Consultation Paper (2002) 2-3.
How tax considerations can influence the place of residence of companies is discussed in Chapter 7.
73
($10 minus $8.25) as a result of the relocation of $100 of investment to Hong
Kong.
90

Source taxation can help, it is argued, to balance taxing power between developing and
developed countries.
91
Source-based taxation has most commonly been used by
developing countries that require capital, while residence-based taxation has been
dominant in developed countries. Developing countries normally regard residence-
based taxation as less attractive, as more revenue would be lost to the residence country
of potential investors. This is because developing countries import capital to promote
large-scale industrialisation and economic development. Under source-based taxation,
a country collects tax on income from inbound investment derived by residents and
non-residents alike and no tax on income from outbound investment. The source-based
approach ensures that residents and non-residents can compete on an equal footing
based on where the income was earned and not who earned it.
92
If residence-based
taxation is adopted, the government collects tax from income on both inbound and
outbound investments from residents, and (in the absence of some form of withholding
tax at source) no tax would be collected on income on inbound investment from non-
residents. Thus, the allocation of tax revenue tends to favour capital-importing
countries which use a source-based system. Taxation at source and withholding at
source can still play an important part in protecting the tax base of a country.

90
Based on an example in United States, Overview of Present-Law Rules and Economic Issues in
International Taxation, above n 85.
91
David L Forst, The Continuing Vitality of Source-Based Taxation in the Electronic Age (1997) 15
92
Countries that follow the territorial tax system do not tax the foreign-source income of residents.
Therefore, there is no need to bother with complex residence rules as tax residence is irrelevant.
74
3.8 Some issues relating to the concept of source of income

When the basic income tax structure was established in the UK two centuries ago, a
receipt typically had to be of a revenue or income nature and fall within a taxable
source under the schedules (meaning A) in order to be liable to income tax. The
schedules were mutually exclusive.
93
One had to know the real nature of the income
before classifying it by means of the schedules. Disputes on the character of income
and the nature of activities engaged in by taxpayers were much debated. These were
largely left to the courts to determine.
94

The schedular tax system, it is said, created difficulties with respect to the definition of
income in the UK tax legislation:
95

Did salaries from employment in a private firm fall under schedules E or D;
were mines to be classified under schedules A or D; and did shares in a private
company fall under schedules C or D? The decision affected what could be set
against profit or income, and whether the actual profit of the year or the
average of several years was taken.
96

Income tax is not a collection of different taxes, but one tax charged on different
sources of income, classified by reference to the source from which they arose:
Income Tax is a tax on income. It is not meant to be a tax on anything else.
It is one tax, not a collection of taxes essentially distinct. There is no
difference in kind between the duties of Income Tax assessed under Schedule
D and those assessed under Schedule A or any of the other schedules of charge.
One man has fixed property, another lives by his wits, each contribute to the
tax if his income is above the prescribed limit. The standard of assessment
varies according to the nature of the source from which taxable income is

93
See Salisbury House Estate, Ltd v Fry (HM Inspector of Taxes) (1930) 15 TC 266.
94
See, for example, Colquhoun (Surveyor of Taxes) v Brooks (1889) 2 TC 490; The Liverpool and
London and Globe Insurance Co v Bennett (Surveyor of Taxes) (1913) 6 TC 327; The National
Provident Institution v Brown and The Provident Mutual Life Assurance Association v Ogston (1921) 8
TC 57; Commissioners of Inland Revenue v John Blott and Commissioners of Inland Revenue v B I
Greenwood (1921) 8 TC 101; Van den Berghs, Ltd v Clark (Inspector of Taxes) [1935] All ER 874.
95
Shipwright and Keeling, above n 24, 138; Daunton, above n 21, 138.
96
Daunton, ibid 6.
75
derived In every case the tax is a tax on income, whatever may be the
standard by which the income is measured.
97

In the Scott case (1935),
98
it was stated the word income
is not a term of art, and what forms of receipts are comprehended within it, and
what principles are to be applied to ascertain how much of those receipts ought
to be treated as income, must be determined in accordance with the ordinary
concepts and usages of mankind, except in so far as the statute states or
indicates ...
99

But the concept of income is difficult to define:
Income, profits and gains are conceptions of the world of affairs and
particularly of business. They are conceptions which cover an almost infinite
variety of activities. It may be said that every recurrent accrual of advantages
capable of expression in terms of money is susceptible of inclusion under these
conceptions. No single formula could be devised which would effectually
reduce to the just expression of a net money sum the annual result of every
kind of pursuit or activity by which the members of a community seek
livelihood or wealth. But in nearly every department of enterprise and
employment the course of affairs and the practice of business have developed
methods of estimating and computing in terms of money the result over an
interval of time produced by the operations of business, by the work of the
individual, or by the use of capital. The practice of these methods of
computation and the general recognition of the principles upon which they
proceed are responsible in a great measure for the conceptions of income,
profit and gain and, therefore, may be said to enter into the determination or
definition of the subject which the legislature has undertaken to tax.
100

The concept of source of income was discussed in the Nathan
101
case in 1918. Issacs J
stated that the Legislature, in using the word source, meant not a legal concept and
the ascertainment of the actual source of income is a practical, hard matter of fact.
102

This sort of test can, fairly readily, be applied to salary and wage earners as a matter of
fact, but difficulties exist with other types of income. In 1938, Romer LJ commented

97
Attorney-General v London County Council (1900) 4 TC 265, 293-4.
98
Scott v Commissioner of Taxation (1935) 35 SR(NSW) 215.
99
Ibid 219.
100
The Commissioner of Taxes (South Australia) v The Executor Trustee, & Agency Co of South
Australia Ltd (1938) 63 CLR 108, 152.
101
Nathan v The Federal Commissioner of Taxation (1918) 25 CLR 183.
102
Ibid 190.
76
on the difficulties in identifying the source of income derived by a resident partner of a
trade carried on wholly abroad:
What is the source of his income? Is it the partnership deed which secures to
him a share in the profits in the partnership? Is it the activities of himself or his
co-partners exercised abroad, or is it the body of commercial contracts entered
into with traders that produces the money out of which the profits and,
therefore, the income is ultimately derived? Or can it be said that the
customers themselves are the source of income?
103

One cannot decide where the source of income is situated unless one knows what is
the source of income.
104

In United Aircraft Corporation (1944),
105
Latham CJ regarded property and acts done
by persons were possible sources of income. It is necessary to have a link between the
taxpayer and the country which sought to tax the relevant income:
If a person has rights over property or in relation to property he may derive
income from that property If a person by himself or by his servants or
agents does work of some kind or acts in some way, he may derive income
from that work or act Income derived from property means income
derived from the property of the person sought to be taxed as having derived
the income. So also the income of a person derived from acts of his servants or
agents. If such a person, being a company, has no servants or agents in
Australia, it cannot derive income from any acts done in Australia. A
person who neither owns anything in a country nor does nor has done anything
in that country cannot derive income from that country.
106

In Mitchum (1965),
107
Barwick CJ considered that determining the source of income is
a conclusion of fact:
There is no statutory definition of source to be applied, the matter being
judged as one of practical reality. In each case, the relative weight to be given
to the various factors which can be taken into consideration is to be determined
by the tribunal entitled to draw the ultimate conclusion as to source. In my

103
Bennet v Marshall [1938] 1 All ER 93, 104.
104
Ibid.
105
Federal Commissioner of Taxation v United Aircraft Corporation (1944) 68 CLR 525.
106
Ibid 536.
107
Commissioner of Taxation v Mitchum (1965) 113 CLR 401.
77
opinion, there are no presumptions and no rules of law which require that
question be resolved in any particular sense.
108

In Esquire Nominees (1973),
109
Barwick CJ affirmed his earlier statement:
But the concept of the Act is that all income is derived from some source
having a geographical location or, at any rate, that it is possible to predicate of
all income that it is so derived. This relation of income to a geographically
located source has provided its problems in the past and no doubt will do so in
the future. I do not think that any single verbal formula can be devised which
by its mere mechanical application to any given factual situation will yield the
answer to the problem of the location of the source of some item of income.
110

The cases provide very limited guidance with their reliance on phrases such as not a
legal concept, a matter of fact and a conclusion of fact. In determining the source
of income, the answer is not to be found in the cases, but in the weighing of the
relative importance of the various factors which the cases have shown to be
relevant.
111
The concept of source of income has developed over time into a set of
geographic source rules that set out the conditions under which items of income are
considered to have been derived from sources within or without a jurisdiction.
112
Case
law has focused on the following factors that may be relevant in the determination of
source of business profits:
the place where business operations are carried on;
the place where a contract is negotiated;
the place where a contract is entered into;
the place where a service is performed; and
the place of payment.
113

108
Ibid 407.
109
Esquire Nominees Ltd v Federal Commissioner of Taxation (1973) 73 ATC 4114.
110
Ibid 4117.
111
Federal Commissioner of Taxation v Efstathakis (1979) 79 ATC 4256, 4259.
112
See footnote 28, Chapter 2, on the source rules for different types of income developed by the courts.
113
Paul McNab and David Porter, Electronic Commerce: Determining Source (1998) 1 The Tax
Specialist 223, 225.
78

It has been suggested that the concept of source of income of a business enterprise
should not be limited to the above factors, but should take into consideration other
factors like:
the place where the products are utilised (for example, consultancy services);
the place where the product is physically produced; and
the place where the commercial need for the product originates.
114

If any of the above factors are to be taken into consideration, then often there will be at
least two jurisdictions involved that can claim a right to tax the relevant business
profits. What constitutes the source of business profits is discussed further in
Chapter 5.

3.9 Some further issues relating to the concept of source of income in an
integrated global economy

Source-based taxation has its territorial limits only income or profits arising in or
derived within the jurisdiction will be subject to tax. Today, significant changes have
occurred to the business and commercial environment and technologies, like the
telephone, have been significantly displaced by the Internet. With virtually
instantaneous international communication and greater levels of participation in direct
investment abroad, world economies have become more tightly integrated. The
elements of a transaction, operation or activity can be performed in any number of
jurisdictions rather than tied to a particular location. For example, a multinational
enterprise (MNE) can operate wherever the markets and factors of production

114
Arvid A Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle (1991) 23.
79
happen to be. It can produce the same goods and services in multiple locations,
establish its back office functions in Country A, technical experts in Country B,
while its registered office is in Country C. Though MNEs operate internationally,
their taxation remains national.
115

It is predicted that MNEs are likely to grow in size (and increase in number) as a result
of rapid technological change, trade and investment liberalisation, privatisation,
deregulation and geographic diversification.
116
The growth of MNEs causes
internationalisation of economic activities and has raised issues such as:
factors, goods and potential bases for taxation can flee a country;
countries have to compete with other countries for tax revenues; and
it is more difficult to collect revenue from tax bases located outside the country.
117

To maximise the return to their shareholders, a large share of global trade and
investment consisting of transfer of goods, intangibles and services is being managed
by MNEs in related-party, cross-border dealings. These companies use different
strategies such as transfer pricing and re-invoicing to shift income from a high-tax to a
low-tax location.

115
Where a domestic company expands its business offshore through a network of separately
incorporated companies, each company will be assessed to tax as a separate taxpayer in accordance with
the rules applicable to the taxing jurisdiction concerned. Thus, a subsidiary is liable to tax on its
undistributed profits and the parent is liable to tax on the profits remitted to it by its subsidiary. The
principal aim behind the taxation of multinational enterprises is to collect revenue on the undistributed
profits of the company and upon the distributions of profits made to shareholders. See Peter T
Muchlinski, Multinational Enterprises and the Law (1999) 277.
116
Prafula Fernandez and J eff Pope, International Taxation of Multinational Enterprises (MNEs)
(2002) 12 Revenue Law Journal 106, 107.
117
Ibid 118.
80
Transfer pricing

Transfer pricing refers to the valuation process for transactions between related entities
and includes goods, services and intangible properties.
118
Some examples of
transactions where transfer pricing issues generally arise include:
sharing of costs for research and development of technology or know-how (i.e.
a cost-sharing agreement); pricing of products manufactured by one entity in
the group of companies for distribution by another entity in the group; and
establishing the rate of royalties for access to intangible property.
119

In transfer pricing, companies set their own prices on related-party transactions as they
are able to trade within their own company structure and transfer the profits across
different tax jurisdictions to arrive at a reduced overall tax burden. Consider, for
example, two related companies: A, a resident in Country A, and B, a resident in
Country B. A manufactures goods in Country A at a unit cost of $40 and sells the
goods to B. Company B then sells the goods to unrelated customers in Country B at a
unit price of $90, thus making a profit of $50. Country B would tax the entire profit
earned by B if Company A did not make any profit and charged it at the cost price of
$40. However, if B were charged $90, then all of the profits would be taxed in
Country A, being the profits of A. If the sale price from A to B is between $40 and
$90, then the profits would be apportioned and taxable in both Country A and Country
B. The source of income is not determined by where the profits were made, but by the
price charged on the sale by A to B.
120

Transfer pricing can result in either too little tax being paid by the branch or subsidiary
in the source country, or too little by the parent company in the residence country. It

118
Rohatgi, above n 58, 335.
119
Ibid.
120
Based on an example in United Nations, Department of Economic and Social Affairs, Manual for the
Negotiation of Bilateral Tax Treaties Between Developed and Developing Countries (2003) 13.
81
can also result in too little tax being paid in both the residence and the source country,
where an intermediary in a low-tax jurisdiction is interposed.
121

In Australia, the Commissioner of Taxation can raise a transfer pricing or profit
reallocation adjustment (increase the assessable income or decrease the deductions)
under both Division 13 of Part III of the ITAA 1936 and the associated enterprises
article of the relevant tax treaty to bring the income of non-residents into the
Australian tax net by giving it an Australian source.
122
In addition, the Commissioner
can deploy Part IVA (which contains the general anti-avoidance rules) to cancel tax
benefits from tax avoidance schemes (for example, where a tax benefit is obtained as a
result of a source-shifting scheme with a dominant purpose of obtaining that tax
benefit).
123
The general anti-avoidance rules only have a role to play to encourage
compliance with any tax regime. They do not provide a solution to the question of
source discussed in the thesis. Unless the non-resident has a presence in Australia, it
remains very difficult for the Commissioner to detect all relevant business income
with an Australian source. Though the Commissioner is given the power to issue an
offshore information notice
124
to someone residing outside Australia, he or she would
not be able to enforce it if the non-resident does not comply. He or she could not go
and get records from offshore businesses to see what they have been selling to
Australian entities.

121
Alex Easson, Taxing International Income in Richard Krever (ed), Tax Conversations A Guide to
the Key Issues in the Tax Reform Debate: Essays in Honour of John G Head (1997) 420.
122
Section 136AE of the ITAA 1936 forms part of Australias sources of income rules. Sections
136AE(1) to (3) allow the Commissioner to determine the source of income when making Div 13
adjustments and also where a business is carried on through a PE.
123
In Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775, Pt IVA
was invoked due to the contrivance of sourcing the interest offshore.
124
Income Tax Assessment Act 1936 (Cth) s 264A.
82
In Hong Kong, there is no specific, detailed legislation that deals with international
profit shifting and transfer pricing. However, s 20(2) of the IRO 1947 deals with
profits earned by a related non-resident from non-arms length transactions with
resident associates. Section 20(2) provides that where a non-resident person conducts
business with a closely connected Hong Kong resident person in such a way that the
resident person declares either no profits which arise in or derive from Hong Kong, or
less than the ordinary profits that could be expected to arise in or derive from Hong
Kong, the business is deemed to have been carried on in Hong Kong. The non-
resident person is then assessable and chargeable to tax in the name of the resident as
if the resident were the agent of the non-resident person. Section 20(2) has rarely been
used, but transfer pricing is an issue that may become relevant in the future.
125

Re-invoicing

Another strategy used to minimise tax is re-invoicing, illustrated in the following
example by an American firm to assign profit on a very profitable product:
The company assembles in a low-tax Asian country a product that is sold in
numerous locations, including Australia. Although the product is physically
shipped from the low-tax Asian country directly to an Australian sales and
distribution center, the invoices follow one of two triangular routes: either
from the low-tax Asian country to Hong Kong and then to Australia or from
the low-tax Asian country to the United States and then to Australia. Hong
Kong is also a low-tax location for this firm, and the Australian and American
operations are taxed at approximately the same higher rate The re-invoicing
objective is to put profit in the low-tax Asian country, Australia, and the United
States in such a way as to satisfy all the taxing authorities and, presumably,
still reduce worldwide taxes. Without re-invoicing, the company believes that
too much profit, relative to the value added, would be split between the low-tax
Asian country and Australia.
126

125
It has been reported that, in recent years, the Inland Revenue Department has increased its transfer
pricing queries significantly. See Patrice Marceau, Hong Kong: Tax Controversies (2003) 9 Asia-
Pacific Tax Bulletin 240, 244; Colin Farrell, News Analysis: IRD Increases Transfer Pricing Queries
(2002) 2 Tax Notes International 687, 687-8.
126
G Peter Wilson, The Role of Taxes in Location and Sourcing Decisions in Alberto Giovannini et al
(ed), Studies in International Taxation (1993) 224.
83

The residual profit, of course, is taxed in the US (residence country) as foreign-source
income.

Re-invoicing is a common practice used in Hong Kong to get the appropriate profits
into a foreign jurisdiction, as foreign-source income is not subject to tax in Hong
Kong.
127
Re-invoicing is also used by Australian businesses. They take part in both
inbound and outbound re-invoicing arrangements either to artificially inflate
Australian tax deductions for goods or services or to artificially depress profits.

An inbound re-invoicing arrangement to artificially inflate Australian tax deductions
for goods and services works as follows:
A third party supplier provides goods or services to the offshore structure at
market value. Subsequently the offshore structure provides the same goods or
services to an Australian resident at a price substantially above market value.
The Australian resident does not disclose their interest in the offshore structure
and pays no Australian tax on the profits. In extreme cases, no actual goods or
services may be provided by the offshore structure, and no third party may
actually be involved.
128

An outbound re-invoicing arrangement to artificially depress profits works as follows:
An Australian resident provides goods or services to an offshore structure
below market value. Subsequently the offshore structure provides the same
goods or services to a third party customer at market value. The Australian
resident does not disclose their interest in the offshore structure and pays no
Australian tax on the profits.
129

127
See Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074 and
Commissioner of Inland Revenue v Magna Industrial Co Ltd (1997) HKRC 90-082 discussed in Part
5.5, Chapter 5.
128
See Australian Taxation Office, Taxpayer Alert TA 2005/6, Use of an Inbound Offshore Re-
invoicing Arrangement to Avoid or Evade Australian Tax.
129
See Australian Taxation Office, Taxpayer Alert TA 2005/5, Use of an Outbound Offshore Re-
invoicing Arrangement to Avoid or Evade Australian Tax.
84
Both the inbound and outbound re-invoicing arrangements involve the establishment
of an offshore structure in a tax haven or a country with bank secrecy and a scheme
promoter, who provides a paper trail of documents designed to conceal the true
nature of the transactions and the taxpayers interest in the offshore structure so that
there would be no liability to Australian tax.
130
The Commissioner considers that both
inbound and outbound re-invoicing arrangements give rise to taxation issues, but, so
far, no guidance has been provided.
131

3.10 Conclusion

Taxation at source and the schedular tax system were originally introduced in an age
when income could be classified by description for example, interest, rents, salary
and wages (meaning A) and tax collected at source. At that time, all payments could
be traced back to the location where the income first arose (meaning B) which
determined the type to which the income belonged (source of income).

Taxation at source has been applied to the direct tax area (especially) over the past two
hundred years. Tax is withheld and collected on relevant types of income before the
income is paid to the recipient or before it leaves a jurisdiction. Taxation at source
introduced a taxing point for collection of tax to address the problem of tax avoidance
(and tax evasion).

The challenge with respect to the taxation of business income is to determine where
the true profits were earned. When the location of the assets and activities that are

130
See Taxpayer Alerts TA 2005/5 and TA 2006/6.
131
Both TA 2005/5 and TA 2005/6 state that the arrangements are now under examination.
85
used to generate the income (for example, the production and export of tangible goods)
are in the same geographic location, then the source of the income is clear. World
economies have become more tightly integrated, and income, increasingly, can no
longer be assigned a geographic location by reference to the source rules for that
particular type of income. Production can take place anywhere in the world with
goods shipped to the final location. An increasing share of product value is in the
form of intangibles such as knowledge, trademarks and patents, which can be
developed in more than one jurisdiction and transmitted electronically. When the
profits of a business enterprise are the result of a combination of transactions,
operations and activities in a number of countries and each transaction, operation or
activity contributes to the profit, the source of income becomes increasingly less clear.
An increasingly asked question is: How can we determine the source of income where
value-adding activities are provided by a network of entities both in terms of broad
product capability and in terms of being tailored to the specific requirements of
particular users?
132

The traditional concept of source of income, relying on the nature of income and the
geographic source rules for that particular type of income, has lost much of its
relevance in todays globalised economy especially that part of it which relies
heavily on the Internet to complete transactions and to deliver goods and services.
133

132
Peter Sheehan and Bhajan Grewal, Firms, Regions, and Strategy in a Diverging World: The
Australian Case in J ohn H Dunning (ed), Regions, Globalization, and the Knowledge-Based Economy
(2000) 308.
133
A statute-based source regime would not be a preferred option. Take the case of the United States
whose formal rules governing the source of business income are contained in sections 861 to 865 of the
Internal Revenue Code (26 USC). Those formal rules generally do not apply in determining tax
jurisdiction over income earned by residents of a treaty state for a number of reasons including:
Source rules are open to challenge and may not match economic reality. The sale of goods and
provision of services by electronic means give rise to issues related to the characterisation of
payment (meaning A). Various types of income may be characterised as either income from the
sale of goods or royalties or income from the provision of services. Though the text of the core
86

source rules covers eight income categories interest, dividends, income from personal services,
rents and royalties, income from disposition of a US real property interest, income from the sale or
exchange of inventory property, insurance underwriting income, and social security benefits and
provides a source rule for each, there is no statutory guidance whatever on how to categorise the
income in question so the appropriate source rule can be applied. For example, the statute does not
address the difficulties in distinguishing between services income and income from property rights
and differentiating lease income from sales income.
Income arising from cross-border transactions may have links with more than one jurisdiction and
may not have a single geographic source. Tax treaties do not apply to other jurisdictions except the
two contracting states.
Treaty rules are based on the concept of permanent establishment, which requires physical presence
of a business in a geographic location to establish a source nexus. Physical presence is meaningless
in the electronic commerce environment. There could be difficulties with collection of tax if the
foreign seller did not operate from a fixed place of business in the source jurisdiction.
See Colin Law and Andrew Halkyard, From E-Commerce to E-Business Taxation (2003) 9 Asia-
Pacific Tax Bulletin 2, 13; Mike McIntyre, Commentary: A Critique of the Source Principle (1989)
1 Tax Notes International 261, 262; H David Rosenbloom, US Source Rules: Building Blocks of
Cross-Border Taxation (2006) 60 Bulletin for International Taxation 386, 390 on source rules and
international taxation. See, also, United States, Department of the Treasury, Office of Tax Policy,
Selected Tax Policy Implications of Global Electronic Commerce (1997) 25 Intertax 148 for a
discussion by the US Treasury Department on the impact of electronic commerce on substantive
principles of taxation.
87
CHAPTER 4: HONG KONG AND AUSTRALIA BACKGROUND

4.1 Introduction

Hong Kong and Australia have some things in common. Both have a British colonial
history and both have adopted the common law system from England.
1
Hong Kong
ceased being a part of the British Commonwealth after the ending of British rule in
1997. Australia has continued to recognise the British Sovereign as the Head of State
since Federation in 1901.

The schedular tax system used in Hong Kong today is still modelled on Addingtons
system of taxation introduced in 1803. But Hong Kongs tax system is unusual. A
series of separate taxes apply in their own special way to different sorts of earnings
and profits derived from or arising in Hong Kong. Only three income-types are
imposed under the schedules being salary income, property income and business
profits. There is no concept of total income, which means income not specifically
charged under the schedules is tax free. Hong Kong entities do not pay tax on foreign-
source income, even if it is remitted to Hong Kong. The residence of a taxpayer is
normally of little practical relevance. Non-residents are taxed on income with a Hong
Kong source.

The current structure of Australias income tax is very different from the schedular
approach to calculating income, and is based on taxable income, that is, assessable
income less allowable deductions. Unlike Hong Kongs territorial tax system which is

1
The British colonies in Australia New South Wales, Queensland, South Australia, Tasmania,
Victoria and Western Australia federated to create the new national state of Australia on 1 J anuary
1901. Australia remained a quasi-colony during its early decades.
88
based purely on source, Australia taxes its residents on their income from all sources
in and outside of Australia and only non-residents are taxed on Australian income.
Temporary residents (as defined) are treated as non-residents and are exempt from
Australian tax on most foreign-source income including capital gains.
2

4.1.1 Purpose and role of chapter

This thesis compares the impact of the source rules on the taxation of profits arising,
especially, from international dealings through trade and investment in Australia and
Hong Kong (by the imposition of income-type taxes). Before discussing in the next
chapter the difficulties in determining the source of income, it is necessary to provide
an overview of the tax system of Hong Kong and Australia. A knowledge of the basic
features of each tax system is necessary to understand the nature of the current source
issues and to see how and why cross-border dealings and financial relationships
(involving interposed entities and profit shifting) are structured to minimise tax and
maximise profits. The diversity of these international dealings adds to the complexity
in determining the real source of income.

4.1.2 Overview

Hong Kongs simple tax structure has played an important part in its economic
development, from a fledgling trading port to an established international trade and

2
In Australia, temporary residents are treated as non-residents and are exempt from Australian tax on
most foreign-source income including capital gains. However, employment-related income earned
during the period of temporary residence is taxable in Australia, including any that is foreign-sourced
and capital gains on shares and rights acquired under employee share schemes. See s 995-1 of the
Income Tax Assessment Act 1997 (Cth) (ITAA 1997) on the definition of temporary resident. See,
also, Subdiv 768-R of the ITAA 1997 on the general tax rules for people in Australia who are
temporary residents.
89
financial centre.
3
Many of the cross-border tax issues that affect Australia are
irrelevant in Hong Kong. There is no withholding tax imposed on outbound dividends
or interest, and there is no formal tax on capital gains from the sale of shares in a Hong
Kong company or from the disposal of assets located in Hong Kong.
4
There are no
taxes on general consumption.

Australia has an open economy, with significant inbound and outbound capital flows.
Australia also has a tax system which is legislatively complex and which imposes high
compliance costs. Difficulties in understanding differing tax laws and their impact on
business and trade are argued to be impediments to doing business in Australia.
5


The next part provides some background information on the tax system of Hong Kong.
It examines the structure of tax laws, the development of the tax system and its key
features, and the sources of revenue. The basic features of the tax system of Australia
are provided in the following part.

4.2 Hong Kong

After more than 150 years as a British territory, Hong Kong reverted to Chinese

3
In the mid-19
th
century, Hong Kong was a small fishing village on the south coast of China. It began
its trading operations as a British colony under British laws and British administration. Trade and
commerce did flourish. Today, Hong Kong is a bustling financial and business centre.
4
Hong Kongs territorial tax system seeks to tax income and not gains from the sale of capital assets.
To the extent that income from the sale or disposal of capital assets is a capital gain, it is generally
treated as exempt from tax. However, Hong Kong has a minimal, de facto capital gains tax regime.
Profits tax has been applied to certain speculative gains related to real estate, especially. See Richard
Cullen, Hong Kong Revenue Law The Present, 1997, and Beyond (1993) 7 Tax Notes International
1109, 1122.
5
See, for example, Robin Speed, Comment: An Internationally Competitive Tax System for Australia
(2003) 32 Australian Tax Review 51.
90
sovereignty on 1 J uly 1997, resulting in the creation of the Hong Kong Special
Administrative Region (HKSAR) of the Peoples Republic of China (PRC).
6
The
Basic Law, Hong Kongs mini-constitution post-1997, came into effect on the same
day.
7
The Basic Law sets out the way in which the HKSAR is to be administered for
50 years beyond 1997. It promised that the socialist system and policies in the PRC
will not apply to the HKSAR under the doctrine of one country two systems.
8
The
doctrine of one country two systems provides that although Hong Kong will become
part of the PRC (one country), it will retain a high degree of autonomy so as to
maintain its current political economy (two systems).
9
In other words, while the PRC
will continue to practise socialism with Chinese characteristics, Hong Kong is to
continue the practice of capitalism with Chinese characteristics.
10

6
Hong Kong consists of the Hong Kong Island, Kowloon Peninsula situated on the mainland opposite
Hong Kong Island, the New Territories comprising the area north of Kowloon up to the Shenzhen River
and 235 islands. Hong Kong Island was ceded in perpetuity to Britain by China in 1842 at the end of
the First Opium War (1839-1842) pursuant to the Treaty of Nanking (Nanjing). Kowloon Peninsula
was ceded in perpetuity in 1860 at the end of the Second Opium War (1856-1860) under the Convention
of Peking (Beijing). The New Territories and the islands were leased for 99 years from 1 J uly 1898
under the Convention Respecting the Extension of Hong Kong Territory. See Chapter 21: History in
Hong Kong, Hong Kong Yearbook 2006 <http://www.yearbook.gov.hk/2006/PDF/en/E21.pdf>at 30
March 2008.
The Hong Kong Special Administrative Region (HKSAR) was established in accordance with the
Joint Declaration of the Government of the United Kingdom of Great Britain and Northern Ireland and
the Government of the Peoples Republic of China on the Question of Hong Kong (Joint Declaration)
signed on 19 December 1984. The Government of the Peoples Republic of China (PRC) declared
that it had decided to resume the exercise of sovereignty over Hong Kong (the leased territories,
together with Hong Kong Island and Kowloon) with effect from 1 J uly 1997. The Government of the
United Kingdom (UK) declared that it would restore Hong Kong to the PRC with effect from 1 J uly
1997. The J oint Declaration entered came into force on 27 May 1985 when the two governments
exchanged instruments of ratification. It was registered as a treaty at the United Nations by the Chinese
and British governments on 12 J une 1985, which creates international rights and obligations for both
parties to it.
There is a difference between the PRC and Mainland China. Mainland China means that part of the
PRC not including the HKSAR and the Macao Special Administrative Region. It also does not include
the renegade province of Taiwan located on the island of Taiwan and some other small islands.
7
See the Basic Law of the Hong Kong Special Administrative Region of the Peoples Republic of China
(Basic Law), enacted by the National Peoples Congress of China on 4 April 1990.
8
Basic Law art 5.
9
Richard Cullen, Stability and Prosperity in Hong Kong: A Palette of Influences in Veronica Taylor
(ed), Asian Laws Through Australian Eyes (1997) 186.
10
Ibid.
91
With the exception of foreign affairs
11
and defence
12
which fall within the ambit of the
Central Peoples Government in China, Hong Kong has full management
responsibility over most other matters. For example, the HKSAR may:
maintain its status as an international financial centre;
13

maintain its status of a free port;
14

issue passports;
15

maintain trial by jury;
16

formulate its own monetary and financial policies;
17

issue Hong Kong currency, backed by a 100 per cent reserve fund;
18
and

11
Basic Law art 13.
12
Basic Law art 14.
13
Basic Law art 109.
14
Basic Law art 114.
15
Basic Law art 154.
16
Basic Law art 86.
17
Basic Law art 110.
18
Basic Law art 111.
The legal tender in Hong Kong is the Hong Kong dollar, which has been linked with the United
States (US) dollar at the fixed rate of approximately HK$7.80 (Hong Kong dollars) to the US dollar
since October 1983. The aim of this link has been to maintain long-term monetary stability. The linked
exchange rate system requires both the stock and flow of the monetary base to be fully backed by
foreign reserves. This means that any change in the monetary base is fully matched by a corresponding
change in foreign reserves at a fixed exchange rate. There is no foreign exchange control in Hong Kong.
The Hong Kong Monetary Authority (HKMA) is the government authority with responsibility for
maintaining currency and banking stability. When the three note-issuing banks (Bank of China (Hong
Kong) Ltd, Standard Chartered Bank (Hong Kong) Ltd and The Hongkong and Shanghai Banking
Corporation Ltd) issue banknotes, they are required by law to purchase certificates of indebtedness,
which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at
the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund, a fund
established to hold the backing to the note issue. The Hong Kong dollar banknotes are therefore fully
backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are
withdrawn from circulation, certificates of indebtedness are redeemed and the note-issuing banks
receive back an equivalent amount of US dollars from the Exchange Fund.
In Hong Kong, the monetary base comprises certificates of indebtedness, coins issued, the balance
of the clearing accounts of banks kept with the HKMA, and Exchange Fund Bills and Notes (debt
instruments issued by the HKMA).
Hong Kong has three measures of money supply:
Money Supply definition 1 (M1): The sum of legal tender notes and coins held by the public plus
customers demand deposits placed with banks.
Money Supply definition 2 (M2): M1 plus customers savings and time deposits with banks plus
negotiable certificates of deposits issued by banks held outside the banking sector.
Money Supply definition 3 (M3): M2 plus customers deposits with restricted licence banks and
deposit-taking companies plus negotiable certificates of deposit issued by these institutions held
outside the banking sector.
92
retain its tax law regime.
19

4.2.1 Statutory framework

The Basic Law also prescribes the legislative systems which are to apply in the
HKSAR. Article 8 provides that the laws in force in the HKSAR shall be the Basic
Law and guarantees the continuation of Hong Kongs legal system:
The laws previously in force in Hong Kong, that is, the common law, rules of
equity, ordinances, subordinate legislation and customary law shall be
maintained, except for any that contravene this Law, and subject to any
amendment by the legislature of the Hong Kong Special Administrative
Region.

Thus, the common law based on judicial precedents and the ordinances that were in
force before 1 J uly 1997 remain applicable after the transfer of sovereignty to China.
One significant formal change was made to the appeals system. The Hong Kong
Court of Final Appeal was established to replace the J udicial Committee of the Privy
Council in the United Kingdom (UK) as the court of final adjudication.
20

Article 106 provides that Hong Kong is to have its own independent finances and
prohibits the PRC from raising taxes in Hong Kong or sharing the HKSARs tax
revenue:
The Hong Kong Special Administrative Region shall have independent
finances.

The Hong Kong Special Administrative Region shall use its financial revenues
exclusively for its own purposes, and they shall not be handed over to the
Central Peoples Government.

Among these three series, HK$ M1 exhibits a significant seasonal pattern, whereas there is no strong
evidence of seasonality in broad money (HK$ M2 and HK$ M3). See Hong Kong Monetary Authority,
Guide to Hong Kong Monetary and Banking Terms (3
rd
ed, 2006) [47]
<http://www.info.gov.hk/hkma/eng/public/ghkmbt/BT_eng.pdf>at 26 April 2008.
19
Basic Law art 108.
20
Basic Law art 81.
93

The Central Peoples Government shall not levy taxes in the Hong Kong
Special Administrative Region.

As regards the tax system, Article 108 provides that:
The Hong Kong Special Administrative Region shall practise an independent
taxation system.

The Hong Kong Special Administrative Region shall, taking the low tax policy
previously pursued in Hong Kong as reference, enact laws on its own
concerning types of taxes, tax rates, tax reductions, allowances and exemptions,
and other matters of taxation.

The Basic Law has stressed the need to preserve the prosperity and stability of Hong
Kong.
21

4.2.2 Structure of tax laws

Hong Kong derived its tax law from the UK. Like the UK, the taxation of earnings
and profits was first introduced in Hong Kong in 1940 as a temporary measure when
Britain went to war with Germany.
22
The War Revenue Ordinance 1940 (WRO
1940) was based upon Addingtons 1803 Act, which introduced the concept of a
schedular system of taxation to tax income from different sources separately.
23
Unlike
Addingtons schedular tax system, the WRO 1940 did not contain a sweeping clause
to tax income not specifically charged under the other schedules.

The WRO 1940 did not enjoy force of law for very long. It effectively came to an end
on Christmas Day 1941 after the J apanese invaded and occupied Hong Kong.

21
Basic Law Preamble.
22
The taxation of earnings and profits was first introduced in Hong Kong in 1940 to impose war taxes
and to regulate the collection thereof. See Andrew Halkyard, The Privy Councils Hong Kong Tax
Legacy [1998] British Tax Review 32, 33.
23
Andrew Halkyard, Source of Profits Rules in Hong Kong Analysis of a Troubling Successful
System (2006) 60 Bulletin for International Taxation 453, 453.
94
Following the Second World War, income tax on earnings and profits was brought
back in 1947 under the Inland Revenue Ordinance 1947 (IRO 1947). The IRO 1947
was similar in form and content to the WRO 1940, and the schedular tax system was
retained. Though there have been many technical modifications to the income tax
legislation since 1947, the fundamental structure has remained the same. The IRO
1947 still represents the income tax law of Hong Kong today.

To be liable to income tax, income must fall within a taxable source caught in one of
the schedules. Thus, the meaning of source is of key importance in Hong Kong tax
law. To reduce the risk of constant disputes with taxpayers on the question of source
and other tax-related matters, the Inland Revenue Department (IRD) publishes
Departmental Interpretation and Practice Notes (DIPN) and advance rulings advising
on source and other issues for the information and guidance of taxpayers. DIPNs do
not state the law but the Commissioners view of the law. Therefore, they have no
binding force and do not affect a persons right of objection or appeal to the
Commissioner, the Board of Review or the Courts.

Since 1 April 1998, taxpayers have also been able to request an advance ruling from
the IRD on any provisions of the IRO 1947, except on the following matters:
imposition or remission of a penalty;
correctness of a return or other information supplied by any taxpayer;
prosecution of any taxpayer; and
recovery of any debt owing by any taxpayer.
24

24
Inland Revenue Ordinance 1947 s 88A; Pt I of Sch 10.
95
Businesses can apply for an advance ruling to address questions of uncertainty on a
seriously contemplated transaction upon payment of an appropriate fee.
25

Notwithstanding the simple low-tax structure, there are opportunities for tax planning.
Anti-avoidance provisions are now incorporated into the IRO 1947. Sections 61,
26

61A
27
and 61B
28
are designed to counteract a tax benefit obtained, and limit the ability
of a taxpayer to acquire and sell companies with assessed tax losses.

4.2.3 Tax system

Hong Kong is a low-tax jurisdiction. Notable features of its revenue structure include:
a schedular tax system;
no concept of total income;

25
A fee of HK$30 000 is charged for a ruling on the territorial source principle or HK$10 000 on other
matters. See Hong Kong, Commissioner of Inland Revenue, Departmental Interpretation and Practice
Note No 31, Advance Rulings.
26
Section 61 was introduced in 1986 to strike down blatant or contrived tax avoidance arrangements.
The section tackles any transaction which reduces or would reduce the amount of tax payable by any
person where the Assessor is of the opinion that the transaction is artificial or fictitious or that any
disposition is not in fact given effect to. Where it applies the Assessor may disregard any such
transaction or disposition and assess the taxpayer accordingly. See Hong Kong, Inland Revenue
Department, Departmental Interpretation and Practice Note No 15 (revised), (A) Limitation of Loss
Relief (Section 22B), (B) Leasing Arrangements (Section 39E), (C) General Anti-Avoidance Provisions
(Section 61), (D) General Anti-Avoidance Provisions (Section 61A), (E) Loss Companies (Section 61B),
(F) Ramsay Principle, (G) Penalty on Tax Avoidance Cases, (H) Guidelines on Lease Financing, (I)
Advance Rulings (DIPN 15), [24]-[29] which sets out the Commissioners view and treatment of s 61
and the meaning of the words transaction and artificial or fictitious, which are not defined in the IRO
1947.
27
Section 61A applies to any transaction entered for the sole or dominant purpose of enabling a person
to obtain a tax benefit. Where it applies, the section provides for an assessment to be made by an
Assistant Commissioner as if the transaction had not been entered into or carried out or in such other
manner as is considered necessary to counteract the tax benefit that would otherwise be obtained. See
Hong Kong, Inland Revenue Department, DIPN 15, ibid [30]-[49], on the application of s 61A. See,
also, Commissioner of Inland Revenue v Tai Hing Cotton Mill (Development) Ltd [2008] 2 HKLRD 40
on what constitutes a tax benefit under s 61A.
28
Section 61B is aimed at the situation where companies with accumulated tax losses are sold for their
losses to the proprietors of businesses that are trading profitably. Once ownership of the loss company
has changed hands, the profitable business is introduced into the company and the losses brought
forward are set off against profits derived. The section restricts this avoidance practice by allowing the
Commissioner to refuse to set off losses brought forward where he/she is satisfied that the sole or
dominant purpose of a change in shareholding is the utilisation of those losses to obtain a tax benefit.
See Hong Kong, Inland Revenue Department, DIPN 15, ibid [50]-[54], on the application of s 61B.
96
territorial source principle;
a narrow tax base;
simple and straightforward tax legislation;
limited network of double tax treaties (DTT); and
heavy reliance on non-tax revenues.

The major taxes and levies in Hong Kong are as follows:
taxes on profits and income of companies and individuals (including rental income)
originating in Hong Kong;
recurrent tax on property or wealth, namely, property rates;
tax on certain property transfers (principally real property), namely stamp duty;
registration and licence duties; and
limited taxes on goods and services including hotel accommodation tax and betting
duty.

Other sources of revenue come from the proceeds of land sales
29
and investment
returns.
30
Estate duty on the transfer of capital upon death (and by way of gift) was
abolished from 13 February 2006. The tax year starts on 1 April and ends on
31 March the following year.

29
Land sales is discussed below under Heavy reliance on non-tax revenues.
30
Up to the fiscal year 1998-99, Hong Kong has experienced budget surpluses over the past 15 years,
and its fiscal reserves have increased steadily (HK$457.5 billion as at April 1998). Investment income
of the fiscal reserves is extremely volatile, representing between 0.5 per cent and 18 per cent of
government revenue over the past decade. See Henry Tang, The 2007-08 Budget (Speech by the
Financial Secretary moving the Second Reading of the Appropriation Bill 2007, 28 February 2007) [79],
Government of the HKSAR of the PRC <http://www.budget.gov.hk/2007/eng/pdf/ebudget.pdf> at
2 May 2008.
97
Schedular tax system

As has been stated earlier, Hong Kong is still using the schedular tax system
introduced by Addington two hundred years ago. Tax is assessed separately at
different rates on income caught under one of the three schedules:
salaries tax is assessed at a progressive
31
or standard (flat) rate on income from an
employment or office or pension;
property tax is assessed at a standard rate on income from land and buildings; and
profits tax is assessed at a standard rate on profits from businesses.

Salaries tax is charged on emoluments arising in or derived from Hong Kong.
32
It
applies on a progressive basis with marginal rates of 2, 7, 12 and 17 per cent, with
segments of HK$35 000 (Hong Kong dollars) each.
33
The highest rate of tax on
salaries is capped at a flat rate of 16 per cent of taxable income.
34
In other words, a
salaries taxpayer cannot pay more than 16 per cent of his/her income in tax.
35
A single
salaries taxpayer (with no dependent parent/grandparent) is charged at the standard
rate if his/her annual income is HK$2.75 million or over for the 2007-08 year of

31
Under a progressive tax, the rate of tax increases as the amount of taxable income rises. This means
taxpayers with more income pay more tax.
32
33
Based on the 2007-08 tax rates.
In the 2008-09 Budget delivered on 27 February 2008, the Financial Secretary proposed a number
of tax relief measures, including widening the tax segment from HK$35 000 to HK$40 000 each. See
Hong Kong, Inland Revenue Department, Tax Information: 2008-09 Budget Tax Concessions
(revised 7 April 2008) <http://www.ird.gov.hk/eng/tax/budget.htm>at 27 April 2008.
34
Progressive rates apply to lower income taxpayers subject to salaries tax. Eventually as their income
rises, they cut out and the 16 per cent standard (flat) rate applies. (The Financial Secretary proposed
that the standard rate be reduced from 16 per cent to 15 per cent starting the 2008-09 financial year.)
35
The standard rate applies to the whole of the taxpayers net assessable income (that is, assessable
income less allowable deductions), but without any deduction for personal allowances. See Inland
Revenue Ordinance 1947 s 13.
In contrast, progressive rates apply to the net chargeable income (that is, assessable income less
allowable deductions and permitted allowances). See Inland Revenue Ordinance 1947 s 12B.
98
assessment.
36
An employer does not have to deduct tax at source, like under
Australias Pay As You Go (PAYG) withholding tax, on the salaries paid to an
employee.
37
Instead, a provisional tax is collected, based on the previous years
assessment.
38
The paid provisional tax is credited against the final salaries tax
assessed for the year.
39

Salaries tax is paid by about 1.2 million of the 3.4 million workforce, which means
that about two-thirds of them pay no tax at all.
40
Most wage or salary earners enjoy
statutory personal allowances to reduce their tax payable to nil. A single person can
earn HK$100 000 and pay no salaries tax.
41
Roughly 60 per cent of the salaries tax
collected came from the top 100 000 salaries taxpayers, or 3 per cent of the workforce,
signifying a reliance on high-income earners.
42
Salaries tax contributed to about 27
per cent of total revenue.
43

Property tax applies to owners of land or buildings in Hong Kong.
44
It is charged at
the standard rate of 16 per cent of the actual rent received, less an allowance of 20 per
cent for repairs and maintenance.
45
A property owned by a corporation carrying on a

36
See Hong Kong, Inland Revenue Department, Tax Information: Tax Rates (revised 23 May 2007)
<http://www.ird.gov.hk/eng/tax/ind_tra.htm>at 27 April 2008.
37
See footnote 40, Chapter 1, for an explanation of Australias Pay As You Go (PAYG) system for
reporting and paying tax on business and investment income and withholding amounts on payments of
employment income.
38
Inland Revenue Ordinance 1947 s 63B.
39
A similar provisional tax regime applies for profits tax and for property tax. See Inland Revenue
Ordinance 1947 ss 63G, 63L.
40
See Chapter 1: Is Tax Reform Required in Hong Kong? in Hong Kong, Broadening the Tax Base
Ensuring Our Future Prosperity Whats the Best Options for Hong Kong? (Consultation Document,
18 J uly 2006) [15] <http://www.taxreform.gov.hk/eng/pdf/Chapter_01.pdf>at 30 September 2007.
41
The basic allowance for a single person is HK$100 000 for the 2007-08 year of assessment.
HK$100 000 is approximately A$14 250 (Australian dollars).
42
Hong Kong, Broadening the Tax Base Ensuring Our Future Prosperity Whats the Best Options for
Hong Kong, above n 40, 4.
43
Ibid 6.
44
45
Based on the 2007-08 tax rate.
99
business in Hong Kong is exempt from property tax, but the profits derived from
ownership are chargeable to profits tax. Property tax is a relatively minor source of
revenue, accounting for about 0.5 per cent of total revenue.
46

Persons, including corporations, partnerships, trustees, and bodies of persons carrying
on any trade, profession or business in Hong Kong are chargeable to profits tax.
47

Profits tax is charged on the net profits of a Hong Kong business. The profits tax rate
is 17.5 per cent for corporations and 16 per cent for non-corporate taxpayers.
48
There
are about 750 000 registered businesses in Hong Kong.
49
Most small businesses pay
little or no tax, and 60 per cent of profits tax was contributed by the top 800
companies.
50
Hong Kong has a noticeably heavy reliance on profits tax, accounting
for about 36 per cent of its total tax revenue.
51

The schedular structure generally does not impose any income-type tax burden on those
receiving passive income (other than rents). Section 14 of the IRO 1947 specifically
excludes profits arising from the sale of capital assets. However, if profits arise from a
sale of otherwise capital assets as part of a profit-making scheme, the transaction will
be regarded as a normal business and that person is required to pay tax on the profits

46
See Chapter 3: The Economy in Hong Kong Yearbook 2006
<http://www.yearbook.gov.hk/2006/PDF/en/E03.pdf>at 30 March 2008.
47
48
Based on the 2007-08 tax rate. The profits tax rate has been proposed to be reduced from 17.5 per
cent to 16.5 per cent for corporations and 15 per cent for non-corporate taxpayers from the 2008-09
financial year.
49
Hong Kong, Broadening the Tax Base Ensuring Our Future Prosperity Whats the Best Options for
Hong Kong, above n 40, [15].
50
Ibid.
51
Profits tax is a major source of revenue. The (average) reliance on corporate profits tax in the OECD
economies is 9.3 per cent. See Chart 1: Hong Kong Tax Revenue Mix as a Percentage of Total Tax
Revenue Compared to the OECD Economies, ibid 6.
100
made. As interest income is not taxed in the hands of the lender (except interest income
earned by financial businesses), interest expense is largely non-deductible.
52

Total income

Hong Kongs tax system is unusual. There is no definition of income or profits.
There is no concept of total income and a taxpayer does not have to aggregate
income from all sources. To be liable to income-type tax, income must fall within a
taxable source. A person pays tax only if he or she is engaged in an activity that is
subject to tax under one of the three headings. The three income-type taxes operate
separately. For example, a person operating a business will pay profits tax on any
profits sourced in Hong Kong made in that business. That person will also be subject
to salaries tax if he or she receives a salary from a job in Hong Kong, but the two
calculations (normally) operate separately. However, an individual may elect for
Personal Assessment, where all of the income is aggregated into a single sum and
assessed at the marginal tax rates to reduce the total tax liability.
53

The IRO 1947 does not contain any provision that incorporates into tax all items of
income not expressly charged elsewhere in the legislation. Taxing under a total

52
See s 16(2) of the IRO 1947 governing the deduction of interest expenses. See, also, Hong Kong,
Inland Revenue Department, Departmental Interpretation and Practice Note No 13A, Profits Tax:
Deductibility of Interest Expenses.
53
In certain circumstances, an individual taxpayer can elect for Personal Assessment which can reduce
the effective level of property tax and profits tax. Under Personal Assessment, an individual taxpayer
is allowed to be assessed at the progressive tax rates on his or her total income from a taxable source, as
opposed to being assessed separately under the three schedules, so as to reduce the total tax liability. A
taxpayer who only derives income chargeable to salaries tax will not benefit by electing Personal
Assessment. See footnote 34, Chapter 2, on how Personal Assessment works to reduce the total tax
liability of an individual taxpayer.
101
income concept would draw income from all sources such as interest, dividends and
foreign-source income into the tax net.
54

Territorial principle

Hong Kong has a territorial tax system derived, in part, from its past constitutional
position. Before the transfer of sovereignty to China, Hong Kongs administration
followed the normal pattern for a British territory overseas, with a governor appointed
by the Crown assisted by nominated Executive and Legislative Councils. The
governance structure was based on the Letters Patent (equivalent to a Constitution). A
colonial jurisdiction has subordinate legislatures, as opposed to sovereign legislatures.
As a British territory, the authorities in Hong Kong were, it is argued, not competent to
institute a system of taxation based on residence because the government did not
possess the power to tax effectively beyond the geographic borders of its territory:
Authority emanates from the Queen in Council in Great Britain and, under
certain orders in Council, consolidated under what are called the Hong Kong
Letters Patent 1917-1988, authority is delegated to a Governor appointed by
the Crown and the Legislative and Executive Councils in Hong Kong
Clause VII of the Letters Patent provides that the Governor, by and with the
advice and consent of the Legislative Council, may make laws for the peace,
order and good government of the Colony. Such words, or words similar in
effect, have been used in almost all of the Letters Patent constituting the
governments of British colonies and there is a substantial body of case law

54
It is argued that the schedular structure is inherently inequitable as it does not support higher rates of
tax on higher incomes. A person whose income falls exclusively into a single category (for example,
profits), is required to pay more tax than one whose total income is the same, but is split among several
categories (for example, profits and rents). See Michael Littlewood, Taxation Without Representation:
The History of Hong Kongs Troublingly Successful Tax System [2002] British Tax Review 212, 217.
Australia does not have a separated schedular system of assessment and tax is assessed on total
income (that is, taxable income is calculated by subtracting a taxpayers allowable deductions from that
assessable income for tax purposes). Different tax rates apply to different income taxpayers.
Companies are taxed at the flat rate of 30 per cent while individual taxpayers at marginal rates at 15, 30,
40 and 45 per cent (plus a Medicare levy of 1.5 per cent) depending on their taxable income. But
Australias tax system is still criticised as unfair and inequitable because of the distortion in tax payable.
See below Part 4.3.3.
For a further discussion of the schedular tax system and differential tax rates, see Richard Cullen
and Tor Krever, Taxation and Democracy in Hong Kong (2005) [5] Civic Exchange <http://www.civic-
exchange.org/publications/2005/taxdemo-E.pdf>at 30 September 2007.
102
relating to them. The Governor in Council is a subordinate legislative body
and, for any law to be validly made under the Letters Patent, there must be a
sufficient nexus with the Colony. The Hong Kong government cannot enact
legislation which does not have a real connection with the Colony. The
jurisdiction of the Governor in Council extends to the colonial territories but
not beyond. Further, para 8 of cl XXVI of the Hong Kong Royal Instructions
1917-1988, which supplement the Letters Patent, provides that the Governor
shall not assent to any Bill of an extraordinary nature and importance
whereby [the Crowns] prerogative or the rights and property of [the Queens]
subjects not residing in the Colony, or the trade and shipping of [the] United
Kingdom and its dependencies, may be prejudiced. These provisions have
great significance in the context of the governments power to levy taxation.
55

Under the territorial principle of taxation, the residence of a taxpayer has limited
relevance in deciding whether an entity has a liability to Hong Kong taxation.
56
Both
residents and non-residents are taxed on income from sources in that jurisdiction and
on property situated in that jurisdiction. Residents and non-residents are treated alike,
which means that offshore profits of Hong Kong businesses are left out of the tax
system. The profits earned by a resident from abroad are not subject to tax, even
though the income is remitted to Hong Kong. A non-resident, however, is liable to tax
on profits derived from or arising in Hong Kong. There is, therefore, a need to
distinguish between non-taxable offshore and taxable domestic profits.

The territorial principle has always been fundamental to the taxation of profits in Hong

55
Peter S A Edwards, The Hong Kong Tax Structure: Recent Tax Developments (1992) 4(3) CCH
Journal of Asian Pacific Taxation 17, 17. This explanation tends to over-emphasise the importance of
constitutional provisions as explanatory factors. See below footnotes 70 and 71 plus accompanying text
for a more practical, less doctrinal, explanation for the application and retention of the territorial
principle in Hong Kong.
56
The residence of an entity is needed to determine if it is carrying on a business in Hong Kong, so as to
decide whether the entity has a liability to pay profits tax.
To reinforce the status of Hong Kong as an international financial centre, non-resident persons are
exempt from tax in respect of profits derived from certain qualifying offshore funds. A definition of
resident person (including individuals, corporations, partnerships and trustees of trust estates) is
contained in s 20AB of the IRO 1947 and applies to the profits tax exemption of offshore funds only.
The residency of a corporation, partnership or trust is the location where the entitys central
management and control is exercised. The residency of an individual is where he ordinarily resides or
where he is actually present for more than half of the income year, whether continuously or
intermittently. See Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice
Note No 43, Profits Tax: Profits Tax Exemption for Offshore Funds.
103
Kong, but determining the source of profits can, at times, be contentious. Different
source rules are applied by the IRD to different types of businesses. For example, the
source of profits for a manufacturing business is the place where the goods are
manufactured.
57
The factor that determines the locality of profits from trading in
goods and commodities is generally the place where the contracts for purchase and
sale are effected.
58
The source of service fees is the place where the service is
performed.
59
How the law on source has developed in Hong Kong is reviewed in
detail in the next chapter.

It has been argued that a territorial tax system cannot be fair.
60
A country following
the source principle cannot have a progressive tax (as the total income is not taken into
account in calculating the taxable income).

Tax base

Generally, a given economy will suffer the least distorting effects (from a taxation-
impact point of view) if the tax rates are kept low and the widest range of persons and
activities are taxed.
61
Hong Kongs tax rates are low, but the base is narrow in
composition and the taxed sector is small. Though revenues are raised from both direct
and indirect taxes, about half of total revenue comes from direct taxes imposed on
personal income, business profits and property income, and significant amounts are
capital revenue from land sales and related transactions. Indirect taxes are imposed on

57
Hong Kong, Inland Revenue Department, Public Forms and Pamphlets: A Simple Guide on the
Territorial Source Principle of Taxation (revised 15 August 2006)
<http://www.ird.gov.hk/eng/paf/bus_pft_tsp.htm>at 27 April 2008.
58
Ibid.
59
Ibid.
60
Michael J McIntyre, Commentary: The Design of Tax Rules for the North American Free Trade
Alliance (1994) 49 Tax Law Review 769, 772.
61
Richard Cullen, A Generic Taxation System Overview (2000) unpublished paper (copy on file with
author) 19.
104
a very limited range of transactions in the form of stamp duties, betting duty, motor
vehicle taxes, excise duties, air passenger departure tax and hotel accommodation tax.

The tax net in Hong Kong is not wide enough to include all gains and benefits within
the tax base. The overall tax burden is borne by those caught under one of the
schedules. The mix of taxes in Hong Kong is narrow as investment income such as
interest, dividends and capital gains are generally not taxed in Hong Kong.
Professional investors (who are not traders) generally escape any liability for income-
type tax. These are people who have the means to make a greater contribution to the
welfare of society via tax payments. The tax system has developed in a way that
favours the very rich. Normally it is the well-off who own capital assets. They save
still more tax dollars if capital gains and investment income are not included in the tax
base.

Hong Kong does not have any form of general consumption tax. The launch of a
detailed discussion of a possible GST (amongst other options) received a hostile
opposition, however.
62
The initial public consultation on tax reform was drastically
altered half way through the nine-month consultation period by removing the
introduction of a GST from the consultation agenda. The overseas trend is towards a
greater reliance on consumption taxes and less reliance on taxes on income and
property.
63
If all goods and services are taxed, then, it is argued that, in a modern

62
See Paul Drum and Anne Edwards, A GST Considered To Be Oh So Wrong for Hong Kong (2007)
77(1) Intheblack 56; Laurence E Lipsher, The Curse of the Not-So-Golden GST (2007) 45 Tax Notes
International 451 and Darryl Tait, GST Plan Bites the Dust (2006) 44 Tax Notes International 832,
reporting on the lead-up to the decision to drop the proposed GST in Hong Kong. See, also, Part 7.4.4,
Chapter 7, for a discussion of a general consumption tax for Hong Kong.
63
Hong Kong, Advisory Committee on New Broad-based Taxes, A Broader-Based Tax System for
Hong Kong? (Consultation Document, August 2001) [31], Treasury Branch of Financial Services and
the Treasury Bureau <http://www.fstb.gov.hk//tb/acnbt/textonly/english/otherdoc/condoc.pdf> at
26 April 2008.
105
economy, the tax burden will be shared more equitably by everyone, from the well-off
to the less well-off. The well-off are the heaviest consumers in monetary terms and
can be expected to pay more (in total monetary terms) in consumption taxes. Broad-
based consumption taxes are regressive, however.
64
The less well-off pay a higher
proportion of their income in tax than the well-off. This can be compensated for, as in
Australia, through new initiatives such as the Senior Australians Tax Offset, allowing
senior citizens to earn more income before they have to pay income tax.
65
For people
paying no income tax, relief can be provided through some form of payments to
compensate low-income earners for their increase in food bills from the additional
revenue raised from the tax, for example.
66

Simple and straightforward

Hong Kongs taxation legislation is simple and straightforward, with the IRD 1947
running to about two hundred pages including subsidiary amendments.
67
A full
bilingual translation of all provisions (in English and Chinese) is available on the
relevant web site.
68
At one level this simple tax system is a major benefit to all
taxpayers since the economic burden of complying with the tax system is minimised
for everyone.

64
A consumption tax is generally a regressive tax since it applies across the board to all goods and
services regardless of the consumers income. The tax on a particular item is the same whether the item
is purchased by a person with a low or high income.
65
Income Tax Assessment Act 1936 (Cth) s 160AAAA. The Senior Australians Tax Offset is a tax
rebate available to eligible persons with effect from the 2000-01 income tax year.
66
Richard Cullen, Revenue Law in Hong Kong: The Future in Raymond Wacks (ed), The New Legal
Order in Hong Kong (1999) 397.
67
Michael Littlewood, How Simple Can Tax Law Be? The Instructive Case of Hong Kong (2005) 38
Tax Notes International 689, 689-90.
68
The Bilingual Laws Information System is a database containing the statutory laws of Hong Kong in
both English and Chinese. See the web site of HKSARs Department of J ustice at
http://www.legislation.gov.hk.
106
To maintain its simple, low-tax, revenue law structure, the tax system deliberately
exempts qualifying offshore profits from Hong Kong profits tax.
69
The charge to
profits tax under the WRO 1940 (predecessor to the IRO 1947) was limited to profits
arising in or derived from Hong Kong.
70
It was already recognised at the time when
the tax legislation was introduced that the imposition of higher or more broad-based
taxes would affect Hong Kongs position as a base for regional trade. Many firms had
set up their head offices in Hong Kong and it would be very easy for them to relocate
their head offices elsewhere.

After the Second World War, a proposal to expand the charge on business profits to
include profits remitted to Hong Kong was put forward but rejected. In introducing
the bill that became the IRO 1947, the Acting Financial Secretary said:
It was originally proposed to tax income arising in, derived from, or received in
the Colony. The Committee has recommended that tax should be restricted to
income arising in or derived from the Colony ... This Colony differs from the
majority of colonial dependencies in that a number of head offices of important
businesses are established here. Profits resulting from business activities in
other countries must pass through the books of the head office and if such
profits were taxable here all sorts of complicated claims in respect of double

69
Richard Cullen, Taxation Rulings: Practice and Policy in Hong Kong (1995) 25 Hong Kong Law
Journal 190, 199.
70
According to the Report of the Inland Revenue Ordinance Revenue Committee 1968, the rationale for
this limitation (as stated by a leading member of the Reconstituted War Revenue Committee in 1941)
was as follows:
(a) Geographically Hong Kong is part of China; it is not a country but a sea port town.
(b) 98% of the population is Chinese and nearly everyone here has connections and a second home
outside the Colony.

(d) The Colony produces no raw materials and is entirely dependent upon imports for such industries
as exist.
(e) The prosperity of the Colony depends upon the facilities it can offer as a conveniently situated
free port from which to carry on trade.
(f) Many firms having their head offices in Hong Kong do by far the greater part of their business
outside the Colony. It would be very easy indeed for them to remove their head offices elsewhere,
with consequent detriment to the Colony generally.
(g) Freedom from taxation, confidence in a good Government and unrivalled port facilities have built
up Hong Kong Should any other place offer greater facilities or less inconveniences, I can see
nothing in Hong Kong itself to keep trade here. The fear of killing the goose which lays the
golden eggs has always been a very real one.
See J efferson VanderWolk, The Source of Income: Tax Law and Practice in Hong Kong (3
rd
ed, 2002)
4.
107
taxation would arise. The Committee felt that this might tend to discourage
firms from establishing their head offices here and that Hong Kongs position
as a financial and commercial centre might be adversely affected.
71

No doubt the territorial source principle is attractive to foreign entities when planning
their business activities in Hong Kong. As the offshore profits are non-taxable, foreign
businesses are able to set up booking centre operations, under which only invoicing,
banking and administrative activities are carried out within the HKSAR. There would
not be any deemed Hong Kong-source income if contracts of sale are negotiated and
executed outside the jurisdiction, and goods are sent outside the territory.
72

The exemption of foreign-source income is a benefit to investors and businesses that
make Hong Kong an attractive centre for conducting trade and investment. However, it
has been argued that the exemption of foreign-source income distorts financial
activities in Hong Kong.
73
Investors and businesses may plan their affairs so that the
financial income is earned from sources in tax haven jurisdictions, such as the Cayman
Islands.
74

Double tax treaties

Due to the territorial source basis of taxation, non-residents are taxed at source and
withholding tax, generally, does not apply.
75
As only three types of income with a
domestic source are taxed under a separate system of schedules, there is thus notably

71
Ibid 5.
72
The contract conclusion test is discussed in Chapter 5.
73
J ack M Mintz and Stephen R Richardson, Taxation of Financial Intermediation Activities in Hong
Kong (2002) 25 Tax Notes International 771, 771.
74
Ibid.
75
Certain sums paid to an offshore company are deemed to have a source in Hong Kong, and
withholding tax applies even if the company does not carry on any business in Hong Kong. See Part 3.6,
Chapter 3, for a discussion of source taxation and withholding.
108
less need for Hong Kong to seek to enter into a range of DTTs to deal with the
allocation of taxing rights for different types of income and to require the residence
jurisdiction to provide double taxation relief for any source taxation levied in
accordance with the DTT. However, Hong Kong is beginning to recognise the certain
other trade-enhancing merits of concluding DTTs with its trading partners,
76
and has
entered a comprehensive agreement with Belgium,
77
Thailand
78
and Luxembourg.
79

For Hong Kong, the Belgium, Thailand and Luxembourg DTTs apply to any person
who is resident in Hong Kong. The term person includes an individual, a company,
an estate, a trust and a partnership.
80
Residence is not defined in the Hong Kong-
Belgium DTT, but any person is liable to tax by reason of his domicile, residence,
place of management or incorporation or any other criterion of a similar nature.
81

Residence is defined in both the Hong Kong-Thailand and Hong Kong-Luxembourg
DTTs and means, in the case of companies, a company incorporated in Hong Kong or
a company not incorporated in Hong Kong but being normally managed or controlled
in Hong Kong.
82
For the first time, the concept of residence has a (limited but) key
role to play in Hong Kongs territorial tax system.

76
In general, tax treaties facilitate international business and investment by removing or reducing tax
barriers to cross-border movement of capital, technology or people. A double tax treaty (DTT) can be
negotiated to reduce withholding tax rates to boost investment by increasing after-tax returns of foreign
investors. A reduction in interest withholding tax will reduce the borrowing costs; a reduction in
dividend withholding tax will help a state to attract and retain foreign direct investment; and a reduction
in the rate of royalty withholding tax will improve a states access to intellectual property.
77
See the Agreement Between the Hong Kong Special Administrative Region of the Peoples Republic
of China and the Kingdom of Belgium for the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with respect to Taxes on Income and on Capital (entered into force 7 October 2004)
(Hong Kong-Belgium DTT).
78
See the Agreement Between the Government of the Hong Kong Special Administrative Region of the
Peoples Republic of China and the Government of the Kingdom of Thailand for the Avoidance of
force 7 December 2005) (Hong Kong-Thailand DTT).
79
See the Agreement Between the Hong Kong Special Administrative Region of the Peoples Republic
of China and the Grand Duchy of Luxembourg for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (entered into force 1 April
2008) (Hong Kong-Luxembourg DTT).
80
Hong Kong-Belgium DTT art 3; Hong Kong-Thailand DTT art 3; Hong Kong-Luxembourg DTT
art 3.
81
Hong Kong-Belgium DTT art 4.
82
Hong Kong-Thailand DTT art 4; Hong Kong-Luxembourg DTT art 4.
109

Hong Kong also has entered limited treaties relating to airline and shipping income,
83

and a comprehensive Arrangement with Mainland China covering business profits,
employment income, capital gains as well as passive income such as dividends,
interest and royalties.
84
The Arrangement is necessary to allocate tax rights between
the two sides due to increasing cross-border commercial activities and each side
administering a different tax system. The concept of permanent establishment (PE)
is used in the Arrangement to determine where tax is to be imposed. In determining
the profits of a PE, deductions are allowed for expenses incurred for the purposes of
the business of the PE including executive and general administrative expenses.
85

However, any royalties paid by the PE to the head office for the right to use
intellectual property, commission or remuneration for provision of specific service or
management, as well as interest on moneys lent to the PE (except for banking
enterprises) are not deductible other than reimbursement of actual expenses.

The Arrangement provides a number of incentives for investing in the PRC through a
holding company in Hong Kong. A Hong Kong company will no longer have to pay
any PRC capital gains tax (CGT) when it sells shares in the PRC businesses, unless
the Hong Kong company holds 25 per cent or more of the shareholding of the Mainland
enterprise or the assets of the Mainland enterprise comprises mainly immovable

83
See footnote 33, Chapter 1, for a brief discussion of Hong Kongs very limited involvement with tax
treaties.
84
See the Arrangement Between the Mainland of China and the Hong Kong Special Administrative
Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to
Taxes on Income (entered into force 8 December 2006) (Hong Kong-China Double Tax Arrangement).
See, also, Second Protocol to Arrangement Between the Mainland of China and the Hong Kong Special
Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (signed on 30 J anuary 2008).
85
Hong Kong-China Double Tax Arrangment art 7.
110
property situated on the Mainland.
86
The withholding tax rates on dividends, interest
and royalties earned from investments in Chinese companies have been lowered to
attract foreign capital and to promote Hong Kong as an international financial centre.
87

As to income from employment, so far as Hong Kong is concerned, a resident of the
Mainland is chargeable to Hong Kong salaries tax on income from employment in
Hong Kong if the period of stay in Hong Kong exceeds 183 days in the aggregate in a
12-month period.
88

Though Hong Kong is now part of the PRC, it is excluded from the Australia-China
DTT.
89
The Australia-China DTT covers the income tax imposed under the laws of
the PRC.
90
The term China means all the territory of the PRC, including its

86
Hong Kong-China Double Tax Arrangement art 13.
87
Under the previous Hong Kong-China Double Tax Arrangement signed in February 1998, the
withholding tax rate for dividends, interest and royalties received by a Hong Kong company was 10 per
cent. Under the new Arrangement signed in August 2006, the withholding tax rate for dividends is now
down to 5 per cent, if the Hong Kong company holds 25 per cent or more of the capital of the Mainland
enterprise. Similarly, the withholding tax rate for interest and royalties received by a Hong Kong
company is now reduced to 7 per cent.
88
The basic charge to salaries tax is imposed by s 8(1) of the IRO 1947 on income arising in or derived
from Hong Kong. In addition to this basic charge, the High Court in the Goepfert case (Commissioner
of Inland Revenue v George Andrew Goepfert [1987] 1 HKLR 888) decided that there is a double test
under s 8(1) (at 902-3):
If during a year of assessment a persons income falls within the basic charge to salaries tax under
s 8(1), his entire salary is subject to salaries tax wherever his services may have been rendered,
subject only to the so-called 60 days rule that operates when the taxpayer can claim relief by way
of exemption under s 8(1A)(b) as read with s 8(1B). Thus, once income is caught by s 8(1) there is
no provision for apportionment On the other hand, if a person, whose income does not fall
within the basic charge to salaries tax under s 8(1), derives income from employment in respect of
which he rendered services in Hong Kong, only that income derived from the services he actually
rendered in Hong Kong is chargeable to salaries tax. Again, this is subject to the 60 days rule.
Therefore, once s 8(1) applies, there can be no claim for so-called time apportionment. If a non-Hong
Kong employment exists, then any income derived from that employment is liable to salaries tax under
s 8(1A) which brings to charge income derived from services actually rendered in Hong Kong. See,
also, Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 10
(revised), The Charge to Salaries Tax.
89
See the Agreement Between the Government of Australia and the Government of the Peoples
Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 28 December 1990) (Australia-China DTT).
90
Australia-China DTT art 2.
111
territorial sea, in which the laws relating to Chinese tax apply.
91
Article 106 of the
Basic Law provides that the PRC shall not levy taxes in Hong Kong. Article 108
stresses that the HKSAR should follow the same territorial basis and low tax rates that
previously existed in Hong Kong. Accordingly, the Commissioner of Taxation does
not accept that the HKSAR taxes would be identical or substantially similar to the
taxes imposed in China to which the DTT applies,
92
and the Australia-China DTT
does not apply to taxes imposed by the HKSAR.
93

Hong Kong is deemed to be a separate foreign country as well as an unlisted
jurisdiction for foreign-source income purposes under Australias controlled foreign
companies (CFC) legislation.
94

Heavy reliance on non-tax revenue

Traditionally, the Hong Kong government has followed a conservative fiscal policy of
zero or minimum deficit financing, which has resulted in the accumulation of sizable
fiscal surpluses. Up until commencement of the Asian financial crisis in 1997, the
government was normally successful in raising more revenue each year than it spent.
95

This outcome arose mainly due to revenue arising from land sales, taxation growth
associated with real property transactions, and the historically limited expenditure

91
92
93
See Australian Taxation Office, Taxation Ruling TR97/19, Income Tax: Tax Implications of
Resumption of Chinese Sovereignty over Hong Kong.
94
Income Tax Assessment Act 1936 (Cth) s 320. The CFC measures are explained below in Part 4.3.3.
95
To meet operating and contingency requirements, Hong Kongs fiscal reserves are maintained at
between HK$190 billion to HK$240 billion, the equivalent of nine to 11 months of government
expenditure. Hong Kongs fiscal reserves as at 31 March 1998 stood at HK$457 billion, the equivalent
of more than 12 months of government spending. See Fiscal Deficit in Hong Kong, Financial
Secretary, The 2003-04 Budget (2003) [113]
<http://www.budget.gov.hk/2003/eng/budget.htm#Fiscal%20Deficit>at 17 J anuary 2008; Appendix
13 Total Government Revenue and Expenditure and Summary of Financial Position in Hong Kong
Yearbook 1998 <http://www.yearbook.gov.hk/1998/ewww/app/app13/index.htm>at 27 April 2008.
112
patterns of successive Hong Kong governments.
96
Though Hong Kong imposes taxes
on the profits and income of companies and individuals, the key sources of
government revenues are derived, either directly or indirectly, from property-related
transactions, including land sales, land premiums, land transaction taxes, property
taxes, taxes on mortgage portfolio profits, profits tax on property development (and,
sales, renovation etc) and companies and salaries tax paid by the thousands of persons
employed within the property industry.
97
A key factor driving this reliance is the fact
that ownership of title to all land is vested in the government and leasehold is the only
type of land tenure that exists in Hong Kong:
Control over existing and future possible use of each and every piece of land is
enforced through restrictive development covenants within each lease, as to
type of use and plot ratios. This control is additionally supplemented by
planning legislation that is based upon the British system of zoning and plot
ratio requirements.

The financial benefit to be gained by a leaseholder from any alteration to a
lease containing restrictive development covenants involves paying a premium
to the government, prior to development, on the basis of the before and after
value of the lease. It is this land premium mechanism that underlies a fair
chunk of the governments annual income.
98

From the 1980s to 1997, especially, the British colonial government had a policy of
restricting the supply of new land for building and the price of land was continually
being pushed up. Hong Kong thus had enjoyed huge fiscal surpluses for decades,
made possible, however, by its heavy reliance on property-related revenues:
In effect, the real estate system has become an integral part of the tax system,
so much so that the government depends a lot on land sales and land-related
income to pay for social spending and capital works.
99

96
Cullen, Taxation Rulings: Practice and Policy in Hong Kong, above n 69, 199.
97
Income from real estate-related activity including land sales, development profits, tax on salaries and
wages in this sector, lease variation payments etc accounted for about half of the governments income
before the Asian Financial Crisis.
98
Stephen Brown and Christine Loh, Hong Kong: The Political Economy of Land (2002)
<http://www.civic-exchange.org/publications/2002/The%20political%20economy%20of%20land.pdf>
at 30 September 2007.
99
Anthony B L Cheung, From the Editor: Dilemma in Tax Reform (2000) Policy Bulletin, Hong
Kong Policy Research Institute Limited
113

The narrow tax base had proved effective at funding expenditure and building up high
reserves in a booming economy. At the time when the HKSAR was created, Hong
Kong was rich after years of strong growth and budget surpluses. Soon after the
handover to China, Hong Kongs economic stability and prosperity faced severe
challenges. The Asian Financial Crisis (AFC), which started (coincidentally) shortly
after Hong Kongs return to China, resulted in the decision by the government to halt
the sale of land, and the unprecedented intervention in the stock market by the Hong
Kong government.
100
Heavy deflationary pressures persisted in Hong Kong with
property prices falling significantly in value by more than 50-60 per cent from their
earlier peaks.
101
An important reason for the dramatic size of this collapse was the
Hong Kong dollar peg to the US dollar.
102
This peg means that the Hong Kong dollar
cannot depreciate (or appreciate) to any significant extent. Thus, when a crisis such as
the AFC hits, all the adjustment has to be absorbed by depreciation of asset values
(rather than, at least partly, via currency devaluation).
103

Budget deficits, which were rare, have been recorded.
104
The government was under
pressure to alter its spending and taxation patterns due to the volatile income from land-

<http://www.hkpri.org.hk/bulletin/15/From%20the%20Editor.html>at 17 April 2008.
100
In August 1998, the HKSAR took the view that it had to intervene to forestall a contrived
manipulation of the currency and equities markets by certain mainly offshore fund managers. As a
consequence, the Exchange Fund Investment Ltd was set up by the Hong Kong Monetary Authority to
manage the equities that the HKSAR has acquired. See Donald Tsang, Hard Lessons and Radical
Reforms in Hong Kong Yearbook 1998 <http://www.yearbook.gov.hk/1998/ewww/01/index.htm>at
27 April 2008.
101
Hong Kong, Government Information Centre, Budget Speech by the Financial Secretary, Press
Release (6 March 2002) [13] <http://www.info.gov.hk/gia/general/200203/06/0306226.htm>at 2 May
2008.
102
See above n 18 for a discussion of the Hong Kong dollar-US dollar peg.
103
See Cullen, Revenue Law in Hong Kong: The Future, above n 66, 391-5 for a discussion of the
impact of the Asian Financial Crisis and the collapse of Hong Kongs real property prices.
104
Budget deficits have been recorded every year since the 1997-98 fiscal year until 2005-06, when a
surplus was achieved in both the operating and consolidated accounts. See Consolidated Account in
Hong Kong, Treasury, Accounts of the Government for the Year Ended 31 March 2006
<http://www.try.gov.hk/internet/pde_ca06.pdf>at 27 April 2008.
114
related transactions experienced over the period from 1998 to 2005.
105
Other pressures
included greater public expenditure in a maturing economy and the changing
demographics of its population (the birth rate is low and the existing population is
ageing rapidly).
106
However, with the recent revival of the property market, proceeds
from land sales have, once again, made a sizable contribution to government
receipts.
107

Hong Kongs tax base is not wide enough to tackle the issue of fiscal sustainability in
times of a crisis. The tax base has, for some time, been heading in the opposite
direction to the overseas trend because of the heavy reliance on non-tax revenue
sources (which are sensitive to economic downturns) in Hong Kong. The narrow tax
base is looking less robust, less balanced and less stable in times of economic
downturns especially when compared to other economies with more broadly-based
taxes.
108
Tax reform has now become the subject of regular political debate.

4.2.4 Conclusion

Throughout Hong Kongs history under British control, businesses had argued for low

105
The Hong Kong government does not normally borrow to fund its public spending. In the past, the
Hong Kong government used fiscal surpluses to fund the rare occasions when public spending exceeded
revenue. Public sector bodies such as the Mass Transit Railways, Kowloon-Canton Railways and
Airport Authority raised funds in their own names in debt markets. To curb the budget deficits, the
HKSAR finally issued debt instruments. In April 2004, it launched the HK$6 billion securitisation of
revenues (Tolls Revenue Bond) from five government-owned tolled tunnels and one bridge. In J uly
2004, it launched the issue of retail notes under the HK$20 Billion Retail Bond Issuance Programme.
106
Cullen, Revenue Law in Hong Kong: The Future, above n 66, 369.
107
Hong Kongs fiscal reserves had decreased from HK$457 billion (as at 31 March 1998) to a one-time
low of HK$241 billion (as at 30 September 2003). As the economy gradually improves, surpluses have
been recorded and the fiscal reserves stood at HK$492.9 billion (as at 31 March 2008). See Hong Kong,
Treasury, Consolidated Statement of Assets and Liabilities as at 30 September 2003
<http://www.try.gov.hk/internet/eharch_acco_gaze_300903.html> at 27 April 2008; Hong Kong,
Treasury, Release of Monthly Financial Results: Provisional Financial Results for the Year Ended
March 31, 2008 <http://www.try.gov.hk/internet/pde_mfr032008.pdf>at 11 May 2008.
108
Hong Kong, A Broader-Based Tax System for Hong Kong, above n 63, 28.
115
taxes and a simple system. The policy behind Hong Kongs simple and
straightforward tax system was to attract businesses from around the world to use
Hong Kong as a base for regional trade under British laws and British administration.
After the handover to Chinese rule, Hong Kong remains a free port and is the only
developed jurisdiction in the world that still taxes on a purely territorial source
basis.
109
A company which carries on a business in Hong Kong, but derives profits
from another jurisdiction, is not required to pay tax in Hong Kong on those profits.
Thus, Hong Kong is an attractive location to generate offshore profits by establishing a
regional holding company or management headquarters. There remain strong
demands to maintain this low and simple tax system in Hong Kong and attract more
businesses to use it as a regional base.

