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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 people's republic of china.
A comparative study of the taxation of business profits - especially 'online' profits - in Australia and the Hong Kong Special Administrative Region of the people's republic of china.
A comparative study of the taxation of business profits - especially 'online' profits - in Australia and the Hong Kong Special Administrative Region of the people's republic of china.
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 4.1.3 Structure of the chapter 89 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 4.3.4 Conclusion 144 CHAPTER 5: DETERMINING THE SOURCE OF PROFITS 146 5.1 Introduction 146 5.1.1 Purpose and role of chapter 146 5.1.2 Overview 147 5.1.3 Structure of the chapter 149 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 Introduction 226 6.1.1 Purpose and role of chapter 227 6.1.2 Overview 227 6.1.3 Structure of the chapter 229 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 Introduction 264 7.1.1 Overview 265 7.1.2 Structure of the chapter 267 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 7.2.5 Conclusion 304 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 7.3.5 Conclusion 339 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 7.4.6 Conclusion 371 CHAPTER 8: SUMMARY AND CONCLUSION 374 8.1 Introduction 374 8.1.1 Research questions 374 8.1.2 Overview 376 8.1.3 Purpose and role of chapter 377 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)
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 Prevention of Fiscal Evasion with respect to Taxes on Income 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 Prevention of Fiscal Evasion with respect to Taxes on Income 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
M2 money supply definition 2
M3 money supply definition 3
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) <http://www.oecd.org/dataoecd/46/25/1923312.pdf>at 1 May 2008; OECD, Forum on Strategic Management, Tax Administration Aspects of Electronic Commerce: Responding to the Challenges and Opportunities (February 2001) <http://www.oecd.org/dataoecd/46/45/1923280.pdf>at 1 May 2008; 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) <http://www.oecd.org/dataoecd/56/36/32997184.pdf>at 1 May 2008; 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) <http://www.oecd.org/dataoecd/55/14/37861293.pdf>at 1 May 2008. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of 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 Inland Revenue Ordinance 1947 s 14. 33 Inland Revenue Ordinance 1947 s 5. 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 Inland Revenue Ordinance 1947 s 14. 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 Income Tax Assessment Act 1997 (Cth) ss 6-5(3), 6-10(5). 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Economic Commerce, above n 12, 160. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Economic Commerce, above n 12, 159. 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 Soos, Taxation at the Source and Withholding in England, 1512 to 1640, above n 3, 90. 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 Soos, Taxation at the Source and Withholding in England, 1512 to 1640, above n 3, 49. 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 Chris Edwards and Veronique de Rugy, International Tax Competition: A 21 st -Century Restraint on 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 Tax Notes International 1455, 1472. 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
4.1.3 Structure of the chapter
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 Inland Revenue Ordinance 1947 s 8. 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 Inland Revenue Ordinance 1947 s 5. 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 Inland Revenue Ordinance 1947 s 14. 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 Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (entered into 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 Australia-China DTT art 3. 92 Australia-China DTT art 2. 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 Fayle, above n 115, 675. 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 Bulletin for International Fiscal Documentation 522, 523. 125 See footnote 40, Chapter 2, on the introduction of uniform income tax legislation in Australia. 126 Fayle, above n 115, 676. 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 Fayle, above n 115, 666. 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 Income Tax Assessment Act 1997 (Cth) ss 6-5(3), 6-10(5). 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.
5.1.1 Purpose and role of chapter
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 5.1.3 Structure of the chapter
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 Territorial Source Principle of Taxation (revised 15 August 2006) <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 OECD, Model Tax Convention on Income and on Capital (condensed version, 2005) 113. 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; 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 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 Commissioner of Taxation (New South Wales) v Hillsdon Watts Ltd (1936-7) 57 CLR 36. 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 International 1109, 1125. 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 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. 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 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]. 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 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, [139]. 146 See Hong Kong, Inland Revenue Department, DIPN 13, above n 65, [2]. 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 Commissioner of Taxation (New South Wales) v Hillsdon Watts Ltd (1936-37) 57 CLR 36. 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 Commissioner of Taxation (New South Wales) v Hillsdon Watts Ltd (1936-37) 57 CLR 36. 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 See Hong Kong, Inland Revenue Department, DIPN 21, above n 74, [9]. 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 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. 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 VanderWolk, Hong Kong: Source of Income and the 1997 Hand-over, above n 230, 44. 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 VanderWolk, Hong Kong: Source of Income and the 1997 Hand-over, above n 230, 43. 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 6.1.1 Purpose and role of chapter
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
6.1.3 Structure of the chapter
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] <http://www.oecd.org/dataoecd/29/25/31663114.pdf>at 1 May 2008. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of 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 Australian Taxation Office, Tax and the Internet, vol 1, above n 38, [7.3.3]. 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 Australian Taxation Office, Tax and the Internet, vol 1, above n 38, [3.1.1]. 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 OECD, Model Tax Convention on Income and on Capital, above n 65, 186. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of 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 Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (entered into 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 Australian Taxation Office, Tax and the Internet, vol 1, above n 38, [7.2.5]. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Electronic Commerce (1997) 25 Intertax 148, 159. 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.
