On June 11, 2010, the Tokyo Stock Exchange (“TSE”) released a copy of an informal ruling request dated November 5, 2009 (the “Request”), which it submitted to the Japanese tax authorities (“NTA”) requesting confirmation of the tax treatment of foreign investors trading on the TSE through a co-location arrangement (http://www.tse.or.jp/ rules/co-location/index.html; for English version, see http://www.tse.or.jp/english/rules/ co-location/index.html). The TSE reported that the NTA had affirmed the analysis and conclusion in the Request that a foreign investor would not be deemed to have a taxable presence in Japan. If the investor does not have a taxable presence in Japan, then income and gain derived from the trading activity conducted through the co-location arrangement is not subject to Japanese tax.
As described on the TSE’s website, “Co-Location” is a service that minimizes the latency between the Trading Participants’ devices, such as automated order placement servers, by allowing Trading Participants to install their devices at the data center where TSE places its Trading Engines and Market Information Systems (“Primary Site”).
The TSE started the “TSE Co-Location Service” at the TSE Primary Site in May 2009. However, there have been concerns raised that trading through the co-location system creates a risk of being subject to Japanese tax on the income and gains from trades made on the faster platform. Generally, foreign persons are subject to Japanese tax if they routinely conduct business activities through a physical presence in Japan (a permanent establishment or “PE”). Because the servers used in the co-location platform need to be physically located next to the Exchange (to minimize latency times) in Tokyo, there is risk that trading conducted through the server would constitute a PE, subjecting foreign investors to Japanese tax on income and gain from such trading activity.
To reduce the uncertainty, the TSE submitted an informal ruling Request to the NTA. A summary of the Request is as follows (The TSE’s translation of the Request can be found at: http://www.tse.or.jp/english/rules/co-location/b7gje60000009826-att/ b7gje6000000a7x9.pdf):
Factual Situation. The Request provides the following factual situation involving the co-location service. The TSE rents space for servers at its Primary Site in Japan. A Japanese securities company, which is a TSE member, (“Participant”) will rent the server space from TSE. The Participant brokers transactions for foreign investors, but sales of securities made through the Participant on behalf of foreign investors, are made in the name of the Participant under a commissionaire (toiya) arrangement. (A toiya arrangement is an undisclosed principal/agent arrangement.)
A foreign investor (“Investor”) and Participant enter into a co-location services agreement under which the Participant will provide a high speed-order platform (kosoku na hatchyu kankyo) on which the Investor can trade securities on the TSE. The Participant will own or lease the server through which the Investor’s trades will be executed. The Investor will not own or lease/sublease the server from the Participant, and cannot freely use (lease, use to provide similar services as Participant, etc.), dispose of (sell, offer as collateral, destroy, etc.), receive delivery of, or have any right of possession of, the server. A single server may be used to execute the trades of a single Investor, or a single server may be used to execute trades of multiple Investors.
The server is expected to be mass-produced product generally available in the market (that is, the server is not created specifically for a particular Investor, and cannot be purchased or set up only by that Investor). The Investor does not have an option to purchase the server. Maintenance on the server will be performed by a third party maintenance company which will be hired and paid by Participant. The Investor is not involved in the maintenance of the server and cannot access the space where the server is located. The fees charged by the Participant have not been determined yet, but for example, may be based on a margin added to the Participant’s normal brokerage fees, which amount is commensurate with the co-location services provided by the Participant.
The Investor can upload, install, and store its own trading program and parameters (and other data) on the server. The program and parameters are owned by the Investor, and are created and set up by the Investor outside of Japan. To create parameters, certain investment decisions must be made, and these decisions are made by the Investor outside of Japan. The Investor can change the parameters at any time from outside of Japan. Orders are executed solely by the program and parameters. No person in Japan is involved in decisions involving such orders.
Analysis. Japanese tax law does not specifically address the issue of whether transactions conducted through a servers constitutes a taxable presence (permanent establishment) in Japan. However, under the OECD Commentary on the Model Tax Convention (art. 5, para. 42.2 and 42.3) (the “Commentary”) involving permanent establishments (“PE”) and internet transactions conducted through a server, the issue of whether a server constitutes a physical presence (which depending on the activity conducted through such physical presence could constitute a PE) depends on whether the server is at the disposal of the taxpayer.
