Landmark Ruling Exempts Foreign Companies From Income Tax on Service Fees

On September 3, 2009, Taiwan’s Ministry of Finance (“MOF”) issued a landmark ruling to provide guidelines for the characterization of Taiwan source income. This ruling will exempt foreign companies from tax liability where they perform service outside Hong Kong for Taiwanese customers.

Taiwan has long been notorious for requiring foreign companies in Taiwan to bear withholding tax on their Taiwan sourced income. Basically, any payment received from Taiwan customers is usually subject to withholding tax, other than for the purchase of tangible goods. Thus, many foreign companies are taxed in Taiwan on fees derived from services they perform outside Taiwan.

Taiwan’s Income Tax Act establishes 11 categories of Taiwan source income. Category 11 is simply defined as “any other revenue derived from within Taiwan.” Taiwan’s tax authority has taken advantage of this catch-all definition to widen the scope of what it regards as “any other revenue derived from within Taiwan.” This expansive interpretation has effectively shifted the tax base from where services are provided to where they are received. Not surprisingly, many foreign companies with customers in Taiwan objected to this wide interpretation and raised challenges. Unfortunately, they rarely won in the courts.

The MOF has recognized the persistent controversy raised by this practice and has now responded to the great pressure from various lobbying efforts by issuing the new ruling to provide new guidelines for characterization of Taiwan source income. The ruling stipulates that the first ten categories must first be carefully analyzed and applied to the income in question before the catch-all Category 11 can even be considered. More importantly, the MOF has stated that profits generated from activities outside Taiwan cannot be regarded as Taiwan sourced income.

If, however, certain activities are performed within Taiwan, then the profit attributable to those activities in Taiwan can be subject to Taiwan income tax.

New procedures will need to be followed and/or documentation requirements will need to be met for foreign companies to enjoy this tax relief.

Foreign companies that previously set up provisions for Taiwan income tax exposure under FIN 48 are encouraged to consult with their tax advisors and re-examine this exposure in light of the new ruling.

It remains unclear how the new ruling will effect pending tax disputes on source issues. It is also unclear whether foreign companies will be able to seek tax refunds for taxes paid in the past. The answers will become clearer as time goes on.