4.3 Australia

Australia is a Parliamentary democracy, with a federal structure. There are three
levels of government, being the Commonwealth (federal), state or territory, and local
government.
110
The functions of the Commonwealth of Australia and the powers of
the Parliament are set out in the Australian Constitution. Only the federal, state and
territory governments have power to make full laws and the local governments have
the power to pass by-laws. There is a system of courts at the federal, state and
territory level. The judicial power of the Commonwealth is vested in the High Court
of Australia, which hears appeals in relation to federal, state and territory matters.

109
Singapore does not tax income on a purely territorial source basis. Income is taxed when received by
or remitted to its residents from outside Singapore, though the remittance basis has been effectively
abolished in many situations. See footnote 14, Chapter 1, on the taxation of income in Singapore and
for a list of jurisdictions which follow the territorial tax regime.
110
The Commonwealth of Australia comprises six states (New South Wales, Queensland, South
Australia, Tasmania, Victoria and Western Australia) and two territories (Australian Capital Territory
and the Northern Territory). The Commonwealth Parliament is the highest level of government,
followed by the State Parliament and Territory Assemblies, and the local government bodies.
116

Taxes and other charges are paid to all three levels of government to fund a range of
government programs. The Commonwealth government imposes most of Australias
taxes including income tax, goods and services tax (GST), fringe benefits tax
(FBT), customs duty and excise. The states now levy payroll tax,
111
land tax,
112

stamp duty, registration fees and gambling taxes. Local government raises money
principally from property rates.

4.3.1 Development of tax laws

The history of European settlement in Australia began when Australia was settled as a
place to send British criminals. Prior to Federation in 1901, Australia did not exist as
a single sovereign state and the continent was divided into six separate British
colonies New South Wales, Queensland, South Australia, Tasmania, Victoria and
Western Australia. These colonies were not set up at the same time and each colony
levied its own taxes. A most important source of revenue throughout the nineteenth
century was not from direct tax, but indirect tax in the form of import duties imposed
on spirits, wine and beers, first introduced in 1800 by Governor J ohn Hunter for
building a jail in New South Wales.
113
Another important source of revenue was from
land sales. However, these taxes and revenue-raising methods proved inadequate to
fund the growing demand for government activity. Soon after, other measures such as
stamp duty, licence fees and probate charges were progressively introduced to widen
the tax base. Tasmania was the first colony to impose a limited tax on income from

111
A tax on the total wages, salaries and non-cash benefits paid to employees.
112
A tax on the unimproved value of taxable land that exceeds certain thresholds.
113
Stephen Mills, Taxation in Australia (1925) 23.
117
certain sources in 1880.
114
The basis of taxation was the source of income and the
location of the property in Tasmania, except dividend income charged on a
withholding basis on all dividends from any company carrying on business in
Tasmania, without regard to where the profits giving rise to the payment of the
dividends arose (that is, according to the residency of the company).

The first comprehensive income tax was introduced by South Australia in 1884,
subjecting to tax gross income (an undefined term which did not include capital
gains) less specified exemptions and allowable deductions.
115
Owing to the prevailing
economic conditions at that time, collections from excise on alcohol and tobacco were
not sufficient to meet South Australias serious deficit. Tax was imposed on income
derived within the colony from personal exertion, income from property and on
landholdings.
116
With similar needs stemming from the influx of settlers, other
colonies followed this lead and, over a period, introduced comprehensive income taxes
based on the South Australian legislation.
117

114
The Real and Personal Estates Duties Act 1880 (Tas) imposed a tax:
1 for the assessed annual value of all landed property in Tasmania;
2 on income derived from dividends or profits of joint stock companies and trading corporations
carrying on business in Tasmania; and
3 on income derived as interest from all mortgages of real property in Tasmania, and from annuities
and rent charges payable out of real property in Tasmania.
See Michael Dirkis, Where We Were; Where We Are; Where We Want to Be (2001) 5 The Tax
Specialist 66, 67, 82; Peter A Harris, Metamorphosis of the Australasian Income Tax: 1866 to 1922
(2002) 63-5.
115
R D Fayle, An Historical Review of the Development of Income Tax in Australia (1984) 18
Taxation in Australia 666, 669-76.
116
Under the Taxation Act 1884 (SA), tax was imposed at 1.25 per cent (three pence in the pound) on
income derived from personal exertion, 2.5 per cent (six pence in the pound) upon income derived from
property, and 0.2 per cent (one halfpenny in the pound) on landholdings. See John Azzi, Historical
Development of Australias International Taxation Rules (1994) 19 Melbourne University Law Review
793, 799.
117
The Victorian government faced a burgeoning budget deficit in 1895, and income tax was imposed in
that year through the Land and Income Tax Assessment Act 1895 (Vic). New South Wales introduced
an income and land tax in the same year for the same economic reason. Western Australia introduced a
tax on company dividends and profits in 1899 which was replaced by a general income and land tax in
1907. Queensland and Tasmania introduced a general income tax in 1902. Ibid.
118
Federation took place in 1901 after the British Parliament passed the Commonwealth
of Australia Constitution Act 1900. Australia officially became a nation and the
colonies became states. The Australian Constitution gave the Commonwealth
government the exclusive taxation power to impose customs and excise duties,
118
and
a non-exclusive power to levy income tax concurrent with those of the states.
119
It
was expected that customs and excise would provide a sufficient source of revenue for
the Commonwealth, and that the states would continue to levy direct taxes.
120

However, faced with budgetary pressures, the Land Tax Act was introduced in 1910 by
the Commonwealth government to collect funds from landowners for both fiscal and
social purposes.
121
Following the outbreak of the First World War, the
Commonwealth government subsequently entered the income tax arena as revenue
from excise and customs was not enough to fund Australias involvement in the war.
The Income Tax Assessment Act and Income Tax Act were introduced in 1915,
122

while the states continued to levy their own land and income taxes independently of
the Commonwealth taxes. The fundamental conceptual formula of the 1884 South
Australian legislation (based on assessable income less allowable deductions) was
carried into the 1915 Commonwealth income tax legislation, which paved the way for
the Commonwealth to eventually assume the taxing powers from the states
123
(see
below).

Difficulties arose from the co-existence of a two-tiered income tax system. In 1920, a

118
Australian Constitution s 90.
119
Australian Constitution s 51(ii).
120
Stuart White et al, State and Local Taxes in Australia: Towards Sustainability (Research Study No
35, Australian Tax Research Foundation, 2001) 14.
121
Fayle, above n 115, 675.
122
All Commonwealth tax laws followed the convention of the two acts, one for the assessment of tax
and one for setting the rates of tax. See s 55 of the Australian Constitution.
123
119
Royal Commission on Taxation
124
was established under the chairmanship of William
Warren Kerr to enquire into the tax system and examine, in particular, the
harmonisation of Commonwealth and state taxation. The Royal Commission made
several recommendations principally to allocate the subjects of direct taxation between
the Commonwealth and the states. As a result, the Income Tax Assessment Act 1915
was replaced by the Income Tax Assessment Act 1922.

In 1932, a second Royal Commission on Taxation (Ferguson Royal Commission) was
established to inquire into ways to standardise and simplify the taxation laws of the
Commonwealth and the states. This led to the introduction of a uniform tax
legislation the Income Tax Assessment Act 1936 by the Commonwealth and the
states in 1936. This Act remains a key authority for the imposition of a national
income tax to the present time. But it was not until 1942 that the Commonwealth
began collecting all income tax on a uniform basis throughout Australia, and
compensated the states for lost revenue.
125

A wholesale sales tax was introduced by the Commonwealth government in 1930 to
meet the sharp fall in customs and excise duties due to the Depression.
126
The sales
tax base was not broad enough to cover all household consumption and services.
127
It

124
A Royal Commission is a mechanism for an independent inquiry (usually with power to compel
evidence) used for a wide variety of purposes in Australia. For the first Royal Commission, the letters
patent (the official instrument used to establish a Royal Commission) were issued by the governments
of the Commonwealth, Queensland, Tasmania and Western Australia. See Michael Dirkis,
Observations on the Development of Australias Income Tax Policy and Income Tax Law (2002) 56
125
See footnote 40, Chapter 2, on the introduction of uniform income tax legislation in Australia.
126
127
The three goods which formed the majority of the wholesale sales tax base were durables, motor
vehicles and beer. See Neil Warren, GST, The Long, Winding Road (1996) 8.
120
was finally replaced on 1 J uly 2000 by a GST.
128

Australia signed its first DTT with the UK in 1946, and gradually developed its
extensive tax treaty network.
129
A withholding tax system was introduced for
dividends in 1959, for interest in 1967 and for royalties in 1993.
130

4.3.2 Structure of tax laws

The Commonwealth Department of Treasury is responsible for the development of
federal taxation laws passed by the Parliament.
131
(The Office of Parliamentary
Counsel is responsible for the actual drafting of taxation laws. The Australian Taxation
Office (ATO) is the main revenue collection agency of the Commonwealth and it has
day-to-day administrative responsibility for collecting taxes as well as ensuring
compliance with the relevant legislation.) Another source of taxation law is the general
law, which is formed by the decisions of courts. The general law is often referred to
when interpreting the meaning of a taxation provision or the meaning of a legal term.

There are, today, two principal Acts dealing with income tax: the Income Tax
Assessment Act 1936 (Cth) (ITAA 1936) and the Income Tax Assessment Act 1997
(Cth) (ITAA 1997). The purpose of the ITAA 1997 is (gradually) to rewrite the

128
Though the goods and services tax (GST) is administered and collected by the Australian Taxation
Office (ATO), the revenue raised from GST goes to the States and Territories. See A New Tax System
(Commonwealth-State Financial Arrangements) Act 1999 (Cth).
129
C J ohn Taylor, Development of and Prospects for Corporate-Shareholder Taxation in Australia
(2003) 57 Bulletin for International Fiscal Documentation 346, 349.
130
Ibid.
131
The Commonwealth Parliament consists of two houses the House of Representatives and the
Senate. Section 53 of the Australian Constitution provides that Tax Bills originate in the House of
Representatives before making their passage to the Senate. A bill becomes an Act only after it has been
passed by Parliament and receives Royal Assent.
121
ITAA 1936 in simplified English and replace it.
132
Currently both Acts are in operation
as the ITAA 1997 only covers a part of the law covered by the ITAA 1936.
133
The
Income Tax Rates Act 1986 (Cth) and the Income Tax Act 1986 (Cth) declare the rates
of income tax and impose income tax on all types of taxpayer individuals, companies,
trusts, partnerships etc. The Taxation Administration Act 1953 (Cth) states how these
taxation laws are to be administered by the Commissioner of Taxation.

Australia moved to a self-assessment system in the 1986-87 year, placing a greater
responsibility on taxpayers to assess their own tax debt or refund.
134
This means the
ATO accepts an income tax return without the process of detailed initial scrutiny
which applied previously.
135
The onus is on the taxpayer to calculate his or her tax
liability correctly. The ATO is allowed many years after the assessment to amend
errors of calculation, mistakes of fact or mistakes of law.
136
A taxpayers final tax
liability would remain uncertain until the relevant review period has lapsed. To assist

132
See the rewrite of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) discussed below in Part
4.3.3.
133
About one third of the ITAA 1936 had been rewritten and enacted in tranches into the ITAA 1997.
See Richard Vann, Australia in Hugh J Ault and Brian J Arnold, Comparative Income Taxation: A
Structural Analysis (2
nd
ed, 2004) 9.
The two income tax assessment acts are read together to determine the taxable income of taxpaying
entities on which income tax is imposed.
134
Self assessment was introduced in stages, from partial self assessment from 1986-87 to full self
assessment since 1989-90. The full self-assessment system applies to a company, the trustee of a
corporate unit trust, a public trading trust, an eligible approved deposit fund, an eligible superannuation
fund or a pooled superannuation trust and does not include an individual (see the definition of full self-
assessment taxpayer in s 6(1) of the ITAA 1936). Under full self assessment, the taxpayer calculates
the tax payable and sends that amount to the ATO together with the income tax return which contains
limited information. The Commissioner does not issue a formal notice of assessment after a return is
lodged. Instead, the Commissioner is taken to have made an assessment and the return itself is deemed
to be a notice of the assessment. For individuals, the lodging of a return does not result in a deemed
assessment (as with full self assessment). The ATO still raises an assessment that is sent to the taxpayer
for payment, which creates the formal obligation to pay tax. See Michael DAscenzo and Tony
Poulakis, Self Assessment: Quo Vadis? (2002) 36 Taxation in Australia 412, 412.
135
Prior to self assessment, taxpayers lodged an income tax return containing information from which
the ATO prepared an assessment of the taxpayers taxable income and tax payable. The assessment was
made by making any necessary adjustments to the taxpayers calculation of taxable income. A notice of
assessment was issued indicating the tax refund or the amount payable and due date for payment.
136
The period of review (that is, the length of time that the Commissioner may make an amendment to
an income tax assessment) is up to four years with some exclusions (for example, unlimited amendment
period for cases of fraud and evasion), or two years for most individuals and very small business
taxpayers.
122
taxpayers in understanding the law and meeting their tax obligations, the ATO
provides free information and binding advice to taxpayers. Such information can be
obtained in the form of advance pricing arrangements,
137
publications,
138
rulings
139

public rulings,
140
private binding rulings,
141
oral rulings
142
etc.

A ruling states the Commissioners opinion on an application of law and does not
make law. Therefore, a taxpayer is not bound to follow any ruling, though public
rulings are now binding on the Commissioner even if he gets the interpretation of the
law wrong. Due to the huge number of public rulings in existence, some tax

137
An advance pricing arrangement is an agreement with the ATO on the future application of the
transfer pricing methods that will be used to determine the arms length price in international dealings
with related parties, thereby resolving any uncertainty around these dealings. See Australian Taxation
Office, International Transfer Pricing: Advance Pricing Arrangements (2005) 2.
138
The Commissioners views can be found in publications like tax return form guides, TaxPacks and
media releases. TaxPacks are provided to taxpayers each year and give practical information in
completing their returns.
139
A ruling is an expression of the Commissioners opinion of the way in which a relevant provision
applies or would apply to a taxpayer. The Commissioner is legally bound to the view expressed in a
ruling. A taxpayer, acting in accordance with the ruling, is protected from any adverse consequences (a
penalty or interest charge on the under-payment) if the law turns out to be less favourable than the ruling
provides. See Div 357, Pt 5-5 of Sch 1 to the TAA 1953 on the common rules that apply to public,
private and oral rulings.
140
A public ruling is an expression of the Commissioners opinion of the way in which a relevant
provision applies, or would apply, to entities generally or to a class of entities. Public rulings are the
opinion of the Commissioner and are not a source of law. But the Commissioner is legally bound to the
view expressed in the ruling so long as the law to which it relates remains in force. The Commissioner
must publish the ruling, and it may be withdrawn by him. Public rulings are grouped in different series,
namely:
Taxation Rulings series (TR series);
Taxation Determination series (TD series);
Class Rulings series (CR series);
Product Rulings series (PR series); and
Product Grants and Benefits Rulings series (PGBR series).
See Div 358, Pt 5-5 of Sch 1 to the TAA 1953 on public rulings. See, also, Australian Taxation Office,
Taxation Ruling TR 2006/10, Income Tax, Fringe Benefits Tax and Product Grants and Benefits:
Public Rulings, outlining the system of public rulings in Australia.
141
A private ruling is an expression of the Commissioners opinion on how the tax law applies to a
named taxpayer in relation to a specified scheme and cannot be taken as a precedent for someone else.
Taxpayers dissatisfied with the ruling can object to the Commissioners decisions and have them
reviewed by the Administrative Appeals Tribunal or the courts. See Div 359, Pt 5-5 of Sch 1 to the
TAA 1953 on private rulings. See, also, Australian Taxation Office, Taxation Ruling TR 2006/11,
Income Tax, Fringe Benefits Tax and Product Grants and Benefits: Private Rulings, outlining the
system of private rulings in Australia.
142
An oral ruling can only be given for individuals if the nature of tax affairs is simple. A taxpayer or
his or her legal personal representative can apply for an oral ruling and the Commissioner must give the
ruling orally together with a registration identifier for the ruling. See Div 360, Pt 5-5 of Sch 1 to the
TAA 1953 on oral rulings.
123
practitioners have claimed that the rulings system is becoming increasingly
unworkable.
143

4.3.3 Tax system

Considering that the Australian states were British colonies, it is perhaps surprising to
find that the early Australian income tax was very different from that of the UK. The
Australian colonies did not adopt the schedular tax system introduced by Addington in
1803 where income was assessed under different schedules classified by description.
Early Australian income taxes adopted an income tax system applying to all forms of
income.
144
Income tax was levied upon taxable income, being assessable income less
allowable deductions, in calculating the tax liability.
145
Income has never been
defined in a comprehensive way for the purpose of Australias income tax.
146
(That is,
income applied to all sources of income meaning A (character of income). Colonial
income taxes generally did not apply to the worldwide income of colonial residents
see further below.)

The UK has always incorporated the concept of residence of a taxpayer into its income
tax system and has all along taxed its residents on their worldwide income, even
though until 1914 it only taxed such income when it was received in the UK.
147
Many

143
Australian Chamber of Commerce and Industry, 2004 Pre-election Survey: Improving the Tax
Compliance Process ACCI Review (August 2004) [4]
<http://www.acci.asn.au/text_files/review/r114.pdf>at 16 April 2008.
144
Sam Reinhardt and Lee Steel, A Brief History of Australias Tax System (Paper presented to the
22
nd
APEC Finance Ministers Technical Working Group Meeting in Khanh Hoa, Vietnam, 15 J une
2006) [10] in Commonwealth Treasury, Economic Roundup Winter 2006
<http://treasury.gov.au/documents/1156/PDF/01_Brief_History.pdf>at 27 April 2008.
145
146
Reinhardt and Steel, above n 144, 11.
147
As has been explained in Chapter 3, Schedule D of Addingtons Income Tax Act 1803 was divided
into two branches residents were charged on their worldwide income and non-residents on income
124
of the early Australian income taxes did not incorporate the concept of residence and
most states imposed tax on a source basis only (meaning B only local, onshore
income was subject to tax). The income tax introduced by the Federal Government in
1915 was a wholly territorial system.
148
The residence principle of extending the tax
base to income derived from sources outside Australia was adopted in 1930 by the
Commonwealth and in some states, shortly thereafter.
149

Foreign-source income

Australia used to have a comprehensive foreign exchange control system to regulate
foreign investments and transactions made by residents.
150
This system helped
prevent its residents from using entities established in tax havens to avoid or defer
Australian tax.
151
When the exchange rate of the Australian dollar was deregulated in
December 1983, the dollar was allowed to float freely. The deregulation of the
Australian dollar provided an opportunity for investors to shop around and select the
most favourable jurisdiction to source income. That is, investment decisions at that
time were based on location. Capital was shifted offshore to earn income in a low-tax

with a source in Great Britain. Though the Income Tax Act 1803 came to an end in 1815 (when the war
against the French forces under Napoleon ended), it was reintroduced in 1842 (based on Addingtons
1803 Act). Income tax then became a permanent feature of the British tax system.
148
Taylor, above n 129, 346.
149
See Part 2.4, Chapter 2, on the introduction of the residency basis of taxation in Australia.
150
Prior to December 1983, a range of outward foreign exchange transactions was subject to procedural
requirements and a taxation clearance certificate issued by the ATO was required. Since the float of the
Australian dollar in December 1983, foreign exchange controls and tax screening arrangements were
progressively lifted and the system was finally abolished from 1 J uly 1990. To facilitate the
administration and enforcement of taxation laws, a new reporting requirement is imposed on persons
who transfer Australian or foreign currency of A$10 000 or more into or out of Australia. The
Financial Transaction Reports Act 1988 (Cth) (FTRA 1988) requires members of the general public to
report the carrying or sending of A$10 000 or more in currency (that is, coin and paper money of
Australia or of a foreign country) into or out of Australia to the Australian Transaction Reports and
Analysis Centre (AUSTRAC). There is no limit to the amount of currency which can be carried or
sent; the FTRA 1988 merely requires these movements of currency to be declared if the amount totals
A$10 000 or more. See Australian Taxation Office, Tax Havens and Tax Administration (2007) 16, 32
on monitoring of international transactions by AUSTRAC.
151
Brian J Arnold, The Taxation of Investments in Passive Foreign Investment Funds in Australia,
Canada, New Zealand and the United States in Herbert H Alpert and Kees van Raad (ed), Essays on
International Taxation (1993) 10.
125
jurisdiction, because the foreign income of an Australian resident was exempt from
Australian tax if it was taxed in a foreign jurisdiction.
152
Later, the foreign tax credit
(FTC) and accruals provisions were introduced to address tax avoidance through
international tax arrangements.

The FTC system of granting Australian residents double tax relief on the amount of the
foreign taxes they paid on that foreign income was introduced on 1 J uly 1987, but it did
not address the problem of Australian residents investing offshore in companies that:
did not declare dividends and in non-resident trusts in which the investor had
no present entitlement to the trust income and which did not distribute the trust
income. In the vast majority of these cases, it was obvious that income was
accumulating for the benefit of the Australian investors in foreign companies
and foreign trusts. However, the law was unable to tax this income as it
accrued.
153

The accruals legislation then came into force on 1 J uly 1990, and the legislation was
introduced in two stages. The CFC and transferor trust measures were effective from
1 J uly 1990, and the foreign investment fund (FIF) measures applied from 1 J anuary
1993.
154
These measures focus on Australian residents who have substantial
investments or involvement in foreign companies and foreign trusts. Australian
residents are liable to pay tax on passive and highly mobile income and gains derived
from foreign sources that have not been comparably taxed offshore on a current year
basis even though profits are not repatriated to Australia.
155

152
See the now repealed s 23(q) of the ITAA 1936.
153
Australian Taxation Office, Foreign Investment Funds Guide (1998) 1.
154
The controlled foreign companies (CFC) legislation is contained in Part X of the ITAA 1936, the
transferor trust measures in Div 6AAA of Pt III of the ITAA 1936 and the foreign investment fund
(FIF) measures in Pt XI of the ITAA 1936.
155
Before the introduction of the accruals legislation, a resident company could defer tax being charged
on foreign income accumulated in an entity managed abroad until the profits were repatriated to
Australia by way of dividends or other payments. Under the accruals legislation, Australian
shareholders who have a certain interest in a foreign company controlled by them are taxed on their
share of the gains and income attributable to that CFC as it is earned. This is not the case generally
where that income is comparably taxed offshore in a listed country or the CFC derives its income almost
126

The transferor trust measures operate to tax Australian residents on an attribution basis
on the profits of the foreign trust. This means that the profits of the trust may now be
included in the taxpayers assessable income even though the taxpayer had not
received a distribution from the trust.
156

The foreign-source income measures went some way towards overcoming the tax
deferral available under the FTC system, but gaps still existed:
For example, Australian residents could avoid current Australian taxation of
income accumulating in the companies and trusts for their benefit if they had:

investments in foreign companies that were not CFCs and

an interest in, but no present entitlement to, the income of a foreign
trust.
157

The FIF measures were introduced to reduce the extent to which Australian residents
can defer Australian tax where they hold interests in foreign entities. The measures
apply to income and gains accumulating in foreign companies that are not controlled
by Australians or foreign trusts that fall outside the scope of the accruals regime.
158

exclusively from active business activities regardless of where it is located. There are currently seven
listed countries Canada, France, Germany, J apan, New Zealand, the UK and the US, and all other
countries are unlisted.
156
Under transferor trust measures, tax is imposed on a taxpayer where they have transferred property or
services to a non-resident discretionary trust or, after 12 April 1989, to a non-resident non-discretionary
trust for inadequate or no consideration. They may have certain income of the non-resident trust
included in their assessable income.
157
Australian Taxation Office, Foreign Investment Funds Guide, above n 153, 1.
158
Under the FIF measures, where the CFC and transferor trust rules do not apply, Australian resident
taxpayers are taxed on income sheltered in offshore companies and trusts in which they do not have a
controlling interest. These measures also apply to Australian residents who hold a foreign life insurance
policy. But there are a number of exemptions to this measure. See Pt XI of the ITAA 1936 on the
taxation of FIFs.
127
Non-residents are taxed on income with an Australian source, and the foreign-source
income derived by them is generally exempt from Australian tax.
159

Double tax treaties

Where a DTT applies, the DTT will contain its own source rules for various types of
income, profits or gains covered by the DTT. The types of income that may be subject
to tax in the source country under Australias DTT include:
business profits (where attributable to a PE in the source country);
income from real property;
income from shipping and air transport (internal traffic only);
investment income such as interest and dividends;
royalties;
income of entertainers; and
pensions and annuities.

A DTT represents an international agreement between two governments, but it has no
force of law in Australia until it is enacted by Parliament and the actual text is
incorporated as a schedule to the International Tax Agreements Act 1953 (Cth)
(Agreements Act). Once this is done, the effect is to incorporate each DTT in the
schedule of the Agreements Act with the Assessment Act (both the ITAA 1936 and
ITAA 1997) and to require the Assessment Act to be read as one with the Agreements
Act. In the case of inconsistency, s 4(2) of the Agreements Act ensures that the

159
128
Agreements Act (including the schedules) prevails over the Assessment Act with the
exception of Part IVA of the ITAA 1936.
160

Australia has concluded DTTs with over 40 states. Each DTT is an agreement reached
by the Australian Government with the government of the contracting state, except the
Taipei Agreement which is between the Australian Commerce and Industry Office and
the Taipei Economic and Cultural Office.

Tax base

The Commonwealth Government collects taxes levied on income, wealth, production,
sale and use of goods and services, and the performance of activities. The relevant
taxes are:
Income tax charged on the income earned by individuals and businesses for
example, salary and business profits plus income tax imposed on capital gains
(see below).
Capital gains tax provisions impose income tax on any net capital gain on the
happening of a CGT event for example, disposal of shares or real estate.
161

Fringe benefits tax charged where an employer provides benefits to an employee,
or to an associate of the employee, in addition to or instead of salary or wages for
example, the use of a business-supplied motor vehicle for private purposes.
Though FBT complements the income tax system, the tax liability is not borne
directly by the person (the employee) receiving the benefit. FBT is payable by

160
Part IVA, comprising ss 177A to 177H of the ITAA 1936, contains the general anti-avoidance
provisions.
161
CGT was introduced in 1985 to bring into assessable income profits made from the sale of certain
assets not covered by the income tax laws. Assets such as the family home and car are not subject to
CGT. See Part 3-1, ITAA 1997, on capital gains and losses.
129
employers.
162

Goods and services tax charged on consumption and spending.
163
Other taxes
imposed on the supply of goods include luxury car tax and wine equalisation
tax.
164

Excise imposed on refined petroleum products, cigarettes and tobacco products,
beer, spirits and other alcoholic beverages, and certain crude oil produced in
Australia.
The superannuation guarantee charge on employers who do not provide enough
superannuation support for their eligible employees.
165

162
Prior to the introduction of the FBT in 1985, it was possible to avoid tax by receiving a non-cash
benefit, such as the private use of a motor vehicle. Taxation of such benefits under existing income tax
laws proved difficult. FBT was introduced to make it possible to tax such a benefit. See Fringe
Benefits Tax Assessment Act 1986 (Cth).
163
Although the GST taxes the private consumption of most goods and services in Australia, it has
been argued that so far as the analysis of individual transactions is concerned, the connection
between the GST and domestic consumption is so tenuous that it is meaningless it is not a sound
basis for the interpretation of the Act nor deciding the scope of its application GST is an
unconvincing expression of domestic consumption because in a variety of common situations:
the tax is not imposed on the act of consumption,
the tax is not imposed on the value of what is consumed,
the tax is not imposed on the person who is a consumer,
the tax is not imposed at the time of consumption.
See Graeme S Cooper, Why GST is not a Consumption Tax and Why it Matters (Paper presented
at the 2003 National GST Intensive Seminar, Taxation Institute of Australia, Manly Pacific, Sydney,
10 October 2003) 1-2.
164
From 1 J uly 2000, sales tax on luxury cars and wine (and certain other alcoholic beverages) was
replaced by the luxury car tax (LCT) and the wine equalisation tax (WET).
The LCT rate is 25 per cent, and is in addition to the GST rate of 10 per cent. If a dealer sells a car
worth $80 000 plus a GST of 10 per cent, the LCT value is $88 000. The LCT threshold for the 2007-
08 financial year is $57 123. The amount subject to LCT is the difference of the LCT value ($88 000)
and the LCT threshold ($57 123), which is $30 877. As the $30 877 amount includes GST, the next
step is to multiply this amount by 10/11 to exclude GST ($30 877 x 10/11 =$28 070). The effect of
excluding GST is that the LCT rate of 25 per cent is payable on $28 070 (not $30 877). The total
amount subject to tax is $95 017 ($88 000 (including GST) plus $7017 ($28 174 x 25 per cent)). See
Div 5 of A New Tax System (Luxury Car Tax) Act 1999 (Cth) on how to work out the amount of luxury
car tax payable.
WET is a value-based tax of 29 per cent, in addition to the GST. The liability for WET is usually
held on wine manufacturers, wine wholesalers and wine importers and they are required to collect and
remit WET to the ATO or Australian Customs Service. See A New Tax System (Wine Equalisation
Tax) Act 1999 (Cth).
165
Australia operates a system of compulsory savings for retirement. The superannuation guarantee
scheme has applied since 1 July 1992 to ensure that as many Australians as possible have access to
superannuation in retirement. All employers are required to provide a minimum level of
superannuation support for all eligible employees in each financial year. Employers who fail to
provide a minimum level of support are liable to pay the superannuation guarantee charge, which is
equal to the amount of the shortfall in the superannuation guarantee, plus an interest component and an
130
The Medicare levy charged on residents to help pay for the public health/hospital
scheme.
166

The higher education contribution scheme charged on higher education students to
pay part of the cost of their education.
Pay As You Go Withholding and Instalment system, which is primarily an advance
collection system for a range of taxes.
167

The petroleum resource rent tax in respect of profits of certain petroleum
projects.
168

As a result of changes to the tax legislation, the superannuation contributions
surcharge and the termination payments surcharge have been abolished from 1 J uly
2005.
169

administrative charge. The shortfall component of the charge is re-distributed to the employees
superannuation account. The superannuation guarantee charge is not tax deductible. See Australian
Taxation Office, Superannuation Guarantee (Quarterly) Instruction Guide and Statement (2004).
166
The Medicare levy is used to partially fund Medicare, the scheme that gives Australian residents
access to health care.
167
See footnote 40, Chapter 1, for an explanation of the PAYG Withholding and Instalment system.
168
The petroleum resource rent tax is imposed by the Petroleum Resource Rent Tax Assessment Act
1987 (Cth). The tax applies to the taxable profits derived from the recovery of all petroleum in a
petroleum project in offshore areas, except certain North-West Shelf projects and projects in the J oint
Petroleum Development Area in the Timor Sea, including
crude oil;
condensate;
sales gas;
natural gas;
liquefied petroleum gas; and
ethane.
See Australia Taxation Office, Petroleum Resource Rent Tax: Overview (13 August 2007)
<http://www.ato.gov.au/print.asp?doc=/content/39230.htm>at 16 April 2008.
169
Before 1 July 2005, there were two types of superannuation surcharge that applied to high-income
earners:
the superannuation contributions surcharge; and
the termination payments surcharge.
The superannuation contributions surcharge was an additional tax on certain superannuation
contributions made after 20 August 1996 and before 1 J uly 2005 to a superannuation provider (such as a
life insurance company, superannuation fund, retirement savings account provider and approved deposit
fund) for members whose income exceeded the threshold for superannuation surcharge purposes. The
surcharge was generally payable by the superannuation provider which held the contributions via an
assessment, but it could pass the cost of the surcharge onto members. The termination payments
surcharge was levied on certain components of an employer eligible termination payment (see below)
131

The tax base encompasses both direct and indirect taxes, with income tax making up
the greatest component of the tax base.
170
With the introduction of the GST on 1 J uly
2000, Australias tax base is gradually shifting to a broader base. At the time the GST
was introduced, income tax rates were reduced.
171
Australias tax imposition burden
has shifted to a degree from income to consumption and spending.

There are more than 11 million individuals and two million businesses that participate
directly in the Australian tax system, but major contributions are collected from large
businesses.
172
The governments ongoing objective is to ensure that the tax system

taken in cash upon termination of employment (commonly referred to as a golden handshake) and paid
by the person receiving the termination payments. See Australian Taxation Office, The Superannuation
Contributions Surcharge and the Termination Payments Surcharge (2006).
Generally, an eligible termination payment was made by a superannuation fund or an employer in
consequence of the termination of employment that were eligible for special tax treatment. From 1 J uly
2007, significant changes were made to the tax treatment of superannuation benefits and the eligible
termination payment was replaced by the employment termination payment (ETP). An ETP is
generally a payment made by an employer in consequence of the termination of a persons employment
that is received no later than 12 months after the termination (though the 12-month restriction is relaxed
in some circumstances). An ETP consists of a tax-free component and a taxable component. Unlike an
eligible termination payment, an ETP cannot be rolled over into a superannuation fund. See Subdiv 82-C
of Pt 2-40 of the ITAA 1997 on the tax treatment of ETPs.
Other changes to the superannuation system include the abolition of the reasonable benefits limit
which restricted the amount of concessionally taxed termination and superannuation benefits a person
can receive over his/her lifetime. Superannuation benefits paid from a taxed source to a person aged 60
or over will be tax free. For an overview of the Australian superannuation system and the changes from
1 J uly 2007, see Australian Taxation Office, Introduction for Employees: Super What You Need to
Know (2007).
170
The major components of total taxation collected by all levels of government in the 2006-07 year are:
individual income tax (37.5 per cent), companies tax (21.2 per cent), goods and services tax (12.9 per
cent), property tax (9.1 per cent), excises and levies (7.4 per cent), payroll tax (4.4 per cent), motor
vehicle taxes (1.8 per cent), gambling taxes (1.5 per cent) and insurance taxes (1.2 per cent). See
Australian Bureau of Statistics, Taxation Revenue 2006-07 (15 April 2008) 5.
171
Australias GST was introduced on the basis that the income tax rates would be substantially
reduced to offset higher indirect taxes. The top marginal tax rate of 47 per cent applied to residents
with a taxable income of over A$50 000 in the 1999-2000 income year. The same rate of tax applied to
residents with a taxable income of over A$95 000 in the 2005-06 income year. The top marginal tax
rate has been reduced to 45 per cent starting the 2006-07 income year and applies to residents with a
taxable income of over $150 000. The company tax rate has gradually been reduced from 36 per cent
in the 1999-2000 income year to 30 per cent since the 2001-02 income year.
172
For Australian tax purposes, taxpayers are separated into market segments individuals, micro-
businesses, small to medium enterprises, large businesses, non-profit and government organisations
due to the size, nature and diversity of the tax system and the taxpaying community. Where an
economic group has a combined turnover of A$250 million or more, it is classified as a large business.
132
has raised adequate revenues to meet the Governments outlay, the tax system is fair
and efficient; and operates to achieve its various policy roles without undue intrusion
into the way individuals and businesses conduct their affairs.
173

Tax rates

Australia uses a progressive tax scale for individuals so that the tax rate increases as the
income rises. A range of income brackets as a set percentage or cents in the dollar is
applied to the taxation of individuals. Residents and non-residents are taxed at different
marginal rates.
174
All ordinary and statutory income of a resident, regardless of its
source, is aggregated and included in the taxpayers taxable income for the year in a
single assessment. The income year (financial year) is from 1 J uly to 30 J une the
following year.
175
Resident individuals enjoy a tax-free threshold of A$6000
(Australian dollars) while non-residents are taxed on every dollar they earn in
Australia.
176
High inflation rates throughout the 1970s and 1980s affected middle-
income earners and often pushed their salaries up to the next highest tax bracket. It was
no longer necessary to be rich to be liable to pay tax at the top marginal tax rate. In the
2003-04 tax year, a salary or wage earner would be paying the top marginal rate of tax
(on the final salary segment) if his or her salary was 1.3 times average weekly earnings,

For the 2005-06 income year, the tax paid by large businesses makes up around 36 per cent of total tax
collected. See Australian Taxation Office, Compliance Program 2007-08 (2007) 7, 32.
173
Commonwealth, Board of Taxation, Inspector-General of Taxation: A Report to the Minister for
Revenue and Assistant Treasurer (2002).
174
The taxable income brackets differ between resident and non-resident individuals. For the 2007-08
income year, the marginal rates at 15, 30, 40 and 45 per cent apply to individuals who are Australian
residents, and 29, 30, 40 and 45 per cent to individuals who are non-Australian residents.
175
Australian subsidiaries of an overseas holding company may apply to the Commissioner of Taxation
to adopt an accounting period which coincides with its overseas parent.
176
The tax-free threshold is the amount of income an individual taxpayer can earn before income tax is
paid.
133
compared with 8.6 times in the late sixties.
177
Some experts believe that the tax system
must be restructured to stop bracket creep,
178
which is eroding the wages of many
ordinary Australian workers.
179
The top marginal rate threshold has been lifted to
A$150 000 from 1 J uly 2006.
180

To provide Australia with an internationally competitive tax system, the company tax
rate has been gradually lowered from 36 per cent to 30 per cent for the 2001-02 and
later years of income.
181
The company income tax rate of 30 per cent is applied both to
retained earnings and to dividends. Under the imputation system of company taxation,
resident shareholders receive credits for company tax already paid on dividends.
182

The tax system has been criticised as fundamentally flawed as there is a wide gap
between the company tax rate of 30 per cent and the top marginal tax rate of 46.5 per
cent applicable to individuals (45 per cent plus a Medicare levy of 1.5 per cent).
183

The steep progress of middle-income earners creeping up the tax scale increases the
incentive for diverting personal services income (PSI) to an entity so as to split the

177
In the 1969-70 income year, the top marginal tax income threshold was $32 000. This was 8.6 times
average earnings and fewer than one per cent of taxpayers were in the top marginal tax bracket (66.7 per
cent). By 2003-04, the top marginal tax income threshold was $62 500. This was 1.3 times average
earnings, but it took an average earner into the top income tax rate. If the income threshold had kept
pace with the growth in average earnings, it would have been almost $413 500. See Sinclair Davidson,
Tax System Gives Us the Creeps, The Australian Financial Review (Sydney), 1 March 2005, 63.
178
Bracket creep occurs when inflation pushed taxpayers into higher tax brackets at a faster rate than
real incomes. See Stan Ross et al, Income Tax: A Critical Analysis (2
nd
ed, 1996) 13.
179
Fleur Anderson, Top Tax Bracket Sting, Herald Sun (Sydney), 18 February 2004, 7.
180
The top marginal tax rate of 47 per cent applied to residents with a taxable income of over A$50 000
in the 1999-2000 income year. The same rate of tax applied to residents with a taxable income of over
A$95 000 in the 2005-06 income year. The top marginal tax rate has been reduced to 45 per cent
starting with the 2006-07 income year and applies to residents with a taxable income of over $150 000.
181
The company tax rate was reduced from 36 per cent to 34 per cent for the 2000-2001 year of income,
and from 34 per cent to 30 per cent for the 2001-02 and later years of income.
182
See footnote 63, Chapter 3, for an explanation of Australias imputation system of company taxation.
183
Mark Leibler, Tax Law is Unfair (6-12 September 2001) 23 Business Review Weekly 49, 49.
134
taxable income and reduce the tax liability.
184
The alienation of PSI rules were
introduced
185
and it is now necessary to consider the relevant legislation before
diverting income to a company, partnership or trust.
186

Australias comprehensive approach to taxation tends to widen the tax base by
requiring those with the same command over economic resources to bear the
approximate same tax burden. But Australias tax rate is not consistent across all
taxpayers. It has been argued that it is not the wealthiest people (see below
Monitoring tax compliance of the highly wealthy) who are facing the top marginal
tax rate, but the well-paid salary earners.
187
This is because the wealthiest use their
investments to minimise income and claim tax breaks not available to regular
workers.
188
For example, wealthy people draw a significant level of their income from
business investments and shares.
189
They benefit from the realised capital gains, as,
since 1999, only half of the gain is included in an individuals assessable income
(provided the asset has been held by the relevant taxpayer for more than 12

184
Personal services income is generally paid to an individual who provides the services or to a
company, partnership or trust (interposed entity) through which the services are provided by an
individual. This is illustrated with an example, based in Leibler, ibid 49:
Assume that the net income derived from a plumbing practice is A$200 000. The plumber
would have a tax liability of A$72 600 (including a Medicare levy of A$3000) taxed at the
2007-08 individual rate. If he incorporated his plumbing business and received a salary of
A$50 000 from the company, his total tax liability would be A$55 350 (being A$10 350
including a Medicare levy of A$750 for himself and A$45 000 for his company). The total tax
paid by him would be reduced from A$72 600 to A$55 350 based on the same net income, a
savings in tax of A$17 250.
185
The alienation of personal services income (PSI) measures became effective on 1 July 2000. These
measures are designed to ensure that PSI is taxed as the individuals personal earnings even if
channelled through a company, partnership or trust. If the alienation measure applies to an individual or
a personal services entity, the amount of the PSI is included in the assessable income of the individual
whose personal efforts or skills generate the income. See Pt 2-42 of the ITAA 1997 on the tax treatment
of PSI.
186
See, for example, Fowler v Federal Commissioner of Taxation (2006) 06 ATC 2476 where it was
held that the PSI legislation is designed in its terms to tax income in the hands of the person whose
exertion caused its receipt and even though in contractual terms another person derived it.
187
George Megalogenis, Nations Rich Pay Only 25pc Tax, The Australian (Sydney), 6 September
2005, 1.
188
Ibid.
189
Ibid.
135
months).
190
It has also been argued that tax benefits for capital gains penalise work
and encourage speculation.
191

There is an argument for a closer alignment between the individual income tax rate
and the company tax rate to:
make the tax system more efficient by taxing income at the same rate, whether
derived by a company or by an individual;
reduce the incentive to set up complex trust
192
and company structures;
reduce the attractiveness of mass-marketed tax reduction schemes;
193
and
provide more incentives for taxpayers to work, save and invest.
194

Complex tax laws

The Australian income tax system, as it stands today, has not been designed by
applying a coherent set of principles.
195
The original ITAA 1936 contained simple

190
Division 115 of the ITAA 1997 applies when a CGT event occurred after 21 September 1999.
Provided the other requirements are met, an individual taxpayer will get a reduction of 50 per cent on
the capital gains realised, that is, the rate of tax on the capital gains is capped at 22.5 per cent.
191
Tim Colebatch, Reform Call on Capital Gains Tax, The Age (Melbourne), 19 J uly 2004, A7.
An investor who realised A$50 000 in capital growth will pay A$2850 in income tax, while a salary
or wage earner who earned A$50 000 on employment income will pay A$9600 in income tax (based on
the 2007-08 resident tax rate excluding Medicare levy).
192
Under Australias tax legislation, discretionary trusts can be used to direct different types of income
to specific beneficiaries because the trustee can choose which beneficiaries to receive a trust distribution.
See footnote 89, Chapter 2, on the use of trusts for tax planning purposes.
193
Mass-marketed tax schemes are discussed below under Aggressive tax planning.
194
Paul Drum, Closing the Tax Gap (June 2002) 72 Australian CPA 15, 15. This argument proceeds
on the basis that there is a need to lower the individual income tax to raise company tax. This clearly
has very significant negative revenue implications for the government.
195
Coherent means that the principles, expressed at a high level, convey a meaningful idea to readers
familiar with the subject. The coherent principles approach to the design of tax law aims to produce law
expressed in principles (and, in particular, states the intended outcome of the law) so that tax law can be
shorter, readily understood, more certain. The traditional black-letter approach tends to emphasise
specific and technical aspects of the law, often in a detailed way. See Commonwealth, Treasury, T-
Notes: Some Information on.. Coherent Principles A New Approach to Tax Law Design
<http://www.treasury.gov.au/documents/1053/PDF/TNote_%20Coherent_Principles_2.pdf>at 21 April
2008; Greg Pinder, The Coherent Principles Approach to Tax Law Design in Commonwealth,
Treasury, Economic Roundup Autumn 2005
<http://www.treasury.gov.au/documents/987/PDF/07_coherent_principles.pdf>at 27 April 2008.
136
provisions with no CGT, FBT, CFC or the consolidation legislation. The tax system
has become increasingly complex over the last two decades, especially. Many
hundreds of pages of tax legislation have been added each year,
196
with exceptions to
exceptions and complexities upon complexities.
197

In 1993, the J oint Committee of Public Accounts (of the Parliament of Australia)
found the ITAA 1936 was in desperate need of a comprehensive overhaul:
Not only has the Act developed into a complex and incomprehensible mass of
convoluted, legalistic and pedantic provisions but, most importantly, the
uncertainty of its meaning acts as a positive detriment to the welfare of
Australia.
198

In December 1993, the Government established a taskforce to restructure, renumber
and rewrite the income tax law in plain language so that it could be more easily
understood by those who need to read it.
199
The idea was that, eventually, all the
material in the ITAA 1936 Act would be rewritten and progressively replaced by
equivalent (but rewritten) provisions in the ITAA 1997, effective 1 J uly 1997. The
ITAA 1936 was to have no application after the last instalment of the redraft was
enacted.
200
The rewrite is happening at a slower pace than expected and, indeed, has

For a discussion as to whether tax laws should be written on rules or principles, see J ohn F Avery
J ones, Tax Law: Rules or Principles? (1996) 17 Fiscal Studies 63; John Prebble, Should Tax
Legislation be Written from a Principles and Purpose Point of View or a Precise and Detailed Point of
View? (2001) 7 New Zealand Journal of Taxation Law and Policy 235; J ohn Braithwaite, Making
Tax Law More Certain: A Theory (2003) 31 ABLR 72; J ohn Braithwaite, Rules and Principles: A
Theory of Legal Certainty (2002) 27 Australian Journal of Legal Philosophy 47.
196
The original Income Tax Assessment Act 1936 (Cth) contained 126 pages. Five hundred pages were
added in the four decades to 1976, a thousand pages in the next decade to 1986, and more than double
the existing amount of legislation in the decade to 1996. A recent estimate of Australias income tax,
FBT, GST and related laws consume almost 13 000 pages and more than 9.5 million words. See Vann,
above n 133, 8.
197
Editorial, Developments in Taxation From 1971 to 1993 (1993) 22 Australian Tax Review 5, 5.
198
Australia, J oint Committee of Public Accounts, An Assessment of Tax A Report on an Inquiry into
the Australian Taxation Office (1993) xviii.
199
The Tax Law Improvement Project (TLIP) was established in December 1993 to rewrite all the
material in the ITAA 1936 in a better structure and to make it easier to understand.
200
Michael Kobetsky, Tax Reform in Australia The New Tax System (2000) 54 Bulletin for
International Fiscal Documentation 67, 68.
137
now been placed on hold.
201
Today, taxpayers and practitioners have to cope with two
principal Acts dealing with income tax.

In the governments comprehensive tax reform project in 1998, A New Tax System
(ANTS), it was noted:
The current tax system is unnecessarily complex The complexity of the tax
system has resulted in over 70 per cent of tax returns being handled by tax
agents. It also imposes high compliance costs on business and distorts
investment decision-making by encouraging investments on the basis of tax
effects rather than economic merit.

As the complexity of the tax system has grown, so too has the incentive for tax
avoidance and minimisation.

Investments subsidised from the tax system rather than being determined by
real economic returns simply transfer wealth from the general community to
the investor. Resources and wealth are wasted and, as a result, our standard of
living is diminished.
202

The government in its ANTS paper made the point that as far as practical, our tax
system needs to avoid exemptions and loopholes that distort investment decisions and
consumer choice.
203
But throughout the period when ANTS was being implemented,
the GST legislation was introduced, amended, amended and amended.
204

Frequent changes to tax laws and rules are a concern in terms of compliance. It is
becoming difficult for both tax practitioners and the general public to keep abreast
with the level of change to the tax law:

201
In August 1998, TLIP was subsumed by the Governments comprehensive tax reform project known
as A New Tax System. The reform recommended the introduction of a goods and services tax and a
number of business tax reforms (to give Australia a modern and internationally competitive tax system).
Tax legislative instructing and drafting resources are fully occupied in meeting the program of tax
reforms and the TLIP redrafting of the ITAA 1936 is being suspended indefinitely. See Michael
Kobetsky et al, Income Tax: Text, Materials and Essential Cases (6
th
ed, 2006) [1.50].
202
Peter Costello, Tax Reform: Not a New Tax, A New Tax System: The Howard Governments Plan
for a New Tax System: Overview (1998) 8-9.
203
Ibid 2.
204
Alice McCleary, Tax Reform Where Are We At? (Paper presented at the Tasmania Convention,
Taxation Institute of Australia, September 2001) 259, 261.
138
Since 2001 there have been approximately 65 Tax Laws Amendment Acts
passed by the Parliament. As at March 2004, over 40 legislative measures
have been enacted. Since 1 J une 2003, around another 40 measures were
before Parliament. A further 15 measures which have been announced by
Government were still to be introduced into Parliament. A large number of
these measures (both announced and in the Parliament) are intended to have
retrospective commencement dates.
205

It has been noted that if Australias income tax law continues to expand beyond control,
within a few years Australia will be the first nation in the world to boast an infinite
number of pages in its income tax law!
206
To eliminate out-of-date and inoperative
provisions, around 30 per cent of the income tax law has now been repealed.
207

Monitoring tax compliance of the highly wealthy

High-wealth individuals (HWI) (according to measures developed by the ATO) are
Australian residents who, together with associates, effectively control
208
a minimum
net wealth of A$30 million.
209
Some of these wealthy individuals have up to hundreds
of companies and trusts that they own or control.
210
Due to the scale of activities and
the potential impact of their non-compliance on the community, a taskforce was set up
in 1996 within the ATO to gather, save and exploit amazingly complex information

205
Michael DAscenzo, Maintaining Integrity and Confidence in the Tax System: Managing Risk.
Make the Right Moves (Speech delivered at the 33
rd
Queensland State Convention of the Taxation
Institute of Australia, 4 J une 2004) <http://www.ato.gov.au/print.asp?doc=/content/45422.htm> at
2 May 2008.
206
Richard Krever, Taming Complexity in Australian Income Tax (2003) 25 Sydney Law Review 467,
468.
207
See Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006 (Cth) (No 101, 2006).
208
Control is based on effective control rather than strict legal ownership. See Australian Taxation
Office, Wealthy and Wise: A Tax Guide for Australias Wealthiest People (2008) 4.
209
Traditionally, tax authorities treat individual persons and corporate entities (partnerships, trusts,
corporations) as separate taxpayers in their case management. The ATO is the only tax authority in the
world to treat the individual return of a very wealthy person and the entities he/she controls as a single
case. See John Braithwaite et al, Tax Compliance by the Very Wealthy: Red Flags of Risk in Valerie
Braithwaite (ed), Taxing Democracy: Understanding Tax Avoidance and Evasion (2003) 205.
210
Mark Leibler, Trust Structures: Witch-Hunt of the Wealthy (1997) 1 The Tax Specialist 14, 16.
139
about the wealthiest Australians.
211
If a risk assessment (conducted by the ATO)
shows that the HWI and associated entities companies, trusts and partnerships
212

pose a risk to revenue (for example, through their utilisation of tax planning and
minimisation techniques),
213
then that HWI and his/her group are subject to a
preliminary risk review, a comprehensive risk review or a specific review.
214

There are approximately 1200 high-wealth individuals in Australia who are associated
with around 25 000 entities.
215
The establishment of the taskforce has lifted the level
of compliance by Australias wealthiest people. Payment of tax has increased due to
audit work of the taskforce,
216
clearer interpretations of the law by the courts and the
ATO, and legislative changes to the law to close some tax loopholes.
217

Aggressive tax planning
218

Tax schemes (avoidance and evasion) have long been a feature of the Australian fiscal

211
Michael Laurence, Watching the Wealthy: The Tax Office is Keeping a Very Close Eye on
Australias Richest People (22 May18 J une 2003) 25 Business Review Weekly 178, 178.
212
The ATO takes a holistic view and assesses the tax risk over the totality of entities controlled by the
HWI, rather than assessing a high-wealth individuals (HWI) personal return and the returns of the
various entities in their control as separate returns. See J ohn Braithwaite, Markets in Vice Markets in
Virtue (2005) 84.
213
See Australian Taxation Office, Wealthy and Wise: A Tax Guide for Australias Wealthiest People,
above n 208, 19, on the features and characteristics that attract the attention of the ATO.
214
See ibid 27-43 for an explanation of the risk review products and how the ATO conducts risk
reviews and audits of HWIs and their group entities.
215
Ibid 5.
216
See Australian Taxation Office, Wealthy and Wise: A Tax Guide for Australias Wealthiest People,
above n 208, 7 on additional revenue collected by the High Wealth Individuals Taskforce since 1997.
217
See J ohn Braithwaite, Through the Eyes of the Advisers: A Fresh Look at High Wealth
Individuals in Valerie Braithwaite (ed), Taxing Democracy: Understanding Tax Avoidance and
Evasion (2003) 247 on the legislative measures introduced by the Australian Government that may
impact on HWIs.
218
Aggressive tax planning, or tax shelter in the American usage, refers to schemes or arrangements put
in place with the dominant purpose of avoiding tax. See Braithwaite, Markets in Vice Markets in Virtue,
above n 212, 16.
140
scene.
219
Such schemes seek to exploit deficiencies or uncertainties in the law. The
bottom of the harbour asset strips, involving some 7 000 companies and millions of
dollars, ran from the mid-1970s to the early 1980s and caused much damage to the tax
system.
220
The aim of the schemes was to enable shareholders to receive the profits of
a company free of both company tax and dividend tax.
221
The method involved either
stripping a company of its assets before tax became payable, or using another company
as the entity which became liable for tax but ensuring that it never had sufficient assets
to pay the money owed, and no company records or books were kept:
222

At the time, a company with no debts and with an annual profit of $100 000
would have a tax liability of $46 000. To avoid this liability, the owner of the
company had only to sell the company to a promoter for the value of the profits,
less an agreed-upon commission (for example 10 per cent). Instead of
finishing the year with $54 000, the former owner of the company would walk
away with $90 000.
223
The promoter, in turn, would keep the $10 000
commission and dispose of the company by turning it over to a person of
limited means, with no knowledge of the companys tax liabilities and no
interest in retaining company records and books. The Australian Taxation
Office and ultimately the honest taxpayers of Australia were $46 000 the
poorer.
224

The records of the stripped companies were, figuratively, sent to the bottom of Sydney
(or any other convenient) harbour, once they had served their purpose. In the late
1970s the legality of these activities was unclear, that is, it was not clear whether these
schemes constituted tax avoidance or minimisation (legal) or tax evasion (illegal).
225

219
The term tax evasion refers to the reduction of tax by illegal means that is, the non-payment of
taxes which are properly payable by a taxpayer in accordance with taxation laws. The element of
illegality distinguishes tax evasion from tax avoidance, a term used to describe the legal arrangement
of a taxpayers affairs so as to reduce his tax liability. See Barry Larking (ed), IBFD International Tax
Glossary (5
th
ed, 2005) 29-30.
220
Peter N Grabosky, Wayward Governance: Illegality and Its Control in the Public Sector (1989) 143.
221
Michael Kobetsky, Tax Reform in Australia The New Tax System (2000) 54 Bulletin for
International Fiscal Documentation 67, 69-70.
222
J ames Popple, The Right to Protection From Retroactive Criminal Law (1989) 13 Criminal Law
Journal 251, 259.
223
The former owner usually would pay no tax on the $90 000 as the consideration would be taken to
be of a non-assessable capital nature (at that time).
224
Grabosky, above n 220, 143.
225
Popple, above n 222, 259.
141
Realising that such practices posed a serious threat to the fairness of the tax system
and had the effect of shifting the tax burden onto others, special legislation was
enacted to recover the company tax that was evaded.
226

Aggressive tax planning behaviour re-emerged in the late 1990s. Mass-marketed
schemes were designed and sold by promoters towards the end of each financial year
to attract high marginal tax rate investors who claimed up-front deductions for the
costs of the underlying business plus interest costs associated with moneys borrowed
to finance the scheme.
227
Many mass-marketed scheme investors were (mis)led into
the schemes by claims made about the investments. They were unaware of the self-
assessment system and the penalties imposed. To deter the ongoing development and
promotion of new tax exploitation schemes, the government has introduced legislation
containing measures, including a new civil penalty regime, to deal with those who
promote aggressive tax schemes.
228

Tax schemes are detrimental to the tax system. Where a particular promoter is taking
a lead role in mass marketing, the ATO investigates the promoters by unannounced

226
See the income tax anti-avoidance provisions in Pt IVA of the ITAA 1936, the Crimes (Taxation
Offences) Act 1980 (Cth), and the now repealed Taxation (Unpaid Company Tax) Assessment Act 1982
(Cth), the Taxation (Unpaid Company Tax Vendors) Act 1982 (Cth) and the Taxation (Unpaid
Company Tax Promoters) Act 1982 (Cth).
227
The mass-marketed schemes operating in the Australian market include:
round-robin schemes, including non-recourse financing, often in agriculture, afforestation and
franchises;
certain film schemes with guaranteed returns that are, in effect, a return of part of the invested funds;
and
employee benefit arrangements that have more to do with creating tax benefits as their main
purpose.
See Kristina Murphy, An Examination of Taxpayers Attitudes Towards the Australian Tax System:
Findings From a Survey of Tax Scheme Investors (2003) 18 Australian Tax Forum 209, 237.
228
See the Tax Laws Amendment (2006 Measures No 1) Act 2006 (Cth) (No 32, 2006) which
introduced a new civil penalty regime that applies to promoters of tax exploitation schemes. The
term tax exploitation scheme is now defined in s 995-1 of the ITAA 1997 and has the meaning given
by s 290-65 in Pt 4-25 of Sch 1 to the TAA 1953. Subdivision 290-B of the TAA 1953 contains the
civil penalty regime.
142
access visits
229
and working with the Australian Federal Police.
230
But tax avoidance
and evasion using offshore structures established in tax havens are inherently difficult
to detect.
231
Taxpayers use offshore structures in an attempt to either create fictitious
deductions or conceal income from tax.
232
In other cases, assessable income derived
offshore is not brought to account in Australia, and is secretly returned to Australia
disguised as a loan, an inheritance, a gift, or through credit and debit cards.
233
To
protect the integrity of the tax system, a multi-agency operation directed at
international promoters and wealthy Australian participants has been set up to find
Australians who use tax havens and countries with bank secrecy to avoid Australian
tax obligations.
234
The ATO also works with tax administrations in other jurisdictions
to investigate Australians who use offshore structures to deliberately hide assets or
income.
235
Taxpayers have been requested to come forward and make disclosures of
unreported income from offshore activities to reduce their shortfall penalties including
criminal prosecution.
236
The central question raised in the crackdown on tax evasion
is: How far should tax authorities and associated investigative and intelligence

229
Section 263 of the ITAA 1936 gives the Commissioner full and free access at all times to all
buildings, places, books, documents and other papers.
230
Australian Taxation Office, Tax Office Visits Melbourne Scheme Promoters, Media Release, No
2002/32 (22 May 2002).
231
Australian Taxation Office, Tax Office Acts on Offshore Schemes, Media Release, No 2005/35
(10 June 2005).
232
Ibid.
233
Ibid.
234
Project Wickenby is a whole-of-government taskforce, launched in 2004, to investigate tax
avoidance, tax evasion and large-scale money laundering. The ATO and the other agencies the
Australian Crime Commission, the Australian Federal Police, the Australian Securities and Investments
Commission and the Commonwealth Director of Public Prosecutions supported by AUSTRAC, the
Attorney-Generals Department and the Australian Government Solicitor, work closely together to
collectively deter, detect and deal with international tax avoidance and evasion. See Australian
Taxation Office, Commissioner of Taxation Annual Report 2005-06 (2006) 161.
235
See Australian Taxation Office, Tax Commissioners Battle Against Tax Evasion, Media Release, No
2008/08 (26 February 2008).
236
Australian Taxation Office, Tax Office Announces Offshore Voluntary Disclosure Initiative, Media
Release, No 2007/34 (18 J uly 2007); Australian Taxation Office, Tax Commissioner Warns Against
Hiding Income or Assets Offshore, Media Release, No 2008/10 (13 March 2008).
143
agencies go to expose and take action against taxpayers who find ways around the
normal working of tax laws to unfairly reduce the tax they pay?
237

Test case litigation program

As Australias tax law is complex and constantly changing, litigation is a necessary
aspect of compliance.
238
To help clarify the law, some litigation is carried out under
the test case program. The aim of the program is to provide financial assistance to
individuals or organisations involved in litigation, to test a point of tax law in court.
The Commissioner regards the program important to the administration of the tax
system as legal precedents provide guidance on how laws should be applied.
239
There
are two aspects of the criteria for funding:
whether or not the issue will clarify taxation law in a manner beneficial to a
substantial segment of the public; and
whether the issue is in the public interest.
240

If the case is approved, the Commissioner will provide funding to both sides of the
argument. But the taxpayer is responsible for carrying on the case and taking it to
conclusion. The funding is limited to a single stage of proceedings. That means if a
case is funded for the Federal Court and the decision is not in the taxpayers favour, a
further application for funding would be required if the taxpayer decides to appeal to
the Full Federal Court.

237
Geoff Kitney, Fishing is OK But Bait May Be Immoral, Australian Financial Review (Sydney),
28 February 2008, 18.
238
A taxpayer who is dissatisfied with the Commissioners decision may elect to refer the objection to
either the Administrative Appeals Tribunal or the Federal Court and, ultimately, the High Court.
239
Australian Taxation Office, Test Case Litigation Program: How to Apply for Funding (2005) 1.
240
Ibid 2.
144
The Commissioner has funded a number of cases, including an aggressively promoted
mass-marketed scheme.
241
Taxpayers taking the Commissioner to court do not have a
high success rate.
242
The Commissioner wins most of the tax cases.
243

The test case program has been criticised as picking winners or selecting those cases
the ATO thought it had the best chance of winning.
244

4.3.4 Conclusion

Australia is an island Continent, with a relatively small population.
245
It relies on
foreign capital to supplement its own financial resources in support of economic
development and higher employment. The governments approach is to welcome and
encourage foreign investment that provides economic benefits to Australia and is
consistent with the needs of the community to ensure that Australia remains a growth
economy with expanding private investment, the development of internationally
competitive and export-oriented industries, and the creation of employment
opportunities.
246
Foreign capital also provides access to overseas markets, new
technology and management skills. But Australias tax system is criticised as a major

241
See Howland-Rose & Ors v Federal Commissioner of Taxation (2002) 49 ATR 206.
242
In 2007, taxpayers who took the Commissioner to court won 13 per cent of cases. See Caitlin
OToole, Taxman Cometh First, The Australian Financial Review (Sydney), 18 J anuary 2008, 20.
243
In 2007, the court found in favour of the Commissioner 66 per cent of the time and 21 per cent of
decisions were split between the Commissioner and the taxpayer. Ibid.
244
Allesandra Fabro, ATO Test Cases to be Scrutinised, The Australian Financial Review (Sydney),
11 March 2005, 3.
245
Australia is almost the same size as Mainland United States, but with a population of 20 million
living mainly in the major cities.
246
See Commonwealth, Foreign Investment Review Board, Summary of Australias Foreign Investment
Policy (April 2008)
<http://www.firb.gov.au/content/_downloads/General_Policy_Summary_April_2008.pdf> at 29 April
2008, on Australias foreign investment policy.
145
obstacle in attracting substantial foreign investment.
247
It is said that Australias tax
policies need to support Australia as both a destination and source of international
investment.
248
In an environment of intense international competition for increasingly
mobile financial and human capital, one view is that ongoing tax reform is essential for
Australia to remain internationally competitive.
249
Business tax reform has been
ongoing for several years.
250
The aim is to enable Australian business to thrive in the
global economy and to develop a structurally sound business tax system for Australia.

247
Michael Wachtel and Alf Capito, Removing Tax Barriers to International Growth: Positioning
Australias Tax System to Maximise the Potential Growth Opportunities from International Business
(2001).
248
Commonwealth, Treasury, Review of International Taxation Arrangements: A Consultation Paper
(2002) 1.
249
Alf Capito et al, Ongoing Reform on the Investment Tax Take is Crucial to Keep Us in the Game,
The Age (Melbourne), 28 February 2006, 4.
250
For a background to Australias business tax review, see Australian Taxation Office, Review of
International Taxation Arrangements: Introduction and History (6 February 2006)
<http://www.ato.gov.au/print.asp?doc=/content/46852.htm>at 16 April 2008.
146
CHAPTER 5: DETERMINING THE SOURCE OF PROFITS

5.1 Introduction

Under taxation law every item of income has a source either domestic or foreign.
1

The geographic origin or location of income determines whether the source is
domestic or foreign (meaning B). Almost every jurisdiction imposes taxes on both
residents and non-residents on income that the jurisdiction considers to have a
domestic source or which the jurisdiction considers is domestic in its origin. A small
number of jurisdictions do not tax their residents on foreign-source income Hong
Kong being the prime example. Most developed jurisdictions tax their residents on
domestic as well as foreign income.


This chapter examines how the law relating to source has developed in Hong Kong
and Australia, and shows the difficulties in determining the source of income where
profits are not necessarily confined to one territorial source. The increasing ease with
which business transactions, operations and activities are conducted and capital moves
across borders has exposed inadequacies in traditional rules governing the source of
income. No tax will be due if the source of income cannot be identified in some
legally effective way. It is, thus, fundamentally important to determine from what and

1
The distinction between domestic and foreign income is necessary to determine whether a jurisdiction
may tax a person on a particular item of income. It has been commented that the notions of domestic
or foreign income became convenient labels for designating activities that are or are not to be subject
to tax and for recognising the right of other countries to primary or exclusive taxing jurisdiction. See
Robert J Patrick J r, General Report Rules for Determining Income and Expenses as Domestic or
Foreign in Cahiers de Droit Fiscal International LXVb (1980) 15.
147
where income is derived and allocate it to a source or be given a deemed source,
including classifying that income into domestic or foreign income.

5.1.2 Overview

Hong Kongs territorial tax system is based on source alone. There is no real
difference in the tax treatment between a domestic and a foreign entity doing business
in Hong Kong. Both are subject to tax if profits arise in or are derived from a source
in Hong Kong.
2
But the existence of a business carried on in Hong Kong is not
decisive of the source of income subject to profits tax. To avoid profits tax, a Hong
Kong business, whether incorporated or unincorporated in Hong Kong, has to show
that the income is from a foreign source.

In Australia, residents are taxed on their worldwide income and non-residents on
income with an Australian source. Determining the source of income is the converse

2
In Commissioner of Inland Revenue v Hong Kong Whampoa Dock Co Ltd [1959] HKLR 625, Gregg J
in the Supreme Court regarded the words arising in and derived from as synonymous (at 627). But in
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1989) 1 HKRC 90-016, Clough JA in the
Court of Appeal said (at 100,204) that derived from has a broader meaning importing the concept of
immediate or mediate origin or source, and OConnor J said (at 100,211) that derived from has a
wider meaning than arising in. When the Hang Seng Bank case reached the Privy Council, Lord
Bridge of Harwich said (at 100,422) that [w]hilst it may be that there is some marginal difference in the
shades of meaning conveyed by the two phrases, their Lordships do not accept that it can possibly be
sufficient to bear the weight sought to be put upon it in distinguishing the Privy Councils decision in
Commissioner of Income-Tax, Bombay Presidency and Aden v Chunilal B Mehta [1938] AIR Privy
Council 232.
In Mehta, the Privy Council had to consider the operation of the Indian Income-Tax Act 1922 which
excluded from taxation profits which did not accrue or arise in British India. The Act laid down a
requirement that taxable profits be sourced within the jurisdiction. The case concerned a broker whose
profits were earned from the purchase and sale of commodities outside British India. The brokers
business was conducted entirely from Bombay. The approach adopted by the Privy Council was to look
at the transaction to see what happened in British India and what happened elsewhere (at 235). The
Privy Council concluded (at 238):
a person resident in British India carrying on business there and controlling transactions abroad in
the course of such business is not by these mere facts liable to tax on the profits of such transactions.
If such profits have not been received in or brought into British India, it becomes or may become
necessary to consider on the facts of the case where they accrued or arose.
The Privy Council upheld the decision of Beaumont CJ in the Indian High Court that the profits were
sourced abroad and fell outside the charge to tax.
148
of Hong Kong. If a non-resident entity based outside Australia is carrying on a
business in Australia, all ordinary
3
and statutory income
4
(except exempt income
5
and
non-assessable non-exempt income
6
) derived
7
directly or indirectly from all Australian
sources will be subject to Australian tax,
8
(though a double tax treaty (DTT) can
apply to tax the business income in the residence jurisdiction if the non-resident entity
does not have a permanent establishment (PE) in Australia).

Although determining the source of income varies to a significant degree in each
jurisdiction, the tax laws of both jurisdictions tend not to be well drafted on this topic.
There is no general statutory definition of source and the meaning is left largely to
the courts to determine.
9

3
Ordinary income is defined in s 6-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) as
income according to ordinary concepts.
4
Statutory income is defined in s 6-10 of the ITAA 1997 as income that is not ordinary income, but
which becomes assessable income because of some specific provision in the legislation that makes it
income. Subsection 6-25(2) of the ITAA 1997 provides that the statutory income provision will prevail
where income is assessable under both an ordinary income provision and a statutory income provision.
5
Exempt income is defined in s 6-20 of the ITAA 1997. Income is made exempt from income tax by a
provision of law or a provision in the ITAA 1997 excludes it (expressly or by implication) from being
assessable income. Some ordinary and some statutory income can be treated as exempt income. If an
amount is exempt income, it is not assessable income and is, therefore, tax-free and is not included in
the tax return as income. Losses or outgoings incurred in deriving exempt income are not allowable as
general deductions. However, exempt income may reduce the deduction allowable for a tax loss.
Exempt income is also taken into account in working out the income tax on other non-exempt income,
eg, exempt income from overseas employment income (s 23AG of the Income Tax Assessment Act
1936 (Cth) (ITAA 1936)) is added to gross-up assessable income so that proportional tax rates will
apply at the higher grossed-up level.
6
Non-assessable and non-exempt (NANE) income is defined in s 6-23 of the ITAA 1997. Income is
made NANE by a provision of law. Some ordinary and some statutory income can become NANE
income. Losses or outgoings incurred in deriving NANE income are not allowable as general
deductions. Unlike exempt income, NANE income is ignored for the purposes of working out the
taxable income and the taxpayers available tax losses. That is, NANE income does not enter into the
calculation of a tax loss and does not affect the deductibility of a prior year tax loss. Thus, NANE
income is effectively treated as if it were never income in the first place. See Australian Taxation
Office, Tax Facts: Non-Assessable Non-Exempt Income (2003) on NANE income measures.
7
The word derived was considered by the Privy Council in Kirks case. Their Lordships attached no
special meaning to the word, but considered it as synonymous with arising or accruing. See
Commissioner of Taxation v Kirk [1900] AC 588, 592.
8
See Appendix One Income Overview for an explanation of Australian income tax.
9
In Australia, there are specific statutory source rules relating to the taxation of certain business
income. See, for example, Div 12 (ss 129 to 135A) of Pt III of the ITAA 1936 that relates to shipping
income derived by a ship owner or charterer whose principal business is out of Australia.
149

The next part provides a background to the taxation of income from a business. This
is followed by a discussion in Part 3 on the guiding principles relevant in determining
the source of particular types of income. Part 4 provides an analysis of the different
approaches adopted by the courts on the question of source of income (in Hong Kong
and Australia). The analysis shows that the principles developed by the courts have
not always been applied consistently. Part 5 explains how entities minimise taxation
and maximise profits by structuring offshore arrangements designed to avoid tax.
Part 6 discusses the nature of the current source issues in Hong Kong and Australia.
Following a series of decisions on the source of profits, determining the source of
profits in Hong Kong is still unsettled and has resulted in many disputes between the
Commissioner of Inland Revenue and taxpayers. Today, Australian businesses have
increasingly taken advantage of the benefits of operating on an international scale.
The lack of statutory source rules provides entities with opportunities to manipulate
the form of international dealings and shift the source of income. Part 7 concludes that
the concept of source of income is, essentially, less clear today in the domestic tax law
of Hong Kong and Australia than before.

5.2 Income from a business

A main form of business structure used to carry on business is a company, although a
business may also be carried on by a sole trader, trust, joint venture or partnership. A
jurisdiction has the right to tax its residents and non-residents on the business profits if
the income-producing activities are characterised as business. If a business exists,
then the profits derived from that business are subject to income or profits tax.
150

Hong Kong

The charge to profits tax in Hong Kong is provided in s 14 of the Inland Revenue
Ordinance 1947 (IRO 1947):
Subject to the provisions of this Ordinance, profits tax shall be charged for
each year of assessment at the standard rate on every person carrying on a trade,
profession or business in Hong Kong in respect of his assessable profits arising
in or derived from Hong Kong for that year from such trade, profession or
business (excluding profits arising from the sale of capital assets) as
ascertained in accordance with this Part.

A person must satisfy three conditions in order to be chargeable to profits tax:
1 the person must carry on a trade, profession or business in Hong Kong;
2 the profits to be charged must be from such trade, profession or business and
carried on by the person in Hong Kong; and
3 the profits must arise in or are derived from Hong Kong.
10

The first test whether a taxpayer is carrying on a trade, profession or business in Hong
Kong is a matter of fact. Trade includes every trade and manufacture, and every
adventure and concern in the nature of trade. Business includes an agricultural
undertaking, poultry and pig rearing and the letting or sub-letting by any corporation
to any person of any premises or portion thereof, and the sub-letting by any other
person of any premises or portion of any premises held by him under a lease or
tenancy other than from the Government.
11
The word profession is not defined and
the ordinary meaning is used when interpreting the word:
Profession involves the idea of an occupation requiring either purely
intellectual skill or of manual skill controlled, as in painting and sculpture or

10
See Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044, 100,419,
discussed below in Part 5.4.1.2.
11
Inland Revenue Ordinance 1947 s 2(1).
151
surgery, by the intellectual skill of the operator as distinguished from an
occupation which is substantially the production or sale or arrangements for
the production or sale of commodities and the line of demarcation may vary
from time to time.
12

Thus, a person who is engaged in professional services and is not in receipt of a salary
is liable to pay profits tax. The issue is whether a business activity is carried on in
Hong Kong. The PE concept applies.
13
But the mere establishment of an office in
Hong Kong does not automatically constitute the carrying on of a business in Hong
Kong. A taxpayer may be regarded as carrying on a business if:
its central management and control
14
is in Hong Kong;
its board meetings are held in Hong Kong;
the daily business decisions are made in Hong Kong;
the daily business operations are carried out in Hong Kong; or
its business activities are conducted through an agent in Hong Kong.
15

As capital gains are not subject to profits tax, it is necessary to review the surrounding
circumstances of the case to see if a business activity constitutes a trade, profession or
business (as against the realisation of an investment, which is not taxable). The
circumstances generally include:
16

the subject matter of the realisation (that is, whether the property is normally the

12
Butterworths, Halsburys Laws of Hong Kong, vol 24 (1999) Taxation and Revenue, 1 Introduction
[370.164]-[370.167].
13
To be liable to profits tax, profits must have a source in Hong Kong. Thus, the permanent
establishment (PE) concept does not apply in determining liability to profits tax. But the PE concept is
relevant in determining if a business is being carried on in Hong Kong. See r 5 of the Inland Revenue
Rules on the meaning of PE and the charge to profits tax on the Hong Kong profits of a foreign
company having a PE in Hong Kong.
14
The meaning of central management and control is discussed in Part 7.3.2.2, Chapter 7.
15
Deborah Annells and Doris Chun, Inbound Electronic Commerce Activities (2000) 21(4) Tax
Management International Forum 21, 21.
16
J inyan Li and Denise Elliott, One Country, Two Tax Systems: International Taxation in Hong Kong
and Mainland China (2003) 57 Bulletin for International Fiscal Documentation 164, 168; Deborah
Annells and Doris Chun, Host Country Taxation of Specialised Problems in International Commerce
(2001) 22(2) Tax Management International Forum 25, 25.
152
subject of trading);
the length of ownership of the item sold;
the frequency or number of similar transactions by the same person;
supplementary or subsequent work done in connection with the property realised;
the circumstances responsible for the realisation of income; and
motive for the transaction.

It looks like any operations in Hong Kong of a commercial nature would satisfy the
test of carrying on a trade or business, even at a very low level of activity.
17

The second test is a matter of financial accounting.
18
Section 14 refers to profits
sourced in Hong Kong, but the term profits is not defined. The source concept
applies to gross profits rather than net profits.
19

The third test is fundamental to the territorial taxation of profits in Hong Kong. The
concept is clear only those profits that arise in or are derived from Hong Kong are
subject to profits tax, but its application in particular cases can at times be a
contentious issue between the Commissioner and taxpayers. Questions about the

17
See Commissioner of Inland Revenue v Bartica Investment Ltd (1996) HKRC 90-080. The placing
and rolling over deposits as security for loans in Australia by a shelf company incorporated in Hong
Kong constituted the carrying on of a business.
18
See Daniel K C Cheung and Percy Wong, Hong Kong and the Territorial Source of Business Profits
(2002) 29(12) Tax Planning International Review 3, 4; Andrew Halkyard and J acqueline Shek, Hong
Kong: Relationship Between Accounting and Taxation Principles (2002) 8 Asia-Pacific Tax Bulletin
143, 143.
19
The Inland Revenue Department has provided this guidance:
The distinction between Hong Kong profits and offshore profits is made by reference to the gross
profits arising from individual transactions. Only those business activities which directly produce
the gross profits are taken into consideration in determining the source of profits. Activities such as
general administration are normally not relevant.
See Hong Kong, Inland Revenue Department, Publications and Forms: A Simple Guide on the
<http://www.ird.gov.hk/eng/paf/bus_pft_tsp.htm>at 27 April 2008.
153
location of source of profits arise regularly. How the law on source was developed in
Hong Kong is discussed below.

