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JILT - 2001 (2) - Subhajit Basu 1



Introduction: What is Electronic Commerce?


Growth of Electronic Commerce


Why We Want to Tax E-commerce


What Characteristics of E-commerce Make Tax Such a Focus of Attention?



Borderless Commerce


Digital Commerce


The 'Virtual' Corporation


Real-time Commerce


Changing Business Models


The Transitional Nature of the Internet Only Adds to the Following Further Problems


Taxable Activities on the Internet


Summary of Some of the Fundamental Tax-related Issues Raised by the Evolution of Cross-border E-commerce Transactions


Basic Principles of International Taxation



Current Principles of Direct Taxation



Concept of Residence


Permanent Establishment


Characterisation of Income


E-commerce Challenges to Direct Tax Systems


Approaches to Indirect Taxation


E-commerce Challenges to Indirect Taxation



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Taxation of Electronic Commerce

Subhajit Basu
Mphil, Liverpool John Moores University
Liverpool, UK

This is a Commentary published on 2 July 2001.

Citation: Basu S, 'Taxation of Electronic Commerce', Commentary, 2001 (2) The Journal of Information, Law and Technology (JILT) < >. New citation as at 1/1/04: <>.

1. Introduction: What is Electronic Commerce?

E-Commerce is doing business over the Internet. Definitions for E-commerce vary considerably. However, consideration of two brief definitions raises some basic issues. Thus it has been said that:

E-commerce is a broad concept that covers any commercial transaction that is effected via electronic means and would include such means as facsimile, telex, EDI, Internet and telephone. For the purposes of this report the term is limited to those trade and commercial transactions involving computer-to-computer communications whether utilising an open or closed network[1].

In addition, it has also been said that:

Electronic commerce could be said to comprise commercial transactions, whether between private individuals or commercial entities, which take place in or over electronic networks. The matters dealt with in the transactions could be intangibles, data products or tangible goods. The only important factor is that the communication transactions take place over an electronic medium[2].

These definitions raise issues in relation to the form of communication, the subject matter of the transactions and the contracting parties. The first of the above definitions emphasises that e-commerce, in broad sense, could encompass trading carried out by means of communication that can be labelled 'electronic'. However, it emphasises computer-to-computer transactions and the concern here is basically email and web-based communication, which are sufficiently different from the more traditional means of communication to raise significant issues for the law. The second definition includes some recognition of the different types of subject matter of electronic contracts. Such contracts may simply be concerned with traditional goods or services to be delivered in the traditional way. However e-commerce does not simply provide a new means of making contracts. In some situations it also provides a new method of performance[3].

In November 1999 the United Kingdom government issued Electronic commerce: The UK's Taxation Agenda. The document defines electronic commerce in the following terms (Para 1.3):

'While there is no internationally accepted definition of e-commerce, the Department of Trade and Industry have proposed this working definition to the OECD:

'Using an electronic network to simplify and speed up all stages of the business process, from design and making to buying, selling and delivery e-commerce is the exchange of information across electronic networks, at any stage in the supply chain, whether within an organisation, between businesses, between businesses and consumers, or between the public and the private sectors, whether paid or unpaid'.

For ages, business has been based on physical presence, and physical delivery of goods and services. In e-commerce, physical presence is not needed and where the goods or services are digitalised, neither is physical delivery. Certain products such as software, video, books, music and even newspapers and magazines no longer have to be physically delivered in hard copy format to the purchaser. Suppliers can instead send the products in digital form over the Internet, providing both time and cost savings[4]. Hence, it is difficult to apply the traditional rules of taxation. This paper examines the principles the have to be applied for taxing e-commerce transactions.

2. Growth of Electronic Commerce

E-commerce is one area where market forecasts made in 1996-97 turned out to be much less than actual performance. To mention about a few recent forecast on E-Commerce, the Emerging Digital Economy II, June 1999 publication of US Dept. of Commerce brings out the emerging E-business/E-commerce market and associated initiatives. According to a survey from IntelliQuest's Worldwide Internet/Online Tracking Service, only 15 percent of Netizens use E-commerce. The research firm Computer Intelligence recently interviewed 40,000 US businesses, and found that less than 2% of the country's 4.8 million computerised business locations are involved in some form of electronic commerce. M/s Forrester Research, Inc. USA, a leading consultancy firm in E-Commerce forecasts that world-wide Internet Commerce will reach between $1.4 trillion and $3.2 trillion in 2003 - up from a range of $55 billion to
$80 billion in 1998. This growth will happens as the world's largest economies come online by 2004. Datamonitor predicts that Western European spend on business-to-business E-commerce solutions will grow to $11bn by 2001, from $380m in 1997, indicating how quickly this market segment will grow. Datamonitor notes that spending on services (consultancy, systems integration) will grow most rapidly, experiencing a 92% compound annual growth rate over the period 1997 - 2002, compared to 66% for hardware and 85% for software.

Datamonitor has also produced forecasts for the business-to-consumer market: it predicts that total revenues from online shopping at European sites will grow from 111m ECUs in 1997 to nearly 5 billion ECUs in 2002. It predicts that travel products will experience greatest growth, from 7% to 35% of the total online product mix over the period 1997-2002: however, this finding is at variance with the EITO survey, which found travel one of the slowest sectors to take advantage of Internet E-commerce. Insurance will also grow, according to Datamonitor, from less than 1% in 1997 to 9% in 2002. All other product categories will experience falling shares of the overall product mix.

