Cutting Taxes Out of the Information Highway.

A consensus is starting to develop on the tax issues of e-commerce electronic commerce is changing the way the world is conducting business. Tax administrations around the world and the Organisation for Economic Co-operation and Development (OECD) have embarked upon a review of their fiscal policies and collection procedures in contemplation of the likely effect of these changes.

On the US legislative front, the Internet Tax Freedom Act was signed in October 1998. This legislation imposes a three-year moratorium on state and local taxes on Internet access fees charged by Internet service providers and on "multiple" or "discriminatory" taxes on electronic commerce.

Until recently, electronic commerce referred primarily to electronic data interchange (EDI) offerings and electronic messaging technologies that facilitated the exchange of information between businesses and organizations. During the past few years, the term "electronic commerce" has broadened to encompass business-to-business and business-to-consumer transactions conducted over the Internet and the World Wide Web. The Internet and Web browsers have created an easy-to-use, standardized infrastructure for conducting business and have made new products and ways of conducting business possible. The use of electronic commerce for business transactions is expected to grow dramatically over the next several years, fuelled by the availability of sophisticated Internet and Web technology and tighter security mechanisms.

Concerns arise because tax legislation and tax treaties were drafted when the presence of bricks and mortar were necessary to conduct business. Now, new technologies significantly reduce the need for a physical presence in a jurisdiction, and reduce the number of intermediaries needed to complete a transaction.

In a global economy, the issues are complex, spanning a multitude of taxing regimes, philosophies and cultures. Nevertheless, a consensus is starting to emerge on some broad principles.

* Tax neutrality: Any changes should provide for different taxpayers to be taxed in the same manner when entering into similar transactions in similar situations.

* Retention of existing principles: For the moment, suggestions that a unique basis of taxation be developed to tax electronic commerce have been rejected. For example, a "bit tax" on the number of bits transmitted and the use of formulae to allocate income among jurisdictions have been advanced. To varying degrees, most countries have taken a position that existing tax principles should be retained and adapted, if necessary, to deal with electronic commerce.

* Co-operation and consensus are essential: Given the global reach of electronic business, counties recognize that a particular jurisdiction cannot make unilateral changes without hurting their residents and their tax bases. At an international level, the OECD has established various consultative committees. In Canada, Revenue Canada has formed four electronic commerce technical advisory groups (TAG) composed of individuals from business, government and academic institutions. These groups will focus on taxpayer service, compliance and administration, interpretation and international cooperation, and consumption taxes. It is expected that these TAG will issue reports in 2001.

In the US, a 19-member public/private sector Advisory Commission on Electronic Commerce, as mandated under the Internet Tax Freedom Act, has been formed and is expected to issue its report in April 2000. Interested readers can consult the Commission's web site for details of their deliberations:

(www.ecommercecommission.org)

The Effect of Electronic Commerce

A number of characteristics of electronic commerce affect how business is conducted and the interpretation of existing tax principles. To illustrate this point, consider the following examples:

* Electronic commerce facilitates international trade and cross-border co-operation within an organization, as well as joint ventures between businesses. Consider, for example, the collaborative development of software by a team of engineers located in Canada and other countries. Barriers of entry are significantly reduced, resulting in an increase in the number of international transactions, most notably among small-and medium-sized businesses with lower-value transactions.

* Products that have been sold in physical form can now be sold in digital form from computer to computer. These include software, music, videos, books and other written material. The transformation of physical goods to digital versions raises issues with respect to the characterization of income and the appropriate tax treatment for domestic, international and sales and customs purposes. Compliance and documentation issues also arise.

* Access to new technologies may also reduce the number of intermediaries in a given transaction, an effect known as "disintermediation". For example, shrink-wrapped software sold through traditional distribution channels (from developer, manufacturer, wholesaler, retailer to consumer) may now be sold directly from the developer to the consumer via the Internet.

Disintermediation raises important concerns, because intermediaries have traditionally acted as tax collectors and provided tax authorities with an audit trail. In addition, the lack of intermediaries may erode a local tax base, especially for a jurisdiction that is a net importer of goods and services transacted electronically. On the other hand, the tax base of a country that is a net exporter likely would not suffer, and may even expand. Clearly, there are competing interests among governments.

* There is no necessary relationship between an Internet address or a Web site, the residence of a party or its physical location. Such anonymity may make it difficult to determine which tax treaty applies to a given transaction and has governments concerned about intentional non-reporting of transactions.

Non-residents

Canadian taxpayers who transact electronically across borders face certain issues.

* With the emergence of a computer server and Web site as vehicles for conducting business, the level of activity necessary to constitute a permanent establishment, and thus be subject to income tax, is uncertain. Various American states have taken a rather aggressive stance in this regard.

* When income derived from electronic commerce is considered business income by Canada, but subject to withholding taxes in a foreign jurisdiction, the current foreign tax credit mechanism fails to provide adequate relief.

