By Peter R. Merrill
In Brief
Progress in a Global Policy Debate
Last year, total sales of goods and services transacted via the Internet were estimated by Forrester Research at $48.3 billion in the United States. Still small but growing fast, e-commerce is viewed by many tax administrators as a threat to revenues from traditional income and consumption tax systems. Some traditional (bricks) retailers are concerned that e-commerce (clicks) retailers gain a competitive advantage from the lighter tax burden. At the same time, computer technologies could be used to improve the functioning of the tax system by streamlining tax administration and compliance functions. Given the limited profitability of many e-commerce ventures, tax policymakers give priority to consumption taxes, such as sales and value-added taxes (VAT).
Electronic commerce shines a spotlight on longstanding issues in current tax rules for remote vendors, services, and intangible property. While Internet sales are still only a small portion of all distance sales in the United States, e-commerce has refocused attention on the state tax nexus issue and precipitated the Internet Tax Freedom Act, the Advisory Commission on Electronic Commerce, and the Streamlined Sales Tax Project.
Motivating much of the tax policy activity surrounding e-commerce is the belief that its growth will be exceptionally rapid and will significantly reduce tax revenues. The Internet has advanced remote commerce in several important ways:
Because of these developments, tax administrators have determined that certain aspects of the existing income and consumption tax regimes require review. Some have even suggested an entirely new tax structure.
Income Tax Issues
Characterization. Under the Organization for Economic Cooperation and Development’s (OECD) model tax convention, payments received in the course of carrying out a business are treated as business profits unless otherwise specified. Income characterization has a number of important U.S. and foreign tax consequences, including the withholding rate (if any), eligibility for treaty benefits, appropriate transfer pricing methodology, and application of U.S. antideferral and foreign tax credit limitation rules. Questions have arisen as to whether payments for copyrighted digital information (e.g., music, videos, and software) are royalties or sales income (business profits). Some older or nonstandard treaties treat payments for “technical services” or the right to use “industrial, commercial, or scientific equipment” as royalties.
Permanent establishment. A fundamental question in applying national income tax systems is whether a legal entity has enough presence in a foreign jurisdiction to justify net income taxation by that jurisdiction. The OECD model allows a jurisdiction to impose net income tax on a business only if its activities in the jurisdiction rise to the level of a permanent establishment (PE). The use of stand-alone computer servers to conduct business within a jurisdiction has raised questions about the PE rules; some tax administrators have suggested lowering existing PE thresholds to allow taxation of companies that do business in a jurisdiction even though they have no physical presence.
Attribution of profits. The tax consequences of a PE depend upon the amount of income that is properly attributable to the PE. The development of e-commerce business models has triggered a fundamental reconsideration of the principles that should guide the division of profits between a home office and a PE.
Place of effective management. For dual-resident companies that are considered a resident under the laws of two countries, the OECD model uses a tie-breaker rule that looks to the place of “effective management”: where key management and commercial decisions are, in substance, made. The Internet makes it difficult to identify where the key business decisions of a company are regularly made.
Antideferral rules. Some countries, such as the United States, subject certain income of controlled foreign corporations to current taxation in the hands of the parent even though this income is not distributed. Such regimes are typically targeted at passive or mobile income, which can be easily moved to tax haven jurisdictions. The U.S. Treasury Department raised concerns that Internet technology may allow companies to avoid the anti-deferral rules. Some suggest that anti-deferral regimes should be strengthened.
Consumption Tax Issues
Characterization. Under the VAT system in the European Union (EU), different rules can apply to goods and services, including the tax rate, place of supply, and manner of payment. Goods characterization is typically limited to physical products, with a few exceptions (such as electricity). Digitized products, such as software distributed over the Internet, are treated as services rather than goods, even though the content is identical to software distributed on a physical medium.
Place of supply. Under the EU VAT, consumption is taxed at the place of supply. For goods, the place of supply is typically where the customer is located; for services, the place of supply is typically the location of the provider. Because digital goods are characterized as services, imports of digital goods into the EU generally are not subject to EU VAT, while exports of digital goods are. The European Commission (EC) has developed several proposals to change the place-of-supply rules for digital goods in order to address concerns that the current rules put EU sellers of digital products at a disadvantage.
