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Hong Kong: Revised guidance, taxation of digital economy and intersection with transfer pricing

Hong Kong: Taxation of digital economy

The Hong Kong Inland Revenue Department (IDR) on 27 March 2020 published a revised version of Departmental Interpretation and Practice Notes No. 39 – Profits Tax Digital Economy, Electronic Commerce and Digital Assets (“revised DIPN 39”) addressing various key issues concerning taxation of e-commerce transactions and digital assets.


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KPMG observation

The guidance concerns an evolving area of tax law, and as the government seeks to encourage the digital economy, it will be important for taxpayers in the sector to understand the basis on which they will be taxed.  The revised DIPN provides practical guidance on the IRD’s views, but is of necessity a temporary measure pending the conclusion of global discussion on BEPS 2.0.


The revised DIPN 39 contains material changes in relation to the previous version of July 2001. The key highlights from the revised DIPN 39 are summarized below:

  • The IRD has set out what it considers to be the key value creators of an e-commerce business, having confirmed the view that data generated and gathered in the course of an e-commerce transaction (e.g., customers’ personal data) as well as direct and indirect network effects are to be understood as key value creators for e-commerce businesses. 
  • The IRD has also confirmed that, in the absence of any specific provisions in the Inland Revenue Ordinance (IRO) that deal with the taxation of e-commerce, the tax consequences of e-commerce transactions are to be determined in accordance with section 14 of the IRO.
  • In addition, the IRD has provided some practical guidance on how to determine the locality of profits in the context of e-commerce transactions. The IRD appears to take the view that the proper approach is to focus on the core operations that have implemented the e-commerce transaction to earn the profits in question and the place where those operations have been carried out, rather than on what has been done electronically (i.e., location of core operations as a test of source). 
  • Regarding the question of whether a non-Hong Kong resident person has a permanent establishment (PE) in Hong Kong, the IRD takes the view that in the context of e-commerce, the decisive criterion may be whether the activities of a fixed place of business (which could be a computer system or server) form an essential and significant part of the e-commerce business as a whole or whether those go beyond preparatory or auxiliary activities.
  • The IRD has reiterated in this revised DIPN that the “Authorised OECD Approach” will be adopted in attributing profit from non-resident to its HK PE, when applicable. This requires a two-step analysis: (1) considering the HK PE as a functionally separate entity and attributing assets and risks to the PE; and (2) applying the arm’s length principle to the transaction of the hypothetical entity (the PE).
  • In the situation when a non-resident is considered as having a “dependent agent PE” (DAPE) in Hong Kong, an issue arises as to whether additional profits are to be attributed to the DAPE assuming that the dependent agent had already earned an arm’s length service fee from the non-resident and is taxed accordingly in Hong Kong.
  • The IRD also provided some relevant comments regarding the taxation of digital assets, namely in respect of digital tokens. The IRD position is that subject to any specific exemptions provided, profits arising in or derived from Hong Kong from an initial coin offering can be charged to profits tax in accordance with the general principles in section 14 of the IRO. Whereas, profits arising from the sale of digital assets bought for long-term investment purposes, would not be chargeable to profits tax (that is, profits from sale of capital assets). Furthermore, the IRD confirmed that in determining if digital assets are capital assets or trading stock reference must be made to the intention at the time of its acquisition.
  • The previous DIPN 39 contained a statement that the taxation of e-commerce is to follow a principle of neutrality and that the ordinance is to be applied to e-commerce on a basis consistent with conventional business. This statement has been removed from the revised DIPN 39.

KPMG observation

The updated DIPN 39 may be viewed as a welcome move in view of the seismic changes that have occurred in the field of electronic commerce and considering recent global developments in the context of the tax challenges arising from digitalisation of the economy. However, while it is useful in giving some practical insights into the IRD’s approach, it perhaps struggles to reconcile a source-based approach to taxation with the realities of digital business. It appears to be far from clear that the core operations and drivers of value creation set out by the IRD are the appropriate basis for determining source, or that the locations in which profits are sourced and business is carried on need necessarily coincide in the context of e-commerce.

The IRD has committed to reviewing its approach next year once the proposals on BEPS 2.0 and the taxation of the digital economy have been finalised.

The revised DIPN 39 indicates that the IRD had reshaped the profits tax principle to some extent by expanding on the previous emphasis on human presence when it comes to e-commerce. The IRD appears to be adopting a broader perspective by considering any Hong Kong-based core operation’s role in a transfer pricing type value creation analysis of the entire business. As such, there is an increasing concern that the IRD may in practice directly apply a transfer pricing principle to determine profit to be taxed in Hong Kong without due consideration of profits tax principle (source principle). It would be helpful for the IRD to further clarify how the source principle and transfer pricing interplay with each other.

The IRD is also silent on when and how additional PE profits are to be determined in DAPE situations. There is an expectation from the business community that no additional PE profit would result if the dependent agent has already received an arm’s length service fee from the related-party non-resident. It is understood that reference can be made to DIPN 60 on DAPE profit-attribution issues, and the IRD considers that it is possible that the result from the application of PE profit-attribution rule can differ from that of the arm’s length principle under an entity-to-entity context, even before the discussion of BEPS 2.0. For DAPE situations, the IRD would only accept that no additional PE profit (on top of arm’s length transfer pricing) would arise if the DAPE does not perform significant people functions on behalf of the non-resident in Hong Kong. In this regard, it is suggested that non-residents with potential DAPE arrangements in Hong Kong need to revisit their current arrangement with their dependent agent to mitigate the risk of creating PEs and potential additional taxable profits in Hong Kong.

For more information, contact the Global Leader of KPMG’s Global Transfer Pricing Services:

Komal Dhall | +1 212 872 3089 |

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