Issue 89 – 13 February 2009


The theme for this month’s Newsletter is how a foreign company can find itself subject to tax in a country other than its place of tax residence. Lara has written an article on e-commerce and the potential for servers to create a taxable presence where they are located. In fact, one of our clients has developed the most fascinating software program for the art industry which we would be happy to explain further to our readers, but here the permanent establishment question was a key component to our advice. The second article has been based on material submitted by our colleagues Parul Jain and Bijal Ajinkya of Nisith Desai Associates in India, and describes the now infamous Vodafone case and how an Indian tax liability has arisen from an externally based transaction. The third article has been written by our good friend Kishore Sakhrani of ICS Trust in Hong Kong and describes how to avoid the problems of doing business in Mainland China by using a Hong Kong holding company, and the benefits this may provide to EU investors through the new Belgian/Hong Kong double tax treaty.

In today’s dire economic climate, it is more important than ever to avoid unwanted tax liabilities, particularly those in a country other than where you or your company are tax resident. It is true of course that we don’t want to pay taxes to our own government and find that these taxes are wasted on unnecessary expenditure amid an absence of regulatory controls. How much more aggravating is it to pay monies to foreign governments from whose countries we derive no commercial or social benefit. This has been predominately my focus for the past 35 years, whether this be assisting multinational corporations, entrepreneurially led companies or individuals receiving employment or other professional income.

Roy Saunders

Where E-commerce becomes PE Commerce

The first ever on-line transaction was only back in 1994. The customer ordered a single CD.  Today, e-commerce has exploded across the developed world, and with it entire industries have been remodelled – just witness the seismic effect that iTunes has had on both record labels and entertainment retailers on the high street.  This article considers some of the international tax issues relevant to ‘e-tailers’ and in particular, whether a web server can create a permanent establishment in the country in which it is located.

Under generally accepted principles of international taxation, the profits of a company will be taxable not only in the country in which that company is tax resident, but also in the country within which that company trades through a permanent establishment (‘PE’). Whereas it is relatively straightforward to ascertain whether a PE has been created if the business in question is a traditional trading entity, it is not so easy for tax authorities to establish where the tax nexus of a cyber company lies. 

The OECD defines the term “permanent establishment” as “a fixed place of business through which the business of an enterprise is wholly or partly carried on”.  Whether these conditions are met in e-commerce operations needs to be examined on a case-by-case basis, and issues such as whether the company owns and operates the server on which its website is stored and used, or whether this is leased from an Internet Service Provider, and the independent nature of such Internet Service Provider, will be relevant in determining whether a PE of the business exists in the country in which the server is located.

Another key issue is the nature of the operations carried on through the server in a country.  No PE will exist where these operations are preparatory or auxiliary in nature to the business of the company.  An example of such an activity would be the non-solicitation of orders but merely demonstrating the application of a particular product on a website – a server located in a country merely to demonstrate products should not create a taxable presence.  After all, transactions over the internet must have at their heart a contract, and for a legally binding contract to exist there must be three elements: offer, acceptance and consideration, and without these constituent parts a contract cannot exist.  It is therefore important to ask the question as to where the component parts actually take place i.e. where is the offer and where is the acceptance?

However, countries take different views as to whether a server can itself constitute a PE.  The view taken by many OECD Member States is that a server, as distinct from mere websites (which cannot fulfil the geographical situs condition) could constitute a PE where the equipment is in fact fixed, i.e. it is located at a specific location for a sufficient duration of time.  The UK does not concur with other OECD Member States in this respect and takes the view that a server cannot constitute a PE of a business that is conducting e-commerce through a website on the server.  This is the case regardless of whether the server is owned, rented or otherwise at the disposal of the business.  Ireland holds a similar view.

In the US, a non-resident alien or a foreign corporation will be taxable at the graduated US tax rate on its net income that is “effectively connected” with its US trade or business, and it is therefore necessary to consider whether any e-commerce sales give rise to such income.  Effectively connected income includes income derived from the sale or exchange of inventory that takes place outside of the US if it is attributable to an office or other fixed place of business within the US.  That place of business must be a material factor in the production of sales income, and activities must be regularly carried on at that place of business for that purpose. However, if the fixed place of business does not have authority to negotiate and conclude contracts in the name of the foreign entity, then foreign sales income may not be effectively connected to the fixed place of business.  In short, if the foreign company does not have a base of operations in the US, then it would be difficult to attribute any sales or income to be effectively connected with a US trade or business.