Overlapping Issues
Income tax and trade consequences of VAT characterization. In addition to the ways in which the application of income and value-added taxes can depend upon whether a transaction is determined to be a sale of goods or services, world trade law distinguishes between goods and services; the latter is covered by the General Agreement on Trade in Services (GATS). As a result, questions have arisen about characterization for one purpose spilling into other areas.
Customs duties. In May 1998, the World Trade Organization (WTO) adopted a temporary moratorium on the application of customs duties on electronic transmissions. Because customs duties are an important revenue source for many developing countries, there may be a trade-off between their willingness to support extension of this moratorium and their willingness to accept a high PE threshold.
Tax Policymaking Process
Decisions that affect taxation of international e-commerce are made in a number of different forums around the world. For U.S. multinationals, this includes the U.S. Congress, Treasury, and IRS. For companies in the 30 OECD member countries, the decisions of the Paris-based OECD regarding the model tax convention and accompanying commentary are important for interpreting bilateral income tax treaties. For companies doing business in the EU, the decisions of the European Parliament in Brussels guide the application of VAT within the 15 member states. For companies involved in international trade, the WTO in Geneva sets the ground rules for application of customs duties in its 142 member countries.
United States
In November 1996, the Treasury Department issued a policy study, “Selected Tax Policy Implications of Global Electronic Commerce,” that advocated the principle that the method of transacting business should not affect tax liability. This neutrality principle reflects the view that the tax system should neither encourage nor discourage Internet-based business models. The study suggested that e-commerce makes it more difficult to identify the source of income and, consequently, priority should be given to taxation in the jurisdiction of residence—a suggestion that some countries viewed as self-serving because a large percentage of companies engaged in e-commerce activities reside in the United States. Consistent with the neutrality principle, the study proposed a substance-over-form approach to determining the character of income. Thus, income from the sale of copyrighted material, such as music, should be characterized in the same manner whether the music is delivered digitally or on a physical carrier medium, such as a CD or cassette tape. The study identified a number of challenges to tax administration, including digital cash, auditing of electronic records, and limitations in identifying the tax status and jurisdiction of customers that make online digital purchases.
In 1998, the Treasury Department issued final regulations (Treasury Regulations section 1.861-18) to address the characterization of software transactions. The regulations classify software transactions as follows:
Following a substance-over-form approach, section 1.861-18 characterizes income from the supply of software based upon the rights transferred to the customer rather than their strict legal form. For example, if the customer receives only the right to personal use of the software, income from the sale of software will not be treated as a royalty, even if the legal form of the supply is a license and the software is delivered electronically.
In December 2000, the Clinton Administration released a policy study on the antideferral regime that applies to income earned through U.S.-controlled foreign corporations. The study noted several aspects of e-commerce business models that make application of U.S. antideferral rules more complicated: the place of performance of services may not be clear (relevant to the foreign base company services income rules); the place of consumption, use, or disposition of digital goods may not be clear (relevant to the foreign base company sales income rules); and the characterization of income may not be clear (goods or services). The study also gave examples of how e-commerce could be used to facilitate avoidance of the antideferral rules. Although the study set forth three options for revising the U.S. anti-deferral regime, none of them target e-commerce, and Congress is unlikely to seriously consider any of these options in the near future.
In January 2001, the Treasury Department issued proposed regulations under IRC sections 863(a), (d), and (e). Under the proposed regulations, the source of income from communications income depends on whether the income is classified as international, U.S., foreign, space or ocean, or transmission between undetermined points.
To date, the only e-commerce-related tax legislation adopted by Congress is the Internet Tax Freedom Act of 1998, which imposes a moratorium through October 21, 2001, on state and local taxation of Internet access fees and multiple and discriminatory taxes on e-commerce (subject to a grandfather rule). The legislation does not address important nexus issues, including the inability of state and local governments to require vendors without nexus to collect sales and use taxes, and does not address whether substantial physical presence is required in order for states and local governments to impose business activity taxes. Due to the controversy surrounding the nexus issues, it is unlikely that any resolution will be soon forthcoming from Congress.