Australia

There is no specific legislation that deals with the taxation of income from a business.
For an entity carrying on a business in Australia, the liability to Australian tax is
determined by the business activity. If an activity constitutes a business, then the
receipts from that activity comprise taxable income, measured by the rules applicable
to the source of that income.
20

There are no hard and fast rules in determining whether an activity amounts to the
carrying on of a business. It is a question of fact and degree, not law, depending upon
a variety of circumstances.
21
The Australian Taxation Office (ATO) looks at all the
circumstances of a case:
whether the activity has a significant commercial purpose or character;
whether the taxpayer has more than just an intention to engage in business;
whether the taxpayer has a purpose of profit as well as a prospect of profit from the
activity;
whether there is repetition and regularity of the activity;
whether the activity is of the same kind and carried on in a similar manner to that
of the ordinary trade in that line of business;
whether the activity is planned, organised and carried on in a businesslike manner,

20
The source from which income is derived is not necessarily identical with the place where the
business is carried on. See Mount Morgan Gold Mining Co Ltd v Commissioner of Income Tax
(Queensland) (1922-23) 33 CLR 76, 93-4.
21
See Californian Copper Syndicate (Ltd & Reduced) v Harris (Surveyor of Taxes) (1904) 5 TC 159;
Blockey v Federal Commissioner of Taxation (1923) 31 CLR 503.
154
such that it is directed at making a profit;
the size, scale and permanency of the activity; and
whether the activity is better described as a hobby, a form of recreation or a
sporting activity.
22

Following the decision in Thiels case (1990),
23
an isolated transaction is sufficient to
constitute the carrying on of a business.
24

It is also necessary to look at Australias DTTs on the taxation of business profits. A
business profits article appears in all of Australias DTTs. To prevent double
taxation of business profits, it is necessary to supplement the definition of PE by
adding to it an agreed set of rules according to which the profits made by the PE are to
be calculated.
25
The taxing of business profits depends on whether they are
attributable to the carrying on of a business through a PE (as defined in the PE article)
in Australia. The term business profits is used in the DTT rather than income. It
has a broad meaning that includes all income derived in carrying on an enterprise.
26

22
See Australian Taxation Office, Taxation Ruling TR 97/11, Am I Carrying on a Business of Primary
Production? [13], which sets out the Commissioners view on how to determine whether an activity
amounts to the carrying on of a primary production business. But the indicators listed are not specific to
the primary production business.
23
Thiel v Federal Commissioner of Taxation (1990) 90 ATC 4717.
24
In Thiels case, a Swiss resident visited Perth in early 1984 and acquired units in a private property
trust, in anticipation of the significant gains that could be made from an imminent public offering. In
November 1984, he converted the units into shares and subsequently sold them. He was assessed on the
profits made on the conversion of units as well as the disposal of shares. The central question in the
appeal to the Full High Court concerned the interpretation of the term profits of an enterprise of one of
the Contracting States in Art 7 of the Agreement Between Australia and Switzerland for the Avoidance
of Double Taxation with respect to Taxes on Income (entered into force 13 February 1981). The key
terms profits and enterprise are not defined in the agreement. The High Court held that business
profits are not confined to profits (or taxable income) derived from the carrying on of a business but
must embrace any profit of a business nature or commercial character. Profit from a single transaction
may amount to a business profit rather than something in the nature of a capital gain even if it does not
involve the carrying on of a business. However, due to the absence of a PE in Australia, the profits
were to be taxed in Switzerland.
25
26
Ibid 129.
155

Each of Australias DTT is different, but the business profits article is generally
structured in this manner.
27
Paragraph 1 provides the basis for the allocation of taxing
rights between the residence and the source jurisdiction. Where an enterprise carries
on business in the source jurisdiction without a PE therein, business profits are taxable
only in the residence jurisdiction. Where an enterprise carries on business in the
source jurisdiction through a PE, only business profits attributable to that PE may be
taxed in the source jurisdiction. Paragraph 2 provides that the arms length principle is
used in ascertaining the profits of a PE.
28
Paragraph 3 provides the rules in
determining the allowable deductions in the calculation of profits of a PE. A PE
cannot claim non-deductible expenses under Australias domestic tax law.

Paragraph 4 states that the profits arising from the mere purchase of goods or
merchandise for an enterprise in Australia are not to be attributed to the PE. Paragraph
5 states the method of attributing profits. Each jurisdiction has the right to compute
the profits according to the provisions of its domestic laws. Paragraph 6 deals with the
determination of profits where information is inadequate. The Commissioner of
Taxation may use Australias domestic tax law to determine the tax liability on such
profits if insufficient information is provided. Paragraph 7 deals with the taxation of
profits governed by a specific article. Where items of income are dealt with separately
in the other articles (such as dividends, interest and royalties), the provisions of those
articles should not be affected by the provisions of Article 7. Paragraph 8 provides

27
Based on the Agreement Between the Government of Australia and the Government of the Peoples
Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 28 December 1990).
28
Paragraph 2 is an anti profit-shifting measure. Profits to be attributed to a PE are those which that PE
would have made as if it were a distinct and separate enterprise under conditions and at prices prevailing
in the ordinary market. See OECD, Model Tax Convention on Income and on Capital, above n 25, 117.
156
Australias taxing rights over the profits of a non-resident carrying on insurance
business in Australia without a PE.
29
Paragraph 9 deals with profits derived by the
trustee of an interposed trust. If the trustee derives business profits from carrying on
business in Australia through a PE, the non-resident beneficiary entitled to a share of
those profits will also be treated as having a PE in Australia and taxed accordingly.
30

The business profits article is in many respects a continuation of, and a corollary to,
the definition of the concept of PE.
31
The PE criterion does not of itself provide a
complete solution to the question of double taxation of business profits. If a foreign
entity is carrying on a business in Australia through a PE, what, if any, are the profits
on which that PE should pay tax? Only profits attributable to the PE are deemed to
have an Australian source, and are brought to account as income under the general
assessable provisions by assessment.
32
The threshold question in the resolution of
whether a particular item of income has an Australian source is, therefore, to
determine whether there is a business being carried on in Australia.

5.3 The guiding principles

Hong Kong and Australia generally have followed the United Kingdom (UK) legal
system in the development of taxation-related case law.
33
The principles in a number

29
The taxation of certain insurance premiums derived by non-resident insurers is contained in Div 15
(ss 141 to 148) of Pt III of the ITAA 1936.
30
This article was introduced to counter the effect of Thiels case (see above footnote 24).
31
OECD, Model Tax Convention on Income and on Capital, above n 25, 113.
32
To ensure that income allocated under a DTT is taxable in Australia, most of Australias DTTs
contain a source of income article that deems any income, profits or gains derived by a non-resident
(under any one or more provision of a relevant DTT, eg the business profits article) to be income from
sources in Australia, regardless of the territorial source of the income under domestic law. See Michael
Dirkis, Ripe for Reform: Australias Domestic Source Rules (2007) 61 Bulletin for International
Taxation 168, 169.
33
The Australian income tax system is structured quite differently from the schedular nature of the
United Kingdom (UK) system. But the UK schedules and the concept of sources of income have
157
of UK and Commonwealth tax cases were considered and applied in the interpretation
of the earlier Hong Kong and Australian cases. However, the language of the UK
income tax acts was not identical with the income tax legislation of the two
jurisdictions. The question in the UK cases was whether profits arose from any trade
exercised in the UK. One must inevitably concentrate on where the physical
operations of that persons trade are conducted to answer that question. Hong Kong
taxes profits arising in or derived from a Hong Kong business. An enquiry into
where someones profits are derived from should not necessarily concentrate on the
location of the physical acts of the person earning the income because those physical
acts may or may not be primarily responsible for the derivation of the income in
question.
34
The answer to the question whether a trade is exercised would not
provide an appropriate answer to the question of whether business profits arose or are
derived from or have a source in a jurisdiction. The relevant earlier Commonwealth
and state income tax acts provided that, in general, tax was imposed only upon income
derived directly or indirectly from some source in the Commonwealth or the state, as
the case may be. The UK decisions on the location of business were not of very great
assistance in determining the interpretation of income tax acts in Australia.
35

5.3.1 The general source rule

In Hong Kong and Australia, there are no comprehensive criteria set out in the tax
legislation to determine the source of income. The word source was discussed in

influenced developments in the Australian income tax system. The UK concepts in cases have often
been applied in determining whether specific items are income. See Richard Vann, Australia in Hugh
J Ault et al, Comparative Income Taxation: A Structural Analysis (2
nd
ed, 2004) 6.
34
William A Ahern, Hong Kong Profits Tax Determining the Source of Profits (1990) 2(2) CCH
Journal of Asian Pacific Taxation 29, 29.
35
Per Latham CJ in Commissioner of Taxation (New South Wales) v Hillsdon Watts Ltd (1936-7)
57 CLR 36, 43.
158
Meeks case (1915).
36
It was held the word source in connection with income
derived from any source in the State by the Income Tax (Management) Act 1912
(NSW) denoted a concept to which locality can be attributed.
37
There are two
questions for determination:
what was the source from which the income was derived (meaning A); and
what is the locality of that source (meaning B).
38

In Nathans case (1918),
39
Issacs J made the following observations:
The Legislature in using the word source meant, not a legal concept, but
something which a practical man would regard as a real source of income.
Legal concepts must, of course, enter into the question when we have to
consider to whom a given source belongs. But the ascertainment of the actual
source of a given income is a practical, hard matter of fact.
40
The Act, on
examination, so treats it.
41

This statement of principle indicates a substance over form approach in determining
the source of income.
42
Though the substance approach lacks certainty, it is less
possible to manipulate as it depends on the facts and circumstances of each case.

36
Commissioner of Taxation (New South Wales) v Meeks (Public Officer of the Sulphide Corporation
Ltd) (1915) 19 CLR 568.
37
Ibid 579.
38
Ibid.
39
Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183.
40
In Kwong Mile Services Ltd v Commissioner of Inland Revenue [2004] 3 HKLRD 168, Bokhary PJ
said (at 173):
The word hard is not used to connote difficulty (although questions as to source can sometimes
be difficult). It is used to mean hard-nosed in that expressions sense of being realistic. This is
brought out in another decision of the High Court of Australia, namely Federal Commissioner of
Taxation v Mitchum (1965) 113 CLR 401 where Barwick CJ said the matter of source is judged
as one of practical reality.
41
Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183, 189-90.
42
The issue of form and substance in tax law relates to the characterisation of transactions and other
legal relations arising in court and administrative cases. Form (or legal form) usually refers to the
literal rule of statutory interpretation. Substance refers to the so-called golden rule which allows a
court to adopt a meaning of the words to avoid absurdity, repugnancy or inconsistency. See Michael
DAscenzo, Substance Versus Form (1997) 3 Asia-Pacific Tax Bulletin 330, 331.
159
Similarly, in Tariff Reinsurance (1938),
43
the court looked at where the substance and
essence of the operations were transacted when determining the source of income:
We are frequently told, on the authority of judgments of this court, that such a
question is a hard, practical matter of fact. This means, I suppose, that every
case must be decided on its own circumstances, and that screens, pretexts,
devices and other unrealities, however fair may be the legal appearance which
on first sight they bear, are not to stand in the way of the court charged with the
duty of deciding these questions. But it does not mean that the question is one
for a jury or that it is one for economists set free to disregard every legal
relation and penetrate into the recesses of the causation of financial results, nor
does it mean that the court is to treat contracts, agreements and other acts,
matters and things existing in the law as having no significance.
44

In Esquire Nominees (1972),
45
it was stated the question of the source of income is to
be decided in accordance with the practical realities of the situation without giving
undue weight to matters of form, and not by the application of absolute rules of law.
46

So the law does not provide determinative rules in relation to the source of income, but
merely lays down principles that can be used to ascertain where source lies as a matter
of fact.
47
Source-based taxation, by its very nature, is confined within certain
territorial limits. But profits are not necessarily confined to one territorial source and
may be related to activities located in several different countries, determined by
different factors. If a company makes profits simply by investment, the source of
income is the place where it has its central management and control.
48
If a company
makes profits out of its manufacturing or trading activities, the source of income is the
place where these activities are carried on.
49
There are no general rules of law which
can be applied to cover a wide range of particular factual circumstances. What might

43
Tariff Reinsurances Ltd v Commissioner of Taxes (Vic) (1938) 59 CLR 194.
44
Ibid 208.
45
Esquire Nominees Ltd v Federal Commissioner of Taxation (1972) 72 ATC 4076.
46
Ibid 4087.
47
Dirkis, Ripe for Reform: Australias Domestic Source Rules, above n 32, 169.
48
Esquire Nominees Ltd v Federal Commissioner of Taxation (1973) 73 ATC 4114, 4117-8.
49
Ibid.
160
be applicable for one type of income might not be applicable for another. The courts
have tended to emphasise particular factors as relevant in determining the source of
particular classes of income. Various key tests have evolved. These include:
the contract conclusion test;
the operations test; and
the provision of credit test.

5.3.2 The contract conclusion test

The contract conclusion test is one test used to determine the location of a trading
business. The primary object of a merchant is to sell goods at a profit. The trade is
exercised or carried on at the place where the contracts are made.

The question in Grainger v Gough (1896)
50
was whether Louis Roederer, a French
wine merchant at Rheims, was carrying on a trade in England by virtue of the fact that
his agent, Grainger and Son, canvassed for orders in England. No contract for the sale
of wine was made in England by the agent. Orders from the UK customers were
forwarded to the French merchant at Rheims. To determine if the foreign wine
merchant had exercised a trade within the UK, the House of Lords made two broad
distinctions between the case of a foreigner making contracts in England and in his
own country, and trading with and within a country.

The case of a foreigner making contracts in England with his English customers for
the sale of his wines, either personally or through a representative, was not the same as

50
Grainger and Son v Gough (Surveyor of Taxes) (1896) 3 TC 462.
161
the case of his making similar contracts with those customers in his own country:
In the present instance the orders forwarded to Louis Roederer were, in law,
nothing more than offers to purchase, until the contract between him and each
offerer was completed by his acceptance at Rheims; and he fulfilled his part of
the contract by making delivery of the wine sold to the purchaser, and at his
risk, in Rheims.
51

Trading with a country is not the same as carrying on a trade within a country. Many
merchants and manufacturers export their goods to all parts of the world, but that does
not mean that they exercise or carry on their trade in every country in which their
goods find customers:
How does a wine merchant exercise his trade? I take it, by making or buying
wine and selling it again with a view to profit. If all that a merchant does in
any particular country is to solicit orders, I do not think he can reasonably be
said to exercise or carry on his trade in that country. What is done there is only
ancillary to the exercise of his trade in the country where he buys or makes,
stores, and sells his goods. Indeed, I do not think it was contended that the
solicitation of custom in this country by a foreign merchant would in all cases
amount to an exercise by him of his trade within this country.
52

It was held that the mere soliciting and transmitting of orders through agents did not
amount to an exercise of trade in the UK. Grainger v Gough established the principle
that, to constitute the exercise of a trade within a jurisdiction, the making of contracts
of sale must be in the jurisdiction.

In Hillsdon Watts (1936-37),
53
Latham CJ commented:
The answer to the question whether a trade is exercised in a particular country
does not, however, necessarily answer the question whether any part of certain
income is derived directly or indirectly from sources within that country.
There is no trade in goods apart from actual or possible sales. A person who
simply manufactures goods and stores them up or gives them away is not
exercising a trade. Thus the place where the contracts of sale are made is, in
the case of a merchants business, held to be the place where the trade is
exercised. But it may nevertheless be true that part of the profit derived as a

51
Ibid 470.
52
Ibid 467.
53
Commissioner of Taxation (New South Wales) v Hillsdon Watts Ltd (1936-7) 57 CLR 36.
162
consequence of such sales is derived from a place other than that in which the
trade is exercised.
54

In Firestone Tyre Co Ltd v Llewellin (1957),
55
Lord Radcliffe pointed out that under
the conditions of international business and modern facilities of communications, the
place of sales test was capable of proving a somewhat ingenuous one.
56
Lord
Radcliffe further said:
the place of sale will not be the determining factor if there are other
circumstances present that outweigh its importance, or unless there are no other
circumstances that can.
57

5.3.3 The operations test

The operations test looks at the operations that contribute to the generation of
income one looks at situations where the physical acts of the taxpayer in question are
obviously and primarily responsible for the derivation of the profits in question.
58

In Smidth v Greenwood (1922),
59
Atkin LJ used the operations test to determine
where the trade of a manufacturer and seller of machinery was exercised, so that
profits accrued to them from that trade were brought into charge. After citing Grainer
v Gough, Atkin LJ said:
Similarly a manufacturer of machinery exercises his trade by making the
machinery and selling it again, with a view to a profit. There are indications in
the case cited and other cases that it is sufficient to consider only where it is
that the sale contracts are made which result in a profit. It is obviously a very
important element in the enquiry, and, if it is the only element, the assessments
are clearly bad. The contracts in this case were made abroad. But I am not
prepared to hold that this test is decisive. I can imagine cases where the

54
Ibid 42-3.
55
Firestone Tyre & Rubber Co Ltd v Llewellin (Inspector of Taxes) (1957) 1 All ER 561.
56
Ibid 568.
57
Ibid.
58
Ahern, above n 34, 31.
59
F L Smidth & Co v F Greenwood (Surveyor of Taxes) (1922) 8 TC 193.
163
contract of re-sale is made abroad, and yet the manufacture of the goods, some
negotiation of the terms, and complete execution of the contract take place here
under such circumstances that the trade was in truth exercised here. I think that
the question is, where do the operations take place from which the profits in
substance arise?
60

The operations test in Smidth v Greenwood, (looking at where the operations
take place from which the profits in substance arose), was widely applied as a general
test for source of income in Hong Kong
61
until the Hang Seng Bank case in 1990.
62

The problem with the operations test is that it tends to assume that operations are
necessarily responsible for profits. It has been pointed out that this assumption is
completely unwarranted, especially when unearned, passive or investment income is
concerned.
63

5.3.4 The provision of credit test

The provision of credit test is often used to determine the source of interest income of
non-financial institutions.
64
The location of interest income is where the funds were
made available by the lender to the borrower, regardless of where the loan was

60
Ibid 203-4.
61
Peter Willoughby, Source of Profits: Controversy, Confusion and Now Fallacies (April 1995) New
Gazette 38, 40.
62
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044. This case is
discussed below in Part 5.4.1.2.
63
Ahern, above n 34, 30.
64
The provision of credit test does not apply to banks and financial institutions. Interest earned by
banks and financial institutions through the use of money represents profits earned from the carrying on
of a banking business. Should the provision of credit test on the place where the credit is made
available to the borrower be used for determining the source of interest, it is possible to carry out
virtually all aspects of banking operations in a jurisdiction with source-based tax regime, like Hong
Kong, and yet no tax would be paid there as credit could be made available outside the jurisdiction. See
Peter G Willoughby, Profits Tax: Territorial Source of Profit From Interest (1978) 8 Hong Kong Law
Journal 215, 216.
164
negotiated, the agreement was signed or the interest paid.
65
This view is based on the
decision of Commissioner of Inland Revenue v N V Philips Gloeilampenfabrieken
(1954),
66
a New Zealand case.
67

That case related to interest derived from New Zealand within the meaning of New
Zealands Land and Income Tax Act 1923. A New Zealand company imported goods
from a Dutch company on terms that payment for the goods would be made in sterling
English currency in Holland, within three months of the close of the month in which
the goods were invoiced and dispatched to New Zealand. There was no provision for
interest payment by the New Zealand company on any unpaid balances if the agreed
period of credit was exceeded. In J uly 1948, the New Zealand company owed the
Dutch company a sum of 80 000 (pound sterling), being the outstanding balance of
unpaid purchase money for goods supplied on credit. The New Zealand company was
unable to discharge this debt and it therefore requested the Dutch company to extend
the time for payment of the debt, together with interest payment. The loan transaction
was entered into in the Netherlands. The question was, what was the source of interest
income on the loan transaction?

65
There is no general rule that defines the source of interest income. Arguably, interest income could
be derived for tax purposes from any of the following sources:
where the loan agreement was made;
where the money was lent;
where the interest is paid;
where the loan funds are used;
where the lenders business is incorporated;
where the lenders business is carried on;
where the borrowers business is incorporated; and
where the borrowers business is carried on.
See Dirkis, Ripe for Reform: Australias Domestic Source Rules, above n 32, 174; David G Smith
and Ayesha Macpherson, Hong Kong Taxation Law and Practice (2006) 227. See, also, Hong Kong,
Inland Revenue Department, Departmental Interpretation and Practice Note No 13 (revised), Profits Tax:
Taxation of Interest Received (DIPN 13), [2].
66
Commissioner of Inland Revenue v N V Philips Gloeilampenfabrieken (1954) 6 AITR 158.
67
Before the Philips Gloeilampenfabrieken case, the Studebaker case established the provision of credit
test. In a simple lending of money, the source of income is where the obligation to pay interest arises.
See Public Officer of the Studebaker Corporation of Australasia Ltd (as agent for the Studebaker
Corporation of America) v Commissioner of Taxation for New South Wales (1921) 29 CLR 225.
165

Applying the practical, hard matter of fact test, the court held that the source of the
interest income was located where the transaction from which the debt (interest) took
its origin, rather than where the debt itself was situated.
68
If the location of the debt
were to be selected as the test, the source would be located differently according as
whether the contract was a simple contract or a specialty.
69
In the latter case, such a
test would not be proper to apply as the location would arbitrarily change with the
actual situation of the deed itself.
70

The problem with the provision of credit test is that the place of lending can be
manipulated, and other relevant circumstances in relation to the transaction as a whole
should be taken into account.
71

5.4 From what and where do profits arise?

5.4.1 Hong Kong

The phrase profits arising in or derived from Hong Kong is defined under s 2 of the
IRO 1947 to include all profits from business transacted in Hong Kong, whether
directly or through an agent.
72
The greatest difficulty is to determine from what and

68
Commissioner of Inland Revenue v N V Philips Gloeilampenfabrieken (1954) 6 AITR 158, 178.
69
Ibid.
A specialty contract is a formal contract under seal. Unlike a simple contract that may be oral, in
writing or only partially in writing, a specialty contract must be in writing, with the seal of the signer
attached. See Bryan A Garner (ed), Blacks Law Dictionary (8
th
ed, 2004) 344, 347, 1434.
70
Commissioner of Inland Revenue v N V Philips Gloeilampenfabrieken (1954) 6 AITR 158, 178.
71
Tom Magney, Some Aspects of Source of Income (Paper presented at the Taxation Institute of
Australia, 5th National Tax Retreat, Sheraton Noosa Resort, Queensland, 7-9 August 1997) 12.
72
Section 2 of the IRO 1947 states that profits arising in or derived from Hong Kong shall, without
in any way limiting the meaning of the term, include all profits from business transacted in Hong Kong,
whether directly or through an agent. The meaning of the words profits from business transacted in
166
where do profits arise, notwithstanding there is a trade, profession or business in Hong
Kong. The factors to be considered in determining the source of profits from a Hong
Kong business are not provided in the IRO 1947.

5.4.1.1 Source of manufacturing profits

In the last two decades or so, Hong Kongs manufacturing industry has migrated to the
Peoples Republic of China (PRC) to take advantage of lower wages, rents and so on.
The manufacturing is done in the PRC, but many aspects of manufacturing and
administrative control are completed in Hong Kong, such as the supply of the
manufacturing plant and raw materials, solicitation and negotiation of orders and
shipment of the finished products.
73
The question of the locality of profits derived
from manufacturing profits is where the profit-making activity is carried out. If goods
are manufactured in Hong Kong, profits arise from the sale of such goods and are fully
taxable in Hong Kong because the profit-making activity is considered to be the
manufacturing operation carried out in Hong Kong.
74
If goods are partly
manufactured in Hong Kong and partly outside Hong Kong, only that part of the

Hong Kong, as defined in s 2, was considered by Gould J in Commissioner of Inland Revenue v
Karsten Larssen & Co (HK) Ltd (1950-1) HKLR 323 (at 344):
The taxable profits include all profits from business transacted in the colony, whether directly or
through an agent the meaning of this provision has not hitherto been judicially considered. If it
was intended merely to make it clear that profits derived from the colony by an agent were taxable
one would have expected other phraseology. An appropriate phrase would have been Shall
include such profits so arising or derived through an agent. Unless the words all profits from
business transacted in the Colony are to be regarded as mere surplusage they must have some
effect on the ordinary meaning of arising in or derived from.
It has been noted that the definition in s 2 does not focus on the role of an agent, as the acts of an
agent carried out within the scope of the agency are those of the principal. Case law indicates that the
definition does not widen in any material sense the scope of the general charging provision in s 14.
Thus, the definition in s 2 has little practical significance in determining the source of profits. See
Andrew Halkyard, Source of Profits Rules in Hong Kong Analysis of a Troublingly Successful
System (2006) 60 Bulletin for International Taxation 453, 455.
73
Agnes Sin Law Yuk-Lin, Hong Kong: the Premier Gateway to China (2000) 6 Asia-Pacific Tax
Bulletin 62, 64.
74
See Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 21,
Locality of Profits (DIPN 21), [13].
167
profits which relates to the manufacture of goods in Hong Kong is to be regarded as
arising in Hong Kong.
75
If the Hong Kong manufacturing business enters into a
contract processing arrangement with a PRC entity,
76
then profits on the sale of the
goods are to be apportioned, generally on a 50:50 basis.
77
If the Hong Kong
manufacturing business enters into an import processing arrangement with a PRC
entity,
78
then the 50:50 basis of apportionment does not apply.
79
If the Hong Kong

75
Ibid [14].
76
A Hong Kong manufacturing business which does not have a licence to carry on a business in the
PRC may enter into a contract processing arrangement with a PRC entity. Under such an arrangement,
the PRC entity is responsible for processing, manufacturing or assembling the goods for export. The
PRC entity does not own the raw materials and finished goods, but provides the factory premises, the
land and labour, and charges a processing fee and exports the completed goods to the Hong Kong
manufacturing business. The Hong Kong manufacturing business normally provides the raw materials
and may also provide technical know-how, management, production skills, design, skilled labour,
training and supervision for the locally recruited labour and the manufacturing plant and machinery.
The design and technical know-how development are usually carried out in Hong Kong. Ibid [15]-[16].
77
In recent years, the shifting of manufacturing activity from Hong Kong to the PRC has increased
significantly and, it is argued, the 50:50 approach in apportioning profits may no longer be fair. This is
because the 50:50 approach applies wherever the factory is located and Hong Kong businesses may
move their remaining manufacturing-related activities from Hong Kong to the PRC or other
jurisdictions like Macao to qualify for tax holidays or tax incentives available. See Andrew Halkyard,
Source of Profits Its Time (For Change) (2005) 35 Hong Kong Law Journal 421, 431.
A tax holiday, often found in developing countries, offers a period of exemption from income tax
for new industries in order to develop or diversify domestic industries. A tax incentive is used to attract
local or foreign investment capital to certain activities or particular areas in a country. The incentive
may include investment credits or allowances, or special deductions. See Barry Larking (ed), IBFD
International Tax Glossary (5
th
ed, 2005) 237, 403.
78
Under an import processing arrangement, the transfers of raw materials and finished products
between the Hong Kong manufacturing business and the PRC entity are dealt with by way of sales and
purchases. That is, the Hong Kong manufacturing business sells the raw materials to the PRC entity
that manufactures its own goods, which are then sold back to the Hong Kong manufacturer. See Ho Chi
Ming, Tax Exemptions for Manufacturing Firms (October 2007) A Plus 48, 49
<http://www.hkicpa.org/hk/APLUS/0710/p48_50.pdf>at 4 May 2008.
79
In law, the PRC entity, as a sub-contractor, is separate and distinct from the Hong Kong
manufacturing business and the question of apportionment does not arise. The concession on
apportionment of profits is given by the Inland Revenue Department, and it is only prepared to give the
concession in the case of manufacturing profits when certain conditions are met. Profits derived from
import processing are regarded as trading profits, to be calculated by deducting from its sales the cost
of goods sold, including any sub-contracting charges paid to the sub-contractor in the PRC. See Hong
Kong, Inland Revenue Department, DIPN 21, above n 74, [16]-[17].
The application of the non-statutory concession on apportionment of profits under paragraph 16 of
DIPN 21 is not clear. In one case, a Hong Kong manufacturing business was unable to obtain the
concession as it had failed to prove that the PRC entity was its manufacturing establishment or agent in
China or that the PRC entity was a mere puppet and dummy. In another case, a Hong Kong
manufacturing business was successful in obtaining the concession due to the taxpayers substantial
involvement in the PRC. See Hong Kong Inland Revenue Board of Review Decision Case No D36/06
(2006) and Case No D43/06 (2006). In the latter case, both the Commissioner and the taxpayer have
filed an appeal to the Court of First Instance (CFI), and the hearing date is pending. See Hong Kong,
Board of Review, Table of Appeals to Court of First Instance (Position as at 31.3.2008)
<http://www.info.gov.hk/bor/eng/pdf/judgment/20080331.pdf>at 26 April 2008.
168
manufacturing business is only involved in the supply of raw materials and is not
involved in the supply of plant or supervision of staff to the offshore contractor, then
this is trading activity and the profits are taxed accordingly (see below).
80

Where a company manufactures goods outside Hong Kong and sells them to Hong
Kong customers, the manufacturing profits are not liable to profits tax in Hong
Kong.
81
However, if the selling activities in Hong Kong are so substantial as to
constitute a retailing business, then profits attributable to the retailing activities have a
source in Hong Kong.
82

5.4.1.2 Source of trading and other profits

The question of the locality of profits derived from trading in commodities or goods
has produced the most controversy and often requires clarification by the courts.
83

The earlier cases

The first judicial decision on the source issue in Hong Kong was the Karsten Larssen
case (1951).
84
Karsten Larssen & Co (Karsten Larssen) was a ship broker company
incorporated in Hong Kong. Under a business arrangement, Karsten Larssen was paid
a commission by shipowners in Norway to find a charter party through brokers in or

80
Hong Kong, Inland Revenue Department, DIPN 21, above n 74, [17].
81
Ibid [19].
82
Ibid.
83
The discussion includes profits earned by the exploitation of property assets by letting property and
dealing in commodities, securities and financial products by financial institutions. It is necessary to refer
to a number of decisions (eg. Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC
90-044 and Commissioner of Inland Revenue v HK-TVB International Limited (1992) 1 HKRC 90-064;
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD
412 discussed below) and clarify the general principles to be followed in determining the locality of
profits.
84
Commissioner of Inland Revenue v Karsten Larssen & Co (HK) Ltd (1950-1) HKLR 323.
169
outside Hong Kong. The contract between the shipowner and the out-port charter
party was signed outside Hong Kong. The question in dispute was the source of the
commission income.

Gould J did not apply the contract conclusion test, but emphasised that it was
important to understand where the operations from which the profits in substance
arose took place (that is, the place where work was done which yielded the profits).
Karsten Larssen had no accredited agents or branches outside Hong Kong. The whole
of its business activities had been confined to Hong Kong there it received
instructions from the shipowner in Norway to find a charterer, sent out enquiries to
various brokers in the out-port, submitted the offers made to the owner including the
total commission charge of the out-port broker, and advised the third-party charterer
when the offer proved acceptable by the shipowner.

Though the commission income was for chartering outside Hong Kong, the court held
that it was derived from a trade or business carried on in Hong Kong. There was no
evidence that the profits in question arose and were derived elsewhere than from the
Colony from such trade or business.
85

The operations test was again applied in the Dock case (1960).
86
The facts of the
case were clear. The Hong Kong & Whampoa Dock Company (WDC) was a public
company in Hong Kong that carried on business as ship-builders, ship-repairers and
general engineers. It received a telephone call from the Hong Kong office of a
shipowner to send a tugboat to the Paracel Islands to assist in the rescue of a vessel

85
Ibid 338.
86
The Hong Kong & Whampoa Dock Co Ltd (No 2) v Commissioner of Inland Revenue [1960] HKLR
166.
170
that had run aground. A contract was executed by the salvage officer on the spot in
the Paracels. So there were two contracts involved in the case the telephone contract
in Hong Kong and the salvage contract outside Hong Kong. The question was
whether the fee for the rescue of the vessel received by WDC was subject to profits tax
in Hong Kong. Reece J considered whether it was the operations of the company or
the salvage contract which gave rise to the profits.
87

Relying on the principle laid down in Smidth v Greenwood (1922)
88
where do the
operations take place from which the profits in substance arose, Reece J focused on
the making of the salvage contract in the Paracel Islands as a relevant operation of
WDC, rather than on the making of the initial telephone agreement regarding the
rescue operation:
Had that contract not been entered into there is no question that there would
have been no profits to assess. And, in my opinion, this salvage contract is
something totally distinct from and independent of the Telephone Contract.
89

The salvage operations were partly rendered in Hong Kong. The equipment and craft
used under the salvage, apart from ground anchors, were employed principally in
connection with the business of ship-repairers. Reece J considered the question of
apportionment and he cited a passage from the judgment of Dixon J in Hillsdon Watts
(1936),
90
an Australian case:
91

when a single profit is recovered as a result of operations which extend beyond
the political boundary of the taxing State, the profit must be considered as
arising on one side of the boundary rather than another. If it is possible to

87
Ibid 178.
88
F L Smidth & Co v F Greenwood (Surveyor of Taxes) (1922) 8 TC 193.
89
Ibid.
90
91
It is argued that Hong Kongs tax law is often looked upon as being very similar to that of Australia,
as both jurisdictions tend to follow similar case law. As a matter of practice, Australian case law is
more often than not accepted in Hong Kong. See Robert Richards, Recent Hong Kong Decisions Are
They Relevant in Australia? (14 February 1995) Butterworths Weekly Tax Bulletin 82, 82.
171
ascertain how much of the profit is obtained although in an unrealized form at
successive stages of the operations, the sum realized may be dissected and
separate parts of it attributed accordingly to the places where the respective
stages of the operations are completed. If this cannot be done and the total
profit recovered is an inseparable whole obtained as the indiscriminate result of
the entirety of the operations, the locality where it arises must be determined
by considerations which fasten upon the acts more immediately responsible for
the receipt of the profit.
92

Based upon the principle enunciated by Dixon J in Hillsdon Watts, Reece J took the
view that in the circumstance where the profit was derived from more than one
location:
the locality where it arises must be determined by considerations which fasten
upon the acts more immediately responsible for the receipt of the profit
(emphasis in original).
93

The critical factor was the place where the services were performed. Hence, the
profits must be said to arise outside of Hong Kong rather than inside, notwithstanding
WDCs infrastructure was in Hong Kong.
94

The Dock case established the operations test in Hong Kong. Profits arise, with
respect to any company, from the relevant operations and not just as a result of its
carrying on business in a particular place. The operations to be considered must be the
particular operations responsible for the earning of the particular profits in question.
95

The Dock case was subsequently used by the Commissioner of Taxation, the Boards of
Review, and perhaps to a lesser extent, the professions and the Hong Kong courts as
a cure-all for source of income problems until 1990.
96

92
The Hong Kong & Whampoa Dock Co Ltd (No 2) v Commissioner of Inland Revenue [1960] HKLR
166, 193.
93
Ibid 194.
94
Ibid.
95
J efferson VanderWolk, The Source of Income: Tax Law and Practice in Hong Kong (3
rd
ed, 2002) 29.
96
Ahern, above n 34, 29. See, also, the Hang Seng Bank case discussed below.
172
The source issue arose again in 1971 in the International Wood Products (IWP)
case.
97
International Wood Products (IWP), a Hong Kong company, acted as agent
for two companies in the Philippines for the sale of timber logs obtained from a group
company. The question in dispute was the source of the commission income. Where
did the operations take place from which the commission income arose?

The court was of the view that the facts in Karsten Larssen differed materially from
those in the IWP case. In Karsten Larssen, there was no evidence that the work was
done outside Hong Kong. The ship-brokers in the out-ports had no authority to
execute charter parties without authority from the Hong Kong company. In the IWP
case, there was no evidence that any work was done in Hong Kong. The documents
were executed in the Philippines. The sub-agents and the vendor companies in the
Philippines were in direct communication in regard to every single contract of sale.

The court emphasised the place of conclusion of the contracts made by the sub-agents
and did not take into consideration the place of appointment of the sub-agents, which
may or may not have been dealt with outside Hong Kong.
98
It was the sub-agents that
built up the volume of business. The sub-agents were given complete authority to
solicit and obtain orders, negotiate the purchase prices and make the shipping
arrangements. IWP merely received from its principals in Manila a monthly statement
of the commission due under the agency agreements and a copy of the invoices.
Therefore, the profits arose from the operations by the sub-agents which took place
outside Hong Kong.

97
Commissioner of Inland Revenue v International Wood Products Ltd (1971) 1 HKTC 551.
98
Ibid 569.
173
The Sinolink case

The approach of focusing on specific operations came to an end with the decision of
the Sinolink case
99
by the Hong Kong High Court in 1985. Sinolink Overseas Ltd
(Sinolink) was incorporated in Hong Kong and carried on business as an importer
and exporter of plywood mainly to China. It had no office other than in Hong Kong.
Sales were negotiated outside Hong Kong by sales personnel despatched from Hong
Kong. Upon conclusion of a contract, they would return to Hong Kong to arrange for
supplies either from local sources or by contacting prospective suppliers overseas.

The question was the source of profits and whether the company was carrying on two
businesses, one domestic and one offshore. The court did not use the contract
conclusion test, but held that the proper test to be applied in the construction of s 14 of
the IRO 1947 was where do the operations take place from which the profits in
substance arise as laid down in Smidth v Greenwood. The companys operations had
to be identified and located, and the court identified the various activities that
collectively produced the profits in question:
(1) pre-contract preparation and management;
(2) the making of contracts of purchase;
(3) the making of contracts of sale; and
(4) post-contract performance and management.
100

The court said that heads (2), (3) and (4) spoke for themselves. The pre-contract
preparation (head 1) was equally important but hardly noticed. Profits could never

99
Sinolink Overseas Co Ltd v Commissioner of Inland Revenue [1985] HKLR 431.
100
Ibid 435-6.
174
have been earned unless some mechanisms for the pre-contract management of the
terms discussed with both buyers and sellers existed. This vital function could only be
controlled and conducted from and through the companys administrative centre in
Hong Kong. In addition, Hong Kongs location, its shipping, communications and
banking systems explained why the company was incorporated in Hong Kong. As
only activity (3) was found to be located in China, the activities which collectively
produced the profits were mostly located in Hong Kong. It was concluded that the
company carried on one business in Hong Kong and profits arose from such
business.
101

The court did not identify exactly what were the essential elements of the profits or ask
where the results of the trading transactions came into existence.
102
The court focused
on the place where the day-to-day operations of the business was managed and
controlled. For offshore traders with no PE outside Hong Kong, the profits must be
derived from what they do in Hong Kong. This approach was a departure from the
line of reasoning in the previous cases.

The Hang Seng Bank case

The Hang Seng Bank case (1990)
103
was the first case decided by the Privy Council on
the question of source. Hang Seng Bank Ltd (HSB) was a financial institution based
in Hong Kong with no offshore operations. The profits in question were made from

101
It is argued the real weakness of the Sinolink case is in the analysis of what acts were more
immediately responsible for the derivation of the profits. Each of the four separate activities was
equally responsible, but the court focussed upon the place where the business was managed and
controlled. No profits would arise or be derived without the contracts of sale the contracts to exploit
what the taxpayer has acquired. See Ahern, above n 34, 31; Andrew Halkyard, The Privy Councils
Hong Kong Tax Legacy [1998] British Tax Review 32, 47.
102
This approach also looks to have taken aspects of common tests for a companys residence
(management and control) and transplanted this into reasoning about the quite separate issue of source.
103
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044.
175
the purchase and resale of certificates of deposit
104
on the London and Singapore
Stock Exchanges (from funds raised from the banks customers in Hong Kong)
through agents acting on instructions issued by HSB. The question was whether the
profits earned through the purchase and resale of certificates of deposit outside Hong
Kong were profits arising in or derived from Hong Kong on the true construction of
that phrase in s 14 of the IRO 1947.
105

As HSBs operations were in Hong Kong only, it was argued by the Commissioner
that all of its profits must have arisen in Hong Kong. The Privy Council, however,
stressed a number of principles on which it based its decision on the locality of profits.
Profits arising from a business carried on in Hong Kong may accrue from different
sources, some located within Hong Kong and others located overseas. That is, a Hong
Kong business could have offshore income without having a PE overseas. A
distinction between Hong Kong profits and offshore profits must be made according to
the nature of the different transactions by which the profits are generated. When
deciding where profits have their source, the broad guiding principle is that one looks
to see what the taxpayer has done to earn the profit in question.
106
The approach is to
look at the individual profit-generating transactions rather than operations, and
apportion the profit where necessary:
There may, of course, be cases where the gross profits deriving from an

104
Certificates of deposit are issued by prime banks agreeing to repay a fixed sum of money on a fixed
date at a fixed rate of interest. Unlike fixed deposits, certificates of deposits are readily marketable at
any time before maturity at a price which will fully reflect the anticipation of the interest element
accrued up to the date of sale. See Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990)
1 HKRC 90-044, 100,419.
105
Had the certificates of deposit been allowed to mature, Hang Seng Bank would be subject to profits
tax on the interest received under s 15(1)(i) of the IRO 1947, which charged financial institutions to
Hong Kong profits tax on offshore interest. But profits from the sale of the certificates of deposits could
not be regarded as interest and therefore s 14, the general charging section, was held to govern the
taxability of the income from the sale of the certificates. See Denis ODwyer, Hong Kong: Source of
Profits (II) Where Do Profits Arise: A Commentary (1992) 10 APTIRC 515, 515.
106
Ibid 100,422.
176
individual transaction will have arisen in or derived from different places.
Thus, for example, goods sold outside Hong Kong may have been subject to
manufacturing and finishing processes which took place partly in Hong Kong
and partly overseas. In such a case the absence of a specific provision for
apportionment in the Ordinance would not obviate the necessity to apportion
the gross profit on sale as having arisen partly in Hong Kong and partly outside
Hong Kong.
107

Though the funds used to finance the transactions were raised from Hong Kong, the
crucial factor was the place the contracts of purchase and sale were effected.
108
The
offshore agents acted on instructions from officers of HSB in Hong Kong to buy and
sell the securities in London and Singapore. Therefore, the profits arose from the
buying and selling of securities overseas, and did not have a source in Hong Kong.

It is clear from the decision that:
one does not apply a management and control test to determine source; and
the absence of a PE overseas does not, of itself, mean that all of the profits of a
Hong Kong business arise in or are derived from Hong Kong.
109

The Hang Seng Bank case affirmed that no simple, single, legal test can be employed
in determining the source of income.
110

Post Hang Seng Bank cases

The HK-TVBI case (1992)
111
concerned the source of royalty income from the rights to

107
Ibid 100,423.
108
Lord Bridge did not clarify whether the word effected meant made or carried out or both.
109
Richard Cullen, Hong Kong Revenue Law The Present, 1997, and Beyond (1993) 7 Tax Notes
110
To close the loophole left open by s 15(1)(i), the IRO 1947 was subsequently amended by the
introduction of a specific charging section for income from the sale of certificates of deposit. In the
case of a financial institution, s 15(1)(l) provides that profits or gains from the sale or disposal or
redemption of a certificate of deposit will be taxable regardless of the source, provided the profits or
gains arise through or from the carrying on of a financial institutions business in Hong Kong.
177
use tapes and films licensed outside Hong Kong. The group holding company, HK-TVB
Ltd (TVB), assigned various film rights to its subsidiary company, HK-TVB
International Ltd (HK-TVBI), to:
broadcast films and programs in Chinese dialect produced by TVB; and
copy duplicates from the master film onto video cassettes.

The issue was whether the profits obtained by HK-TVBI from its sub-licensing
operations based outside Hong Kong were liable to tax in Hong Kong. Applying the
broad guiding principle laid down in the Hang Seng Bank decision, the first question
to be determined was: what were the transactions which produced HK-TVBIs
profits?
112
Those transactions were, it was found:
the acquisition of the exclusive rights of granting sub-licences together with the
relevant films; and
the granting of those sub-licences together with provision of the film by contracts
with individual customers.
113

The exercise of intellectual property rights cannot be compared to the exploitation of
immovable property, the court said. The fact that these property rights were exploited
in jurisdictions other than Hong Kong did not mean that profits arose from the
exploitation of property outside Hong Kong. The relevant business of HK-TVBI was
the granting of the sub-licenses and that took place in Hong Kong. The proper
approach was to ascertain what were the operations which produced the relevant

111
Commissioner of Inland Revenue v HK-TVB International Limited (1992) 1 HKRC 90-064.
112
Commissioner of Inland Revenue v HK-TVB International Limited (1992) 1 HKRC 90-064,
100,540.
113
Ibid 100,540.
178
profits and where those operations took place.
114

The Privy Council drew a parallel with a Hong Kong manufacturer who sold his goods
outside Hong Kong. The source of profits arose from the manufacturing operation in
Hong Kong and not the place where payment was made:
If a manufacturer in Hong Kong sells his goods to a merchant in Manila the
payment which he receives is no doubt sourced in Manila but his profit on the
transaction arises in and is derived from his manufacturing operation in Hong
Kong.
115

The Privy Councils analysis was that once there was a business in Hong Kong, it
followed that in nearly every case the source of profits would also be in Hong Kong.
This appears to be contrary to the Hang Seng Bank decision where the Privy Council
stated that:
the structure of the section presupposes that the profits of a business carried on
in Hong Kong may accrue from different sources, some located within Hong
Kong, others overseas. The former are taxable, the latter are not.
116

Section 14 requires the three tests of source of profits to be considered separately. To
do otherwise would be otiose since it would be sufficient to show that profits were
earned by a business carried on in Hong Kong to make them taxable.
117
The Hang
Seng Bank decision made it clear that a Hong Kong business without an overseas PE
could have offshore income. The decision in the HK-TVBI case clearly implies that
the source of profits of a Hong Kong business without a PE overseas could not be
offshore. The Privy Council ignored the fact that the source of profits is not
necessarily in the location of the business (for example, profits can arise from the

114
Ibid 100,542.
115
Ibid 100,543.
116
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044, 100,419.
117
Ibid.
179
activities carried out by independent agents overseas).
118
Perhaps the outcome would
have been different if the contracts were prepared and concluded outside Hong Kong
by an independent agent. The reasoning in the HK-TVBI case continues to be a matter
of debate in Hong Kong.
119

The question of the source of commission income arose again in Wardley (1993).
120

Wardley Investment Services (Hong Kong) Ltd (WIS) was an investment adviser
engaged under contracts with its customers in the management of their investment
portfolios, and was entitled to receive rebates of commissions it obtained from brokers
in the buying and selling of shares on behalf of the customers. The entire operation,
organisation and facilities of WIS were situated in Hong Kong. The issue was the
source of the rebates received by WIS, paid by the overseas brokers in relation to the
overseas transactions.

The Court of Appeal emphasised the importance of the profit-producing activities of
WIS, as opposed to the overall operations giving rise to the profit. In the Court of
Appeals view, WIS had done nothing outside Hong Kong to earn the relevant profits:
The taxpayer while carrying on business in Hong Kong, instructed the
overseas broker from Hong Kong to execute a particular transaction. The
Taxpayer was carrying out its contractual duties to its client and performing
services under the management agreement in Hong Kong and in return
receiving the management fee as well as the additional remuneration as

118
It is argued that decisions from other Commonwealth jurisdictions indicate that the location of
intellectual property rights being exploited is highly relevant in determining the source of royalty
income. However, the Privy Council in the HK-TVBI case appears to have highlighted where the
companys business was carried on. See Halkyard, Source of Profits Rules in Hong Kong Analysis of
a Troublingly Successful System, above n 72, 459.
119
As a matter of practice, the HK-TVBI case has mainly been confined to its own facts. That is, the
apparent flaws in the reasoning have meant that it has not had a wide impact on different source fact
situations. See Denis ODwyer, above n 105, 515; J efferson P VanderWolk, Hong Kong: The Privy
Council Wanders in the Wilderness (1993) 47 Bulletin for International Fiscal Documentation 33;
Willoughby, Source of Profits: Controversy, Confusion and Now Fallacies, above n 61, 40.
120
Wardley Investment Services (Hong Kong) Ltd v Commissioner of Inland Revenue (1993) 1 HKRC
90-068.
180
manager to which it was entitled under that agreement the Taxpayer did
nothing abroad to earn the profit sought to be taxed. The Taxpayer would be
acting in precisely the same manner, and in the same place, to earn its profit,
whether it was giving instructions, in pursuance of a management contract, to a
broker in Hong Kong or to one overseas.
121

The Court of Appeal disregarded the acts of the foreign brokers involved in the
transactions and held that the source of the profits was the management contracts with
the customers that were clearly made in Hong Kong.

The all-in-all-out basis of determining tax liability was used until the Indosuez case
(2002),
122
where the court explicitly endorsed the apportionment concept. The facts of
the Indosuez case were similar to Wardley, but the approach was totally different.
Indosuez was a Hong Kong company and a member of an international stockbroking
group with subsidiaries and offices at various places including New York, London,
Singapore, Indonesia, Taiwan, Thailand and J apan. The tasks of liaising with clients,
processing, handling and managing the overseas orders were performed by the groups
overseas offices. Indosuez derived income from brokerage commission both in
respect of the Hong Kong market and the overseas markets. The issue was the source
of commission income derived by Indosuez in respect of orders executed in the
overseas markets for its Hong Kong and overseas clients.

On appeal to the Court of First Instance (CFI), the court held it was appropriate to
apportion profits between that arising in Hong Kong and that arising outside Hong
Kong because there was no specific statutory provision that preclude income from
apportionment. Longley J relied on the dictum of Lord Bridge in the Hang Seng Bank

121
Ibid 100,602.
122
Commissioner of Inland Revenue v Indosuez W I Carr Securities Ltd; Indosuez W I Carr Securities
Ltd v Commissioner of Inland Revenue (2002) HKRC 90-117.
181
case in approving the apportionment concept for multi-source profits (that is, profits
derived partially from outside Hong Kong and partially from within). Longley J did
not mention the weighing of the onshore and offshore portion, but remitted the case
back to the Board of Review for reconsideration.
123
It now appears that apportionment
of profits is to be permitted, but the decision did not provide guidance as to what is a
multi-source case and how profits should be apportioned in such a case.
124

The Hong Kong Inland Revenue Department does not consider that apportionment of
profits will have a wide application.
125
Profits are generally taxed on an all-in-all-
out basis except for certain manufacturing and commission income where activities
take place partly in and partly outside Hong Kong.
126
Where apportionment is
appropriate, the vast majority of cases will be dealt with on a 50:50 basis according to
the official view.
127
It is argued that this restrictive approach of determining tax
liability fails to take into account the extent and value of profit-earning activities
performed in Hong Kong, and is incompatible with todays increasingly seamless and

123
The Indosuez case has not been finalised. When the case was remitted to the Board of Review for
reconsideration, the Board remained of the view that the source of profits generated from orders from
overseas clients on overseas markets arose substantially offshore. But the profits derived from
commissions generated from orders from Hong Kong clients on overseas markets were to be
apportioned 50 per cent onshore and 50 per cent offshore. See Inland Revenue Board of Review
Decision Case No D79/03 (2003).
The Commissioner disagreed with the decision and requested to state a case, but the request was
rejected by the Board. The Commissioner then applied to the CFI for judicial review against the
Boards refusal to state a case, and her application was successful. See Commissioner of Inland
Revenue v Board of Review & Another [2006] 2 HKLRD 26.
The taxpayer, however, has further appealed to the Court of Appeal. By a judgment issued on
27 April 2007, the taxpayers appeal was dismissed. See Commissioner of Inland Revenue v Board of
Review and Indosuez W I Carr Securities Ltd [2007] CACV 57/2006 (Unreported, Court of Appeal,
Rogers VP, Le Pichon JA, Sakhrani J , 27 April 2007)
<http://legalref.judiciary.gov.hk/doc/judg/word/vetted/other/en/2006/CACV000057_2006.doc> at
5 May 2008.
The taxpayer has now appealed to the Court of Final Appeal, but the date of hearing has not yet
been scheduled. See Hong Kong, Inland Revenue Department, Status of Tax Cases as at 31 March
2008 (revised 15 April 2008) <http://www.ird.gov.hk/eng/tax/stc.htm>at 27 April 2008.
124
Halkyard, Source of Profits Its Time (For Change), above n 77, 436.
125
DIPN 21, above n 74, [22].
126
Ibid [13]-[19], [28].
127
Ibid [22].
182
sophisticated cross-border business operations.
128
It has been argued that Hong Kong
should perhaps consider using the arms length principle of transfer pricing to reflect
the true value of the functions performed in Hong Kong and elsewhere and allocate
profits appropriately.
129

The Kwong Mile case (2004)
130
concerned profits arising from the sale of property in
Guangzhou, China. Kwong Mile Services Ltd (KMS), a Hong Kong company,
intended to make a profit from the development of a building in Guangzhou. Instead
of directly buying and later selling the building for a profit, KMS chose to underwrite
the sale of units in the building for a guaranteed minimum sum. If the sale of the units
in the building was less than the guaranteed minimum sum, KMS would pay the
relevant shortfall to the developer as well as take up the unsold units. If the sale of
units exceeded the guaranteed minimum sum, KMS would be entitled to any excess
amount representing the payment for the over-quota units. The underwriting
contract was entered between KMS and the developer in Guangzhou. Advertising was
done by KMSs agent in Hong Kong, including the negotiation and conclusion of sales.
The purchasers first had to sign a pre-contract provisional agreement in Hong Kong,
and then a pre-contract formal agreement with the developer in Guangzhou. KMS
was not a party to these agreements.

The issue was whether profits accrued from a Hong Kong source. As there is no
universal test to determine the source of profits, the Court of Final Appeal (CFA),
relying on the guiding principles of the Hang Seng Bank and HK-TVBI cases,

128
Halkyard, Source of Profits Rules in Hong Kong Analysis of a Troublingly Successful System,
above n 72, 460.
129
Ibid.
130
Kwong Mile Services Ltd v Commissioner of Inland Revenue [2004] 3 HKLRD 168.
183
emphasised the need to grasp the reality of each case, focusing on effective causes
without being distracted by antecedent or incidental matters.
131
Turning to what the
taxpayer had done to earn the profits and where it had done it, it was the underwriting
arrangement, the court said, which was of an unusual nature.
132

The fact that the building was situated in Guangzhou was not the determinative factor.
The profits in question resulted from the taxpayers exertions in the form of its
activities in marketing, and those activities took place in Hong Kong.
133
Clearly, the
profits were subject to profits tax in Hong Kong.

The CFA made a distinction between an owner and a non-owner of property which
can be highly relevant to what the taxpayer has to do to earn his profits:
Where the exploitation or participation in the exploitation of property
particularly immovable property is concerned an owner would at least in
general be better placed than a non-owner to earn profits with relatively little
exertion. An owners relative passivity could provide considerable support for
the conclusion that his profit was earned in the place where the property was
situate even though what he did, such as it was, had been done elsewhere.
Conversely, a non-owners relatively high degree of activity could provide
considerable support for the conclusion that his profit was earned in the place
where he had been highly active even if that is not where the property was
situate.
134

This case illustrates the difficulty in proving that profits do not arise in or derive from
a Hong Kong business, notwithstanding the property in question was located outside
Hong Kong. One could take the view that the decision is not consistent with the
guidelines provided by the Commissioner of Inland Revenue which state that profits

131
Ibid 175.
132
Ibid 183.
133
Ibid.
134
Ibid 182.
184
from the sale of real estate arise from where the property is located, although in this
case profits arose indirectly from the sale of the real estate.
135

There are two recent cases on the question of source of profits which show that
resolving matters of fact can be decisive and complex: Kim Eng Securities
(2007)
136
and ING Baring Securities (2008).
137
Each case involved profits derived by
Hong Kong stockbrokers earning brokerage commission and other income for orders
placed outside Hong Kong, but, in each case, the CFA arrived at a different
conclusion.
138

Kim Eng Securities (Hong Kong) Ltd (KESHK) was a company incorporated in
Hong Kong. To provide a more competitive service for clients, KESHK was
interposed between a group company in Singapore and overseas clients for trades on
the Singapore Stock Exchange. This was done for the purpose of circumventing
certain restrictions prescribed by the Singapore Stock Exchange so as to allow the
Singapore company to charge 50 per cent of the minimum commission that it would
otherwise have to charge if it dealt with the clients directly.

The CFA dismissed the taxpayers appeal. The CFA rejected the argument that
KESHKs presence and activities in Hong Kong went only to the existence and
operation of a Hong Kong business. Based on the finding by the Board of Review that

135
See Hong Kong, Inland Revenue Department, DIPN 21, above n 74, [20].
136
Kim Eng Securities (Hong Kong) Ltd v Commissioner of Inland Revenue [2007] 2 HKLRD 117.
137
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD 412.
138
Although both cases were heard by the same permanent judges, the two panels consisted of different
non-permanent judges. Kim Eng Securities was heard before Bokhary, Chan and Ribeiro PJ J , Mortimer
and Lord Scott of Foscott NPJ J , and the leading judgment was delivered by Bokhary PJ on 29 March
2007. ING Baring was heard before Bokhary, Chan and Ribeiro PJ J , Nazareth and Lord Millett NPJ J ,
and the leading judgment was delivered by Ribeiro PJ on 5 October 2007.
185
the successful execution of the clients order on a foreign stock exchange preceded the
paperwork which made the client KESHKs client for that dealing, the CFA concluded
that it was the act of making the client KESHKs client outside Singapore that
freed the dealing from the minimum commission rates prescribed by the Singapore
Stock Exchange.
139
KESHK earned its commissions not from transactions in
Singapore which had already taken place, but from taking part in what Lord Scott NPJ
described as a dressing-up arrangement which was orchestrated and implemented in
Hong Kong.
140

ING Baring Securities was in the agency brokerage business that is, the
undertaking, on behalf of its own clients and those of its international group of
companies, of trading of securities listed in global stock markets. The issue was the
source of certain profits (brokerage commission, placement income and marketing
income) derived from the execution of trades in securities listed on the stock markets
outside Hong Kong by clients of the taxpayer or clients of the taxpayers group of
companies.

The CFA held that the Board of Review did not actually decide the issue of source, but
simply held that the taxpayer had not discharged its onus under s 68(4) of the IRO
1947 of proving that the determination appealed against was excessive or incorrect.
The CFA stated that, in a case like ING Baring Securities, source is determined by the
nature and site or location of the profit-producing transactions, and not the place where

139
Kim Eng Securities (Hong Kong) Ltd v Commissioner of Inland Revenue [2007] 2 HKLRD 117, 143.
140
Ibid 147.
186
the taxpayers business is administered or its commercial decisions taken.
141
This
finding by the CFA is consistent with the broad guiding principle laid down in the
Hang Seng Bank case in ascertaining the source of profits. This is that one looks to
see what the taxpayer has done to earn the profit in question, by reference to the nature
of the particular transaction in question. Even though the taxpayer was interposed
between the clients and the overseas agents who executed the trades on the overseas
stock exchanges, the profit-producing transaction was the successful execution of each
trade and the source of profits in question was determined by the location of the stock
exchange on which the trade was executed. The Kwong Mile case was cited in ING
Baring Securities, and the CFA re-emphasised the need to grasp the reality of each
case, focusing on establishing the geographic location of the taxpayers profit-
producing transactions themselves as distinct from activities antecedent or incidental
to those transactions.
142
Such antecedent activities would often be commercially
essential to the operations and profitability of the taxpayers business, but they do not
provide the legal test for ascertaining the geographic source of profits for the purposes
of s 14 of the IRO 1947.
143

The decisions in these two cases illustrate the complexities in determining the source
of income. In Kim Eng Securities, Bokhary PJ noted that the cornerstone of the
taxpayers argument was that it had executed the orders on the foreign stock
exchanges albeit through agents outside Hong Kong, so what it did to earn the net
commission or brokerage was done abroad.
144
For this argument, the taxpayer relied

141
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD 412,
[48].
142
Ibid [38].
143
Ibid.
144
Kim Eng Securities (Hong Kong) Ltd v Commissioner of Inland Revenue [2007] 2 HKLRD 117, 142.
187
on the notion that the acts of an agent are those of the principal. But the CFA did not
consider what the taxpayers overseas brokers had done because the CFA effectively
found that the overseas brokers were acting on behalf of the end-user clients, not the
taxpayer. ING Baring Securities established the source rule in respect of trading
profits or profits in the nature of brokerage to be the place where the trading
transaction is executed, whether carried out by the taxpayer or his agent. If those
transactions had not taken place, no profits of any description would have arisen. The
focus is upon the particular transaction which gives rise to the profit and what the
taxpayer has done to earn it. In this case, it seems that there was no possible third-
party (end-user) client(s) for whom the agent might truly be said to be acting. In
distinguishing the ING Baring Securities case from Kim Eng, the CFA stressed that the
critical feature of the Kim Eng case was that the taxpayers involvement took place
after the event.
145

5.4.1.3 Source of interest income

Interest received by or accrued to a person carrying on a trade, profession or business
in Hong Kong is chargeable to tax under profits tax. If a Hong Kong non-financial
institution makes funds available to an offshore borrower, the source of the interest
income is assumed to be the place where the loan money was made available to the
borrower (the provision of credit test).
146
Unfortunately there is a grey area in
relation to cases where interest income may arise partly from a business carried on in
Hong Kong and partly overseas. Schemes can be set up by using offshore subsidiaries

145
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD 412,
[139].
146
188
that are technically not financial institutions to make loans from outside Hong Kong of
funds raised originally in Hong Kong.
147

The Orion Carribean case (1997)
148
was one such tax arrangement set up for no
apparent reason other than tax avoidance.
149
Orion Caribbean Ltd (OCL) was set up
in the Cayman Islands to be the interposed entity between its Hong Kong parent
company, Orion Royal Pacific Ltd (ORPL), and the ultimate borrowers outside Hong
Kong. OCLs profits took two forms:
1 the net interest gained from the borrowing and lending of money; and
2 various fees which it received from participating in loan syndicates.

The Privy Council did not apply the provision of credit test in determining the source
of interest income, but used the (modified) operations test as laid down in the Hang
Seng Bank case because the case was not a simple type of loan transaction. If ORPL
lent its own money to a borrower in, say, New York, then, other things being equal,
the interest income on the loan would not have had its source in Hong Kong.
150
In the
case where a company had borrowed money before it was lent (like the commodities
which had to be bought before they could be resold), one has to look at what the
taxpayer did to earn the profits in question, and where he did it:
The borrowing and on-lending were carried on for OCL by ORPL, acting
for OCL on each side of the transaction. If one asks what OCL did to earn the
profits in question, and where OCL did it, the answer is that OCL allowed
itself to be interposed between ORPL and the ultimate borrowers.
151

147
Peter Willoughby, Hong Kong: Source of Interest Profits (1997) 25 World Tax Report 192, 192.
148
Commissioner of Inland Revenue v Orion Carribean Ltd (in vol liq) (1997) HKRC 90-089.
149
Willoughby, Hong Kong: Source of Interest Profits, above n 147, 192.
150
Commissioner of Inland Revenue v Orion Carribean Ltd (in vol liq) (1997) HKRC 90-089,
100,828.
151
Ibid.
189
It was held that OCL was used as a channel for loans of funds raised or provided by
ORPL in Hong Kong and passed through OCL to the ultimate borrowers under loan
agreements negotiated, approved and serviced by ORPL.
152
Consequently, the profits
of OCL including the net interest and the related participation fees arose from business
transacted in Hong Kong by ORPL on OCLs behalf.

The Orion Carribean case has stressed the need to consider all the relevant facts. The
Privy Council affirmed that the source of profits generally cannot be determined
simply by applying mechanical rules (for example, the source of interest income is
always located in the place where the money was lent) and that previous mechanistic
formulations of source rules must be applied in the context of more reasonable
approaches.
153
The provision of credit test is no longer appropriate to decide the
source of interest income in a fact situation such as this.

5.4.2 Australia

The word source is not defined in either the Income Tax Assessment Act 1936 (Cth)
(ITAA 1936) or the Income Tax Assessment Act 1997 (Cth). But the income tax
legislation contains some source rules that denote the character of the receipt of (and
attribute a source to) certain types of income. For example, s 6C of the ITAA 1936
provides that a royalty payment will have a source in Australia where it is paid or
credited to a non-resident by an Australian resident or the Australian PE of a non-
resident. It is the origin of a receipt in Australia that is relevant, not the source of such

152
Ibid.
153
Michael Olesnicky, 1997 Asia-Pacific Tax Update Hong Kong (1997) 15 Tax Notes International
2143, 2145.
190
income. Section 6(1) gives an extended definition of royalties with an Australian
source. Also, s 44(1)(b) deems an Australian source for dividends paid to a non-
resident shareholder out of profits derived by the company from sources in Australia.

The source of profits from the sale of goods depends on the common law source
rules.
154
Apportionment applies if an item of income is the product of commercial
activities occurring in a number of countries. The question is: How to attribute
appropriate proportions of this profit to the various activities in the different countries
as all of these activities may contribute to the profit (for example, the mining,
treatment and sale of ore from and into different countries, or borrowings by a
financial institution from a number of countries which are blended and re-loaned in
other countries)?
155
What are the dominant factors to be applied when determining the
source of profits from multiple sources?
156

154
Australia used to have source rules that related to the taxation of business carried on partly in and
partly out of Australia. The now repealed ss 38 to 43 of the ITAA 1936 allowed the Commissioner to
determine which parts of certain business income have their source in Australia. It was considered ss 38
to 43 ceased to perform the role in determining the source of profits with the enactment of transfer
pricing provisions of Div 13 of Pt III of the ITAA 1936. Sections 38 to 43 have now been repealed as
inoperative by the Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006 (Cth) (No 101,
2006).
Under the former s 25(2) of the ITAA 1936, interest (except interest paid outside Australia to a
non-resident on debentures issued outside Australia by a company or an eligible unit trust within the
meaning of s 128FA) on money secured by mortgage on any property in Australia was deemed to be
derived from a source in Australia.
155
Geoffrey Lehmann and Cynthia Coleman, Taxation Law in Australia (1989) 853.
156
There is no fixed rule of law on apportionment of profits. Whether an apportionment is called for
depends upon the facts of each particular case. In Commissioner of Taxation (N.S.W.) v Cam and Sons
Ltd (1936) 4 ATD 32, Jordan CJ identified the factors that are to be taken into consideration where
income was derived from multiple sources (at 34):
if the source of income consists substantially in the making of contracts, the place where the
contracts are made may be regarded as the only significant factor;
if both the making of contracts and then carrying them into effect are substantial elements, an
apportionment must be made; and
if the making of the contract is an insignificant factor, and the only substantial element is its
performance, the place of performance is the only relevant locus of the source.
See Part 5.4.2.1 below for a discussion of the basis of apportionment.
191
5.4.2.1 Source of manufacturing profits

The question of manufacturing income derived from multiple sources had been
considered in a number of cases.
157

In Kirks case (1900),
158
a company incorporated in Victoria carried on the business
of mining on leasehold lands at Broken Hill, New South Wales (NSW). A certain
portion of crude ore was sold in NSW, but the greater part was treated by the
companys concentrating plant at Broken Hill. The sales of the concentrates of the
company in NSW were either made in London or in Melbourne, Victoria that is, no
contracts for sale of concentrates were made in NSW. The issue before the Privy
Council was whether any part of the profits of the company were earned or produced
from sources in NSW.

The Privy Council considered that the residence of the company was wholly
immaterial because the real question was whether any part of the profits of the
company were earned or produced in NSW and this was a question of fact.
159
There
were four processes in the earning or production of the income, namely:
extracting ore from the soil;
manufacturing it into a merchantable product;
selling the product; and

157
Taxation by reference to source of income had long been a feature of fiscal legislation in Australia,
income being depicted as a flowing stream fed from identifiable sources (per Evatt J in Federal
Commissioner of Taxation v W Angliss and Company Pty Ltd (1931) 46 CLR 417, 441). The question
of the territorial source of income had been considered in a number of cases, in fact prior to the levying
of income tax by the Commonwealth. Due to the number of cases involved, only a number of them are
selected for discussion in this thesis.
158
Commissioner of Taxation v Kirk [1900] AC 588.
159
Ibid 591-2.
192
receiving the moneys arising from the sale.
160

The Privy Council said that all these processes were necessary stages which
terminated in money and the income was the money resulting less the expenses
attendant upon all the stages.
161
In Kirk, the Privy Council found that part of the
profits attributable to the first two processes was derived from sources in NSW,
notwithstanding that the finished products were sold exclusively outside NSW.
162
But
there was no finding as to how the income should be apportioned.

The Kirk case emphasises the fallacy of leaving out of sight the initial stages in the
production of income and fastening attention exclusively on the final stage.
163

The Kirk case was considered in Meeks case (1915).
164
A company incorporated in
England conducted its Australian business at Melbourne in Victoria, but the practical
operations of the company the mining, treating and smelting ore were carried out
at Broken Hill and Cockle Creek in NSW. By a contract made in London, the
company agreed to sell to another English company a large quantity of concentrates
produced from Broken Hill. Advance payments were made but no concentrates were
appropriated, set apart, or treated by the company for the purchaser. Later the original
contract was cancelled, but the company was entitled to retain all moneys paid in
advance under the contract, though no concentrates were ever delivered under the
contract.

160
Ibid 592.
161
Ibid.
162
Ibid.
163
Ibid 593.
164
Commissioner of Taxation (New South Wales) v Meeks (Public Officer of the Sulphide Corporation
Ltd) (1915) 19 CLR 568.
193

The question for determination was whether the money paid in advance was income
derived from a source in NSW. The taxpayer argued that the true source of income
was the agreement entered into and wholly performed outside of NSW. Griffith CJ of
the High Court was of the opinion that damages received as compensation for non-
performance of a business contract stand on the same footing as the profits for the loss
of which the damages are paid.
165
The source from which the income was derived
was the business undertaking mainly carried on in NSW, but the taxpayer could
establish a case for apportioning it.
166
Issacs J held that it was the essence of the
business being carried on, and not the place where the contract was made, that is the
dominant factor:
where a business is carried on of which contracts are the essence, then you
look to the place where those contracts are made. And, if antecedent
operations, whether manufacture, or purchase, or requests, are not part of the
essence of the business carried on, but preparatory only, then, however
necessary they may be to the very existence of the business, they are not part
of it, in the sense at all events required for income tax purposes.
167

It was held the advance payment should be treated as profits from the business of
mining and treating and smelting ore which was carried on mainly in New South
Wales, rather than from the contract. Although the principle of apportionment was
held to be applicable, again, no basis of apportionment was laid down.

The apportionment of income was discussed in Michell (1931).
168
It was held that, in
the absence of statutory rules, no fixed rule or formula of apportionment was possible,
and any apportionment must depend upon business judgment and experience applied

165
Ibid 580.
166
Ibid.
167
Ibid 588.
168
Michell v Federal Commissioner of Taxation (1931) 46 CLR 413.
194
to the facts of the particular case, the nature and character of the business, and the
mode in which it was actually carried on.
169
On the basis that the control of the
business resided in Australia and the bulk of the operations of the company was
carried on overseas, income of the company was apportioned in equal parts as between
Australia and places overseas.
170

The principle of apportionment was finally laid down by the High Court in Angliss
(1931).
171
In Angliss, an Australian company exported preserved meats which it
prepared in Australia to London, where they were sold at a profit (as there was no
market for such meats in Australia). The company also exported tallow a small
proportion of which was produced by the companys own operations and the
remainder bought by it in Australia. The contracts for the sale of the preserved meats
and tallow were made and performed in England, but the net proceeds of the
realisation of the commodities exported by the company were brought to Australia.
The question was the source of profits from the sale of the preserved meat and tallow
exported to London.

The court held that the particular legislation involved implied that a single business
may derive its profits from more than one source and that some of the sources may be
within and some outside Australia.
172
The amount of profit with an Australian source
depended on the value of the goods which existed in Australia, independently of the

169
Ibid 415.
170
Ibid 415-6.
171
Federal Commissioner of Taxation v W Angliss and Company Pty Ltd (1931) 46 CLR 417.
172
Ibid 434.
By the combined effect of the War-time Profits Tax Acts 1917-1918 and the Income Tax
Assessment Act 1915-1918, a tax was levied on all war-time profits arising in an accounting period from
sources in Australia. The War-time Profits Tax Assessment Act 1917-1918 imposed tax on the actual
profits arising in the accounting period from sources in Australia, while the subject matter of income
taxation under the Income Tax Assessment Act 1915-1918 was taxable income derived directly or
indirectly by every taxpayer from sources within Australia.
195
exterritorial operations of the taxpayer.
173
In order to ascertain the actual profit, it is
necessary to distinguish between the profits derived from each function of production
and distribution. In the case of preserved meats, the goods had no market in Australia.
The value at the time of export was not greater than the cost of the production.
Therefore, no profit whatever arose from sources within Australia. In the case of the
tallow for resale in England, it was bought by the taxpayer at the prevailing prices in
Australia and, thus, there was no Australian source profit. In the case of the tallow
which was produced by the companys own operations, the difference between the
cost of producing the tallow and the price it could be sold in Australia was an
Australian source profit.

The question of apportionment was again discussed in Hillsdon Watts (1936).
174
The
taxpayer company carried on the business of wholesale nurserymen and seedsmen in
Sydney that involved three classes of transactions:
Sale of Kentia palm seeds the seeds were grown on Lord Howe Island and were
brought to Sydney for disposal. The price was fixed annually by the Lord Howe
Island Board of Control. The taxpayer company purchased the seeds from the
Sydney office of the Lord Howe Island Board of Control wholly for sale abroad
as there was no wholesale market for the seeds in NSW.
Sale of nursery seeds and plants all seeds and plants were sold to buyers in other
states or in New Zealand or South Africa.
Sale of agricultural grass seeds the taxpayer company purchased the seeds from
merchants in Sydney exclusively for resale in the United States (US) under a
partnership agreement with a New York firm, profits being equally divided.

173
Ibid 435.
174
196

The question before the High Court was whether the whole or any part of three
different kinds of income derived by the taxpayer (from the production of plants and
seeds within NSW and their sale within and out of NSW) was income taxable as being
derived directly or indirectly from any source in NSW. In relation to the Kentia palm
seed, the court found that what was done in NSW plainly made some contribution to
the ultimate profit and therefore at least some portion of the profit actually made must
be regarded as income derived from a source in New South Wales.
175
It would be
inconsistent with the reasoning in Kirk to say that, because the contracts of sale were
made in foreign countries, the whole income was derived from sources in those
countries.
176
But some portion of the profits would have to be attributed to sources in
foreign countries as there would have been no income at all without the contracts of
sale made overseas.
177
The Commissioner must apportion the actual profit as best he
or she can so as to attribute a proper proportion of it to a source in NSW.
178
The same
reasoning applied to income derived from the second and third types of transactions,
and apportionment was required between sources in and out of NSW.

175
Ibid 45.
176
Ibid.
177
Ibid.
178
The court was of the opinion that the Commissioner should not estimate hypothetical profits at any
stage independently of the actual profit at the final stage. He should take the actual profit as his basis
and assign some portion of it to a source in NSW. No doubt, as a general rule, the treatment or packing
of goods in a particular manner increases the value of the goods so that a profit may have been made in
the treatment and packing (the profit being the difference between the cost of creating the added value
and the amount of the added value), the profit may be regarded as income derived in the place where
the treatment and packing take place. But this will not always be the case. If, for example, the goods
were ultimately sold at a loss and there is no profit in the final result, it would not be possible to treat
the taxpayer as having nevertheless derived income from the intermediate stage of packing or treating
the goods. Ibid 46.
197
5.4.2.2 Source of trading profits

A trading business depends for its profits or gains upon the sale of goods bought or
acquired for that purpose. The place where the whole profit of such a business is made
is that where the goods are sold, even though there may be a series of operations in
different jurisdictions that culminates in the sale of goods. The leading case is
D & W Murray (1929).
179
The company was incorporated in England and carried on
the business of wholesale softgoods warehousemen through branches in several states
of Australia. The head office in London bought and paid for the goods, and arranged
for export of the goods to the branches in Australia. Each branch was debited, and the
head office credited, with a charge of five per cent, upon the amount of the purchases
for the branch. The actual expenses incurred by the head office were calculated twice
a year. If the total amount of the charge of five per cent was greater than the expenses,
the difference would be credited to the Australian branches. The issue was the source
of the profits from selling goods in Australia. The company maintained that when the
net profit arising from the companys operations of buying goods in England and
selling them from its warehouse in Western Australia (WA) had been calculated,
they could not all be considered as earned or made in WA. Some part of such profits
was produced by the buying and other operations in England and therefore
attributable to a source outside WA.

The High Court held that the entire profits arising from selling goods by its WA
branch arose in WA because the wholesale business depended for its profits or gains
on the sale of softgoods bought or acquired for that purpose.
180
The court said that

179
Commissioner of Taxation of Western Australia v D & W Murray Ltd (1929) 42 CLR 332.
180
Ibid 345.
198
while buying goods was a necessary part of the business and skill and judgment in
buying essential to the successful or profitable conduct of the business, it did not
follow that in order to determine where the profits were made required inquiry into all
the causes which operated to produce them.
181
The court said that to attempt to
appraise the relative efficacy or potency of contributory factors, when and if
ascertained, and to distribute the profit accordingly among the localities to which the
factors have been assigned, was to lose sight of the true nature of the question, which
was not why, but where the profits were earned.
182

The court further said that the case was not one where operations in one place had
produced a merchantable commodity, or had given or added value to things, marketed
in another.
183
In such a case, value or wealth was produced or increased and was
contained in disposable assets that is, unrealised profits existed in the territory from
which they were transported for the purpose of sale.
184
Here, the business operations
conducted in England by the head office consisted only in buying, which neither gave
nor added value to the things which were purchased.
185
There were no unrealised
profits brought into existence, and contained in the goods when exported from
England.
186

However, the decisions in later cases Angliss (1931)
187
and Hillsdon Watts (1936)
188

(discussed above in Part 5.4.2.1) provide considerable support for the view that, at

181
Ibid 346.
182
Ibid.
183
Ibid.
184
Ibid 348.
185
Ibid.
186
Ibid.
187
Federal Commissioner of Taxation v W Angliss and Company Pty Ltd (1931) 46 CLR 417.
188
199
least in some circumstances, a part of any profit arises where the goods are sold.

5.4.2.3 Source of interest income

The source of interest income is not defined, and the general law is considered when
determining source.

Under a DTT, interest is deemed to have its source in the state in which the payer is
resident. The interest does not need to be actually paid to the non-resident to be
subject to tax. Subsection 128A(2) of the ITAA 1936 provides that an amount of
interest is deemed to have been paid if it is reinvested, accumulated, capitalized,
carried to any reserve, sinking fund or insurance fund however designated, or
otherwise dealt with on behalf of the other person or as the other person directs.
Where the interest is paid to a non-resident, the interest income is subject to
withholding tax and is excluded from assessable income by virtue of s 128D of the
ITAA 1936.
189
The amount subject to withholding depends on whether the recipient is
a resident of a country that has a DTT with Australia.

5.5 Source of income and tax avoidance

Hong Kong

It has been common practice in Hong Kong to maximise offshore profits by
establishing a two-company structure to conduct re-invoicing transactions to try and

189
Withholding does not apply to interest payments made to non-residents who carry on business
through a PE in Australia and the payments are effectively connected with that business. These
payments are taxable by assessment at normal rates of tax. In the case of interest payments made by a
temporary resident to a non-resident who does not carry on a business through a PE in Australia, the
amount is non-assessable non-exempt income by virtue of s 768-980 of the ITAA 1997. See footnote 2,
Chapter 4, on the meaning of temporary resident.
200
establish a source of income outside of Hong Kong. This involves the use of an
offshore company (typically incorporated in a tax haven) for the business operations
occurring outside Hong Kong and a Hong Kong company for administrative
support.
190
The offshore company then enters into a service agreement where the
Hong Kong company performs services for the offshore company for a fee (typically
cost plus a percentage of cost, say five per cent or ten per cent).
191
In this way, there is
no need to report the profits of the offshore company to the IRD provided the structure
is implemented carefully so that the offshore company does not conduct business in
Hong Kong.
192
The Hong Kong company receives orders from offshore buyers and
then forwards them back to the manufacturer. The goods are then sent to the buyer
without going through Hong Kong. It is likely that the IRD may claim that some or all
of the profits arise in Hong Kong if all operations are housed in a Hong Kong
company. There is no clear answer as to where a companys main business lies and
there are conflicting decisions.

Euro Tech (1995)
193
was a re-invoicing case and involved the source of trading
income. Euro Tech (Far East) Ltd (Euro Tech) was the Hong Kong subsidiary of a
UK company. Euro Tech purchased electronic and medical equipment from its parent
in the UK and other related companies offshore, and then sold this equipment to
independent distributors in Korea and Singapore. Euro Tech invoiced the Korean and
Singaporean purchasers from Hong Kong, collected moneys from Korea and
Singapore and paid moneys to the UK. It took no active part in the purchase and sale
of the equipment.

190
J efferson VanderWolk, Hong Kong (September 1997) International Tax Review 17, 17.
191
Ibid.
192
Ibid.
193
Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074.
201

The question was whether the profits made from sales to independent distributors
outside Hong Kong were liable to tax. The Hong Kong High Court looked at the
whole operations of the taxpayers business to identify the source of profits. It moved
away from the guiding principles derived from the Hang Seng Bank case that trading
profits arising from a business carried on in Hong Kong may accrue from different
sources, some located within Hong Kong and others located overseas. In Euro Tech,
orders were forwarded mechanically to a related offshore supplier, which then
dispatched goods direct to the purchaser. In the High Courts view, Euro Tech was
doing no more than bringing together the complementary needs of sellers and buyers,
and that took place in Hong Kong. Euro Tech was liable to pay profits tax in Hong
Kong as the profits arose from operations carried on in Hong Kong.