Double tax treaty arrangements provide a limited degree of certainty in this matter, provided that the company in question can benefit from being resident in a country with which the US has an applicable double tax treaty, and whose provisions are relevant to that entity. If a double tax treaty exists and is relevant, then the company itself must have a PE in the US before it is subject to US tax.

A typical US treaty excludes from the term PE ‘the use of facilities or maintaining a stock of goods or merchandise solely for the purpose of storage, display or delivery of the goods or merchandise; maintaining a stock of goods solely for the purpose of processing by another enterprise; or maintaining a fixed place of business solely to carry out any other activity of a ‘preparatory or auxiliary’ character.’  Whether the company in question (if located in a tax treaty jurisdiction) has a US PE as a result of sales activities generated by or through the US primarily depends upon whether the US based server hosts web pages on which contractual arrangements involving both offer and acceptance are conducted.

IFS is currently involved in structuring several clients’ international e-commerce business where we need to consider all the above issues.  However, key to all client matters is the workability of the arrangements from a commercial viewpoint.  Ultimately, if it is the case that the server on which a company’s sales software is located must be in the US or another high tax jurisdiction for bandwith or other technical reasons, or if it is the case that a base of operations is essential in such a jurisdiction, the business will need to accept a certain tax exposure therein, and we will then be tasked with finding ways to mitigate such exposure.

The Vodafone Case

The Supreme Court of India recently added to the woes of Vodafone in another twist to one of the most controversial tax litigations in recent times. In this case, a Cayman Islands company HTIL owned by the Vodafone Group transferred shares that it held in another Cayman Islands company CGP Investments to Vodafone International Holdings BV for a consideration of approximately US$12 billion. CGP Investments held a stake in a series of Mauritian and Indian companies which cumulatively held approximately 67% in Vodafone Essar Ltd, an Indian company. Despite the transaction being between a Cayman Island holding company and a Dutch holding company, and despite the fact that the shares actually being transferred were also a Cayman Island company, the Indian Revenue Authorities assessed the vendor company HTIL for failure to withhold Indian tax at source in respect of the sale, basically stating that the gain made was an Indian source capital gain. Moreover, the notices were levied on Vodafone Essar Ltd as the representative of the Vodafone Group.

Although an application was made to challenge the validity of these notices, it appears from various media reports that the Supreme Court is unlikely to intervene to dismiss the Special Leave Petition filed by Vodafone. In fact, the court has made five observations on the merits of the case, although it is yet to be determined if Vodafone is liable to pay the relevant tax:

1. Vodafone had approached the Foreign Investment Promotion Board (‘FIPB’) before effecting the transfer of shares of the Cayman Islands entity. Therefore it was within the jurisdiction of the Revenue to proceed against Vodafone and the Notice served was valid;

2. The transaction amounted to an indirect transfer of a controlling interest in Vodafone Essar Ltd, an Indian company, and hence an indirect transfer of capital asset situated in India;

3. The transaction created a ‘real link’ between India and Vodafone, so as to bring the consideration to tax in line with the ‘Effects Doctrine’ as understood in USA;

4. The agreement entered into between Vodafone and the vendor was not furnished before the revenue authorities or the Court. The Court further observed that the case involved numerous questions arising out of disputed facts, which cannot be ascertained in absence of the abovementioned agreement. Therefore the Court held that Writ Petition cannot be maintainable under Article 226 of the Constitution of India;

5. The writ petition to impugn the Notice was not maintainable when an alternative statutory remedy was available to Vodafone.

Clearly the issue as to whether the assessment to withholding tax is correct has not yet been settled before the Indian Courts. Were the shares in CGP Investments Ltd effectively an Indian situs capital asset? Or if CGP Investments Ltd had sold any of the shares in the Mauritian companies, would these have been a capital asset with its source in India? No other country, to my knowledge, has been successful in extending its tax legislation to the sale of shares in a non-resident company, unless specific legislation exists which deem the sale of the shares to a local source; this is normally only where real estate in the relevant country is owned by a foreign company, and the shares of that company are sold.