Organization for Economic Cooperation and Development
In 1997, the OECD initiated a major project to address tax and nontax aspects of e-commerce. At an October 1998 ministerial meeting in Ottawa, the OECD approved a framework for the taxation of e-commerce intended to guide tax legislation within the member countries and to provide a basis for reviewing the OECD model treaty and transfer pricing guidelines. The framework conditions provide for neutrality in the taxation of e-commerce; affirm that, subject to appropriate interpretation, existing OECD tax principles remain adequate for taxing e-commerce; and specifically reject proposals for a separate tax on e-commerce, such as a bit tax (a tax on the transmission of data). The OECD agreed to establish five business-government technical advisory groups (TAG) with a two-year mandate to advise the Committee on Fiscal Affairs (CFA) on e-commerce tax policy matters in five areas: business profits taxation, income characterization, consumption taxation, technology, and audit-related issues.
The TAGs are a significant innovation in OECD policymaking in that non-OECD member countries and private sector representatives were invited into the tax policy development process at an early stage.
On February 12, 2001, the OECD formally released 11 documents representing the work product of the TAGs and the CFA. The documents address the definition of permanent establishment, the characterization of income, the attribution of income to a permanent establishment, the resolution of a taxpayer’s place of residence, the application of consumption taxation to digital commerce, technology issues, tax administration issues, and TAG progress reports. The CFA indicated that it would continue working on these issues, with particular priority given to consumption taxes on digital commerce, likely a response to the ongoing debate within the EU over taxing digital imports.
Characterization. On February 1, 2001, the income characterization TAG reported its unanimous recommendations for revising the commentary on two articles of the OECD model, which will likely be adopted by the CFA.
This TAG report analyzed the character of income arising in 28 common e-commerce fact patterns, providing guidance useful for distinguishing business profits from copyright licenses; know-how; and the right to use industrial, commercial, or scientific equipment. Examples provide guidance for distinguishing payments for property from payments for services and distinguishing technical services (treated as a royalty in some treaties that do not follow the Model Tax Convention) from other services.
The most significant issue that the report addressed is the distinction between business profits and royalties in the case of payments for the use of, or right to use, a copyright. The report adopts the substance-over-form approach set forth in the U.S. regulations but applies it more broadly to all copyrights, not only software. Consequently, when the CFA adopts the TAG report recommendations, taxpayers will be able to structure digital transactions involving copyrighted material with much greater confidence that income from transactions will be characterized as the taxpayer intended.
Definition of permanent establishment. On December 22, 2000, the CFA approved a revision to the commentary on Article 5 of the OECD model regarding PEs. Subject to reservations by Spain and Portugal, the revision clarifies that a website alone does not create a PE because it is intangible and thus not a fixed place of business.
The commentary distinguishes a website (software) from the server (hardware) that hosts the site. Website owners often contract with an Internet service provider (ISP) to host the site, and ISPs typically do not provide website owners with control over hosting equipment. The commentary specifically states that “except in very unusual circumstances” a web-hosting arrangement with an ISP will not create a “deemed” PE for the website owner because an ISP will not be considered an agent of the website owner.
Computer equipment that is located for a sufficient period of time within a jurisdiction and is used to carry on part or all of a business may constitute a PE even if no personnel are at that location. The preamble to the commentary specifically rejects the view expressed by many business commentators that Article 5 of the Model Treaty requires human intervention for a PE to exist. The commentary states that the determination of whether a business is carried on through such equipment is to be examined on a case-by-case basis.
