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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
In my last commentary, I reported on the issuance by the Canada Revenue Agency of an important public ruling regarding the application of the permanent establishment (PE) rules of the U.S.-Canada Income Tax Treaty to a data center owned and operated by a Canadian affiliate of a U.S. principal.1 Now the Inland Revenue Board of Malaysia (IRB) has weighed in with a document entitled "Guidelines on Taxation of Electronic Commerce" (Guidelines), which covers various issues arising under the general heading of e-commerce tax policy, in particular the significance of the physical location of a server and a website hosted thereon for purposes of determining tax nexus and source of income, and revenue characterization of certain payments for digital products and technical services.2 At first reading, the Guidelines appear to adopt a fairly clear position on role of servers and websites in determining nexus to tax and source of income. Unfortunately, follow-up discussions with the IRB suggest that the guidance may not be as clear as it seems. The Guidelines also contain a brief discussion of the character of revenue derived from the delivery of digital products and technical services. Unfortunately this guidance also does not provide much additional clarity to the currently uncertain revenue characterization rules in Malaysia.
Tax Nexus and Source of Income
Malaysia is a source-based tax jurisdiction. The Guidelines note that a basic principle of Malaysia's tax system is that income tax is imposed on the income of any person accruing in or derived from Malaysia. Nonresidents, therefore, are taxed only on income that is accrued in or derived from Malaysia. Even residents, except for those in certain industries, are exempt from tax on income derived from sources outside Malaysia.
The fundamental principle expressed in the Guidelines is that tax nexus and the source of income are determined by the location of business operations and not by the location of servers which host the websites supporting the business.
In this regard, Malaysian case law indicates that the location where income-generating activities are carried out determine the source of income. For income from the sale of goods and services, the activities of accepting orders and concluding contracts normally would be the most important factors in determining where business operations are carried out.
The Guidelines apply these principles to various examples of a server and website located in Malaysia. On their face, the Guidelines suggest that a server and website located in Malaysia, standing alone, do not constitute engaging in business operations, even though the server may host communications with users which result in the conclusion of contracts, process payments, host data and content, and serve up digital products or content for download or remote viewing.
If this were a correct interpretation of the Guidelines, then they would represent an interesting addition to the policy discussion in several countries about the relative significance of "man vs. machine" in determining tax liability for e-commerce transactions. In order to test that conclusion, my colleagues in Kuala Lumpur, queried the relevant IRB officials on various interpretation issues in the Guidelines. Unfortunately, the Guidelines may not have solved as many problems as it seems.
The principal purpose of the Guidelines seems to be to eliminate the possibility that enterprises carrying on business in Malaysia could assert that their income is not derived from Malaysian sources if the transactions are effected through a website hosted on servers located outside of Malaysia. The Guidelines seem to apply this principle evenhandedly by also expressing the conclusion that an enterprise carrying on a business outside of Malaysia will not be regarded as deriving income from Malaysian sources solely on the basis that it maintains servers inside of Malaysia hosting the sites through which business transactions are conducted. The applicable principle is stated quite clearly in the Guidelines:
A website is hosted on a server which is located at a certain place. Both server and website would facilitate the performance of business activities. However, a server/website itself do not carry any meaning in determining derivation of income. Business income from e-commerce would be considered as Malaysian income if the operations test shows that the person is carrying on a business in Malaysia. Even though the server is fully automated in performing business activities, the substantial part of the business activities such as updating and maintaining the current information on the website is still managed by a human.3
The Guidelines then apply that principle to three examples involving trading, services, and manufacturing businesses, all of which engage in business activities in Malaysia through personnel, but also maintain websites outside of Malaysia which automate the full range of e-commerce functions, including storage of content, receipt of orders, transaction processing, and downloading of purchased content. In all three cases, the existence of the offshore servers/website was determined to have no effect on the determination of the source of income derived from the business operations conducted in Malaysia.