The judgment caused considerable concern and added to the confusion created by the
decision of the Privy Council in HK-TVBI that once there was a business in Hong
Kong, it followed that in nearly every case the profits would also be sourced in Hong
Kong. This meant that, for a company which has its principal place of business in
Hong Kong, it looked to be notably difficult to establish that its profits were earned
elsewhere even though the substantive dealing might appear to have been conducted
overseas.
194
On the other hand, it is obvious that the source of profit of a re-invoicing
arrangement is where the re-invoicing takes place.
195

The tax consequence of re-invoicing was clarified by the Court of Appeal in the

194
Hong Kong Puzzle on Reinvoicing Source (1995) 6(6) International Tax Review 5, 5.
195
Richards, above n 91, 84.
202
Magna case (1997).
196
Magna Industrial Co Ltd (Magna) was a Hong Kong
company. Its profits arose from the buying of goods manufactured overseas (from its
wholly-owned subsidiary in Hong Kong) and selling them overseas via a network of
independent contractors, known as export managers outside Hong Kong. The export
managers were responsible for finding suitable distributors, train and supervise them,
and promote the sale of the products. The issue was whether the profits arose outside
Hong Kong and therefore fell outside the charge to profits tax.

The Board of Review stated that, in the case of trading profit, the purchase and the sale
were the important factors, but not the only or the determinative factor.
197
In the
Boards view, Magnas selling activities through its agents were far more substantial
than Magnas purchasing activities it was the overseas distributors, who were
separate persons from Magna, which had concluded the sales on behalf of Magna
outside Hong Kong.
198
The Boards conclusion that the profits had arisen outside
Hong Kong and were not taxable was confirmed by the Court of Appeal.
199
Litton VP
approved the operations test adopted by the Board and stated:
Obviously the question where the goods were bought and sold is important.
But there are other questions: For example: How were the goods procured and
stored? How were the sales solicited? How were the orders processed? How
were the goods shipped? How was the financing arranged? How was payment
effected?

196
Commissioner of Inland Revenue v Magna Industrial Co Ltd (1997) HKRC 90-082.
197
Case E63 (1995) 1 HKRC 80-360, 92,031
198
Every trading transaction has a purchase and a sale. The Board rejected the statement made by the
Commissioner that any trader who either buys or sells in Hong Kong is liable to profits tax on any
resulting profit. In the Boards view, Magna was not simply a case of the buying and selling of
products. Magna purchased the products from its wholly owned subsidiary (A Ltd) in Hong Kong and
sold the products to overseas distributors by export managers which all took place outside Hong Kong.
The purchase of goods was not even a phone call away as a computer was able to handle the
automatic ordering of goods from A Ltd. Activities like invoicing, shipping, collecting payment were
ancillary and not the true source of the profit. Without the activities of the export managers there
would have been no sales, no purchases, no business and no profits. Export managers did everything
in their own territories outside of Hong Kong. Ibid 92,031 and 92,038.
199
Commissioner of Inland Revenue v Magna Industrial Co Ltd (1997) HKRC 90-082.
203
This was, in essence, the Board of Reviews approach. At para 7.23 of the
stated case the Board said:

This is a case of a trading profit and the purchase and the sale are the
important factors. We place on record that we have included in our
deliberations all of the relevant facts and not just the purchase and sale
of the products. Clearly everything must be weighed by a Board when
reaching its factual decision as to the true source of the profit. We must
look at the totality of the facts and find out what the Taxpayer did to
earn the profit.

No criticism can be made of this approach.
200

There were undoubtedly substantial activities taking place in Hong Kong, attributable
to Magna, without which the gross profits from the sales could not have been
earned.
201
However, this case has an exceptional feature:
the sales of essentially low-value products, in large numbers, were effected
overseas by a network of independent contractors, resident in their own
regions, who nevertheless had authority to bind the taxpayer to specific orders.
Stocks of the entire range of products were maintained by the distributors who,
as far as the taxpayer was concerned, were the buyers. Such features are rare,
and underpin the Boards conclusion.
202

The Magna decision establishes that it is possible for Hong Kong businesses to earn
tax-free profits from offshore sales.
203
Following the Magna decision, it became clear
that a wider approach, where the totality of facts is considered, is necessary to
determine the source of trading income. One cannot simply look at the purchase and
sale of the goods, but take into account all the relevant factors.

The approach of looking at all the facts was applied in the Consco case (2004).
204

Consco Trading Company Ltd (Consco) was a Hong Kong company and carried on

200
Ibid 100,768.
201
Ibid 100,770.
202
Ibid 100,772.
203
But the court pointed out that, as a matter of commonsense, it can only be in rare cases that a
taxpayer with a principal place of business in Hong Kong can earn profits which are not chargeable to
profits tax. Ibid 100,771.
204
Consco Trading Company Limited v Commissioner of Inland Revenue [2004] 2 HKLRD 818.
204
the business of trading in polysilicon. The raw materials were shipped directly from
the US to a subcontractor in Beijing for processing into finished products according to
the specific requirements of customers in the PRC or the US. Consco did not have any
overseas office or any other form of PE outside Hong Kong. Conscos role was quite
passive. It had no knowledge or experience in the business of polysilicon and had to
rely on a commission agent in the PRC who had absolute authority to negotiate,
conclude and execute contracts with suppliers and buyers on its behalf. The question
was whether profits from the purchase and sale of polysilicon arose in or were derived
from Hong Kong.

The Board of Review looked at the totality of the facts of the case, not just the place
the purchases and sales were effected, and identified five heads of activities.
205
The
Board concluded that a high preponderance of the profit-making activities was
completed in Hong Kong.
206
Consco effected payments and received trading
payments through its bank in Hong Kong. It entered into the processing agreements
with the Beijing subcontractor in Hong Kong. It also effected payment of the
processing fees to the Beijing subcontractor through its bank in Hong Kong. A crucial
factor considered by the Board related to the opening of letters of credit because, it

205
The five heads of activities were:
the pre-contract negotiations;
the making of contracts of purchase;
the making of contracts of sale;
the post-contract performance such as agreement for finance, preparation of shipping documents,
delivery of goods and effecting and receipts of payments; and
the making of processing agreements with the Beijing subcontractor and effecting payments of the
processing fees to that subcontractor.
See Hong Kong, Inland Revenue Board of Review Decision Case No D172/01 (2002) [86]
<http://www.info.gov.hk/bor/eng/pdf/dv17_first/d17201.pdf>at 30 November 2006.
206
Ibid [91].
205
was argued, the provision of securities for the necessary credit facilities was a vital
role in the profit-making process.
207

On appeal, the CFI held that the Board applied the proper legal principles by
considering all the circumstances and activities which generated the profits. The Court
held that there is no rule of law that the place where the contract of sale and purchase
is conclusive of the source of profits,
208
and that the Board was correct in holding the
profits arose in or were derived from Hong Kong because the provision of securities
for the necessary credit facilities was a vital role in the profit-making process:
Without the purchase which was made possible by the ready credit facilities
secured by the Taxpayer in Hong Kong, there could be no sale from which the
profits derived. Thus we find that the opening of letters of credit and placing
of orders by the Taxpayer in Hong Kong were relevant and crucial factors in
determining the source of profits in question.
209

The decision appears to be contrary to the Commissioners previously expressed view
that profits would not be taxable if the Hong Kong business merely engaged in
ancillary functions such as arranging letters of credit and did not accept or issue sale or
purchase orders in Hong Kong.
210

Due to the close economic relationship between Hong Kong and the PRC, businesses
are increasingly conducting their activities partly in Hong Kong and partly in the PRC.
The Consco case suggests that Hong Kong businesses may find it more difficult to
establish that trading profits have arisen outside of Hong Kong, if the totality of facts
test is used to determine the source of trading profits.

207
Ibid [89].
208
Consco Trading Co Ltd v Commissioner of Inland Revenue [2004] 2 HKLRD 818, [31].
209
Ibid [47].
210
206
Australia

Australias comprehensive coverage of all tax aspects of inbound and outbound
investment by Australian residents does reduce opportunities for source-based tax
planning, compared to Hong Kong. But the ease with which businesses may engage in
a diversity of international dealings and Australias comparatively high rate of tax
present a risk of increased erosion of the effectiveness of Australias income tax
system. The meaning of source and its application have, in fact, been frequently
considered by Australian courts.

In Thorpe Nominees (1988),
211
the taxpayer company, which acted as the trustee of a
discretionary trust, attempted to shift part of its income offshore to escape its tax
liability in Australia. The properties in question were two blocks of land in NSW
which had considerable development potential, owned by Collaroy Holdings Pty Ltd,
an Australian company. Collaroy Holdings granted Thorpe Nominees or its nominee
options to purchase the blocks of land for $189 000. Subsequently Thorpe Nominees
retired from the trust and a third Australian company, Vaucraft (No 10) Pty Ltd, was
appointed the trustee. Vaucraft then authorised its Swiss attorney to accept a written
offer from the fourth Australian company, Nawor Investments Pty Ltd, to purchase for
$410 000 the right to be nominated as the person to exercise the options to purchase
the two blocks of land.
212
The agreements for the sale of the nomination rights
between Vaucraft and Nawor were executed in Switzerland; but Nawor exercised the

211
Thorpe Nominees Pty Ltd v Federal Commissioner of Taxation (1988) 88 ATC 4886.
212
Should the plan succeed, the price received by the trustee from the sale of the nomination rights was
perceived as being a receipt from a source outside Australia, thus attracting no Australian income tax.
At that time, income derived by a resident from sources out of Australia was exempt income under the
then s 23(q) of the ITAA 1936, provided that there was a liability for tax in the country where that
income was derived.
207
options in Sydney, NSW. The moneys were paid and received in Australia. The
taxpayer and all other companies were related.

The question was whether the price received by the trustee from the sale of the
nomination rights was from sources within Australia or from Switzerland. On the
basis that the nomination rights in relation to the options took place in Switzerland, it
was the taxpayers view that the income received from the nomination would be from
sources from Switzerland. The Full Federal Court dismissed the taxpayers appeal.
Lockhart J acknowledged that:
the phrase practical, hard matter of fact embodies the notion that the
question must be decided in accordance with the practical realities of the
situation without giving undue weight to matters of form.
213

Lockhart J looked at the relevant events as a whole from the date of incorporation of
Thorpe Nominees to the exercise of the option and the subsequent receipt of the
moneys in question as it was unreal to sever the relevant events into occurrences in
Australia on the one hand and Switzerland on the other.
214
In searching for the real
source, Burchett J highlighted that the truth of the matter be sought with an eye
focused on practical business affairs, rather than on nice distinctions of the law,
because the word source had no precise or technical reference.
215
The Full Federal
Court found that the whole plan or scheme, involving the disposal of land situated in
Australia, had been devised in Australia by Australian residents for the purpose of
avoiding income tax.
216
The legal acts performed in Switzerland were ineffective in
themselves because they were taken on advice from Australian lawyers and were

213
Thorpe Nominees Pty Ltd v Federal Commissioner of Taxation (1988) 88 ATC 4886, 4893.
214
Ibid 4893-4.
215
Ibid 4897.
216
Ibid 4893.
208
plainly taken pursuant to a plan prearranged in Australia.
217
Thus, the real source of
income was Australia. It is argued this case is a particularly important one because the
court took a substance rather than a form approach in determining the source of the
income emphasis was placed on the activities of the relevant parties leading up to the
making of the nominations and the generation of the income.
218

Where the transaction is complex in terms of its background, its nature and its
execution, and where important aspects of the transaction have their origin in locations
in several different countries, determining the source is a matter of judgment and
assessment of the relative weight of all of the relevant surrounding circumstances.
219

The arrangements in Spotless Services (1993),
220
like the arrangements in Thorpe
Nominees, were designed to change the character of the receipt from assessable to
exempt income (to take advantage of the now repealed s 23(q) of the ITAA 1936 on
the basis that withholding tax had been paid on the interest in the Cook Islands). Two
Australian resident companies, Spotless Services Ltd and Spotless Finance Pty Ltd,
had surplus funds of $40 million as a result of a successful public flotation of shares.
They sought a suitable short-term investment in which to place their funds and
received an information memorandum and other documents from an investment
adviser concerning the investment of funds with the European Pacific Banking Co Ltd
(EPBCL), incorporated in the Cook Islands. A bank account was opened in
Singapore and another one in the Cook Islands. The funds were transferred from
Singapore to the Cook Islands bank account, and an attorney was appointed to draw a
cheque from the Cook Islands bank account in favour of EPBCL. EPBCL issued a

217
Ibid.
218
Magney, above n 71, 5.
219
Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775, 4791.
220
Spotless Services Ltd & Anor v Federal Commissioner of Taxation (1993) 93 ATC 4397.
209
certificate of deposit to the attorney, secured by a letter of credit issued by the
Singapore bank. On maturity, the attorney surrendered the certificate of deposit and
received back the $40 million (from the Cook Islands) together with interest less Cook
Islands withholding tax. The question was the source of interest income.

Lockhart J of the Federal Court cited a number of cases involving the determination on
the question of source. He acknowledged that:
What emerges from the authorities is plainly enough that the test to be applied
in determining the source of income for the purposes of the Act is to search for
the real source and to judge the question in a practical way.
221

He made the following comments:
The cases demonstrate that there is no universal or absolute rule which can be
applied to determine the source of income. It is a matter of judgment and
relative weight in each case to determine the various factors to be taken into
account in reaching the conclusion as to source of income. As Bowen CJ
said
the answer is not to be found in the cases, but in the weighing of the
relative importance of the various factors which the cases have shown
to be relevant.
222

In his opinion, the place where the relevant contract of loan was made from which the
income was derived was held to be of no particular significance because:
where the source of interest payable under a contract of loan lies at the heart
of the judicial inquiry the place or places where the contract was made and the
money lent are of considerable importance; but it goes too far to say that the
source of the interest in the present case is necessarily determined solely by
reference to the place where the contract of loan was made and the money in
fact lent.
223

Lockhart J considered the other factors. The borrower, EPBCL, was incorporated in
the Cook Islands and carried on business there. It did not carry on business in

221
Ibid 4409.
222
Ibid 4409-10.
223
Ibid 4410.
210
Australia. The deposit was repaid, together with interest, less withholding tax, from
the Cook Islands. A key issue was where the contract had been formed:
It is impossible to ignore the legal effect of the arrangements entered into by
the parties with respect to the lending of the money. Until the cheque for
$40m was handed over on 11 December in the Cook Islands (10 December CI
time) and the certificate of deposit received in return there was no contract
between the lender (the taxpayers) and the borrower (EPBCL). If EPBCL
failed to honour the certificate of deposit on the due date the taxpayers could
have sued on the certificate and there would have been no answer in law to
their right to judgment.
224

Accordingly, Lockhart J concluded that the source of interest income was the Cook
Islands.

On appeal to the Full Federal Court, the decision at first instance was, essentially,
confirmed.
225
It was held that the form and substance of the scheme ensured that the
source of the interest payment was the Cook Islands.
226
The crucial document was the
certificate of deposit which gave rise to rights vested in the taxpayers against EPBCL,
and it was only in default of that certificate being honoured that Spotless Services was
entitled to call on the letter of credit.
227

It is argued that the court should take a more realistic approach, as in Thorpe Nominees,
as nothing would have happened in the Cook Islands at all without activities (that is,
the dealings between the parties) undertaken in Australia.
228
In the Spotless Services
case, the question of source was not judged in a practical way, though the main
structural driver of this arrangement was to reduce assessable income in Australia.
229

224
Ibid 4411.
225
Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775, 4791.
226
Ibid.
227
Ibid.
228
Magney, above n 71, 13-14.
229
Ibid.
211

5.6 Nature of the current source issues

Hong Kong

Hong Kongs jurisdiction to tax business profits is based solely on the territorial
source of income. One policy driving this taxation principle has been the desire to
attract foreign companies to base and retain their business activities in Hong Kong. It
was recognised early in 1947 that Hong Kongs prosperity depended on the benefits
offered by its free port status and its use as a base for regional trade. Britain also
needed a trading enclave on the south coast of China to trade with the Chinese (under
British laws and British administration).
230
Hong Kong soon attracted traders from
around the world as well as Chinese from the Mainland to earn money in a free-trade
environment. It is convincingly argued that freedom from [high] taxation, confidence
in a good government and unrivalled port facilities have built up Hong Kong from a
fledgling trading port to an established international trade and financial centre with
state-of-the-art business and communications infrastructure and a skilled labour
force.
231

Hong Kongs economy has undergone a remarkable transformation since the original
income tax legislation was enacted in 1947. During the 1960s and 1970s, Hong
Kongs manufacturing sector grew rapidly due to an abundant supply of inexpensive
labour from the PRC. In the early 1980s, Hong Kong rapidly began to move its
manufacturing sector offshore to southern China to take advantage of the cheaper
land and labour costs offered when the PRC began opening its doors to outside

230
J efferson VanderWolk, Hong Kong: Source of Income and the 1997 Hand-over (1997) 3 Asia-
Pacific Tax Bulletin 43.
231
Sunny Choong, Hong Kongs Source Dichotomy (1995) 6(7) International Tax Review 37, 37.
212
investors. Hong Kong is now a centre for international banking and a service
headquarters for manufacturing, construction, media and other operations through Asia
and beyond. Given the international nature of businesses carried on in Hong Kong,
determining the source of profits has long been an area of uncertainty and results in
many disputes between the Commissioner of Inland Revenue and taxpayers. The
words arising in or derived from Hong Kong are still used in the IRO 1947 to
determine the locality of profits, despite the numerous cases considered by the courts
in Hong Kong and the Privy Council in the UK (before the return of sovereignty to
China) on that issue. In this sense, Hong Kongs tax system has failed to reflect the
changes that have occurred in the business and commercial environment since that tax
system was introduced some sixty years ago. The place where income is derived is not
necessarily identical with the place where business is carried on. The decisions of the
Privy Council and other Commonwealth courts on the source of profits reflect the
vexatious nature of the question in the modern world of telecommunications and
international business.
232
The problem has been described as follows:
At the time taxes on income were introduced, most sovereign jurisdictions
would have regarded themselves as having the clear right to levy taxes upon
those individuals, and later business entities, who derived benefit from
activities carried on within that jurisdiction. There would rarely have been any
dispute as to where a particular item of income or profit had arisen as a matter
of fact and which jurisdiction had the clear right of taxation. Source and
residence would usually have gone hand in hand. As, however, international
communications and money transfer systems have developed with growing
pace during this century, the original sharp distinctions have become blurred,
disputes have arisen as to where income or profits should properly be taxed
and many practical problems with taxation by source have emerged.
233

The difficulty is that the source of trading profits, in the majority of cases, must be
determined on an all-in-all-out basis, whereas profits can be derived from a series of

232
VanderWolk, The Source of Income: Tax Law and Practice in Hong Kong, above n 95, 100.
233
Stephen Edge, Taxation By Source or By Residence? in J acqueline Dyson (ed), Recent Tax
Problems: Current Legal Problems (1985) 75.
213
transactions, operations or activities carried out both in and outside Hong Kong.
Until the mid-1980s, profits derived from sales concluded outside Hong Kong to
offshore customers were not subject to profits tax. If sales contracts were negotiated
and executed outside Hong Kong, then in substance the profits arose offshore. The
fact that administrative activities took place in Hong Kong was irrelevant. The critical
issue at that time was what operations were relevant for the test:
A Hong Kong company would not be liable for profits tax if it were merely used
as a conduit for commission income. The mere fact that the company entered into
a contract in Hong Kong to derive income did not mean that the income had a
source in Hong Kong, provided all the work to generate the income was
performed outside Hong Kong by independent agents.
A Hong Kong company would not be liable for profits tax if both the profit-
generating activity and the signing of the contract were performed by staff
members outside Hong Kong.
A Hong Kong company would not be liable for profits tax if outside agents were
appointed to derive income, provided the agents were not acting on the principals
authority nor receive any assistance from the principal.
234

The decision of the Sinolink case
235
in 1985 took a different view. If a taxpayer did
not have any PE outside Hong Kong to which the profits could be attributed, the
profits arose in Hong Kong regardless of the level of activity carried out in Hong Kong.
The line of reasoning in Sinolink was overturned by the Privy Council in Hang Seng

234
Wallace Cameron, Hong Kong Corporation Profits Tax and Source of Income (1976) 5 Australian
Tax Review 113, 119-20.
235
Sinolink Overseas Co Ltd v Commissioner of Inland Revenue [1985] HKLR 431. The Sinolink case
is not authority for the necessity for the company to have an overseas PE before profits can be
considered offshore.
214
Bank in 1990.
236
Trading profits arise from the effecting of transactions (that is, the
purchase and sale of goods) and not from the general operations regarding the sale and
purchase of the goods. The Privy Council reaffirmed that a business in Hong Kong
can derive offshore profits and, therefore, the offshore profits would not be subject to
profits tax. The proper approach is to look at the individual profit-generating
transaction rather than the day-to-day operations in determining the locality of
profits. The Privy Council gave examples of its possible application in different
situations:
if a service is rendered or goods are manufactured, the profit arises from the place
where the service was rendered or the profit-making activity was carried on;
if the profit is earned by the exploitation of property assets, such as by letting
property or lending money, the profit arises where the property was let or where
the money was lent; and
if the profit is earned from dealing in commodities or securities by buying and
reselling them at a profit, the profit arises where the contracts of purchase and sale
were effected.
237

But the proper approach remains unclear. In the HK-TVBI case (1992),
238
the Privy
Council held that it could only be in rare cases that a taxpayer with a principal place of
business in Hong Kong could earn profits which were not chargeable to profits tax.
The fact that the exploitation of film rights were exercisable overseas was irrelevant in
that case as the court found that HK-TVBIs business operations were essentially in
Hong Kong. Clearly, the decisions of the Hang Seng Bank case and the HK-TVBI case

236
Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044.
237
Ibid 100,422-3.
238
Commissioner of Inland Revenue v HK-TVB International Limited (1992) 1 HKRC 90-064.
215
were not consistent. It is argued the two decisions of the Privy Council on the source
principle are difficult, if not impossible, to reconcile with each other.
239

Decisions in court cases regarding source are still in conflict. The Wardley decision
(1993),
240
involving the sharing of commissions earned by foreign brokers,
emphasised that the focus is on what the taxpayer has done, not what some other
person or entity has done. A different approach was taken in Indosuez (2002),
241
with
facts similar to Wardley, where the Court looked at what the taxpayers overseas
agents had done. In Kim Eng Securities (2007),
242
the Court did not consider what the
taxpayers overseas brokers had done because it was the clients who gave instructions
directly to the overseas brokers to execute the orders. The overseas brokers were
acting on behalf of the clients, not the taxpayer.
243
In ING Baring Securities (2007),
244

the CFA emphasised that, in considering the source of profits, it is not necessary for
the taxpayer to establish that the transaction which produced the profit was carried out
by him or his agent in the full legal sense.
245
It is sufficient that it was carried out on
his behalf and for his account by a person acting on his instructions.
246
Nor does it
matter whether the taxpayer was acting on his own account with a view to profit or for
the account of a client in return for a commission.
247
In one re-invoicing case, a
taxpayer was assessable to profits tax in spite of its low level of activities in Hong

239
VanderWolk, Hong Kong: Source of Income and the 1997 Hand-over, above n 230, 44.
Though commentators have argued that the Hang Seng Bank and HK-TVBI cases are in conflict,
the fact remains that the Privy Council did not think so.
240
Wardley Investment Services (Hong Kong) Ltd v Commissioner of Inland Revenue (1993) 1 HKRC
90-068.
241
Commissioner of Inland Revenue v Indosuez W I Carr Securities Ltd; Indosuez W I Carr Securities
Ltd v Commissioner of Inland Revenue (2002) HKRC 90-117.
242
Kim Eng Securities (Hong Kong) Ltd v Commissioner of Inland Revenue [2007] 2 HKLRD 117.
243
Ibid 145.
244
presently known as Macquarie Securities Ltd) v Commissioner of Inland Revenue [2008] 1 HKLRD
412.
245
Ibid [139].
246
Ibid.
247
Ibid.
216
Kong.
248
In another decision, a Hong Kong business was able to earn tax-free profits
from the trading activities of its wholly-owned subsidiary in Hong Kong because the
words profits arising in or derived from Hong Kong in s 14 of IRO 1947 have a
wide meaning and can accommodate a variety of situations in which it could not be
said to be wrong to arrive at a conclusion one way or the other.
249
The Court did not
look at the operations from which the profits in substance arose nor where the sales
and purchases were effected, but applied the totality of facts test to determine the
source of trading profit. This test was then applied in another case, and the uncommon
ancillary function of credit facilities was taken into account as the crucial factor in
determining the source of profits.
250

In the Orion Carribean case (1997),
251
the Privy Council applied the modified
operations test, rather than the provision of credit test, to an offshore company
carrying on money-lending business based in Hong Kong. In this case, the Privy
Council took a broad view of the facts. In the case of a loan of money, a distinction
has to be made between a situation where the taxpayer lends out its own funds and
where money has to be borrowed before it can be lent. The latter case is like the
commodities which have to be bought before they can be resold, and the source of
income is the place where the activities which resulted in the profits were undertaken.
The determination of the source of profits for Hong Kong tax purposes was already

248
See Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074,
discussed above in Part 5.5.
249
See Commissioner of Inland Revenue v Magna Industrial Company Ltd (1997) HKRC 90-082,
100,772, discussed above in Part 5.5.
250
See Consco Trading Co Ltd v Commissioner of Inland Revenue [2004] 2 HKLRD 818, discussed
above in Part 5.5.
251
Commissioner of Inland Revenue v Orion Carribean Ltd (in vol liq) (1997) HKRC 90-089.
217
problematic, it is argued, and the Orion Carribean decision will make it more so.
252

The case law interpretation of the words profits arising in or derived from Hong
Kong has not been consistent. It has been pointed out that an incorrectly-based court
decision (for example, the Euro Tech case (1995)
253
) can create confusion in the law
and threaten Hong Kongs position as an international trading centre:
Hong Kong claims to be the regional headquarters for some 670 multinational
groups. The dictum of Barnett J has already been faxed around the world
and has been received with very great concern. Already some may be
preparing to relocate. This is not only unfortunate for Hong Kong, it is also
entirely unnecessary if the decision in CIR v Hang Seng Bank is applied and
the inconsistencies of HK-TVB are acknowledged.
254

Hong Kong is the only developed economy in the world whose tax system is still so
fundamentally based on source, without considering the residence of the taxpayer. It
has been argued that Hong Kongs territorial system has been eroded:
it is fair to say that the tax system is not territorially limited at all. The written
tax laws, which limit the scope of Hong Kong profits tax and salaries tax to
income arising in Hong Kong, have become increasingly obscured by
decisions of the courts and practice directives issued by the Inland Revenue
Department which effectively extend the scope of the taxes to income arising
outside Hong Kong.
255

Hong Kong remains a favoured place for carrying on business in its own right,
particularly in the Asia-Pacific region.
256
The legal and political environment attracts
traders to carry on business in Hong Kong. By itself, Hong Kong has little in the way
of economic resources relative to the rest of Asia:
Its territory is tiny, it possesses no valuable natural resources, except for its

252
J efferson VanderWolk and Philip Brook, Hong Kongs Handover: The Privy Councils Last
(Unhelpful) Word on the Source of Profits (1997) 51 Bulletin for International Fiscal Documentation
356, 357.
253
Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074.
254
Willoughby, Source of Profits: Controversy, Confusion and Now Fallacies, above n 61, 43.
255
256
Choong, above n 231, 37.
218
harbour (but there are now many other commercial shipping ports in the area);
its population is relatively small; and it has no special strategic importance
from a military perspective. The only explanation for Hong Kongs
commercial success is the uniquely facilitative legal and political environment
of Hong Kong, in which traders have been able to carry on business with the
economically resource-rich neighbouring countries, notably China.
257

Operations in the past may have necessitated travel outside Hong Kong to solicit
orders, meet with clients and negotiate contracts.
258
Modern technology such as the
fax, electronic mail and teleconferencing has changed the way to conduct a business.
Physical acts by agents can be reduced or eliminated. Should the operations test be
expanded to look beyond services and activities performed under the contract to
activities leading up to the contract, it would be more likely to produce a source in
Hong Kong.
259
There must be activities (including decision making) by individuals
(that is, human beings) behind all initiations, negotiations and other activities leading
to the conclusion of a transaction.
260
It has been suggested that the source or origin of
income should be:
where the intellectual element (among the assets) is to be found. This
intellectual element is provided by activities of individual human beings.
Only individuals can create income; things in themselves cannot. The
allocation of tax jurisdiction on income based on the principle of origin,
however, should be restricted to a substantial income-producing activity in the
state concerned. Income-producing activity should be considered
substantial if this activity forms an essential and significant part of the
activity as a whole.
261

So when are profits sourced in Hong Kong? The question of source continues to be
the most significant contentious and fraught areas between the Commissioner of

257
258
Choong, above n 231, 40.
259
Ibid.
260
Magney, above n 71, 19.
261
International Fiscal Association, Abusive Application of International Tax Agreements (2001)
vol 25b, 74.
219
Inland Revenue and taxpayers.
262
Imposing tax on a territorial basis, rather than a
global one, leaves Hong Kong at a significant potential disadvantage, given today's
ever-increasing cross-border transactions, operations and activities.
263
It has been
stated that Hong Kongs retrograde tax system needs to adopt to the growing
sophistication of international trading and financial markets.
264
It has been suggested
that profits should not be determined on an all-in-all-out basis and perhaps should be
apportioned in calculating taxable profits in todays business climate.
265
The world is
changing Hong Kong must change with it.
266

Australia

Up to the 1980s, Australian businesses were largely focused on operations in Australia,
with a limited role in the ownership or management of foreign subsidiaries or
businesses.
267
Foreign-source income was exempt from Australian tax under the then
s 23(q) of the ITAA 1936 if some tax had been paid in a foreign jurisdiction. The
source of income could be planned to arise from a low-tax or no-tax jurisdiction.
268

An interposed entity based in a low-tax or no-tax jurisdiction could be used to

262
Halkyard, Source of Profits Its Time (For Change), above n 77, 428.
263
It is a question of debate whether Hong Kong should negotiate comprehensive DTTs with its major
trading partners to strengthen its international position. Virtually all DTTs prescribe the circumstances
in which one contracting state may tax the residents of the other contracting state. However, it is
argued the source-based tax regime, the low tax rates, zero withholding rates on dividends and interest,
and nominal withholding rates on royalties are considered sufficiently conducive to the mutual flows of
investments without a DTT. See Michael Olesnicky, Hong Kong: 2001 Year in Review (2001) 24
Tax Notes International 1400, 1400; Dick Rijntjes, Does Hong Kong Need Tax Treaties? (1997) 3
Asia-Pacific Tax Bulletin 34, 42.
264
Michael Olesnicky, Quo Vadis Hong Kongs Tax System? (1999) International Tax Review
Supplement 69.
265
Halkyard, Source of Profits Rules in Hong Kong Analysis of a Troublingly Successful System,
above n 72, 460.
266
Olesnicky, Quo Vadis Hong Kongs Tax System, above n 264, 69.
267
Commonwealth, Board of Taxation, International Taxation: A Report to the Treasurer (2003) vol 1,
9.
268
See Thorpe Nominees Pty Ltd v Federal Commissioner of Taxation (1988) 88 ATC 4886 and Federal
Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775 discussed above in Part
5.5.
220
accumulate income. No Australian tax would be due until a dividend was paid or a
distribution made to the Australian resident shareholder or beneficiary. This issue of
tax avoidance through offshore arrangements was addressed with the introduction of
the foreign tax credit system
269
in 1987 and the accruals legislation
270
in the 1990s.

As a trading nation, many cross-border dealings will give rise to assessable income
involving commercial transactions, operations and/or activities with elements both in
and outside Australia.
271
How much of the profits will be treated as having an
Australian source depends upon the source rules and/or the relevant DTT. To
maintain Australias status as an attractive place for business and investment and to
make Australian businesses more competitive internationally, a review of business
taxation was undertaken in 1999. The review found that Australia needs a tax system
which equips it for the coming decades that is, a tax system capable of dealing with a
changing world environment, changing technology and changing lifestyles as well as
raising revenue in an equitable and efficient manner.
272
Among the issues that need to
be reviewed were Australias source rules.
273
They have been criticised as lacking a
degree of certainty as they involve a mixture of general law, statutory source rules and

269
See footnote 43, Chapter 2, on the operation of Australias foreign tax credit system.
270
The accruals legislation focuses on residents with substantial investments or involvement in controlled
foreign companies (CFC) and foreign trusts. An offshore company will be treated as a CFC if it is
controlled by Australian residents, in which case the income of that company may be attributed back to
those Australian controllers. Australian controllers of foreign companies are required to pay tax on an
accruals basis on their share of certain tainted income of the company (mainly passive income and
income from related-party transactions) from foreign sources that have not been comparably taxed
offshore, even though the profits are not repatriated to Australia. Australian companies are
disadvantaged if they have investments in low-tax countries and are deriving tainted income. See Part
4.3.3, Chapter 4, on foreign-source income and the introduction of the accruals legislation in Australia.
271
Graeme S Cooper et al, Cooper, Krever & Vanns Income Taxation: Commentary and Materials (2
nd

ed, 1993) 20-48.
272
J ohn Theodore Ralph, Review of Business Taxation: A Tax System Redesigned: More Certain,
Equitable and Durable: Overview, Recommendations, Estimated Impacts (1999) 1 and 9.
273
Ibid 683-8.
221
DTTs.
274
This lack of clarity provides entities with opportunities to manipulate the
form of transactions and shift income and expenses from one country to another.
275
It
has been suggested that Australias source rules should be consolidated in the tax law,
and ideally should follow the underlying concept of economic connection with
Australia:
functions performed in Australia;
assets located or used in Australia; or
risks assumed in Australia.
276

The possible approaches to source rules are:
adopt a substance over form approach specifying the factors that should or
should not be taken into account such as:
where any assets that are the subject of, or used, in the transaction are located;
where significant activities or functions are undertaken by, or on behalf of, the
taxpayer;
which taxpayer or part of a business or activity assumes the financial risks;
whether payments are made from Australia; or
whether payments are tax deductible in Australia.
277

or
adopt a specific rule approach incorporating source rules in domestic law so that
transactions between Australia and both treaty and non-treaty countries are treated
on a uniform basis.
278

274
J ohn Theodore Ralph, Review of Business Taxation: A Platform for Consultation: Building on a
Strong Foundation (Discussion Paper 2, 1999) vol 2, 698.
275
Ibid 697.
276
Ralph, Review of Business Taxation: A Tax System Redesigned: More Certain, Equitable and
Durable, above n 272, 684.
277
See Ralph, Review of Business Taxation: A Platform for Consultation: Building on a Strong
Foundation, above n 274, 699.
222

It has also been suggested that source rules should not involve added complexity or be
developed independently of an international consensus on such rules (developed
through an organisation such as the OECD).
279

It may also be necessary to provide rules to deal with treaty shopping.
280
In treaty
shopping, residents of non-treaty countries structure their cross-border business and
investment activities to take advantage of the treaty source rules through treaty
countries.
281
In the Lamesa case (1997),
282
a limited partnership resident in the US
used Lamesa Holdings BV (Lamesa), an interposed subsidiary incorporated in the
Netherlands, to mount a takeover bid for a company (Company A) that owned gold
mining leases in Australia. The issue was the treatment of profits made by Lamesa
from the sale of shares in Company A which held interests indirectly in Australian real
property (the gold mining leases). As Lamesa did not carry on business in Australia
through a PE, article 7 (business profits) of the Australia-Netherlands DTT did not
apply.
283
The Commissioner argued that article 3 (income from the alienation of real
property) applied. This argument was rejected by the Full Federal Court because

278
Ibid 700.
279
Ralph, Review of Business Taxation: A Tax System Redesigned: More Certain, Equitable and
Durable, above n 272, 686.
280
Ralph, Review of Business Taxation: A Platform for Consultation: Building on a Strong
Foundation, above n 274, 699.
281
In treaty shopping, a subsidiary incorporated in a foreign country is used to obtain the benefits of
that countrys tax treaties, which would not be available to the parent company if it invested directly in
the other country. See Michael Kobetsky, The Aftermath of the Lamesa Case: Australias Tax Treaty
Override (2005) 59 Bulletin for International Fiscal Documentation 236, 241.
282
Federal Commissioner of Taxation v Lamesa Holdings BV (1997) 97 ATC 4752.
283
The facts in this case were that Lamesa did not, at any time, have an office, or branch, or any other
place of management in Australia, nor did it have any officer or an employee resident in Australia.
Lamesa did not own, lease or occupy any property of any kind in Australia or conduct any business or
undertake any transaction in Australia, other than the acquisition and resale of the shares. Lamesas
dealings in Australia have been conducted on its behalf by brokers or solicitors acting in the ordinary
course of their business or profession, and attorneys, proxies or representatives appointed under the
corporations law. See Lamesa Holdings BV v Federal Commissioner of Taxation (1997) 97 ATC 4229,
4233.
223
article 13 was concerned with direct interests in land analogous to leasehold
interests.
284
Article 13 did not, on any view of the matter, treat as interests in land
rights to wind up companies and seize control of assets.
285
Article 13 could only apply
to the sale of shares to realty to one tier of companies due, ultimately, to recognition of
separate legal personalties.
286
Thus, the profits fell outside article 13. They did fall to
be taxed under article 4 (residence), in this case in the Netherlands.
287
But the profits
were not assessable under the domestic law of the Netherlands either.
288
As a result,
the parent company of Lamesa Holdings, the US limited partnership, received the
profits free of tax in the US. This is just a further example to illustrate that there
clearly is no universal set of source rules that can readily be applied to every
circumstance to determine the source or locality of profits, even if the activity has a
connection with Australia and the source of the profits could well be in Australia. It
transpires that it is not only necessary to treat each case on its own facts and determine
what the taxpayer has done to earn the profit in question and where he has done it, but
also consider the existence of a DTT in the case of non-residents.
289

284
Federal Commissioner of Taxation v Lamesa Holdings BV (1997) 97 ATC 4752, 4760.
285
Ibid.
286
Ibid 4761.
287
Ibid 4760.
288
The business profits made by Dutch companies from foreign business activities are exempt from tax
in the Netherlands. See Paul Vlaanderen, Why Exempt Foreign Business Profits? (2002) 25 Tax
Notes International 1095, 1095.
289
To overcome the shortcomings of the alienation of real property article in most of Australias DTTs,
the government decided to amend the International Tax Agreements Act 1953 (Cth) (Agreements Act)
to clarify the interpretation of the alienation of property article in Australias DTTs, instead of
amending each DTT. See Commonwealth, Treasurer, Alienation of Property and Australias Double
Tax Agreements, Press Release, No 39 (27 April 1998).
Section 3A was introduced into the Agreements Act to ensure that Australias taxing right extends
to alienation of Australian real property through interposed entities. The section applies to income,
profits or gains from the alienation or disposition of shares or interests. See Tax Laws Amendment Act
(No 4) 2000 (Cth) (No 114, 2000).
It takes considerable time and effort to amend a flaw in a countrys treaty network and re-negotiate
a DTT. It has been commented that while DTTs have been effective in preventing double taxation,
they have not been effective in countering tax avoidance. See Kobetsky, above n 281, 236.
224
5.7 Conclusion

The concept of source of income is, essentially, less clear today in the domestic tax
law of Hong Kong and Australia. Notwithstanding that the ascertainment of the actual
source of an item of income is a practical, hard matter of fact, it is argued that many
court decisions on source would seem odd to the practical person.
290
Determining the
source of income in Hong Kong and Australia depends on applying the law to the facts
of the case. This can be a very complex process. The difficulty of making such
determinations is growing as the outcome turns on weighing the various factors in
each case, and no simple, single, legal test can be employed in determining the source
of income.
291

Hong Kong is unique in the developed world in that it still retains a virtually
unqualified, territorial tax system and the meaning of source has been the subject of
much litigation. Hong Kongs source rules have become increasingly complex due to
some inconsistent case law principles. It is difficult to distinguish between domestic
and foreign income or prove that profits do not arise from offshore, given the growth
of trade and financial services and the shift of labour-intensive manufacturing out of
Hong Kong. It is acknowledged by the Hong Kong government itself that Hong
Kongs revenue law is out-dated.
292

290
Lehmann and Coleman, above n 155, 853.
291
It is argued that the cases lay down principles that can be used to ascertain where source lies as a
matter of fact. In Australia, there are administrative difficulties to determine source from the facts and
circumstances approach. The case-by-case nature of application means that the ATO is unable to give
simple broad pronouncements on how the law operates, as evidenced by the absence of public rulings
on source. See Dirkis, Ripe for Reform: Australias Domestic Source Rules, above n 32, 169, 178-9.
292
Richard Cullen and Tor Krever, The Relationship Between Tax Reform and Political Reform in
Hong Kong (2006) 24(2) Law in Context 10, 10.
225
The Australian income tax law was premised upon an economy relying on
manufacturing, agricultural and extractive industries, all of which involved sale of
tangible products. It was not drafted to deal with the diversity of international trade,
driven by technological development and the kinds of business innovation common
today, involving, increasingly, sale of intangible products. Nor was it drafted to
address the revenue risks faced by a knowledge economy relying increasingly on
service provision and remote sales. It is argued that Australias general law source
rules are inadequate and unsuited to the commerce of the future where trade in
intangible services will continue to expand and possibly outstrip trade in goods.
293

The issues raised in this conclusion are discussed further in Chapters 7 and 8.

293
Michael Dirkis, Is It Australias? Residency and Source Analysed (Research Study No 44,
Australian Tax Research Foundation, 2005) 335.
226
CHAPTER 6: ELECTRONIC COMMERCE

6.1 Introduction

Globalisation is the process by which entities seek to locate and manage networks of
worldwide activities (such as production, research and development, financing and
marketing) as a single, effective unit.
1
The Internet is clearly an important means by
which to further globalisation. Its advent has changed the dimensions of international
trading, finance and commerce. The geographic location where a transaction, operation
or activity is carried out, whether in terms of the supplier, service provider or buyer of
goods or user of the service, becomes comparatively unimportant as the interaction is
between the buyer and the seller over computer networks, connected by cable,
telephone wire, cellular network or satellite. Businesses use the Internet to reach new
markets and customers without establishing a presence in the customers location.
Customers use the Internet to access a broader range of goods and services, which, in
some cases, can be purchased and delivered electronically, independent of where they
reside.
2
Even money can be transferred instantaneously to anywhere in the world.
3

1
Commonwealth, Bureau of Industry Economics, Multinationals and Governments: Issues and
Implications for Australia (Research Report 49, 1993) 6.
This thesis adopts a narrow definition of globalisation, though there are many different definitions
of it. For example:
it refers to the trend for people, firms and governments around the world to become increasingly
dependent on and integrated with each other;
it is the increasing internationalisation of all markets, industries and commerce; and
it is a worldwide process of more intensive cross-border movement of goods, services, factors of
production (labour and capital) and financial instruments.
See Matthew Bishop, Essential Economics (2004) 112; J ohn O E Clark (ed), Dictionary of
International Banking and Finance Terms (2001) 169; William R White, Globalisation and the
Determinants of Domestic Inflation (Bank for International Settlement Working Paper No 250, March
2008) [11] <http://www.bis.org/publ/work250.pdf?noframes=1>at 28 November 2008.
2
A difference between traditional commerce and electronic commerce is that, in electronic commerce,
some products can be digitised and delivered electronically. Digitisation refers to the technology that
allows information such as text, sound, images, video and other content to be converted into a digital
format so that it can be transmitted over computers located throughout the world.
3
See below Part 6.3.3 on the use of electronic money.
227

Existing taxation source rules based on the character of income and the geographic
origin or location of income are significantly tested by cross-border trade and services
involving two or more locations. The intangible nature of digitised goods and services
means that the source jurisdiction may not be able to monitor the tax base (and
determine from what and where the income arose) and collect the appropriate amount
of tax on profits derived from electronic commerce. This chapter examines the
challenges and opportunities the Internet presents as electronic commerce grows,
looking at issues such as the difficulty of characterising the nature of payment and
establishing a nexus or link between a taxable transaction, operation or activity and a
taxing jurisdiction, and the difficulty of locating the transaction, operation or activity
and identifying the taxpayer for income tax purposes. A tax authority must be able to
identify the correct taxpayer and the jurisdiction within which a business operates in
order to impose tax effectively.
4

6.1.2 Overview

Electronic commerce is the conduct of commercial activities and transactions by
means of computer-based information and communications technologies.
5
Its advent
has revolutionised the way numbers of businesses are conducted as transactions in

4
This thesis does not discuss the taxation of global trading of financial instruments and the viability of
source-based taxation. With the rapid growth of Internet-based trading, financial markets have become
increasingly globalised. Innovative financial instruments have been developed to meet the often
different global demands of both the product provider and the product purchaser and also to exploit
uncertainties and inconsistencies in the tax treatment of given transactions. It is beyond the scope of
the thesis to examine in detail the source of income from financial instruments, both as regards the
taxation of the product purchaser of innovative products and the provider of such instruments in each
location where global trading is carried on.
5
Barry B Sookman, Computer, Internet and Electronic Commerce Terms: Judicial, Legislative and
Technical Definitions (2001) 112.
228
tangibles can be converted into transactions in intangibles and delivered across the
Internet digitally rather than physically. There are two definitions of electronic
commerce transactions endorsed by the OECD member countries, based on the narrow
and broad definitions of the communications infrastructure:
the broad definition covers electronic transactions (conducted over computer-
mediated networks which include any online application used in automated
transactions such as the Internet and interactive telephone systems); and
the narrow definition covers Internet transactions (conducted over the Internet
which include any Internet application used in automated transactions such as web
pages and web-enable application accessed through a mobile (telephone) or a
television (TV) set).
6

Both definitions refer to the sale or purchase of goods or services, whether between
businesses, households, individuals, governments and other public or private
organisations. It is the method by which the order is placed or received, not the
channel of delivery, that determines whether it is an electronic or an Internet
transaction. This thesis uses the narrow definition of electronic commerce and refers
only to commercial operations, transactions and activities in which orders are placed
through the Internet and the products are delivered in tangible or digitised form.
7

There are two main types of electronic commerce:
business-to-business (B2B) dealings where transactions are conducted between
businesses; and

6
Alessandra Colecchia et al, Measuring the Information Economy (2002) 89.
7
This narrow definition allows for an in-depth review of the issues addressed in this thesis.
229
business-to-consumer (B2C) dealings where businesses sell their products via a
web site on the Internet to customers around the world.
8


Part 2 of this chapter provides a brief introduction to the Internet, followed by an
overview of how electronic commerce works. Part 3 looks at some of the security and
integrity issues resulting from the development of the Internet and how they are being
addressed, and the use of electronic money. Part 4 examines the tax administration
and enforcement issues in cyberspace as a state can only tax a person who has some
nexus or link to the jurisdiction under its domestic law. Part 5 explains the
difficulties in determining the real source of income generated by a globalised
Internet transaction as the traditional source rules do not apply easily to electronic
commerce. Part 6 discusses the impact of electronic commerce and the traditional
rules governing the source of income in Australia and Hong Kong. The business
profits of foreign sellers trading with the residents of these two jurisdictions will not
be subject to source country taxation unless there is a sufficient nexus or link to the
jurisdiction. Part 7 concludes that the challenges presented by electronic commerce
give rise to practical difficulties which threaten to seriously undermine the effective
application of source-based taxation.

8
There are also consumer-to-consumer or customer-to-customer (C2C) transactions, which are used
for people to sell and buy items. Sellers offer items for sale by listing them on the web site and buyers
can bid or buy for them (for example, the online auction and shopping web site of eBay). This thesis is
not focused on C2C transactions.
230
6.2 What is the Internet?

The Internet is a system of stand-alone computers, independent computer networks
and devices (such as routers, switches, software), logically connected to each other
from all over the world, that operate as a single network.
9
The connections of these
computers are completed through the use of various telecommunications media such
as the thousands of miles of telephone lines crisscrossing the continents, satellites and
the submarine telecommunication fibre optic cables connecting the continents.
10
Once
connected to the Internet, users can share services and communicate directly between
computers on the network.

The way information travels on the Internet is based on packet switching. Data is
digitised before being broken down into discrete packets of information for
transmission from the source to its destination. Each packet is transmitted individually.
Once a packet enters the network, it is forwarded from one router or switch to the next
based on the traffic and availability of the network paths, regardless of national
boundaries until it ultimately reaches its destination and then the information is re-
assembled into a whole message. Each packet may follow a different route over a
network to get to the destination.
11
If there is a temporary breakdown in one part of the
network, the data can be re-routed along some alternate path.

9
A router is a special computer that receives and routes messages between network systems, or
between complete networks. A switch is used in a telecommunications network to route calls from one
telephone to the next. An item of software is a program or instructions for a computer to function. See
Francis Botto, Dictionary of e-Business: A Definitive Guide to Technology and Business Terms (2
nd
ed,
2003) 279, 304; Sookman, above n 5, 161-9, 262-3.
10
Eric N Roose, Global Taxation of Electronic Commerce (1998) 4 Asia-Pacific Tax Bulletin 248, 249.
11
Botto, above n 9, 251.
231
The Internet is used to conduct business because it has the ability to collect, share,
process and manipulate information in real-time on Internet-driven networks (and to
do so cost-effectively). The evolution of the Internet has opened up opportunities to
develop new products such as:
electronic money;
Internet banking; and
online trading.

6.2.1 How does electronic commerce work?

Unlike the physical world that requires a physical address to carry on a business, an
entity conducts its business on the Internet by a web site without the need to establish
a presence or the use of an employee or agent in the country of the customer. An
entity can arrange to have a web site, its virtual shopfront, accessed through a
computer server that is maintained by the entity, or by an Internet Service Provider
(ISP) or a third party. The web site may advertise its products, collect information
and create databases, solicit business, communicate, receive and confirm orders,
deliver goods digitally, provide services, process and conclude transactions and
collect payments.

Similarly, the potential customer visits the sellers shopfront by logging on to a
computer connected to the Internet. The initial connection is often provided by the
customers telecommunication provider through existing telephone lines.
12
Once
connected to the telecommunications network, the customer can access the Internet

12
Stand-alone computers and networks can be connected to the Internet by using a variety of means
including cable, broadband and satellite.
232
through a connection referred to as a point-of-presence (POP), which could be near
the customer or at a distance.
13
The customer can then communicate freely with web
sites around the world, and the ISP is responsible for sending the customers electronic
communication to its final destination. If that final destination happens to be a
computer also connected to that ISP, the signal may never leave that ISPs network
except during the communication from the customer to the ISPs POP.
14
In other
cases, the ISP will pass on the communication at a centralised interconnect point to
some other ISPs who will then be responsible for delivery of the communication.
15
A
single electronic communication may be passed on several times between various ISPs
before reaching the ISP of the recipient.
16

A potential customer can visit the web site by keying in a Uniform Resource Locator
or clicking at a link in a web page.
17
A potential customer may also choose to run a
keyword search for a particular topic. In this situation, the search engine would
display numerous results after completing a search, each identified by a domain name,
title and possibly a brief summary of the contents of each enumerated web page.
18

The link between the user and the web page may involve routing the connection

13
A point-of-presence (POP) is a site along a computer network equipped with telecommunications
equipment. Internet service providers have computer networks with one or more POPs within their
service area for subscribers to access the Internet. See Daniel Amor, The E-Business (R)evolution
(2000) 605.
14
Howard E Abrams and Richard L Doernberg, How Electronic Commerce Works (1997) 14 Tax
Notes International 1573, 1581.
15
Ibid.
16
Ibid.
17
A Uniform Resource Locator (URL) refers to the address that lets a user locate a particular site on
the Internet. There are two parts in a URL:
an indication of the transmission protocol to be used; and
the location in the form of a domain name.
An example is http://www.abc.com.au, where http is the transmission protocol (HyperText
Transmission Protocol), and www.abc.com.au is the domain name.
18
J ohn Edmund Hogan, World Wide Wager: The Feasibility of Internet Gambling Regulation (1998)
8 Seton Hall Constitutional Law Journal 815, 826.
233
through numerous jurisdictions.
19

6.3 Electronic commerce security and integrity issues

In electronic commerce, there is no face-to-face contact between the buyer and the
seller. It is hard to know the identity of the person at the other end of the connection
and whether the person making the payment is the person authorised to do so. With
increasing amounts of information being stored and processed in computer networks,
security of financial transactions is a concern. To ensure the safety and integrity of
online transactions, Internet security protocols have been developed to ensure that
information cannot be read by any individual without authorisation, such as data
encryption and the use of a digital certificate (DC).

6.3.1 Encryption

A person can use encryption techniques to encode and decode messages when using
the Internet (including transferring money digitally). The approach to encryption is
based on the idea that information is transformed to stop it from being read or altered
by anyone but the intended recipient.
20
Information may still be intercepted by
hackers, but it will not be understandable to another person without the ability to
decrypt the message. Encryption and decryption require a mathematical formula or
algorithm to convert data between readable and encoded formats and a pair of keys,
each of different mathematical values and use:
21

a public key that can be published without doing any harm to the systems overall

19
Ibid 825.
20
Bart Vasevenant, Rise of Digital Signatures: Is J ohn Smith Actually J ohn Smith (2003) 24 Credit
Control 11, 11.
21
Ibid.
234
security; and
a private key that is kept with the owner and is not to leave his or her possession.
22

Encryption is done using one of the keys, but decryption can only be done using the
other. That is, the sender encrypts the message with the recipients public key, and the
recipient decrypts the message with his or her private key in order to read it:
23

For example, imagine that every one in the world knew how to multiply by 7,
but Ann is the only one who knows the inverse: how to divide by 7. Dividing
by 7 would be Anns private key, while multiplying by 7 would be her public
key. Ann could protect her stored information by multiplying all numbers by
7. People could similarly send Ann numbers without risk of eavesdropping by
first multiplying those numbers by 7. Ann could also use her knowledge for
authentication, i.e., to prove its really her, because, if you pick a number and
multiply it by 7, then Ann is the only one who can tell you what the original
number was. Finally, Ann can use this approach to guarantee the integrity of
her messages, i.e., to ensure they have not been tampered with. If she sends a
number and that number [is] divided by 7 and someone tries to alter the
original number, the recipient will be able to tell this by multiplying by 7.
.24

(Emphasis in original.)

In practice, encryption techniques solve the security problem, but not authentication of
content and sender:
If Ann wants to send a protected message to her bank Z, Z sends her its public
encryption key, so Ann can encrypt the message prior to sending, and only Z
can decrypt it.

The problem is, however, that Z may not be Z, that is, the entity
communicating with Ann may be someone pretending to be Z. Ann could be
tricked into sending her message to a third party X, if X poses as Z and
provides an encryption key that X can decrypt.
25

22
The private key must be kept by the owner so that it cannot be used by someone else. See Rolf
Oppliger, Security Technologies for the World Wide Web (2
nd
ed, 2003) 96-7.
23
Pete Loshin et al, Electronic Commerce: On-Line Ordering and Digital Money (3
rd
ed, 2001) 96.
24
J on M Peha and Robert P Strauss, A Primer on Changing Information Technology and the Fisc
(1997) 50 National Tax Journal 607, 614.
25
Based on an example in Andreas Furche and Graham Wrightson, Computer Money: A Systematic
Overview of Electronic Payment Systems (1996) 90.
235
Therefore, it is necessary to establish the credentials of the parties when doing
business on the Internet to prevent situations such as the illegal transfer of funds or the
unauthorised ordering of goods and services. This can be done by the application of a
DC (see below) to certify features such as the identity of the holder of the key or the
authenticity of an electronic document.

6.3.2 Digital certificate

Digital certificates are electronic documents attesting to the binding of public keys to
an individual or entity, and allow verification of ownership.
26
A certificate contains
data records about individuals or businesses which includes six main elements:
certificate owners identifying information, such as name, organisation, address
and so on;
certificate owners public key;
dates between which the certificate is valid;
serial number of the certificate;
name of the certificate owner; and
digital signature of the certificate issuer.
27

A DC is attached to an email message or a program embedded in a web site that
verifies that the sender or web site is who or what it claims to be.
28
Though a
certificate is hard to counterfeit, one could be issued in error or be stolen.
29

26
There are two types of certificates used in electronic commerce a client side certificate and a server
side certificate. Client side certificates allow web sites to identify themselves to users and to encrypt
transactions with visitors such as their business partners. Server side certificates are used to provide a
secure channel between a users web browser and the host. See OECD, Record Keeping Guidance [24]
27
Gary P Schneider, Electronic Commerce: The Second Wave (5
th
ed, 2004) 411.
28
Ibid 410.
236

If the DC issued by a Certificate Authority (CA) in one domain is to be accepted in a
foreign domain as proof of identity, there needs to be assurance that the CAs perform
their roles and duties with high levels of integrity and security.
30
At the present time,
there is no internationally recognised central authority to cross-certify each CA to
establish a trust relationship between two CAs.
31

6.3.3 Electronic money

Payments by electronic money
32
are attractive to buyers and sellers as they can be
exchanged over a network, take negligible time, and work equally well for transactions
of a few cents and a few billion dollars.
33
There are three basic categories of
electronic money:
An account-based notational system that uses conventional financial institutions and
the transactions are recorded (for example, credit card payments on the Internet,
ATM and EFTPOS facilities).
34
The issuer maintains an audit trail of transactions.
A stored-value tokenised system, designed to facilitate small value retail payments
by offering a substitute for banknotes and coins, which may work outside the
traditional banking infrastructure. Card-based products are intended to

29
See J ohn Markoff, Warning From Microsoft on False Digital Signatures The New York Times, 23
March 2001, C.6; Andrew Roth, VeriSign Security Breach Said Fixed; Banks Wary (2001) 166
American Banker, 17.
30
J ames Backhouse, Assessing Certification Authorities: Guarding the Guardians of Secure E-
Commerce? (2002) 9 Journal of Financial Crime 217, 219.
31
Ibid.
32
Electronic money is also called e-money, e-cash or electronic cash, digital cash, digital currency,
digital money and cyberpayments. See Sarah N Welling and Andy G Rickman, Cyberlaundering:
The Risks, The Responses (1998) 50 Florida Law Review 295, 298.
33
Peha and Strauss, above n 24, 614.
34
An ATM (automated teller machine) is an unattended terminal-type device that provides simple
banking services such as cash withdrawals, transfer of funds between accounts and account balances at
locations other than counters staffed by tellers in financial institutions. In an EFTPOS (electronic funds
transfer at point of sale) transaction, funds are transferred electronically at a payment terminal within
the premises of a trader. See Patrick Quirk et al, Electronic Commerce and the Law (2
nd
ed, 2003),
121; Sookman, above n 5, 11.
237
complement rather than substitute for traditional retail payment instruments such
as traditional currency, cheques and credit and debit cards.
35
The card contains a
chip that automatically deducts the purchase from the card and transfers it to the
trader. For example, Hong Kongs Octopus Card is a non-bank electronic cash
card used to pay fares and make single purchases.
Software-based electronic cash stored as a computer code on a plastic card or on
the hard drive of a personal computer. The electronic cash is basically a speck of
value in digital form that a computer can read:
J ust as traditional currency is not value itself but merely represents value,
so the digital speck represents value. Electronic cash is issued and sold by
private companies. The electronic cash can be sent over open information
systems like the Internet or encoded on a plastic card. Consumers use
traditional money to buy the electronic cash from the issuing company, and
then use it to buy goods and services from merchants who accept electronic
cash as payment.
36

This type of electronic cash can be spent anywhere by anyone with no proof of
identity, made possible by encryption and digital signature technologies.
37
The
electronic cash passes through the economy, like paper currency, and it is very
unlikely to be monitorable.
38

Although software-based electronic cash is still not a very dynamic area in the field of
retail payments, its development raises policy concerns for central banks due to the
possibility of funds being able to circulate independently of the banking system.
39
For
this reason, electronic cash is more challenging than physical cash (already a problem

35
Bank for International Settlements, Committee on Payment and Settlement Systems, Survey of
Developments in Electronic Money and Internet and Mobile Payments (March 2004) [2]
<http://www.bis.org/publ/cpss62.pdf>at 16 April 2008.
36
Welling and Rickman, above n 32, 298.
37
Loshin et al, above n 23, 161, 344.
38
Electronic money can in principle be sent as an attachment to an email. From a taxation perspective,
payments such as this are very unlikely to be monitorable. See Australian Taxation Office, Tax and the
Internet (1997) vol 1 [4.6.2].
39
See Bank for International Settlements, above n 35, iii.
238
for all tax authorities) as electronic payments are likely to have significant adverse
impacts on the enforcement of tax law.
40
The Internet was designed to have no central
control.
41
This key to its robustness and efficiency also makes it extremely difficult
for governments to monitor or prevent transmissions of information or electronic cash
across the Internet.
42
Access powers provided under the domestic law of one country
generally have no force in another country.
43

6.4 Tax administration and enforcement issues in electronic commerce

The advent of the Internet and electronic commerce has changed substantially the way
people do business in the domestic and international environments. In the past, the
production, distribution and consumption of goods were easily traceable. Virtually all
assets, products and services require a physical presence for their delivery and each
transaction could be traced back to its origin. Broadly, physical goods were produced

40
In Australia, cash transactions over A$10 000 (Australian dollars) are reported by cash dealers to the
Australian Transaction Reports and Analysis Centre. The use of electronic cash would be unlikely to
attract the provisions of the Financial Transactions Report Act 1988 (Cth) (FTRA 1988). See
footnote 150, Chapter 4, on the reporting requirement under the FTRA 1988.
41
The initial use of the Internet was for military purposes and then amongst the educational and
research communities. Since then, it has expanded at a phenomenal rate within the commercial sector
and for public usage. See Christos J P Moschovitis et al, History of the Internet: A Chronology, 1843
to the Present (1999), for a history of the Internet. See, also, Quirk et al, above n 34, 15-17 on the
bodies that can manage and control the Internet as a whole.
42
There are several technical features of the Internet that are likely to have a significant impact on the
operation of tax systems:
the lack of any central control;
the lack of central registration;
the difficulty if not impossibility of tracing activities; and
the weak correspondence between an Internet domain name and reality (the actual geographic
location of the addressee or the computer equipment used to transmit or receive the information).
43
In Australia, the law gives the Commissioner of Taxation access and information-gathering powers,
divided into three categories:
the power to gain access to premises and documents;
the power to require attendance and to provide information and evidence; and
the power to require documents to be provided.
These powers are exercised by the Commissioner under ss 263 (access to books), 264 (request for
information and evidence) and 264A (request for information or documents kept outside Australia) of
the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). However, these access powers have no
force in another jurisdiction.
Hong Kong does not have similar provisions in its tax legislation.
239
at a factory, shipped to wholesalers, ordered by retailers and sold to the final consumer.
The Internet has opened up a multitude of opportunities for trading in a remote area
through the use of new communications technologies. Companies are able to structure
operations in the most cost-effective and efficient manner as location bears no
necessary relationship to the place of business.
44
For example, companies can supply
their wares direct to retailers and consumers through web-based ordering from their
home location or some alternative location. Certain value-producing activities such as
the marketing and after-sales service could be outsourced to those places that yield the
greatest return on investment. Direct sales by manufacturers and wholesalers mean that
business profits may be taxed, if at all, in jurisdictions where physical production
actually takes place, and not where the company is located. A sale of an item by a
foreign seller can be completed on the Internet (including offer, acceptance,
arrangement of the terms and conditions of the sale and payment (and sometimes
delivery)). These activities can occur without the use of an employee or agent in the
country of the customer. A jurisdiction needs to address a number of issues before it
can exercise its right to tax the business profits of a non-resident entity selling goods
into the jurisdiction without a physical presence. These are discussed below.

6.4.1 Location and identity of the taxpayer

In order to impose tax effectively, a tax authority must be able to identify the correct
taxpayer conducting electronic commerce and the jurisdiction within which a business
operates so that legal notices can be served or action taken against the party in case of
default. In the physical world, there are proof of identity arrangements to ensure the

44
Colin Lau and Andrew Halkyard, From E-Commerce to E-Business Taxation (2003) 9 Asia-Pacific
Tax Bulletin 2, 7.
240
trading names are regulated and registered to taxable entities, and identity trails can be
followed. On the Internet, the domain name (for example, www.abc.com.au) and IP
address (for example, 123.45.67.890) serve as the location of a web site.

The domain name of a web site does not necessarily bear any relation to the residence
or geographic location of the business, or tell where the actual activity is undertaken:
The pieces of an Internet address (or domain-style name) tell you who is
responsible for maintaining that name. It may not tell you anything about the
computer corresponding to the actual Internet address, or even where that
machine is located. Even if an e-mail address is clearly associated with a
certain person and computer, that person and her computer could be located
anywhere in the world. This makes it difficult to determine a persons
location and identity, which is often important for tax purposes.
45

In Australia, domain names are managed by Domain Administration Ltd. Though the
registration of com.au and net.au domain names is restricted to Australian
companies, a foreign company trading in Australia is entitled to a com.au domain.
46

In Hong Kong, domain name registrations are managed by the Hong Kong Domain
Name Registration Company Ltd (HKDNR). HKDNR scrutinises applications for
domain names in respect of technical restrictions and application qualifications only,
and does not make judgments as to whether the registration or use of a domain name
infringes the rights of any third parties.
47
Domain names can become a reliable
indicator of location only if an international agreement on domain name registration is
reached.

45
United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications
of Global Electronic Commerce (1997) 25 Intertax 148, [6.3.3].
46
.au Domain Administration Ltd, Domain Name Eligibility and Allocation Rules for the Open 2LDs
(8 May 2002) [6] <http://www.auda.org.au/pdf/auda-2002-07.pdf >at 16 April 2008.
47
See Hong Kong Domain Name Registration Company Ltd, Domain Name Registration Agreement
for .hk Domain Names (version 4.0 effective 28 September 2006)
<https://www.hkdnr.hk/register/registraion_agreement.jsp>at 20 April 2008.
241
An IP address, consisting of four groups of digits, is used to identify networks and its
connected computers.
48
The IP numbers are allocated by Internet Access Providers
(IAP) to Internet users.
49
The IP address of the web site has no connection to any
physical unit in the world. In particular, the communications protocols TCP/IP
50
do
not tell who sent the data, from where the data were sent, to where (geographically)
the data are going, for what purpose the data are going there, or what kind of data they
are.
51
If an Internet user elects to move to a different IAP, the IP number is
relinquished to the IAP, who can then re-allocate it.
52
So the scheme of identifying the
owner of the IP number cannot be relied on.

There are software programs (such as Traceroute) that record the route taken by an
Internet packet from the ISP to its final destination.
53
However, such programs may
not be successful if the server has been configured not to respond to Traceroute
commands.
54

From a taxation perspective, it is normally more important to know the identity of the
seller than the buyer on the Internet. The foreign seller may be liable for income tax

48
Botto, above n 9, 158.
49
Internet Access Providers include both Internet Service Providers (ISP), which offer users with
Internet access, and Online Services, which offer proprietary content in addition to Internet access. See
Sookman, above n 5, 169.
50
The communications protocols TCP/IP are used to manage the transfer of information. TCP handles
the breaking of messages into packets, and IP makes sure the packets arrive correctly at their
destination and in the proper order. See Quirk et al, above n 34, 8.
51
Lawrence Lessig, Code and Other Laws of Cyberspace (1999) 32.
52
Australian Taxation Office, Tax and the Internet (1997) vol 2, 151.
53
Traceroute is a program that will theoretically find the sequence of routers on the way to a destination
computer. The way this works is to send packets to the destination with increasing maximum hop
count and observe which routers send back a hop count exceeded error packet. Unfortunately some
routers do not return error packets. Also, the accuracy of the technique can be compromised by
tunneling which can make multiple hops seem like one. Ibid 171.
54
Malcolm Allen and Stuart Hamilton, The Need for Implementation of a Tax at Source and Transfer
Sales Tax Model to Overcome the Impacts of Internet Sales on the US Economy, Advisory Commission
on Electronic Commerce [9]
<http://www.ecommercecommission.org/document/212TaxAtSourceTransfer.pdf>at 21 October 2007.
242
and the foreign seller is also likely to be responsible for collecting indirect
consumption tax, if any, from the customer and forwarding it to the tax authority.
55
It
is, therefore, necessary to establish the identity of the foreign seller and the
jurisdiction to tax. If the control, beneficial ownership, substance of the business
activity and location of the business cannot be traced back from a web site, there is no
jurisdiction to impose tax on a foreign seller.

6.4.2 Nexus in electronic commerce

Income or business profits are subject to source taxation only if there is sufficient
nexus or link between a taxable transaction, operation or activity and a taxing state.
56

Nexus can be created or established by activities conducted within a jurisdiction that
contribute substantially to the taxpayers ability to maintain operations in that
jurisdiction.
57
The permanent establishment (PE) concept, relying on a place of
business with an element of both geographic and temporal permanence, is an
important threshold for source-based taxation of business profits. The PE concept has
been used for traditional businesses typical of the late 19
th
century and most of the 20
th

century, such as manufacturing and retailing, as it was not possible to carry on a
business without having a physical presence in the source country.
58
Physical
presence may no longer be appropriate for a knowledge economy of the 21
st
century,

55
See, for example, Australian Taxation Office, Selling Goods Into Australia (21 May 2007)
<http://www.ato.gov.au/print.asp?doc=/Content/65473.htm>at 16 April 2008 on the tax obligations of
foreign sellers selling goods into Australia without a physical presence in Australia.
56
See footnote 2, Chapter 1, on the meaning of the term nexus.
57
In the US, it was held in Quill Corp v North Dakota, 504 US 298 (1992) that nexus requires out-of-
state vendors to maintain operations in a state to collect and pay a use tax on goods purchased for use in
the state. Nexus does not exist where there are no outlets or sales representatives in the state and the
business is conducted by mail and common carriers. However, in America Online, Inc v Ruth E
Johnson, Commissioner of Revenue, Tenn App LEXIS 555 (2002), it was held that nexus does not
require physical presence and could be established by activities carried on within the state by affiliates
and independent contractors.
58
See footnote 101, Chapter 2, for a brief discussion of the development of the PE concept.
243
based primarily on services and remote sales. Products and services are offered on
web sites without any physical connection to the jurisdiction in which the income-
producing activity occurs:
For example, if Anne, who lives in Australia, is running a commercial site on
the Internet for U.S. customers, using a computer located in Canada, Anne can
control the Canadian computer from Australia through a series of computer
programs which can be configured to leave no audit trail. Moreover, if the
need arises, operations can be shifted to somewhere else on the Internet.
59

With businesses increasingly linked to the Internet to compete in a globalised economy,
defining, establishing and asserting jurisdiction are much more difficult on the Internet
than they are in the physical world because transactions occur electronically between
the web site of the business and the customers computer.
60

A tax authority may not be able to monitor business activities and transactions if web
sites exist on servers located offshore or business transactions are encrypted. A
foreign seller may not wish to leave an audit trail for tax authorities to follow by using
encryption techniques. Encrypted messages could make it extremely difficult for a tax
authority to gather evidence and take prosecution action without the relevant

59
Global Electronic Commerce, above n 45, [6.3.5].
60
Once information is uploaded to a web site (that is, information is placed in a storage area managed
by a web server), it is usually accessible to all Internet users everywhere in the world and it is uncertain
whose law governs. The tort of defamation focuses upon publications causing damage to reputation.
Traditional defamation cases in Australia in the pre-Internet cases involved identifying the place at
which the defamatory material was made available to third parties. One of the issues in Dow Jones &
Co Inc v Gutnick (2002) 210 CLR 575 concerned defamation on the Internet. This case involved an
action brought by an Australian resident against an American publisher. The place in which the
publisher acts and the place in which the publication is presented in comprehensible form were, it was
found, in two different jurisdictions. The High Court of Australia reasoned that, in the Internet era,
material is not available in comprehensible form until downloaded onto the computer of a person who
has used a web browser to pull the material from the web server. It is where that person downloads the
material that any damage to reputation may be done (that is, defamation occurs in the jurisdiction
where articles are read and not where a publisher places material on an Internet server). This ruling is
different from those of the United States where defamation cases occur in the jurisdiction where the
speech is uttered or published or where you targeted it. See Mark J urkowitz, Australian Ruling is
Raising Worries, Boston Globe (Boston, Massachusetts), 16 December 2002, C.1; Felicity Barringer,
Internet Makes Dow J ones Open to Suit in Australia, New York Times, 11 December 2002, 6.
244
decryption and recovery keys. It will be impossible for tax authorities to detect or
determine commercial activity on the Internet without some form of regulation,
61
or
use of an alternative approach that would apply to electronic commerce operations.
62

Electronic commerce has substantially increased source-related revenue risks given the
typical reliance on the physical presence of a business in a geographic location to
establish a source nexus. There could be difficulties with collection of tax if the
foreign seller did not operate from a fixed place of business.
63

6.4.3 Migration of business to a web site

A web site is virtual in nature and can be programmed from a remote location. It is
common for the web site through which an entity carries on its business to be hosted
on the server of an ISP.
64
Thus, it is difficult to identify a web site as a fixed place of
business.
65
When goods are increasingly purchased from a web site managed and
controlled by a non-resident entity, the source country may lose the income tax

61
Australian Taxation Office, Tax and the Internet, vol 1, above n 38, [7.3.4].
62
See, for example, OECD, E-commerce: Transfer Pricing and Business Profits Taxation (Tax Policy
Studies No 10, 2005) 105-150, on some of the alternatives to the current treaty rules for taxing business
profits.
63
In Australia, the income tax obligation of a foreign seller exporting goods to Australia without
having a physical presence in Australia (for example, agent, subsidiary or PE) depends on whether or
not the foreign seller is a resident entity of a country that has a tax treaty with Australia. If so, the
foreign seller will be subject to residence taxation and will not be liable to pay Australian income tax.
Otherwise, the foreign seller is subject to tax in Australia. The foreign seller must lodge an Australian
tax return and pay tax. The foreign seller would need to self assess the Australian income tax
obligation and determine the source of income. For example, the source of goods and
information/knowhow is generally the place of contract, the source of exports of services is generally
the place where the services are performed although it may be the place of contract. But the
Commissioner may not be able to monitor international transactions, operations and activities involving
Australia over the Internet and collect tax in case of non-compliance by the foreign seller. See
Australian Taxation Office, Doing Business in Australia Overview (3 J anuary 2008)
<http://www.ato.gov.au/print.asp?doc=/content/64191.htm>at 1 May 2008.
64
OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework
Conditions (2001) 83.
65
A web site is a combination of software and electronic data, and does not in itself constitute tangible
property. It does not have a location that can constitute a place of business as there is no facility
such as premises or, in certain instances, machinery or equipment as far as the software and data
constituting that web site is concerned. See Commentary on Article 5 concerning the definition of
permanent establishment in OECD, Model Tax Convention on Income and on Capital (condensed
version, 2005) 103.
245
revenue to the residence country (or, effectively, to a tax haven). This is especially the
case with low-value imports, where de minimis relief from customs duties applies
because the cost of collection is more than the amount of tax due.
66
The migration of
businesses to a web site poses a problem in determining the legal jurisdiction to
impose tax because:
Under accepted international tax principles, legal jurisdiction to impose tax
requires the existence of a territorial nexus between the subject of the taxation
and the country imposing the tax. The mobility of Internet businesses, their
inherently global nature and independence from traditional physical links to a
specific geographical location has the potential to make the determination of
whether the relevant territorial nexus exist somewhat more problematic.
67

Take, for example, the case of Australia. If a foreign seller does not conduct business
in Australia through a subsidiary or a PE, Australia could not determine any part of the
profits even though a substantial part of the business may be conducted with Australian
residents via the Internet.
68
There is a potential for revenue to be shifted to the country
of residence if entities remove themselves legally from the Australian income tax
system by migrating the server to a low-tax jurisdiction to avoid source taxation.

66
In Australia, s 32B of Customs Tariff Act 1995 (Cth) provides that customs duty concessions include
goods of insubstantial value.
67
Australian Taxation Office, Tax and the Internet: Second Report (1999) [5.1.2].
68
The non-resident enterprise will not, by virtue of the web site alone, have a PE in Australia. Whether
a non-resident enterprise has a PE in Australia is a question of fact and degree, determined by reference
to the individual circumstances of each case. In some circumstances, a non-resident may be deemed to
carry on business through a PE, either under the provisions in the domestic law or under specific
articles of the relevant DTT, even though it does not conduct activities itself through a fixed place of
business in Australia, provided the four conditions are satisfied:
(a) there is a person acting on behalf of the non-resident enterprise in Australia;
(b) that person is not an agent of independent status to whom a subsequent paragraph of the PE article
applies;
(c) the person has authority to conclude contracts on behalf of the non-resident enterprise; and
(d) the authority is habitually exercised.
For a discussion of non-residents and PE, see Australian Taxation Office, ATO Interpretative
Decision ATO ID 2004/602, Permanent Establishment: Non-Resident Services Provided by Resident
Beneficiary No Authority to Bind Non-Resident; Australian Taxation Office, Taxation Determination
TD 2005/2, Income Tax: Does a Resident of a Country with which Australia has a Tax Treaty, have a
Permanent Establishment Solely from the Sale of Trading Stock through the Internet Website Hosted by
an Australian Resident Internet Service Provider?
See, also, Unisys Corporation Inc v Federal Commissioner of Taxation (2002) 02 ATC 5146 on
the difficulties of taxing the profits of a non-resident enterprise if it does not conduct activities itself
through a fixed place of business.
246

A server is a piece of equipment storing the web site and may constitute a fixed place
of business of the enterprise that operates that server.
69
It has a physical location and
can be placed in any geographic place by a foreign seller. Therefore, the substance of
electronic commerce would not be affected by where the server is placed. The
Australian Taxation Office (ATO) was aware of the problem that migration of
businesses to a web site may open tax avoidance and evasion opportunities:
A key issue will be the extent to which the Internet will allow business
activities to be undetectable or anonymous, so that the key taxing and auditing
requirements of the existence and identity of persons or transactions cannot be
determined. A high level of non-detection could lead to tax evasion in a
highly competitive global business environment where businesses may be
forced to adopt non-compliance facilities to compete with other businesses,
thus exacerbating non-compliance.
70

The situation applies to jurisdictions, such as Hong Kong, that tax on a territorial basis
as the server can be migrated to another location to avoid source taxation. This means
the business profits of foreign sellers will not be taxed in the source jurisdiction, unless
a business is carried on within its territory.

When there is no requirement under the income tax legislation to provide the web site
address of a business trading on the Internet, it becomes difficult to impose taxes
because we have a taxpayer, the physical location of whose business cannot be
accurately identified.
71
Prima facie, it is clear that a company can avoid the control of
a high-tax authority by locating a server in a tax-haven country to sell its products to
private customers.

69
See Commentary on Article 5 concerning the definition of PE in OECD, Model Tax Convention on
Income and on Capital, above n 65, 103.
70
71
Taxpayers in Australia and Hong Kong are asked to provide in their tax return if they have Internet
trading, or state if they use the Internet to sell goods or services. However, there is, as yet, no
requirement under the tax legislation to provide such information.
247

6.5 Taxation of business profits derived from electronic commerce

Technological development and business innovation raise the question from what and
where the source of online profits lies as a matter of fact for example, what is the
nature and site or location of the profit-producing transaction, what are the operations
giving rise to the profit and where those operations took place, what has the taxpayer
done to earn the profits and where this activity was carried out, which acts are more
immediately responsible for the receipt of the profit, what are the dominant factors to
be applied when determining the source of online profits from multiple sources etc.
The broad guiding principles that emerged from the cases discussed in Chapter 5 do
not apply easily to electronic commerce.

6.5.1 Characterisation of income

There are three types of sale transactions that can occur over the Internet:
online ordering of physical goods with physical delivery to the customer in which
the Internet merely facilitates the transaction (for example, flowers purchased over
the Internet);
online ordering of services with the supply in its traditional format (for example,
holiday packages); and
online ordering and delivery of digitised goods and services, which can be
downloaded over the Internet (for example, books, newspapers, movies, computer
software, music, architectural drawings and radiological images).