Under the general rules of the OECD model, a PE does not exist where the business operations are restricted to “preparatory and auxiliary” activities. In the case of a computer server, the new commentary provides five examples of activities that will generally be regarded as preparatory or auxiliary:
The preparatory and auxiliary exception does not apply, however, where “such functions form in themselves an essential and significant part of the business activity of the enterprise as a whole, or where other core functions of the enterprise are carried on through the computer equipment.” Whether activities are core functions depends upon the nature of the enterprise’s business.
In the case of an electronic retailer, the commentary states that a server used exclusively for advertising, catalog display, or providing information to customers does not constitute a PE. However, if sales activities are carried on through the server (e.g., contract conclusion, payment processing, and delivery of products), the preparatory and auxiliary activities exception may not apply. OECD member states have differing views about how many of these sales activities must be present to trigger a PE. The United Kingdom reserved on this point, taking the view that e-tailers’ servers and websites do not by themselves create a PE regardless of the electronic sales activities conducted.
Barring operational restrictions, the new OECD interpretation should make it relatively easy to avoid or create PEs in OECD countries by planning the location and function of equipment (although avoiding PE status in Spain and Portugal may be difficult). Where bandwidth and other considerations require that services be located in a particular jurisdiction, care should be taken to avoid exceeding a preparatory and auxiliary activities threshold if a PE is not desired.
Attribution of profits to a permanent establishment. Under the OECD model, if a taxpayer’s e-commerce activities are significant enough to constitute a PE then that income may be subject to tax in that jurisdiction. The OECD model provides guidelines for attributing income to PEs. In contrast to transactions between a parent company and a subsidiary, income from dealings between a head office and a PE are not necessarily split on an arm’s-length pricing basis. The commentary to Article 7 effectively mandates sharing the costs and benefits of intangibles between a home office and a PE. Moreover, as noted by the CFA in a February 8, 2001, discussion draft: “there is no consensus amongst the OECD member countries as to the correct interpretation of Article 7.”
Parallel to its work on e-commerce, the CFA reconsidered the attribution of profits to PEs and published its finding for comment. The CFA recommended treating a PE as a distinct legal entity (the working hypothesis) and applying the arm’s-length pricing principles for related legal entities under the OECD’s 1995 transfer pricing guidelines. The CFA report tests the attribution of profits under the working hypothesis to PEs in general and to PEs in the financial sector in particular, where large amounts of global trading activity is conducted through branches.
As part of the OECD’s e-commerce project, the business profits TAG in February 2001 issued a draft discussion paper that applies the working hypothesis to the attribution of profits to an e-tailer PE. The discussion paper considers four fact patterns:
The TAG draft concludes that in the first three cases the PE should be treated as a contract service provider with attribution of only a modest profit based upon a markup on its processing costs. In the fourth case, however, the discussion paper concludes that the PE should be treated as the economic owner of the software and should be entitled to the profit associated with the exploitation of such intangible property. Thus, the profit attributed to a PE hinges on whether it is the economic owner of the software.
If a PE were a separate legal entity, it would be considered the economic owner of intangible property (absent a cost contribution agreement) only if it bore the economic risk of its development. CFA and TAG drafts do not, however, consistently apply this principle. To avoid potential double taxation until the model is clarified, taxpayers should be careful when locating e-commerce servers in foreign jurisdictions.
Place of effective management. In February 2001, the business profits TAG released a discussion paper identifying options for modifying the existing standard for determining a taxpayer’s place of residence. These options include replacing the existing place of effective management standard (POEM), refining POEM, creating subsidiary tests where POEM is inconclusive, and denying treaty benefits to companies whose residence cannot be resolved under POEM. The discussion paper suggests several tests that could serve as alternatives, or as subsidiary tests where POEM is inconclusive, including—
Under current circumstances, where dual residence would result in double taxation taxpayers should take measures to identify and document a place of effective management.
Consumption tax. All 30 OECD member countries, except the United States, now have national VATs or similar goods and services taxes (GST). While the OECD historically has played a substantial role in coordinating income taxes, it has not exerted the same leadership for consumption taxes. Historically, leadership in this area has come from the EU, whose 15 member states must conform to EU VAT directives (with standard rates of 15–25%).