The Guidelines then proceed to discuss 10 "business models" and apply these principles to those 10 business models. The models endeavor to present different combinations of factors, such as the taxpayer being a resident or nonresident, conducting business operations in Malaysia or not, establishing the server inside or outside Malaysia, and the like. Despite the discussion of multiple models, the examples chosen do not really express a large number of variables of the critical factors. What is clear, however, is that a nonresident enterprise can establish a server and website inside Malaysia, and not be regarded as deriving Malaysia-source income, as long as its income-generating activities are carried out outside of Malaysia. If the nonresident sets up a branch in Malaysia to conduct a portion of its business activities, income will be attributed to the branch and the offshore operations in accordance with the business activities actually conducted inside and outside the country, without regard to the physical location of the server and website.4
The Guidelines do not address the case covered in the Canadian ruling referenced above, namely where the Malaysian-based servers are owned and operated by an affiliate of the entity recognizing the revenue. In contrast to the facts considered in the Canadian ruling, the Guidelines would seem to indicate that a separate legal entity in Malaysia is not required to avoid a taxable presence of the principal, in that the location of the equipment does not determine the source of income of the nonresident. There remains the interpretative question of under what circumstances the on-premises personnel that would necessarily be required to maintain and operate the equipment might rise to the level of conducting "business operations."
The "man vs. machine" policy debate exists in many areas of the international tax law, both inside and outside the United States. While the statement in the Guidelines that the location of the equipment and website "do not carry any meaning" may not translate precisely into other contexts, such as U.S. concepts of determining source of income or the OECD Model Convention rules on the creation of a PE, it is certainly a more valid conclusion than the opposite, which is to personify the equipment as performing the business functions of the processes automated through the website. For example, the view that business activities generally are conducted by humans rather than by equipment leads to the conclusion that a server and website alone cannot be regarded as a contract-concluding agent within the meaning of Article 5(5) of the OECD Model Convention, and that a transaction-processing server operated by an affiliate in the United States by itself could not be regarded as a U.S. office with authority to negotiate or conclude contracts under §864(c)(5)(A).5 On the other hand, in an issue of particular significance for e-commerce companies whose income is characterized as service fees, U.S. law does seem to accept that equipment contributes in some way to determining the source of services income.6 How a taxpayer determines the allocation of services income between the contributions of personnel vs. the contributions of the equipment, where those contributions are performed in different jurisdictions, however, is very unclear.
So where is the ambiguity in these Guidelines? The facts in the various examples state that users may "identify products," "order the products," and "make payments for the purchase," all without those activities constituting the conduct of substantial business activities at the server location in Malaysia. The facts do not, however, directly state that the user exchanges with the server result in the conclusion of contracts of sale without other human intervention. Based on our discussions with IRB officials, it appears that the IRB may still assert that fully automated contract conclusion could constitute engaging in substantial business activities at the server location, apparently in reliance on case law that identifies contract conclusion activity as one of the most significant determinants of the existence of business activity at a place. In that event, there would not seem to be much to preclude an argument that other significant operations automated through the server also could rise to the level of substantial business activities.
The message for taxpayers is that these Guidelines need to be approached with caution, as in practice the presence of computer equipment may not be as safe as the Guidelines seem to say. We can hope, however, that further guidance will be forthcoming to clarify IRB's intentions in this area.
The Guidelines also touch on the characterization of revenue derived from e-commerce transactions. As is the case in many countries, the principal issue is whether the payment will be classified as a royalty or as something else. Under Malaysian law, a payment characterized as a royalty is subject to withholding tax at source at the rate of 10%. No Malaysian treaty reduces the withholding tax rate below 5% for royalty payments.
Unfortunately, the Guidelines are not particularly illuminating. The Guidelines set out the general principle that the term "royalty" under domestic law includes payments for the use of or the right to use: (1) copyrights; (2) know-how; or (3) information concerning technical, industrial, commercial, or scientific knowledge, experience, or skill, and then provides examples of cases falling under each of those three categories:7The first category of payments for the use of copyrights is illustrated as follows:
Payment for the use of, or the right to use copyrights of intangible products such as
(a) Downloading of a digital product to a customer's hard disk or similar media.
(b) Licensing arrangements to reproduce, modify and adapt, the absence of which would constitute an infringement of copyright.