248
The first two forms of online transactions pose less of a taxation issue. In each case,
profits can be taxed in much the same way as when goods and services are ordered in
the conventional way (by physically visiting a provider or telephoning them within the
jurisdiction).
72
The third form of transactions presents a different case. Digitisation is
unique to electronic commerce. Digitised products are transmitted over computers and
are able to penetrate into the global market without any need to establish a physical
presence in the buyers jurisdiction or to have to rely on any sort of local delivery
system. The movement of such goods is hard to trace as the contents are downloaded
onto the computer of the purchaser without actually leaving the sellers computer. The
sale of goods and services by electronic means gives rise to problems in the collection
of direct and indirect taxes, and the characterisation of income according to the nature
of the transaction, operation or activity that generates the moneys received
(meaning A).

Characterisation of moneys received for digitised products is important because
different types of income are subject to different sourcing rules. The character of
income also determines whether the income should be taxed in the residence or the
source jurisdiction. Digitised information can represent a variety of goods and
services including money, software, music, copyright images, personal signatures and
detailed specifications to build physical products.
73
A particular transaction may be
characterised as the use of an intangible asset, the supply of goods or the rendering of
a service. Take the case of someone who would like to purchase ten copies of a bound
book. That person may purchase ten copies from a publisher, or purchase ten copies
of an electronic version by downloading it via the Internet, or may simply purchase

72
The first case, though, can present collection cost difficulties where there are, for example, thousands
of orders placed for goods to be delivered by post (etc) from offshore.
73
249
one electronic copy and acquire the right to make nine additional copies.
74
How is the
transaction to be considered for tax purposes?

If the payment is for the use of an intangible asset, it will be a royalty for tax purposes.
The tax treatment of royalties is usually not the same as the tax treatment of business
profits. Under many double tax treaties (DTT), the source country can tax royalties
as business profits only if those royalties are earned through a PE in the source country.
In the absence of a DTT, royalty income is generally subject to withholding tax on the
gross amount at a lower rate of tax than business profits in the source country. Income
from the sale of goods or services is generally taxable by assessment on a net basis in
the source country only if the seller or service provider has a PE or presence in that
country.

The United States (US) Treasury Department is of the opinion that:
This transaction might literally be considered to create royalty income, at least
in part, since the right to make reproductions is a right reserved to the
copyright holder and by allowing a third party to make reproductions, the
payment is, at least in part, in consideration for the use of the copyright.
However, this transaction may also be viewed as merely a substitute for the
purchase of ten copies from the purchaser in which the purchaser has
undertaken to make the copies, a process which would not be feasible were the
information not digitized.
75

The US Treasury Department concluded that it is necessary to apply the definition of
royalties in a manner that takes into account the unique characteristics of digitised
information.
76
However, the OECD suggests that the main question to be addressed is
the identification of the consideration for the payment:

74
Based on an example in United States, Department of the Treasury, Office of Tax Policy, Selected
Tax Policy Implications of Global Electronic Commerce, above n 45, [7.3.2].
75
Ibid.
76
Ibid.
250
for transactions that permit the customer (which may be an enterprise) to
electronically download digital products (such as software, images, sounds or
text) for that customers own use or enjoyment the payment is essentially
for the acquisition of data transmitted in the form of a digital signal and
therefore does not constitute royalties but falls within Article 7 or Article 13,
as the case may be. To the extent that the act of copying the digital signal onto
the customers hard disk or other non-temporary media involves the use of a
copyright by the customer such copying is merely the means by which the
digital signal is captured and stored. This use of copyright is not important for
classification purposes because it does not correspond to what the payment is
essentially in consideration for (i.e. to acquire data transmitted in the form of a
digital signal), which is the determining factor for the purposes of the
definition of royalties.
77

Tax rules should be neutral. Like products should be taxed in the same way, whether
purchased through conventional or electronic means. Digitisation can change the
nature of the business actually transacted, and may result in inequitable tax treatment
between conventional and electronic products of the same kind.

6.5.2 Source of online profits

If a business exists within a jurisdiction, the next question is to determine the source of
income from that business. How to rely on source rules interpreted by the courts (for
example, the operations test) to determine what, where, when and who has created the
economic activity generating the income that can be measured and taxed in an
integrated world market where geographic location no longer matters? The Internet
provides an environment where businesses are conducted by the use of
telecommunications network and computers. If the source of income is determined by
the place where the income-generating activity occurs, would it be:
1 the location where the web site is created;
2 the location of the intelligent server where it can advertise and solicit sales; or

77
251
3 the location where the customer uses his or her computer to access the server and
interact with the web site?
78

If the focus is on where the operations take place from which the profits in substance
arise, the factors to be considered are the place of production, the place of contract, the
place of performance and the place of payment for the product sold. Activities such as
concluding the contract with the customer, processing payments and delivery of the
products can be performed automatically by an intelligent server with minimum
human intervention. Thus, the steps to complete the transaction can all be structured
to be outside of where the customer resides.

Unlike a traditional commerce transaction which can be traced back to its origin,
digitised products are delivered on the Internet and various tax collection and data
gathering points can be eliminated, such as retailers, warehouses, transporters,
forwarders and insurance brokers. Traditional source rules become much less
effective due to the difficulty involved in observing and preventing electronic
transmissions of information or electronic cash across the Internet, and identifying the
location of the web site. The computer storing the electronic records may have no
physical connection to the jurisdiction in which the income-producing activity occurs.
As a result, income that might have been subject to tax in the host (source) jurisdiction
were it earned through traditional commerce may escape taxation when earned through
electronic commerce.

78
William C Benjamin and Michael J Nathanson, Conducting Business Using the Internet: Gauging
the Threat of Foreign Taxation (1998) 9(3) Journal of International Taxation 28, 31.
252
6.5.3 Source of services income

Services
79
income may be sourced in:
the country where the activity is performed (performance);
the country where the service is used (utilisation);
the country of residence of the provider of such services (residence);
the country where the payment is received (payee); or
the country where the payer is resident (payer).
80

Generally, most developed countries use the place of performance test to determine
the source of income from services and developing countries adopt the place of use
test. Under the place of performance test, the source of services income is the
location in which the service is physically performed (that is, where the income-
generating activities occur or where the value is created).
81
The requirement is based
on the view that there is generally an independent, substantial significance to the
location where the person rendering the service is located, with the result that it is
reasonable for that country to tax such service.
82
Under the place of use test, income
from services is taxed in the country where it is delivered or utilised (that is, where the

79
There is generally no accepted comprehensive definition of what constitutes a service, which is non-
storable and intangible. In order to be tradable, services have to be applied or embodied in objects,
information flows or persons. See Joel Slemrod and Reuven Avi-Yonah, (How) Should Trade
Agreements Deal With Income Tax Issues? (2002) 55 Tax Law Review 533, 538.
80
Ibid 537-8.
Income from independent personal services used to be dealt with under art 14 of the OECD Model
Tax Convention on Income and on Capital (OECD MTC). The article provided that the source
country had the right to tax income from independent services derived by a resident of the other
contracting state if the person had a fixed base regularly available to the non-resident in the source state.
However, art 14 was removed from the OECD MTC on 29 April 2000. Consequently, source taxation
of income from independent personal services is treated as business profits under art 7. See OECD,
Model Tax Convention on Income and on Capital, above n 65, 204.
81
Stephen R A Bates et al, Tax Planning for Providers of Cross-Border Services (2005) 106 Tax Notes
1411, 1417.
82
Global Electronic Commerce, above n 45, [7.4.1].
253
client is located). A non-resident service provider rendering services from his or her
country of residence to a customer in a developing country will be taxed in the source
country on a withholding basis on the gross amount.
83
The income may also be treated
as domestic income in the non-resident service providers country of residence (as the
work is done there).

The Internet opens a new market for the provision of services which, in some cases,
can be performed without physical contact between the service provider and the
customer. Suppose a programmer living in New Zealand is contracted to design a
database for an Australian bank, and conducts all of the development from a terminal
in New Zealand.
84
Instead of making site visits to discuss the work, clients having
problems with the software contact the Service Centre for support:
and technicians will attempt to debug the customers software. Depending
on the time of day or other circumstances, the technicians working on the
problem may be in the United States, Asia or Europe. A complex problem
may be passed from one location to another before it is solved.
85

It may be difficult to identify the exact place of performance if the solution to the
problem comes from the joint efforts of a team of professionals in different locations.
It is equally difficult to identify the place of use if the client is a multinational
enterprise and the software is loaded on servers located in different locations.
86

83
Business and Industry Advisory Committee to the OECD, Tax Issues and Ramifications of Electronic
Commerce (December 1999) [7] <http://www.biac.org/statements/tax/J ointPaperfinal.pdf>at 16 April
2008.
84
Based on an example from New Zealand, Inland Revenue, GST & Imported Services: A Challenge
in an Electronic Commerce Environment: A Government Discussion Document (J une 2001) [2.1.3]
<http://www.taxpolicy.ird.govt.nz/publications/files/html/gstimported/index.html>at 1 May 2008.
85
David R Tillinghast, The Source of E-Commerce Income Characterized as Services Income: An
Everyday Problem With No Clear Solution (2004) 33 Tax Management International Journal 429,
430.
86
As there is a DTT between Australia and New Zealand, the New Zealand programmer would need a
fixed base in Australia before the ATO could tax his business income. Australia could not, therefore,
tax the business income of the programmer if he did not have an actual place of business in Australia.
See art 14 of the Agreement Between the Government of Australia and the Government of New
254

Both the place of performance test and the place of use test are hard to apply in an
electronic environment if the value the client is paying for and the place this value was
created cannot be ascertained:
The value to the customer consists of access to an assemblage of digital
products created by the taxpayer. Much of the value is attributable to in-puts
which have been supplied to the taxpayer by employees or others located in
various countries. It would break with tradition to assign source based upon
the geographical location of suppliers of input. Such a preparatory activity
as purchasing has been generally disregarded in determining a taxpayers
liability to tax at the source. Moreover, the taxpayer is unlikely in fact to be
subject to tax in the countries from which it acquires third party in-puts.
87

The ability to complete work off-site anywhere in the world and split tasks has
weakened the relationship between the service providers location and the clients
location. Service providers will find it easier to relocate to a low-tax jurisdiction and
avoid being taxed at all, irrespective of which test is used to determine the source of
services income. Services such as taxation services, legal services and scientific or
engineering consultancies can be provided over the Internet. With the growth of
Internet connectivity, the focus is upon what constitutes the fairest way to allocate
income between the residence and the source jurisdiction.

Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to
Taxes on Income (entered into force 29 March 1995). See, also, Protocol Amending the Agreement
Between the Government of Australia and the Government of New Zealand for the Avoidance of
force 22 J anuary 2007).
If the programmer is a resident of a country with whom Australia does not have a DTT, say Hong
Kong, he would be deriving Australian income, as his business was partly carried on in Australia.
However, little of the income would be likely to be attributable to Australia when looking at where
services are performed.
87
Tillinghast, above n 85, 431.
255
6.6 Application of source rules to electronic commerce transactions

The principles of residence and source are central to a states jurisdiction to tax. The
analysis of case law in Chapter 5 shows that the source rules interpreted by the courts
are based on formal underlying events. Traditional source rules based on the character
of income and the geographic origin or location of income do not apply easily to
electronic commerce. In an electronic commerce environment, functions are highly
flexible and matters of form may prove difficult to establish or test (for example, the
technical requirements regarding the place of contract can be altered according to how
a web site is structured).
88
When both the economic activity and geographic location
can be shifted to a nowhere zone in an electronic environment, to what extent can the
traditional concept of source still apply appropriately to Internet-based commerce?

Australia

In August 1997, the ATO released its findings on the impact of the Internet on revenue
collection and administration in Australia.
89
The report considered the impact of the
Internet on the source of income, residence, PE and the potential erosion of the tax
base. The ATO has acknowledged that Australias source rules are challenged in
many ways by electronic commerce:
Universal access to a web site, automation and high mobility mean that most
electronic commerce activities may generate considerable revenue without
necessarily being located in close physical proximity to the market and
without significant use of any infrastructure anywhere. For highly mobile
activities, (eg high value services), source rules based on location are more
likely to facilitate tax planning.

The need to apply source rules to different types of income on a case by case
factual approach will create considerable difficulties in an Internet

88
89
Australian Taxation Office, Tax and the Internet, vol 1, ibid; Australian Taxation Office, Tax and the
Internet, vol 2, above n 52.
256
environment with a large number and variety of interfaces, activities and
modes of delivery.
90

Following the First Report in August 1997 on tax and the Internet, the ATO published
a Second Report
91
in December 1999 in which it stated that:
while electronic commerce does not pose any significant threat to revenue at
this time, there are some immediate actions that can and should be taken to
address electronic commerce issues in the current environment to ensure that
the ATO is well positioned to take advantage of the opportunities offered by
the new technology and meet the challenges as and when they emerge.
92

The Second Report also acknowledged that:
Electronic commerce poses challenges to the traditional rules for determining
source. Many of the challenges arise from the fact that Australias tax rules
relating to source are based on common law concepts that were developed
early in the century.

While there is some scope for the rules to evolve to meet modern
developments, there has already been considerable concern that the existing
domestic source rules are not appropriate to meet modern trends such as
globalisation, let alone the impact of developments as far reaching as those
provided by electronic commerce.
93

Though Australia taxes its residents on their worldwide income, it may not be easy for
the ATO to locate all the business transactions, operations and activities and income
earned abroad through electronic commerce. For example, if more than one server is
used, it would be difficult to identify which server was used to make the transaction
and where the inventory was held.
94
Both the residence and the source jurisdiction can
lose tax revenues if business activities are carried on through servers located in third
countries.

90
Australian Taxation Office, Tax and the Internet, vol 1, above n 38, [7.2.9]-[7.2.10].
91
Australian Taxation Office, Tax and the Internet: Second Report, above n 67.
92
Ibid 4.
93
Ibid [5.2.2-3].
94
Roy Rohatgi, Basic International Taxation (2002) 516.
257
It has been argued that Australias ability to tax international trade will be reduced by
developments in electronic commerce because an increasing number of such
transactions will be conducted by foreign sellers with Australian residents.
95
It is
likely that Australias income tax and indirect taxes (customs and GST) can be
avoided or evaded in an electronic environment because Australias DTTs all use tests
of physical presence as their starting point (for example, the existence of a place of
business such as premises, machinery or equipment). A significant portion of the tax
revenue otherwise payable in Australia will not, practically, be collectable and/or will
flow to the residence country.
96

Self assessment relies on a significant level of voluntary compliance by taxpayers.
Though the ATO may check the claims made on the income tax return at a later date,
it has no comprehensive way of determining whether or not taxpayers have declared
all their income. Australias tax law only requires a taxpayer to declare all earnings,
but Australian taxpayers can still (illegally but effectively) hide their income in
offshore accounts.
97
The ATO has reported this case of tax avoidance:
We identified an Australian resident earning income from an electronic
commerce business that was not declared as assessable income. This income
was deposited into an offshore bank account and was accessed using a credit
or debit card.
98

95
Paul McNab, International Reaction to Electronic Commerce Developments (1998) 27 Australian
Tax Review 219, 219.
96
The ATO considers Internet-based business activities currently have little immediate impact on tax
revenues, and Australia can meet the challenges offered by the Internet. A question has been inserted
in the income tax return requesting an Australian business to answer whether it has conducted Internet
trading. Registered businesses with the ATO are issued with a digital certificate and encryption keys to
deal electronically with the ATO. See Australian Taxation Office, Tax Office at Forefront of E-
commerce Discussions, Media Release, Nat 99/86 (10 December 1999).
97
Allesandra Fabro, Overseas Cash: What the ATO Must Know The Australian Financial Review
(Sydney), 3 November 2003, 10.
98
Australian Taxation Office, Tax Havens and Tax Administration (2004) 14.
258
There are practical limitations involved in requesting foreign sellers to lodge an
income tax return and self-assess their tax liability on the profits derived from trading
with Australian resident consumers.
99
With the ease of migration of a web site to a
low-tax jurisdiction, it is difficult to ensure that these businesses comply with
Australias tax laws. Australias existing tax system, based on the principles of
residence and source, was adopted in 1936 and was suitable for the economy at that
time. The income tax legislation does not contain specific provisions that deal with
electronic commerce and foreign sellers that have no physical presence, assets or
agents in Australia.
100
The ATO can only adapt the current residence and source
principles to fit them into an electronic context. The real challenge for the ATO is to
ensure that Australia receives its fair share of tax from the cross-border movement of
trade and investment based on existing legislation.

Hong Kong

There are no provisions in the Inland Revenue Ordinance 1947 (IRO 1947) that deal
specifically with the taxation of electronic commerce. The territorial system of
taxation means that profits are subject to tax if the source is within Hong Kong.
Regarding the taxation of electronic commerce, the deciding factor is physical
presence in Hong Kong and there are two main issues to consider:
whether a business is carried on in Hong Kong; and
whether there are profits from that business sourced in Hong Kong.

99
Under s 161 of the ITAA 1936, the Commissioner of Taxation publishes a notice in the
Commonwealth Gazette each year calling for the lodgment of tax returns and specifying the classes of
taxpayer required to lodge an income return. However, the Commissioner could not enforce a foreign
seller to comply with this notice if the seller does not have a presence in Australia, including a server or
an agency relationship with an Australian resident ISP.
100
The ITAA 1936 allows the Commissioner of Taxation to collect a tax debt. However, the ATO has
no tax debt to collect if the foreign seller does not have a presence or assets in Australia. See footnote
50, Chapter 7, on the Commissioners powers of recovery against both a company and its directors.
259

The view of the Inland Revenue Department (IRD) on the treatment of electronic
commerce is contained in the Departmental Interpretation and Practice Note No 39
(DIPN 39). DIPN 39 stated that:
many different factors may be relevant in determining whether a person is
carrying on a trade or business in a particular jurisdiction. Apart from the
nature of any contracts concluded in the jurisdiction, it may be relevant to note
factors such as the places where goods are stored and delivered by the person,
services are provided, payments are made and received, purchases and sales
are made, bank accounts are maintained, and business back-up services are
provided. It should also be noted that such operations could be performed by
either the taxpayer or his agents. All such operations should be examined in
the context of the nature of the business and the business model under which it
is being conducted.
101

The IRD takes the view that, in electronic commerce, the proper approach is to focus
more on what and where the underlying physical operations were carried out by the
taxpayer to earn the profits in question than on what had been done electronically.
102

In deciding the issue of whether a business is carried on in Hong Kong, the IRD would
look beyond the server and examine the extent of the persons other operations in
Hong Kong.
103
A server, even an intelligent one, requires human control. Therefore,
it is the location of the physical business operation, rather than the location of the
server alone, that determines the locality of the profits. The IRD provides a general
principle:
(a) a company which has all of its business operations in Hong Kong apart from
operating a server (intelligent or otherwise) which is at its disposal and located
outside Hong Kong for electronic commerce purposes will be liable to profits
tax; and

101
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 39,
Profits Tax: Treatment of Electronic Commerce, [8].
102
Ibid [14].
103
Ibid [9].
260
(b) a company which has all of its business operations outside Hong Kong apart
from operating merely a server (intelligent or otherwise) which is at its
disposal and located in Hong Kong will not be liable to profits tax.
104

In summary, the aim is that most Hong Kong-based electronic businesses will be
subject to Hong Kong profits tax, irrespective of the location of the server. For foreign
businesses engaged in electronic commerce, the Hong Kong tax consequences will
generally depend on the companys physical presence in Hong Kong, and not merely
on the location of the server. (Whether this aim will be accomplished is another
matter.)

The territorial-source principle in Hong Kong is under increasing operational
challenge where the physical location where electronic transactions take place cannot
readily be identified. Hong Kong is developing into a regional hub for electronic
commerce. Its world-class telecommunications infrastructure provides the backbone
for electronic commerce to flourish.
105
The Profits Tax Return has been updated by
requesting taxpayers to provide additional information if the business entity is engaged
in electronic commerce whether the entity accepts any orders, sells any goods,
provides any services or accepts any payment over the Internet. Entities have to
provide to the Inland Revenue Department:
the web site address;
name of the company hosting the web site; and
name of the company providing the payment gateway.

104
Ibid [17].
105
See Hong Kong, Commerce, Industry and Technology Bureau, Communications and Technology
Branch, Hong Kong, HK to Become a Major Regional Hub of Electronic Commerce, Press Release
(16 J anuary 2001) <http://www.info.gov.hk/gia/general/200101/16/0116122.htm>at 21 October 2007.
261

These questions only target entities with a physical presence in Hong Kong and
outbound electronic commerce activities. Currently, certain types of payment are
deemed to be liable to profits tax even if the foreign seller has no physical presence in
Hong Kong,
106
but the IRO 1947 does not cover inbound electronic commerce
activities.

6.7 Conclusion

Source-based taxation, by its very nature, is confined within certain territorial limits.
Only income or profits arising in or derived within a particular jurisdiction will be
subject to tax. The rise of electronic commerce has particularly highlighted certain
deficiencies in the existing income tax system and the traditional source rules.
Defining, establishing and asserting jurisdiction are much more difficult on the
Internet than they are in the physical world because geographic boundaries do not exist.
Electronic commerce has made it easier for foreign sellers to conduct a substantial
business in a jurisdiction by setting up a web site on the Internet, while making it
harder for tax authorities to collect tax at source on the income derived from that
business. Even money can be transferred instantaneously to anywhere in the world
without leaving any easy audit trail to follow. The issues raised by electronic
commerce present practical difficulties that were not foreseeable when taxation at
source was introduced by Addington in 1803. At that time, it was thought a tax
authority would have no great difficulty in finding out how much income was earned
by its residents and tax was thus assessed and collected at source (both in the sense of

106
See Part 3.6, Chapter 3, for a discussion of the application of s 15(1) of the Inland Revenue
Ordinance 1947 and deeming certain receipts to have a source in Hong Kong.
262
the character of the income and its geographic location). It was not envisaged just how
businesses, such as the financial sector, services sector and even manufacturing would
become mobile internationally. That one could arrange the transfer of money with an
offshore bank or over the Internet was unthought of. And it could not be foreseen that
developments in telecommunication systems and the growth of the Internet would
create a previously unknown territory called cyberspace. Technological
development and business innovation raise the question where income from electronic
commerce will be taxed. Traditional source rules interpreted by the courts are based
on formal underlying events and do not apply easily to electronic commerce. The
basic question is: How can a jurisdiction apply the traditional concept of source to a
transaction, operation or activity that takes place in whole or in part in cyberspace,
where much of the economic activity does not occur in an identifiable way in the
physical world? Does the transaction, operation or activity largely take place in the
jurisdiction where the customers computer is located, where the sellers computer is
located, or where the sellers server is located, or somewhere else again? A customer
can log on to a computer anywhere in the world. The sellers server can be moved
from jurisdiction to jurisdiction. The challenges presented by electronic commerce are,
at base, practical difficulties in the application of the law. Instead of allocating income
to the place where the activity generating that income occurs, the source of income can
now be planned to produce a desired (low-tax) source for the taxpayer. The taxation
of business profits arising from online sales may ultimately be very difficult to collect
unless there is a physical presence within a source jurisdiction.

Searching for the real source of income (the origin of the yield or the profits) has
become more problematic with the increase in globalisation and the rapid growth of
263
Internet-based commerce. The traditional concept of source of income has lost
traction as a fundamental basis for effectively imposing income taxation, especially in
todays globalised economy.

264
CHAPTER 7: POSSIBLE SOLUTIONS

7.1 Introduction

Discussions in the previous chapters show that existing source rules are proving
inadequate to tax business profits effectively, given the growth in new forms of doing
transnational business and especially web-based commerce. Too many international
trade and investment activities fall outside of the tax net. This chapter considers ways
to deal with issues arising from our significant reliance on the source principle, as it is
currently understood. The understanding in this thesis derives from an in-depth
examination of two jurisdictions (Australia and Hong Kong) where the courts have
played a key role in defining the meaning of source. The issues identified are, it is
clear from the wider literature, being generally examined, however.

Three of the most prominent options for addressing the identified issues are critically
reviewed in this chapter. These options have been identified following an extensive
literature review. First, there is the proposal to establish a jurisdictional framework for
the source-based taxation of electronic commerce transactions by introducing a
refundable withholding mechanism (hereafter the Pinto Proposal).
1
The Pinto
Proposal is the most systematic, recent single academic-researched proposal to tax
web-based transactions using known concepts. Next, the United States (US)
Treasury Department has suggested essentially abandoning source-based taxation
altogether in favour of residence-based taxation due to difficulties which it sees in

1
Dale Pinto, E-Commerce and Source-Based Income Taxation (2003).
265
determining the source of income.
2
This proposal reflects the view of the US Treasury
Department. Lastly, this chapter also considers the option of relying less on income
tax by placing a greater reliance on consumption tax, to help overcome the increasing
difficulties in applying the source principle in the (income) taxation of business profits.
This option of shifting the tax base more from income to consumption is increasingly
argued a number of thought-through reform options are now on the table, arguing
for the replacement of an income tax (or a profits tax) with a general consumption
tax.
3

These options are considered after reviewing the possible strategies available to
revenue authorities to be the options having the strongest potential to address the
increasingly evident drawbacks of relying too heavily on traditional income source
rules.

7.1.1 Overview

Under current, accepted cross-jurisdictional taxation practice, a source jurisdiction
needs to address a number of issues before it can exercise its right to tax the business
profits of a non-resident entity:
the identity of the taxpayer;
the nexus or link to the jurisdiction;

2
3
See Chris Edwards, A Primer on Replacing the Corporate Income Tax with a Cash-Flow Tax (2003)
100 Tax Notes 1293; J ohn H Makin, Real Tax Reform: Replacing the Income Tax (1985); Daniel N
Shaviro, Replacing the Income Tax With a Progressive Consumption Tax (2004) 103 Tax Notes 91;
United States, The Presidents Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth:
Proposals to Fix Americas Tax System (November 2005) <http://taxreformpanel.gov/final-report/>at
1 May 2008.
266
the permanent establishment (PE) threshold requirement;
geographic source rules to determine what income and expenses are properly
attributable to the PE;
rules for computing the business profits of a non-resident; and
rules with respect to the enforcement of tax payable by a non-resident, including
the information gathering and tax collection mechanisms.
4

The residence principle of taxation is based on the place of (tax) residence of the
person receiving the income. Residence-based taxation reduces the importance of
determining the real source of income derived from a multitude of transactions,
operations or activities, some of which might occur outside a jurisdiction. Residents
(both individuals and companies) are (normally) taxed on their worldwide income.

A consumption tax is a source of revenue closely linked to increases in consumption.
5

It can apply to registered suppliers at any and every stage of the supply chain or
commercial flow of goods and services. Each transaction is considered on its merits as
a separate economic activity, whether done by traders, manufacturers or service
providers.
6
The character of a particular transaction in the supply chain cannot be
altered by earlier or subsequent events. Virtually any type of entity can be subject to
consumption tax including individuals, companies whether incorporated or not,
superannuation funds, government bodies and non-profit organisations. Generally, a

4
Brian J Arnold et al, Introduction: Perspectives on the Taxation of Business Profits Under Tax
Treaties in Brian J Arnold, J acques Sasseville and Eric M Zolt (ed), The Taxation of Business Profits
Under Tax Treaties (2003) 1.
5
Alan A Tait, Value Added Tax: International Practice and Problems (1988) 23.
6
The term economic activity covers any activity of producers, traders or persons supplying services,
including mining and agricultural activities and activities of the professions. See art 9(1) of Council
Directive No 2006/112/EC of 28 November 2006 on the Common System of Value Added Tax [2006] OJ
L 347 (European Union) (VAT Directive).
267
consumption tax is adopted when a jurisdiction is not satisfied with the existing tax
structure.
7
It has become a crucial part of the overall revenue regime for jurisdictions
using it.


The Pinto Proposal and the argument for the continued viability of source-based
taxation on income derived from electronic commerce are discussed in the next part,
followed by a discussion of greater reliance on the residency principle in Part 3.
Finally, the option of reducing the reliance on taxation based on income and shifting
more to taxation based on consumption is discussed in Part 4. In each case, the three
particular options are critically evaluated.

7.2 The Pinto Proposal

Under a double tax treaty (DTT), the PE threshold acts as a source rule to the extent
that, as a general rule, the only business profits of a non-resident that may be taxed by
a country are those that are attributable to a PE.
8
The current PE threshold depends on
a physical presence of some kind at a fixed place of business in the source country and
the carrying on of business by the non-resident through this fixed place of business for
a certain period of time.
9
Professor Dale Pinto (hereafter Pinto) argues that these
requirements are likely to create problems to determine taxable nexus in source
countries because physical presence could become more elusive (or even absent) in an

7
Tait, above n 5, 9.
8
OECD, E-Commerce: Transfer Pricing and Business Profits Taxation (Tax Policy Studies No 10,
2005) 77.
9
See Part 2.6.3, Chapter 2, for a discussion of the concept of permanent establishment (PE).
268
electronic commerce context and the PE threshold may no longer represent an
appropriate instrument for the taxation of business profits.
10

Pinto has argued two key points which, he says, makes the continued application of
source-based taxation of profits from electronic commerce activities both sensible and
feasible:
Source-based taxation is theoretically justifiable and applicable for income that
arises from international transactions that are conducted in an electronic commerce
environment.
11

While source-based taxation is theoretically justified in an electronic commerce
context, the way in which source is defined for active business profits (including
services income) under the PE threshold needs to be reconceptualised to
adequately accommodate electronic commerce transactions due to the difficulties
in defining source under traditional principles.
12

Pinto puts forward a refundable withholding approach (as an alternative to two other
approaches) to re-define or reconceptualise the concept of source under the PE
threshold.
13
He argues in favour of:

10
Pinto, above n 1, 208-9.
11
The argument that source-based taxation of electronic commerce transactions is theoretically
justifiable is based on the principles of benefit theory, neutrality considerations (for example, capital-
import neutrality), equity (for example, inter-nation equity), the concept of entitlement, and pragmatic
considerations including the prospect of double taxation and likely impediments to international trade.
Ibid 6, 17-45.
12
Professor Dale Pinto (hereafter Pinto) argues that the most significant characteristic of electronic
commerce which impacts on the way in which source is defined is the irrelevance of geographical
considerations and the borderless nature of the medium. The characteristics of electronic commerce
may create problems for applying traditional principles that define source. This is because electronic
commerce allows businesses to earn income from source countries without the need for maintaining a
physical presence in these countries and this could impact on the way source is defined under the PE
concept contained in double tax treaties (DTT). Ibid 6, 58-9, 67.
13
The two other approaches to reconceptualise the concept of source under the PE threshold are the base
erosion approach (put forward by Professor Richard Doernberg) and the virtual PE approach (put
forward by Professor Luc Hinnekens).
269
adopting a monetary threshold test as a proxy for determining taxable nexus in
source countries;
14
and
applying the proposed monetary threshold test to all income that is generated by
electronic commerce irrespective of the character of income (thereby overcoming
the potential problems of characterising the income (meaning A)).
15

If the monetary threshold is satisfied, the foreign seller would be subject to (ultimate)
source state taxation. Conversely, if the monetary threshold is not satisfied, the
foreign seller would not be subject to source state taxation a refund would be paid.
In fact, a preliminary tax would be collected virtually immediately as each separate
electronic commerce transaction was concluded (see further below). It is this

The base erosion approach seeks to address the concern that electronic commerce importing
countries may lose some of their existing tax base and the likelihood of double taxation because of
inconsistencies in the application of existing tax principles to income generated by electronic commerce.
It works by allowing for the withholding in source countries on payments that may erode the tax base
(that is, if the payment is deductible or added to the cost of goods sold) in those countries where no PE
is found to exist. The base erosion approach works as follows. Suppose R Corp, a resident of State R,
has no presence in State S other than a customer base. Thus, R Corp would not be subject to income tax
in State S. If an international consensus could be reached, a single withholding rate would be applied to
any payment that is borne by a State S payer to a State R beneficial owner that erodes the tax base of
State S. For this approach to work, the payment must be deductible by a State S purchaser or goes into
the cost of goods sold of a State S reseller, and the withholding tax imposed by State S must be
creditable in State R. All payments (for example, royalties, interest, compensation, or cost of goods
sold) except dividends would be subject to withholding. Dividends do not erode the tax base of the
payers state as they are not deductible. Also excluded from withholding are payments made by State S
consumers to State R vendors because the consumer does not deduct the cost of consumption. Under
this approach, the withholding by State S may result in a transfer of tax revenue from State R to State S,
but R Corp would be indifferent because the overall level of tax would be unchanged. See Richard L
Doernberg, Electronic Commerce and International Tax Sharing (1998) 16 Tax Notes International
1013, 1015-8.
The virtual PE approach reinvents a taxable nexus in source countries. It works by introducing a
special article in the existing DTTs and allocating the right to tax profits from business over the Internet
to their source state even in the absence of a PE. See Luc Hinnekens, Looking for an Appropriate
J urisdictional Framework for Source-State Taxation of International Electronic Commerce in the
Twenty-first Century (1998) 26 Intertax 192, 195-9.
According to Pinto, both the base erosion and virtual PE approaches have advantages and
disadvantages. However, he argues that difficulties may exist in practice under both approaches and his
refundable withholding approach is an alternative to the two approaches for determining taxable nexus
in source countries. See Pinto, above n 1, 173-205 on his analysis of the base erosion and virtual PE
approaches.
14
Pinto, ibid 211.
15
Ibid 216.
270
preliminary tax which would either be permanently withheld or refunded after
the time came for application of the monetary test.

In this part, the operational detail of the Pinto Proposal is explained. An evaluation on
how well it addresses the income source issues faced by most revenue authorities
today is also provided.

7.2.1 The refundable withholding model

The Pinto Proposal would operate as follows:
All international transactions involving goods or services that are either
provided electronically (e.g. computer software) or purchased via electronic
means (e.g. flowers purchased over the Internet) would be treated as
withholding income, which would then be subject to a uniform rate of
withholding by source countries irrespective of the category of income
involved. The only exception to withholding would be in relation to passive
dividend or interest income, which will continue to be treated under existing
rules, whereby such income is generally taxed by residence countries, though
consistent with current practice, dividend and interest income may continue to
be taxed on a withholding basis by source countries that withhold tax on such
income Subject to the exception from withholding for passive dividend and
interest income as discussed above, at the end of a relevant period, if a sellers
total gross sales into a jurisdiction remained below a de minimis threshold, then
the seller would not be subject to tax in the source country but would need to
file a return in the source jurisdiction to obtain a refund of withheld amounts.
Conversely, if a sellers total gross sales into a jurisdiction for the period
exceeded the de minimis threshold, then the vendor would be subject to source
country taxation and amounts withheld would generally not be refunded in this
situation. At the same time, sellers whose operations exceed the de minimis
threshold will be able to elect to file a return in the source country and be taxed
on a net basis.
16
(Emphasis in original.)

It is proposed that withholding occur in the location of the customer, as shown on the
digital certificate (DC).
17
Customers could either be business purchasers or private

16
Ibid 209-10.
17
Pinto has also suggested other mechanisms to determine the location of the customer:
an electronic resident card (obtained from trusted third parties such as banks) designed to identify
the country where an electronic commerce consumer is located;
271
consumers of goods and services.
18
As it would be extremely unlikely for customers
to collect the tax, it has been suggested that an intermediary such as a payment
provider could be used to collect same.
19

The system would work as follows:
A customer would contact a company electronically and indicate that they
wished to purchase a good or service. A government-approved intermediary
(e.g. a credit card company like Visa) would then seek the details of the digital
certificate of the customer, which would serve to establish the location of the
customer and therefore the country where withholding needs to occur. The on-
line intermediary would then process the payment details and remit the
withholding tax to the source-country tax authority, and the payment (net of
withholding tax) to the retailer.
20

a computer chip containing a serial number that would allow Internet companies to identify
companies that contacted their web sites; and
the address supplied by the customer when a purchase is made.
However, he argues that the easiest current method to track sales would be through the use of a digital
certificate, which could be used to verify the residence of a consumer in a country. Ibid 221-2.
18
Ibid 222.
19
Ibid 223.
20
Ibid 223-4.
272
The Pinto Proposal is illustrated with an example, as follows:
21

Pinto argues that, from the perspective of a customer, the whole process could be
automated and would be an instantaneous and seamless process.
22

Pinto also argues that the reasons advanced for the abandonment of source-based
taxation in an electronic commerce environment are principally based on practical and
administrative considerations and are therefore based on expediency, rather than being
founded on theoretical grounds:
23

how something can be done (which involves practical or administrative
considerations) should be a secondary consideration to whether it can be
theoretically justified and therefore should be done in the first place (emphasis
in original).
24

21
Assume that a customer in Country X purchased goods worth $100 from a seller in Country Y. Also
assume that withholding was levied at five per cent and that the online intermediary was allowed to
retain one per cent of that amount to cover its costs of collection.
1 Customer in Country X placed an order of $100 with a seller in Country Y.
2 Seller informed the online intermediary.
3 Online intermediary checked customers digital certificate and location.
4 (a) Online intermediary processed the payment ($100), deducted withholding tax of $5 and sent
the net amount of $95 to the seller in Country Y.
(b) Of the $5 withheld, $1 would be retained to cover the intermediarys costs, and the balance of
$4, along with details of the gross sale ($100), would be remitted to the tax authority in Country X.
Ibid.
22
Ibid 224.
23
Ibid 223.
24
Ibid 7.
Customer
Country X
Foreign Seller
Country Y
Online
Intermediary
Country Unknown
Tax
Authority
Country X
1 Order of $100 placed
4(a) $95
(net of
refundable
withholding
tax) sent to
the foreign
seller
3 Digital certificate details and location
of customer checked
2 Online
intermediary
informed
4(b) Refundable withholding tax of $4 ($5 less $1 to
cover cost) remitted to the tax authority
273

The Pinto Proposal relies on a new approach to the taxation of business profits, which,
in a more ideal world, looks to have some notable attractions. However, compliance,
enforcement and collection of the correct amount of tax are all essential to the
management of any tax system and a number of challenges would need to be
overcome to adopt such a system. The operation of the Pinto Proposal and the
taxation of business profits are illustrated in the roadmap below:

Are goods or services
supplied or sold
via electronic means?
The foreign seller is
not subject to source
state taxation.
The foreign seller is subject to
the Pinto Proposal.
Withholding occurs in the location of
the customer .
The foreign seller is not subject to
the Pinto Proposal.
Withholding does not apply.
Yes No
The foreign seller is
subject to source
state taxation.
Yes No
Amounts withheld by the source
state would be refunded.
The foreign seller needs to file a
tax return in the source state to
obtain a refund.
Is the foreign sellers total gross
sales into a state for a relevant
period above the de minimis
threshold?
See the taxation of
business profits below.
Source state taxation limited
by rate with residence
state relief.
Full taxation by the source
state elected by the
foreign seller.
The Pinto Proposal
Residence state
taxation.
or
Full taxation by the residence state.
Tax withheld by the source state or
tax paid in the source state
creditable by the residence state.
The foreign seller needs to file a tax
return in the source state and be
taxed on a net basis.
Amounts withheld by the
source state would
generally not be refunded.
Is there a non-resident
foreign seller?
Yes
Sales by resident
entities are not subject
to the Pinto Proposal.
No
274

7.2.2 Main characteristics of the Pinto Proposal

The main characteristics of the Pinto Proposal are as follows:
the source of income is determined by
the way in which the order is placed or delivered electronic or non-electronic
means (meaning A); and
the location of the customer as shown on the digital certificate (meaning B);
Is there a double tax
treaty with the other
state?
The taxation of
business profits
Residence state
taxation.
Double tax treaty
provisions prevail over
the domestic law.
Domestic law
applies.
Yes No
Are profits
attributable to
the PE?
Yes
Full taxation by both the
source and the residence
states with residence
state relief.
The enterprise is not liable to tax in the
other state on its business profits (except
where an article applies, eg, income
from real property situated in the other
state may be taxed by that other state).
Yes
No
Is the enterprise carrying
on a business through a
PE (as defined) in the
other state?
For example, non-residents carrying on
a business in Australia are taxable on
ordinary and statutory income with a
source in Australia. Businesses are
taxed in respect of profits arising in or
derived fromHong Kong.
No
275
a monetary threshold as an indication of the level of business activity in the source
jurisdiction is introduced;
the burden of tax collection from electronic commerce transactions is shifted to an
online intermediary;
a preliminary tax is collected virtually immediately as each electronic commerce
transaction is completed; and
a refundable withholding tax based on sales turnover of the seller in the
purchasers jurisdiction is established.

Source of income (meaning A) is determined by the way the order is placed or
delivered

The Pinto Proposal provides an alternative to determine the source of income derived
from electronic commerce without the need to characterise the income (meaning A).
Pinto proposes that his withholding mechanism be applied to all international
transactions involving goods and services that are either provided electronically or
purchased via electronic means, irrespective of the type of income involved with the
exception of passive dividend, interest and royalty income which would continue to be
treated under the existing rules. The Pinto Proposal is, therefore, based on form (on
how the order is placed or delivered) and not stated in terms of source of income (the
nature of the transaction, operation or activity that generates the moneys received).
Although it is becoming increasingly common for web-based businesses to receive
orders via email, some are still taking orders sourced from the Internet via mail or
telephone.
25
How are these orders to be classified electronic or non-electronic?
Instead of determining from what transaction, operation or activity the income

25
Mandy Bryan, SMEs Go Online for Business, The Australian Financial Review (Sydney), 4 May
2004.
276
originates, it seems there is still a need to determine how the order is placed or
delivered and whether or not it would be subject to the Pinto Proposal.

Characterisation of receipt is important as it determines whether the income should be
taxed in the residence or the source jurisdiction, or both. The right to tax passive
income not effectively connected with a PE is shared between the residence and the
source jurisdiction. Thus, passive income is taxed on a withholding basis by the
source jurisdiction that withholds tax on such income, with an exemption or credit on
the tax paid granted by the residence jurisdiction. Active income derived from
genuine business activities in the source jurisdiction is taxed on a net basis by
assessment under the source jurisdictions domestic law. Under a DTT, business
profits are taxed in the residence jurisdiction only, or full taxation by both the source
and the residence jurisdiction (with residence jurisdiction relief), depending on
whether or not a PE exists in the source jurisdiction and profits are attributable to that
PE.
26
Determining the source of income is necessary as the basis for the allocation of
tax revenue between the residence and the source jurisdiction depends on the type of
income involved. For example, interest paid in respect of debt claims forming part of
the assets of the PE or otherwise effectively connected with the PE is treated as
business profits.
27

Source of income (meaning B) is determined by the location of the holder as shown
on the digital certificate

The Pinto Proposal depends on the online identification of the location of the
purchaser. This is because withholding tax is to be remitted to the tax authority of the

26
See Part 5.2, Chapter 5, for a discussion of the business profits article in Australias DTTs.
27
277
purchaser. Under this approach, when an order is placed or delivered electronically, it
is the address of the purchaser, as shown on the DC, which determines where the
source of income is situated (meaning B) and that tax be withheld and collected from
the purchaser (by the online intermediary).

A DC is issued by a Certificate Authority (CA) to certify that the person granted the
certificate is who he or she claims to be. It is not issued by a central governing body.
Thus, the proof of identity requirements of CAs varies and the standard may not meet
the requirements of tax administration.
28
One cannot allocate income to a source or
give it a deemed source by the location of the holder of the DC, because a DC
typically does not state the tax residence of the holder. The following example
demonstrates the difficulties which can arise.

The Hong Kong government has introduced a Smart ID Card to replace the identity
cards for its residents.
29
A Hong Kong resident can opt to have an e-Cert (digital
certificate) embedded in the new Smart ID Card to prove their identity as well as send
encrypted messages.
30
Thus, the e-Cert helps reduce the key concerns businesses and
consumers have about electronic transactions authentication of the identities of the
parties, integrity and confidentiality of the content of electronic transmissions and non-
repudiation of the transaction made.
31
Though the Smart ID Card and the digital
identity will enable Hong Kong residents to perform secure transactions over the

28
In Australia, many online services with the Australian Taxation Office (ATO), for example, the Tax
Agent Portal, Business Portal and the Australian Business Register, are only accessible with a digital
certificate (DC) issued by the ATO. The use of these DCs is restricted to dealings with the ATO only.
29
Hong Kong introduced an identity card system in 1949, with the growth of population and influx of
migrants from Mainland China. Under s 3 of the Registration of Persons Ordinance (Cap 177), every
person in Hong Kong must carry an identity card unless an exemption applies.
30
This e-Cert is issued by the Hongkong Post, one of the Certificate Authorities that can issue electronic
certificates in Hong Kong. See Hong Kong Information Centre, e-Cert (3 April 2007)
<http://www.smartid.gov.hk/en/ecert/index.html>at 20 April 2008.
31
Claudine Kolle, Safer Cyber-Shopping (2002) 38(4) Asian Business 29, 29.
278
Internet, its main purpose is to certify the residency status of the holder (permanent or
temporary resident) in Hong Kong and not the tax residence. It does not restrict the
rights of the holder to remain a resident of another country. For example, a person
who has the right of abode in Hong Kong can be a (tax) resident of Australia as well.
The business profits on the purchases made by such a person might properly be taxed
in Australia, but, in this example, they would bypass the Australian tax system if the
location on the DC shows a Hong Kong address. Increasing numbers of individuals
now hold rights to reside in two or more jurisdictions.

Even if tax residence of the holder were stated in the DC, purchasers could change
their residence or establish their residence in more than one jurisdiction during the
year. Instead of determining the source of income, there is a need to determine the tax
residence of the purchaser.
32
A DC could only be used to prove the tax residence of a
person if it is certified by the relevant tax authority of the purchaser each time an
electronic transaction is conducted.

A monetary threshold as an indication of the level of business activity in the source
country

To meet the other condition of the level of business activity under the PE definition,
Pinto proposes to use a monetary threshold as an indication of the level of business
activity in the source country. Pinto recommends a low withholding tax rate as well as

32
See the term resident or resident of Australia defined in s 6(1) of the Income Tax Assessment Act
1936 (Cth) (ITAA 1936)..
279
a generous monetary threshold, so that small businesses would ultimately not be subject
to source country taxation if their total gross sales fell below the monetary threshold.
33

A question arises on how to set the monetary threshold for a very mobile tax base.
Who should set the dollar amount? Would it be indexed annually? If it were set at a
low level, small dot-com stores with a low sales turnover would be taxed in the source
jurisdiction. This would tend to favour the source jurisdiction and discourage genuine
cross-border business activities. On the other hand, if it were set at a high level, it
would tend to favour the residence jurisdiction. This is because the sales turnover of
small dot-com stores would be likely to remain below the high monetary threshold and
tax revenue would be shifted to the residence jurisdiction. Pinto proposes to set the
monetary threshold at a generously high level. The sales turnover of small businesses
would tend to stay below the threshold and the business profits would not be taxed in
the source jurisdiction. The issue here is, thus, that a monetary threshold based on
gross sales turnover likely would not permit sufficient scope for source taxation as it
limits the right of the source country to tax business profits. The Pinto Proposal does
not require physical presence of foreign sellers in the source jurisdiction. Pinto argues
that electronic commerce allows for business profits to be earned in source
jurisdictions without any physical presence and that the taxing nexus in source
jurisdictions needs to be independent of a physical presence.
34
Since physical
presence would not be required, entities could even establish a presence in the source
jurisdiction and their business profits would not be taxed as long as their sales turnover

33
Pinto is of the opinion that the residence countries would be willing to fully permit a credit on taxes
withheld at source (that is, not apply any excess foreign tax credit rules) in exchange for a low rate of
withholding in the source country. See Pinto, above n 1, 218 and 225-6.
34
Ibid 211.
280
stayed below the threshold.
35
This provides tax planning opportunities and could lead
to entities relocating their businesses to low-tax jurisdictions.

The burden of tax collection from electronic commerce transactions is shifted to an
intermediary

Pinto proposes that tax be collected by an intermediary and remitted to the tax
authority of the purchaser. An intermediary is someone whose functions lead to the
acceptance of the legal and administrative responsibilities of a non-resident supplier
who would normally be required to account for tax.
36
The tax would be collected by
the intermediary from foreign sellers that have sold goods and services to purchasers
business purchasers or end consumers in the source jurisdiction, at the time of
purchase.
37
Pinto does not indicate whether the agency principle applies to the
intermediary and who should be held accountable for any shortfall or omission of tax
whether the principal (purchaser) or the agent (online intermediary).

The agency principle plays a role in collecting tax from non-residents. Generally, the
principal is the party who authorises the agent to act on his or her behalf. Thus, the
acts of the agent within the scope of the authority are the acts of the principal. The
intermediary is, in fact, an agent. In Hong Kong, if a non-resident is chargeable to tax
either directly or in the name of his agent in respect of all his profits arising in or
derived from Hong Kong, the agent is required to retain from the assets of the non-

35
In this regard, businesses have to remain as a non-resident in the source jurisdiction in order to be
treated as a non-resident for income tax purposes. Residency rules are discussed in Part 7.3.2 below.
36
OECD, Centre for Tax Policy and Administration, Electronic Commerce: Facilitating Collection of
Consumption Taxes on Business-To-Consumer Cross-Border E-Commerce Transactions (2005) [10]
37
Pinto, above n 1, 222.
281
resident sufficient money to pay tax to the Inland Revenue Department (IRD).
38

Australias tax legislation requires that non-residents pay tax on any Australian-source
income.
39
In the case where a withholding tax is imposed instead of an income tax
(for example, interest, dividend and royalties), the burden of collecting tax is shifted
from the non-resident recipient of the income to the person who pays the income. A
person who has receipt, control or disposal of money that belongs to a non-resident
who derives income or profits or gains of a capital nature from an Australian source is
authorised to withhold sufficient money to pay the tax due or that will become due by
the non-resident.
40
The payer is personally liable to pay the tax on behalf of the non-
resident.
41
(Under the GST legislation, it is the maker of the taxable importation (and
taxable supply) that is held responsible for the GST on the importation (and supply) of
goods and services, even if it is made through an agent.
42
)

Pinto proposes that tax be withheld by the intermediary. Pinto does not discuss the
location of the intermediary, who may or may not be located in the same jurisdiction
of the purchaser.
43
If the intermediary were located in the same jurisdiction as the
purchaser, the online intermediarys role would be redundant as tax would be
collected, any way, directly from the recipient of goods and services (or the supplier)

38
See ss 20A and 20B of the Inland Revenue Ordinance 1947 (IRO 1947) which facilitate the
collection of tax. See, also, the discussion in Part 3.6, Chapter 3, on the application of ss 20A and 20B
in Hong Kong.
39
40
Income Tax Assessment Act 1936 (Cth) s 255.
41
Income Tax Assessment Act 1936 (Cth) s 255(1)(c).
42
Division 153 of A New Tax System (Goods and Services Tax) Act 1999 (Cth) (GST Act) contains
special rules for supplies and acquisitions made through an agent. See, also, Australian Taxation Office,
Fact Sheet: GST and the Treatment of Supplies Made Through Agents (2004).
43
The intermediary may be located in a number of other jurisdictions:
the location of the purchasers taxing authority;
the location of the seller;
the location of the sellers taxing authority; or
another location.
In any event, a jurisdiction must have taxing rights with respect to the business profits of a foreign
seller.
282
by the relevant tax authority. If the intermediary were not located in the same
jurisdiction as the purchaser and outside of the taxing jurisdiction, how could a
jurisdiction establish a clear right under the law to impose and enforce a tax claim?

A jurisdiction must have legislative (legal) and enforcement (practical) jurisdiction
over the party liable for the tax.
44
Legislative (legal) jurisdiction to impose tax
currently requires the existence of a PE and territorial nexus between the taxpayer and
the country imposing the tax. If it is argued that even if the physical presence
threshold would satisfy the legal basis of tax jurisdiction residence, source and PE
there is still the question of whether or not a tax administrator has enforcement
(practical) jurisdiction over the party liable for the tax. Enforcement (practical)
jurisdiction requires the identification of a legal entity on which to impose tax and
association with physical proximity to enforce the tax liability:
A taxation administrator can exercise practical jurisdiction over a resident
taxpayer in a country because the taxation administrator can bring sanctions to
bear on a taxpayer who does not voluntarily comply with taxation obligations.
Similarly, where the income of a non-resident is sourced within a country, tax
administrators have practical jurisdiction because they can tax the income
before it leaves the country.
45

Enforcement (practical) jurisdiction is based on the concept of state sovereignty. The
enforcement of an international tax claim by a state poses a question of enforcement
jurisdiction.
46
For example, a business using an Internet site that is outside of
Australia may have placed itself outside of the enforcement (practical) jurisdiction of
the Australian Taxation Office (ATO), depending on what view is taken as to where
the business is being conducted.

44
Legislative jurisdiction refers to a states competence to legislate. Enforcement jurisdiction refers to
the actual enforcement of the law. See Australian Taxation Office, Tax and the Internet (1997) vol 1,
47; Asif H Qureshi, The Public International Law of Taxation: Text, Cases and Materials (1994) 22.
45
Australian Taxation Office, Tax and the Internet, ibid 48.
46
Qureshi, above n 44, 308.
283

The critical problem is how to get non-resident intermediaries to comply with the legal
and administrative requirements of the taxing jurisdiction. It is a well-established
principle in English law that the courts of one country will not assist in the
enforcement of tax debts due to another country.
47
It has been pointed out in the
Frandsen case (1999)
48
that:
It is a rule now well established of our law and of international custom that
besides treaties, in tax matters everyone is master in his own State and the
authority of each individual State does not go beyond its own frontiers. This
applies to all areas of tax such as the amount that will be taxed, the recovery of
taxes, the levying of individual taxes, and fines It may be considered that
this line of thinking is obsolete, but it still remains anchored within us that we
will not permit the presence in our country of foreign tax men, even if
represented by intermediaries; we do not tolerate that any help may be given to
them.
49

Pinto does not appear to address how cross-border taxation debts can be enforced
under his proposal should the online intermediary fail to remit the tax to the relevant
tax authorities. In Australia, the Commissioner of Taxation has powers of recovery
against both a company and its directors if they fail to comply with taxation
obligations.
50
However, these powers could not be applied to dot-com stores and

47
The leading case that established this principle is Government of India, Ministry of Finance (Revenue
Division) v Taylor [1955] AC 491. In that case, a United Kingdom (UK) registered company operated
an electricity supply undertaking and tramway undertakings in India. In 1947, the company sold its
undertakings and the proceeds from the sale were remitted to England. After selling its undertaking, the
Indian Income Tax and Excess Profits Tax (Amendment) Act 1947 was passed. Section 12B was
inserted in the Indian Income Tax Act 1922 which charged capital gains tax in respect of any profits or
gains arising from the sale, exchange or transfer of a capital asset effected after 31 March 1946. On 25
May 1949, the company went into voluntary liquidation in England. The Government of India lodged a
claim against the liquidator in respect of the unpaid capital gains tax. However, the court held that only
liabilities that could have been enforceable against the company in the English courts were receivable.
Claims of a foreign state to recover taxes due under its laws were unenforceable in English courts.
48
QRS 1 Aps & Others v Frandsen [1999] STC 616.
49
Ibid 628.
50
The Commissioner of Taxation has powers of recovery against both a company and its directors if
they fail to comply with taxation obligations. Sections 222AOC and 222AOD of the ITAA 1936
provide that each director of the company can incur a personal liability if a company fails to remit
deductions as required. Further, the Commissioner can serve a notice of demand upon a company for
payment of an outstanding debt that is due and payable (for example, unpaid PAYG and other
284
foreign sellers that have no presence or connection with Australia. Though there may
be reciprocal arrangements between countries for the enforcement of judgments, they
do not usually apply to tax judgments.
51
In the absence of an agreement, no state can
exercise jurisdiction in the territory of another state on tax claims.
52
There may be a
need to re-negotiate DTTs to provide for mutual assistance in collection of cross-
border tax debts.
53
However, this process may take considerable time and effort.

The Pinto Proposal is also, arguably, lacking in efficiency. There is an added cost,
namely the additional cost incurred by the online intermediary in processing each
transaction. Pinto proposes that the cost be borne by the relevant tax authority. This
would add to the cost of collection. On the other hand, if it were borne by the
purchaser, it would push up the cost of the item. And if it were borne by the
intermediary, it would add to the cost of compliance. With perhaps millions of
potential taxable transactions, basic compliance becomes a significant practical
problem.

remittance amounts). Should the company fail to comply, he can apply for an order under s 459P of the
Corporations Act 2001 (Cth) for the winding up of the company.
51
In Australia, the Foreign Judgments Act 1991 (Cth) establishes a statutory scheme under which
judgments of foreign courts can be enforced in Australia. However, the scheme is limited to money
judgments of certain specified countries and courts. Section 3 provides a definition of money judgment,
which is a judgment under which money is payable. But an enforceable money judgment does not
cover taxes or charges of a similar nature. Common law rules will apply to the enforcement of
judgments that fall outside the statutory scheme.
In Hong Kong, a judgment granted by a foreign court may be recognised and enforced under the
Foreign Judgments (Reciprocal Enforcement) Ordinance (Cap 319) or at common law. Section 3
provides that the ordinance applies to judgments of certain specified countries and courts and does not
apply to judgments in respect of taxes or charges like a fine or penalty.
52
Qureshi, above n 44, 308.
53
In Australia, mutual assistance in collection of foreign tax debts can be activated if there is in force an
agreement between Australia and a foreign country or territory that contains an article relating to
assistance in collection of foreign tax debts (see Div 263, Pt 4-15 of Schedule 1 to the Taxation
Administration Act 1953 (Cth) (TAA 1953)). The Commissioner can collect from tax-paying entities
who are resident in Australia, or who hold assets in Australia, that have unpaid tax debts in a foreign
country or territory, an amount in respect of a tax debt that the person owes to such a country or territory
or take action to conserve assets of the entity. Australia has, thus far, amended one DTT that provides
for the mutual assistance in collection of taxes. See the Protocol Amending the Agreement Between the
Government of Australia and the Government of New Zealand for the Avoidance of Double Taxation
and the Prevention of Fiscal Evasion with respect to Taxes on Income (entered into force 22 J anuary
2007) that provides for mutual assistance in collection of cross-border tax debts.
285

As withholding covers all types of goods ordered and delivered electronically, there
are other matters to consider, for example: Is the computer processing system robust
enough to handle the return of goods, the cancellation of orders and the application for
tax refunds by customers? Has the intermediary the authority to approve tax refund
applications by customers as well?

A preliminary tax is collected on each electronic commerce transaction

Under the Pinto Proposal, a preliminary tax is collected virtually immediately as
each separate electronic commerce transaction is concluded. If the monetary threshold
is not satisfied, the foreign seller would not be subject to source state taxation and a
refund would be paid. If the monetary threshold is satisfied, foreign sellers would be
subject to (ultimate) source state taxation. The preliminary tax would be
permanently withheld and no refund could be claimed by the foreign seller. If the
foreign seller elects to be taxed on a net basis, he would have to lodge an income tax
return. The Pinto Proposal could create a significant compliance burden for (properly
complying) businesses. For example, if a seller sold goods to customers residing in
ten countries, the seller may have to lodge ten income tax returns to the respective tax
authorities at the end of the financial year to either obtain a tax refund or be taxed on a
net basis.

A question arises about how to set the withholding tax rate. Generally, non-residents
are taxed on their income that is not effectively connected with the conduct of a trade or
business on a withholding basis by the source jurisdiction. Withholding tax rates are
286
usually significantly below the company income tax rate.
54
Unless the withholding tax
and the company income tax rates are equal, there is an incentive to conduct a business
using the Internet to avoid paying at the higher company tax rate. A non-resident entity
could avoid paying at the higher company tax rate by establishing its residence in a tax
haven to stay below the threshold. The company could also hide its financial
information there, which, very likely, would be protected by secrecy provisions.

A tax system should produce the right amount of tax at the right time, and the potential
for evasion and avoidance should be minimised.
55
The Pinto Proposal of collecting
tax, for the reasons outlined above, unfortunately, does have the potential to
undermine the effectiveness and fairness of a given tax system.

A refundable withholding tax based on net income

Pintos withholding tax is not a final tax. Sellers whose operations exceeded the
monetary threshold would have the option to lodge an income tax return in the source
jurisdiction and be taxed on a net basis.
56
Otherwise, tax withheld would not be
refunded.

If business income is taxed on a net basis, deduction of costs and expenses in earning
the profits must be allowed from the selling price to arrive at a correct statement of net
income. Pinto does not seem to address how the source of expenses is determined.
Most countries do not have detailed rules associating expenses with foreign or
domestic activities, or distinguishing between allocations to domestic or foreign

54
See Part 3.6, Chapter 3, for a discussion of withholding tax rates.
55
Conditions (2001) 10.
56
287
income (or taxable and non-taxable income).
57
There is no consensus on the proper
rules in determining the source of deductions. The issues that relate to determining
whether expenses are to be treated as domestic or foreign include:
Whether all deductions must be allocated?
Whether allocations are to past, present or future income?
Whether an expense is considered to relate to all income of the taxpayer or only to
specific income?
Whether expenses are to be allocated between domestic and foreign, and what
method or formula is utilised for making the allocation or apportionment? Is it
appropriate to allocate to all forms of gross income in equal weight (that is, to sales
income and dividend or interest income)?
Whether expenses are allocated on a separate company basis or on a consolidated
basis?
58

It has been noted that the answers to many of these issues have not been systematically
developed under domestic tax legislation.
59
The identification of expenses as
domestic or foreign arises primarily in two contexts:
where foreign income is exempt (for example, Hong Kong), deductions associated
with the production of exempt foreign income are denied; and

57
In Australia, only actual deductions are allowed under both the domestic legislation and DTTs.
However, there is little detailed guidance in the tax legislation on the allocation of deductions between
income sourced in Australia and elsewhere and the matter is largely determined under the general law.
See Australian Taxation Office, Taxation Ruling TR 2001/11, Income Tax: International Transfer
Pricing Operation of Australias Permanent Establishment Attribution Rules, [1.3], [ 3.36].
In Hong Kong, s 16(1) of the IRO 1947 provides that in ascertaining the assessable profits of any
year there shall be deducted outgoings and expenses to the extent to which they are incurred in the
production of the profits chargeable to tax. Expenses directly attributable to the profits arising outside
Hong Kong are to be disallowed and an apportionment made of such expenses as are partly one and
partly the other. See Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice
Note No 3 (revised), Apportionment of Expenses, [1], [2].
58
Robert J Patrick, J r, General Report Rules for Determining Income and Expenses as Domestic or
Foreign in Cahiers de Droit Fiscal International LXVb (1980) 29-30.
59
Ibid 30.
288
where a foreign tax credit (FTC) applies (for example, Australia), foreign
expenses are allocated to foreign income to measure the net amount of foreign
income and limit the maximum FTC that can be claimed.
60

It has been argued that a great deal of the tax planning undertaken by multinational
enterprises (MNEs) involves taking advantage of or avoiding the source of deduction
rules.
61
The problem with the Pinto Proposal, in this regard, is that it does not address
this issue of how expenses should be allocated between income sourced in the host
(source) jurisdiction and elsewhere and the effects of the other paragraphs of the
business profits article (for example, expenses allowed as deductions, purchase of
goods or merchandise etc).
62
There is a need to have deduction rules so that
businesses know which expenses incurred in earning the profits are deductible under a
jurisdictions domestic tax legislation and under DTTs. Without adequate source of
income as well as deduction rules, a jurisdiction could not expect to collect tax
revenue from non-resident entities conducting business transactions, operations and
activities within its borders.

60
Ibid 17.
In Australia, existing foreign tax credit (FTC) rules are to be replaced by new simplified foreign
income tax offset rules with effect from 1 J uly 2008. These rules allow taxpayers to claim relief for
foreign income taxes paid on an amount included in their assessable income (rather than foreign-source
income). See the Tax Laws Amendment (2007 Measures No 4) Act 2007 (Cth) (No 143, 2007) which
amended the income tax law to abolish FTC (and foreign losses) quarantining and to streamline the
remaining foreign tax credit rules.
61
Michael J McIntyre, Commentary: A Critique of the Source Principle (1989) 1 Tax Notes
62
The requirement for a PE merely establishes a minimum threshold to determine which treaty state has
a right to tax the income of an enterprise of the other treaty state. Where there is such a PE in the host
(source) jurisdiction, it is necessary to go to the business profits article which contains the rules that
determine what income or profits are properly attributable to the PE.
289
7.2.3 Practical implications of the Pinto Proposal

Though the Pinto Proposal provides a new threshold for source taxation of electronic
commerce transactions, the operational practicality is subject to serious questioning on
a number of grounds.

The monetary threshold does not provide a complete resolution of double taxation of
business profits

Under a DTT, the taxation of business profits is governed by the business profits
article. The application of the business profits article is dependent upon whether an
enterprise which is a resident of one state carries on business through a PE (as defined)
in the other state and, if so, whether income derived by that enterprise is attributable to
that PE. The difficulty in applying the business profits article to electronic commerce
transactions relates to the finding of a PE and rules for determining profits that are
attributable to the PE. It follows that there are two questions to ask before a source
state can levy tax on the profits of a non-resident enterprise:
whether the non-resident enterprise has a PE; and
if so, what, if any, are the profits on which that PE should pay tax.
63

If, under the Pinto Proposal, the monetary threshold is satisfied and the foreign seller
thus becomes subject to source jurisdiction taxation, the question may still arise, in
some cases, of what criteria should be used in attributing profits to the foreign seller
from transactions between enterprises under common control. Under a DTT, the test
that business profits should not be taxed in the source jurisdiction unless there is a PE

63
290
is one that should apply to the profits of the enterprise and not to the enterprise itself.
64

In taxing the profits that a foreign enterprise derives from a particular jurisdiction, one
should look at the separate sources of profit that the enterprise derives from the source
jurisdiction and should apply to each the PE test,
65
as the right to tax does not extend
to profits that the enterprise may derive from that jurisdiction otherwise than through
the PE.
66

Consider the following hypothetical example:
A non-resident enterprise, ForCo, sells computer products to independent
customers in Country A through its selling agent SubCo (an enterprise
associated with ForCo). ForCo manufactures the products outside Country A.
All activity related to selling the products in Country A is performed by a sales
force employed by SubCo. ForCo has no presence in or connection with
Country A other than through SubCo. The agency agreement between ForCo
and SubCo provides that SubCo acts for the account and at the risk of ForCo in
performing marketing, sales and distribution activities in Country A for the
products. In return, ForCo pays SubCo a commission for its agency services,
calculated as a percentage of sales revenue.
67

There are two different sources of income:
profits derived by ForCo through its dependent agent PE; and
profits derived by SubCo through its agency activities.
68

Suppose that some orders from independent customers in Country A were (1) taken
via the Internet by ForCo and passed on to SubCo for handling, while (2) other orders
came directly through SubCo. How should Category 1 profits be attributed, assuming

64
Ibid 115.
65
Ibid.
66
In principle, a country may tax non-resident enterprises on income attributable to a PE. The force-
of-attraction rule permits the source country to tax the entire profits of the non-resident enterprise
sourced in that country, irrespective of whether or not those profits are attributable to the PE. But the
use of the latter method in taxing business profits of non-residents is unacceptable by the OECD. See
Barry Larking, IBFD International Tax Glossary (5
th
ed, 2005) 176.
67
Based on an example in Australian Taxation Office, International Transfer Pricing: Attributing
Profits to a Dependent Agent Permanent Establishment (2005) 8.
68
Ibid 4.
291
that a PE arises for ForCo in Country A? Under the Pinto Proposal, the source of
profits arises from electronic commerce. For example, if the tax rate were set at five
per cent and gross sales of $100 million (in Category 1) were generated in Country A,
then $5 million would be withheld by Country A. In principle, whether income is
attributable to the PE is a question of fact. The arms length principle is used when
attributing profits to a PE and a distinction needs to be made between two different
taxpayer enterprises with different functions, assets and risks and, invariably, different
taxable profits.
69
The above example illustrates the difficulty that may arise for a
foreign seller through the activities of a third party (even a related third party).
70
The
foreign seller is caught by the Pinto Proposal (with respect to Category 1 income) via
the monetary threshold test, but the other (Category 2) income needs to be dealt with
under the attribution rules. The Pinto Proposal does not fully cover all circumstances.
It may still be necessary to determine from what and where the income originates and
attribute profits appropriately to the relevant parties so that Category 2 income is not
caught within the Category 1 income or, possibly, in both.

The monetary threshold test advocated by Pinto does not provide a complete
resolution of double taxation of business profits. Most countries assert the right to tax
the business profits of non-residents under their domestic law without any PE
threshold requirement, unless a DTT provision prevails and overrides the domestic

69
The arms length principle means that related parties are charged the same price that would be
charged by unrelated parties in otherwise comparable transactions.
Australias PE attribution rules use a two-step process a functional and comparability analysis
to apply an arms length separate enterprise principle in attributing profits to a PE. The functional
analysis attributes to the PE the functions performed, assets used and risks assumed (FAR) by the
enterprise in respect of the business it carries on through the PE. The comparability analysis determines
an arms length return for the FAR attributed to the PE. See Australian Taxation Office, International
Transfer Pricing: Attributing Profits to a Dependent Agent Permanent Establishment, above n 67, for a
summary of the principles and approaches the ATO uses to attribute profits to dependent agent PEs.
70
See Australian Taxation Office, International Transfer Pricing: Attributing Profits to a Dependent
Agent Permanent Establishment, ibid, for examples illustrating how the attribution rules are applied to
sales agency and toll manufacturing arrangements.
292
law.
71
In Australia, the general principles for calculating the taxable income of a
taxpayer do not have regard to whether a PE exists.
72
A non-resident carrying on
business in Australia is taxable on ordinary and statutory income with a source in
Australia. Similarly, businesses are taxed in respect of profits arising in or derived
from Hong Kong. Source rules are necessary to determine which business profits
derived by non-resident entities are taxable in the source jurisdiction.

A digital certificate is not a reliable indicator of ultimate residence and source

The Pinto Proposal would require all purchasers to be in possession of a DC to
determine where the source of income is situated. At the present time, there is no
requirement by law that every Internet user must have a DC and use it for electronic
transactions. Further, a person may have more than one DC installed in his computer.
If the address of the customer, as shown on the DC, is used to determine the source of
income (meaning B), the location would arbitrarily change if the DC is not used
correctly (for example, the DC does not really belong to the listed holder), as
illustrated with the following examples.

Consider Person A (a tax resident of J urisdiction A) who would like to make a
purchase while visiting in J urisdiction B but does not have a DC. Person A may use
the computer of Person B (a permanent resident of J urisdiction B) to make the
purchase, and use Person Bs DC. Now suppose that the tax residence of Person B is
not J urisdiction B, but J urisdiction C (see Part 7.2.2 above). If tax revenue were to be
collected and remitted by the online intermediary, to which jurisdiction should it go?

71
Brian J Arnold, Threshold Requirements for Taxing Business Profits Under Tax Treaties (2003) 57
72
See Australian Taxation Office, Taxation Ruling TR 2001/11, above n 57, 6.
293
Technically, it should go to the tax residence of Person A, which should be
J urisdiction A. But J urisdiction A would not be able to collect the revenue because
Person A used Person Bs DC. Further, the tax residence of Person B, J urisdiction C,
would not be able to collect the revenue because the DC did not show Person Bs tax
residence. Any revenue collected would thus go to J urisdiction B merely because the
location of Person Bs computer is J urisdiction B.

An order placed or delivered via electronic means can cover a whole range of goods
and services, from the provision of intangible items with electronic delivery to the
provision of traditional items with physical delivery. Take the case of the provision of
services. As stated in Chapter 6, the source of services income may depend on the
country of residence of the provider of such services, the place of performance, the
place of utilisation, or the place of the payee or payer. Under a DTT, income from
professional services or other activities of an independent character is now dealt with
as business profits under the business profits article, which depends on the existence of
a PE in the source jurisdiction. But services (and goods) do not have to be ordered (or
acquired) and consumed in the same location, as illustrated with the following
example:
Assume that a non-professional speaker is paid $25 000 to deliver a speech at a
conference taking place in state S. Assume further that the speaker also
prepares that speech during his presence in state S. It is difficult to argue that
the source of the income paid to the speaker is not state S; yet state S is
prevented from taxing the income because the speaker does not have a
permanent establishment therein.
73

Suppose the speaker is a resident of State R. Under the existing rules, State R would
be able to tax the payment of $25 000. However, if the DC showed that someone in

73
J acques Sasseville, The Future of the Treaty Rules for Taxing Business Profits in Canadian Tax
Foundation, World Tax Conference, 2000 World Tax Conference Report (Westin Innisbrook, Tampa
Bay, Florida, 26 February-1 March 2000) 5.2.
294
State X placed the order electronically and made the payment for the speakers
performance, then, under the Pinto Proposal, the income would be taxed in State X.
This example demonstrates a flaw in the Pinto Proposal in that it can fail to allocate
income according to the factual or economic connection of activities.

The address shown on a DC cannot, ultimately, be relied upon to determine the true
tax residence and source of income in many sorts of transactions.

No allowance for payment other than by credit card

Pinto does not address the issue of payment other than by credit card. A popular form
of payment for electronic commerce transactions is electronic cash.
74
The circulation
of tokenised electronic cash does not involve a financial institution (after its initial
purchase by an individual or business) and is totally anonymous and unaccounted for.
Unlike a credit card payment, it is not necessary to verify the identity of the customer.
The digital symbol, stored as a computer code, is sent on the Internet when making a
purchase. The digital symbol itself is like physical cash, and it is not necessary to get
money from a credit card company and so could bypass the online intermediary. As
stated earlier, it is hard to monitor the use of this type of payment. In this case, how
would be intermediary be able to collect tax from purchasers?

74
Pinto does not address the issue of electronic cash in any detail. He recommends the use of digital
certificates as a method to track sales, rather than electronic cash. He states if a system of determining
location were to be based on addresses, perhaps a credit card billing address could be used as an
alternative to a residential address, but even this may not be a stable long-term solution once electronic
cash which may not need to rely on any address details becomes more widespread. See Pinto,
above n 1, 222.
295
The additional financial cost to implement and support the Pinto Proposal

Pinto recognises that his refundable withholding approach is not without its problems,
but his approach is designed to avoid the difficulty in characterising income (meaning
A) due to the intangible nature of many electronic commerce transactions.
75
He
argues that the perfect should not be the enemy of the good and his refundable
withholding approach should be operationally possible with the use of new
technologies to assist with the collection, distribution and refund of taxes that are
withheld under the approach.
76

Although the Pinto Proposal is conceptually interesting, it is argued, in practice,
revenue authorities would be placed under additional financial burden to afford the
implementation and updating of information and communications technology to
support this model.
77
Moreover, the effective implementation of the Pinto Proposal
depends on a very high level of multilateral agreement across national taxation
jurisdictions a level of cooperation not, thus far, ever achieved in the history of tax
agreements and arrangements traversing national boundaries.

7.2.4 Pintos comments on the possible criticisms of his proposal

Pinto has highlighted a number of possible criticisms of his proposal which need to be
satisfactorily addressed before his proposal can be successfully implemented.

75
Ibid 230.
76
Ibid.
77
Angel Schindel and Adolfo Atchabahian, Source and Residence: New Configuration of their
Principles General Report in Cahiers de Droit Fiscal International Volume 90a (2005) 89.
296
Principle of neutrality

The Pinto Proposal would apply to all situations where the Internet is used to facilitate
transactions involving the production, distribution, sale and delivery of goods and
services in the marketplace, otherwise non-neutralities may exist.
78
In other words, it
is the way in which the order is placed or delivered that determines whether the
transaction would be subject to the Pinto Proposal:
For example, the delivery of a book would be subject to withholding if
ordered on-line (whether delivered digitally or traditionally), but if ordered by
some other (non-electronic) means (e.g. phone or mail order), withholding
would not apply.
79

Pinto argues that the difference in treatment of similar items purchased in a traditional
and electronic commerce context is justified on the basis that the issues raised by
electronic commerce are in many ways unique to it.
80
There would be no need to
extend the treatment of electronic commerce transactions to other forms of commerce,
as these can continue to be dealt with under existing principles including the PE
threshold.
81

Thus, there would be two ways of taxing the business profits of foreign sellers:
one for business profits derived from electronic transactions (based on the
monetary threshold); and
one for business profits derived from non-electronic means (based on the existing
concept).

78
79
Ibid 226-7.
80
Ibid 227.
81
Ibid.
297
If the source of income were determined by how the order was placed or delivered and
by satisfying a monetary threshold, related entities would be able to exploit
opportunities for the best return by organising their business affairs to result in the
desired source of income, as illustrated by the following example. Entities could stay
below the monetary threshold by establishing interposed entities to service customers
in different jurisdictions. Each member of the group is a separate accounting unit. For
example, Company A would service the customers in J urisdiction A, Company B
would service the customers in J urisdiction B, and so on. If the turnover of Company
A were approaching the monetary threshold, Company X would take over from
Company A and service the customers in J urisdiction A. By structuring the group in
this way, each member would be able to obtain a tax refund from the different source
jurisdictions, and profits from electronic transactions would eventually not be taxed at
all in the source jurisdictions.
82
It may be necessary to revert to other means such as
the accruals legislation and transfer pricing rules to try and protect the tax base of a
jurisdiction.

82
Pinto discusses the possibility that businesses may desegregate their activities to avoid whatever
numerical threshold, though, is set:
For example, assume the gross sales threshold is set at $1 million and company A is a seller of
computer consulting services, with sales of $800 000 in a source country. Also assume that this
company has a 51% interest in company B, which is an on-line seller of computer consulting
software, generating revenue in the same source country of $500 000. If treated as separate entities,
then neither company A nor company B would exceed the threshold governing taxable nexus in the
source country. However, if the two companies were grouped because of their relationship to each
other, then clearly they will exceed the threshold for source taxation.
He proposes that grouping rules be set up to determine the threshold within a related group. See Pinto,
ibid 215-6.
Under Australias consolidation regime, contained in Div 703 of the Income Tax Assessment Act
1997 (Cth) (ITAA 1997), eligible entities within a wholly-owned group can choose to consolidate and
operate as a single entity for income tax purposes as group relief (for example, tax loss transfers) is
generally not available to non-consolidated groups. However, non-resident entities within the same
wholly-owned group are not eligible to join a consolidated group. Thus, businesses can remain below
the set threshold under the Pinto Proposal by establishing a separate entity in numerous offshore
jurisdictions to service the local customers (assuming the current provisions continue to apply) as the
consolidation regime does not apply to non-residents.
298
The withholding mechanism

A withholding tax based on gross receipts could be distortionary because foreign
sellers would have to wait till the end of a financial period to calculate their tax
liability.
83
In the case of a refund, a foreign seller would need to lodge an income tax
return in the source country. This would add to the burden of compliance of the seller
as well as add to the cost of collection of the relevant tax authority. Pinto argues that
the effects could be minimised if the tax withheld were creditable by residence
countries and the withholding tax rate kept low.
84
Pinto recommends that his proposal
be introduced unilaterally by countries, though bilateral or multilateral coordination
between countries would obviously be advisable to ensure that conflicts between
systems are minimised.
85

The Pinto Proposal would, to achieve a really successful outcome, require a substantial
structural reform of the tax system of many if not most jurisdictions around the world.
An agreement would be required that every significant trading country would operate

83
Pinto, ibid.
84
Ibid 228.
85
Ibid 227.
It is questionable if the Pinto Proposal would be acceptable at a multilateral level. Take the case of
the multilateral trade agreements dealt with by the World Trade Organization (WTO). One of the key
principles of the world trade system of the WTO is trade without discrimination, based around the
unconditional obligations of:
the most-favoured nation treatment countries cannot normally discriminate between their trading
partners; and
the national treatment countries cannot treat their own nationals better than their trade or
investment treaty partners in like circumstances.
WTO members are prohibited from imposing higher internal taxes or more burdensome regulation
on products imported from one member than on similar imports from other members (most favoured
nation obligation) or on similar domestic products (national treatment obligation). Any concession
given to other trading partners will also be applied to the other party to the agreement. See Servaas van
Thiel, General Report in Michael Lang et al (ed), WTO and Direct Taxation (2005) 15-44.
The Pinto Proposal would create different tax treatment between transactions conducted by
electronic and non-electronic means which, arguably, promotes trade with discrimination. An
international agency might be needed to deal with tax rules and achieve cooperation and harmonisation
at a multilateral level. The argument for an international agency to coordinate harmonisation of tax
treaties with trade agreements is discussed in Part 8.4, Chapter 8.
299
the same system of taxation by allowing a credit on the withholding tax paid. But the
tax withheld at source under the Pinto Proposal may not be of use and creditable in the
residence jurisdiction, whether adopting a worldwide or a territorial tax system. For
example, the foreign branch profits of Australian companies are not assessable to
Australian tax.
86
Therefore, a credit in respect of the tax paid on the foreign income
derived in carrying on a business through a PE in the source jurisdiction is of no use in
Australia as it relates to non-assessable non-exempt income.
87
In Hong Kong, the
deductibility of foreign taxes is governed by s 16(1) of the Inland Revenue Ordinance
1947 (IRO 1947). To be allowable as a deduction, the foreign tax in question must
be one that is charged on the gross amount of the earnings that are themselves
chargeable to profits tax in Hong Kong.
88

The impact of this approach on a Hong Kong Internet-based business would likely be
as follows. The foreign income of a Hong Kong dot-com store would not be subject to
tax in Hong Kong under the territorial source principle of taxation. Nor would a
foreign dot-com store selling goods and services to Hong Kong customers be subject
to tax there. This is because Hong Kong asserts jurisdiction to tax profits from
electronic commerce transactions solely on the basis that they arise from a trade or
business carried on in Hong Kong and the profits are derived from a source within
Hong Kong. The foreign dot-com store would be liable to profits tax only if it carries
on a trade or business in Hong Kong and profits are derived from such a trade or
business. The mere selling of products to customers in Hong Kong by a remote

86
Income Tax Assessment Act 1936 (Cth) s 23AH.
87
See footnote 6, Chapter 5, on the meaning of non-assessable non-exempt income.
88
Deductibility of Foreign Taxes.
300
business would not be taxed unless the profits are generated through a PE. This, again,
raises the issues discussed earlier, and there are two questions to ask:
whether the online activity constitutes the carrying on of a business; and
whether the activity takes place within as opposed to with Hong Kong.

