e-Commerce & Tax – The Locality Factor

The recent dilemma of the Inland Revenue Services’ attempt to tax both the Duchess of Cambridge and their royal baby highlights how even royals cannot escape the need for good tax planning.

In the case of Commissioner of Inland Revenue V. Li & Fung (Trading) Ltd [2011] HKCFI 261; HCIA 3/2010 (18 April 2011), the Courts found in favour of the Company, a multi-national corporation (“MNC”), where it affirmed the principle that the gist of the tax charging legislation is that only “… profits derived from or in Hong Kong are subject to tax …” under s. 14 of the Inland Revenue Ordinance.

This ruling had resulted in the Inland Revenue Department’s revision of their internal guidelines for the assessment of taxes and have specific implications on e-commerce.


Over the past 10 years, many MNCs maintain their headquarters running administrative and/or financial functions in Hong Kong, but with business operation carried out largely in the rest of the Asia Pacific.

Those business revenues are booked in the name of their Hong Kong headquarters, and consolidated through banks in Hong Kong.

In the Li & Fung case, the tax authority sought to charge tax on 100 percent of the profits on the grounds that such revenue had been generated in Hong Kong, reasoning that the profits had been generated through “a commission agent” of the Company.

This assertion was however strongly resisted by the Company by reason that those profits were not “… (wholly) derived from or in Hong Kong …” – thus set the stage for the discussion what ought to be considered as ‘profits generated within the jurisdiction’.

The Decision

In a nutshell, the IRD’s claim failed. The Courts agreed with the Company that as foreign clients of the Company were handled by “foreign entities” with specified contractual obligations, even though the eventual profits had been booked under the name of their Hong Kong headquarters, such income generated, under this case’s specific circumstances, was nonetheless deemed to be “foreign”.

As a result, said foreign income was NOT taxable. It was therefore emphasised that the Company “only had to pay tax on income specifically generated in Hong Kong”

IRD’s Dissent: The Brain Factor

It was argued by the IRD that the use of a ‘brain’ analogy or the place of administration of the business as criteria for ascertaining the geographical source of profits is plainly inconsistent with the decisions in Commissioner of Income Tax, Bombay Presidency and Aden v Chunilal B Mehta of Bombay [1938] LR 65 IA 332 and CIR v Hang Seng Bank Ltd [1990] 1 HKRC.

In a case like the present, source is “determined by the nature and situs of the profit-producing transaction and not by where the taxpayer’s business is administered or its commercial decisions taken.”

The Court of Appeal however accepted that “one looks to see what the taxpayer has done to earn the profit in question and where he has done it”.

In this case, distinctions were specifically drawn between ‘profit generating services’ and activities which ‘although commercially essential to operations do not provide the legal test for ascertaining the geographical source of profit’ (ie back-office activities).

It is therefore trite law that “… senior administrative staff headquartered in Hong Kong who oversaw the activities of various overseas affiliates within the group … is not the appropriate test for ascertaining the geographical location of a profit”.

The Conclusion – The Move to Cyberspace

Since the ruling in the Li & Fung case, several Court of Final Appeal judgments seem to have confirmed such approach with those MNCs succeeded in minimising their tax exposure to a large extent.

Similar reasoning applies to companies running e-commerce, which maintain a Hong Kong (headquarter) office running adminstrative and finance functions. The relevant elements are as follows:

1. The contract with individual customers was made in the “cyberspace” or at best the physical locality of the consumer but not in Hong Kong;

2. The location of servers (if not located in Hong Kong); likewise, the location of the operational teams such as IT and customer service;

3. The majority of the marketing and logistic operations (if any) are not carried out by the Hong Kong office; and

4. The key personnel are not located in, or otherwise travel frequently out of, Hong Kong.

Take Away Points

Ultimately, the subject company eventually managed to scale down its tax charge rate from 16 percent down to a much lower percentage (which is substantial savings for most MNCs).

With the evolution of the internet in today’s day and age, the application of this decision will therefore put the question to many MNCs to consider whether it is more advantageous to move their entire business to cyberspace.

A modernised practice as observed in the Li & Fung case is that companies may attempt to conduct “Tax Parking”, a practice involved by paying tax to:

1. a low or nil e-commerce tax rate jurisdiction (ie Malta or Cyprus); failing which

2. a tax jurisdiction where tax assessment is flexible or negotiable.

The fact that such case or practice exists also puts the question to law makers as to whether Hong Kong has positioned itself as sufficiently friendly towards e-commerce, wherein, if the policy in Hong Kong is more e-commerce friendly, such MNCs may desire to return to Hong Kong as opposed to arguing in Court against the IRD that their operation is overseas to begin with.


Solicitor, ONC Lawyers

Joshua Chu is a Litigation Solicitor qualified to practice in Hong Kong. Before becoming a lawyer, Joshua worked in the healthcare industry serving as the IT department head at a private hospital as well as overseeing their procurement operations.

Since embarking upon his legal career, his past legal experience includes representing the successful party in one of Hong Kong’s first cryptocurrency litigation cases as well as appearing before the Review Body on Bid Challenges under the World Trade Organization Government Procurement Agreement concerning a health care industry related tender.

Today, Joshua’s practice is mainly focused in the field of dispute resolution and technology law.

Aside from his legal practice, Joshua is currently also a Senior Consultant with a regulatory consulting firm which had been founded by ex-SFC Regulators as well as being a management consultant for the Korean Blockchain Centre.

Partner, Ravenscroft & Schmierer, Hong Kong

Anna is a Hong Kong qualified lawyer and is responsible as a partner at Ravenscroft & Schmierer for the commercial litigation department. Aside from her legal background, Anna is also an advisor to the Ohkims Blockchain Centre in South Korea and Hong Kong qualified lawyer and a regulatory consultant specialized in IT control and compliance.  

Before starting her practice as a lawyer, Anna worked closely with the United States Patent and Trademark Office (USPTO) and US Food and Drug Administration (FDA) on intellectual property and FDA regulatory matters. 

​Since embarking on her legal career, Anna was part of the team that defended a party in Hong Kong High Court proceedings involving the jurisdiction’s first cryptocurrency cases where she leveraged her science and engineering skills extensively to help improve her client’s case’s position. This feat was repeated again shortly after when Anna again leveraged her science background in a healthcare-related tender dispute. 

​Today, Anna is proactively working on various Distributed Ledger Technology related projects where she combines her love for science and technology together with the logic behind regulatory framework.