Total business-to-business Internet commerce - defined as the value of goods and services purchased over the Internet by businesses - has grown from virtually zero in 1990 to an estimated $43 billion in 1998. According to Forrester Research, Business- to-Business (B2B) E-commerce is projected to reach over $1.3 trillion by 2003, comprising over 9% of the US GDP. Volpe Brown Whelan, an investment bank specialising in Internet and E-commerce, estimates that overall hub revenue (both transaction and advertising) in the US will grow from $290 million in 1998 to $20 billion by 2002. The estimates by the Precursor Group are even higher: $50 billion and $130 billion by 2002. Outside the United States the E-commerce opportunity is even greater with approximately 30 million businesses world-wide that want to identify, qualify and conduct business with one another. European B2B E-commerce is projected to grow over 2400 percent from $7.15 billion in 1998 to $176 billion by 2003. The UK government has a target of 90% (by volume) of routine goods electronically by 2000/2001, and making 25% of the government services available online by 2001. Also, the Asia-Pacific region is expected to grow even faster with 20% of business executives expecting over 20% of their revenues to come from. Even developing economies understand the economic growth engine that B2B E-commerce provides.

The countries that are leading in this field and, therefore, defining the way E-Commerce is done are mainly USA, European Union and Australia. Malaysia, Mexico, Singapore and India are among the countries that are striving hard to follow the leaders and evolve mechanisms and technologies specific to their own business environment.

3. Why We Want to Tax E-commerce

It should not come as surprise to anybody that the question of how the Internet and E-commerce will affect taxes has received such early and intense policy attention. Most analyses of E-commerce and tax tend to focus on the specifics of how to implement existing regimes given the changing environment. This is understandable since business tax accountants and government revenue authorities have to deal right now with the very real questions of, on the one side, what taxes do I owe to whom, and, on the other side, how much revenue are we likely to receive into government coffers[5].

Taxation should be viewed in terms of its effect on the economy as a whole and fiscal policy as the major policy tool of governments. Taxation is clearly part of a political economy. Tax principles naturally involve ethical and political questions. Taxation is the principle means by which governments can attempt to redistribute wealth and bring about social change through various social policies[6].

There are several reasons why E-commerce should be taxed. It's only fair - taxes should not depend on the way you buy an item, or from whom you buy it. As E-commerce stands right now, a local music store has to collect 5% sales tax on a CD when it is purchased, while you could buy the same exact CD over the phone or on the Internet from directly, and by doing so avoid any sales tax[7 ]. Taxes are very important for the state governments, who heavily rely on sales taxes to fund schools, pay state salaries, and repair roads. States are worried that if E-commerce continues to grow, business will shift more to tax-free Internet shopping, taking business away from the normal methods of shopping. By doing so, the states will lose valuable revenue. States are already losing $3 to $4 billion a year on mail-order sales. The states will use the revenue, according to the National Governors Association:

'to support a wide range of public services, including police protection, education, community service, and health care'.

4. What Characteristics of E-commerce Make Tax Such a Focus of Attention?

As I sit in my home in Liverpool, I log on to Barnes & Nobles' website via a server based in Dallas and use my international credit card to buy a book for my friend which will be delivered in Delhi. Incidentally, the credit card company head-quartered in New York has a data processing centre in Brussels to process the transaction. Meanwhile, the book is being shipped from a store in Singapore.

The questions that arise here are who should get the revenue if such transaction is to be taxed. At which point is the transaction to be taxed?

In the above example if we suppose that the book is delivered electronically, then the question arises what taxes and custom charges apply to the product? How are these taxes and charges 'policed' and collected? Could the charges and taxes be avoided by simple expedient of maintaining an electronic 'manufacturing' facility in some third country?

The complexity of E-commerce taxation is a reflection of five trends occurring within the growing Internet economy. These include the rise in borderless commerce, the emergence of digital commerce, the hollowing out of the corporation, the explosion of real-time transactions and the revolution of new business models.

4.1 Borderless Commerce

E-commerce does not respect geographical boundaries, and Internet transactions flow seamlessly across the globe. The rise in remote commerce will lead to an enormous increase in cross-border transactions and related taxation issues. Mail-order sales raised many of the same issues, but Internet commerce is expected to be five times larger than mail-order sales within five years.

Cross-border transactions have historically been one of the most problematic areas of taxation. The process of dis-intermediation, in which remote vendors sell directly to customers in other jurisdictions without the buffer of a wholesale distributor or retail outlet, will result in hundreds of thousands of entities dealing with taxes in additional states or countries for the first time. Both 'dot-coms' and brick-and-mortar companies will need to cope with tax rules in numerous additional jurisdictions.

Thus, the exponential growth of remote commerce during the first decade of the 21st Century is likely to lead to a significant increase in cross-border tax issues and controversies, particularly in relation to international income taxes, VATs, and sales and use taxes. Borderless commerce will expand both business tax compliance efforts in multiple new foreign jurisdictions and nexus and jurisdictional disputes over which states or nations can impose income or transactional taxes on Internet vendors.

4.2 Digital Commerce

The Internet will accelerate the trend toward the digital economy. Direct E-commerce is composed of companies that sell goods and services that are both purchased and delivered by electronic or digital means. There is a wide variety of goods and services that can be digitalized or otherwise transferred electronically to customers without the need for any form of more traditional physical delivery.

The vast expansion of the digital economy raises some of the most complex tax issues. The digital economy will significantly increase tax controversies and compliance-related problems associated with income earned from services and intangibles. States and nations will have to deal with issues such as the characterization of income, the bundling of services and products, sourcing rules, transfer pricing, and the valuation of intangibles. The absence of tax rules adaptable to the digital economy will cut across both direct (income) and indirect (transactional) tax systems.