Discussions in Chapter 6 on the application of existing source rules to electronic
commerce transactions showed that the business profits of foreign sellers will not be
subject to source taxation, unless the online activity constitutes the carrying on of a
business in Hong Kong.
89
The Hong Kong IRD takes the view that, in electronic
commerce, the proper approach to be taken in determining the locality of profits is to
ascertain what were the taxpayers operations which produced the relevant profits and
where those operations took place.
90
Therefore, it is the location of the physical
business operations required to conduct the electronic commerce transactions that is
relevant. The Pinto Proposal would not work in Hong Kong under this current policy.
For foreign businesses engaged in electronic commerce, the Hong Kong tax
consequences will generally depend on the foreign companys physical presence in
Hong Kong and are not merely based on the monetary threshold.

A withholding tax is a barrier to the use of cross-border goods and services. It creates
compliance problems and adds to the cost of compliance imposed on those persons
responsible for collecting revenues.
91
The taxation reality means that entities will

89
Hong Kong asserts taxing right on income arising in or derived from Hong Kong and the IRO 1947 is
applied to electronic commerce on the same basis as to traditional forms of commerce. Thus, there is no
difference in the tax treatment of profits derived from electronic commerce and profits from traditional
commerce.
90
Profits Tax: Treatment of Electronic Commerce.
91
Persons who are responsible for the collection of tax face substantial penalties for non-compliance. It
is argued that those costs are extensive and that withholding is not the most efficient means of collecting
301
continue to seek to increase their profit margins by incorporating their businesses in
low-tax jurisdictions. Some countries, like tax havens, are likely to continue stand
apart from international cooperation in order to attract Internet business. The Pinto
Proposal does not explain how such revenue adverse (for non-tax haven jurisdictions)
effects can be contained. The prospects of international acceptance of the Pinto
Proposal look to be rather remote. It has long been a practice among jurisdictions to
attract trade and investment that bring major benefits to a jurisdiction. The Pinto
Proposal could work against this aim because tax competition can influence the
location of trade and investment.
92

Approach may be inconsistent with an income tax system

Pinto acknowledges that problems could arise if his proposal is seen to create a
consumption-based system of taxation, as withholding is based on the ultimate
destination of the electronic transaction (that is, the country of the customer) and not
associated with the place of production of income.
93
Against this line of reasoning, he
cites an argument by Professor Reuven Avi-Yonah:
94

the issue of which tax base to choose (income or consumption) is different
from the question of which jurisdiction should get the revenues (production or
consumption).
95

tax revenue. See Richard L Doernberg, The Case Against Withholding (1982) 61 Texas Law Review
595, 595.
92
Tax incentives for foreign direct investment are extensively used by many countries. See Alex
Easson, Tax Incentives for Foreign Direct Investment (2004), on his study on the taxation of foreign
direct investment and the use of tax incentives to attract foreign direct investment.
93
94
See Reuven S Avi-Yonah, International Taxation of Electronic Commerce (1997) Tax Law Review
507, 532-41 on his proposal for a (largely) source-based regime imposing a withholding tax on sales and
services provided through electronic means that resembles a destination-based VAT.
95
Avi-Yonah, International Taxation of Electronic Commerce, ibid 539 cited in Pinto, above n 1, 228.
302
On this basis, Pinto argues that it is not necessarily illogical to allocate income tax
revenues to countries in which consumption takes place.
96
That is similar, he says, to
allocating an origin-based value added tax (VAT) or goods and services tax (GST)
to a production country which is treated as acceptable.
97
However, relief from double
taxation may not be granted for a consumption-type tax under DTTs.
98
To overcome
this possibility, Pinto argues that it may be necessary to alter DTTs to ensure that
withholding taxes under his proposal are treated as being creditable taxes. It is
acknowledged that this process could impose both cost and time burdens.
99

Although there are similarities between a consumption tax and an income tax, the tax
base and rights to revenues from such taxes may be different. The tax base of a
consumption tax is expenditure on consumption rather than income. The allocation of
income tax revenue is based on where productive activities occur or value is added,
with no recognition for the country in which the consumption of goods or services
occurs.
100

96
97
Ibid.
98
Ibid.
99
Ibid 228-9.
A treaty is a formal agreement between two jurisdictions which is binding at international law. As
the parties to a treaty are the respective states, a treaty must be incorporated into the domestic law of the
state concerned if it is to take effect on the residents.
In determining whether a need exists for a tax treaty with a particular jurisdiction or amendment
thereof, consultations with relevant stakeholders are necessary. The negotiation process itself is a
lengthy and technical one, and include:
identification of the need for a treaty or amendment;
appointment of a delegation;
conduct of the negotiations;
preparations for the signature of the treaty; and
procedures for bringing the treaty into force.
See J D B Oliver, Double Tax Treaties in United Kingdom Tax Law [1970] British Tax Review 388,
388; United Nations, Department of Economic and Social Affairs, Manual for the Negotiation of
Bilateral Tax Treaties Between Developed and Developing Countries (2003) 220-225.
100
Brian J Arnold et al, Symposium: Summary of the Proceedings of an Invitational Seminar on the
Taxation of Business Profits Under Tax Treaties (2002) 50 Canadian Tax Journal 1979, 1984.
303
The distinction between an income tax and a consumption tax is based on the person
responsible for payment of the tax, not the manner in which it is collected. Under an
income tax, the liability for tax rests with each taxpayer and the tax cannot be passed
on to another person. Under a consumption tax such as a GST, the liability rests with
registered businesses and the burden of paying tax on each transaction can be shifted
to another entity such as the end consumer. A registered business can recover the GST
levied in previous stages on business purchases. The Pinto Proposal applies to
business purchasers and final consumers acquiring goods and services from foreign
sellers. In the case of business purchasers, Pinto states that deductibility for inputs
could be linked to the business being able to prove that they withheld tax for their
electronic commerce purchases.
101
In the case of final consumers, the withholding
tax would be collected by an intermediary. The Pinto Proposal is arguably a de facto
consumption tax as, fundamentally, it bears some resemblance of a general
consumption tax:
it is a tax on goods and services that applies to the purchaser;
the tax is levied on the amount a purchaser spends;
the tax is calculated by reference to the price of a transaction;
the tax is payable at each transaction;
it is an indirect tax as it is levied on the supply of goods and services rather than
directly on income; and
it is ultimately borne by the consumer rather than the supplier or the retailer.
102

101
102
It is unlikely that the supplier or the retailer would bear the Pinto tax. They would mostly likely
increase the amount to cover non-creditable input and pass on the tax to the consumer, who ultimately
would bear the tax.
304
It has been argued that the appropriate tax to be levied on the sale of goods and
services by foreign sellers is a consumption tax rather than an income tax, as the only
productive activity occurring in the source country is sales or consumption.
103
As it
happens, this argument supports the conclusion reached in this thesis to shift the tax
base more from income to consumption as a strategy for addressing the source
challenges.

7.2.5 Conclusion

Pinto argues that source-based taxation should continue to apply in an electronic
commerce context as it is theoretically justifiable. The theoretical debate on whether a
source country has a right to tax income derived by foreign sellers through electronic
commerce reflects two opposing positions:
income is impossible without the sale of goods or services to customers, and this is
sufficient nexus to justify source country taxation of non-resident sellers; and
income should not be taxed in the source country, but should be taxed in the
country in which productive activities occur or in which value is added.
104

It has also been argued that, whatever the theoretical justification for source country
taxation of business profits, it is the practical enforcement of source country taxation,
rather than the theoretical justification for such taxation, which really matters.
105
Tax
authorities will tax any business profits of non-residents which they can tax

103
Arnold et al, Symposium: Summary of the Proceedings of an Invitational Seminar on the Taxation
of Business Profits Under Tax Treaties, above n 103, 1990.
104
Arnold, Threshold Requirements for Taxing Business Profits under Tax Treaties, above n 71, 491.
105
Ibid.
305
effectively, unless there is some good reason not to do so.
106
One commentator has
stated that tax theory may follow tax practice or precede it, but it is clear that both
theory and practice generally reflect developments in the real world, in which ideas
are formulated and taxes collected.
107

The fundamental problem to be resolved on the sale of goods and services on the
Internet is who should be entitled to tax. There are three main potential claimants:
the country in which the product is consumed (which also has the right to impose
consumption taxes);
the country in which the product is produced; and
the country of residence of the entity that produces the product.
108

The Pinto Proposal, with its reliance on a refundable withholding mechanism, suffers
from certain implementation and enforcement problems. Electronic commerce allows
consumers to purchase their products directly from foreign sellers, which can be
located anywhere. The cross-border nature of electronic commerce makes it difficult
to monitor a very mobile tax base and levy tax on the profits of foreign sellers.
Revenue would tend to go to the residence jurisdiction (if anywhere) if foreign sellers
do not have a PE in the source jurisdiction. For the reasons set out above, my view is
that the Pinto Proposal, despite offering an interesting conceptual approach, does not
resolve the fundamental problems discussed in this thesis of how best to determine the
source of income when the Internet is engaged to conduct business.

106
Ibid.
107
Richard M Bird, Experience From a Century of Change in Herbert Stein (ed), Tax Policy in the
Twenty-First Century (1988) 31.
108
Alex Easson, Taxing Electronic Commerce: Enforcement Problems Must Be Addressed (1998)
9 Canadian Current Tax 21, 22.
306
7.3 Residence-based taxation

We now come to consider the second major reform option noted at the outset of this
chapter, the substantial (if not total) abandonment of source-based income taxation
concomitant with a move to far greater reliance on the residence principle to establish
a taxation nexus. The US Treasury Department has argued for this reform because, it
says, source-based taxation could lose its rationale and be rendered obsolete by
109
By contrast, almost all taxpayers are resident somewhere.
110

This part reviews residency rules, then dual or multiple residence, then the practical
difficulties in applying the corporate residency rules, before arguing that the proposed
reform mode does not recommend itself.

7.3.1 Introduction

The rationale of a residence and source basis of taxation has been explained by the
Supreme Court of South Africa in the Kerguelen Sealing and Whaling case (1939):
111

In some countries residence (or domicile) is made the test of liability, for the
reason, presumably, that a resident, for the privilege and protection of
residence, can justly be called upon to contribute towards the cost of good
order and government of the country that shelters him. In others the
principle of liability adopted is source of income, again, presumably, the
equity of the levy rests on the assumption that a country that produces wealth
by reason of its natural resources or the activities of its inhabitants is entitled to
a share of that wealth, wherever the recipient of it may live.
112

109
110
Ibid.
111
Kerguelen Sealing and Whaling Co Ltd v Commissioner for Inland Revenue (1939) 10 SATC 363.
112
Ibid 380.
307
The court has emphasised that, whichever basis of taxation is adopted, a country must
have the effective means to enforce the levy.
113

When the schedular tax system was first introduced in Hong Kong in 1940, it was
intended to be a temporary wartime measure. A normal income tax, it was said,
would be established within a year or so.
114
However, the basic structure of the
income tax system in Hong Kong has remained the same until the present day. There
is no requirement to aggregate income from all sources. The residence principle is
generally irrelevant as residents and non-residents are, for most purposes, treated
alike.
115
Both are taxed on income arising in or derived from Hong Kong caught
under one of the three schedules being salary, property or profits tax. Foreign
income earned by a resident is normally exempt from income tax. The exemption to
tax income derived from foreign activities provides residents with a tax incentive to
invest abroad. The tax base is particularly at risk when resident businesses may plan
to conduct their trading activities outside of Hong Kong.

Prior to 1930, the income tax systems introduced in Australia by the colonies/states
were founded on the source principle rather than residency (except Tasmania).
116
The
general use of the residence principle to tax Australian residents on their worldwide

113
Ibid.
114
Michael Littlewood, Tax Reform in Hong Kong in the 1970s: Sincere Failure or Successful
Charade? in J ohn Tiley (ed), Studies in the History of Tax Law (2004) 380.
115
As the jurisdiction to tax in Hong Kong is based on the source of income, the residence of a taxpayer
is normally of little practical relevance, except for treaty purposes. The term resident is included in its
comprehensive DTT with Belgium, Thailand and Luxembourg, and the Double Taxation Arrangement
with Mainland China. It means any person who is liable to tax by reason of domicile, residence, place
of management or any other criterion of a similar nature. It is said the intention to have a definition of
resident is, nevertheless, to treat Hong Kong-based persons as though these criteria are relevant for the
purposes of liability to tax in Hong Kong. The business profits of entities, whether locally owned or
controlled by non-residents, are treated alike and are taxed if the profits earned by the entity are sourced
in Hong Kong. See Peter Willoughby, Hong Kong: Double Tax Arrangement with Mainland China
(April 1998) World Tax Report 77, 77. See, also, footnote 56, Chapter 4, on the meaning of resident
person for the purposes of the tax treatment of offshore funds.
116
The development of tax laws in Australia is discussed in Part 4.3.1, Chapter 4.
308
income was first adopted (by the Federal government) in 1930. Under this regime,
residents began to be taxed on their foreign as well as domestic income. But the
foreign income of Australian residents that was taxed in another jurisdiction was
usually exempt from income tax. The FTC system was introduced on 1 J uly 1987, and
Australia moved from the partial exemption system to the credit method of providing
relief from double taxation. Since that time, Australian residents have been normally
taxed on all income, whether derived in Australia or elsewhere (residence principle),
and non-residents on their Australian source income (source principle). The FTC
system of granting double tax relief normally allows Australian resident taxpayers to
reduce the Australian income tax on their foreign income by the amount of the foreign
taxes they paid on that income.
117
Today, income tax is levied solely by the
Commonwealth government based on the dual principles of residence and source. If
an Australian resident derives any income from a jurisdiction that adopts the residence
principle (for example, the United Kingdom (UK)), that resident will ultimately be
subject to tax in Australia only (unless an article in the Australia-UK DTT provides
otherwise).
118
However, if the same Australian resident derives any income from a
jurisdiction that adopts the source principle (for example, Hong Kong), that resident
will be subject to tax in the source jurisdiction as well as in Australia (unless tax is
specifically excluded by a provision of the Income Tax Assessment Act 1936 (ITAA
1936) or the Income Tax Assessment Act 1997 (ITAA 1997)).
119
If the source
jurisdiction imposes tax at a higher rate than Australia, the FTC allowed by Australia

117
See above footnote 60 on the introduction of new simplified foreign income tax offset rules to
replace the existing FTC rules. From 1 J uly 2008, taxpayers will be able to claim relief for foreign
income taxes paid on an amount included in their assessable income regardless of the source of the
underlying income.
118
Any tax paid in the UK by an Australian resident with UK-source income would be subject to a tax
credit in Australia under the FTC system.
119
See, for example, s 23AG which exempts certain income (including personal exertion income)
derived by Australian residents from an offshore location when no DTT applies (for example, Hong
Kong) provided that relevant income is subject to tax in that offshore jurisdiction.
309
is likely to offset any Australian tax on income from that entitys operations in the
source jurisdiction. Further, if the same Australian resident derives any foreign
income from a jurisdiction with a lower tax rate than Australia or foreign income not
taxed in the source jurisdiction (for example, dividends distributed by a Hong Kong
company), that resident will be subject to tax in Australia. Residence-based taxation
thus picks up the residual tax when an item of income is taxed at a lower rate in the
source jurisdiction or collects the tax by default if an item of income is not taxed at all
in the source jurisdiction. If a jurisdiction were to exercise the residence principle
only, it would forgo tax on the economic activity within its territory by non-residents,
the benefits of which could accrue to those non-residents.
120

7.3.2 Residency rules

Residency rules are designed to tax income earned from all sources, regardless of
whether it is domestic or foreign. In Australia, the residence of an entity determines
how its income will be taxed. A finding of residency will subject income from all
sources to the Australian tax system.
121
A finding of non-residency will limit the
assessable income to the ordinary and statutory income derived directly or indirectly
from an Australian source.
122
It is, therefore, important to find out the entitys
connecting factors with Australia and determine the residency status for tax purposes.

120
Ian Gzell, Resident and Permanent Establishments (Paper presented at the 5
th
National Tax Retreat
of the Taxation Institute of Australia, Queensland, 7-9 August 1997) 20.
121
122
Income Tax Assessment Act 1997 (Cth) ss 6-5(3), 6-10(5). In Australia, there is another category of
taxpayer temporary residents. See footnote 2, Chapter 4, on the tax treatment of temporary residents
in Australia.
310
Under s 995-1(1) of the ITAA 1997, the term Australian resident means a person
who is a resident of Australia for the purposes of the ITAA 1936. Under s 6(1) of the
ITAA 1936, the term resident or resident of Australia means:
(a)
(b) a company which is incorporated in Australia, or which, not being
incorporated in Australia, carries on business in Australia, and has
either its central management and control in Australia, or its voting
power controlled by shareholders who are residents of Australia.

Thus, a company incorporated in Australia is an Australian resident.
123
For a company
not incorporated in Australia, there are two separate requirements to be met before it
will be considered to be a resident taxpayer:
it must be carrying on a business in Australia; and
it either has its central management and control (CM&C) in Australia or has its
voting power controlled by shareholders who are residents of Australia.

If a company incorporated abroad does not carry on a business in Australia, it is not a
resident of Australia.
124
On the other hand, the carrying on of business in Australia by
a foreign company is not by itself sufficient to make such a company a resident of
Australia. It must have its CM&C in Australia or be controlled by Australian resident
shareholders.
125

In this chapter, the focus is on the residence of companies. (What constitutes the
carrying on of a business has been discussed in Chapter 5.) Below is a framework

123
The definition of a company is provided in s 995-1 of the ITAA 1997, and means a body corporate or
any other unincorporated association or body of persons, but does not include a partnership or a non-
entity joint venture.
124
See Australian Taxation Office, Taxation Ruling TR 2004/15, Income Tax: Residence of Companies
not Incorporated in Australia Carrying on Business in Australia and Central Management and
Control.
125
See below footnote 134 plus the accompanying text on the two requirements of the CM&C test.
311
setting out the rules for determining residence of companies in Australia under the
domestic legislation and a discussion of the residency rules applicable to companies in
Australia.

7.3.2.1 Place of incorporation test

The first statutory test to establish the residence of a company is its place of
incorporation. This test means that incorporation in Australia in itself is decisive of
residence.
126
The test is based upon a prescribed strong nexus peculiar to incorporated
companies and relating to their legal personality.
127
The registration of a company
brings an artificial person into existence, corresponding to the birth of an individual.
A company has a separate legal status and (usually) a limited liability is provided to its

126
Koitaki Para Rubber Estates Ltd v Federal Commissioner of Taxation (1941) 64 CLR 241, 251.
127
Robert Couzin, Corporate Residence and International Taxation (2002) 4.
Is the company
incorporated in
Australia?
Determining residence
of companies in
Australia
The company is not
a resident of
Australia.
The company is a resident of
Australia.
Is the company carrying on
a business in Australia?
Yes No
Is the central
management and
control located in
Australia?
Yes No
The company is a
resident of
Australia.
The company is
not a resident of
Australia.
or
Are voting powers
controlled by
shareholders who are
residents of Australia?
Yes No
The company is a
resident of
Australia.
The company is
not a resident of
Australia.
Yes No
312
shareholders. It is a taxable entity separate and distinct from its shareholders.

The place of incorporation test was designed to capture companies incorporated in
Australia but operating outside Australia, and to ensure that residence could be
determined regardless of where the head office of control may be situated.
128
The
place of incorporation determines whether a company is treated as a resident or a non-
resident of Australia for income tax purposes, and this is a matter of fact.

7.3.2.2 Central management and control test

The second statutory test deems a company to be an Australian resident if it carries on
business and has its CM&C in Australia. In the Malayan Shipping case (1946),
129
the
taxpayer argued that there were two issues as the test referred to both carrying on
business and CM&C. This argument was rejected by the High Court:
The purpose of requiring that, in addition to carrying on business in Australia,
the central management and control of the business or the controlling
shareholders must be situate or resident in Australia is to make it clear that
the mere trading in Australia by a company not incorporated in Australia will
not of itself be sufficient to cause the company to become a resident of
Australia. But if the business of the company carried on in Australia consists
of or includes its central management and control, then the company is
carrying on business in Australia and its central management and control is in
Australia. If, on the other hand, a company incorporated elsewhere is merely
trading in Australia and its central management and control is abroad, it does
not become a resident of Australia
130

The Malayan Shipping case established the view that once CM&C is established, it
would be inferred that a business is being carried on and that by itself would be
sufficient to make it a resident of Australia. However, it has been argued that the

128
Michael Dirkis, Australias Residency Rules for Companies and Partnerships (2003) 57 Bulletin for
129
Malayan Shipping Company Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156.
130
Ibid 159.
313
general law is not entirely clear and there are problems caused by this interpretation.
131

Why is there the additional explicit requirement of carrying on business in the
statutory definition if a finding of CM&C ipso facto means that the taxpayer is also
carrying on business in Australia?
132
It is argued that if merely exercising CM&C
alone may constitute the carrying on of a business, it would significantly broaden the
range of the test, and some businesses might arrange their affairs (at some cost) to
guard against this.
133

This issue has now been clarified by the ATO via a taxation ruling (TR 2004/15) as
follows:
For a company to be a resident under the second statutory test two separate
requirements must be met. The first is that the company must carry on
business in Australia, and the second is that the companys central
management and control must be located in Australia.

If no business is carried on in Australia, the company cannot meet the
requirements of the second statutory test and, in these circumstances, it is not a
resident of Australia under the second statutory test. In these situations there is
no need to determine the location of the companys CM&C, separate from its
consideration of whether the company carries on business in Australia. If the
company carries on business in Australia it also has to have its CM&C in
Australia to meet the second statutory test.
134

But rulings issued by the ATO are not necessarily correct, and do not set a
precedent.
135
Although the views expressed by the Commissioner do not have the
force of law, they are binding on the Commissioner if they are favourable to taxpayers.
Taxation Ruling TR 2004/15 does clarify how the ATO believes tax residence should
be determined for companies.

131
Commonwealth, Treasury, Review of International Taxation Arrangements (August 2002) 54.
132
Abe I Greenbaum, Australian Income Taxation: A Concise Casebook (1994) 365.
133
Commonwealth, Treasury, Review of International Taxation Arrangements, above n 131, 54-5.
134
Australian Taxation Office, Taxation Ruling TR 2004/15, above n 125, [5]-[6].
135
Taxation laws are either passed by the Commonwealth Parliament or formed by the decision of
courts. The ATO has day-to-day administrative responsibility for collecting taxes as well as ensuring
compliance with the relevant legislation.
314

There is no definition of central management and control in the tax legislation.
However, there are a number of cases that provide some guidance on its meaning. The
basic principle is that a company resides where its real business is carried on. This
was laid down in the Cesena Sulphur case (1876):
136

the definition of the word residence is founded upon the habits and relations
of a natural man, and is therefore inapplicable to the artificial and legal person
whom we call a corporation. But for the purpose of giving effect to the words
of the Legislature an artificial residence must be assigned to this artificial
person, and one formed on the analogy of natural persons. You do not find any
very great difficulty in defining what is the residence of an individual; it is
where he sleeps and lives the residence of an artificial person, like a trading
corporation, must be considered to be where he carries on his business, where
the real trade and business is carried on.
137

The leading case that established the CM&C test is De Beers (1906).
138
De Beers, a
South African company, also maintained an office in London. The general meetings
of shareholders had always been held in Kimberley, South Africa; but the directors
meetings were held in both places. De Beers made profits by the mining and sale of
diamonds in South Africa. An issue arose about the residence of the company. In
ascertaining where the CM&C actually abided, Lord Loreburn said that this was a
pure question of fact, to be determined, not according to the construction of this or that
regulation or byelaw, but upon a scrutiny of the course of business and trading.
139

Lord Loreburn stated:
In applying the conception of residence to a company, we ought to proceed
as nearly as we can upon the analogy of an individual. A Company cannot eat
or sleep, but it can keep house and do business. We ought, therefore, to see
where it really keeps house and does business. An individual may be of
foreign nationality, and yet reside in the United Kingdom. So may a Company.
Otherwise, it might have its chief seat of management and its centre of trading
in England, under the protection of English law, and yet escape the appropriate

136
Cesena Sulphur Co Ltd v Henry Nicholson (Surveyor of Taxes) (1876) 1 TC 88.
137
Ibid 103.
138
De Beers Consolidated Mines, Ltd v Howe (Surveyor of Taxes) (1906) 5 TC 198.
139
Ibid 212.
315
taxation by the simple expedient of being registered abroad and distributing its
dividends abroad ... a company resides, for purposes of Income Tax, where its
real business is carried on the real business is carried on where the central
management and control actually abides.
140

Lord Loreburn added that if the place of incorporation were used alone as the test in
determining residence, a company would be protected within a jurisdiction and yet
would escape the appropriate taxation by the simple expedient of being registered
abroad and distributing its dividends abroad.
141
In Lord Loreburns opinion, it was
through the meetings of directors in London that the real control of the company was
exercised and profits were made:
London has always controlled the negotiation of the contracts with the
Diamond Syndicates, has determined policy in the disposal of diamonds and
other assets, the working and development of mines, the application of profits,
and the appointment of directors. London has, also, always controlled matters
that require to be determined by the majority of all the Directors, which include
all questions of expenditure except wages, materials, and such like at the mines,
and a limited sum which may be spent by the Directors at Kimberley.
142

The CM&C test, as set out in De Beers, has been applied in a number of subsequent
decisions involving the residence of companies.
143
It was described by Lord Radcliffe
in the Unit Construction case (1959)
144
as being:
as precise and as unequivocal as a positive statutory injunction I do not
know of any other test which has either been substituted for that of central
management and control or has been defined with sufficient precision to be
regarded as an acceptable alternative to it. To me, at any rate, it seems
impossible to read Lord Loreburns words without seeing that he regarded the
formula he was propounding as constituting the test of residence (emphasis in
original).
145

140
Ibid 212-3.
141
The common law view is that incorporation in itself is not conclusive of the place where the central
management and control is exercised, and is therefore not decisive in determining residency.
142
De Beers Consolidated Mines, Ltd v Howe (Surveyor of Taxes) (1906) 5 TC 198, 212-3.
143
See American Thread Company v Joyce (Surveyor of Taxes) (1913) 6 TC 1; The Egyptian Hotels
Ltd v Mitchell (Surveyor of Taxes) (1914-5) 6 TC 542; Todd v Egyptian Delta Land and Investment Co
Ltd (1927-8) 14 TC 119; Union Corporation Ltd v Commissioner of Inland Revenue (1952-3) 34 TC
207.
144
Bullock (H.M. Inspector of Taxes) v Unit Construction Co Ltd (1959) 38 TC 712.
145
Ibid 738.
316
The CM&C test focuses on the place where directors meet for their board meetings.
Directors are the brains that control the business operations from which profits and
gains arise.

7.3.2.3 Voting power control test

The third statutory test to determine a companys residence is voting power control.
Voting power is exercised at a general meeting of shareholders. A non-resident
company that carries on business in Australia will be a resident of Australia if its
voting power is controlled by Australian shareholders. The voting power control test
looks at the residence of persons who actually manage the affairs of the company. It is
intended to ensure that resident shareholders who receive dividends from profits not
charged to tax outside Australia will be taxable on the dividends.
146
It is necessary to
look at the terms shareholder, voting power and control.

The word shareholder was discussed in Patcorp Investments (1976),
147
and means a
person whose name is entered into the register of members of the company or a person
whose name ought to be registered, in terms of an absolute entitlement:
When the word shareholder is used in the Income Tax Assessment Act it
refers to a person who is regarded as a shareholder under the general law
governing the relationship of a person so described to the association in which
he has a share It also includes a person who is entitled as against the
company to be registered and whom the company is absolutely entitled to
register as a member of the company. If a company is at the relevant date
absolutely entitled to register the person concerned and he is absolutely entitled
to have the register rectified so that his name appears thereon as a shareholder
at that date, such a person has more than a beneficial interest in the shares
enforceable primarily against the vendor. He is in a direct relationship with the
company involving reciprocal rights and duties between them.
148

146
Dirkis, Australias Residency Rules for Companies and Partnerships, above n 128, 408.
147
Patcorp Investments Ltd & Ors v Federal Commissioner of Taxation (1976) 76 ATC 4225.
148
Ibid 4238-9.
317

Thus, beneficial ownership without registration does not make a person a
shareholder.
149
For shares held by nominees, an entry on the register is necessary to
constitute membership of a company.

The words voting power are not defined in the Act. But the words voting power in
the company were discussed in the Kolotex Hosiery case (1975).
150
Voting power in
the company refers to the entire voting power that may be exercised at the general
meeting by members of the company and includes all voting power however
conferred.
151
This means that it is permissible to look beyond the voting power
attached to shares and determine who has control of a company.

The word control is also not defined in the Act. In the Keighery case (1957),
152
it
was held that a company was capable of being controlled by a person where two
conditions existed:
the person is able to dictate the decisions of the general meeting, through a
preponderance of voting power which either is vested in him or is subject to his
command, and
the person has a presently existing power of control.
153

Control cannot be satisfied where the resident owners have beneficial control, with the
actual control vested in a non-resident trustee or nominee. The Esquire Nominees case

149
Ibid 4234.
150
Kolotex Hosiery (Australia) Pty Ltd v Commissioner of Taxation (1975) 132 CLR 535.
151
Ibid 571.
152
W P Keighery Pty Ltd v Federal Commissioner of Taxation (1957) 100 CLR 66.
153
Ibid 85-6.
318
(1972)
154
provides guidance on the use of a nominee company. Esquire Nominees
was the trustee of the Manolas family trust. It was incorporated in Norfolk Island and
had its registered office there. The directors were Norfolk Island residents. The
issued capital of the company comprised A class shares and B class shares. The
A class voting preference shares were held by Norfolk Island residents. The B
class shares with limited voting rights were held by a company incorporated in
Victoria, Australia and operated by a firm of accountants Wilson, Bishop, Bowes
and Craig, who were financial advisers for the Manolas family. All meetings of the
company and of the directors were held in Norfolk Island. The Commissioner argued
the company was a resident of Australia since de facto control was in the hands of an
Australian firm of accountants and the directors merely followed the instructions of
the Australian accountants. This argument was rejected by Gibbs J :
But if it be accepted that the appellant did what Messrs. Wilson, Bishop,
Bowes and Craig told it to do in the administration of the various trusts, it does
not follow that the control and management of the appellant lay with Messrs.
Wilson, Bishop, Bowes and Craig. That firm had no power to control the
directors of the appellant in the exercise of their powers or the A class
shareholders in the exercise of their powers or the A class shareholders in the
exercise of their voting rights. Although it is doubtless true that steps could
have been taken to remove the appellant from its position as trustee of one or
more of the trust estates, Messrs. Wilson, Bishop, Bowes and Craig could not
control the appellant in the conduct of its business of a trustee company. The
firm had power to exert influence, and perhaps strong influence, on the
appellant, but that is all ... It was in my opinion managed and controlled there,
none the less because the control was exercised in a manner which accorded
the wishes of the interests in Australia.
155

Gibbs J believed that if the directors had been instructed to do something which they
considered improper or inadvisable, they would not have done it and, therefore, they

154
Esquire Nominees Ltd (Trustee of Manolas Trust) v Federal Commissioner of Taxation (1972) 72
ATC 4076.
155
Ibid 4086.
319
were not controlled by the nominee firm of accountants.
156
On appeal, the judgment
of Gibbs J on this point was upheld by the Full High Court.
157

To satisfy the voting power control test, a company has to be controlled by resident
members or registered nominees who have more than 50 per cent of all voting power
of the company.

The relationship between the central management and control test and the voting
power control test was explained by the court in the Malayan Shipping case (1946):
158

if the business of the company carried on in Australia consists of or includes its
central management and control, then the company is carrying on business in
Australia and its central management and control is in Australia. If, on the
other hand, a company incorporated elsewhere is merely trading in Australia
and its central management and control is abroad, it does not become a resident
of Australia unless its voting power is controlled by shareholders who are
residents of Australia
159

7.3.3 Dual or multiple residence

As residence can be determined in several different ways, it may be possible that a
company resides in two or more jurisdictions. The question of dual residence arose for
judicial consideration in the Swedish Central Railway case (1925).
160
The Court held
that a company, like an individual, might have a dual residence. The company could
have a residence in Sweden (where its board of directors met to conduct the
companys business) and still could have, at the same time, a residence in the UK

156
Ibid.
157
Esquire Nominees Ltd as Trustee of Manolas Trust v Federal Commissioner of Taxation (1973) 73
ATC 4114.
158
Malayan Shipping Company Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156.
159
Ibid 159.
160
Swedish Central Railway Co Ltd v Thompson [1925] AC 495.
320
(where the companys seal was kept and where all transfers of shares were made or
registered) for income tax purposes:
a registered company can have more than one residence for the purposes of the
Income Tax Act. It has been often pointed out that a company cannot in the
ordinary sense reside anywhere and that in applying the conception of
residence to a company it is necessary (as Lord Loreburn said in the De Beers
case) to proceed as nearly as possible upon the analogy of an individual. A
company, he said, cannot eat or sleep but it can keep house and do business
when the central management and control of the company abides in a particular
place, the company is held for purposes of income tax to have a residence in
that place; but it does not follow that it cannot have a residence elsewhere. An
individual may clearly have more than one residence ... and in principle there
appears to be no good reason why a company should not be in the same
position. The central management and control of the company may be divided,
and it may keep house and do business in more than one place; and if so may
have more than one residence.
161

In Koitaki Para Rubber Estates (1941),
162
the court stated that a finding that a
company is a resident of more than one country ought not to be made unless the
control of the general affairs of the company is divided or distributed among two or
more countries. The crucial test is to ascertain where the real business is carried on,
not in the sense of where it trades, but in the sense of from where its operations are
controlled and directed:
It is the place of the personal control over and not of the physical operations of
the business which counts In order that a company may acquire a residence
in two countries for the purposes of income tax, therefore, the central
management and control must be divided between such countries so as to
abide in them both. The company through the central control is then
metaphorically speaking bodily present and residing by analogy in both
countries.
163

The issue of dual residence was again raised in the North Australian Pastoral case
(1946).
164
The company was incorporated in the Northern Territory (NT), with a
branch office in Brisbane, Queensland. The business of the company was the

161
Ibid 501.
162
Koitaki Para Rubber Estates Ltd v Federal Commissioner of Taxation (1940) 64 CLR 241.
163
Ibid 248-51.
164
North Australian Pastoral Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 623.
321
breeding, purchasing, depasturing and selling of cattle upon and from an extensive
cattle station in Alexandria in the NT, and a large part of its income was derived from
that source. The issue was whether the company resided in the NT (place of business
operations) or in Queensland (place of management). The court did not look at the
place of management because
the criterion of corporate residence which looks to the place where the
effective control of a companys operations is exercised means that a search is
to be conducted for the person or persons whose will is most likely to prevail
in any matter affecting the company. If he is found and identified his residence
and the companys are yet two different things.
165

Instead, the court looked at the location of its actual business operations because the
directors met in Queensland only as a matter of convenience:
The undertaking, for the carrying on of which the company came into existence,
is wholly within the Territory. The company takes its corporate life from
registration in the Territory. And both by its registered office and its public
officer for legal and fiscal purposes, it there lives its formal and ostensible life.
These are three salient facts. There are certain other fairly obvious
considerations to be added to these facts. One of them is that it was not to
facilitate the conduct of the companys affairs that the directors met in
Brisbane, but because that was for their common convenience the most
convenient course.
166

The court found that the more important questions concerning the management of the
station rested primarily with the station manager. Decisions of policy were arrived at
with him during visits made by some of the directors to the station in the NT:
These visits meant the occasional exercise of the superior controlling authority
where the business was carried on. A circumstance which perhaps points to
the common conception of where the affairs of the company were naturally
centred is the practice of keeping not merely station accounts at Alexandria but
a full set of books for the company. The companys enterprise was not a
financial or trading business the control and management of which might be
considered to depend on decisions of policy and upon the judgment and
capacity of the general manager independently of the locality. It was
essentially localized. There has not been a case so far in which, although the

165
Ibid 628.
166
Ibid 633.
322
place where the substantial business of a company is carried on is the same as
that of its incorporation and its formal life, the company has been held not to
reside there.
167

The basal principle is that a company resides where its real business is carried on and
that it is for the purpose of ascertaining where that is that the subsidiary principle is
invoked that the place where the superior direction and control is exercised determines
where the real business is carried on.
168

If a company has a dual residence, for example, it was incorporated in Country A but
centrally managed and controlled in Country B, both Country A and Country B may
regard the company as a resident under their domestic tax legislation. If that is the
case, the company could be liable to tax on a residence basis in both countries. If
Country A and Country B do not have a DTT, unrelieved double taxation may result,
that is, the same item of income would be subject to tax in more than one country.
This places a burden on the company and is a barrier to trade. A way to avoid this
situation is to insert a tiebreaker clause in a DTT, a criterion used to make a company
resident in one jurisdiction only.

There are generally two primary tests used in Australias DTTs to determine the
residency of a person other than an individual the place of incorporation and the
place of effective management.
169
These tests are used either solely or in
combination.
170
The place of effective management is where key management and

167
Ibid 633-4.
168
Ibid 629.
169
Most of Australias DTTs use the place of effective management as the sole test to determine the
residence of companies. Other tests used are the place it is created (eg the Danish Agreement) and the
place it is managed and controlled (eg the Singapore Agreement).
170
See, for example, the Fijian and Kiribati agreements which use both the place of incorporation and
the place of effective management to determine residence of companies.
323
commercial decisions that are necessary for the conduct of the entitys business are in
substance made.
171
It is the place where the most senior person or group of persons
(for example, a board of directors) makes its decisions or the place where the actions
to be taken by the entity as a whole are determined.
172
An entity may have more than
one place of management, but it can only have one place of effective management at
any one time.
173
However, there is no definitive rule to determine the place of
effective management. It is, again, necessary to refer to the general law test such as
central management and control when considering the meaning of the term place of
effective management.

7.3.4 Practical difficulties in applying the corporate residency rules

Globalisation and advances in technology have facilitated wide-ranging changes in the
way a business may be conducted internationally. Entities have a greater freedom to
choose the place of incorporation and move their business operations online to a low-
tax jurisdiction or tax haven, removing the link to a jurisdiction artificially.
174
The
place where directors and shareholders meet can be manipulated through infrequent
meetings in a location remote and different from business operations. The basic
question in establishing the residence of a company is: How to define a sensible
connecting factor for the residence taxation of incorporated companies, and how to
choose between potentially competing connecting factors?
175

171
172
Ibid.
173
Ibid.
174
See Uta Kohl, The Horror-Scope for the Taxation Office: The Internet and its Impact on
Residence (1998) 21 UNSW Law Journal 436, 443 on the ease of registering a company online on the
Internet.
175
Couzin, Corporate Residence and International Taxation, above n 127, 22.
324
Place of incorporation

When the definition of resident was first introduced in Australia in 1930, it was
already noted that large companies which have the prospects of extending their
operations beyond Australia will be driven to incorporate themselves outside
Australia.
176
This is because the requirement to keep a registered office (and a
register of shareholders in the place of incorporation) serves as a physical token of the
companys existence only, without regard to where it carries out its activities.

Though the incorporation test seems straightforward to apply, it is highly vulnerable to
manipulation and offers an incentive to select incorporation sites that are tax driven, as
evidenced by the corporate inversion transactions in the US.
177
The US adopts a
worldwide income tax system. That is, a US person
178
is subject to US income tax on
all income, whether derived in the US or abroad, and a foreign person on income that
has a sufficient nexus to the US. A company is domestic if it is incorporated under the
laws of the US.
179
A company is foreign if it is not domestic.
180
Other factors such as
the location of the companys management activities, employees, business assets,
operations, revenue sources, the exchanges on which the companys shares are traded

176
Commonwealth, Parliamentary Debates, House of Representatives, 29 J uly 1930, 4859.
177
An inversion transaction is defined as a transaction through which the corporate structure of a US-
based multinational group is altered so that a new foreign corporation, typically located in a low-tax or
no-tax country, replaces the existing US parent corporation as the parent of the corporate group. See
United States, Department of the Treasury, Office of Tax Policy, Corporate Inversion Transactions:
Tax Policy Implications (May 2002) [1] <http://www.treas.gov/press/releases/docs/inversion.pdf>at
1 May 2008.
178
A US person is defined in 7701(a)(30) of the Internal Revenue Code (26 USC) (IRC) and
includes citizens, residents and domestic corporations.
179
Internal Revenue Code 7701(a)(4).
180
Internal Revenue Code 7701(a)(5).
325
or the residence of the companys shareholders are not taken into account in
determining the residence of a company.
181

The tax treatment of a US MNE depends significantly on whether the top-tier parent
company of the group is a domestic or a foreign company. In general, a domestic
company pays taxes on profits made by its US and foreign operations. The active
income of their foreign subsidiaries is generally subject to US tax only when such
income is repatriated to the US through a distribution of dividends to the US domestic
parent company. The foreign income is then reported in the companys tax return in
the year the distribution is received, and tax is imposed on such income at that time. If
the same company inverts and places itself below a foreign company that legally
becomes the firms headquarters, it becomes the subsidiary of a foreign parent
company. Income from foreign operations conducted by foreign subsidiaries will no
longer be subject to US tax, but will be subject to tax in the country where the foreign
subsidiary is located as well as the country where the new foreign parent is located.
Where the new foreign parent is located in a country that has a low or nil income tax,
which is the case in most of the inversion transactions, the foreign operations will only
be subject to tax where they are located.
182
This is similar to the treatment that would
result where the foreign parent is located in a country with a territorial (source) tax
system, where both residents and non-residents are taxed on income from sources
within its jurisdiction.
183
That is why an inversion activity has been referred to as
self-help territoriality.
184

181
United States, J oint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax
Expenditures (J CS-02-05, 27 J anuary 2005) 178 <http://www.house.gov/jct/s-2-05.pdf>at 1 May 2008.
182
United States, Department of the Treasury, Office of Tax Policy, Corporate Inversion Transactions:
Tax Policy Implications, above n 177, 29.
183
Ibid 29.
184
Ibid.
326

A key reason for the reincorporation in a foreign country is the reduction in overall
corporate taxes which can be achieved. Shareholders also recognise that the after-tax
earnings are likely to be higher and bid up share prices due to the savings in corporate
taxes, thereby compensating shareholders for the other taxes they may incur in the
process.
185

The reincorporation to an offshore site has no real effect on the operation of the
company, but the tax base is eroded as more inversion transactions take place. The
frequency, size and profile of inversion transactions in the US raised public concerns
and finally led to the introduction of legislation to curtail inversion transactions.
186

Section 7874 of the Internal Revenue Code (26 USC) now applies to two types of
expatriated entities, that is, certain domestic entities that moved offshore, after
4 March 2003:
80 per cent inversions If the former owners of the US domestic entity continue to
own at least 80 per cent (by vote or value) of the inverted company, the foreign
company is treated as a surrogate foreign company for US tax purposes. This
means the surrogate foreign company is treated as a domestic company and taxed
on its worldwide income (including the foreign income that it earns).

185
Inversion transactions may take many different forms, including stock inversions, asset inversions,
and various combinations of and variations on the two. Most of the known transactions have been stock
inversions where US shareholders may realise a capital gain, based on the difference between the fair
market value of the share of the foreign company and the adjusted basis of the share of the US company
exchanged. Thus, the inversion process imposes a tax on shareholders though ownership does not
change. An asset reorganisation may also give rise to US tax consequences at the corporate level. See
CCH Editorial Staff Publication, Federal Tax Guide (2004) 17,143; Carol P Tello, The Upside Down
World of Corporate Inversion Transactions (2001) 30 Tax Management International Journal 161,
161-3.
186
For a discussion of the history of inversion transactions, see Mihir A Desai and J ames R Hines J r,
Expectations and Expatriations: Tracing the Causes and Consequences of Corporate Inversions (2002)
55 National Tax Journal 409; Reuven S Avi-Yonah, For Havens Sake: Reflections on Inversion
Transactions (2002) 27 Tax Notes International 225.
327
60 per cent inversions If the ownership is less than 80 per cent but at least 60 per
cent (by vote or value), then the inverted company remains foreign for tax
purposes. This means the inverted US company is not permitted to use any tax
attributes (such as net operating losses and foreign tax credits) to shelter any gains
realised from the inversion transaction for a ten-year period following the
inversion transaction.

In addition to the anti-inversion legislation, there is a proposal to add another
residency test to curtail corporate inversions, based on the concept of place of primary
management and control.
187
Under this proposed test, if a company is incorporated in
the US, it is considered a domestic company and one does not have to look any further
to determine its residence. For companies whose legal place of residency is outside
the US, it is the place of primary management and control that determines its residence.
Each case is based on its own facts and circumstances. If the proposed test is satisfied,
a foreign-incorporated entity would be a US resident company if its place of primary
management and control is in the US. The place of primary management and control
is where the executive officers and senior management exercise day-to-day
responsibility for the strategic, financial and operational policy decision making for
the company (including direct and indirect subsidiaries):
Under a centralized management structure, these employees would generally
be those individuals who have executive officer positions and report to the
corporate headquarters office. However, some companies may operate under a
more decentralized management structure, where many strategic policy
decisions are delegated to individuals who are directors of subsidiary
companies. In this situation, individuals who are not executive officers and
senior management employees of the corporate headquarters may be carrying
on the strategic, financial and operational policy decisions for the company.

187
See United States, Options to Improve Tax Compliance and Reform Tax Expenditures, above n 181,
178-81; United States, The Presidents Advisory Panel on Federal Tax Reform, above n 3, 135.
328
The decision-making activities of these individuals are taken into consideration
in determining the companys residence.
188

It is argued that the day-to-day management of a business concept differs from the
traditional management and control concept and is more difficult to manipulate:
Moving the management of a company generally requires the physical
relocation of top executives and their families to an office in a foreign
jurisdiction. It also requires the movement of support staff and administrative
functions that are normally performed at the corporate headquarters office.
189

What can be drawn from this test is that, where there is a highly decentralised
management structure, residency based on the location of a companys day-to-day
management and control activities would be a more meaningful test if the company
were incorporated outside the US.

But a change to the definition of residence might have the effect of discouraging
companies from locating top management in the US, the presence of which is
beneficial to the US in many respects:
These corporate headquarters operations employ senior executives who pay
taxes to the United States, hire U.S.-based service providers for their
companies and generally contribute to the economic health of the communities
in which they are located. These companies, and their senior management,
also contribute to our communities in many other ways including supporting
local charities, participating in civic life, and supporting cultural institutions.
190

Companies may be encouraged to move headquarters operations to locations such as
Hong Kong and Ireland should the primary place of management and control as well
as the place of incorporation be used to determine the residence of companies.

188
United States, Options to Improve Tax Compliance and Reform Tax Expenditures, ibid 180.
189
Ibid 180-1.
190
J ohn M Peterson J r and Bruce A Cohen, Corporate Inversions: Yesterday, Today and Tomorrow
(2003) Taxes 161, 184.
329
A (so far) rare example with respect to Australian resident companies choosing to
adopt an inversion strategy was the restructuring of J ames Hardie Industries Ltd
(J HIL), a multinational in building products.
191
Before restructuring, J HIL was an
Australian company, being incorporated in Australia. After restructuring, a new
parent company, J ames Hardie Industries NV (J HI NV), was formed in the
Netherlands. It obtained a primary listing on the Australian Stock Exchange and a
secondary listing of American Depository Receipts on the New York Stock
Exchange.
192
It is clear that J HI NV is a resident in the Netherlands under its domestic
law as it is registered there. It is also clear that J HI NV is not an Australian resident
under the Australia-Netherlands DTT because:
it was incorporated in the Netherlands;
its operational and financial management and chief executive officers are located
in the US; and
its directors are residents of Australia, the US and the UK and hold board meetings
at a variety of locations around the world.
193

J HIL moved to the Netherlands primarily to reduce tax on foreign income as the
Australian income tax system provides disincentives for resident companies investing
offshore.
194
In the 2001-02 financial year, J HIL found that it was unable to generate

191
C J ohn Taylor, The J ames Hardie Restructuring and Review of Australias International Taxation
Arrangements (2004) 58 Bulletin for International Fiscal Documentation 118.
192
Ibid 122.
193
Ibid.
194
It is reported that J ames Hardie Industries Ltd (J HIL) relocated its head office to the Netherlands
not only for tax reasons, but also to avoid its asbestos compensation liabilities. J HIL was the leading
maker in Australia of asbestos-based building products from the 1920s until the mid 1980s, when
production stopped. But workers diagnosed with asbestos-related diseases still continue to seek
compensation from the company.
Before moving to the Netherlands in October 2001, J HIL set up the Medical Research and
Compensation Foundation (MRCF) in February 2001 with A$293 million (Australian dollars) to meet
its asbestos-related compensation claims. In late 2003, the compensation pool had dried up, but the
company had no plans to inject more funds to the MRCF. It was thought the company would no longer
330
enough revenue in Australia to pay dividends to its Australian shareholders, and
needed to repatriate US-source income in the form of dividends as most of the groups
income was earned there.
195
The repatriated dividends would be exempt from tax in
Australia under s 23AJ of the ITAA 1936 (being non-portfolio dividends funded from
fully taxed profits from a broad exemption listed country).
196
As a consequence, these
repatriated dividends would be unfranked as payments of foreign tax would not
generate Australian imputation credits.
197
Further, these dividends would be subject to
a 15 per cent dividend withholding tax under the then Australia-US DTT. This means

have a legal or moral responsibility to cover future compensation claims. Further, Australia does not
have a treaty with the Netherlands for the enforcement of civil court judgments, which means asbestos
victims in Australia could not pursue their right to compensation against a company incorporated in the
Netherlands.
The asbestos compensation claim received a great deal of public attention. In February 2004, a
Special Commission of Inquiry (the J ackson Inquiry) was set up by the New South Wales (NSW)
government to inquire into the financial position of the MRCF and whether it would be likely to meet its
future asbestos-related liabilities in the medium to long term. The J ackson Inquiry found that the
MRCF had been underfunded, and to a very significant degree by up to A$2.24 billion. The company
began talks with unions, asbestos victims support groups and the NSW government about setting up a
new statutory scheme to fund all outstanding and future liabilities. In December 2004, an agreement to
compensate asbestos victims over the next 40 years was signed. But the payout was delayed after the
ATO refused to allow the payments to be tax deductible. It was not until November 2006 that an
agreement with the ATO was reached, which allows compensation payouts to be tax deductible. Finally,
in February 2007, the A$4 billion asbestos compensation deal met the overwhelming approval of
shareholders.
See Commonwealth, Senate Hansard, 11 August 2004, 25871 (Questions Without Notice: Health:
Asbestos Related Disease); D F J ackson, Report of the Special Commission of Inquiry into the Medical
Research and Compensation Foundation (September 2004) NSW Cabinet
<http://www.dpc.nsw.gov.au/publications/publications/publication_list_-_new> at 27 April 2008;
Elizabeth Knight, Black Hole Law Lightens Load for J ames Hardie; Costello Will Claim Otherwise,
but Part of the Legislation Was Purpose-Built for J ames Hardie, Sydney Morning Herald, 30 March
2006, 23; ABC Online, James Hardie Wins Tax Deduction Request for Asbestos Compo Payouts,
29 J une 2006 <http://www.abc.net.au/news/newsitems/200606/s1675142.htm> at 16 April 2008;
Nassim Khadem, Tax Ruling to Benefit Asbestos Victims, The Age (Melbourne), 10 November 2006,
5; Australian Associated Press, Timeline of Major Events in J ames Hardie Asbestos Battle, AAP
Newswire, 8 February 2007; Belinda Tasker, The Rocky Road to Asbestos Payout, Ballarat Courier,
13 February 2007, 9
195
About 90 per cent of J ames Hardies shares are owned by Australian residents, but 85 per cent of the
groups income was earned offshore, principally in the US. See Taylor, above n 191, 119 and 121.
196
Before 1 J uly 2004, countries were classified as broad exemption listed countries, limited exemption
listed countries or unlisted countries for controlled foreign company (CFC) purposes. The seven
broad exemption listed countries have a tax system broadly similar to Australias, being Canada, France,
Germany, J apan, New Zealand, the UK and the US. All other countries were either limited exemption
listed countries or unlisted countries. From 1 July 2004, countries are either listed or unlisted.
197
As explained in footnote 63, Chapter 3, Australia moved from a classical system of company
taxation to an imputation system of company taxation in 1987. The dividend imputation system allows
shareholders of Australian companies to receive franking credits for taxes paid by the company. A
franking credit arises only in respect of Australian company taxes paid, not foreign company taxes paid.
See Div 205 of Pt 3-6 of the ITAA 1997 on the imputation system and franking accounts.
331
that shareholders would not be allowed a credit for any foreign taxes paid (being a
portfolio investment in a resident company with offshore earnings). If the same
dividends were distributed by J HI NV Netherlands (rather than J HIL Australia),
Australian shareholders would be allowed a direct foreign tax credit for any foreign
withholding taxes paid (being a portfolio investment in a non-resident company with
offshore earnings). The relocation to the Netherlands did not change the nature of the
foreign income, but the tax treatment of the dividends in the hands of Australian
shareholders was entirely different.

The move by J HIL to the Netherlands to minimise tax charges
198
has forced the
Australian government to re-examine its international tax policy as other Australian
multinationals such as CSR, Southcorp and Fosters have been considering
relocation.
199
Realising that a source-based tax treaty policy creates significant tax
obstacles to foreign investment (due to the high withholding tax rates), Australia is
now moving towards a more residence-based tax treaty policy, with a key aim of
negotiating lower withholding tax limits.
200

In the case of Hong Kong, as only income arising in or derived from Hong Kong is
taxed, the residence of a taxpayer is normally of little practical relevance. Hong Kong

198
The maximum rate of withholding tax on dividends is only five per cent in the US under the tax
convention with the Netherlands. See Taylor, above n 191, 123.
199
Graeme Cooper, Australian Government Re-examines Tax Policy to Stem Corporation Emigration
(2001) 23 Tax Notes International 683, 683.
200
See, for example, the Protocol Amending the Convention Between the Government of Australia and
the Government of the United States of America for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to Taxes on Income (entered into force 12 May 2003) and the
Convention between the Government of Australia and the Government of the United Kingdom of Great
Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income and on Capital Gains (entered into force 17 December 2003)
that provide a complete exemption of dividend withholding tax in some cases.
332
businesses are able to establish their legal residence outside of Hong Kong without
being taxed on their foreign income.
201

Central management and control

The CM&C test can attribute residency status to foreign companies carrying on a
business outside the place of incorporation. To avoid being taxed on income from all
sources, an entity needs to prove that it is a non-resident. A need, thus, arises to
distinguish between a domestic (resident) and a foreign (non-resident) company in
jurisdictions such as Australia. It has been pointed out that the distinction between a
domestic and a foreign company was clear some fifty years ago as a company would
be incorporated and run from one jurisdiction:
A US multinational raised most of its capital (both debt and equity) in the US,
was managed from the US, and had most of its operations and biggest market
in the US. Although there were some operations and sales overseas, the bulk
of the income came from the US and vice versa for a foreign
multinational.
202

But the distinction between a domestic and a foreign company is far more uncertain
today:
no distinction can be made between US and foreign multinationals on the basis
of where their capital is raised (both trade shares and borrow at home and
overseas), where their operations are (all over the world), and where their
customers are (the most profitable markets for US multinationals are frequently
overseas).
203

201
The relocation of a Hong Kong entity to an offshore location is due more to political considerations
than business reasons. The J ardine Group, a trading company controlled in the UK with significant
operations in Hong Kong and Mainland China, shifted its legal residence from Hong Kong to Bermuda
in 1984 due to the uncertainty of Hong Kongs future after the handover in 1997. Another group, the
HSBC Holdings, moved its tax residence from Hong Kong to the UK in 1993 for tax purposes when it
took over the Midland Bank. The move by HSBC Holdings is widely seen as risk insurance, for the
same reason as the J ardine Group, due to the uncertainty of Hong Kongs future post-1997. See Kalok
Chan et al, What if Trading Location is Different from Business Location? Evidence from the J ardine
Group (2003) 58 Journal of Finance 1221, 1224; J ason Gorringe, HSBC May Quit UK Over Taxes.
Or Not, News.com (London), 9 October 2006.
202
Avi-Yonah, For Havens Sake: Reflections on Inversion Transactions, above n 186, 228.
203
Ibid.
333

Though there is little significant difference today in the capital structure, operations, or
markets of a MNE such as General Motors or Toyota, it is said, there is still a
meaningful distinction between two companies such as General Motors and Toyota.
204

The former is still clearly run from Detroit, whereas the latter is run from Tokyo.
205

For this reason, it has been argued that the CM&C test, if properly defined and
interpreted, offers the most promising current definition of residence of a company
the one most congruent with business realities and therefore least open to abuse.
206

The crucial factor is the place where the company is centrally managed and controlled.
The CM&C test focuses on the persons who exercise actual control of the operations
from which profits and gains are derived. This leads to the following questions: (a)
what are the decisions of the highest level of control of the business of the company;
(b) who are the persons that occupy the pinnacle of power; and (c) where are those
decisions exercised. The constituent documents of a company (for example,
memorandum and articles of association) may provide that the power to control the
company is vested in a board of directors. Since policy and strategic matters relating
to the direction of the business are generally decided by the board of directors in board
meetings, the location of board meetings is considered the place where CM&C is
exercised.
207
But the location of board meetings is not necessarily conclusive:
In some cases, for example, central management and control is exercised by a
single individual. This may happen when a chairman or managing director

204
Ibid 229.
205
Ibid.
206
Ibid.
207
Central management and control can be exercised by persons other than the board of directors for
example, shareholders at a general meeting (John Hood & Co v W E Magee (Surveyor of Taxes) (1918)
7 TC 327), key personnel of the company (Malayan Shipping Company Ltd v Federal Commissioner of
Taxation (1946) 71 CLR 156) or the directors of the parent company (Bullock (H.M. Inspector of Taxes)
v Unit Construction Co Ltd (1959) 38 TC 712).
334
exercises powers formally conferred by the companys Articles and the other
board members are little more than cyphers, or by reason of a dominant
shareholding or for some other reason. In those cases the residence of the
company is where the controlling individual exercises his powers.
208

The issue is how to identify the level of management that would be considered
relevant for the purposes of determining where the business is managed:
board of directors may provide only framework resolutions. Examples might
include decisions to effect mergers and acquisitions of a particular monetary
value over a particular period of time or to establish a share buy-back program
in a specific dollar amount, also over a particular period of time. In those cases,
it is possible that a different high-level organ of management will make the
crucial decisions about which company to acquire or when to redeem the
shares when the board (exercising the framework powers) is the organ
bearing ultimate responsibility for failure, it may be viewed as the body
exercising the critical control and management if the effectuator organ has
very broad discretion and can deviate from a framework resolution without
advance approval, it can be argued that the control and management of the
company is vested with that body.
209

With the growth of cross-border trade, companies have established local and regional
structures. Decision making can occur at different management levels of the company
and in different locations. The place of meetings can be planned without affecting
business operations and the production of income. The CM&C test encourages
companies to shift their management activities from Australia, for example, and
arrange for the company to be controlled by persons abroad:
The residency test causes Australian companies with foreign subsidiaries or
joint venture companies to ensure that the subsidiarys management is out of
Australia, and thereby minimises Australian involvement. To do otherwise
would expose the foreign subsidiarys earnings (as well as actual or deemed
capital gains) to tax in Australia.
210

208
United Kingdom, HM Revenue & Customs, Statement of Practice SP1/90, Company Residence.
209
J oel Lubell, Israeli Income Tax Commission Clarifies Concept of Control and Management (2002)
26 Tax Notes International 575, 576.
210
Michael Wachtel and Alf Capito, Removing Tax Barriers to International Growth: Positioning
Australias Tax System to Maximise the Potential Growth Opportunities from International Business
(2001) 28.
335
There are proposals that Australia should abandon the CM&C test.
211
The CM&C
rules, do not, it is argued, operate in Australias interest. They tend to push the
headquarters and management of offshore subsidiaries out of Australia.
212
Any
foreign incorporated company with significant management or board connections to
Australia runs the risk of having its CM&C in Australia which would allow it to be
taxed as an Australian resident on its foreign income and capital gains.
213
This can
have an adverse impact on Australian employment and business development and
could restrict the growth of Australia as a regional headquarters location for foreign-
owned groups.
214

The OECD has suggested that jurisdictions consider a combination of factors in
determining the residence of companies, such as:
the place where the centre of top level management is located;
the place where the business operations are actually conducted;
legal factors such as the place of incorporation, the location of the registered office,
public officer etc;
the place where controlling shareholders make key management and commercial
decisions in relation to the company; and
the place where directors reside.
215

A further factor suggested as relevant is the number of board meetings and the nature
and materiality of the business done at those meetings.
216
Another suggestion is to

211
Wachtel and Capito, ibid 83; Commonwealth, Treasury, Review of International Taxation
Arrangements, above n 131, 54.
212
Wachtel and Capito, ibid 83.
213
Ibid.
214
Ibid.
215
Conditions, above n 55, 148.
336
adopt the place where the economic nexus is strongest, characterised by factors of
production like land, labour, capital and enterprise.
217
This approach is closer to the
rationale for source taxation rather than for that typically applying to determine
residence taxation that is, allocating income on the basis of economic links within
the borders of a jurisdiction. Should this test be made a dominant one, residence
taxation would be rendered largely redundant because it would become merely a
second layer of taxation levied on the basis of the same rationale as the first layer:
if the rationale for residence taxation really is similar to the rationale for source
taxation, and if it is accepted that profits should only be effectively taxed once
(so that when they are taxed twice, the second amount of tax should be reduced
by the first amount of tax) This would make a case for taxing all profits at
source (where the permanent establishments which make the profits are located)
and not imposing any tax on the basis of residence.
218

Another commentator has suggested that the residence of a company should be based
on the location of the head office.
219
This is because the head office is normally the
place where the managing directors meet and perform their management tasks. But
there are circumstances where management of the company would not be in the hands
of the managing directors, but in the hands of others. For example:
if the nature of the business requires specific knowledge which a managing
director does not possess; and
if the managing director works for a number of companies then that person cannot
meet all the specific requirements of a given company (for example, the case for
trust companies).
220

216
Institute for Fiscal Studies, Report of the Working Party on Company Residence, Tax Havens, and
Upstream Loans (IFS Report Series No 3, 1982) 13.
217
Conditions, above n 55, 153.
218
Richard Baron, Breaking Residence Ties (2001) 3(7) Tax Planning International E-Commerce 6, 7.
219
Francois Hoenjet, Registered Office Used in Netherlands (1995) 6(6) International Tax Review 26,
26.
220
Ibid.
337

There is no definition of the term head office either, and one suggestion is the place
where the real business of the company is carried on, or where its central management,
and administration and control takes place.
221
This, though, just brings back the
CM&C test.

One commentator has argued that tax authorities are in a no win situation if the
CM&C test, rather than the place of incorporation test, is used:
If it is beneficial for a corporation to be resident in Canada, the necessary
information can be marshalled to show that the required decision-making
activities took place in Canada. If it is disadvantageous for a corporation to be
resident in Canada, the tax authorities have enormous difficulty collecting the
necessary information to prove the case. I am not aware of any recent
situations where the Canada Customs and Revenue Agency has successfully
asserted residence on the basis of central management and control. Therefore,
the effect of repealing the test would be simply to remove a tax-planning
device. The only caveat I have is that the central management and control test
may have some prophylactic benefit with respect to transactions such as the US
corporate inversions. On the other hand, such problems might be dealt with by
the application of the general anti-avoidance rule or specific anti-avoidance
rules.
222

The CM&C test is outdated. With advancement in technology such as
videoconferencing, it is possible to hold discussions and make decisions without
meeting face-to-face.
223
Mobile companies challenge the effectiveness of the
residency as well as the source rules:
The global nature of the Internet creates challenges for tax jurisdictions and the
current source, residency, permanent establishment and allocative rules. It is
likely that the existing international rules will need to be substantially revised
in light of electronic commerce. There are also concerns about the increased
scope for tax planning, especially using tax havens, and for increased

221
Graeme Smaill and Steven Grant, New Zealands Provisions (1995) 6(7) International Tax Review
41, 41-2.
222
Brian J Arnold, A Tax Policy Perspective on Corporate Residence (2003) 51 Canadian Tax Journal
1559, 1564.
223
Conditions, above n 55, 149-50.
338
accidental non-compliance, as small to medium businesses engage in
international trade and become subject to international taxation obligations
with which they may not be familiar.
224

The ATO acknowledged that there are practical difficulties in applying the CM&C test
in an Internet environment, and the test needs to be modified:
There is sufficient authority to indicate that it is likely that the courts will be
able to modify the application of the central management and control test to the
Internet environment, eg, video conferences. However, applying a factual test
to a course of business or trading on the Internet is likely to prove difficult,
given the wide variety of business types and modes of operation that could
arise on the Internet.

The instantaneous and global facilities provided by the Internet are expected to
allow residents to more easily influence the operations of their offshore
subsidiaries (which would include tax haven entities). There is no clear
guidance as to where such a business would be regarded as being really carried
on. Moreover, there would be difficulties in applying the concept of central
management and control. The possibly undetectable, anonymous or
unverifiable nature of these communications could make it even more difficult
for the ATO to obtain evidence of these activities should a taxpayer wish to
conceal or disguise them.
225

Voting power control

The voting power control test depends on the residence of shareholders and their
interests in the company. A test based on the residence of shareholders does not
provide an answer as shareholders can be geographically spread out. For example,
shareholders who are residents of Australia might agree to transfer their shares to
persons who are residents outside Australia, who would hold the shares as trustees.
226

Alternatively, the voting power could be granted to a non-resident proxy, nominee or
trustee.
227
There are no tracing rules in the tax legislation to look through the
interposed nominee companies for indirect interests. The shares of most MNEs trade

224
Australian Taxation Office, Tax and the Internet, vol 1, above n 44, 8.
225
Ibid [7.2.20]-[7.2.21].
226
Edward Aloysius McTeirnan, Commonwealth, Hansard, House of Representatives, 29 J uly 1930,
4862, cited in Dirkis, Australias Residency Rules for Companies and Partnerships, above n 128, 409.
227
Dirkis, ibid.
339
on several exchanges. How can one identify the ultimate beneficial owners of publicly
listed companies? Also, a company might avoid Australian residency by simply
refraining from voting at the general meeting.
228

One commentator has suggested that the residency rules must be defined in terms of
links that are important to a company and are difficult to move offshore.
229
The place
where the annual shareholders meeting is held is a ceremonial event and does not
serve the purpose of determining the residence of a company.
230

7.3.5 Conclusion

The residence principle of taxation is based on the place of residence of the person
receiving the income, rather than where the income-producing activity or investment is
located. Residence-based taxation attempts to tax residents on income from all
sources, irrespective of the geographic location where an item of income is derived. In
theory, there should be no dispute as to which jurisdiction had the right to tax if
residence-based taxation were applied by all jurisdictions. An agreement could be
reached that each entity could only have a single, agreed place of residence. However,
in the real world, the principles of residence and source are both used (and are
needed) to tax cross-border business profits.

228
Ibid.
229
Michael J McIntyre, Determining the Residence of Members of a Corporate Group (2003) 51
Canadian Tax Journal 1567, 1571.
230
Ibid.
340
It has been argued that residence is not a coherent concept because it is premised on
the assumption that companies can be analogised to individuals.
231
The metaphor of a
company as an individual in this context has almost no meaning because a company
simply cannot have a residence and keep house like an individual, due to the many
residency rules which are easy for taxpayers to manipulate.
232
It has also been argued
that the concept of residence, as applied to companies, is becoming meaningless:
large multinational corporations are becoming nationless in the sense that
their shareholders, employees, business activities, and income are increasingly
spread throughout the world, rather than concentrated predominantly in any
one country.
233

If Hong Kong were to adopt the residence principle of taxation (as it is applied in
Australia, for example), this would place its tax system in line with other developed
economies. But the revenue implications could be significant. The locality or source
of profits would become relatively unimportant as Hong Kong residents would be
taxed on their entire (global) income. The main issues to consider are the taxation of
the Hong Kong income of non-residents and the foreign income of Hong Kong
residents. Unlike under the current territorial source principle of taxation, the income
of non-residents would no longer be taxed in Hong Kong unless it were derived from a
business conducted in Hong Kong through a PE. Hong Kong could not assess any part
of the profits even though a substantial part of the business may be conducted with
Hong Kong residents if there were no PE. To avoid double taxation, there would be a
need to conclude comprehensive DTTs with Hong Kongs significant trading partners.
The worldwide approach would treat the Hong Kong income and foreign income of

231
Robert Couzin, Policy Forum: Comments on Corporate Residence and International Taxation
(2003) 51 Canadian Tax Journal 1556, 1557.
232
Ibid.
233
United States, J oint Committee on Taxation, Background Materials on Business Tax Issues Prepared
for the House Committee on Ways and Means Tax Policy Discussion Series (J CX-23-02, 4 April 2002)
56 <http://www.house.gov/jct/x-23-02.pdf>at 1 May 2008.
341
residents in an identical manner. There would be no need to distinguish between
domestic and foreign income for tax purposes. There would be little (tax) purpose in
investing overseas in low-tax jurisdictions or engaging in re-invoicing activities to
change the source of income from domestic to foreign. Taxation would not have any
effect on the location of the income-producing transaction, operation or activity as
income, anyway, would be subject to tax. Unless a concession like tax sparing relief
were in place, there would be no tax incentives for an active business to be located
outside Hong Kong.
234
Any tax benefits would be lost as Hong Kong businesses
would be fully taxed on their foreign income (with a credit allowed for the foreign
taxes paid). A resident company might wish to establish a subsidiary company to
derive foreign income. The profits of the subsidiary would be taxed when repatriated
to Hong Kong. If the CFC legislation were to apply as well, tainted income accrued
abroad (but not repatriated) would be taxed in Hong Kong on a current basis.

Australias definition of residence was introduced in 1930 when companies generally
could not function unless face-to-face meetings with directors and shareholders were
held in the one territorial location. The general law approach in establishing the place
of residence of a company is to attribute an artificial residence to an artificial and legal
person, formed upon the analogy of natural persons. This approach is outdated.
Today, global instantaneous communications and electronic commerce challenge the
application of the residency tests of a company. A company can choose its residence
by the place of incorporation and the place to hold its directors and shareholders
meetings without regard to where its real business operates. As residence can be
determined in several different ways, it is possible for a company to reside in two or

234
Under a tax sparing relief, tax is notionally borne by the source jurisdiction and a credit is granted by
the residence jurisdiction.
342
more places. Though the place of incorporation test provides certainty, a company can
shift its country of residence for tax avoidance purposes. The voting power control
test has been criticised as a ceremonial event and subject to manipulation. Where a
DTT exists, the place of effective management is generally used as a tiebreaker test,
which is similar to the place of central management and control. There is a proposal to
abandon the CM&C test and adopt the place of incorporation as a sole test to
determine the residency of a company. On the other hand, the US has proposed
adding another test to determine the residence of a company, based on the place of
primary management and control. This test is different from the CM&C test as it is
based on the day-to-day responsibility of executive officers and senior management of
the company. It is argued that the place of management activities is a more
meaningful test to determine the tax residence of a company.

Residence-based taxation clearly does not provide a complete solution to taxing
business profits in todays environment. It seems to be necessary to regularly rethink
the residence principle as companies are increasingly free to choose whether to be
taxed, or not to be taxed, as residents. The inversion transactions have shown that tax
considerations continue to influence the place of residence of companies. The erosion
of the tax base of the residence jurisdiction can occur if the tax burden is shifted to
low-tax jurisdictions. Given the fundamental importance of the residence principle in
the taxation of cross-border business profits, tax authorities may need to trace the
residence of the masterminds of the company or the ultimate owners of income (as
residing in a place alone could not create profits or generate gains). This, however,
may not be easy and would require the assistance of other tax authorities. With the
ongoing shift from a resources-based to a knowledge-based economy relying
343
increasingly on service provision and remote sales, a transaction, operation or activity
may be complex in nature. Income may be derived from several different jurisdictions.
If the source jurisdiction does not inform the residence jurisdiction about income
earned within its jurisdiction, the residence jurisdiction would not be able to enforce
the worldwide taxation of its residents. The courts of one country will not normally
assist in the enforcement of tax debts due to another country. Taxation based on
residence may tend to lose its meaning if there is no effective means to enforce tax
compliance.

For the reasons outlined above, a major move to greater reliance on residence-based
taxation as a key means to address the growing difficulties associated with source-
based taxation does not recommend itself.

7.4 General consumption taxes

The many uncertainties related to the income taxation of cross-border trade and
commerce in todays globalised economy have already been highlighted. In this part,
consideration is given to the option of placing a greater reliance on a general
consumption tax levied at the retail level as a strategy for addressing the problems
related to income source rules identified in this thesis.
235
It has been argued that a
general consumption tax such as the value added tax (VAT) and its equivalent, the
goods and services tax (GST), could provide a more stable tax base in the face of

235
Consumption taxes are split into two categories: a general consumption tax such as VAT/GST, and
taxes on specific goods and services such as customs duties and excise taxes. See OECD, Consumption
Tax Trends: VAT/GST and Excise Rates, Trends and Administration Issues (2006) 10.
344
increasing global tax competition, as consumption is less mobile than flows of
investment capital.
236

Though there are different types of VAT that vary in their tax treatment of purchases
of capital inputs (plant and equipment),
237
this thesis focuses on consumption VAT
that is, capital purchases are equivalent to expensing.

7.4.1 What is a VAT/GST?

A VAT or a GST (hereafter GST unless otherwise stated) is a broad-based
consumption tax that has an extremely wide coverage. It applies to all forms of supply
(including the performance of services) made at any point in the production or
distribution chain as well as on imports of goods up to and including the retail stage.
Tax is charged on supplies by a supplier of goods or services. Unlike a sales tax that is
collected at the point of final sale, a GST is collected fractionally at every stage of
production and distribution on the net value added by the supplier of goods or
services that is, the value added to the supply by processing or handling it with
labour and other capital goods (for example, machinery and buildings).
238

GST is built into the purchase price of goods and services. This means that the tax is
effectively payable by business enterprises and private individuals whether they are

236
st
Government (2002) 27 Tax Notes International 63, 107.
237
There are three types of VATs consumption VAT, income VAT and gross product VAT. Under
the consumption VAT, the purchase price of a capital input (plant and equipment) is deducted at the
time of purchase. Under the income VAT, the VAT paid on capital inputs is not deducted at the time of
purchase, but amortised (credited against the firms VAT liability) over the expected lives of the capital
inputs. Under the gross product VAT, no deduction for the VAT is allowed against the companys VAT
liability on purchases of capital inputs. See J ames M Bickley, Value Added Tax: Concepts, Policy
Issues, and OECD Experiences (2003) 3.
238
Carl Shoup, Public Finance (1969) 251.
345
registered for GST or not. However, a registered business enterprise can claim an
input tax credit for the amount of the GST it has paid on things
239
acquired or
imported in the carrying on of its enterprise. An input tax credit prevents cascading of
the tax (tax on tax) and ensures that GST is not a cost to business. It also provides a
way of passing the GST liability along the chain of transactions from sales made by
registered businesses to their customers, so that the GST is included in the ultimate
purchase price paid by the end consumer. Thus, the fundamental effect is that an end
consumer bears the economic cost and that person cannot claim tax credits levied in
previous stages.

The supply and liability for GST in Australia is illustrated with a chart as follows:
240

239
In Australia, a thing means anything that can be supplied or imported and is the subject matter of
the supply or importation. See A New Tax System (Goods and Services Tax) Act 1999 s 195-1. See,
also, Australian Taxation Office, Goods and Service Tax Ruling GSTR 2000/31, Goods and Services
Tax: Supplies Connected with Australia, [170].
240
Based on an example in Australian Taxation Office, Your Introduction to Taxation: Students
Resource (2006) 32.
346

Supplies and
liabilities for GST in
Australia
Manufacturer 1 produces
timber and sells stock to a
carpenter (manufacturer 2)
for a price of $550 including
$50GST
GST on sale $ 10
Less GST paid $ 0
Producer to remit to ATO $ 10
GST on sale $ 50
Less GST paid by producer $ 10
Manufacturer 1 to remit to ATO $ 40
Manufacturer 2 makes
furniture and sells stock to a
wholesaler for a price of
$1100 including $100 GST
GST on sale $100
Less GST paid by producer
and manufacturer 1 $ 50
Manufacturer 2 to remit to ATO $ 50
Wholesaler sells furniture to
a retailer for a price of $1430
including $130 GST
GST on sale $130
Less GST paid by producer,
manufacturer 1 and
manufacturer 2 $100
Wholesaler to remit to ATO $ 30
GST paid by the consumer on this
transaction $200
which is collected fractionally from
the following registered entities:
Producer $ 10
Manufacturer 1 $ 40
Manufacturer 2 $ 50
Wholesaler $ 30
Retailer $ 70

Total GST collected by the ATO $200
Retailer sells furniture to a
consumer for a price of
$2200 including $200 GST
GST on sale $200
Less GST paid by producer,
manufacturer 1, manufacturer 2
and wholesaler $130
Retailer to remit to ATO $ 70
Plantation (producer) grows
trees to sell wood to a mill
(manufacturer 1) for a price
of $110 including $10 GST
347
7.4.2 Is GST suitable for electronic commerce?

Today, most developed countries apart from the US levy a consumption tax such as a
VAT or a GST.
241
Each jurisdiction asserts its taxing right using a system for place of
taxation that is origin-based, destination-based or a mixture of the two.
242

Under the destination principle, local goods (and, today, usually services) are either all
or mostly taxed in the jurisdiction in which the customer is based. This means that
imports (purchases from abroad) are taxed (at the rate that would have applied had the
goods been purchased from a domestic supplier) but exports (sales to abroad) are
exempt from tax.
243
The exemption of exports from consumption tax by
J urisdiction A should encourage businesses to locate production facilities at home
rather than outside J urisdiction A.