The ability of consumers to import digital goods and services electronically has caused countries to reconsider the implications of imposing VAT or GST on services at the place of supply rather than consumption. Reversing the application of VAT on services from an origin to a destination basis requires more cooperation between jurisdictions, because tax must be collected on sales made by vendors who may have no physical or legal presence within the customer’s jurisdiction.
Recognizing the need to coordinate the application of VAT or GST on global digital commerce within both OECD and non-OECD countries, the scope of the OECD e-commerce project has from its outset encompassed both consumption and income taxes. The Ottawa Taxation Framework Conditions established three core principles regarding the application of consumption taxes to digital commerce:
In February 2001, a CFA working party released for public comment a report on the consumption tax aspects of e-commerce. This report focused on three issues crucial to implementation of the Ottawa Taxation Framework Conditions:
The report recognizes the importance of an agreed-upon definition of the place of consumption to eliminate double taxation and to ensure that taxpayers need only a single customer identification technology for every VAT jurisdiction in which they do business. The report recommends that the place of consumption be where the customer is established, in the case of VAT-registered customers, or usually resides, in the case of non-registered customers.
Consistent with the Ottawa Taxation Framework Conditions, the working party recommends a reverse charge mechanism for collecting tax in the case of VAT-registered customers. For non-registered customers, the report recommends technology-based systems, such as digital certificates and trusted third-party systems, in the long term. For the short term, the report concludes that there is no viable option to a simplified registration-based system under which e-commerce vendors would be required to register, collect, and remit consumption tax in every jurisdiction in which its customers make digital purchases. Because over 100 countries have national consumption taxes, a registration system would impose heavy compliance burdens on vendors and be difficult to enforce.
Recognizing these drawbacks, the working party’s report calls for immediate further examination of technology-based solutions in cooperation with the business community. It also recommends that the OECD’s future work program focus on developing ways to authenticate online customers’ residence and tax status; creating registration thresholds to exempt low-volume vendors from national registration requirements; identifying options for simplifying VAT and GST compliance; and promoting international administrative cooperation among OECD and non-OECD countries.
The report does not address the potential non-neutral tax treatment of digital goods and their physical analogues under VAT systems.
European Union
Under the EU Sixth VAT Directive, digitized products are generally treated as supplied where the vendor is established. Consequently, imports by EU consumers of digitized products from non-EU vendors are not subject to EU VAT (or any VAT, in countries that do not impose VAT, such as the United States). EU member states are increasingly concerned about the potential competitive advantage enjoyed by non-EU vendors selling digitized products to EU consumers.
On July 1, 1997, the EU adopted a derogation to the Sixth VAT Directive which allows member states to treat the place of supply of telecommunication services as the place where the customer, rather than the operator, is located.
On June 7, 2000, prior to the release of the OECD’s recommendations regarding the application of consumption taxes to e-commerce, the EC released a proposed amendment to the EU VAT directives that would have required non-EU vendors making digital supplies of more than €100,000 to unregistered EU customers annually to register and collect taxes in one of the 15 member states. The EC proposed that a customer’s residence and tax status be determined by the billing address of the credit card used in the purchase. The Clinton Administration issued a press release harshly criticizing the proposal, faulting it for bypassing the OECD e-commerce project, creating the potential for non-neutral taxation of digitized products and their physical analogues, impeding trade, exposing non-EU vendors to EU income tax and other legal requirements, and threatening enforcement actions that raised due process concerns (such as failure to protect intellectual property sold by noncooperative vendors).
Amendments to EU VAT directives require unanimous agreement of the 15 member states and the proposed VAT directive ultimately failed. Notwithstanding U.S. opposition, the proposal failed because of the “Luxembourg problem.” Under the proposal, non-EU vendors would have been given considerable flexibility in choosing a state of registration, and it was widely suspected that Luxembourg, with a 15% VAT rate, would divert e-commerce revenues from high-tax countries such as Denmark and Sweden (where the VAT rate is 25%).