4.3 The 'Virtual' Corporation

The Internet is also accelerating the trend toward 'virtual' corporations with narrowly defined core competencies. In the information age, there is less need for vertical integration. Companies are more likely to narrowly define their core competencies and leave manufacturing. distribution, fulfilment, customer service and other functions to third parties. In part, this is because of the ease with which companies can enter into joint ventures, partnerships, outsourcing agreements and other affiliations to bring products to market.

For instance, Cisco Systems, is primarily a virtual corporation. Cisco Systems sells many of the routers, circuits and other equipment used to construct the infrastructure of the Internet. Over three-quarters of all Cisco Systems product orders are made online. Over two-thirds of all Cisco Systems manufacturing is out-sourced to other companies. As a result, for a large percentage of its product sales, no Cisco employee ever comes into contact with either the customer or the actual product involved in a transaction.

An even more dramatic example of the virtual corporation is eMachines. This personal computer reseller sold 1.7 million computers globally in 1999, producing over US$1 billion in revenue. Incredibly, the company used only 20 employees to conduct its business, relying on other entities for virtually all of its operational functions.

With the narrowing of core competencies, Internet businesses will frequently have more flexibility to relocate (or initially locate) their property and payroll in jurisdictions with more favourable income tax rules and rates. It is far easier to shift the location of computer servers, headquarter employees, or information technology personnel than it is to move around large factories. Thus, the emergence of the virtual corporation is going to put pressure on tax laws - particularly in the income tax arena - to develop new rules for apportioning the income of more mobile and dynamic businesses. In a complementary development, the Internet also places a premium on intangible values (such as brand names and customer information), leading to more tax compliance, planning, and litigation over the value and location of such intangibles.

4.4 Real-time Commerce

The Internet also facilitates a significant increase in real-time, paperless transactions. This trend is likely to enhance the momentum toward tax compliance reengineering and automated tax solutions for transactional taxes. It also will increase the pressure on taxing authorities to simplify the substantive and procedural tax rules to make an automated system more workable and less costly.

During the 1990s, the growing interest in the automation of sales and use tax or VAT compliance was part of a larger movement toward the use of enterprise resource planning (ERP) software to automate corporate-finance, distribution and other operational functions. The explosion of E-commerce and the growth of Internet-based transaction processing for both business-to-business sales and business-to-consumer sales will accelerate the creation of a less paper-oriented environment in which electronic databases largely supplant filing cabinets filled with sales invoices and purchase orders.

Indeed, in the United States, a broad coalition of state and local government groups made a sweeping proposal to the federal Advisory Commission on Electronic Commerce (a commission created by the 1998 Internet Tax Freedom Act) for a 'zero-burden' real-time compliance system for sales and use tax collections. The system would be at least partially government funded and rely on a technology-driven solution using third-party contractors to collect sales and use taxes on behalf of remote vendors.

4.5 Changing Business Models

Finally, the Internet is also causing a revolution in business models that is creating new and challenging issues for state, federal, and international tax systems. The Internet is characterized not just by remote selling but also by a range of evolving business models such as online auctions, reverses auctions, virtual communities, infomediaries, aggregators, and brokers. Traditional industries such as automobiles, clothing, book publishing and pharmacies are being turned upside down by the potential of online retailing to replace conventional store purchases. Many manufacturers are being transformed into retailers; many conventional intermediaries such as wholesalers and distributors are disappearing or being replaced by new Web-based intermediaries.

These business models are significantly altering the landscape of interactions between suppliers, sellers, and buyers - creating many new tax issues. For instance, gift certificates are currently an $11 billion market in the United States. Prior to the Internet, gift certificates were primarily purchased at retail outlets. In the last two years, however, a number of Internet start-ups such as and have begun to build an online marketplace for gift certificates. These entities buy the gift certificates from retail outlets at a discount and resell them over the Internet. The emerging business models for gift certificates and gift giving raise new and difficult tax issues regarding the identity of the actual retailer, the sourcing of consumption, the classification of the good or service sold and the relevant sales price for transactional tax purposes.

4.6 The Transitional Nature of the Internet Only Adds to the Following Further Problems[8]

As the physical location of an activity becomes less important, it becomes more difficult to determine where an activity has taken place and hence it becomes difficult to determine the source of income. There is little technical difference between electronic transmission within a country and between countries.

Mirror sites, a copy of a website held on one or more other servers around the world add to location confusion. The mirrors reduce the amount of electronic traffic to a web server, but it is not always easy to tell whether you are looking at the original server or a mirror.

Companies can more easily move to favourable tax regimes, or keep moving from one to another, never settling permanently in one place. The increase in international trade also brings potential, unintentional, compliance problems, especially from smaller businesses, which may not have the resource or experience required to deal with international tax compliance. The dynamic nature of E-commerce development presents its own problems; for example, the increasing use of 'intelligent' agent software on a web server, gathering information and presenting conclusions without the intervention of a human adds to the confusion over where a business is conducted.

In general the proof of identity requirement of Internet use is very limited. The Internet address or the domain name only indicates who is responsible for maintaining that name. It has no relation to the computer or user corresponding to that address or even where the machine is located. Reduced use of information reporting and withholding institutions: traditionally the taxing statutes have imposed reporting and withholding requirements on financial institutions, which are easy to identify. In contrast one of the greatest commercial advantages of electronic commerce is that it often eliminates the need of intermediary institutions. The potential loss of these intermediary functions poses a problem for tax administrations.

5. Taxable Activities on the Internet[9]

Internet access - Internet service providers offer a variety of services including email services, browser programs, and Internet access and custom websites.

Retail - businesses advertise and sell products through their own websites and cyber-malls delivering the products via postal and courier services. Examples of products that are sold in this manner are books, computers, and sports gear.

Digitalised products - businesses advertise and sell products through their own websites and cyber-malls, and then deliver the products via Internet. Products that are sold and delivered in this manner are software, music, newspapers, and magazines.