Under the origin principle, the consumption tax of J urisdiction A is imposed where the
supplier is based. Everything produced domestically or which has originated within
J urisdiction As borders, regardless of whether the products are consumed by residents
in J urisdiction A or sold to non-residents residing elsewhere, are taxed. Therefore,
imports are exempt but exports bear tax at the rate applicable in the country where the
supplier is established.
244
A country will generate more revenue under the origin
principle if it can produce more than it consumes because goods and services for

241
The majority of states in the United States impose a sales tax on the end purchase of a good or
service.
242
OECD, Centre for Tax Policy and Administration, Report: The Application of Consumption Taxes to
the Trade in International Services and Intangibles (2004) [5]
243
Larking, above n 66, 119; Alan Schenk and Oliver Oldman, Value Added Tax: A Comparative
Approach, With Materials and Cases (2001) 46.
244
Larking, ibid 291; Schenk and Oldman, ibid 47.
348
export are taxed in the country of production. As purchases from abroad are not taxed,
this means net-importing countries collect less revenue under the origin principle. For
this reason, a destination-based tax is usually characterised as a tax on consumption
occurring in the taxing jurisdiction, while an origin-based tax is usually characterised
as a tax on the jurisdictions production of consumer goods.
245
The international norm
for the consumption taxation of goods and services is the destination principle.
246
Tax
is levied in the country where the final consumption (sale) is made so the customers
choice is not influenced by the tax rates of different countries.

The GST tax base is the total value added to the thing on domestic consumption in
the private sector of the economy.
247
Under the destination principle, it consists of
expenditures on domestic consumption of goods and services.
248
Under the origin
principle, it consists of domestic consumption plus net exports.
249
Although GST is a
tax on domestic consumption, it operates as a business tax. It is the maker of a
taxable supply
250
or taxable importation
251
who is liable for paying it. The tax base
is determined as follows:
Business base = revenues from sales material expenses capital
expenditures (net of disposals)
252

245
Charles E McLure, Jr, Electronic Commerce, State Sales Taxation, and Intergovernmental Fiscal
Relations (1997) 50 National Tax Journal 731, 740.
246
OECD, Centre for Tax Policy and Administration, International VAT/GST Guidelines (February
2006) Preface [4] <http://www.oecd.org/dataoecd/16/36/36177871.pdf>at 1 May 2008.
247
Alan A Tait, Value Added Tax (1972) 19.
248
See Issues in Consumption Taxation in United States, Background Materials on Business Tax
Issues Prepared for the House Committee on Ways and Means Tax Policy Discussion Series, above
n 233, 70.
249
Ibid.
250
A New Tax System (Goods and Services Tax) Act 1999 (Cth) s 9-40.
251
252
J ack M Mintz, The Thorny Problem of Implementing New Consumption Taxes (1996) 49 National
Tax Journal 461, 465.
349
An enterprise accounts for GST on realised expenditures using cash-flow
accounting.
253
A supplier acquired a thing at a GST-inclusive price. GST is
collected on the value added at each stage of the production and distribution cycle of
products and services to the end consumer. The tax applies to the value of each
transaction in the chain of supply between supplier and purchaser, and effectively
becomes a tax on consumption when the thing is sold to an end consumer. The
supplier claims an input tax credit when the thing is sold. Claiming an input tax
credit is based on the value added, and income and capital are disregarded. The
supplier adds value to the thing it acquired from other suppliers by processing or
handling it with its own labour and its own machinery, buildings or other capital goods.
The sales proceeds contribute to pay salaries to employees, other costs of doing
business, and a return on investment to the owner of the business. The value added to
the thing is the difference between the gross revenues from sales and the cost of
materials, including capital goods, which it has purchased from other suppliers. The
GST base can be represented by the following equation:
Gross sales cost of goods sold = profit +cost of labour
254
+annual
depreciation of capital goods the sum of other surplus income (such as
interest)
255

This is the same as:
Profit = gross sales cost of goods sold cost of labour annual depreciation
of capital goods +the sum of other surplus income (such as interest)

253
Cash flow is the movement of money through a business from the time it is received as income or
borrowing (cash inflow) to the time it leaves the company as payments (cash outflow). It is generally
defined as net profit plus depreciation (net cash flow). See J ohn O E Clark (ed), Dictionary of
International Banking and Finance Terms (2001) 66; Graham Bannock and William Manser,
International Dictionary of Finance (2003) 40.
254
In Australia, the wages and salaries of employees are not treated as business inputs. See A New Tax
System (Goods and Services Tax) Act 1999 (Cth) s 9-20(2)(a).
255
See Graeme S Cooper and Richard J Vann, Implementing the Goods and Services Tax (1999) 21
Sydney Law Review 337, 345-6; Russell Mathews, The Case for Indirect Taxation (1984) 1 Australian
Tax Forum 54, 57.
350
Provided that profit is understood as being measured in pure cash flow terms, it has
been argued that the GST tax base is equivalent to imposing tax on an enterprises
profits plus its payroll.
256
It has also been argued that a broad-based consumption tax
is more suitable than an income tax for goods provided through electronic commerce
as the consumption tax base is typically territorial rather than worldwide
257
that is,
tax is only imposed on economic activity within the borders of a jurisdiction. Tax
authorities do not have to monitor the economic activities outside their jurisdiction and
pursue tax claims in the territory of other jurisdictions.

7.4.3 GST the enforcement challenges

The aim of a GST is to impose a tax on final consumption including imports. If residents
do their shopping within their own country, then all purchases would equal sales and all
domestic consumption would be taxed by a GST. Serious enforcement difficulties arise
if the supplier and the recipient of goods and services are not in the same jurisdiction. A
jurisdiction can impose a tax on the goods and services used by its residents, but it cannot
enforce foreign suppliers to account for the collection of indirect taxes.
258

256
Cooper and Vann, ibid 345.
257
See Issues in Consumption Taxation in United States, Background Materials on Business Tax Issues
Prepared for the House Committee on Ways and Means Tax Policy Discussion Series, above n 233, 66, 70.
258
A typical DTT covers income tax and does not require each state to assist in the collection of indirect
taxes, though some of Australias revised tax treaties provide for reciprocal assistance in the collection of
taxes imposed under the federal law of Australia (including the GST). See, for example, the Agreement
Between the Government of Australia and the Government of Finland for the Avoidance of Double
Taxation with respect to Taxes on Income and the Prevention of Fiscal Evasion (entered into force
10 November 2007).
The comprehensive DTTs with Belgium, Thailand and Luxembourg and the Arrangement with China
entered into by Hong Kong cover three types of tax (being salaries tax, property tax and profits tax). These
agreements do not cover other taxes nor assistance in the collection of taxes. See the Agreement Between
the Hong Kong Special Administrative Region of the Peoples Republic of China and the Kingdom of
Belgium for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes
on Income and on Capital (entered into force 7 October 2004); Agreement Between the Government of the
Hong Kong Special Administrative Region of the Peoples Republic of China and the Government of the
Kingdom of Thailand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 7 December 2005); Agreement Between the Hong Kong
351

In Australia, the supply of a right or option to acquire another thing is connected with
Australia (and subject to GST) even if the right to obtain supply is granted outside
Australia.
259
For example, GST is payable on Australian holiday packages whether
supplied domestically or offshore.
260
But for this to happen the foreign tour operator
needs to be registered or required to be registered for GST in Australia.
261
Unless the
foreign tour operator also conducts other activities in Australia, there is no requirement
for registration for GST in Australia, however.
262
Given this reality, a domestic tour
operator may well be tempted to change its status to a non-resident enterprise. The
ATO does not have enforcement powers over foreign enterprises. The question is:
How to force a foreign supplier to pay tax on supplies connected with Australia, but
where the right to obtain the supply is created overseas?
263

Special Administrative Region of the Peoples Republic of China and the Grand Duchy of Luxembourg for
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income
and on Capital (entered into force 1 April 2008); Arrangement Between the Mainland of China and the
Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with respect to Taxes on Income (entered into force 8 December 2006); Second Protocol to
Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income
(signed on 30 J anuary 2008).
259
260
The taxable components of Australian travel packages include:
hotel accommodation;
car hire;
domestic transfers;
tickets for entry to entertainment venues; and
restaurant meals.
See Australian Taxation Office, Fact Sheet: GST and Australian Travel Packages Sold by Foreign Tour
Operators (2005) 2.
261
Under s 9-5 of the GST Act, a supply would not be a taxable supply if the foreign supplier did not carry
on an enterprise in Australia and was not registered for GST purposes.
262
Australian Taxation Office, Fact Sheet: GST and Australian Travel Packages Sold by Foreign Tour
Operators, above n 260, 1.
263
This is illustrated with the following example, based on Australian Taxation Office, Fact Sheet: GST
and Australian Travel Packages Sold by Foreign Tour Operators, ibid 1-2.
UK Travel is a foreign tour operator based in the UK with no premises or employees in Australia. UK
Travel buys Australian tour packages from Oz Travel, a resident tour wholesaler in Melbourne registered
for GST. The purchase price of each package includes GST.
Suppose X, a UK tourist wishing to travel to Australia, buys a tour package from UK Travel to stay at
Hotel C in Melbourne. UK Travel pays Oz Travel $110 per night inclusive of GST, but charges X $132 per
night. The GST collected by Australia depends on whether UK Travel is registered for GST in Australia:
352

In addition to supplies of goods and services, imported goods are subject to GST but
collected by customs. Cross-border services and intangible goods, it is generally
agreed, cannot easily be taxed under a GST as imports have become invisible and
boundary checks cannot be monitored. In Australia, a taxable importation arises only
when tangible goods are imported. GST is collected by the Australian Customs
Service (ACS) from the importer, regardless of whether it is registered or even
carrying on an enterprise. The supply of conventional products (for example, a
compact disc) is treated as a taxable importation and tax may be collected by the ACS
at the time of importation. For electronically supplied products, there is no physical
delivery address for the ACS to rely upon to collect the GST.
264

Thus, if a private consumer acquires services from an Australian company GST is
charged. If instead the purchase is made from a foreign company supplying services
from offshore GST is not charged.
265
The difference in the tax treatment arises
because there is no effective way to collect the tax. The reverse charge rules do not
apply to private consumers.
266
Effectively imposing a GST on individually imported

If UK Travel is registered for GST in Australia, it is liable for GST of $12, with a credit of $10 for
the GST included in the price from Oz Travel (being 10 per cent of a GST-inclusive price of $132
sold by UK Travel to X). Australia collects a GST of $12 on the supply of one nights
accommodation at Hotel C to X.
If UK Travel is not registered for GST in Australia, it is not liable for GST (no GST is charged on
the price of $132 sold by UK Travel to X). Also, it cannot claim the GST credit of $10 included in
the price from Oz Travel. Australia collects a GST of $10 on the supply of one nights
accommodation at Hotel C to X.
264
The transaction costs involved in collecting tax on thousands of low-value individual transactions
presents another problem.
265
Mark J ones, Taxing Times in Cyberspace, Australian Financial Review (Sydney) 17 March 2007, 25.
266
The reverse charge rules under Div 84 of A New Tax System (Goods and Services Tax) Act 1999 (Cth)
apply if the recipient of the services is an enterprise that is registered or required to be registered for GST.
The impact of the reverse charge rules is that GST is payable and collected by the recipient of the supply,
not the supplier. But the reverse charge rules only apply where the Australian party (being an entity that
is registered or required to be registered for GST) would not be entitled to a full input tax credit on its
acquisition because the net impact on revenue will be nil. There will be an input tax credit entitlement on
353
digitised products is often administratively impracticable. The tax cannot be collected
from offshore suppliers in the absence of a physical presence and business activities in
the host (source) jurisdiction. And, where transactions are low value and numerous,
the cost of tax collection can easily exceed the value of tax collected. Unlike business-
to-business transactions, private consumers are unlikely to be able to be held
accountable for GST-type taxes on purchases from overseas.

Electronic commerce thus raises the issue of how to collect tax on the cross-border
shopping of private consumers for goods and services (and especially those that can be
delivered completely through electronic transmission). When physical goods are
imported, the Customs Office can, at least in theory, hold the goods until the consumer
pays the tax. Digital technology enables numbers of products that are currently often
supplied in a physical form (and subject to consumption tax) to be delivered
electronically through the Internet. Examples include music and video files, legal or
accounting advice, and insurance policies. The digitised information can cross the
boundaries of nations and bypass any border check by Customs because digitised
products can enter a country by cable, telephone wire, cellular network or satellite, all
of which pose enforcement and tracing difficulties in determining who is subject to
pay any indirect tax that may apply. If tax is imposed where the consumer receives the
supply (destination), there is the difficulty of identifying the location of the consumer
(and then collecting tax from perhaps thousands of private consumers). If tax is based
on where the supplier is established (origin), then there is the difficulty in identifying
the site or location of the supplier unless there is a fixed place of business in the
consumers jurisdiction. The digitisation of information creates difficulties in defining

the self-assessed GST to the extent of the recipients creditable purpose. See David Scott, Australian
Guide to e-Business Taxation (2001) 114-5.
354
the origin and destination of both production and consumption. The supply of goods
and services via the Internet raises the question of whether it is more practicable to
collect GST from offshore suppliers (origin) or the numerous private customers within
a taxing jurisdiction (destination).

The current international consumption tax environment leaves the tax base in many
jurisdictions open to some risk. The tax base is bound to be undermined if digitised
products previously delivered through traditional channels can now be supplied and
delivered on the Internet. As Hong Kong does not impose a GST and Australias GST
system is relatively young,
267
it is useful to examine the VAT/GST systems that are
more established, such as in the European Union (EU),
268
and learn how they have
responded to the challenging issue of VAT collection.

Within the EU, a common system of VAT is applied on the supply of goods and
services up to and including the retail trade stage.
269
The place of supply determines
the jurisdiction where the transaction is subject to VAT. For the supply of goods,
VAT is generally due in the place where the goods are located at the time they are sold
(the destination principle).
270
For the supply of services, the basic rule is the place

267
GST was introduced in Australia on 1 J uly 2000.
268
VAT was introduced in Europe and had evolved through many stages. A tax on the gross turnover of
businesses was introduced in France and Germany in the early 1920s. Tax was collected every time a
product was transferred in the process of production and distribution (from the manufacturer to the
retailer), without any credit of tax paid in the previous stages. In 1948, France sought to address the
cascading effect and introduced the tax credit principle into their producers tax. A manufacturer could
offset the amount of tax already paid on these inputs against the tax due from the sale of outputs. In
1954, the tax was applied to capital goods and the name VAT (taxe sur la valeur ajoute) was created.
In 1968, the European Community adopted a common system of VAT as an alternative to the
(cascading) sales taxes was adopted. Any country joining the European Community as a full member
was obliged to replace its existing sales taxes by the VAT. See OECD, Taxing Consumption (1988) 79;
Tait, Value Added Tax, above n 247, vii, 6-9.
269
Pursuant to the VAT Directive, see above n 6.
270
VAT Directive art 31.
355
where the supplier is established (the origin principle).
271
However, there are a large
number of exceptions to this basic (services) rule, such as:
the supply of tangible services provided by an intermediary (for example, car hire
and live entertainment) is taxed in the same place where the main transaction, in
which they intervene, is taxable;
272

the supply of services connected with immovable property is the place where the
property is located;
273
and
the supply of intangible services (for example, intellectual services and consulting)
is taxed in the place where the customer is located when the supplier is outside of
the EU.
274

Thus, both the destination and the origin principles are applied on sales between the
EU supplier and the EU private customer, depending on the nature of supply and the
location of the supplier. Advances in technology have made it increasingly possible
for a number of supplies to be delivered electronically to EU private customers. This
raises the question of collection of VAT when the supplier (the taxable person) is
based outside the EU, as private customers will generally not be registered for VAT
and it would not be practicable to impose a reverse charge whereby such recipients
would be required to account for VAT. To ensure that the same transactions in the EU
are subject to VAT, non-EU businesses have to apply VAT when selling certain
electronically supplied services (such as software and downloaded music) to private
customers within the EU. The VAT rate applicable is the rate in the jurisdiction where
the private customer is located. When the same product is supplied online by an EU

271
272
273
274
356
supplier to an EU private customer, the VAT rate applicable is the rate in the
jurisdiction where the seller is located, however. So there are two different sets of
rates that apply to electronically supplied services based on the location of
consumption (destination) and the location of the service provider (origin). EU
businesses will be able to charge the same rate to every EU private customer (based on
the location of the EU business), while non-EU businesses will have to calculate the
tax rate for each EU private customer (based on the location of the private customer).

The EU has made it clear that it will rely on (self-interested) voluntary compliance.
275

The basic enforcement mechanisms chosen are:
non-EU businesses are required to be registered and be familiar with the rules
pertaining to all member states in which they have private customers;
the online systems of non-EU businesses must be capable of levying the correct
rate of VAT depending upon the location of the private customer;
non-EU businesses will report and remit their VAT tax liabilities in Euros to the
member state in which they are registered;
VAT returns are to be submitted online on a quarterly basis, within 20 days after
the quarter to which the returns refer;
the member state in which the non-EU business is registered will redistribute VAT
to the member state in which the sale was made;
the non-EU business needs to file a separate request for refunds of input credits
under the 13
th
VAT Directive from each individual member state in which it has

275
Torsten Fetzer, Digital Sales and the European Union: Taxing Times Imminent (2003) 5 Tax
Planning International E-Commerce 5, 7.
357
incurred an input VAT;
276
and
the tax administration of the member state of consumption may request to audit a
sellers VAT compliance.
277

The EU has concluded that a VAT system is the only possible solution for the global
taxation of electronic commerce.
278
The EU takes this view because:
tax authorities cannot track sales of services delivered electronically;
suppliers can collect the tax from private customers and report on the quantity of
their sales;
tax is imposed on all electronic transactions equally whether or not the supplier
is located in a EU member state or a non-EU jurisdiction; and
the EU system applies the same basic rules universally.
279

Service providers have to establish the status of their EU customers in order to comply
with their VAT obligations. This likely will increase the compliance obligations of
service providers. It will be interesting to see how the EU tax authorities deal with the
challenges of enforcement against suppliers with no presence in the EU.

276
See Thirteenth Council Directive 86/560/EEC of 17 November 1986 on the Harmonization of the
Laws of the Member States Relating to Turnover Taxes Arrangements for the Refund of Value Added
Tax to Taxable Persons not Established in Community Territory [1986] OJ L 326.
277
Fetzer, above n 275, 6-7; Christine Sanderson et al, Remote Control: A Guide for U.S. E-
Commerce Vendors to the New EU VAT Directive (2002) 26 Tax Notes International 1113, 1119.
To simplify VAT arrangements for the suppliers of electronic services, a one-stop shop system
will be adopted to enable suppliers to fulfil, in their home member state, a single set of obligations for
VAT registrations, declarations and payments, including for services provided in other member states
where they are not established. VAT revenue will then be transferred from the country where the
supplier is located to that where the customer is situated, whose VAT rates and controls will be
applicable. See European Union, Council of the European Union, Council Adopts New Rules for VAT
on Services, with Taxation in the Country of Consumption and Reduced Compliance Costs for
Businesses (Brussels, Presse 6359/08) (12 February 2008)
<http://www.consilium.europa.eu/ueDocs/cms_Data/docs/pressData/en/misc/98709.pdf>at 2 May 2008.
278
Trevor Drury and Chuck Gnaedinger, EU Tax Official Discusses Proposed VAT E-Commerce
Amendment (2000) 21 Tax Notes International 306, 308.
279
Drury and Gnaedinger, above n 278, 306-8.
358
7.4.4 A general consumption tax for Hong Kong?

Hong Kong is one of the few developed economies that does not levy some form of a
general consumption tax. This means an income tax is used as the dominant revenue
raiser. But Hong Kong also relies heavily on non-tax revenue such as land sales (and
land-related transactions) which are sensitive to economic cycles. With persistent
operating deficits in Hong Kong since 1998-99 until the 2004-05 fiscal year, there are
suggestions that Hong Kongs tax system needed to be reformed and the tax base be
broadened (and stabilised).
280
In considering the most appropriate option for
broadening the tax base, three principles, it was argued, should be taken into account:
the option must be effective in broadening the tax base and providing stable and
considerable revenue;
the option must be fair and in line with the capacity to pay principle; and
the option is in line with Hong Kongs simple and low-tax system so as to attract
capital and talent and maintain Hong Kongs competitiveness.
281

It is claimed that GST is the only option that can satisfy all these conditions, after
considering a number of other options such as introducing a green tax, a land and sea
departure tax, a capital gains tax etc.
282
These latter options, it was argued, were not
long-term solutions to solving Hong Kongs narrow tax base.
283

280
Hong Kong, Advisory Committee on New Broad-based Taxes, Final Report to the Financial
Secretary (2002) <http://www.fstb.gov.hk/tb/acnbt/english/finalrpt/btreport.pdf> at 26 April 2008;
Hong Kong, Financial Services and the Treasury Bureau, Public Consultation on Tax Reform: Final
Report (2007) <http://www.taxreform.gov.hk/eng/pdf/finalreport.pdf>at 27 April 2008.
281
Hong Kong, Financial Services and the Treasury Bureau, Public Consultation on Tax Reform: Final
Report, ibid iv.
282
Ibid.
283
Ibid.
359
As noted in Chapter 4, Hong Kongs tax base is narrow in composition and the taxed
sector is small. The tax net in Hong Kong is not wide enough to include all gains and
benefits within the tax base. The overall tax burden is borne by those caught under
salaries tax, profits tax and property tax. Under a GST, the burden of paying tax is
shifted from income to spending. A GST would include a larger base of taxpayers in
the tax net as it applies to virtually all private consumption of goods and services
including imports. The wide coverage of private consumption would include all
persons without relying only on a small proportion of taxpayers currently caught in the
income tax net.

The capacity to pay is a measurement of a persons ability to pay taxes. A taxpayers
tax burden is reflected in his economic capacity to bear that burden relative to other
taxpayers.
284
One key acknowledged, prima facie drawback of consumption taxes is
their regressive nature the tax rate is the same whether the consumption is spent by a
person with a low income or a person with a high income.
285
Though a person with a
lower capacity to spend pays less tax, the person consumes all or a greater portion of
the income, compared with a person with a higher income who consumes only a
fraction of his wealth. Thus, a higher relative burden is imposed on the lower income
groups. The regressive impact of a GST can be addressed by imposing multiple rate
brackets (although this increases the operational complexity of a GST and the potential
for GST tax planning). For example, Australias GST legislation allows exemptions

284
Larking, above n 66, 1.
285
During a discussion held on 6 J uly 2006 at the IBFD Meeting of Research Students, Professor Huub
Bierlaagh mentioned to the author as well as to the other participants that the VAT is not as regressive
as expected, based on the results of an investigation conducted in the Netherlands. See Anuschka
Bakker, Report of Discussion on Thursday 6 J uly in IBFD Meeting of Research Students 2006
<http://www.ibfd.org/portal/synopsis_wong_report.html>at 16 April 2008.
360
for necessities such as basic food and charges a higher rate on luxury cars.
286

Regressivity can be further addressed through a cut in income taxes, which is
progressive the rate of tax increases as the amount of taxable income rises.
287
This
means a person pays income tax proportionate to his or her income a person with
more income pays more tax. In the case of Hong Kong, as the less well-off do not pay
income-type tax, relief can be provided through some form of compensation measures
for the increased cost of living.
288

A disadvantage of a GST is the high administrative cost borne by registered enterprises
in filing returns.
289
They have to account for the tax and apply for the refunds. Like an
income tax, a GST is capable of being collected by withholding at the source. The
administrative burden of collection of GST revenue is lower than the collection of
income taxes. Only registered enterprises are required to lodge an activity statement (as
compared with lodging an income tax return by all taxpayers deriving income). Hong
Kong does not have a system of withholding tax at the source, such as Australias
PAYG where employers are required to deduct at source the tax on the salaries paid to
their employees. The introduction of a GST can take a number of years and may
require a large increase in the administrative costs of government. There may be
resistance by final consumers because the prices paid for most goods and services
would be likely to rise by the tax rate. Adequate training may have to be provided to

286
The luxury car tax (LCT) applies to the excess value above the LCT threshold. See footnote 164,
Chapter 4, on how to work out the LCT.
287
See footnote 171, Chapter 4, on the reduction in income tax with the introduction of Australias GST.
288
See, Hong Kong, Broadening the Tax Base Ensuring Our Future Prosperity Whats the Best
Options for Hong Kong? (Consultation Document, 18 J uly 2006)
<http://www.taxreform.gov.hk/eng/doc_and_leaflet.htm> at 26 April 2008 on tax relief and other
compensation measures proposed for Hong Kong to accompany the GST.
289
In Australia, registration is optional for an enterprise operating on a small scale. Under s 23-15 of
the GST Act, the annual turnover threshold for compulsory registration is A$75 000 (Australian dollars)
for businesses or A$150 000 for non-profit bodies. Unregistered suppliers do not have to pay GST on
the supplies they make, but they are not entitled to claim an input tax credit on the GST paid on their
acquisitions (purchases or expenses).
361
taxpayers to comply with the new tax. It has been argued that the lack of adequate
discussion or preparation by taxpayers might lead to withdrawal, albeit temporary, or
unforeseen delay in introducing such a tax.
290
The compliance costs are likely to be
high due to the reporting requirements and the large number of transactions that have to
be recorded. This is especially so during the early years of GST operation as businesses
collecting and remitting GST carry a very heavy learning load. With the passage of
time, however, assuming that the GST system remains stable, the compliance burden
should reduce as the learning phase is completed.

To make the tax system simple and easier to comply with, micro businesses would be
exempt from registration by setting a high registration threshold. The GST rate to be
adopted should be low so as not to undermine Hong Kongs simple and low-rate tax
system.
291

This thesis argues that Hong Kong needs a broad tax base to generate stable streams of
revenue that are economically sustainable over the long term. It has been argued that
the primary reason for considering a GST is the significant potential for improving
fiscal management (under deficit reduction) by applying a low tax rate to a broad
base.
292
Most governments run deficits. These are sustainable as long as economies
are growing more rapidly than debt.
293
GST is designed to raise substantial amounts
of revenue on an ongoing basis without creating economic distortions as it does not

290
Parthasarathi Shome, Tax Policy and the Design of a Single Tax System (2003) 57 Bulletin for
291
Hong Kong, Financial Services and the Treasury Bureau, Public Consultation on Tax Reform:
Interim Report (December 2006) [8] <http://www.taxreform.gov.hk/eng/pdf/interim.pdf>at 27 April
2008.
292
Bickley, above n 237, 8.
293
David R Burton, Destination Principle Consumption Tax Would Be Good for the U.S. (2004) 36
362
overly rely on a limited range of economic activities to collect tax revenues.
294
Even
in times of a recession, it provides a steady source of revenue without the need to
increase income taxes as basic spending must continue. The potential revenue
generated by each percentage point in the rate of GST depends on the
comprehensiveness of the tax base.
295
It is estimated that one percentage point in the
rate of GST would generate revenue of HK$6 billion a year in Hong Kong.
296
A five
per cent GST would generate approximately HK$30 billion a year in revenues,
depending on exemptions. This would be a significant source of revenue, considering
Hong Kongs fiscal deficit was HK$40.1 billion for the year ended 31 March 2004 and
HK$4 billion for the year ended 31 March 2005 (and Hong Kongs total expenditure
was HK$247.5 billion and HK$242.2 billion for the respective years).
297

Hong Kong relies heavily on direct taxes and property-related transactions. This
stands in stark contrast to a developed economy, such as Australia, where a general
consumption tax (now) co-exists with an income tax. One argument for a GST is that
it makes good sense to introduce such a tax when there is little room for further
increases in direct taxes on income. If a country wants a competitive taxation regime
and a decent level of public expenditure, then it needs, it is argued, a taxation base to
sustain it.
298
Hong Kongs now dominant service sector relies heavily on foreign

294
Alan Tait, Value-Added Tax, National in J oseph J Cordes (ed), The Encyclopedia of Taxation and
Tax Policy (1999) 422.
295
A broad-based VAT/GST with limited exclusions would generate more revenue, compared with a
narrow-based VAT/GST with numerous exclusions. A broad-based VAT/GST would tax 77.7 per cent
of total consumption and a narrow-based 46.5 per cent. See Bickley, above n 237, 8-9.
296
See Hong Kong, Financial Secretary, Broadening the Tax Base in The 2004-05 Budget, [109]
<http://www.budget.gov.hk/2004/eng/ebudget.pdf>at 27 April 2008.
297
See Hong Kong, Treasury, Consolidated Account in Accounts of the Government for the Year
Ended 31 March 2005 [11] <http://www.try.gov.hk/internet/pde_ca05.pdf>at 27 April 2008.
298
Peter Costello, Challenges and Benefits of Globalisation (Address to the Sydney Institute, 25 J uly
2001) Commonwealth, Treasurer
<http://www.treasurer.gov.au/DisplayDocs.aspx?doc=speeches/2001/003.htm&pageID=005&min=phc
&Year=2001&DocType=1>at 2 May 2008.
363
investment flows (often related to Mainland China). If the profits tax rate were raised,
it is argued businesses would explore ways to reduce their income tax burden and
would quickly shift substantial amounts of profits out of Hong Kong.
299
This could
lead to issues in transfer pricing, capital flight and financial arbitrage, all making Hong
Kong less competitive.
300
To stay competitive, a jurisdiction needs to avoid relying
too much on direct tax income tax and company tax. One acknowledged way of
sharing the burden of funding public expenditure is to use a broad-based indirect
tax.
301
A GST is more receptive to the need to broaden the tax base the GST rates
can be increased to finance a reduction in income taxes to improve a jurisdictions
international competitiveness.
302

The operation of a general consumption tax results in quite different impacts on the
cross-border flow of goods and services, depending on the principle used in
implementation. Under the destination principle, neither consumption by residents
taken for use abroad nor earnings paid to non-residents for consumption abroad are
subject to tax.
303
But both types of consumption would be subject to tax if the origin
principle is adopted. A consumption tax under the destination principle possibly
assists international competitiveness of a jurisdiction as GST is not applied on exports

299
It is argued a country with a high corporate income tax rate can lose revenue to other jurisdictions, as
profits are very mobile and respond to differences in statutory tax rates across countries. See J ack M
Mintz, Is National Tax Policy Viable in the Face of Global Competition? (1999) 18 Tax Notes
International 99, 100-1.
300
High taxation on capital, which includes taxes on business profits and taxes on individuals receipts of
dividends, interest, and capital gains, causes capital flight and reduces domestic productivity, wages,
and income. See Edwards and de Rugy, above n 236, 64.
301
Costello, above n 298.
302
Lee Fook Hong, Singapores 2007 Budget To Build Capabilities for the Future (2007) 61 Bulletin
for International Taxation 207 on the case of Singapore.
303
For example, travellers leaving Australia with accompanied goods purchased in Australia, but for use
outside Australia, may receive a refund of the GST paid. See A New Tax System (Goods and Services
Tax) Act 1999 (Cth) s 168-5.
364
(goods and services for consumption outside a jurisdiction).
304
Overseas customers do
not pay any additional tax and so the tax would not affect international trade. On the
other hand, income tax is a cost to business and an increase in income tax would
minimise the return on investment unless the cost is passed on to customers. It has
been argued that the absence of a GST inhibits the competitive capacity of a
jurisdiction because exporters lose out in two ways:
indirect (hidden) taxes form part of the cost of exports, whereas foreign
competitors obtain a refund of the input taxes; and
higher company and personal income taxes (which affect retained earnings, the
funding of investment in plant and technology etc) paid by exporters, whereas
foreign competitors pay a lower income tax rate with the co-existence of a GST.
305

It is also argued that the business communities often do not support a GST due to its
adverse impact on the retail and tourism businesses because it tends to push up the
purchase price of a supply.
306
On the other hand, it is argued that a GST would not
affect the retail industry.
307
Overseas experience with the implementation of a GST,
including Australia, has shown that a GST has only a minor and temporary effect on
the economy.
308
In Australia, a GST is a growth tax. The introduction of the GST
has been, it is said, a stunning success, with GST revenues consistently higher than

304
This would make re-invoicing activities irrelevant because export sales would be exempt from GST.
In a re-invoicing transaction, an intermediary is used between a customer and an exporter to change the
source of profits from, say, Hong Kong to a no-tax or low-tax jurisdiction. The prices set for the re-
invoicing transaction would not affect the tax base (domestic consumption) unless value is added in
Hong Kong.
305
Richard Buchanan, Corporate Taxation: Toward a Tax-Competitive Australia (1996) 5 Taxation in
Australia (red ed) 66, 67-8.
306
Daniel K C Cheung, Debate on the Hong Kong Tax Base Its Criteria, Principles, and Problems
(2001) 27(2) International Tax Journal 57, 70.
307
Frederick Ma, How Tax Reform Will Help Hong Kongs Long-Term Sustainable Development?
Hong Kong, Secretary for Financial Services and the Treasury
<http://www.taxreform.gov.hk/eng/pdf/sfst_article.pdf>at 27 April 2008.
308
Ibid.
365
budget predictions.
309
It has gained community confidence and has been widely
accepted. Its administration does not present complex problems, except in the
treatment of property and financial services.
310
The possible impact of GST on
tourism can be reduced by a tax refund scheme for purchases made by visitors.

Though Hong Kongs tax base is narrow, the majority of the public clearly do not
currently consider that the GST is an appropriate option to solve the tax base problem.
The launch of a formal discussion about the introduction of a GST in Hong Kong has
received hostile opposition and generated much heated debate. The GST aspect of the
interim review of public consultation on tax reform was dropped well before the end
of the nine-month consultation period.
311
With the recent recovery in Hong Kongs
economy, the case for a GST has been weakened in that it is no longer so immediately
necessary to raise additional revenue to fund operating deficits. The road to a GST in
Hong Kong may prove to be, similar to Australia, a long and winding one.
312
It took,
in total, around thirty years to enact a GST in Australia.
313
It has been argued that the
abandonment of the GST proposal in Hong Kong is not the end or the beginning of the
end, but perhaps the end of the beginning.
314
It is right, therefore, to continue to ask,
when will Hong Kong take action to reform its tax system to help ensure its future
growth and prosperity?

309
GST A Stunning Success, The Australian (Sydney), 28 J une 2005, 23.
310
Ibid.
311
See Hong Kong, Government Information Centre, FS Speaks on Public Consultation on Tax Reform,
Press Release (5 December 2006) on cancellation of the GST part of the consultation on widening Hong
Kongs tax base.
312
Richard Eccleston, The Thirty Year Problem: The Politics of Australian Tax Reform in Research
Study No 42, Australian Tax Research Foundation (2004); Neil Warren, GST, The Long, Winding Road
(1996).
313
Eccleston, ibid 141.
314
Quotation from Professor Richard Cullen, paraphrasing Sir Winston Churchill, cited in Andrew
Halkyard and Stephen Phua Lye Huat, Common Law Heritage and Statutory Diversion Taxation of
Income in Singapore and Hong Kong [July 2007] Singapore Journal of Legal Studies 1, 22.
366
The general problems with the Hong Kong tax base noted in this thesis are notably
amplified by Hong Kongs uncommon reliance on source-based taxation. This
reliance makes the Hong Kong tax base more vulnerable, overall, to revenue leakage
arising out of operation of electronic commerce.

7.4.5 Consumption vs income taxation

There are three main sources of tax revenue upon which governments depend:
capital,
315
income and consumption. The bulk of government tax revenues come from
the latter two.
316
The VAT/GST has now become the most important indirect tax in
both developed and developing economies,
317
and typically accounts for one-fifth of
total tax revenue in more than 141 countries adopting it.
318

Income is consumption plus saving. The tax base of an income tax includes capital
income. If a person spends less than current income, that person will have saving. If a
person spends more than current income, that person either borrows to finance the
spending or draws down prior saving.
319
Saving is generally taxed under an income
tax when money is earned and again when interest is earned. This is likely to cause
people to spend more and save less, thereby depressing the level of capital
accumulation.
320
However, a consumption tax does not tax income from saving and
investment. It is argued the shift towards greater reliance on consumption taxes

315
Capital income refers to investment income, as distinguished from other types of income such as
earned income. See Larking, above n 66, 56, 238.
316
Donald J J ohnston, Tax and Wealth Creation (2002) Issue 230 The OECD Observer 3, 3.
317
Scott Riswold, Value Added Tax in Sub-Saharan Africa: A Critique of IMF VAT Policy (2004) 32
Intertax 427, 428.
318
Ine Lejeune, Shifting the Balance: The Evolution of Indirect Taxes (2007) 5(6) Tax Planning
International Indirect Taxes 7, 7; OECD, Centre for Tax Policy and Administration, International
VAT/GST Guidelines, above n 246, Preface [1].
319
Michael J Graetz, The Decline (and Fall?) of the Income Tax (1997) 198.
320
Ibid.
367
should spur saving and, ultimately, raise the standard of living.
321
This is because
private saving would likely increase domestic capital formation which would benefit
international trade through reduced cost of capital to domestic businesses.
322
It should,
also, improve productivity and the price competitiveness of goods and services in
foreign markets, resulting in less demand for imported goods, an increase in the rate of
economic growth and an improvement in the balance of trade.
323

It has been argued that indirect taxes are more popular than direct taxes because each
person can normally choose how much they spend:
The consumer who ultimately pays indirect taxes has greater apparent choice.
He or she may choose not to acquire the goods or services on which the tax is
levied or may select a product on what the tax is lower. The direct taxpayer
may also choose not to earn the income on which tax is payable, but this will
usually be a less rational choice than a decision to save and reduce ones
indirect tax. Indirect taxes are impersonal and direct taxes involve an invasion
of personal privacy.
324

Both an income tax and a consumption tax aim to tax the economic activities of a
person, and different concepts are used as the basis for each tax. Income tax uses the
word profits or income. Neither are entirely clear concepts. In Hong Kong, profits
tax is assessed on assessable profits, but the term profits is not defined in the IRO
1947. It is essentially an accounting concept. In Australia, the word income is not
defined in the tax legislation, but it includes typical earnings such as business profits,
employment income and investment income. It is necessary to know the nature of
income and classify the different types of income. Given the difficulties in
determining the character of income arising from the diversity of cross-border

321
William G Gale, Building a Better Tax System (1995) 13(4) The Brookings Review 18, 22.
322
United States, Background Materials on Business Tax Issues Prepared for the House Committee on
Ways and Means Tax Policy Discussion Series, above n 233, 66.
323
Ibid.
324
Geoffrey Lehmann and Cynthia Coleman, Taxation Law in Australia (1989) 7.
368
transactions, operations and activities, it is particularly difficult to ascertain the true
profits attributable to each jurisdiction. An income tax is calculated with reference to
assessable income and allowable deductions. In calculating the tax liability of a
taxpayer, in addition to the distinction between income and capital, there is a question
to ask as to when income is derived and expenditure incurred. The timing of income
and expenses adds complexity to the calculation of net income or profits.

A GST could reduce the potential for double taxation or non-taxation of cross-border
electronic commerce transactions that involve other jurisdictions with a consumption
tax, as tax is only supposed to be imposed on certain supplies that are for domestic
consumption.
325
There would not be a need to establish the nexus or link between a
taxable transaction, operation or activity and a taxing jurisdiction, and to determine the
source of income and address the allocation of taxing rights between the source and the
residence jurisdictions, as the liability to tax is based on transactions defined under
taxable supply and taxable importation. It is argued that a consumption tax may form
the most important source of revenue in countries with difficulties in collecting income
tax because a consumption tax is more difficult to avoid than an income tax.
326
Tax is
applied on the goods and services consumed or used by residents and non-residents
within a jurisdiction. A larger base of taxpayers should be caught in the tax net.

325
See Issues in Consumption Taxation in United States, Background Materials on Business Tax
Issues Prepared for the House Committee on Ways and Means Tax Policy Discussion Series, above
n 233, 66.
326
Althea Dressel and Trevor Drury, Worldwide Tax Overview (2000) 21 Tax Notes International
2093, 2093.
369
National income tax systems vary significantly in the design.
327
Tax systems may be
complex with frequent revisions that make it more difficult and costly for taxpayers to
comply and for the taxing authority to enforce the laws. In contrast, general
consumption taxes are implemented around the world with some common core
features, as follows:
the tax is on general consumption and levied on a broad base (not a tax on specific
goods and services such as customs duties and excise taxes);
the tax is based on transactions and is paid, ultimately, by final consumers;
businesses (and other persons) conducting a taxable activity are generally required
to register for the tax;
such businesses charge the tax on taxable supplies and remit it to the taxing
authority; and
such businesses are able to recover tax paid in previous stages.
328

There would be significant advantages in relying more on general consumption taxes.
Businesses would benefit from greater consistency in tax administration and greater
certainty in applying GST tax rules. They do not have to deal with the asymmetrical
operation of different income tax rules across jurisdictions to comply with their tax
obligation. Tax authorities do not have to monitor the economic activities outside
their jurisdiction and pay regard to foreign tax jurisdictions.

327
See Chapter 4 for an overview of the income tax systems of Australia and Hong Kong. There is a
big contrast between the income tax systems of the two jurisdictions Hong Kong is peculiar in its use
of operationally separate schedules, while Australia has a tax system which imposes a single income tax
levied on a taxpayers total income, for example.
328
Alastair McKenzie, A Growing Presence: Value Added Tax in Asia Pacific (1992) 4 CCH Journal
of Asian Pacific Taxation 28; OECD, Centre for Tax Policy and Administration, International
VAT/GST Guidelines, above n 246, I.A. Introduction [1].
370
Income can be highly variable and a taxpayer may omit to declare his or her
worldwide income. A consumption tax does not attempt to fine-tune the tax liability
to fit the unique status of each taxpayer.
329
The tax liability arises when income is
spent. Even purchases made by people with illegal sources of income or who evade
income taxes are caught in the net. If the tax burden is to be shared by all persons, the
GST is an ideal choice as it is a tax on spending.

The collection of the tax is less vulnerable as it is collected by registered enterprises at
the point of sale along each stage of the chain of production and distribution. The value
added at the next stage would reveal if tax had been paid at the previous stage. For
example, for enterprises carrying on a business in Australia, the Australian Business
Number (ABN) is used as a single identifier for all business dealings with the
Australian government, including the ATO. If a business supplies goods or services to
another business without quoting its ABN to the recipient, the payer must withhold 46.5
per cent (the top marginal income tax rate including Medicare levy) of the payment and
send it to the ATO.
330
Tax evasion may be reduced as the input tax credit is allowed to
registered enterprises on the basis of a tax invoice showing the ABN.

In summary, cross-border transactions are more likely to be effectively caught by GST
than by income tax as the tax is relatively difficult to avoid than most income-type
taxes.
331
However, there is the possibility of shifting consumption over the border.
332

329
Charles Y Mansfield, Tax Reform in Developing Countries: The Administrative Dimension (1990)
44 Bulletin for International Fiscal Documentation 137, 141.
330
See s 12-190 of Sch 1 to the Tax Administration Act 1953. See, also, Australian Taxation Office,
Taxation Ruling TR 2002/9, Income Tax: Withholding from Payments where Recipient Does not Quote
ABN, on the Commissioners interpretation of s 12-190 of Sch 1 to the TAA 1953.
331
Hong Kong, Advisory Committee on New Broad-based Taxes, A Broader-Based Tax System for
Hong Kong? Consultation Document (2001) [19]
<http://www.fstb.gov.hk//tb/acnbt/textonly/english/otherdoc/condoc.pdf>at 26 April 2008.
332
Ibid.
371
The main challenge posed by the GST is the compliance, enforcement and collection
of tax on internationally traded intangible goods and services because there is no
effective method to collect tax. It is administratively impracticable for tax authorities
to monitor the economic activities of their residents outside the jurisdiction and
impose boundary checks. There is and would be an increasing need (assuming greater
reliance on a GST) to address the operational problems of such a system. Still, the EU
has argued that a VAT system is the only possible solution for the global taxation of
333

7.4.6 Conclusion

A broad-based consumption tax has the following characteristics:
it applies, in principle, to all commercial activities involving the production and
distribution of goods and the provision of services;
it is borne ultimately by the person at the end of the supply chain (usually the final
consumer) and, therefore, is not a charge on businesses;
it is charged and collected fractionally as a percentage of the value of sales and
services provided, which means that the actual tax burden is visible at each stage in
the production and distribution chain;
the tax is neutral regardless of how many transactions are involved;
it is paid to the revenue authorities by the seller of the goods, who is the taxable
person, though it is actually paid by the buyer to the seller as part of the price; and

333
The VAT/GST applies to indirect taxation. So far, no jurisdiction has come up with a solution in the
direct taxation area on how to tax the business profits derived from online sales that works well with the
Internet.
372
it is an indirect tax on the value of transactions (not on the profit derived from
them).
334

The merits of introducing a general consumption tax are:
it provides a more stable source of revenue, even in times of cyclical economic
fluctuations, without increasing income taxes; and
it is less easy to avoid and less subject to the pressures of globalisation and capital
flight than income tax because the tax liability has to be borne by a person when
money is spent and goods or services are consumed.

It is submitted that more reliance can and should be placed on the use of a general
consumption tax to stabilise the revenue base and provide a steady source of revenue as
revenue authorities seek to address the revenue-leakage challenges posed by the
increasing use of web-based commercial, business and financial transactions. A
general consumption tax is measured by the notion of supply the thing purchased or
consumed by a person. The source of the transaction is either the country of destination
or the country of origin. If the destination approach is viewed as impractical to collect
tax from private consumers (for example, on their cross-border shopping of a thing),
then the source of the transaction can be viewed to be the place where the goods
originate and tax can be collected by registered enterprises at the point of sale. Tax
authorities do not have to monitor the economic activities outside their jurisdiction.

334
European Union, General Overview: What is VAT? (9 March 2007)
<http://ec.europa.eu/taxation_customs/taxation/vat/how_vat_works/index_en.htm> at 20 April 2008;
Greg Sinfield (ed), VAT Deductions: A Comprehensive Guide to Recovery of VAT in the UK (2004) 1.
373
In the final chapter, I return to the issue of how to deploy a consumption tax as a key
means of coping with the erosion of the income tax base due to the growth of Internet-
based commerce and global corporate-tax/profits-tax competition.

374
CHAPTER 8: SUMMARY AND CONCLUSION

8.1 Introduction

Australias source rules have been criticised as lacking a degree of certainty, providing
business entities with opportunities to manipulate the form of transactions and shift
income and expenses from one country to another. Following a series of decisions on
the question of source, determining the source of profits in Hong Kong is still
unsettled and has resulted in many disputes between the Commissioner of Inland
Revenue and business taxpayers. The general tax structures of Australia and Hong
Kong, developed in an era when economies were relatively closed and the movement
of money across borders were limited, do not take into account the integration and
globalisation of economies and the move towards a worldwide knowledge economy.
The increasing ease with which business transactions, operations and activities are
conducted and with which money moves across borders has exposed inadequacies in
traditional rules governing the source of income.

8.1.1 Research questions

In Chapter 1, the following research questions were identified:
What is the essence of the concept of source of income as it has been developed in
the domestic tax law of Australia and Hong Kong?
Are the traditional rules governing the source of income, relying on the nature of
income and the geographic origin or location for that particular type of income,
adequate to deal with the taxation of business profits in a changing world
environment, changing technology and changing lifestyles?
375
If these traditional source rules can be demonstrated to be less adequate than
before, what response options can be suggested and considered?

The brief answers to these questions are:
The concept of source of income is, essentially, less clear today in the domestic tax
law of Australia and Hong Kong than before. Determining the source of income in
Australia and Hong Kong can be a very complex issue. The difficulty related to
making such determinations is growing.
Searching for the real source of income (the origin of the yield or the profits) has
become still more problematic with the increase in globalisation and the rapid
growth of Internet-based commerce. The traditional concept of source of income
has lost traction as a fundamental basis for effectively imposing income taxation,
especially, in todays globalised economy.
Existing source rules do not deal adequately with certain revenue-leakage issues
confronting us today and, even more, the likely issues of tomorrow.

We need to reconsider how we can better address these issues. The thesis establishes
that this is so for Australia and Hong Kong. It also reasons that this proposition
generally holds true for most developed tax jurisdictions. Three main options are
suggested and considered:
introducing a refundable withholding mechanism for the continued source-
based taxation of electronic commerce (proposed by Professor Dale Pinto);
abandoning source-based taxation altogether in favour of residence-based
taxation (proposed by the United States (US) Treasury Department); and
376
shifting the tax base more from income to consumption (proposed by a number
of commentators on tax reform).

In the remainder of this chapter, the reasoning behind these answers is summarised
and the overall conclusions of this thesis are set out.

8.1.2 Overview

The source of income, for taxation purposes, has typically been identified by reference
to the character of moneys received (meaning A) and the geographic origin or location
where the income arises (meaning B). The test to be applied in determining the source
of income (as developed by the court-based approach on which this thesis is focused)
is to search for the real source (the true nature of a transaction, operation or activity
and its location) and to judge the question in a practical way, weighing the relative
importance of the various factors which need to be considered in each case.

The source of income is an important concept in taxation law as it determines
whether a state can assert its jurisdiction to tax a person on a particular item of income.
The source of income is also used to determine whether a jurisdiction is willing to
concede primary jurisdiction to a foreign country to tax its residents on income earned
by them in that foreign country and which part of the foreign income qualifies for
double taxation relief.

The concept is fundamentally important to both Australia and Hong Kong. Australia
adopts a worldwide tax system that taxes its residents on Australian and foreign
income and non-residents on Australian income, whilst Hong Kong adopts a territorial
377
tax system that forgoes taxing foreign income irrespective of who has derived it. The
fundamental basis for taxation under a territorial tax system is the source of income;
while the fundamental basis for taxation under a worldwide tax system is the concept
of residence.


This thesis has compared the impact of the source rules on the taxation of business
profits arising from cross-border dealings and financial relationships in Australia and
Hong Kong. This comparative study is designed to draw on the experience with the
widely differing reliance on source-based taxation in these two jurisdictions in order to
delineate certain conclusions on the nature of current source rules, generally, and the
adequacy of these rules in the face of major changes in the way in which business is
conducted.

This chapter draws on the discussions in the previous chapters in order to summarise
the key issues which need to be addressed. This chapter also summarises the
discussion of possible solutions to enhance the fair and effective taxation of profits in
an era where electronic commerce is set to continue expanding significantly.

8.2 Summary of thesis

Australia has a tax system which is legislatively complex and which imposes high
compliance costs. The tax legislation covers aspects of inbound, outbound and
conduit investment and trade. The tax base encompasses both direct and indirect taxes,
of which income tax makes up the greatest component. Australia collects taxes levied
378
on income, wealth, production, sale and use of goods and services, and the
performance of activities. The ease with which businesses may engage in a diversity
of international dealings and Australias comparatively high rate of tax present a risk
of increased erosion of the effectiveness of Australias income tax system. Related-
party, cross-border and tax haven dealings remain an issue, as the taxable profits
returned in Australia generally do not reflect the real economic contribution made in
Australia or the taxable nature of imports.

Hong Kong was a British colony from 1842 until it became a Special Administrative
Region of China on 1 J uly 1997. The doctrine of one country two systems allows
Hong Kong to have its own legal system and its own tax system, distinct from the tax
system operating in the Peoples Republic of China. The Inland Revenue Ordinance
1947 (IRO 1947) imposes three separate taxes on income arising in or derived from
Hong Kong being salary income, property income and business profits. Investment
income (such as interest and dividends) and capital gains are generally not taxed in
Hong Kong. The mix of taxes is narrow. There are no taxes on general consumption.
There is no concept of total income nor a catch-all provision to bring into charge
income not specifically covered under the schedules. To help maintain its simple,
low-tax, revenue law structure, the tax system deliberately exempts qualifying
offshore profits from profits tax. There is an incentive to re-arrange activities so as to
shift the source of income from domestic to foreign.

The argument is that the general tax structures of Australia and Hong Kong, based on
the sale and manufacture of tangible goods with physical delivery and the provision of
services with physical presence, were developed in an era when establishing the source
379
of income (both in terms of the nature of the income and its geographic or territorial
source) was fairly straightforward. These tax structures were suitable for their time,
but they obviously predate the world in which the notion of geographic place has less
meaning due to the growth of globalisation and the advent of electronic commerce.
This older income tax legislation was not drafted to address the new diversity of
international trade, driven by technological development and business innovation,
which is characterised increasingly by the provision of services and remote sales.

This thesis began with a theoretical overview of taxation at source and has outlined
how it has been applied over the past two hundred years. Income was divided into
different sources and tax was raised under a system of schedules, each with its own
rules of assessment and collection. At that time, one could classify income according
to the different types (meaning A). Also, it was typically clear exactly what the
geographic or territorial source of the relevant income was (meaning B). The aim of
taxation at source was to reduce opportunities for tax evasion. It was designed: (a) to
make the calculation of tax payable straightforward; and (b) to make the collection of
tax due effective. Tax was collected, wherever possible, by the payer based on income
classified under the relevant, then applicable, schedules at the time of payment.

How the law relating to source has developed in Australia and Hong Kong is
explained in Chapter 5. Source rules interpreted by the courts are based on formal
underlying events. Traditional source rules based on the character and geographic
location of income do not apply easily to electronic commerce. The challenges and
opportunities presented by the Internet are examined in Chapter 6. The sale of goods
and provision of services by electronic means give rise to issues related to the
380
characterisation of payment (meaning A) and the location of the income (meaning B).
There is a need to identify the correct taxpayer conducting electronic commerce, the
jurisdiction within which a business operates and the taxable transaction, operation or
activity. In electronic commerce, various tax collection and data gathering points can
be eliminated such as retailers, warehouses, forwarders. In the physical world, there
are proof of identity arrangements to ensure that trading names are regulated and
registered to taxable entities, and identity trails can be followed. On the Internet, the
domain name (for example, www.abc.com.au) and IP address (for example,
123.45.67.890) serve as the location of a web site and do not tell where the actual
transaction, operation or activity is undertaken. The deciding factor is nexus or link
to the source state and there are two main issues to consider:
whether a business is carried on there; and
whether there are profits sourced from that business.

Chapter 7 explains that ultimately we have to establish the legislative (legal) and
enforcement (practical) jurisdiction over the party liable for the tax. Without the
establishment of adequate jurisdiction, revenue is at risk as there is no basis on which
to impose tax legally. In Australia, the Commissioner of Taxation can serve a notice
on a person who is in receipt or control of money from a non-resident to retain
sufficient money to meet the non-residents ultimate income tax liability.
1
Similar
provisions exist in Hong Kong. If a non-resident is chargeable to tax either directly or
in the name of his agent in respect of all his profits arising in or derived from Hong
Kong, the agent is required to retain from the assets of the non-resident sufficient

1
Income Tax Assessment Act 1936 (Cth) s 255.
381
money to pay tax to the Inland Revenue Department.
2
But practical tax collection
problems exist without proof of a jurisdictions right to tax.

8.3 The source challenge

This thesis has argued that the concept of source of income depends on the concepts
of source and income, which are difficult to define and determine particularly in
todays almost infinite variety of commercial arrangements. Even once we are able to
identify and classify a particular item of income, we still need to link that income to a
particular taxing jurisdiction. The type of connection that establishes the link between
a taxable transaction, operation or activity and a taxing jurisdiction depends (based on
lengthy historical practice) on the concepts of territoriality and the geographic
presence of the taxpayer in the jurisdiction. For example, a royalty payment will have
a source in Australia where it is paid or credited to a non-resident by an Australian
resident or by another non-resident carrying on business through a permanent
establishment (PE) in Australia.
3
The method of taxation is by withholding, which
means, generally, the source jurisdiction may tax the income but only to a specified
extent. But if the royalty income is derived by a non-resident who also carries on
business in Australia through a PE, then the royalty income is taxed fully in Australia
as business profits on an assessment basis under the ordinary provisions of the Income
Tax Assessment Act 1936 and the Income Tax Assessment Act 1997.

Receipts for the use of or right to use a patent, design, trademark, copyright, secret
process or formula or other property of a similar nature outside Hong Kong are not

2
Inland Revenue Ordinance 1947 ss 20A, 20B.
3
Income Tax Assessment Act 1936 (Cth) s 6C.
382
chargeable to tax in Hong Kong. But if the sum is deductible in ascertaining the
assessable profits of the payer under profits tax, it is treated as a trading receipt and is
deemed to have a source in Hong Kong.
4

A double tax treaty (DTT) typically contains its own source rules in relation to the
taxing rights of the residence and the source jurisdiction, but a DTT identifies these in
an indirect way. For example, the source of business profits is the place of the PE,
implying it is the existence of a PE that determines the source of profits.
5
The source
of dividends is the country of residence of the company paying the dividends, rather
than the country where the profits giving rise to the payment of the dividend arose.
6

Income from sources not expressly mentioned in the DTT is caught under the catch
all article.
7

This thesis, because it is focused on Australia and Hong Kong, concentrates on the
meaning of source as derived, primarily, from decisions of courts. Certain
jurisdictions attempt to define source statutorily whereas others tend to leave the major
definitional role to the courts. Some influential court cases have concluded that the
concept of source is not a legal concept, but something which a practical man would
regard as a real source of income.
8
The courts have tended to emphasise particular
factors as relevant in determining the source of particular types of income and various
key tests have evolved, such as the contract conclusion test, the operations test and the

4
Inland Revenue Ordinance 1947 s 15(1)(ba).
5
OECD Model Tax Convention on Income and on Capital art 7.
6
7
8
Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183; Tariff Reinsurances Ltd v
Commissioner of Taxes (Vic) (1938) 59 CLR 194; Thorpe Nominees Pty Ltd v Federal Commissioner
of Taxation (1988) 88 ATC 4886.
383
provision of credit test. Lockhart J commented in the Spotless case (1993)
9
that there
is no universal set of source rules that can readily be applied to every circumstance to
determine the source or locality of profits. It is a matter of judgment which requires
weighing the relative importance of the various factors in each case in reaching the
conclusion as to the source of income.
10
In practice, one has to see what the taxpayer
has done to earn the profits in question and where he has done it. In the final analysis,
the source of income is a matter to be determined on all the facts and circumstances
and no single legal test can be employed. So the law provides no final, determinative
rules in relation to the source of income. What might be applicable for one type of
income might not be applicable for another. Where some factors indicate a mixed
source of income, there is a question which factor should be regarded as dominant and
whether the income should be apportioned and be taxed in two (or more) jurisdictions.
However, guidelines on how apportionment should be done are not normally provided
for in the tax legislation.

Income serves as the basis of a taxpayers liability to income tax, but income means
different things to different people. Income may be regarded as receipts from salaries,
rents, profits of a business or as a return from investments such as dividends. The
judicial concept of income sees income as a flow. Income (according to ordinary
concepts) is what comes in, but frequently does not include (according to some courts)
a capital gain (for example, in Australia and Hong Kong). The accounting and
economists concept of income sees income as the measure of a persons economic
gain over a set period. Income tax law needs a concept of income so that a taxpayer
may know which gains are subject to tax and which are not. Income from the carrying

9
Spotless Services Ltd & Anor v Federal Commissioner of Taxation (1993) 93 ATC 4397.
10
Ibid 4409-10.
384
on of a business is generally assessable, but gains from casual, infrequent, sporadic or
haphazard sales are not generally liable to tax (although businesses can be carried out
with a very low level of activity).
11
On the other hand, profits from a single
transaction may amount to a business profit rather than something in the nature of a
capital gain even if it does not involve the carrying on of a business.
12
Income tax has
not been designed by applying a coherent set of principles. Tax laws have, rather,
developed (and been adapted) over time, to deal with a complex and changing
commercial world.

The concept of income has changed with the economic growth of society. Under the
schedular tax system introduced in the United Kingdom in the early nineteenth century,
land, trade or business, and labour were classified as sources of income. To be liable
to income tax, a receipt had to fall within a taxable source under the schedules. Thus,
ownership and possession of land within a jurisdiction occupied a dominant place in
an agricultural economy as a source of income.
13
As the twentieth century progressed,
cross-border trade, commerce and investments grew. A resident of one jurisdiction
was able to conduct substantial business operations in another jurisdiction. Business
income is generally derived from the sale of goods (or services), often produced,
manufactured, extracted or purchased in one jurisdiction but delivered in another. The
issue is then to determine the source of income where activities are not confined to one
territorial source and see which jurisdiction may lay a claim to tax that income. In
days gone by, almost all companies used to need some sort of presence to conduct

11
See Commissioner of Inland Revenue v Bartica Investment Ltd (1996) HKRC 90-080.
12
See Thiel v Federal Commissioner of Taxation (1990) 90 ATC 4717.
13
In spite of its name, land tax included a tax on deemed income from personal property and annuities
and other yearly payments such as money, debts, goods, wares, merchandises, chattels or other personal
estate based on the annual yield. See John F Avery J ones, The Special Commissioners from Trafalgar
to Waterloo [2005] British Tax Review 40, 41.
385
their business (for example, a PE, an agent, an employee). One would look at how
significant or substantial the connection with a jurisdiction was in generating the
income. The source of income was to be found where the factors of production were
dominant (for example, where the business was carried on or where the sale contracts
were concluded). Today, businesses rely much less on physical labour and natural
resources as the key inputs for profit making. With improved telecommunications and
reduced barriers to trade in goods and services, world economies have become more
tightly integrated and the growth of financial markets has accelerated. Information
and knowledge are increasingly incorporated into an economic activity, and shared by
the group in the supply chain to cut costs and improve profits. An increasing share of
product value is in the form of intangibles such as research and development,
trademarks, patents and copyrights. These are, frequently, the key to the profitability
of companies. Services (for example, call centres and helpline functions) can be
outsourced to lower cost providers where traditionally these functions have been
performed in-house. When the profits of a business enterprise are the result of global
design, production and marketing, the source of income becomes increasingly less
clear.

Globalisation and access to world markets provide greater opportunities for tax
planning. The source of different types of income (such as profits derived from
manufacturing, trading and loan transactions) can be planned to minimise taxation and
maximise an investors return. Global collaboration on the sale of goods, provision of
services and the licensing of intellectual property poses a challenge to the traditional
rules for determining the source of income. The nexus or link between the taxing
jurisdiction and the income, entity, property or activity it seeks to tax becomes more
386
difficult to pinpoint. The US Treasury Department has commented that offshore
global collaboration on tax collection requires source rules as well as transfer pricing
rules designed to allocate correctly the resulting income between the jurisdictions
involved.
14
With transfer pricing, the source of income is not determined by where the
profits were made, but by the price charged on the sale by one related party to another.
The issue then becomes the correct allocation of profits between the residence and the
source jurisdiction. In Australia, the Commissioner can determine the source of
income and make adjustments (increase the assessable income or decrease the
deductions) to bring the income of non-residents into the Australian tax net by giving
it an Australian source.
15
In addition, the Commissioner can deploy Part IVA (which
contains the general anti-avoidance rules) to cancel tax benefits from tax avoidance
schemes (for example, where a tax benefit is obtained as a result of a source-shifting
scheme with a dominant purpose of obtaining that tax benefit). The general anti-
avoidance rules only have a role to play to encourage compliance with any tax regime.
They do not specifically address the issues discussed in the thesis and do not provide a
solution to the question of source. Unless the non-resident has a presence in Australia,
it remains very difficult for the Commissioner to detect all relevant business income
with an Australian source, especially under a system of self assessment. Though the
liability to tax in Hong Kong is based purely on source and transfer pricing is less of a
major issue, the facts in most cases on source involved dealings between associated
companies.
16

14
15
See Div 13 of Pt III of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
16
It has been argued that the real issue is not source at all, but the abusive pricing of transfers between
associates. See Michael Littlewood, The Orion Carribean Case and the Source of Interest (1999) 7
Asia Pacific Law Review 121, 128.
387
The question of determining the source of income has been further complicated with
the advent of electronic commerce, where the source of income arises from online
trading and, in particular, the supply of digitised items on the Internet. Digitised items
can be perfectly reproduced, often by the purchaser, and this raises the question of the
character of such income (meaning A). A particular digitised item may be
characterised as the use of an intangible asset, the supply of goods or the rendering of
a service, each subject to different source rules. If the payment is for the use of an
intangible asset, it will be a royalty for tax purposes. The tax treatment of royalties is
usually not the same as the tax treatment of business profits. Under many DTTs, the
source country can tax royalties as business profits only if those royalties are earned
through a PE in the source country. In the absence of a PE, royalty income is
generally subject to withholding tax on the gross amount, normally at a lower rate of
tax than business profits in the source country (where a DTT exists). Income from the
sale of goods and services is generally taxable by assessment on a net basis in the
source country only if the seller or service provider has a PE or a presence in that
country and profits are attributable to that PE. The intangible nature of digitised items
means that the source jurisdiction may not be able to monitor the tax base and collect
the appropriate amount of tax on profits earned from electronic commerce. Even the
US, whose source rules are detailed in the Internal Revenue Code (26 USC), has
suggested essentially abandoning source-based taxation altogether in favour of
residence-based taxation due to difficulties in determining the source of income in the
world of electronic commerce. This official stance in the US Treasury Department
strengthens a basic argument of this thesis that the foundations of source-based
taxation are less stable today. If a transaction, operation or activity is complex in
nature and sourced in several different jurisdictions, it becomes increasingly difficult
388
to determine from what and where the income originates. Existing source rules, more
than ever, struggle to bring the relevant income within the tax net.

8.4 Addressing the source challenge general observations

The Pinto Proposal

Though the advent of electronic commerce has caused many to question the continued
viability of source-based taxation, there is a proposal that it should continue. Professor
Dale Pinto (hereafter Pinto) has proposed establishing a jurisdictional framework for
the source taxation of electronic commerce transactions by introducing a refundable
withholding mechanism (the Pinto Proposal) to overcome the challenges related to the
taxation of electronic commerce. Pinto argues that the way in which source is defined
for active business profits under the PE threshold needs to be reconceptualised to
adequately accommodate electronic commerce transactions. The current PE threshold
depends on physical presence of some kind at a fixed place of business in the source
country and the carrying on of business by the non-resident through this fixed place of
business for a certain period of time. He argues that these requirements are likely to
create difficulties in determining the taxable nexus in source countries, because
physical presence could become more elusive (or even absent) in an electronic
commerce context and the PE threshold may no longer represent an appropriate
instrument for the taxation of business profits. He argues in favour of:
adopting a monetary threshold test as a proxy for determining taxable nexus in
source countries; and
applying the proposed monetary threshold to all income that is generated by
electronic commerce irrespective of the character of income (thereby overcoming
389
the potential problems of characterising the income (meaning A)).

This thesis has critically evaluated how well the Pinto Proposal addresses the question
of source faced by most tax authorities today. This evaluation found that the
refundable withholding mechanism contains certain implementation and enforcement
problems and, despite offering an interesting conceptual approach, it does not appear
to resolve the fundamental issue of how best to determine the source of income when
the Internet is engaged to conduct business.

The Pinto Proposal relies on the monetary threshold, rather than the PE threshold, to
allocate or distribute taxing rights over online profits between the residence and the
source jurisdiction. If the monetary threshold is satisfied, the seller would be subject
to (ultimate) source state taxation. Conversely, if the monetary threshold is not
satisfied, the seller would not be subject to tax in the source state and a refund would
be paid. But the monetary threshold test advocated by Pinto does not provide a
complete resolution of double taxation of business profits. Most countries assert the
right to tax the business profits of non-residents under their domestic law without any
PE threshold requirement, unless a DTT provision applies and overrides the domestic
legislation. In Australia, the general principles for calculating the taxable income of a
taxpayer do not have regard to whether a PE exists. Non-residents carrying on
business in Australia are taxable on ordinary and statutory income with a source in
Australia. Similarly, businesses are taxed in respect of profits arising in or derived
from Hong Kong. Source rules are still necessary to determine which business profits
derived by non-resident entities are taxable in the source jurisdiction.

390
Apart from this fundamental difficulty with the Pinto Proposal, this thesis has argued
that the proposal is not convincing for a number of other reasons. These include:
The Pinto Proposal applies to goods and services that are purchased or delivered
via electronic means with the exception of passive dividend, interest and royalty
income (which would continue to be treated under the existing rules). So it is the
way in which the order is placed or delivered that determines the source of income
(meaning A) and the character of income is irrelevant. There would be two ways
of taxing the business profits of foreign sellers: one for business profits derived
from non-electronic means (based on the existing concept) and one for business
profits derived from electronic transactions (based on the Pinto Proposal). The PE
concept and the requirement for physical presence would still apply to all other
items not ordered or delivered electronically.
The Pinto Proposal requires that each customer be in possession of a digital
certificate (DC). The geographic source of income (meaning B) is determined by
the location of the holder, as shown on the DC. A DC typically does not state the
tax residence of the holder, however.
Pintos withholding tax is not a final tax. Sellers whose operations exceeded the
monetary threshold have the option to lodge an income tax return in the country
of the customer and be taxed on a net basis. This means deduction of costs and
expenses from the gross income is allowed and the foreign seller is assessed on the
net profit. To arrive at a correct statement of profit, it is necessary to determine the
source of income as well as the source of relevant expenses. Source rules are still
necessary to determine income as well as deduction of expenses when attributing
profits to a PE.

391
The operational practicality of the Pinto Proposal is subject to serious questioning on a
number of grounds. A preliminary tax would be collected virtually immediately as
each separate electronic commerce transaction was concluded. It is this preliminary
tax which would either be permanently withheld by the source jurisdiction with
residence jurisdiction relief (if the sales turnover exceeds the threshold) or refunded by
the source jurisdiction and full taxation by the residence jurisdiction (if the sales
turnover stays below the threshold), after the time came for application of the
monetary test. Any tax is vulnerable to evasion and fraud, and the credit and refund
mechanism offers opportunities for abuse.
17
The complexity of the tax system and the
global business environment make it inevitable that unanticipated consequences that
operate inappropriately would be bound to arise if any radically new taxation regime
were to be introduced.
18
With the Pinto Proposal, there could be a need to ensure that
the intent of the withholding mechanism could be achieved and any adverse

17
Michael Keen and Stephen Smith, VAT Fraud and Evasion: What Do We Know and What Can Be
Done? (2006) 59 National Tax Journal 861, 861.
18
It has been noted that every intended consequence has an equal and opposite unintended consequence,
though it is not always obvious what this unintended consequence is. See Andrew Flint, Unintended
Consequences (2005) Issue 775, The Tax Journal 24, 24.
An unintended consequence in taxation law may involve perceptions of:
unnecessary complexity and uncertainty in the laws application;
inconsistency with commercial practice or taxpayer behaviour;
difficulties in compliance and/or administration; and
inconsistency with the policy the legislation was intended to implement.
In each such instance the complaint is that the law operates inappropriately. See John Theodore Ralph,
Review of Business Taxation: A Tax System Redesigned: More Certain, Equitable and Durable:
Overview, Recommendations, Estimated Impacts (1999) 134.
For example, the intention of the CGT provisions in Australia is to bring net capital gains (or losses)
within its reach upon the disposal of an asset, including deemed disposals of assets as stipulated in the
then s 160M(3)(b) of the ITAA 1936, which included a debt, a chose in action or any other right, or an
interest or right in or over property the cancellation, release, discharge, satisfaction, surrender,
forfeiture, expiry or abandonment, at law or in equity, of the asset. It was found in the Orica case (ICI
Australia Ltd v Federal Commissioner of Taxation (1996) 96 ATC 4680; Federal Commissioner of
Taxation v Orica Ltd (formerly ICI Australia Ltd) (1998) 98 ATC 4494) that the performance of an
obligation under a contractual right would not constitute a disposal of asset:
The words discharge and satisfaction cannot be construed as extending to the performance
of obligations under an agreement Those words must be confined to cases where the rights are
satisfied or discharged otherwise than by performance of the obligations which give rise to the
rights by the other party to the contract (ICI Australia Ltd v Federal Commissioner of Taxation
(1996) 96 ATC 4680, 4694).
This case throws up unintended consequences arising from reliance on the words discharge and
satisfaction, which are relevant words on what constituted the disposal of an asset.
392
consequences such as avoidance, cheating or rorting be minimised. Such
activities would be very difficult to combat in an international environment. The tax
gap (the difference between what ought to be collected and what has actually been
paid) would be hard to assess. It would require ongoing monitoring and enforcement
activities by both the residence and the source jurisdiction to detect omitted taxable
transactions, operations or activities. What if, after its adoption, the Pinto withholding
mechanism did not achieve its original intent and did not generate enough revenue?
Would it be replaced by another mechanism? Or, alternatively, would it be withdrawn
and would the original income tax system have to be used again? A tax system is
fundamentally interlinked to the systems of business, finance and the economy, all of
which are subject to continual development and innovation in a global environment.
19

If the Pinto Proposal were to be adopted, an agreement would be required that almost
every significant trading country would operate the same system of taxation for
transactions covered by the proposal. Businesses today operate in a global
environment. Where one jurisdiction acts alone, there is a very real risk that
businesses would start relocating to another jurisdiction to avoid compliance with any
given tax law. Achieving the sort of outcome on which the success of the Pinto
Proposal is premised looks likely to prove seriously challenging.
20
An internationally
consistent approach is required to secure the taxation of business profits derived from
electronic commerce to ensure the effectiveness of the tax system as a result of
globalisation. An international agency such as the World Trade Organization (WTO)
might be needed to coordinate harmonisation of bilateral tax agreements with

19
Ralph, ibid 133.
20
I have argued in this thesis that the practical enforcement of source country taxation is really what
matters, rather than the theoretical justification for source country taxation of business profits. It would
be an extremely difficult task to monitor tax law compliance in an international setting, especially tax
refunds under a system of self assessment. Auditing international transactions may require access to
foreign-based information and documentation for verification purposes. Such measures are expensive
and are often not practicable in tax administration.
393
multilateral trade agreements as tax policies cannot be isolated from international
trade.
21
Both trade and tax agreements share similar non-discrimination provisions.
22

However, trade agreements are multilateral and binding.
23
In contrast, there is as yet
no multilateral binding rule of income tax agreements.
24
The broader WTO
membership (over 150 nations) than the OECD (30 countries) and the multilateral
feature and enforcement mechanism
25
all make the WTO potentially a more suitable

21
A multilateral trade agreement covering tariffs only would not be sufficient to achieve free trade.
Non-tariff barriers to trade, such as subsidies and taxes, are also dealt with in trade agreements. The
three main clusters of the World Trade Organization (WTO) provisions that are relevant to taxation
are:
the rules in international trade in goods members are prohibited to impose higher internal taxes or
more burdensome regulation on imported products or on similar domestic products;
the rules on subsidies and countervailing measures members are prohibited to provide any
government financial contribution which confers a benefit, including tax incentives, by means of
which the government foregoes revenue that it would otherwise have collected; and
the rules in international trade in services countries which host foreign professionals or investors
in the services sector may not differentiate between foreign service providers (including foreign
owned branches and subsidiaries) from different host countries, but must impose the same tax
burden on all foreign investors irrespective of their home country.
See J ennifer E Farrell, The Effects of Global and Regional Trade Agreements on Domestic Tax Law
and Bilateral Tax Conventions: Proceedings of a Seminar held at the 60
th
International Fiscal
Association Congress (2007) 35 Intertax 286, 286-91; Tulio Rosembuj, Taxes and the World Trade
Organization (2007) 35 Intertax 348, 348; J oel Slemrod and Reuven Avi-Yonah, (How) Should Trade
Agreements Deal With Income Tax Issues? (2002) 55 Tax Law Review 533, 534; Servaas van Thiel,
General Report in Michael Lang et al (ed), WTO and Direct Taxation (2005) 17-44.
22
The trade without discrimination principle of trade agreements is based around the unconditional
obligations of the most-favoured nation treatment and the national treatment, discussed in footnote 85,
Chapter 7.
A non-discrimination clause forbidding a treaty partner to impose discriminatory income taxes is
embodied in some of Australias double tax treaties (DTT). For example, the reduction in withholding
tax rates in the Protocol Amending the Convention Between the Government of Australia and the
Government of the United States of America for the Avoidance of Double Taxation and the Prevention
of Fiscal Evasion with respect to Taxes on Income (entered into force 12 May 2003) triggered the
most-favoured nation clause in the DTTs with eight countries France, Italy, Switzerland, Austria,
Finland, the Netherlands, the Republic of Korea and Norway which needs to be addressed. Australia
has an obligation to enter into negotiations with each of these eight countries with a view to providing
similar treatment in relation to withholding tax rates as agreed with the US. See Commonwealth,
Minister for Revenue and the Assistant Treasurer, Public to Have Say on Australian Tax Treaty
Negotiations, Press Release, No C101/03 (6 November 2003).
23
WTO members are free to agree any new international trade rules or amendments to existing rules.
The rules, once agreed, are binding upon all. See van Thiel, above n 21, 44.
24
Ccille Brokelind, The Evolution of International Income Tax Law Applied to Global Trade (2006)
34 Intertax 126, 126.
25
The WTO has compulsory jurisdiction. Decisions are binding on the parties and sanctions may be
imposed if decisions are not observed. For example, if a member state has a dispute or a disagreement
with another member state, that other state must go through the WTO dispute settlement process. See
Marco Bronckers, The Effect of the WTO in European Court Litigation (2005) 40 Texas International
Law Journal 443, 443; Mitsuo Matsushita et al (ed), The World Trade Organization: Law, Practice,
and Policy (2
nd
ed, 2006) 104.
394
candidate to foster the creation of a World Tax Organisation.
26
Considering that tax
is so central to the notion of national sovereignty, could, however, a sufficient number
of governments ever be persuaded to relinquish a significant part of their taxing
powers so as to allow part-regulation of their tax systems by an international
institution?

Residence-based taxation

The US Treasury Department has suggested abandoning source-based taxation in
favour of residence-based taxation because of the growing difficulties in determining
the source of income. If a jurisdiction adopts a worldwide tax system, it is a source as
well as a residence jurisdiction. Where the income flows between two jurisdictions
are relatively equal, what a jurisdiction gives up as a source jurisdiction it recoups as a
residence jurisdiction.
27
Where circumstances warrant it (and bargaining power
permits), a jurisdiction can negotiate its DTTs to reflect its position in the global
economy as a significant exporter of, or a significant importer of, or both, capital and
technology.

In theory, there would be no dispute as to which jurisdiction had the right to tax if
residence-based taxation were applied universally. An agreement could be reached
that each entity could only have a single, agreed place of residence. The research in
this thesis has shown that it is not easy to implement and maintain effective residence-

26
Reuven S Avi-Yonah, The WTO, Export Subsidies, and Tax Competition in Michael Lang et al (ed),
WTO and Direct Taxation (2005) 131.
There are other possible candidates proposed to take up the role of World Tax Organisation, such as
the International Monetary Fund, the United Nations, World Customs Organisation, and the
Organisation for Economic Cooperation and Development. See Adrian Sawyer, Developing an
International (World) Tax Organisation for Administering Binding Rulings and APAs The Way
Forward (2006) 21 Australian Tax Forum 287; Farrell, above n 21, 293.
27
Alex Easson, Do We Still Need Tax Treaties? (2000) 54 Bulletin for International Fiscal
Documentation 619, 624.
395
based taxation because there is no single concept of residence. In determining the
tax residence of a company, the tests are based on the place of incorporation, the
place of central management and control or the voting power control by resident
shareholders. The connection with a jurisdiction is based on its incorporation
documents; or where the directors carry out their activities; or the residence of
shareholders or directors. The general law approach in establishing the place of
residence of a company is to attribute an artificial residence to an artificial legal person,
formed upon the analogy with natural persons. This approach is outdated. It is
necessary to rethink the residence principle as companies are increasingly free to
choose whether to be taxed, or not to be taxed, as residents. Companies can choose
where to organise themselves they can choose their residence by the place of
incorporation and the place to hold their shareholders and directors meetings
without regard to where the companys real business operates. As residence can be
determined in several different ways, it is possible for a company to reside in two or
more places. Taxing companies becomes much more difficult where there is a highly
decentralised management structure. This is especially so if dealings are channelled
through tax havens which make it hard to trace an item of income and the identity of
its real owner. A given residence jurisdiction is not able to enforce the worldwide
taxation of its residents if it is not informed by all relevant source jurisdictions about
income earned within those jurisdictions. The frequency of inversion transactions, in
the US especially, have shown that tax considerations continue to influence the place
of residence of companies. The erosion of the tax base of the residence country occurs
when taxable arrangements are shifted to low-tax jurisdictions. The taxation reality
means that entities will continue to seek to increase their profit margins by
incorporating their businesses in low-tax jurisdictions using devices like these.
396

What, then, is the future outlook of source-based taxation in a globalised economy?
What I have argued is that neither the adoption of the Pinto Proposal nor greater
reliance on residence-based taxation would serve the best interests of Australia or
Hong Kong (and many other jurisdictions like them). Either or both would be
impractical and/or possibly harmful for small-medium developing (and developed)
economies. Both these reform measures would require substantial, difficult to achieve,
structural reforms of the tax system of many if not most jurisdictions around the world
to have any significant hope of achieving a really successful outcome. In Part 8.6
below, I summarise my own view of, if not the best, the preferred solution.