In the above example, if the payment is for the use of, or the right to use copyrights, the income constitutes royalty. On the other hand if the payment is for the purchase of the product, the transaction would not result in royalty income.
The Guidelines do not give further guidance as to when the downloading of a digital product would be regarded as the "purchase of the product." The good news, perhaps, is that the Guidelines at least contemplate the possibility that digital products can be acquired in ways which do not give rise to royalties. The bad news, however, is that the IRB seems not to be prepared to provide guidance as to where the line is to be drawn between product and royalty transactions. The IRB seems not to be ready to adopt a position similar to the U.S. or OECD guidance,8 so taxpayers unfortunately must continue to content with uncertainty.
The examples given of the second and third categories also fall short of illustrating the applicable principles. The following example is given of a know-how transfer:Any form of electronic supply of know-how (i.e. undivulged technical knowledge, information, experience or technique that is necessary for the industrial reproduction of a product or process) which take the form of technical data, samples or patterns, or details of processing or production methods for which payment is made constitutes "royalty".
The Guidelines elaborate on the example as follows, distinguishing between the supply of know-how and the provision of technical services:In the above example, a distinction should be made between contracts for the supply of existing knowledge or experience which can be used by the customer to produce an outcome and contracts where the supplier applies his knowledge and experience to create a result for the customer. The former refers to a contract for the supply of know-how (royalty) and the latter refers to a contract for the provision of services (technical fee).
This is a useful distinction, since payments for know-how are subject to tax in all cases, while technical service fees are not subject to withholding tax if the services are performed wholly outside Malaysia.
The third category classified as a royalty is payments for the use of, or the right to use, information concerning technical, industrial, commercial, or scientific knowledge, experience, or skill. This category is illuminated by the following example:Any electronic use or the right to use the above information which may include access to unpublished knowledge or information gained through scientific, technical etc. experience. This may include supply of information on markets or fashion trends, information concerning future technological advances or access to unpublished information contained in a database.
The scope of transactions covered by this category is not clear. The critical factor seems to be that the information is "unpublished" or otherwise not generally available to the public. This could indicate a very wide scope of possible withholdable transactions, as shown by the conclusion that payments for access to information on "fashion trends" could be regarded as royalties subject to withholding tax, on par with payments for the acquisition of "technical, industrial, commercial, or scientific knowledge."
The Guidelines do not provide a description of technical services that are not subject to withholding tax. Absent such an example, it is difficult to determine where the line is drawn in any particular case between: (1) know-how and unpublished knowledge on the one hand; and (2) technical services on the other. The importance of clearly articulating these distinctions will likely receive greater attention in the near future, as the U.N. Committee of Experts on International Cooperation in Tax Matters (normally referred to as the U.N. Tax Committee) has embarked on a review of the taxation of services. One proposal which has generated some support within the Committee is to add an article to the U.N. Model Convention dealing with income from the provision of technical and other similar services, which would be subject to source-based taxation.9 Defining the services to be covered by such a provision likely will be the most challenging element of the project.
In any event, taxpayers welcome thoughtful guidance in the e-commerce area, as there remains a long way to go before international consensus is reached on many important issues. Despite the ambiguities, the Guidelines are a welcome development, as they at least present a framework for further elaboration of these issues. By issuing the Guidelines, Malaysia perhaps is indicating an intention to play a larger role in international policy discussions in the future. It is worth noting that the Tax Policy Department of the IRB, which issued the Guidelines, is located in Cyberjaya (which translates to "Cyber Success" in English), in the heart of Malaysia's Multimedia Super Corridor. Taxpayers can hope that IRB will supplement these Guidelines to resolve at least some of the ambiguities.
This commentary also will appear in the July 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties - Income Not Attributable to a Permanent Establishment, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income, ¶7160, U.S. Income Tax Treaties.
5 Whether such an operation could be regarded as a dependent agent which "has a stock of merchandise from which it regularly fills orders on behalf of" another person is a harder question for enterprises engaged in the business of selling digital products, in light of the fact that Regs. §1.861-18 characterizes the delivery of digital software copies as sales of copyrighted articles.
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