Internet transactions and PE issues.

Foreign persons doing business on the Internet or through a website have the potential to conduct extensive commercial activities within the U.S. without establishing a permanent physical presence. This article examines how present rules on permanent establishments and effectively connected income should be applied to foreign-source income from Internet transactions and their adaptability to the taxation of e-commerce technology.

Foreign persons doing business on the Internet or through a website have the potential to conduct extensive commercial activities within the U.S. without establishing a permanent physical presence. Taxation of this type of electronic commerce (e-commerce) is generally subject to the same rules and principles that apply to other foreign-source income, such as effectively connected income (ECI) and permanent establishment (PE) requirements. However, these rules must be interpreted and adapted to take into account technological developments and to implement Treasury's stated policy of neutrality in currently rejecting any new or additional taxes on e-commerce.

An article in the April 2003 issue (1) described how present interpretations of the sourcing rules to conventional commerce should be applied to e-commerce transactions. This article examines how present U.S. rules on PE and ECI should be applied to foreign-source income from

Internet transactions and their adaptability to taxation of e-commerce technology.

PE and ECI

In general, Secs. 871(b) and 882(a) tax a foreign person like a U.S. person on U.S.-source (and certain foreign-source) income effectively connected to a U.S. trade or business. Thus, the U.S. taxes foreign persons at regular graduated rates on their net income effectively connected with the conduct of a trade or business within the U.S. (2) Similarly, under U.S. income tax treaties, a foreign person is subject to regular U.S. income tax rates on income connected with a U.S. PE. (3)

The U.S. has negotiated an extensive network of income tax treaties with over 60 nations, in which the concept of income attributable to a PE replaces that of income "effectively connected with U.S. trade or business" in determining whether a foreign person's income is subject to U.S. income taxation under the same rules that apply to a U.S. person. (4) In general, treaties define a PE as a fixed place of business through which an enterprise carries on transactions, with certain exceptions; this generally is a substantially higher threshold of presence than the Code requirements for engaging in a U.S. trade or business.

U.S. Trade or Business

Whether a foreign person is engaging in a trade or business in the U.S. largely depends on the person's physical presence in the U.S. Such presence is tested by the foreign person's (or its agent's) "continuous, considerable and regular" business activities in the U.S., including the performance of personal services. (5) In Inez deAmodio, (6) the Tax Court used both quantitative and qualitative analyses to determine whether the taxpayer's activities were sufficiently "continuous, considerable and regular" to constitute a U.S. trade or business.

Whether a foreign person's trade or business is engaged "in the U.S" is often a difficult question, particularly when that business is conducted electronically. In Piedras Negras Broadcasting Co., (7) a Mexican radio station that aimed its programming and signal primarily at a U.S. audience, earned foreign-source services income, because all income-producing activities (e.g., the radio transmission) occurred outside the U.S., and its activities lacked permanency in the U.S. Similarly, a foreign person who merely solicits orders within the U.S. through advertising and the n sends tangible goods to the U.S. in satisfaction of the orders is unlikely to be engaged in a U.S. trade or business. (8)

Because the Internet allows businesses to conduct extensive commercial activities within the U.S. without establishing a physical presence, the result in Piedras Negras may require Treasury to reconsider whether new rules are needed to create neutrality between the conduct of e-commerce and conventional commerce. For example, if the IRS promulgated new regulations that adopt a substance-over-form-test (rather than a physical-presence test) for a U.S. trade or business, it is unclear whether such a test would have sufficient clarity to avoid a chilling effect on expansion of e-commerce by foreign nationals into the U.S. Thus, it appears preferable at this early stage in e-commerce evolution to keep the rules clear, even at the risk of compromising neutrality.

Internet Service Providers and ECI

Sec. 864(c)(3) deems any U.S.-source income to be effectively connected to a U.S. trade or business. In general, foreign-source income is subject to U.S. tax only if it is attributable to a fixed place of business in the U.S. Regs. Sec. 1.864-6(b)(1) provides that a particular item of income is attributable to a fixed place of business if that place (1) is a material factor in the production of that income and (2) regularly carries on the type of activities from which the business generates income.