Information databases - for a fee, users can subscribe to information databases accessed through the Internet.

Gambling - gamblers can wager through online casinos and bookmakers. The question is, who pays the tax - the gambler or the operator? Hitherto, gamblers could only bet in countries where this was legal, and on events sanctioned there - now they are able to gamble on the Internet with relative ease, even though legislation in their home countries may prohibit gambling. For example, gambling is legal over the Internet in the USA as long as the company running the gambling site is located in a state where gambling is legal. In the UK, punters in high street betting shops can choose to pay a betting tax of 9% either on the stake before the event, or on the winnings and stake after the event. Now punters can bet on UK events on-line with bookmakers located in, for example, the Channel Islands (e.g., and pay no taxes at all.

Banking - banks are offering online banking services.

Share trading - share broking firms offer the facilities for investors to trade shares and manage their investments over the Internet.

6. Summary of Some of the Fundamental Tax-related Issues Raised by the Evolution of Cross-border E-commerce Transactions

a) Is there a need to develop new norms and tenets of interpretation to determine the nature and character of income from cross-border E-commerce transactions?

b) Is there a need to create new definition and meaning of permanent establishment?

c) Is there a need to change the basis of taxation (e.g. residence-based taxation)?

d) While considering taxation of E-commerce transactions, should principles of tax neutrality be adhered to?

e) Will electronic commerce increase the incidence of non-compliance with or avoidance of consumption taxes? How will the characterisation of intangible products and services affect that trend?

f) Will the ease of conducting business electronically lead to 'harmful' tax competition among countries?

g) Business is concerned about E-commerce taxation for the 'Tax system equality' and 'The potential for multiple taxation on single transaction'.

Neutrality is a fundamental tenet of taxation. It requires that taxation rules shouldn't affect economic choices and that, therefore, economically similar incomes should be taxed similarly. That is to say that the same taxation principles that apply to income from conventional ways of conducting business should also apply to income from E-commerce transactions.

In cases of cross-border E-commerce transactions, the tax issues are more complex because, according to the recognized principles of international taxation, when a resident of one country earns income from economic activity in another country, both countries have a right to tax the same income: the home state based on residence rule and the host state based on the source rule of taxation. While the principles of applying the source rule in the case of the conventional method of transactions have been fairly established, those for the e-commerce transactions pose considerable difficulties.

There are two main areas in which clarity needs to be established. One is the determination of the character of income that is generated by the E-commerce transaction: is it royalty, business profit, or fees for technical services? The other area is the determination of what constitutes a PE in the source country and attribution of income to the PE.

7. Basic Principles of International Taxation

Among international organisations, the OECD membership, in conjunction with non-member governments and private sector groups representing business and tax accountants, has been analysing since 1997 how electronic commerce might impact international and domestic taxes. The outcome of that effort was the 'Tax Framework Conditions' which reaffirms five key principles that guide governments generally in the application of taxes within the overall regime: neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility. In their conduct, tax neutrality, and perhaps fairness, appear to be the overarching principles for policymakers as they face E-commerce, although their interpretation of neutrality has yielded different outcomes. In its discussion paper on E-commerce taxation issues, states that it considers that widely accepted general tax principles should apply to the taxation of E-commerce[10]:

  • The system should be equitable: taxpayers in similar situations that carry out similar transactions should be taxed in the same way;

  • The system should be simple: administrative costs for tax authorities and compliance costs for taxpayers should be minimised as far as possible;

  • The rules should provide certainty for the taxpayer so that the tax consequences of a transaction are known in advance: taxpayer should know what is be taxed and when - and where the tax is to be accounted for.

  • Any system adopted should be effective: it should produce the right amount of tax at the right time and minimise the potential for tax evasion and avoidance.

  • Economic distortions should be avoided: corporate decision-makers should be motivated by commercial rather than tax considerations.

  • The system should be sufficiently flexible and dynamic to ensure that tax rules keep pace with technological and commercial developments.

  • Any tax arrangements adopted domestically and any changes to existing international taxation principles should be structured to ensure a fair sharing of Internet tax base between countries, particularly important as regards division of tax base between developed and developing countries.

The conclusion from the OECD's initial assessment was that, generally, existing domestic and international tax systems could cope with the networked world[11]. The areas targeted for further examination in the area of indirect taxation were cross-border application of consumption and value-added taxes, particularly given the different treatment of goods and services by governments. In the area of direct taxation, the OECD's Model Tax Convention (which serves as the basis for many bilateral international tax treaties)[12] was generally viewed as applicable, with further analysis targeted at how electronic commerce activities might be treated under the rules of permanent establishment, how transactions might fall into business profits vs. royalty income, and how transfer-pricing rules might be affected. In fact, the areas that the OECD determined would require additional analysis are exactly the areas where governments are trying to extend existing tax law to e-commerce transactions, leading to inconsistent treatment of transactions, both within countries and across their borders.

7.1 Current Principles of Direct Taxation

Direct taxes in the international context currently rely on the twin concepts of source and residence to specify who is liable for taxes and, for those who are what income is subject to tax.

In the United States, income taxes account for 60 percent of total tax revenues at the federal level, with about 80 percent of that raised from individual income taxes. As a general statement, income earned by US firms and individuals are taxed at US rates regardless of where the income was earned-so-called 'residence' based taxation. Developing countries to varying degrees also depend on income taxes, including taxation of income earned by non-resident firms operating in the country-so-called 'source' based taxation.