In the spring of 2001, the Economic and Finance Committee of the European Parliament advanced a compromise VAT proposal under which non-EU electronic vendors with unregistered EU customers would be required to register for VAT in one of the member states and to remit VAT to the state of registration based upon the applicable rates in their customers’ jurisdictions. Under the proposal, the registration state would have been required to redistribute its VAT receipts, to the extent attributable to transactions with customers located in other member states.
While addressing the revenue-sharing concerns of the high-VAT countries, the compromise proposal would have created a striking non-neutrality between EU and non-EU vendors: The former would continue to collect VAT at the rate in the country of establishment, while the latter would be required to collect VAT at the rate in their customers’ countries of residence. Moreover, the proposal would have imposed considerably higher compliance burdens on non-EU vendors, constituting a possible violation of the EU’s obligations under the WTO. Indeed, the technological infrastructure does not currently exist to allow real-time online authentication of a customer’s residence and tax status.
The committee ultimately abandoned the compromise proposal in April 2001 when it became clear that the U.K. would oppose such a system absent the development of a workable technological solution to tax collection.
Non-OECD Countries
Outside of the OECD, countries have adopted widely varying policies toward e-commerce taxation. Some countries are seeking to tax the income of foreign companies based solely on an “economic” rather than a physical presence. Such countries may characterize payments from domestic subsidiaries for use of their foreign parents’ computer systems as royalty income rather than payment for services. At the other end of the spectrum, Singapore has adopted an approved cyber-trader tax incentive regime to promote e-commerce operations. This tax regime includes a 10% concessionary tax rate on incremental off-shore trading income derived by the approved cyber-trader from Internet transactions in non-Singapore currency, a 50% investment allowance on approved capital equipment, and full or partial relief on certain royalty payments made to nonresidents.
Protectionist tax policies may ultimately be self-defeating because the Internet allows developing countries to compete in global markets in ways that previously were impossible. For example, software development and data processing firms in India have used the Internet to win business customers around the world, often where the competition is located much closer to the market.
World Trade Organization
In May 1998, the WTO adopted a temporary moratorium on the imposition of customs duties on electronic transmissions. Whether this moratorium will be extended is unclear. Moreover, the rules for classifying digitized products as goods or services under GATS need to be elaborated.
Looking Ahead
Following release of reports to the public in February 2001, the OECD restructured the business-government TAGs, reducing their number from five to three, adding a technology panel to serve as their resource, and extending their mandate for an additional two years. The TAG experiment in business-government cooperation in OECD tax policy formation has universally been judged a success, and this structure is likely to be used in the future. Expanded participation by non-OECD member countries also appears to be a new trend, promising potential benefits to both OECD governments and multinationals.
If business-to-consumer e-commerce grows at the rates anticipated by many forecasters, pressures to impose consumption taxes on cross-border transactions will rise. The EC is likely to find a compromise solution acceptable to the member states, and many non-EU countries will follow this lead. The OECD may be able to promote better coordination of consumption tax regimes by developing a model consumption tax treaty similar to its model income tax convention.
If the EU and other countries successfully impose VAT obligations on U.S. companies with no physical presence abroad, this will almost certainly affect the state tax nexus debate in the United States. If a company with nexus only in California can collect French VAT, surely New York will argue that it would not be an “undue burden” for the California company to collect sales and use taxes for New York customers. Similarly, the states will undoubtedly argue that foreign companies with no U.S. presence should be required to collect tax on sales to U.S. customers. With more than 7,000 state and local taxing jurisdictions in the United States, the lowering of state nexus thresholds will require massive simplification.
While consumption taxes are the current priority in both the OECD and the EU,
the reexamination of transfer pricing rules may have even greater long-term
consequences for multinationals, particularly if this review leads to modifications
in the treatment of intangible property under the OECD guidelines.
Finally, just as developing countries in Asia and South America have come to
embrace the reduction of tariff and non-tariff barriers to trade and investment
as the best long-term strategy for economic growth, it is likely that developing
countries increasingly will see e-commerce as an opportunity for growth, and
shift their tax policies accordingly.
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