7.1.2 Structure of the chapter
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 OECD, Model Tax Convention on Income and on Capital (condensed version, 2005) 173. 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] <http://www.oecd.org/dataoecd/51/33/34422641.pdf>at 1 May 2008. 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 Income Tax Assessment Act 1997 (Cth) ss 6-5(3), 6-10(5). 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 OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework Conditions (2001) 10. 56 Pinto, above n 1, 219. 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 International 261, 262. 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 OECD, Model Tax Convention on Income and on Capital, above n 27, 113. 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 Bulletin for International Fiscal Documentation 476, 482. 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 Pinto, above n 1, 226. 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 See Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 28, 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 See Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 39, 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 Pinto, above n 1, 228. 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 Pinto, above n 1, 228. 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 Pinto, above n 1, 222. 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 electronic commerce. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Economic Commerce, above n 2, 159. 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 Income Tax Assessment Act 1997 (Cth) ss 6-5(2), 6-10(4). 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 International Fiscal Documentation 405, 405. 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 OECD, Model Tax Convention on Income and on Capital, above n 27, 82. 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 OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework 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 OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework 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 OECD, Taxation and Electronic Commerce: Implementing the Ottawa Taxation Framework 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 Chris Edwards and Veronique de Rugy, International Tax Competition: A 21 st -Century Restraint on 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] <http://www.oecd.org/dataoecd/56/36/32997184.pdf>at 1 May 2008. 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 A New Tax System (Goods and Services Tax) Act 1999 (Cth) s 13-15. 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 A New Tax System (Goods and Services Tax) Act 1999 (Cth) s 9-25. 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 VAT Directive art 43. 272 VAT Directive art 44. 273 VAT Directive art 45. 274 VAT Directive art 56. 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 International Fiscal Documentation 99, 103. 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 Tax Notes International 443, 443. 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 electronic commerce. 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.
8.1.3 Purpose and role of chapter
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 OECD Model Tax Convention on Income and on Capital art 10. 7 OECD Model Tax Convention on Income and on Capital art 21. 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 United States, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Electronic Commerce (1997) 25 Intertax 148, 166. 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 International 741, 742. 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] <http://www.oecd.org/dataoecd/17/59/38055311.pdf>at 1 May 2008. 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?
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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 J , 27 April 2007) <http://legalref.judiciary.gov.hk/doc/judg/word/vetted/other/en/2006/CACV000057_2006. doc>at 5 May 2008 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 D152/01 (2002)
Hong Kong Inland Revenue Board of Review Decision Case No D172/01 (2002)
Hong Kong Inland Revenue Board of Review Decision Case No D72/03 (2003)
Hong Kong Inland Revenue Board of Review Decision Case No D79/03 (2003)
Hong Kong Inland Revenue Board of Review Decision Case No D36/06 (2006)
Hong Kong Inland Revenue Board of Review Decision Case No D43/06 (2006)
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 (2006 Measures No 1) Act 2006 (Cth)
Tax Laws Amendment (2007 Measures No 4) Act 2007 (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
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
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 10 (revised), The Charge to Salaries Tax
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 13 (revised), Profits Tax: Taxation of Interest Received
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 13A, Profits Tax: Deductibility of Interest Expenses
465 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
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
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 21, Locality of Profits
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 28, Deductibility of Foreign Taxes
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 31, Advance Rulings
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note No 39, Profits Tax: Treatment of Electronic Commerce
Hong Kong, Inland Revenue Department, Departmental Interpretation and Practice Note 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 <http://www.ato.gov.au/print.asp?doc=/content/75026.htm>at 2 May 2008 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 <http://www.ato.gov.au/print.asp?doc=/content/45422.htm>at 2 May 2008
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 Income Tax Assessment Act 1997 (Cth) s 6-15. 11 Income Tax Assessment Act 1997 (Cth) s 6-1(5). 12 Income Tax Assessment Act 1997 (Cth) s 6-5. 13 Income Tax Assessment Act 1997 (Cth) s 6-10. 14 Income Tax Assessment Act 1997 (Cth) s 6-25(2). 15 Income Tax Assessment Act 1997 (Cth) s 6-20. 16 Income Tax Assessment Act 1997 (Cth) s 6-15(2). 17 Income Tax Assessment Act 1997 (Cth) s 8-1(2)(c). 18 Income Tax Assessment Act 1997 (Cth) s 36-10(3). 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.