Because source and residence based taxation schemes must yield double-taxation of some income, bilateral and multilateral tax treaties attempt to allocate income earned to the source and to the residence according to 'permanent establishment' and give tax credits accordingly to minimise double-taxation[13]. Under the OECD Tax Convention, the authority to tax income earned in a particular country is limited to income earned by a 'permanent establishment' in that country. International income tax treaties are designed to allocate income among the parties to the treaty and to avoid double-taxation of income streams. However, many non-OECD countries do not subscribe to this Convention, are not participants in international tax treaties, and view income earned by any assets in their country as falling within their tax jurisdiction[14].

Moreover, the 'character' of income earned (business profits or royalty income) is not classified consistently across countries. In March 2000, the OECD Technical Advisory Group (TAG), which included OECD member governments, non-member governments, as well as business advisory groups, tabled for comment 'Treaty Characterization of E-Commerce Payments'[15]. It does not resolve the issues, although it presents the majority and minority views on how to treat income earned by selected E-commerce transactions. Notably, the TAG's mandate was to interpret existing tax codes, not modify the tax code.

7.1.1 Concept of Residence

A taxpayer is generally taxed on their worldwide income in the country of residence (residence based taxation). In the case of a company this is usually the place where the company is incorporated, registered, or has its place of central management and control.

The company may also be taxed in another country if it has recognised source of income there (source based taxation). Generally tax treaties restrict the use of domestic source rules by requiring a certain minimum nexus to allow taxation in that jurisdiction. Thus taxation of business income on the basis of the source rule requires the presence, in the country of source of a PE of the enterprise sought to be taxed.

The country of source also taxes income from immovable property, gains from alienation of such property, income from activities of artists and sportsman, directors' fees etc. Where there is no physical presence, the source country is generally only allowed in the form of withholding taxes on certain items of income, such as royalties, interest and fees for technical services.

Where the income or capital is taxed in the country of source, the country of residence has the obligation to give relief from double taxation. Such relief is granted either by accepting such income form taxation in the country of residence or by giving credit for the taxes paid in the source country.

7.1.2 Permanent Establishment

Under the tax treaties[16] based on the OECD Model Tax convention, an enterprise providing services abroad is taxable in that country where it conducts business only if it has PE there. According to the article 5 Para 1 of OECD MC, a PE presupposes the 'fixed place of business', which may include premises, facilities or installations. A permanent establishment is generally defined as a fixed place of business, including an office, a branch, a factory or a similar location. This definition excludes places of business that are mobile. And the definition is similar in many respects to the definition of a trade or business. However, a taxpayer's activities often must rise at least slightly above the trade or business standard in order to result in a permanent establishment.

There are three tests in determining whether a permanent establishment[17] exists:

The first test, the assets test, is an objective test, which focuses on the tangible and intangible assets of the activity.

The difficulties with E-commerce activities under the asset test are that E-commerce involves non-physical elements and E-commerce transactions are carried out electronically. One question is whether having a server in a country is enough to establish a permanent establishment. Warehouse and storage facilities are not considered permanent establishments due to their passive nature.

Thus, by analogy, many believe that a server should not qualify as a permanent establishment. Many also feel that treating a server, as a permanent establishment is inappropriate because the server is merely incidental to the underlying transaction.

Agency Test: A permanent establishment will result if a non-resident employs a dependent agent having contracting ability in the taxing jurisdiction.

Some argue that agreements and transactions with Internet service providers create a dependent agency situation. However, because the services performed by the Internet service provider do not include the contractual authority that is normally associated with a dependent agency, the Treasury Paper concludes otherwise. Article 5(5) and 5(6) of OECD MC.

Activities Test: This is perhaps the most widely applied test. Under the activities test, certain activities result in a permanent establishment while others clearly will not. The physical presence of a server might also have an impact under the activities test. Many feel; as discussed above, that the presence of a server simply acts like a warehouse storing information and processing orders. Others, however, believe that the presence of a server may constitute a permanent establishment.

The Treasury Paper[18] cites the example of a foreign citizen clicking on an US retail website and buying a product from that site. The Treasury Paper treats the sale to the foreign person via the Internet the same as a sale to a foreign customer via a phone call. In other words, the paper will look to substance of the transaction instead of method of consummating the transaction.

E-commerce will not result in a permanent establishment in most circumstances under the analysis of the Treasury Paper because the E-commerce 'place of business' is likely to be too mobile to be sufficiently 'fixed.' Moreover, based on the warehouse and storage analogy, treating the E-commerce 'place of business', as a permanent establishment is not appropriate. Many also believe that the mere solicitation of customers in the US by electronic means is not enough to constitute an US trade or business.

7.1.3 Characterisation of Income

Many types of information can be digitalised and transferred electronically, including computer programs, books, music, and various types of images (e.g., motion pictures, videotapes, etc.). A purchaser of such information could be restricted to using the purchased information, could be granted the right to make a limited number of reproductions (for internal distribution to its affiliates), or could be granted the right to reproduce the information for resale to a mass market. These types of transactions have occurred for many years in more traditional formats and will continue to be consummated in both electronic and non-electronic form. Accordingly, any changes to be effected in the tax rules involving such data transfers must be applied to non-electronic transactions as well as to their electronic counterparts in order to ensure neutrality of treatment.

Technology makes it far easier to reproduce and disseminate digitalised information. We do not believe new rules are necessary to govern the classification of income. Facts and circumstances have always played a major role in determining the tax consequences of business activities. The ability to handle data transfers electronically is just a change in facts and circumstances that can be accommodated under existing tax rules.

Software can be readily transmitted electronically and may warrant special attention because of complications that currently exist that can result in double taxation. Tax authorities may feel the need to develop internal rules on the characterisation of software transactions for tax purposes, and develop rules to distinguish software transactions that constitute licensing transactions from those that constitute sales of property. It is crucial that tax authorities strive to adopt uniform principles in the software area to promote some level of conformity in international tax characterisation. Such consistency should be encouraged lest differences in characterisation will result in double taxation.