(1) Server Is Not “at the Disposal” of Investor. Whether the server is used only by a single Investor or by multiple Investors, the server is not deemed to be at the disposal of the Investor(s) because:
- the Investor does not own, lease, or option to purchase the server (there is no pre-agreement that the server will be sold to the Investor);
- the Participant has the right to freely use or dispose of the server (and the Investor cannot freely use (lease, use to provide similar services as Participant, etc.) or dispose of (sell, offer as collateral, abandon, etc.) the server;
- the server can be purchase by anyone (that is, the server is not created specifically for a particular Investor, and cannot be purchased or set up only by that Investor);
- the service agreement concluded with the Participant is not a lease agreement for use of the server (rather it is a agreement to provide services), the Investor cannot freely use the server other than for the purpose of receiving the high speed-order platform services;
- maintenance on the server is performed by a third party maintenance company which will be hired and paid by Participant (the Investor is not involved in the maintenance of the server);
- the Investor cannot access the space where the server is located.
In the case where a server is used by a single Investor, even if, at the time of purchase of the server by the Participant, the Investor can instruct the Participant as to the specifications for the server, the Investor is not deemed to be able to freely dispose of the server. Moreover, in this case, because the server is owned or leased by the Participant, the Participant is deemed to be able to freely use or dispose of the server. The fact that there are certain restrictions imposed on the Participant’s use of the server (to protect the Investor’s rights in its program and parameters) does not mean that the Investor is deemed to be able freely use or dispose of the server.
(2) Computer Program Is Not a Physical Presence. The Commentary provides that a website is not a tangible asset and thus, by itself does not constitute a physical presence. In this case, the Investor’s program and parameters are similar to a website, and the Participant is similar to an ISP. Because the Investor only operates through a program and parameters, which are similar to a website and thus, such program and parameters by themselves do not constitute a physical presence.
(3) No Agent PE. The server itself is not a person and thus, cannot be an agent (which could create an agent PE). In addition, the Participant acts as a third party broker, not as an agent of Investor, because the Participant only conducts its regular securities trading business, does not conclude contracts on behalf of its customers, retain client assets for filling customer orders, or performs an essential part of order receiving activities.
Conclusion. The TSE’s translation of the NTA’s unofficial confirmation is as follows:
With regards to your (TSE) inquiry, on the basis of the facts stated in the inquiry, your view stated in the inquiry will be affirmed. That is, if a foreign investor sets up and saves computer programs and other data to be used for placing orders to buy/sell stocks, etc., and operates such programs, on the server of a Trading Participant located at TSE’s Primary Site or access points pursuant to the terms of the TSE Co-Location Service, on the basis of the facts stated in the inquiry, such foreign investor will not be treated as having a permanent establishment in Japan solely by reason of such activities. http://www.tse.or.jp/english/rules/co-location/ b7gje60000009826-att/b7gje6000000a7xh.pdf.
It is unclear whether and to what extent foreign investors can rely on the confirmation of the Request obtained by the TSE, or whether it might apply to co-location services at another Japanese securities exchange. Although taxpayers cannot rely on the NTA’s response to an informal ruling request, the NTA will not generally take a position inconsistent with its informal response. In addition, it is important to note that the NTA itself did not issue any official policy, such as a Circular or official explanation, regarding the taxation of co-location arrangements, which are generally used to make public official positions. Thus, as a technical matter, foreign investors cannot rely on the NTA taking a consistent position with that reported by the TSE.
However, as a practical matter, it is unlikely that the NTA to would take an inconsistent position with respect to any foreign investors trading activities under a co-location arrangement; provided that the arrangement is substantially similar to that described in the Request. On the other hand, if a particular Investor’s factual situation is different than the facts in the Request, the NTA may conclude that such Investor has a PE and thus, is subject to Japanese tax on income and gain from trading through the co-location arrangement (for example, if the fee charged by the Participant includes a fee for use of the server, or the Investor exercises control over the server, the NTA). Thus, each foreign investor contemplating participating in a co-location arrangement should carefully evaluate their own situation and consult with Japanese tax advisors as necessary to determine the Japanese tax consequences.