By Douglas S. Stransky
If the buzzword of the ’90s—exemplified by the hit movie You’ve Got Mail—was “email,” the catchphrase for the decade ushering in the new millennium is “e-commerce.”
The term e-commerce or “electronic commerce” refers to using computer networks (whether internal within a company or external to it) to facilitate commercial transactions such as the sale and delivery of goods and services. In facilitating commercial transactions, these networks communicate with other networks via cables, satellites, television or telephone systems, and other computer networks. Together, all these connections between millions of computers worldwide are known as the Internet. The Internet isn’t centralized. Instead, it’s a network of networks that permits computers to share servers and communicate directly; although information—and money or e-credit—may pass between a number of routers before arriving at its intended destination.
Advances (e.g., bandwidth increases) on the Internet, the increasing ease and familiarity with such advances and international competitiveness have ignited an explosion of new businesses; and ways of doing business using various e-commerce models have freed traditional businesses from geographical limitations. For example, service providers in the United States (e.g., brokerages, ticketing offices, banks or professional consultants) may furnish their services to clients on a worldwide basis with very little additional expense or practical difficulty than would otherwise be necessary to serve U.S.-based clients. Other examples of transactions that can be accomplished electronically across borders include sales and delivery of digital material (i.e., music, software and video), publishing of electronic magazines or newspaper, and providing access to online databases. In addition, new activities will likely develop while existing ones (e.g., Internet telephony) will become increasingly commonplace.
Instant global players
Even if the closest your company comes to global business is croissants at the weekly staff meeting, e-commerce’s rapid expansion and the Internet make you an international player as soon as www.your-company.com goes live. Indeed, some experts estimate that by the year 2002, non-U.S. buyers will generate almost 40 percent of e-commerce at U.S. firms’ websites. Likewise, many foreign-based companies are making Internet-based sales to the United States in an ever-increasing amount.
All companies operating (or planning to operate) in cyberspace face a formidable number of tax issues—some unique and others familiar—that will require businesses to consider the U.S. and foreign tax rules addressing cross-border transactions. Although e-commerce taxation has focused primarily on state sales and use tax, most countries, including the United States, have started to examine international income taxation of e-commerce. For now, traditional international tax principles apply. In the future, new rules will likely develop that are appropriate for e-commerce transactions. In fact, the Organisation of Economic Cooperation and Development (OECD) recently released a draft proposal that presents opposing views of the 29 member states on various e-commerce taxation issues in cross-border transactions.
One of the first international tax issues to arise in cross-border transactions involves the permanent establishment (PE) concept. The PE concept, which requires the existence of a “fixed place of business,” is embedded in more than 1,500 tax treaties throughout the world. A physical presence or PE generally determines which jurisdiction has the primary right to tax the income generated in that location. Yet, traditional concepts of PE are difficult to apply in the e-commerce arena because companies can now operate their Internet-based businesses from anywhere in the world, and generate income in countries with little or no physical presence in those countries. Business transactions can occur on a server located in the country of the seller, the buyer, in some other country altogether or on several different servers located in different countries. The effect of server location is unknown under existing tax law, although this issue is open to interpretation by the tax authorities and courts of each country. At least some countries may conclude that a server constitutes “a fixed place of business.”
In addition, the character of a cross-border transaction, in most cases, determines its taxability. The cross-border sales of products, such as water filters, are ordinarily subject to income tax in the customer’s country only when the seller has a permanent establishment in that country. On the other hand, where a cross-border royalty is paid, the recipient of the payment is ordinarily subject to tax in the country where the customer is located, regardless of whether the recipient has a permanent establishment in the country. Ordinarily, the customer must withhold tax on the royalty payment. In e-commerce, however, no clear rules currently exist for determining the character of income from cross-border transactions.
Another principle of international taxation provides that the country where a business earns its income (the “source country”) is the country with primary taxing rights over business profits, not the country or countries where the business is incorporated, managed and controlled. Under U.S. tax law, the source of taxation is critical for determining U.S. residents and domestic corporations’ taxable income because taxpayers may take a foreign tax credit for foreign taxes paid on foreign source income.
With the acceleration of e-commerce, however, this sourcing principle might be ripe for re-examination. In particular, the U.S. Treasury stated in 1996 on tax implications of e-commerce that residence-based taxation—or exclusive jurisdiction to tax by a person’s country of residence—likely will eclipse source-based taxation. In e-commerce, it’s often difficult to apply traditional source concepts to link an item of income with a specific geographical location. Therefore, source based taxation could lose its rationale and be rendered obsolete by e-commerce.
Easier and harder
E-commerce makes it easier for companies to engage in global product development, collaboration, and sales. As companies continue to increase their global activities, they can expect an increase in the tax problems inherent in global endeavors. One of these problems is transfer pricing, which encompasses the pricing of transactions in goods, intangibles and services between related entities. On-line inventory controls, purchasing systems and intra-company debt adjustments are all types of transactions that these rules can affect. Sales and licenses of intangibles between related persons—such as the use of a parent company’s software by its subsidiary—must also comply with transfer pricing rules. Tax authorities around the world are ever vigilant for manipulation of transfer prices between related entities that result in income distortions. For instance, tax authorities are watchful for transfer prices that result in income from product sales being allocated disproportionately to tax haven countries.
The dynamic and expansive nature of e-commerce presents new tax questions because no one owns, controls or regulates it. Companies continue to conduct new types of potentially taxable cross-border transactions as well as traditional taxable transactions over the Internet. How these transactions—which are accomplished in novel ways—should be taxed isn’t always clear. Current rules aren’t sufficiently advanced to deal with all the issues such transactions raise. Therefore, governments will have to determine how to change the existing tax rules to tax income arising from what’s sure to continue to be substantial economic activity over the Internet. Any such efforts should avoid double taxation and assure the continued expansion of global enterprises.
And keep in mind that if the children’s book store that Meg Ryan’s character ran in “You’ve Got Mail” had gone global with e-commerce, there’s a very good chance The Shop Around the Corner wouldn’t have been swallowed up by the superstore, Fox Books.
About the author
Douglas S. Stransky, J.D., LL.M., is a manager with Arthur Andersen’s International Tax Consulting practice and is based in Cincinnati. Stransky advises clients in a variety of international business and tax matters, with a specialization in the development of International Growth Strategies. He has advised clients on inbound and outbound transactions, including export documentation and letters of credits, all aspects of transfer pricing, and strategic issues ranging from new start-ups to acquisitions and restructuring of existing global operations. He holds a bachelor’s degree from Harvard University, as well as Juris Doctorate and Master of Laws in Taxation degrees from the University of Miami in Florida. He can be reached at (513) 762-0365 or email: [email protected]