7.1.4 Transfer Pricing

Global trading has increased over the last decade from an almost insignificant level to the significant role that it now plays in the global economy. This is a result of the trend away from regional and national economies to a global economy, coupled with the technological explosion in telecommunications and information technologies. Global trading could not exist without this sophisticated technology.

Transfer pricing is the primary tax issue that arises in this subject area. It is an issue, however, which should not be considered in a discussion purely of the tax consequences of E-commerce. Ascertaining the appropriate allocation and apportionment of income and expenses (for example, arising from the cross-border trading of financial products) is a matter of properly applying existing transfer pricing rules. It is not related to the reliance of industry on enhanced technology[19].

7.2 E-commerce Challenges to Direct Tax Systems

The characteristics of value-creation-networked the global, networked marketplace will increasingly strain the definition of permanent establishment, and will make the allocation of income to different governmental jurisdictions increasingly difficult. The threat of double taxation increases, along with the incentives for non-compliance, particularly by mobile firms.

The definition of a permanent establishment rests on two foundations: fixed place of businesses or physical presence[20] and dependent agents who, among other activities, must be able to conclude contracts on behalf of the corporation as a normal course of business. Permanent establishment runs into trouble in the networked world from the fundamental factors that define this marketplace.

First, for information-rich and network-based production, physical presence is much less important for value-creation (consider software code). Second, the mobility of information-based firms further undermines physical presence as well as calls into question the characterisation of dependent agents. Finally, the complexity of Internet marketplaces (consider the examples of virtual auctions and exchanges for business-to-business transactions) challenges the notion that there is a single 'head' to the organisation which could help define either physical presence or dependent agent.

Most practical attention to this question has focused on websites and servers: do they constitute physical presence if located within a country or do they constitute a dependent agent even if they are not located in a country but are 'open for business' there? There is no consensus yet, but arguments revolve around the range of activities that a user can do on a Web site and the extent to which a server is tied to a firm.

Servers control data flow among computers on a network and websites are the presentation of information or locus of activity for a firm. Data flows can be initiated by the server and channelled to a website (for example, targeted advertising) or can be remotely accessed by the user (for example, information gathering). Does either of these activities represent permanent establishment?[21] If the server or Web-site merely broadcasts information or advertising, then neither contacts the purchaser, but the purchaser contacts the Web site that then contacts the server. In this case, it would seem impossible that the physical location of the server and/or the website would constitute a dependent agent or nexus.

Looking forward, however, what if the server can individually target a consumer in another country? Does this change the notion of permanent establishment, dependent agent, or nexus? Consider two buyers both from the same country and buying the same product and digitally downloading it from the server. Suppose one buyer was contacted individually by the server in a targeted effort; the other buyer happened upon the Web site and downloaded the product. How can it make sense (and what kind of incentives result) when the two purchases are afforded different tax treatment? One can imagine a sort of 'route-around' service whereby the server would automatically route purchases through the least taxed environment, much as 'call-back' telephone services re-route and reduce telephone charges for users in countries with high telephone tariffs.

Two other issues facing the direct tax system on corporate income are treatment of royalty income and transfer pricing. Income earned from sales and income earned from licenses or royalties are taxed at different rates, and the nature of network transactions that give rise to royalty income differs by country, as discussed earlier. The higher information content of network products highlights these disparities and creates incentives for tax avoidance.

Transfer pricing is potentially a larger issue in the Internet marketplace, but not necessarily as a form of tax avoidance. Transfer pricing, or more generally the pricing of transactions at non-transparent, arms-length rates, is more likely in the context of complex information-based products where network effects are a key component of prices. Or consider auction-type environments where prices are endogenous to the number of participants in the market[22].

7.3 Approaches to Indirect Taxation

Many tax systems depend on indirect taxes, such as sales taxes, value-added taxes (VAT) or goods and services taxes (GST) to raise a substantial share of government revenues[23]. Both the United States and the European Union have been struggling with how to apply sales and VAT to E-commerce transactions, both within and across borders[24]. Neither body fully recognises that decisions taken in the domestic arena have implications for cross-border application of these types of taxes. Inconsistent tax treatment of transactions between the US and the EU and within each country as well, already has surfaced.

In the US, when the Congress passed the Internet Tax Freedom Act in 1998 (which kept domestic Internet transactions free from any 'new' taxes for three years but did not revoke existing sales or use taxes), it mandated review of the implications of E-commerce for domestic sales taxes. A majority of members of the Gilmore Commission proposed (they could not formally recommend to Congress, because no super-majority view was agreed to) that digital products downloaded over the Internet (including software, books, or music) should not be taxed. Moreover, in the interests of tax neutrality, their tangible equivalents also would be tax exempt. This represents a 'harmonising down' approach, which could generate inconsistent treatment of purchases over the Internet via and through other means for products not explicitly exempted. While still being reviewed, one objective of this proposal was to encourage states and localities to harmonise their own rates and reduce the myriad state and local taxes (some 30,000 within the United States) which are both administratively cumbersome and encourage tax-strategizing behaviour.

In contrast to the US, the EU tax authorities are drawing a bright line between goods and services purchased over the Internet, and to a greater extent than the US already have captured these transactions in their tax orbit. All electronic transmissions (those under the general term 'soft goods', such as software, books, or architectural drawings) have been deemed services and, therefore, should be taxed at the appropriate VAT rate.