8.5 Addressing the source challenge specific observations: Australia and
Hong Kong

This thesis has highlighted the many uncertainties that relate to the taxation of
business profits in an increasingly integrated globalised economy. Notwithstanding
the inadequacies in traditional rules governing the source of income, we are not about
to see income tax disappear. J urisdictions worldwide rely on income tax as a primary
source of revenue.
28
The residence and source principles and the PE concept have still
to be used as the tax benchmarks for the allocation of tax revenue among jurisdictions.
Determining the source of income is still necessary to protect the tax base.

28
Of the countries that are members of the International Monetary Fund, only the Bahamas and Vanuatu
do not have an income tax. Several countries impose an income tax with limited application:
Maldives has a tax on bank profits only;
St Kitts and Nevis tax the income of corporations, but not individuals;
Paraguay taxes businesses only;
the United Arab Emirates, Oman, and Qatar have corporate taxes, but these apply mostly to oil
companies and financial institutions;
Palau has a hybrid schedular system that includes a tax on wages, a modified turnover tax on
businesses, and a tax on the net income of financial institutions.
See Victor Thuronyi, Comparative Tax Law (2003) 231.
397

Source rules for certain types of income (especially passive income) are often
embodied in legislation and do not rely upon a court-based concept of source in order
to determine tax liability (for example, interest, dividends and royalty payments).
Thus, non-residents deriving such income without a PE in Australia continue to be
taxed on a withholding basis because this is the most direct way to collect tax.
Australia is moving towards a more residence-based treaty policy in substitution for
the treaty model based on the source taxation of income, with a key aim of negotiating
lower withholding tax limits. Changes have been made in some DTTs that reduce,
substantially, withholding taxes on certain dividend, interest and royalty payments.
This means tax paid by non-residents of the other contracting state on Australian-
source passive income will be reduced. This also means that Australia can collect
more tax when Australian residents invest in the other contracting state, as Australia
does not have to provide a credit on the foreign tax paid at source. But the
withholding tax regime does not apply to business profits connected with the PE of a
non-resident. For business profits derived by non-residents attributable to a PE, tax
treaties (and source rules) still govern the allocation of taxing rights between the
residence and the source jurisdiction, unless detailed source rules (similar to the US)
are defined in the tax legislation.
29

One may argue that residence-based taxation reduces the importance of determining
the real source of income in a multi-source activity as residents are (normally) taxed
on income derived from all sources. The main difference between residence- and
source-based taxation is the treatment of the foreign income of residents. The

29
This may, though, be of limited use given the US Treasury Departments suggestion to abandon
source-based taxation and push for more reliance on residence-based taxation.
398
operation of residence-based taxation means that residents are taxed on their foreign as
well as their domestic income, and double taxation relief is provided by the residence
country on the foreign tax paid at source on foreign income. In Australia, the
assessable income of residents includes foreign income. The tax treatment of the
foreign income of residents depends on the type of income (for example, branch
profits, passive investments, employment income), where derived (listed or unlisted
country) and category of income (assessable, exempt, non-assessable non-exempt
(NANE)). Thus, source is still crucial to the taxation of residents as it determines
whether the foreign income is subject to tax and which part of the foreign income
qualifies for double taxation relief.

With the ongoing globalisation of the Australian economy, more and more residents
are becoming involved in cross-border trade and investment, and tracing an item of
foreign income and the identity of its real owner through interposed entities becomes
more complicated. Existing source rules based on geographic location are
significantly tested by cross-border trade and investment involving two or more
locations. A separate evaluation of all the activities out of which the profit is derived
is almost impossible. To assist Australian companies with offshore investments to be
more competitive, sweeping changes have been made to the tax legislation that allow
certain foreign branch profits and certain foreign non-portfolio dividends received by
Australian companies and their controlled foreign companies to be tax exempt,
regardless of whether those branch profits or dividends relate to listed or unlisted
countries. For example, the active foreign branch income derived by Australian
companies from a PE located in any foreign country after 30 J une 2004 is NANE
399
income, provided the active income test is satisfied.
30
The foreign income does not
have to be taxed overseas in order to be NANE.
31
Australian companies are now able
to establish a presence in a tax haven to conduct their business without being exposed
to Australian tax liability, contrary to the Commissioners earlier stance in tackling
tax havens.
32
Further, to reduce the complexity of tracing the foreign income, certain
non-portfolio dividends (as defined in s 317 of the ITAA 1936) paid to an Australian
company by a foreign company after 30 J une 2004 will be NANE.
33
There is no need
to determine the source of foreign income and see if the non-portfolio dividends are
paid from a company in a listed or an unlisted country. These changes are aimed to
improve the competitiveness of Australian companies with offshore operations as
well as to reduce the compliance costs. So there is no need to trace through entities
(and interposed entities) in foreign jurisdictions and attribute the gains and losses to
their real owners. These changes mean that, although a worldwide tax system applies
to Australian taxpayers, business profits derived from a trade or business offshore can
still be exempt from Australian tax. This is similar to a (limited and targetted)
territorial tax system whereby foreign income earned by residents is not taxed.

The research in this thesis has shown that determining the source of profits in Hong
Kong has long been an area of uncertainty and has resulted in many disputes between
the Commissioner and taxpayers. Despite guidance provided by the Inland Revenue
Department on the locality of profits, disputes on the source of profits have escalated

30
Income Tax Assessment Act 1936 (Cth) s 23AH.
31
Under the former s 23AH provisions, the foreign branch income had to be subject to tax in a listed
country to qualify for exemption.
32
See Australian Taxation Office, Tax Havens and Tax Administration (2004) and (2007).
33
Income Tax Assessment Act 1936 (Cth) s 23AJ.
400
in recent years.
34
It has been argued that there is a danger that Hong Kongs source-
based system of taxing business profits may in certain respects become illusory.
35

The best primary tax reform option for Hong Kong is, I believe, to move to introduce a
new general consumption tax. This thesis shows just how particularly vulnerable the
Hong Kong revenue base is to revenue leakage due to its very great reliance on
traditional source-based taxation of business profits. Both income and consumption
tax revenues typically account, today, for a significant part of the total tax revenue of
many jurisdictions. It has been argued that a general consumption tax may form the
most important source of revenue in countries with difficulties in collecting income
tax because the tax is difficult to avoid. Tax is applied on the goods and services
consumed or used by residents and non-residents within a jurisdiction. A larger base
of taxpayers should be caught in the tax net.

The next section discusses the general merits of relying more on consumption taxes in
order to better address the challenges to the revenue base outlined in this thesis. I also
argue, in the context of the next section, the detailed case for Hong Kong introducing
its first ever, general consumption tax.

34
The Hong Kong Inland Revenue Department (IRD) revised its Departmental Interpretation and
Practice Note 21, Locality of Profits, in 1998, following a series of court decisions on the locality of
profits. But determining the source of profits is still unclear. The real problem is mapping them to
existing departmental practice of the IRD and then applying them to common forms of cross-border
transactions, where taxpayers are frequently at odds with the IRD. See Andrew Halkyard, Source of
Profits Its Time (For Change) (2005) 35 Hong Kong Law Journal 421, 421.
35
Ibid.
401
8.6 Conclusion

8.6.1 The preferred solution

The imperfect tax world in which we live looks set to grow more so as the growth of
electronic commerce continues. Within this real tax world, this thesis argues that the
preferred solution is to increase the reliance on consumption taxes to maintain sound
revenue flows.
36
That is, greater reliance should be placed, by most jurisdictions, on a
value added tax (VAT) or a goods and services tax (GST), based on private
consumption and not on profits (hereafter GST). This looks to be the best strategy to
help overcome the increasing difficulties in applying the source principle in the
(income) taxation of business profits. The GST has stood the test of time. It has
continually proven to be an effective revenue-generating instrument to maintain
government revenue flows. It can provide a robust and predictable source of revenue
that typically accounts for one-fifth of total tax revenue in more than 141 countries
adopting it. Its pitfalls (and certain remedies, therefore) are known.
37
There is and
would be an increasing need (assuming greater reliance on a GST) to address the
operational problems of such a system. But taking this approach means there would
be far less need to assess the uncertain impact of new laws and address likely,
unintended significant, initial structural flaws in any radically new tax system. This
approach also avoids having to cope with the uncertainty and practical difficulties

36
A KPMG corporate and indirect tax survey in 2007 concludes that indirect taxes appear to be playing
an increasingly important role in the revenue-gathering strategies of many countries around the world.
There is a clear tendency among nations in competition to attract and keep inward investment, to reduce
their corporate tax rates and seek to make up the shortfall with increases in indirect taxes. One
advantage of a GST over an income tax is that it provides a steady flow of revenues throughout the year
rather than lump sums at widely spaced intervals. See KPMG, KPMGs Corporate and Indirect Tax
Rate Survey 2007 (2007) 1-3.
37
See Christophe Grandcolas, The Occasional Failure in VAT Implementation: Lessons for the
Pacific (2005) 11 Asia-Pacific Tax Bulletin 6, on why the implementation of VAT failed in some
Pacific countries.
402
bound to arise in the management of any radically new tax system across future
years and decades.

It has been argued that a consumption tax could provide a more stable tax base in the
face of increasing global tax competition, as consumption is less mobile than flows of
investment capital.
38
A broad-based consumption tax such as the GST is
comparatively difficult to avoid and less subject to the pressures of globalisation.
Unlike income tax that is measured by the rules applicable to the source of income and
the residence of the taxpayer, a general consumption tax is measured by the notion of
supply the thing purchased or consumed by a person. Customers include private
individuals and business enterprises. Each transaction is considered on its merits as a
separate economic activity, whether done by traders, producers or service providers.
The character of a particular transaction in the supply chain cannot be altered by
earlier or subsequent events. The source of the transaction is either the country of
destination (where goods and services are destined for personal consumption) or the
country of origin (where production takes place or value is added to those goods and
services). Today, the international norm for consumption tax is the destination
principle. The allocation of consumption tax revenue under the destination principle is
based on where goods and services are delivered for personal consumption, and the
place of consumption is a pivotal issue in the allocation of consumption tax revenue.
If the destination approach is viewed as impractical to collect tax from numerous

38
The tax base of a consumption tax is expenditure rather than income. Employment income and the
consumption of those who earned the income are not particularly mobile, compared with capital and
investment activities that can be shifted to another location (and the appropriate tax base is also shifted
to the new jurisdiction). See Singapore, Ministry of Finance, Consumption Tax as a Source of
Government Revenue in Budget Highlights: Financial Year 2007 Ready for the Future, Ready for
the World (presented to Parliament on 15 February 2007) [21]
<http://www.mof.gov.sg/budget_2007/budget_speech/downloads/FY2007_Budget_Highlights.pdf > at
1 May 2008.
403
private customers, then the source of the transaction can be viewed to be the place
where the goods originate and tax can be collected by registered enterprises at the
point of sale. The main problem with the GST is the compliance, enforcement and
collection of tax on internationally traded services and intangibles because there is no
effective method to collect tax. Though for each taxable transaction there is always an
entity responsible for remitting the GST, it is administratively impracticable for tax
authorities to monitor the economic activities of their residents outside the jurisdiction
and impose boundary checks. The real issue is the right mix of tax policies that
balances potentially conflicting objectives such as revenue collection and compliance
costs, tax neutrality and tax competition.

Hong Kong is a notable low-tax jurisdiction. If Hong Kong plans to maintain its
tradition of simple and low direct taxes for many years into the future, there is a need
to widen the currently narrow tax base.
39
The option of a GST still looks to provide
the best way of buttressing the longer-term foundations for maintaining Hong Kongs
territorial source-based direct tax system. Taxing consumption can not only broaden
the tax base, but also reduce future pressures to increase income taxes to meet
expenditure needs.

One acknowledged way of sharing the burden of funding public expenditure is to use a
broad-based consumption tax.
40
A GST can be combined with an income tax to
produce a tax system that is equitable while providing needed revenue. The

39
See KPMG, Tax Base Study for the Hong Kong Government Advisory Committee on New Broad-
based Taxes (July 2001) [116-9]
<http://www.kpmg.com.cn/en/virtual_library/Tax/Tax_Base_Study0107.pdf>at 29 April 2008.
40
In Australia, the introduction of the GST has been said a stunning success, with GST revenues
consistently higher than budget predictions. See GST A Stunning Success, The Australian (Sydney),
28 J une 2005, 23.
404
introduction of a GST provides the opportunity to reduce existing taxes and boost
competitiveness for foreign investments.
41
If a general consumption tax were to be
implemented in Hong Kong, its wide coverage of private consumption would include
all persons regardless of their economic situation. The tax liability arises when
income is spent. Even in times of a recession, it provides a steady source of revenue
without the need to increase income taxes (or rely on increased debt or use of reserves)
as basic spending must continue. A shift toward greater reliance upon a general
consumption tax would include a larger base of taxpayers in the tax net (for example,
purchases made by people with illegal sources of income or who evade income taxes
are caught in the net). If the tax burden is to be shared by all persons, the GST is a
good choice as it is a tax on spending and less easy to avoid than most income-type
taxes.

This thesis has shown that the GST has now become the most important indirect tax in
both developed and developing economies. The EU has concluded that a VAT system
is the best workable means to tax Internet-reliant electronic commerce. J urisdictions
look likely, in the future, to have to rely on a GST more, as one way to cope with the
growth of e-business.

Hong Kong is one of the few developed economies that does not levy some form of a
general consumption tax. This stands in stark contrast to a developed economy, such
as Australia, where a general consumption tax (now) co-exists with an income tax.

41
Take the case of Singapore. GST has been a stable source of revenue for the Singapore government
since its introduction on 1 April 1994 as part of a restructuring of the tax system away from direct
taxation of income. To boost competitiveness for foreign investments, Singapores corporate income
tax rate is reduced from 20 to 18 per cent with effect from the 2008 year of assessment, and the GST
rate has been raised from 5 to 7 per cent with effect from 1 J uly 2007. See Singapore, Ministry of
Finance, above n 38, [21].
405
This thesis contends that Hong Kong really needs a GST. The tax base in Hong Kong
is, demonstrably, too narrow for such a developed economy. In the economic context,
a general consumption tax would raise substantial amounts of revenue without creating
economic distortions as it does not overly rely on a limited number of widely
fluctuating, cyclical sources of revenue. A GST was proposed in Hong Kong in J uly
2006, but the launch encountered hostile and widespread opposition. The majority of
the public clearly do not consider that the GST is an appropriate option to solve the tax
base problem (or they do not perceive or agree that there is any tax base problem).
The GST aspect of public consultation on tax reform was dropped. It has been argued
that the abandonment of the GST proposal in Hong Kong is not the end or the
beginning of the end, but perhaps the end of the beginning. With a largely service-
based economy that relies increasingly on Internet-reliant business activities, the
pressure is greater than ever for Hong Kong to develop and reform its dated tax system
and move to a modern system to broaden the narrow tax base and meet the challenges
of the 21
st
century. It is right, therefore, to continue to ask, when will Hong Kong take
action to reform its tax system to help ensure its future growth and prosperity?

8.6.2 Future outlook and further research questions

Any fundamental tax reform is bound to have far-reaching effects. When looking at
the feasibility of tax reform, one must seriously consider institutional choice
42
and the

42
The institutional theory of law emphasises the importance of institutions to the understanding of law.
Within a state are rules which we commonly call law. But rules cannot be said to exist simply because
they are the product of legislation, of judicial decision, or of custom. Theories of law have meaningful
existence only if they are recursively recreated within specific practices and activities. Under the
institutional theory of law, law is a system of norms having reference to institutions as legally
personified sets of social relations. For example, the Parliament or the Legislative Council, the law
courts, the legal profession, the political parties, the law reform commissions have to be dealt with as
institutions, the social reality underlying law. The social reality is anterior to and more permanent than
406
way in which reform is likely to be shaped by voter preferences at the ballot box
and/or driven by policy elites or entrepreneurs.
43
Managing the political process of tax
reform is crucial to the successful enactment of a new tax in any jurisdiction. The
complexities associated with the implications of tax reform are generally beyond the
understanding of the general public.
44
Even if they are interested and well informed,
their focus is on the gains they will enjoy under the reform and not the structure of the
tax system and the long-term consequences of policy issues. Politicians are strongly
motivated by their vested interests. They generally pay limited attention, at best, to
changes in the fiscal system as a whole and the extent of income and wealth
redistribution the new tax would bring. It took, in total, around thirty years to enact a
GST in Australia due to the significant institutional influence on the political strategies
employed within Australias competitive (primarily) two-party system.
45
The
introduction of a GST in Australia, it was argued, was, ultimately, a product of Prime
Minister J ohn Howards political skills.
46
Similarly, the launch of a debate about the
introduction of a GST in Hong Kong generated much heated debate. At the time of
the launch, it was already being argued that the proposal could not be expected to pass
and that it may be used to control the spin regarding tax reform for Hong Kong in the
future and see which political faction of the legislature might support the next GST

the rules. See Brian H Bix, A Dictionary of Legal Theory (2004) 99; Neil MacCormick and Ota
Weinberger, An Institutional Theory of Law (1986) 17-27; Peter Morton, An Institutional Theory of
Law (1998) 1-11; David M Walker, The Oxford Companion to Law (1980) 626.
43
Miranda Stewart, Introduction: New Research on Tax Law and Political Institutions (2006) 24(2)
Law in Context 1.
44
Eng-Hin Poh, Broad-based Consumption Tax Reform: The Economics and Politics of the Equity
Implications (2003) 29(1) International Tax Journal 41, 45
45
Richard Eccleston, The Thirty Year Problem: The Politics of Australian Tax Reform (Research Study
No 42, Australian Tax Research Foundation, 2004) 141.
46
For a history of tax reform that led to the introduction of a broad-based consumption tax in Australia,
see Anne Daly, Unfinished Business: Reform of the Tax System in Chris Aulich and Roger
Wettenhall (ed), Howards Second and Third Government: Australian Commonwealth Administration
1998-2004 (2005) 221.
407
proposal.
47
The road to a GST in Hong Kong may prove to be, similar to that in
Australia, long and difficult.

Tradeoffs and favours to many politicians and many taxpayers are needed before new
measures and major tax reforms, such as a GST, can be introduced successfully in a
jurisdiction without being over-powered by the inevitable coalition of opposing forces.
When one considers the implications of the full Pinto Proposal, the institutional
obstacles to its introduction look notably larger. Electronic commerce is a truly global
phenomenon. International consensus is needed to give businesses certainty and
making sure that taxation is not a barrier to the growth of electronic commerce.

Would the Pinto Proposal be acceptable by politicians, lobbyists, taxpayers etc if all
obstacles were removed? The Pinto Proposal provides an alternative to determine the
source of income derived from electronic commerce without the need to characterise
the income (meaning A). The Pinto Proposal offers a new approach to the taxation of
business profits. The challenges of adopting it could be overcome if the following
conditions were met:
the Pinto Proposal were to be adopted as part of the standard tax law regime of
most taxing jurisdictions;
48

a uniform withholding tax rate and monetary threshold were to be used by all
jurisdictions to avoid creating vigorous tax policy competition among jurisdictions;
withholding taxes deducted at source were to be treated as being creditable taxes
by the home (residence) jurisdiction of the foreign seller; and

47
Laurence E Lipsher, Hong Kongs Proposed GST A Boon for An Elite Few (2006) 43 Tax Notes
48
Professor Richard Vann seeks to address the problem of complexity in tax laws at the international
level by standardisation of tax laws. See Richard J Vann, Improving Tax Law Improvement: An
International Perspective (1995) 12 Australian Tax Forum 193, 201.
408
all relevant taxing jurisdictions were to have the information and communications
technology (ICT) to support the Pinto Proposal.

In the real world, different tax systems are used by different taxing jurisdictions to
attract businesses with international operations. Some jurisdictions (for example,
Malaysia, Singapore and, of course, Hong Kong) adopt a territorial income tax system
to varying degrees,
49
and some (for example, the UK, the US and Australia) generally
adopt a worldwide system that taxes income from all sources. Similarly, tax rates are
not equal among jurisdictions. Some rely more on indirect taxes as a major source of
government revenue and some rely more on direct taxes.
50
To attract and retain
foreign investment and promote growth, some cut their income tax rates but increase
their GST rates to finance the income tax cut (for example, Singapore). The Pinto
Proposal would have widely varying effects on the tax liabilities of businesses
depending on the location of their foreign operations, unless tax systems and tax rates
are identical (or close to identical) around the world. It has long been a practice
among jurisdictions to attract trade and investment that bring major benefits to a
jurisdiction. The Pinto Proposal could work against this aim because tax competition
can influence the location of trade and investment. It has been pointed out that the
implementation and updating of ICT to support and update the Pinto Proposal would
create an additional financial burden for most revenue authorities. Moreover, the
effective implementation of the Pinto Proposal depends on a very high level of
multilateral agreement across national taxation jurisdictions. It may be necessary to
alter DTTs to ensure that withholding taxes under the Pinto Proposal are treated as

49
See footnote 14, Chapter 1, on the territorial tax system of Malaysia and Singapore.
50
For example, Mexico and Iceland make heavy use of taxes on goods and services, while South Africa
receives a greater share of its taxes from income. See OECD, Revenue Statistics 1965-2004 (2005) 34.
409
being creditable taxes. This process, acknowledged by Pinto, could impose both cost
and time burdens.

The US Treasury Department has suggested that shifting to residence-based taxation is
necessary as the remote sale of products and the performance and delivery of services
via the Internet will render source-based taxation that is tied to physical presence less
important. It has been argued, however, that abandoning source-based taxation in
favour of residence-based taxation in the context of electronic commerce would
violate the generally accepted international consensus, as embodied in the DTTs and in
most income tax legislation.
51
This consensus is based on the principle that the
primary right to tax active business income is given to the source jurisdiction and
passive investment income to the residence jurisdiction. A shift to residence-based
taxation would tend to benefit net-exporting jurisdictions of electronic goods and
services, while net-importing jurisdictions would suffer significant revenue losses.
Under residence-based taxation, net-exporting jurisdictions grow richer as their
residents make and earn income from commerce, capital, investment and technology.
The tax base of smaller, net-importing jurisdictions (like Australia and Hong Kong)
would be eroded if no tax can be imposed on income derived from extensive online
trading with their residents.
52
It is highly unlikely that net-importing jurisdictions
would voluntarily agree to residence-only taxation (as a mechanism to try and

51
Reuven S Avi-Yonah, International Taxation of Electronic Commerce (1997) 52 Tax Law Review
507, 525.
52
Capital outflows are generally thought to diminish national wealth (and reduce the tax base). Thus,
capital-exporting jurisdictions would seek a low or nil withholding tax on interest, dividends and
royalties paid to their resident investors. Capital inflows are generally considered desirable. Capital-
and technology-importing jurisdictions would resist the attempts of capital- and technology-exporting
jurisdictions to reduce their tax base by imposing a low or nil withholding tax on interest, dividends and
royalties. See Brian J Arnold and Michael J McIntyre, International Tax Primer (2
nd
ed, 2002) 6.
410
overcome difficulties with the application of source rules) in view of these potential
adverse revenue consequences.
53

On the other hand, there have even been suggestions that the US should abandon
residence-based taxation and move to a pure territorial (source) tax system on the
taxation of companies to curtail inversion transactions.
54
This is because US MNEs
would be able to compete on a level playing field in foreign markets (as foreign
income would not be taxed). Such a system would (briefly) work (have an impact) as
follows:
a US parent company with foreign subsidiaries would not have to invert and place
itself below a foreign company;
foreign subsidiaries would remain as foreign subsidiaries of the US parent
company;
the US parent company would pay taxes to the US government on all US income;
and
the US parent company would no longer pay US tax on its foreign income earned
by its foreign subsidiaries.

53
A superpower, like the US, can be most persuasive, of course, in bilateral negotiations. But achieving
widespread international agreement on major business law changes is notoriously difficult. One only
needs to consider the latest round of WTO negotiations. See Philip Bowring, FTA is not the Way,
International Herald Tribune, 3 April 2007
<http://www.iht.com/articles/2007/04/03/opinion/edbowring.php>at 16 April 2008 on Americas new
trade agreement with South Korea concluded on 1 April 2007.
54
See Veronique de Rugy, Quick-Fix Curbs on Corporation Inversions Mask the Real Problem (2002)
28 Tax Notes International 805, 808; Daniel J Mitchell, Tax Harmonization Threatens U.S.
Competitive Advantage in Global Economy (2002) 25 Tax Notes International 1079, 1089; Cornelius
C Shields, Territoriality for U.S. Corporations Getting Closer, but Important Issues Remain (2005) 38
Tax Notes International 311; United States, The Presidents Advisory Panel on Federal Tax Reform,
Simple, Fair, and Pro-Growth: Proposals to Fix Americas Tax System (November 2005) 132-5
<http://taxreformpanel.gov/final-report/>at 1 May 2008.
411
In addition, the adoption of source-based taxation would encourage foreign MNEs to
move their operations and profits to the US (as only income sourced in the US would
be taxed). MNEs would not have to manipulate transfer prices as a means to shift
profits from a high-tax to a low-tax jurisdiction. Thus, difficulties are encountered
with the operation of both the residence and source rules. Determining the tax
residence of companies and the source of income have become increasingly difficult
for tax authorities.

The OECD plays a leading role in the area of international taxation. Its model tax
convention (MTC) on income and on capital provides a basis for the negotiation,
application and interpretation of bilateral tax treaties. The worldwide network of tax
treaties based on the OECD MTC (and the United Nations MTC)
55
help to avoid the
danger of double taxation by providing consensual rules for taxing income and capital.
The OECD has recognised that electronic commerce raises significant issues for tax
authorities, whose focus should be on how to address the challenges in a spirit of
collective cooperation.
56
It acknowledges that there are no universally agreed
principles to determine what is a fair allocation of tax revenue between the residence
and the source jurisdiction. But the existing treaty rules are compatible with existing
international trade rules.
57
They are widely accepted internationally and any change to
the current international norms for taxing business profits would require a large degree
of consensus before it could be applied universally.
58
There is no evidence yet that
electronic commerce leads to a significant loss of the direct tax revenues of a country

55
See footnote 7, Chapter 1, on the two major standard models used in negotiating DTTs.
56
OECD, E-Commerce: Transfer Pricing and Business Profits Taxation (Tax Policy Studies No 10,
2005) 3.
57
Ibid 99.
58
Ibid.
412
that could be attributed to electronic commerce.
59
Thus, the OECD does not
recommend changes and alternatives to the current treaty rules for taxing business
profits, such as:
modifying the PE definition to exclude activities that do not involve human
intervention by personnel including dependent agents, or to provide that a server
cannot, in itself, constitute a PE;
modifying the existing rules to add a force-of-attraction rule dealing with
electronic commerce;
adopting supplementary nexus rules for purposes of taxing profits arising from the
provision of services;
adopting rules similar to those concerning taxation of passive income to allow
source taxation of payments related to some forms of electronic commerce (that is,
subject them to source withholding tax);
adding a new nexus rule that focuses only on whether the foreign enterprise is
receiving a payment from an in-country payor that the payor may deduct for
domestic tax purposes rather than on where the activities giving rise to the product
or service are located; and
adding a new nexus of electronic (virtual) PE.
60

The OECD states that any attempt to change the existing treaty rules would create
difficulty given the fact that many countries would likely disagree with such changes.
Any set of rules for the allocation of taxing rights over business profits must remain
politically acceptable if these rules are to continue to prevail.
61
The rules need to be

59
Ibid 100.
60
Ibid 105-150.
61
Ibid 100.
413
agreed to by as many countries as possible so as to avoid double taxation or non-
taxation as well as reduce compliance burdens. Instead, the OECD has
recommended a need to continue monitoring how direct tax revenues are affected by
changes to business models resulting from new communication technologies.
62
The
challenges presented by electronic commerce are, at base, practical difficulties in the
application of the law. The OECD has not been able to offer any better alternative
source rules for taxing business profits, apart from trying to address the problems
through changes to bilateral tax treaties.
63

If multilateral solutions are not being proposed by the OECD, there is more need to
rely on local tools. It is left to the respective jurisdictions to address real problems
such as tax compliance and enforcement and establish acceptable nexus rules.
J urisdictions may consider adopting a more liberal stance in granting exchange of
information and assistance in the collection of taxes in light of the changes brought
about by globalisation and the developments in electronic commerce when concluding
DTTs.

This thesis concludes that there are no clear one-stop remedies. The thesis argues
that the challenges to the revenue identified will best be met by working harder on
making existing taxes more effectual it is back to the future, in other words.
64
The

62
Ibid 151.
63
The OECD recognises that some problems could be addressed through changes to bilateral tax treaties
(for example, modification of the PE definition to provide that a server cannot, in itself, constitute a PE).
As a consequence, changes to domestic law would also be required to eliminate double non-taxation
risks in cases where the residence country relieves double taxation through the exemption method. See
OECD, E-Commerce: Transfer Pricing and Business Profits Taxation, ibid 151.
64
The term back to the future is taken from a film produced in 1985 with the same name. A 17-year
old school boy goes back in time from 1985 to 1955 to manage aspects of what happens in 1955 so as to
ensure that all is right 30 years into the future. See Wikipedia, Back to the Future (modified 27 April
2008) <http://en.wikipedia.org/wiki/Back_to_the_Future>at 27 April 2008.
414
future growth in international trade and investment is likely to be significant. We need
a tax system to grow and adapt at a rate that aims to keep up with changes in the way
international trade and investment are conducted as well as to meet the fiscal and
policy goals of a jurisdiction. We can work to make direct taxes more effective. We
can place a greater reliance upon and work, too, to make indirect taxes more effective
(such as the GST).

A number of areas for further research and development suggest themselves. In
practice, tax law development very likely will have to be meshed with related changes
to other regulatory regimes including those governing corporations, banking and
finance, international trade and privacy. We need to resolve particular issues
highlighted in the thesis. A range of particular points of practical applicable research
and more theoretical research are set out in Appendix A of this chapter.

8.6.3 Tackling the taxation of electronic commerce profits today and tomorrow

We can learn, to a degree, from Addington. He introduced a schedular tax system that
classified all items of income by description under schedules two hundred years ago.
The success of his tax system relied on what was, for its time, much thought and
careful drafting. We should, today, investigate the potential of well-crafted statutory
definitions of source. We can define income, as best we can, as being derived from
goods, services or Internet transactions to make it harder for taxpayers to manipulate
source rules and change the character of income (meaning A). We have to identify
who is the taxpayer and where does he derive his income (meaning B). Also, like

The term is being used as shorthand for locating and applying existing systems (which are systems
of some antiquity) so that they work more effectively today.
415
Addington, who introduced taxation at source at the same time as he introduced his
schedular tax system, we can improve our information gathering and collection
mechanisms. For Internet business identification, we can aim to make it a requirement
that all businesses trading on the Internet must provide in their tax return:
the web site address used by them to provide goods and services to customers;
name of the company hosting the web site; and
name of the company providing the payment gateway.
65

In an online environment, a business might not have a fixed place of business
anywhere. Its presence is not observable and it is identifiable, primarily, by its domain
name. Each domain name provides a unique address on the Internet and does not
necessarily bear any relation to the residence or geographic location of the business.
66

Clearer tax-focused regulation of Internet trading and domain names could help
provide a more reliable indicator of ultimate residence and source. For accurate
identification of the location of businesses, we need to reach an international
agreement on domain name registration so that domain names can become a reliable
indicator of geographic tax presence (and thus act as a proxy for geographic
presence).
67

65
Currently taxpayers in Hong Kong have to provide the above information in their income tax return if
they are engaged in electronic commerce. There should be a requirement under the law to provide such
information to the relevant tax authorities to establish the identity and location of business, the accuracy
of information obtained and to take action against the taxpayer in case of disputes.
66
Domain names only indicate who is responsible for maintaining that name and may not tell anything
about the computer corresponding to the actual Internet address or where that computer is located. Even
if an e-mail address is clearly associated with a certain person and computer, that person and the
computer could be located anywhere in the world. This makes it difficult to determine a persons
location and identity based on the domain name. See United States, Department of the Treasury, Office
of Tax Policy, above n 14, [6.3.3].
67
A domain name is generally obtained by registering with an accredited and accreditation-qualified
registrar in a country or territory. Though the country code suffix (such as .au and .hk) indicates a
link to a country or territory, a domain name is not a reliable indicator of geographic presence. In
Australia, the registration of a com.au domain name is not restricted to Australian companies. A
foreign company trading in Australia is entitled to it as well. In Hong Kong, a .hk domain name may
be transferred to another party. See .au Domain Administration Ltd, Domain Name Eligibility and
416

For accurate verification of jurisdiction, we can aim to make it a requirement that each
cyberspace entity must be linked to a physical taxable entity and provide accurate and
reliable information on the web site such as:
the legal name of the business;
the trading name of the business;
the place of incorporation of the business;
the geographic address of the business;
any other relevant statutory registration numbers (for example, the Australian
Business Number and/or the Australian Company Number);
the name of the public officer;
appropriate contact details such as the email address of the business; and
the applicable law or jurisdiction on the resolution of disputes between businesses
and consumers.

To verify compliance, taxpayers are required to keep appropriate records for tax audits
and to produce those records when requested to do so. We need to verify the
authenticity of electronic transactions. We need to verify that an electronic order has
not been altered in transit. For records stored in another jurisdiction, we can seek to
extend access powers and make requests for documents stored in another

Allocation Policy Rules for Open Second Level Domains (2LDs) (8 May 2002) [6]
<http://www.auda.org.au/pdf/auda-2002-07.pdf> at 16 April 2008; Hong Kong Domain Name
Registration Company Ltd, Domain Name Registration Agreement for .hk Domain Names (version 4.0
effective 28 September 2006) <https://www.hkdnr.hk/register/registraion_agreement.jsp>at 20 April
2008.
Domain names may also be traded on the web such as on eBay. See Annette Nellen, Domain
Names and Other Intangibles for Internet Businesses (2001) 14(4) Journal of Taxation of Financial
Institutions 31, 32.
417
jurisdiction.
68
For encrypted records, we can request the relevant decryption and
recovery keys. We can also seek assistance from an Internet Service Provider to apply
software on servers to determine the sender and destination of a particular encrypted
message.
69
If web sites exist on servers located offshore or if the entity does not hold
any assets in a jurisdiction, we can work to strengthen cooperation with other tax
authorities. We can provide mutual assistance in collection of tax debts on behalf of
another tax authority or to take conservancy measures to ensure the collection of
debt.
70
We can devise a better tax debt management strategy and develop a new
Model Tax Debt Enforcement Treaty, perhaps with the OECD, to solve the problem of
collection and enforcement of international tax claims.

To keep track of activities throughout an Internet transaction, we need to incorporate
audit trail control points into computer systems. For example, we can make it a
requirement that a serial transaction number must be generated by the computer
system of the seller each time an item is downloaded directly from the sellers
computer to the purchasers computer, similar to a barcode that is used for inventory

68
See, for example, ss 263, 264 and 264A of the ITAA 1936 on the access and information-gathering
powers of Australias Commissioner of Taxation. However, these access powers have no force in
another jurisdiction.
69
As explained in Chapter 6, the way information travels on the Internet is based on packet switching.
Data is digitised before being broken down into discrete packets of information for transmission from
the source to its destination. Each packet is transmitted individually. The packet header has a source
and destination Internet Protocol number and the information cannot be encrypted. So it may be useful
to determine the sender and the destination of an encrypted message.
70
Prior to 14 September 2006, the Commissioner of Taxation in Australia has very limited authority
under the tax legislation to collect a tax debt from a country debtor on behalf of the country in which
that tax debt arose. The tax legislation has been amended to enable the Commissioner to collect a tax
debt on behalf of a foreign tax authority or to take conservancy measures to ensure the collection of that
debt (see s 263-5 of the Taxation Administration Act 1953 (Cth) (TAA 1953)). Mutual assistance in
collection of foreign tax debts can be activated if there is in force an agreement between Australia and a
foreign country or territory that contains an article relating to assistance in collection of foreign tax
debts. The Protocol Amending the Agreement Between the Government of Australia and the
Government of New Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income (entered into force 22 J anuary 2007) is Australias first DTT
that provides enforcement of tax debts due to another country.
418
control of physical goods. We can develop and provide electronic record-keeping
software to help businesses meet their taxation reporting obligations.

We can make it a requirement that all material data is stored including electronic
signatures and digital certificates. One benefit of DCs is that they provide an audit
trail that makes it difficult for someone to later repudiate a transaction by claiming
they never authorised it.
71
To be used as a reliable indicator of residence, we can
make it a requirement that a DC must state the tax residence of the holder.
72
(This,
however, likely will raise privacy issues which will have to be addressed.)

A DC is issued by a Certification Authority (CA), a third party that verifies the
holders credentials. To assure the integrity of CAs, we need to establish an
internationally recognised central authority to cross-certify most if not all CAs. If a
DC were to be used as proof of identity in cyberspace, CAs should be regulated by an
internationally recognised central authority. Alternatively, it may be necessary for
taxing authorities to issue their own DCs to their residents conducting electronic
commerce.
73

We need to regulate the use of digital currency in the digital world. We need an
electronic payment system that identifies the parties to the transaction and the method
of payment. If electronic cash is used, we need to know the identity of the issuer or

71
J im Middlemiss, Digital Certificates Draw Wireless Attention (2002) 20 Wall Street & Technology
47, 47.
72
Digital certificates (DC) have been discussed in Part 6.3.2, Chapter 6. A DC contains data records
about individuals or businesses. It does not state the tax residence of the holder and, therefore, cannot
be used as a reliable indicator of tax residence.
Even if tax residence of the holder is stated in the DC, a person can still change his tax residence
during the year.
73
In Australia, DCs issued by the Australian Taxation Office (ATO) are used to authenticate online
dealings with the ATO and cannot be used for other purposes.
419
the sponsor and where the token value resides. We need to monitor closely
developments in payment systems so that significant transactions with full anonymity
of parties are not adopted.

We can combat offshore tax evasion and avoidance by concluding tax information
exchange agreements with our trading partners covering not just direct taxes, but also
a wider range of taxes such as the GST.
74
We can amend our tax treaty source rules
and specify exactly the income to be taxed in one contracting state or the other. We
can rely more heavily, in the more difficult cases, on the general anti-avoidance rules
to cancel any tax benefit taxpayers have received if a scheme is entered into or carried
out for a dominant purpose of obtaining a tax benefit.
75
We can impose heavy
penalties on entities engaged in unacceptable re-invoicing and source-shifting
arrangements.

The collection of a destination-based consumption tax like GST is based on
transactions and the supplier is responsible for the collection of tax on each transaction.
We need to verify the correct jurisdiction (where consumption takes place) and the
status of the customer (whether business or private). We need to ensure that a supplier
has applied the correct rate of tax at the time the transaction takes place. We can make
it a requirement that the computer system of a supplier must be able to:
identify transactions when they take place;

74
The taxes covered by a DTT generally include income tax and may include petroleum resource rent
tax and fringe benefits tax, but do not include a general consumption tax such as GST. Australias new
treaty obligations to exchange information on tax matters with other revenue authorities cover a broader
range of taxes. See the Protocol Amending the Agreement Between the Government of Australia and
the Government of New Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income (entered into force 22 J anuary 2007) that provides for
exchange of information on a broader range of taxes (for example, GST).
75
See Pt IVA of the ITAA 1936 and ss 61, 61A and 61B of the Inland Revenue Ordinance 1947. In
Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775, Pt IVA was
invoked due to the contrivance of sourcing the interest offshore.
420
register for GST transactions if the registration threshold is satisfied;
verify jurisdiction and customer status whether or not the customer is registered
for GST so that the reverse charge applies;
determine if there is a taxable supply;
charge the correct amount of tax;
remit the tax to the correct revenue authority; and
comply with record-keeping requirements.

The reform measures just outlined are numerous and some, indeed many, will take
much time to be implemented effectively. These initiatives involve working with
known concepts, however, with the aim of improving the definitional, operational,
collection and enforcement aspects of current tax systems. Many of these reform
measures can be implemented (and verified) on a step-by-step basis. Their
implementation will bring incremental gains. They also avoid the serious
implementation, enforcement and adaptation problems bound to arise from resort to
the more radical tax system overhauls described above.

It is argued that a tax system is a vast bureaucracy of collection and enforcement.
76

No jurisdiction can simply rely on voluntary compliance to collect the tax in a
complex and interrelated world. There are areas that are likely to be difficult in
applying the (taxation) rule of law. And there are areas that the intended consequences
of the law would not be achieved but unintended consequences would follow. There is
no perfect tax system that is simple and sustainable,
77
nor is there a standardised

76
J oel Slemrod, My Beautiful Tax Reform in Alan J Auerbach and Kevin A Hassett (ed), Toward
Fundamental Tax Reform (2005) 135-6.
77
Ronald A Pearlman, A Tax Reform Caveat: In the Real World, There is No Perfect Tax System in
Auerbach and Hassett, ibid 106.
421
international tax law that applies to all jurisdictions. The issues that confront us are,
therefore, not simple. We need to identify the tax base, measure its size, allocate it
jurisdictionally and enforce tax liability according to who is buying, who is selling and
where all this is taking place.
78
It is argued that, in the end, the real tax policy issue is
how governments agree to allocate tax revenues from cross-border transactions,
operations and activities.
79
Tax administration must keep pace with the developments
of the 21
st
century growth in international trade, related-party dealings and profit-
shifting, cross-border financing, innovative financial arrangements etc. In managing
the impact of globalisation on tax compliance, we need to work together with other
revenue authorities. It would be pointless if a jurisdiction passes laws concerning the
compliance and enforcement of tax laws beyond that jurisdiction, but other
jurisdictions do not agree to cooperate on the enforcement of those laws.

In conclusion, we need to make the Internet fit for all forms of commerce in this
complex and highly integrated global economy. That, in turn, means that better tax
regulation of profit-generating transactions, operations and activities on the Internet
will have to be continually developed. We need a tax system to match the revenue
needs and, at the same time, strike an appropriate balance between the taxation of
business profits and the operation of businesses in a competitive globalised market.
We need to build and maintain better ties with other jurisdictions to share emerging
tax risks and adjust our policies so as to ensure that tax systems will operate
effectively across future decades.

78
Richard Bird, Taxing Electronic Commerce: A Revolution in the Making (C. D. Howe Institute
Commentary No 187, September 2003) [4] <http://www.cdhowe.org/pdf/commentary_187.pdf> at
16 April 2008.
79
Robert Goulder, American Bar Association Section of Taxation Panel Eyes OECD Conclusions on
Taxation of E-Commerce (2001) 22 Tax Notes International 360, cited in Bird, ibid 14.
422
Appendix A Ongoing Research Agenda

Source of income
How to determine the source of income in a changing electronic world, given
that ultimately source is a practical, hard matter of fact?
How to distinguish between goods and services when downloaded from the
Internet?
How to classify income properly for tax purposes on internationally traded
intangibles if the nature of the activity is not available?
How to determine the source of services income if the person performing the
services is not physically present in the jurisdiction, if the generally accepted
principle is based on where the person rendering the services is located?
Should the source of sales income be the location of the underlying selling activity?
How to allocate taxing rights and prevent double taxation or non-taxation of
income where several taxing jurisdictions are involved in an operation, transaction
or activity?
How to detect if some value-added functions and assets have been transferred to
another jurisdiction?
What are the implications for transfer pricing and the use of tax havens?

Internet business identification
What are the badges of Internet trading?
How to determine if a business is selling goods over the Internet into J urisdiction
A and if there are profits sourced in J urisdiction A?
How to determine the location within which an online business operates?
423
How to determine where an activity is carried out electronically, given that there is
no control over the type of information that travels over the Internet?
How to identify the physical taxable entity and the correct parties to an electronic
business transaction?
What should be the tax treatment of foreign entities engaging in extensive online
trading with residents of a jurisdiction, if they are physically located outside the
taxing jurisdiction?

Tax administration
How to prove a jurisdictions right to tax when items are sold over the Internet?
How to verify the identity of a counterpart if withholding taxes are to be imposed
on electronic commerce (for example, to determine if the payee is entitled to a
treaty benefit)?
How to check that businesses are properly declaring their online profits, especially
under a system of self assessment?
How to measure the income generated by an activity carried out on the Internet?
How to raise an assessment and collect tax from a virtual business with no
physical presence or assets in the taxing jurisdiction?
How to check that records and control systems are in place and tax registrations
are up to date?
How to verify that accurate returns and correct information are supplied by
virtual businesses?
How to establish an audit trail when auditing an Internet transaction given various
tax collection and data gathering points can be eliminated?

424
Internet governance
How to deal with electronic cash where value is represented in digital form and no
audit trail can be provided?
How to verify compliance if electronic cash is used in a transaction?
How to trace an item supplied electronically?
What are the tax information requirements on web sites for information gathering
purposes?
How to ensure the privacy rights of taxpayers and the need for audit trails?
80

How to develop a standard on the recognition and enforcement of electronic
transactions?

Cross-jurisdictional disputes (in the absence of a DTT)
81

How to solve cross-jurisdictional disputes on tax matters?
How can a jurisdictions tax decision be enforced in another jurisdiction?
Which jurisdictions law should govern in case of a cross-border tax dispute?

80
In Australia, there are privacy and secrecy laws that restrict the collection, storage, access, use and
disclosure of information relating to taxpayers collected by government agencies including the ATO.
See the requirement to comply with the Information Privacy Principle under the Privacy Act 1988 (Cth)
and s 8XA of the TAA 1953 which prohibits unauthorised access to taxation records. In Hong Kong,
the Personal Data (Privacy) Ordinance (cap 486) protects the privacy of individuals in relation to
personal data. It sets out the six principles to regulate the collection, storage, access, use and security of
personal data. Section 4 of the IRO 1947 contains strict secrecy provisions to protect the confidentiality
of information relating to taxpayers.
81
Cross-border tax disputes (eg interpretation of a treaty provision) between treaty states are usually
dealt with under the mutual agreement procedure, which is an informal negotiation between the tax
authorities of the states involved and no common understanding of the treaty is required. To improve
the resolution of tax treaty disputes, the next update of the OECD Model Tax Convention on Income
and on Capital, to be published in 2008, will provide for an arbitration process to deal with unresolved
issues and reach a decision that is binding on all parties. See Chloe Burnett, International Tax
Arbitration (2007) 36 Australian Tax Review 173, 173; OECD, Committee on Fiscal Affairs,
Improving the Resolution of Tax Treaty Disputes (2007) [4]
To be effective, the proposed changes would need to be included in a DTT. The questions raised
under this heading are for consideration by treaty states where such an arbitration provision does not
exist or by non-treaty states.
425
Is there a need for some new type of international tax organisation to resolve
international tax disputes and reach a decision that is binding on all parties, and is
the establishment of any such organisation feasible?
Should guidelines be available on settlement of debts (rather than going through
the courts) if there is a cross-border dispute?

General consumption tax issues
How to determine where consumption takes place when a supply is made via the
Internet?
What is the VAT/GST treatment of resident individuals purchasing items from
foreign sellers via the Internet?
How to check that a supply of anything other than goods or real property (such as
services) is connected with a jurisdiction?
How to check that non-resident enterprises are registered for GST purposes if they
make supplies connected with a jurisdiction?
How to prevent loss to the revenue should the foreign seller fail to pay the GST
collected from customers to the relevant tax authority?

426
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Cases

America Online, Inc v Ruth E Johnson, Commissioner of Revenue, Tenn App LEXIS 555
(2002)

American Thread Company v Joyce (Surveyor of Taxes) (1913) 6 TC 1

Attorney-General v London County Council (1900) 4 TC 265

Bennet v Marshall [1938] 1 All ER 93

Benwerrin Developments Pty Ltd v Federal Commissioner of Taxation (1981) 81 ATC
4524

Blockey v Federal Commissioner of Taxation (1923) 31 CLR 503

Bullock (H.M. Inspector of Taxes) v Unit Construction Co Ltd (1959) 38 TC 712

Californian Copper Syndicate (Ltd & Reduced) v Harris (Surveyor of Taxes) (1904) 5 TC
159

Central Asbestos Co Ltd v Dodd [1972] 2 All ER 1135

Cesena Sulphur Co Ltd v Henry Nicholson (Surveyor of Taxes) (1876) 1 TC 88

Colquhoun (Surveyor of Taxes) v Brooks (1889) 2 TC 490

Commissioner of Income-Tax, Bombay Presidency and Aden v Chunilal B Mehta [1938]
AIR Privy Council 232

Commissioner of Inland Revenue v Bartica Investment Ltd (1996) HKRC 90-080

Commissioner of Inland Revenue v Board of Review & Another [2006] 2 HKLRD 26

Commissioner of Inland Revenue v Board of Review and Indosuez W I Carr Securities Ltd
[2007] CACV 57/2006 (Unreported, Court of Appeal, Rogers VP, Le Pichon J A, Sakhrani
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<http://legalref.judiciary.gov.hk/doc/judg/word/vetted/other/en/2006/CACV000057_2006.
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456

Commissioner of Inland Revenue v British Salmson Aero Engines Ltd (1938) 22 TC 29

Commissioner of Inland Revenue v Euro Tech (Far East) Ltd (1995) 1 HKRC 90-074

Commissioner of Inland Revenue v George Andrew Goepfert [1987] 1 HKLR 888

Commissioner of Inland Revenue v Hang Seng Bank Ltd (1990) 1 HKRC 90-044

Commissioner of Inland Revenue v HK-TVB International Ltd (1992) 1 HKRC 90-064

Commissioner of Inland Revenue v Indosuez W I Carr Securities Ltd; Indosuez W I Carr
Securities Ltd v Commissioner of Inland Revenue (2002) HKRC 90-117

Commissioner of Inland Revenue v International Wood Products Ltd (1971) 1 HKTC 551

Commissioner of Inland Revenue v Karsten Larssen & Co (HK) Ltd [1950-1] HKLR 323

Commissioner of Inland Revenue v Lever Brothers & Unilever Ltd (1946) 14 SATC 1

Commissioner of Inland Revenue v Magna Industrial Co Ltd (1997) HKRC 90-082

Commissioner of Inland Revenue v N V Philips Gloeilampenfabrieken (1954) 6 AITR 158

Commissioner of Inland Revenue v Orion Caribbean Ltd (in vol liq) (1997) HKRC
90-089

Commissioner of Inland Revenue v Tai Hing Cotton Mill (Development) Ltd [2008] 2
HKLRD 40

Commissioner of Taxation (NSW) v Cam and Sons Ltd (1936) 4 ATD 32

Commissioner of Taxation (NSW) v Hillsdon Watts Ltd (1936-37) 57 CLR 36

Commissioner of Taxation (NSW) v Meeks (Public Officer of the Sulphide Corporation
Ltd) (1915) 19 CLR 568

Commissioner of Taxation (WA) v D & W Murray Ltd (1929) 42 CLR 332

Commissioner of Taxation of the Commonwealth of Australia v Myer Emporium Ltd
(1987) 163 CLR 199

Commissioner of Taxation v Kirk [1900] AC 588

Commissioner of Taxation v Mitchum (1965) 113 CLR 401

Commissioner of Taxes (SA) v The Executor Trustee, & Agency Co of South Australia Ltd
(1938) 63 CLR 108

Commissioner of Inland Revenue v Hong Kong Whampoa Dock Co Ltd [1959] HKLR 625
457

Commissioners of Inland Revenue v John Blott and Commissioners of Inland Revenue v B I
Greenwood (1921) 8 TC 101

Consco Trading Co Ltd v Commissioner of Inland Revenue [2004] 2 HKLRD 818

Curtis Brown Ltd (as agents for Stella Brown) v Jarvis (1929) 14 TC 744

De Beers Consolidated Mines, Ltd v Howe (Surveyor of Taxes) (1906) 5 TC 198

Dow Jones & Co Inc v Gutnick (2002) 210 CLR 575

Eisner, as Collector of United States Internal Revenue for the Third District of the State of
New York v Macomber, 252 US 189 (1919)

Esquire Nominees Ltd (Trustee of Manolas Trust) v Federal Commissioner of Taxation
(1972) 72 ATC 4076

Esquire Nominees Ltd as Trustee of Manolas Trust v Federal Commissioner of Taxation
(1973) 73 ATC 4114

Evans v Federal Commissioner of Taxation (1989) 89 ATC 4540

F L Smidth & Co v F Greenwood (Surveyor of Taxes) (1922) 8 TC 193

Federal Commissioner of Taxation v Cooke & Sherden (1980) 80 ATC 4140

Federal Commissioner of Taxation v Efstathakis (1979) 79 ATC 4256

Federal Commissioner of Taxation v Lamesa Holdings BV (1997) 97 ATC 4752

Federal Commissioner of Taxation v Orica Ltd (formerly ICI Australia Ltd) (1998)
98 ATC 4494

Federal Commissioner of Taxation v Spotless Services Ltd & Anor (1995) 95 ATC 4775

Federal Commissioner of Taxation v Stone (2005) 59 ATR 50

Federal Commissioner of Taxation v United Aircraft Corporation (1943) 68 CLR 525

Federal Commissioner of Taxation v W Angliss and Company Pty Ltd (1931) 46 CLR 417

Firestone Tyre & Rubber Co Ltd v Llewellin (Inspector of Taxes) (1957) 1 All ER 561

Fowler v Federal Commissioner of Taxation (2006) 06 ATC 2476

G P International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124

Government of India, Ministry of Finance (Revenue Division) v Taylor [1955] AC 491

458
Grainger and Son v Gough (Surveyor of Taxes) (1896) 3 TC 462

Hong Kong Inland Revenue Board of Review Decision Case No D8/00 (2001)







Hong Kong Inland Revenue Board of Review Decision Case No E63 (1995) 1 HKRC
80-360

Howland-Rose & Ors v Federal Commissioner of Taxation (2002) 49 ATR 206

ING Baring Securities (Hong Kong) Ltd (formerly known as Baring Securities (Hong
Kong) Ltd and presently known as Macquarie Securities Ltd) v Commissioner of Inland
Revenue [2008] 1 HKLRD 412

John Hood & Co v W E Magee (Surveyor of Taxes) (1918) 7 TC 327

Kerguelen Sealing and Whaling Co Ltd v Commissioner for Inland Revenue (1939)
10 SATC 363

Kim Eng Securities (Hong Kong) Ltd v Commissioner of Inland Revenue [2007] 2 HKLRD
117

Koitaki Para Rubber Estates Ltd v Federal Commissioner of Taxation (1941) 64 CLR 241

Kolotex Hosiery (Australia) Pty Ltd v Commissioner of Taxation (1975) 132 CLR 535

Kwong Mile Services Ltd v Commissioner of Inland Revenue [2004] 3 HKLRD 168

Lamesa Holdings BV v Federal Commissioner of Taxation (1997) 97 ATC 4229

Liquidator, Rhodesia Metals Ltd (in liq) v Taxes Commissioner (1940) 3 All ER 422

Malayan Shipping Company Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156

Max Factor & Co v Federal Commissioner of Taxation (1984) 84 ATC 4060

Michell v Federal Commissioner of Taxation (1931) 46 CLR 413

459
Mount Morgan Gold Mining Co Ltd v Commissioner of Income Tax (Queensland)
(1922-23) 33 CLR 76

Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183

National Westminster Bank, PLC v USA, 44 Fed Cl 120 (1999)

North Australian Pastoral Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 623

Orica case (ICI Australia Ltd v Federal Commissioner of Taxation (1996) 96 ATC 4680

Orion Caribbean Ltd (in vol liq) v Commissioner of Inland Revenue (1996) HKRC
90-077

Patcorp Investments Ltd & Ors v Federal Commissioner of Taxation (1976) 76 ATC 4225

Premier Automatic Ticket Issuers Ltd v Federal Commissioner of Taxation (1933) 50 CLR
268

Public Officer of the Studebaker Corporation of Australasia Ltd (as agent for the
Studebaker Corporation of America) v Commissioner of Taxation for New South Wales
(1921) 29 CLR 225

QRS 1 Aps & Others v Frandsen [1999] STC 616

Salisbury House Estate, Ltd v Fry (HM Inspector of Taxes) (1930) 15 TC 266

Scott v Commissioner of Taxation (1935) 35 SR(NSW) 215

Sherritt Gordon Mines (Federal Commissioner of Taxation v Sherritt Gordon Mines Ltd
(1977) 77 ATC 4365

Sinolink Overseas Co Ltd v Commissioner of Inland Revenue [1985] HKLR 431

Spotless Services Ltd & Anor v Federal Commissioner of Taxation (1993) 93 ATC 4397

State of South Australia & Anor v Commonwealth (1942) 65 CLR 373

State of Victoria & Anor v Commonwealth (1957) 99 CLR 575

Swedish Central Railway Co Ltd v Thompson [1925] AC 495

Tariff Reinsurances Ltd v Commissioner of Taxes (Vic) (1938) 59 CLR 194

The Egyptian Hotels Ltd v Mitchell (Surveyor of Taxes) (1914-5) 6 TC 542

The Hong Kong & Whampoa Dock Co Ltd (No 2) v Commissioner of Inland Revenue
[1960] HKLR 166

460
The Liverpool and London and Globe Insurance Co v Bennett (Surveyor of Taxes) (1913)
6 TC 327

The National Provident Institution v Brown and The Provident Mutual Life Assurance
Association v Ogston (1921) 8 TC 57

Thiel v Federal Commissioner of Taxation (1990) 90 ATC 4717

Thorpe Nominees Pty Ltd v Federal Commissioner of Taxation (1988) 88 ATC 4886

Todd v Egyptian Delta Land and Investment Co Ltd (1927-8) 14 TC 119

Union Corporation Ltd v Commissioner of Inland Revenue (1952-3) 34 TC 207

Unisys Corporation Inc v Federal Commissioner of Taxation (2002) 02 ATC 5146

Van den Berghs, Ltd v Clark (Inspector of Taxes) [1935] All ER 874

W P Keighery Pty Ltd v Federal Commissioner of Taxation (1957) 100 CLR 66

Walsh v Rother District Council [1978] 1 All ER 510

Wardley Investment Services (Hong Kong) Ltd v Commissioner of Inland Revenue (1993)
1 HKRC 90-068

Westfield Ltd v Federal Commissioner of Taxation (1991) 21 ATR 1398

Legislation and regulations

Australia

A New Tax System (Commonwealth-State Financial Arrangements) Act 1999 (Cth)

A New Tax System (Goods and Services Tax) Act 1999 (Cth)

A New Tax System (Luxury Car Tax) Act 1999 (Cth)

A New Tax System (Wine Equalisation Tax) Act 1999 (Cth)

Australian Constitution

Corporations Act 2001 (Cth)

Crimes (Taxation Offences) Act 1980 (Cth)

Customs Tariff Act 1995 (Cth)

Financial Transaction Reports Act 1988 (Cth)

461
Foreign Acquisitions and Takeovers Act 1975 (Cth)

Foreign Judgments Act 1991 (Cth)

Fringe Benefits Tax Assessment Act 1986 (Cth)

Income Tax and Social Services Contribution Assessment Act 1936-1956 (Cth)

Income Tax Assessment Act 1936 (Cth)

Income Tax Assessment Act 1997 (Cth)

Income Tax Laws Amendment (Royalties) Act 1976 (Cth)

International Tax Agreements Act 1953 (Cth)

New International Tax Arrangements (Foreign-Owned Branches and Other Measures) Act
2005 (Cth)

Privacy Act 1988 (Cth)

Taxation Laws Amendment Act (No 2) 1997 (Cth)

Tax Laws Amendment Act (No 4) 2000 (Cth)

Tax Laws Amendment (2004 Measure No 1) Act (Cth)

Tax Laws Amendment (2005 Measures No 1) Act 2005 (Cth)



Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006 (Cth)

Taxation (Unpaid Company Tax Promoters) Act 1982 (Cth)

Taxation (Unpaid Company Tax Vendors) Act 1982 (Cth)

Taxation (Unpaid Company Tax) Assessment Act 1982 (Cth)

Taxation Administration Act 1953 (Cth)

Hong Kong

Basic Law of the Hong Kong Special Administrative Region of the Peoples Republic of
China

Foreign Judgments (Reciprocal Enforcement) Ordinance (Cap 319)
462

Inland Revenue Ordinance 1947 (Cap 112)

Personal Data (Privacy) Ordinance (Cap 486)

Registration of Persons Ordinance (Cap 177)

Other jurisdictions

Income Tax Act (Cap 134) (Singapore)

Income tax Act 1967 (Malaysia)

Internal Revenue Code (26 USC) (United States)

Thirteenth Council Directive 86/560/EEC of 17 November 1986 on the Harmonization of
the Laws of the Member States Relating to Turnover Taxes Arrangements for the Refund
of Value Added Tax to Taxable Persons not Established in Community Territory [1986] OJ
L 326 (European Union)

Council Directive No 2006/112/EC of 28 November 2006 on the Common System of Value
Added Tax [2006] OJ L 347 (European Union)

Treaties

Agreement Between Australia and Switzerland for the Avoidance of Double Taxation with
respect to Taxes on Income (entered into force 13 February 1981)

Convention Between the Government of Australia and the Government of the United States
of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with respect to Taxes on Income (entered into force 31 October 1983)

Joint Declaration of the Government of the United Kingdom of Great Britain and Northern
Ireland and the Government of the Peoples Republic of China on the Question of Hong
Kong (entered into force 27 May 1985)

Agreement Between the Government of Australia and the Government of the Peoples
Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with respect to Taxes on Income (entered into force 28 December 1990)

Agreement Between the Government of Australia and the Government of New Zealand for
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to
Taxes on Income (entered into force 29 March 1995)

Protocol Amending the Convention Between the Government of Australia and the
Government of the United States of America for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to Taxes on Income (entered into force 12 May
2003)
463
Convention Between the Government of Australia and the Government of the United
Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and
the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains
(entered into force 17 December 2003)

Agreement Between the Hong Kong Special Administrative Region of the Peoples
Republic of China and the Kingdom of Belgium for the Avoidance of Double Taxation and
the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital (entered
into force 7 October 2004)

Agreement Between the Government of the Hong Kong Special Administrative Region of
the Peoples Republic of China and the Government of the Kingdom of Thailand for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes
on Income (entered into force 7 December 2005)

Arrangement Between the Mainland of China and the Hong Kong Special Administrative
Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
respect to Taxes on Income (entered into force 8 December 2006)

Protocol Amending the Agreement Between the Government of Australia and the
Government of New Zealand for the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with respect to Taxes on Income (entered into force 22 J anuary 2007)

Agreement between the Government of Australia and the Government of Antigua and
Barbuda on the Exchange of Information with respect to Taxes (signed on 30 J anuary
2007)

Agreement Between the Government of Australia and the Government of Bermuda [as
authorised by] the Government of the United Kingdom of Great Britain and Northern
Ireland on the Exchange of Information with respect to Taxes (entered into force
20 September 2007)

Agreement Between the Government of Australia and the Government of Finland for the
Avoidance of Double Taxation with respect to Taxes on Income and the Prevention of
Fiscal Evasion (entered into force 10 November 2007)

Second Protocol to Arrangement Between the Mainland of China and the Hong Kong
Special Administrative Region for the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with respect to Taxes on Income (signed on 30 J anuary 2008)

Agreement Between the Hong Kong Special Administrative Region of the Peoples
Republic of China and the Grand Duchy of Luxembourg for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on
Capital (entered into force 1 April 2008)

Agreement between the Government of Australia and the Government of the Kingdom of
the Netherlands in respect of the Netherlands Antilles for the Exchange of Information with
respect to Taxes (entered into force 4 April 2008)

464
Other Sources

Rulings

Australian Taxation Office, Goods and Service Tax Ruling GSTR 2000/31, Goods and
Services Tax: Supplies Connected with Australia

Australian Taxation Office, Taxation Ruling TR 97/11, Am I Carrying on a Business of
Primary Production?

Australian Taxation Office, Taxation Ruling TR97/19, Income Tax: Tax Implications of
Resumption of Chinese Sovereignty over Hong Kong

Australian Taxation Office, Taxation Ruling TR 2001/11, Income Tax: International
Transfer Pricing Operation of Australias Permanent Establishment Attribution Rules

Australian Taxation Office, Taxation Ruling TR 2001/13, Income Tax: Interpreting
Australias Double Tax Agreements

Australian Taxation Office, Taxation Ruling TR 2002/5, Income Tax: Permanent
Establishment - What is a Place at or through which [a] Person Carries on any Business
in the Definition of Permanent Establishment in Subsection 6(1) of the Income Tax
Assessment Act 1936?

Australian Taxation Office, Taxation Ruling TR 2002/9, Income Tax: Withholding from
Payments where Recipient Does not Quote ABN

Australian Taxation Office, Taxation Ruling TR 2004/15, Income Tax: Residence of
Companies not Incorporated in Australia Carrying on Business in Australia and Central
Management and Control

Australian Taxation Office, Taxation Ruling TR 2006/10, Income Tax, Fringe Benefits Tax
and Product Grants and Benefits: Public Rulings

Australian Taxation Office, Taxation Ruling TR 2006/11, Income Tax, Fringe Benefits Tax
and Product Grants and Benefits: Private Rulings

Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note
No 3 (revised), Apportionment of Expenses

No 10 (revised), The Charge to Salaries Tax

No 13 (revised), Profits Tax: Taxation of Interest Received

No 13A, Profits Tax: Deductibility of Interest Expenses

465
No 15 (revised), (A) Limitation of Loss Relief (Section 22B), (B) Leasing Arrangements
(Section 39E), (C) General Anti-Avoidance Provisions (Section 61), (D) General Anti-
Avoidance Provisions (Section 61A), (E) Loss Companies (Section 61B), (F) Ramsay
Principle, (G) Penalty on Tax Avoidance Cases, (H) Guidelines on Lease Financing, (I)
Advance Rulings

No 17 (revised), The Taxation of Persons Chargeable to Profits Tax on Behalf of Non-
Residents

No 21, Locality of Profits

No 28, Deductibility of Foreign Taxes

No 31, Advance Rulings

No 39, Profits Tax: Treatment of Electronic Commerce

No 43, Profits Tax: Profits Tax Exemption for Offshore Funds

Tax Determinations

Australian Taxation Office, Taxation Determination TD 2005/2, Income Tax: Does a
Resident of a Country with which Australia has a Tax Treaty, have a Permanent
Establishment Solely from the Sale of Trading Stock through the Internet Website Hosted
by an Australian Resident Internet Service Provider?

ATO Interpretative Decisions

Australian Taxation Office, ATO Interpretative Decision ATO ID 2004/602, Permanent
Establishment: Non-Resident Services Provided by Resident Beneficiary No Authority
to Bind Non-Resident

Taxpayer Alerts

Australian Taxation Office, Taxpayer Alert TA 2005/5, Use of an Outbound Offshore Re-
invoicing Arrangement to Avoid or Evade Australian Tax

Australian Taxation Office, Taxpayer Alert TA 2005/6, Use of an Inbound Offshore Re-
invoicing Arrangement to Avoid or Evade Australian Tax

466
Speeches

Costello, Peter, Challenges and Benefits of Globalisation (Address to the Sydney
Institute, 25 J uly 2001) Treasurer, Commonwealth
<http://www.treasurer.gov.au/DisplayDocs.aspx?doc=speeches/2001/003.htm&pageID=00
5&min=phc&Year=2001&DocType=1>at 2 May 2008

DAscenzo Michael, International Profit Shifting The ATO Perspective (Speech
delivered at the Corporate Tax Summit, 20 J une 1989) Australian Taxation Office
DAscenzo Michael, Maintaining Integrity and Confidence in the Tax System: Managing
Risk. Make the Right Moves (Speech delivered at the 33
rd
Queensland State Convention
of the Taxation Institute of Australia, 4 J une 2004) Australian Taxation Office

Tang, Henry, The 2007-08 Budget (Speech by the Financial Secretary moving the
Second Reading of the Appropriation Bill 2007, 28 February 2007) Government of the
Hong Kong Special Administrative Region of the Peoples Republic of China
<http://www.budget.gov.hk/2007/eng/pdf/ebudget.pdf>at 2 May 2008

Press/Media Releases

Australian Taxation Office, Tax Office at Forefront of E-commerce Discussions, Media
Release, 1999/86 (10 December 1999)

Australian Taxation Office, Tax Office Visits Melbourne Scheme Promoters, Media
Release, 2002/32 (22 May 2002)

Australian Taxation Office, Tax Office Acts on Offshore Schemes, Media Release, No
2005/35 (10 J une 2005)

Australian Taxation Office, Tax Office Announces Offshore Voluntary Disclosure
Initiative, Media Release, No 2007/34 (18 J uly 2007)

Australian Taxation Office, Tax Commissioners Battle Against Tax Evasion, Media
Release, No 2008/08 (26 February 2008).

Australian Taxation Office, Tax Commissioner Warns Against Hiding Income or Assets
Offshore, Media Release, No 2008/10 (13 March 2008)

Commonwealth, Minister for Revenue and the Assistant Treasurer, Public to Have Say on
Australian Tax Treaty Negotiations, Press Release, No C101/03 (6 November 2003)

Commonwealth, Treasurer, Alienation of Property and Australias Double Tax
Agreements, Press Release, No 39 (27 April 1998)

Commonwealth, Treasurer, International Tax Reforms, Press Release, No 044/05 (10 May
2005)

467
European Union, Council of the European Union, Council Adopts New Rules for VAT on
Services, with Taxation in the Country of Consumption and Reduced Compliance Costs
for Businesses (Brussels, Presse 6359/08) (12 February 2008)

Hong Kong, Government Information Centre, HK to Become a Major Regional Hub of
Electronic Commerce, Press Release (16 J anuary 2001)

Hong Kong, Government Information Centre, FS Speaks on Public Consultation on Tax
Reform, Press Release (5 December 2006)

Hong Kong, Government Information Centre, Budget Speech by the Financial Secretary,
Press Release (6 March 2002)

Singapore, Ministry of Finance, Budget 2007: Ready for the Future, Ready for the World,
Press Release (15 February 2007)

Other

United Kingdom, HM Revenue & Customs, Statement of Practice SP1/90, Company
Residence

468
APPENDIX ONE INCOME OVERVIEW
SOURCE CLASS CATEGORY

This chart is not comprehensive, but is meant to provide a synopsis of the broad understanding of:
sources of income;
classes of income; and
categories of income.
Source of income

The concept of source of income for income tax purposes has two primary meanings: (A)
the character of income; and (B) the geographic origin or location of income.
1
The
character of income refers to the classification of income according to the nature of the
transaction, operation or activity that generates the moneys received (for example, income
from business, income from property, income from personal exertion). The source of income
in a territorial sense means the geographic location where an item of income is derived,
including classifying into domestic or foreign income. Characterisation of receipts is
necessary as source rules vary depending on the type of income involved.

In Australia and Hong Kong, the decisions of the courts on the meaning of source have been
crucial in defining the concept of source of income for tax purposes.
2

1
See Commissioner of Taxation (New South Wales) v Meeks (Public Officer of the Sulphide
Corporation Ltd) (1915) 19 CLR 568, 579, ING Baring Securities (Hong Kong) Ltd (formerly known as
Baring Securities (Hong Kong) Ltd and presently known as Macquarie Securities Ltd) v Commissioner
of Inland Revenue [2008] 1 HKLRD 412, [48] and Roger Hamilton, International Aspects of Australian
Income Taxation in Richard E Krever and Gretchen Kewley (ed), Australian Taxation: Principles and
Practice (1987) 276 on the meaning of source.
2
Australias tax rules on the question of source are a mixture of general law and statutory provisions. In
Hong Kong, certain amounts are assessable to profits tax because they are deemed to be receipts arising
in or derived from a business carried on in Hong Kong. In both cases, the source of business profits is
not defined, but determined by the rules developed by the courts. This thesis concentrates on the
meaning of source as derived, primarily, from decisions of courts, given that it focuses on a comparison
between Australia and Hong Kong.
Geographic origin or
location of income
Earned Unearned
Domestic Foreign
Income from
personal services
Income fromcarrying
on a business
Income from
immovable property
Income from
investments
eg, employment
income
eg, profits derived
frommanufacturing
and trading
eg, income derived
fromdirect use or
letting of mines
eg, dividends,
interest, capital
gains
Character of income
Meaning B the geographic location where an
itemof income is derived
Meaning A characterisation of income
according to the nature of the transaction,
operation or activity that generates the
moneys received
Particular or specific types of income
generated by the taxpayers activity
Source of
income
469
Class of income

Class refers to the classification of income with respect to the taxing rights of the
source jurisdiction under a double tax treaty (DTT). The OECD has classified
income into three classes:
income that may be taxed without any limitation in the state of source or location;
income that may be subjected to limited taxation in the state of source; and
income that may not be taxed in the state of source or location.
3

A DTT contains its own source rules for various types of income, profits or gains,
regardless of the statutory tax rules or general law rules of each contracting state.
Normally source is used in DTTs in a purely territorial sense meaning the place where
the income originates,
4
either by specifying that the geographic source of certain items
of income is in one contracting state or by specifying the items of income which are
taxable in the other contracting state. Each item of income has to be characterised as
falling within a particular or specific type for source purposes so as to identify the
class it belongs to. Classification of income is necessary to determine a jurisdictions
right to tax an item of income.

Income that may be taxed in the source jurisdiction without any limitation includes:
income from immovable property situated in the source jurisdiction;
income related to the performance of entertainers and athletes.

Income that may be subjected to limited taxation in the source jurisdiction includes:
passive (investment) income such as interest and dividends.

Income that may not be taxed in the source jurisdiction includes:
profits from the operation of ships or aircraft in international traffic.
5

3
See OECD, Model Tax Convention on Income and on Capital (condensed version, 2005) 12-13 on the
different classes of income and the respective rights to tax of the state of source or location and of the
state of residence.
4
See John F Avery Jones, Does the UK Give Credit for Tax on a Permanent Establishment Abroad?
(1994) 12 APTIRC Bulletin 221.
5
These profits are taxable only in the residence jurisdiction mainly because of the difficulties associated
with determining the source of such profits. See Australian Taxation Office, Taxation Ruling TR
2001/13, Income Tax: Interpreting Australias Double Tax Agreements [14].
Class of
income
Income that may be
taxed without any
limitation in the source
jurisdiction
Income that may be
subjected to limited
taxation in the source
jurisdiction
Income that may not be
taxed in the source
jurisdiction
eg, active (business)
income attributable to
a permanent PE in the
source jurisdiction
eg, passive (investment)
income not effectively
connected with a PE in
the source jurisdiction
eg, business profits
not attributable to a
PE in the source
jurisdiction
470
Category of income

Category refers to the identification of income based on the tax treatment of it by a jurisdiction.

The Australian income tax law has recognised three categories of income:
assessable income;
exempt income; and
non-assessable non-exempt (NANE) income.
6

Categorisation of income is necessary to deal with the issue of what amount of income is
taxable under domestic law, even if the source of income has been determined and the state
can assert its jurisdiction to tax a person.

For example, royalty income not earned through a PE is generally subject to withholding tax
on a gross basis in the source jurisdiction.
7
In Australia, royalty withholding tax is a final tax
and the royalty income is NANE by virtue of s 128D of the Income Tax Assessment Act 1936
(Cth) (ITAA 1936). On the other hand, royalties are assessable income and taxed as
business profits on a net basis by assessment under the ordinary provisions of the ITAA 1936
and Income Tax Assessment Act 1997 if attributable to a PE in Australia.
8

Hong Kong adopts an (operationally separated) schedular system of taxation. Only three
income-type taxes are charged under the schedules being salary, property and profits tax.
Income which does not fall within a taxable source (for example, dividends and foreign
income) in one of the schedules is tax exempt. Thus, there are two categories of income.
Earnings and profits are either chargeable to tax or tax exempt.

In principle, a Hong Kong business will be chargeable to profits tax under s 14 of the Inland
Revenue Ordinance 1947 in respect of profits arising in or derived from that business from
Hong Kong unless specifically exempt (for example, s 26A(1A) which exempts from profits
tax certain profits derived by specified investment schemes such as mutual funds and unit
trusts).

6
See Australian Taxation Office, Tax Facts: Non-Assessable Non-Exempt Income (2003) on the
categories of income.
7
Under a gross basis, no deductions are allowed and the gross amount is subject to withholding tax.
The withholding tax rate for royalty payment is 30 per cent, but may be reduced if the non-resident is a
resident of a jurisdiction that has a DTT with Australia.
8
Under a net basis, deductions are allowed and the taxpayer is assessed on the net income. The
company tax rate is 30 per cent.
Assessable
Exempt
Non-assessable
non-exempt
Ordinary Statutory
Category
of income
eg, income accepted by
the courts as income
for tax purposes
eg, capital
gains
eg, income earned in
overseas employment
under s 23AG of the
ITAA 1936
eg, amounts paid out of
attributed income under
s 23AI of the ITAA 1936
471
A note on Australian income tax

Australian income tax is levied upon a taxpayers taxable income, calculated by subtracting a
taxpayers allowable deductions from assessable income
9
which includes ordinary and
statutory income, but does not include exempt income or NANE income.
10
That is, an amount
of ordinary income or statutory income can have only one status (assessable income, exempt
income or NANE income) in the hands of a particular entity.
11
In general, assessable income
is income derived by an entity, eg, salary and wages, business profits, bank interest and
dividend income. Thus, assessable income has to be calculated first in order to calculate
taxable income.

Ordinary income is income according to ordinary concepts,
12
as developed by the courts.

Statutory income is income that is not ordinary income, but which becomes assessable income
because of some specific provision in the legislation that makes it income.
13
The statutory
income provision will prevail where income is assessable under both an ordinary income
provision and a statutory income provision.
14

Income is made exempt from income tax by a provision of law.
15
Some ordinary and some
statutory income can be treated as exempt income. If an amount is exempt income, it is not
assessable income and is, therefore, tax-free and is not included in the tax return as income.
16

Losses or outgoings incurred in deriving exempt income are not allowable as general
deductions.
17
However, exempt income may reduce the deduction allowable for a tax loss.
18

Exempt income is also taken into account in working out the income tax on other non-exempt
income, eg, exempt income of an individual from an approved overseas project
19
and overseas
employment income
20
is added to gross-up assessable income so that proportional tax rates
will apply at the higher grossed-up level.

Income is made non-assessable non-exempt by a provision of law.
21
Some ordinary and some
statutory income can become NANE income. Losses or outgoings incurred in deriving NANE
income are not allowable as general deductions.
22
Unlike exempt income, NANE income is
ignored for the purposes of working out the taxable income and the taxpayers available tax
losses. That is, NANE income does not enter into the calculation of a tax loss and does not
affect the deductibility of a prior year tax loss. Thus, NANE income is effectively treated as if
it were never income in the first place.
23

9
Income Tax Assessment Act 1997 (Cth) s 4-15.
10
11
Income Tax Assessment Act 1997 (Cth) s 6-1(5).
12
13
14
15
16
17
Income Tax Assessment Act 1997 (Cth) s 8-1(2)(c).
18
19
Income Tax Assessment Act 1936 (Cth) s 23AF.
20
Income Tax Assessment Act 1936 (Cth) s 23AG.
21
See subdivision 11-B of the Income Tax Assessment Act 1997 (Cth) for a list of non-assessable non-
exempt (NANE) income provisions.
22
Income Tax Assessment Act 1997 (Cth) s 8-1(2)(c).
23
See Australian Taxation Office, Tax Facts: Non-Assessable Non-Exempt Income, above n 6, on
NANE income measure.

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A comparative study of the taxation of business profits

especially online profits

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