But for example, the Lamesa Holdings BV v FCTcase in Australia denied the application of this real estate rule higher up the chain where it was the shares of a holding company that were sold, this holding company in turn holding shares in a real estate owning company. It is true that a double tax treaty was in place in the Lamesa case which interpreted the definition of real property and prevented this applying to shares of a non-resident holding company with an indirect interest in real property.  In the Vodafone case, the sale of shares of CGP Investments Ltd is certainly more than one step removed from any Indian source capital asset. In any event, the international tax world has been somewhat taken aback by this extraordinary case.

IFS would like to thank Parul Jain and Bijal Ajinkya of Nisith Desai Associates for the above article. Should you require any further information, please contact either Parul at or Bijal at

Investing Into China

When  investing in Mainland China through a Chinese subsidiary company, the immediate tax considerations are how to extract dividend income in a tax efficient manner, how to reduce local Chinese corporate taxation through financing techniques, and how to avoid capital gains tax on the ultimate disposal of the Chinese company.  All of these concerns, for European Union investors, can be addressed by using a Hong Kong local holding company owned by a Belgian ultimate holding company for the EU investor, and benefiting from the new Belgium-Hong Kong Double Tax Agreement (DTA). With no limitation of benefits clause, the DTA can be used by residents of all EU and indeed non-EU countries.

Prior to the DTA, dividends paid to a Belgian parent by a Hong Kong subsidiary were subject to Belgian tax at the rate of 25%.  Under the DTA, the tax rate on such dividends is reduced to nil, provided the parent owns more than 25% of shares in the Hong Kong subsidiary, and has held such ownership for 12 months or more.

As regards interest payments, Hong Kong does not impose withholding tax on any interest paid by the subsidiary to the parent in Belgium, and if relevant loans are made to Chinese subsidiaries, this can effectively reduce the direct corporate tax rate in China.  And finally, royalty payments made by the Hong Kong subsidiary to the parent are subject to a withholding tax under the DTA of 5%, compared to pre-agreement rates as high as 17.5%; again, licensing IP rights into a Chinese subsidiary from a Hong Kong company may be very tax advantageous.

These favorable tax rates enhance the inherent attractiveness of doing business through a Hong Kong holding company.  Hong Kong has no capital gains tax so an eventual sale of a Chinese subsidiary company will be tax exempt.  No dividend withholding taxes are payable, and its system of territorial taxation exempts from tax all non-Hong Kong-sourced income (including income from Mainland China).  Even where profits are deemed to be Hong Kong-sourced, the tax rate is a relatively favorable 16.5%.

The DTA can work in conjunction with a similar agreement signed between Hong Kong and Mainland China, to create favorable conditions for EU investors using Hong Kong as an entry/exit point to China.

Consider a situation where a Chinese subsidiary pays dividends to say a Belgian parent owned by an EU investor.  If payment is made directly from China to Belgium, it will first be subject to China’s unified income tax at a rate of 25%, and then to Chinese withholding tax at a rate of 10% (under the terms of Belgium’s DTA with Mainland China, the dividends received would not be subject to Belgian corporate income tax, assuming the parent owns shares in the subsidiary).

By contrast, if payment is made first to a Hong Kong subsidiary, the dividends will still be subject to the unified income tax rate of 25%, but the Chinese withholding tax rate would be lowered to 5%, thanks to the provisions of the Mainland China-Hong Kong DTA.  The provisions of the Belgium-Hong Kong DTA then take over; as we have seen, as long as the Belgian parent has owned 25% or more of the Hong Kong subsidiary for a year or more, the tax rate on the dividends received from Hong Kong to Belgium will be nil.  Simply put, the benefit in respect of just dividend payments is 50% tax saving on the withholding tax that would otherwise apply.

But more importantly, the legal system of a Hong Kong company is based on UK law, so this is familiar territory for EU investors. Joint venture participations with Chinese and other parties for investments into China, a very common requirement, are easily effected in a flexible system that for example allows preference participations or pre-emption arrangements to reflect the requirements of shareholders.  With a Hong Kong holding company, it is relatively easy to add or change shareholders, to obtain debt financing or to totally dispose of one’s Chinese investment, whereas with a Chinese subsidiary, all of these are more difficult, more time consuming and likely subject to additional Chinese taxes.

IFS would like to thank Kishore Sakhrani for the above article. Kishore is a director of ICS Trust (Asia) Ltd, a Hong Kong based trust company that provides a range of services to North American and European companies looking to do business in Asia. Their website is