In June 2000, the European Commission proposed rules that would have forced online sellers from around the world to collect VAT on sales of digital products and services location and rates for taxing to European customers. The main goal of these rules was to protect European sellers, who must collect VAT, from competition by foreign sellers who do not. US sellers targeted for tax collection declared the proposals unacceptable by many. Late in 2000, Europeans found the proposals. The EC is now rethinking ways to protect European sellers of digital products, while maintaining a workable VAT system.

The original proposals were made in June 2000[25]. The proposed legislation would have required non-EU sellers to collect VAT on sales of digital products and services to non -business consumers in Europe. Only those sellers with more than 100,000 Euro in sales from Europe would have been subject to these rules. The types of sales that would have been subject to the tax included, among other things, downloaded products, like software and music, and online entertainment services, such as pay-for-use video broadcasting.

The reason for the proposed laws was summarised in a statement by Frits Bolkestein, European Commissioner for taxation:

'Today European producers of digital products, such as computer games and software, are at a competitive disadvantage compared with non-European producers because they have to apply VAT to their products within Europe. US competitors, by contrast, can export to Europe free of VAT. Similarly European exporters to the US are now obliged to pay European VAT, whereas US producers are not faced with the same obligation.

I propose to put European producers of digital products on an equal footing with US and Japanese competitors by applying VAT to digital imports into the EU and exempting digital exports from the EU. This would create a global level playing-field for European and non-European companies'.

The attempt by the EU to impose VAT collection on sellers outside the EU was seen as overreaching in many countries. However, it was a logical solution to a real problem. The ease of selling digital products across international borders gives vendors from non-European countries, especially the US, a competitive advantage over those in Europe.

However, the proposals encountered far to many complaints. For instance, there was considerable doubt whether the EU could enforce compliance on sellers with no presence in Europe. Backers of the proposals felt that non-EU sellers, especially well-known ones, would be hesitant to build up a large unpaid VAT liability in the EU.

Supporters of the proposals suggested that the EU could withhold protection of the intellectual property rights of non-compliant sellers. This threat was seen by some as fairly ill conceived, because:

1. the seller may not be the holder of the intellectual property rights, so punishment would be misplaced; and

2. the tax authorities may not have the power to affect enforcement of intellectual property rights, which are the subject of international agreements.

A more serious complaint came from inside the EU itself. The proposals allowed non-EU vendors to register in only one EU country, and collect and remit only that country's VAT. Countries such as Denmark, with a 25% VAT rate, did not like this part of the proposal. Most agreed that non-EU vendors would pick a country like Luxembourg, with its 15% rate, in which to register. For Denmark, non-EU vendors would still enjoy a VAT advantage. Not only that, but VAT from non-EU vendors would flow into only a few countries.

Some European countries would have non-EU vendors' register to collect VAT in all 15 EU member states. While this solves the problems presented by allowing vendors to register in only one country, it presents a worst-case scenario for sellers. Tax compliance would be very difficult, and many vendors would simply not comply. The advantage of one-country registration is that it makes collecting and remitting VAT fairly simple. The simpler the process, the more likely a foreign seller will comply.

So, the June 2000 proposals have pretty much been rejected. The final blow was the ECOFIN meeting on November 27, 2000, where the EC was asked to rework the proposals. This means that non-EU sellers of digital products need not worry about new rules requiring them to collect VAT on digital product or service sales to European customers, at least not for now[26].

7.4 E-commerce Challenges to Indirect Taxation

Fifty years ago, VAT was a simple system to administer and audit-thus its popularity as a tax system. However, times have changed, and by and large, VAT has not. Services transactions unravel the clarity and simplicity of the VAT system, and it is instructive to examine this more closely for the difficulties that E-commerce, when it grows more significant, will create for a VAT system.

For many services, the supplier under the presumption that the customer for the services needs to be relatively geographically close to receiving the services collects VAT. However, for intangible or intellectual services (copyrights, licenses, advertising, professional and consultant services and financial transactions) the customer already pays VAT. If the customer is not VAT registered, he is supposed to declare the transaction and pay the tax[27]. Certain types of service firms, including financial intermediaries, and looking forward, possibly Internet service providers, often cannot recover VAT and end up paying it as if they were final consumers.

If digitalised products are treated as services, the inconsistencies created by the VAT increase. Some products, such as books and music, when they are purchased as tangible goods have lower VAT than if they are digitised and therefore treated as services. On the other hand, a digitalised product that is downloaded from a site outside the European Union often generates no tax revenue unless the customer declares and pays it. In this simple example, a single product yields three possible tax rates depending on the form and geography of the transaction-hardly the OECD goal of 'neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility'.

Under these circumstances, it is not surprising that businesses expend time and effort tax strategizing. For example, Internet service providers (ISPs) are the 'portal' or starting point for many activities on the Internet. Looking forward, ISPs could end up playing the role of tax collector (as the delivery man does with flowers) or might have to pay the service VAT themselves (as in the case of financial intermediaries). The clear incentive is to move the ISP activity offshore so as to blur responsibility for paying or collecting VAT, and indeed some European ISPs have been set up in low-tax jurisdictions.

The issue facing the US vis-à-vis sales taxes offers similar examples of tax strategizing. For example, '' is incorporated as a separate business entity from the parent stores so as to avoid 'nexus' (or physical presence) and the requirement to apply sales taxes on all purchases through the Internet. However, because these entities must remain separate, business synergies and brand-extension cannot be exploited. For example, someone who prefers to shop and buy a book on-line (because they like the additional features of book reviews available on-line) cannot go and pick up the book at a local store branch.