With an increase in payments to nonresidents regarding electronic commerce, Canadian withholding obligations also need to be considered. These withholding requirements apply to payments to nonresidents for services rendered in Canada (raising issues such as where a service is performed and whether a Canadian recipient will even know the residency of a service provider over the Internet) and for information, licenses and sales of digitized products.

One way to view business conducted electronically is that only the method of delivery is changing, not the purchaser's underlying rights. The delivery of product by land, sea or air does not affect its taxation; why should the purchase of a digital product be taxed differently from the purchase of a physical newspaper or CDROM, if in both cases the purchaser effectively obtains the same bundle or rights? The OECD has recently issued revised commentary to the royalty article of the model treaty in which it has adopted an approach based on the nature of rights.

Canadians that conduct business through controlled foreign affiliates must be alerted to the possibility that income earned by those affiliates may be considered foreign accrual property income (FAPI). FAPI is generally passive income from property, as opposed to income from an active business. FAPI is subject to immediate taxation in Canada, with compensation for foreign tax paid by the controlled foreign affiliate.

The FAPI issues are numerous:

* To the extent that processes become more automated, activities that once were considered the carrying on of business now might be considered to give rise to FAPI.

* Many companies within an international organization will likely be earning royalty and similar income. These types of income are generally considered passive, and are subject to the FAPI rules unless earned by the originator of the intellectual property.

* The FAPI rules also have a number of provisions that deem active business income to be FAPI. Depending on how these provisions are interpreted, electronic business has the potential of changing the nature and character of income generated by controlled foreign affiliates. Given that the FAPI regime was developed in a pre-electronic era of physical goods and traditional services, previous interpretations may no longer be appropriate.

Non-residents Transacting Electronically with Canadians

Non-residents transacting electronically with Canadians will have to consider whether their activities constitute carrying on a business in Canada that, subject to treaty protection, makes the non-resident taxable in Canada.

Again, there are many issues to consider.

* Could viewing a non-resident's Web page from a computer located in Canada constitute carrying on business? Although it is generally agreed that such activity alone should not constitute carrying on business, the degree of activity that will constitute carrying on business in the electronic age is less clear. Additionally, the OECD has recently indicated that a web page does not constitute a permanent establishment.

* At what point does a contract conclude when entered into by a Canadian with a non-resident via a Web page? Offer and acceptance rules (push vs. pull technologies) will need to be examined carefully, as the place of contract is one of the factors in the determination of whether business is being carried on in Canada.

* Can a Canadian Internet Service Provider (ISP) be considered to be acting as an agent for a non-resident when it hosts a non-resident's Web page? Current views suggest that the ISP is, at most, be an independent agent; however, a number of factors must be considered in such a determination.

* Is the storing by a non-resident of digital product on a computer situated in Canada tantamount to maintaining a stock of merchandise in Canada? This is another factor in the determination of the carrying on of a business. Given the ease with which such inventory can be moved to any jurisdiction, is this criterion even relevant for electronic commerce?

The same issues must also be kept in mind regarding foreign jurisdictions when Canadians are transacting abroad.

Application of traditional interpretations will lead to unsatisfactory results in many cases. To avoid an onslaught of new legislation that is unlikely to keep up with the pace of technological change, governments will have to interpret existing legislation in a fair and pragmatic manner, keeping in mind their underlying policy objectives.

Sales Taxes

Many issues that arise with respect to sales tax are similar to those raised above for income tax. For example, the "carrying on of business in Canada" and "place of supply" rules are critical for application of the goods and services tax to both Canadian residents and non-residents. Businesses also need to be aware of registration, collection and filing requirements. Similar concerns arise with respect to provincial sales taxes, state sales and use taxes and European value-added taxes.

What's Next?

Until a consensus is reached between taxing jurisdictions, it will be essential for companies to monitor the tax implications of how they conduct business. Businesses that are able to minimize major problem areas and maximize the benefits from planning opportunities, are the ones that will have a competitive advantage in the digital age.

Pierre Bourgeois is a member of PricewaterhousesCoopers LLP International E-Business Tax Group.

International Income Tax Issues

Just as electronic commerce is clearly a global issue, so are the tax issues raised by conducting business electronically. Until an international consensus emerges, there will be a risk of incompatible treatment of revenue derived form electronic commerce when more than one jurisdiction is involved.

Underlying all the issues is one of today's greatest concerns for governments: transfer pricing. Although transfer pricing issues that must be considered in the context of electronic commerce are not new, they are particularly complex. For example, the creation, ownership, valuation and transfer pricing methods relating to intangibles raise difficult issues for businesses transacting globally. The use of a branch or a subsidiary can have vastly different results when intangibles are involved.

Taxation and Tax Treaties

The traditional method of avoiding double taxation, tax treaties between nations, will also require new interpretations to implement the underlying principles upon which they were drafted.

Issues that arise in a treaty context are similar to those raised domestically- the characterization of income, the existence of a permanent establishment, residency of a corporation and the location of "mind and management" and, more fundamentally, the determination of which countries are even involved in a particular electronic transaction.