Taxing Cross Border Digital/Internet Commerce

Author: Serge Perkovic, Principal,

Northfields Lawyers, 3 October 2016

TAXING CROSS BORDER DIGITAL/INTERNET COMMERCE 

Internet transactions between participants in different jurisdictions may be subject to taxation in multiple jurisdictions. However, for e-commerce the prevailing opinion is that traditional legal mechanisms will suffice to confront challenges promoted by cross-border e-commerce.  

Major Problems

The Internet is a borderless medium. The USA Treasury Department mentioned, in the one of the first reports on tax and the Internet, in the year 1996: “From a certain perspective, e-commerce doesn’t seem to occur in any physical location but instead takes place in the nebulous world of cyberspace.”

In contrast to traditional commerce, the Internet promotes the transmission of digital goods, services or intangibles where the cost of their creation is usually fixed and maybe excessive while the cost of distribution is minor.

Additionally, electronic commercial transactions may create difficulties and confusion in determining where transactions took place and what type of income was produced. Users of technology maybe anonymous and  geographic issue is often blurred.

Cross Border Business Profits

Although the international tax rules apply, digital commerce poses specific problems.

Firstly, the traditional concepts of physical contact or activities through an agent must apply to new situations which are specific for digital commerce. If there is no a tax treaty then a test used by many counties is whether a business entity “carries on business” in foreign jurisdiction. If countries have negotiated a tax treaty then a higher threshold – the permanent establishment test applies. Finally, even if a country claims jurisdiction, there may be enforcement concerns as sometimes it is hard to locate or seize assets of a taxpayer.

Many countries do not tax solely on the basis of territorial connection but require some threshold presence. For example, in the USA, if server of a provider of goods and services in the USA is located outside the country, it may be difficult to find connection with the local jurisdiction that it is engaged in a US trade or business through its own activities. Moreover, mere lease of local access numbers or authorisation of local shipping companies without a person in the USA being hired to represent the provider of goods and services will not give rise to agency relationship. In many countries, whether there is jurisdiction, absent of any other territorial connections, in transaction between foreign e-commerce provider and a resident depends on whether the display of goods and services on provider’s website amounts to an “offer to sell” (likely subject to domestic jurisdiction) or a mere “invitation to treat” (likely not subject to domestic jurisdiction).

Server/Permanent Establishment Rule

Even if countries’ domestic laws would permit them to tax income from cross-border Internet transactions, in many cases bilateral treaties may impose higher thresholds. It is a typical position in a bilateral treaty that a contracting state taxes only business profits which are attributable to a permanent establishment in other contracting state. A physical permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on and includes any premises, facility being on disposal to the enterprise but it also may include tangible assets used in carrying on the business.

The OECD members addressed the issue of the permanent establishment definition in the context of e-commerce (1997 Turku meeting, 1998 Ottawa meeting) and made a point that a website in and of itself cannot constitute a permanent establishment. However, the server on which the website is stored is tangible property and has a geographical location and may constitute a permanent establishment. OECD and other governments have generally followed the OECD server/permanent establishment rule. This issue has created the most divisive reactions. There was a strong opposition to this rule, however, the OECD governments ultimately agreed to this rule despite of the fact that application of this rule may permit firms to shift profits outside of relatively high income tax jurisdictions.

Cross Border Internet Services

The situation will vary dependable on how different jurisdictions addressed major problems regarding taxing cross border services.   The major problems jurisdictions face is classification whether income is generated from the performance of services or falls into another category and determination where services were actually performed. In the US, the sole criteria of determination are where services are performed is where they are rendered. Under the OECD Model Treaty, the permanent establishment rule still applies and a contracting country would only be able to tax income generated from services if the income is attributable to a permanent establishment of other contracting country. The United Nations model tax treaty deems services to constitute a permanent establishment in some cases.

Cross Border Internet Royalties

The treatment of royalty income and gains from the sale of computer software involves consideration of various aspects of transactions:  whether downloading software fee constitutes royalty fee or a fee for the performance of services or a right to use tangible property (e.g. hard drive), or, if ownership is transferred, simply a sale.  

The US Treasury issued Regulations addressing aspects of the classification issue of transfer of a computer program by which it can be determined whether the transfer consists of a copyright right or a copyrighted article. After that it should be determined whether the transaction is a sale (exchange) or a license (lease). Sometimes the transaction will be treated as a transfer of services.

Article 12 of the OECD Model addresses the taxation of royalties whereby the residence state (a contracting state where person receiving a payment resides) has exclusive taxing authority where a person making a payment resides in other contracting state. The term royalties is precluded to be interpreted solely by reference to domestic laws as Article 12(2) contains a treaty definition of this term. The principles articulated in the OECD Commentaries are not universally accepted, as, for example, Spain, adopted wider interpretation of royalties so transactions which some countries might consider a sale of software might be characterized as a royalty in Spain.

The OECD Commentaries address mixed payments where the payment might be partly for services, partly for know-how, and partly for the use of intellectual property – in which case the amount payable can be broken down on the basis of the contracts between the parties or by means or reasonable apportionment.

Problems with Applying Traditional Residence Rules to E-Commerce

The “Cyber resident” issue regarding individuals does not pose serious problems The OECD Model (a 4(2) provides that if an individual has a permanent home in neither of in both contracting states, a criteria for determining residence is the individual’s “centre of vital interests”.

Article 4(3) provides a test for competing claims with respect to corporate residence to be the “place of effective management”. In contrast, the USA determine residence by looking to where a corporation is incorporated (in absence of treaty provisions).

By the OECD Model treaty in the absence of any specific transfer pricing rules for e-commerce, the OECD positon on the treatment of global trading of financial instruments (as per OECD Global Trading Report 1998) may provide some useful insight (MAYBE).

Controlled Foreign Corporations

Discussions about this topic is beyond the scope of this article, however, it is noted that that tax heavens are now easier to be reached by commerce participants than ever before and there is difficulty in detecting that they are actually from tax heavens so it may become difficult to enforce existing controlled foreign corporation legislation, 

Consumption Taxes – International VAT/GST Guidelines

Rules of international taxation related to consumption taxes apply to e-commerce equally.   It is noted that there  is almost universal adoption of the destination principle in preference to the origin principle.

In the year 2015 the OECD published the paper “International VAT/GST Guidelines” seeking to set standards ensuring neutrality in cross border trade.

Conclusion

Any international Cyber-projects should be planned carefully with consideration given to national laws and international treaties.

It seems that un-modified international taxation rules are engaged and will continue to engaged in addressing cross-border e-commerce transaction. However, it seems that rapid development of e-commerce made some historical perspectives on international activities regarding development of international taxation: for the first time in history countries engaged in multinational discussion leading to agreement on tax principles, OECD joined with members of industry to agree on frameworks, non OECD countries such as China, Russia and Brazil though the appointment of representatives to OECD Technical Advisory Groups, and other.

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