In sum, the Internet market place characterised by cross-border trade in information-rich products will increasingly strain systems of indirect tax both because of diminishing coverage and because myriad tax rates are costly to administer and invite strategizing. In particular, economic transactions created from various international and domestic locations make it increasingly difficult to make sense of or to apply the credit-invoice method of accounting for VAT at each stage of the value-chain; there is not a value-chain but a network creating value. Because governments do need to raise revenues, they need to look at other ways of doing so.

8. Conclusion

It is assumed that European Commission staffers have gone back to the drafting table to come up with something that will please everyone. This is going to be really difficult.

The answer probably lies in technology. Systems should be developed that allow online vendors to easily handle VAT collection - in all countries - simply through plugging into an online collection system. This is the solution being sought in the US, where the Streamlined Sales Tax Project hopes to create a kind of 'plug-and-play' tax collection system for online sellers. In the US, the system has to be simple because the States are unable to compel most online vendors to collect tax. The vendors will have to do so voluntarily. To attract voluntary participants, the States must have an attractive system.

The States have already developed a legal framework under which streamlined online tax compliance will go forward. This is at least one step ahead of the Europeans. The States have not yet addressed online compliance related to digital products. However, because at least half of the States currently collect sales tax on digital products this is an issue that will have to be worked on.

If the States are successfully in putting into place a streamlined system of online tax collection, and if they are able to successfully deal with the issue of digital products, the Europeans may be able to adapt these systems to collect VAT.

Clearly, it is important for all countries to agree to an internationally standardised tax treatment of E-commerce. Otherwise, cyber-merchants may find that the taxation issues are too complex.

This paper deals with the principles of international taxation and how E-commerce affects it, this paper does not put forward any solution, but it is an attempt to revisit the issues.


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2. Davies, LJ (1998), 'Model For Internet Regulation', available at: <>.

3. Rowland, Diane and Macdonald, Elizabeth (2000), Information Technology Law, 2nd Edition, pg 251-252.

4. Chissick, M and Kelman, A (2000),'Electronic Commerce Law and Practice', 2nd Edition, para 3.07.

5. Mann, Catherine L (2000), 'Transatlantic Issues in Electronic Commerce', Working Paper, para. Tax Issues, available at: <>.

6. Lewis, Alan (1992), 'The Psychology of Taxation', pg 4.

7. Brady, Joe (1999), 'E-Commerce and Taxation', 10th November 1999, TAXNET.

8. GIIC New Delhi. 'A White Paper on India's Legal Regulatory Frame Work for E-Commerce', Seminar paper, International Conference on Electronic Commerce, 15- 16 June 1999. <> (path: events/ec990615india.html).

9. Pitt, L F, Berthon, P R, and Berthon, J P (1999), 'Changing Channels: The Impact of the Internet on Distribution Strategy', Business Horizons, 42, 2 (March-April), 19-28.

10. OECD OBSERVER NO. 208 (1997), Organization for Economic Co-operation and Development (1998). Electronic Commerce: a discussion paper on taxation issues, 17 September. <>.

11. OECD, Committee on Fiscal Affairs (1997), The Communications Revolution and Global Commerce: Implications for Tax Policy and Administration.

12. OECD Model Tax Convention 1997.

13. Lukas, Aaron (1999), Tax Bytes A Primer on the Taxation of Electronic Commerce, Cato Institute, 17 December 17 1999, 26-27, and Judd A. Sher, A Band-Aid or Surgery: It is time to evaluate the health of the permanent establishment concept, Tax Management Journal, Washington, 9 July 1999, 415-26.

14. Maguire, Ned, 'Taxation of E-commerce: An Overview, International Tax Review, 3-12.

15. See <>.

16. OECD Model Tax Convention (2000), 'The Application of The Permanent Establishment Definitions In The Context of Electronic Commerce: Proposed clarification of the Commentary on Article 5 of The OECD Model Tax Convention', Revised Draft for Comments, 3 March 2000. <>.

17 . Calvert, Walter R (2000), 'Taxation of Internet Commerce'. <> (path: Internet/tax.html#international).

18. 1996 Treasury Paper. November 1998 'Selected Tax Policy Implications of Global Electronic Commerce', A Discussion Paper. United States Treasury Department Office of Tax Policy. <>.

19. EU Committee (2000), 'Position Paper on the Taxation of Electronic Commerce', see <>, February 1, 2000.

20. However, facilities for inventory or for collecting information do not confer physical presence.

21. The analogy for the US sales tax is nexus.

22. For more on practical analysis of existing transfer pricing rules, see Brad Rolph and Jay Niederhoffer, Transfer Pricing and E-commerce, International Tax Review, September 1999, 34-39.

23. In the OECD, all the countries except the United States have or will soon have a VAT/GST system. In the countries of the European Union, VAT revenues account for about 30% of total tax revenues. In the US states, sales and goods taxes account for about 12% of total revenues, but range to much higher percentages in some states.

24. The VAT is a tax on supplies of goods and services applied at all stages of the production process. It is charged by the supplier and then credited by the users of the inputs in the course of doing business. Each transaction leaves an invoice path, so the VAT system essentially relies on 'double-entry' book-keeping by VAT-registered businesses on both sides of a transaction. The final consumer is not a VAT-registered entity, so ultimately pays the tax. The US sales tax system is different in that final users (usually retail) pay the taxes, principally only on tangible property (with exceptions) and usually not on services. Business inputs generally are exempt from the tax.

25. Hardesty, David (2000), 'Europe Proposes New Taxes on Non-EU Sellers', (6/18/00) <>.

26. Hardesty, David (2001), 'EU Withdraws Proposals for VAT on Digital Sales', February 4th 2001, see <>.

27. OECD (1997), 'Electronic Commerce: The Challenges to Tax Authorities and Taxpayers' An informal Round Table Discussion between Business and Government, Turku, Finland, 18 November 1997, 15-19.

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