Under Regs. Sec. 1.864-7(d)(1), a foreign person's fixed place of business includes a person present in the U.S. who is not an "independent agent" (9) and who negotiates contracts on behalf of the foreign person under authority delegated to him by such person. Any income generated by the efforts of such an agent (10) likely is effectively connected to a U.S. trade or business.

In applying these rules to retail e-commerce (e-tailing), an issue arises as to whether a foreign person's use of an Internet service provider (ISP) whose server is located in the U.S. constitutes a fixed place of business, (11) thereby potentially subjecting the foreign person's income generated through the ISP to U.S. income tax. The ISP's hosting of the foreign person's website accessible by customers in the U.S. is regularly providing a service that is a material factor in the foreign person's production of income in the U.S. (12) However, under Kegs. Sec. 1.864-7(d)(1), the ISP'S presence in the U.S. cannot be attributed to any foreign user unless the ISP is the foreign user's "dependent agent." To be the foreign person's dependent agent, the ISP must have authority to negotiate and conclude contracts in the foreign person's name, and regularly exercise such authority. (13) Generally, ISPs are mere carriers of information and do not have authority to conclude contracts for their users.

The physical presence of an ISP in the U.S. acting as an independent contractor for many persons using its server should not result in any foreign user having an office or other fixed place of business in the U.S. Thus, foreign-source income earned by a foreign seller using a website maintained by an independent ISP should not be effectively connected to a U.S. trade or business taxable in the U.S.

OECD Commentary

In an effort to adopt and modify income tax rules that take into account the unique features of e-commerce in international wade, the OECD adopted new Commentary to its Model Treaty (Commentary) that illustrates the application of the PE concept to e-commerce transactions. In December 2000, it clarified the meaning of PE in the e-commerce context. (14)

Changes to the Commentary on Article 5 of the OECD Model Treaty defining a PE make clear that a website cannot, in itself, constitute a PE. Similarly, a website-hosting arrangement generally does not result in a PE, because the ISP is not a dependent agent of the enterprise engaging the ISP, except in rare circumstances.

The distinction between a website and the server on which the foreign person stores its website is important, because the enterprise that operates the server may not be the same enterprise that conducts business through the website. Most contracts between ISPs and their users do not consider the users' website to be a physical presence at a location but, rather, a mere intangible electronic record housed on the server. (15)

Consideration should also be given to whether the enterprise's business is wholly or partly carried on at a location where the enterprise has equipment (e.g., a server at its disposal) and whether the enterprise operates such equipment. When an enterprise operates the equipment, a PE may exist, even though no personnel of that enterprise is required to operate the equipment at that location. In any event, the presence of an enterprise's own personnel to operate the equipment would not be a requirement for a PE if the equipment could be operated without human supervision. (16) To the extent that an enterprise has its own equipment at a location, that equipment might constitute a PE if it remains in the location for sufficient time. (17)

Whether the mere presence of computer equipment in a state would constitute a PE depends on whether the functions performed through that equipment exceed a preparatory or auxiliary threshold, which can be decided only on a case-by-case basis. Examples of activities that are merely preparatory or auxiliary and would not constitute a PE include: (18)

* Providing a communications link (e.g., a telephone line between suppliers and customers).

* Advertising goods or services.

* Relaying information through a mirror server for security and efficiency purposes.

* Gathering market data.

* Supplying information.

Thus, an enterprise that conducts e-tailing is not in the business of operating servers; the fact that it may use a U.S. server may not raise that activity beyond preparatory and auxiliary. However, if the above functions are an essential and significant activity of the enterprise or if the enterprise carries on other essential core functions (e.g., conclusion of contracts with customers) through the computer equipment, a PE would exist. (19) Although OECD pronouncements are not binding on the U.S., they are nonetheless important. (20)

Example 1: A foreign-owned ISP that maintains its own servers located in the U.S., offers hosting of websites and applications for other enterprises. In light of the changes to the OECD Model Treaty, the ISP's operation of servers to provide services to customers is an essential part of its commercial activity and should not be deemed preparatory or auxiliary. Thus, the ISP would likely have a U.S. PE.

Example 2: A foreign enterprise sells products to consumers through its website hosted by a foreign-owned ISP that maintains its own servers located in the U.S. In this case, the foreign enterprise is not in the business of operating servers; the fact that it conducts transactions through the ISP's U.S. location should not give rise to a PE, even though the servers perform essential functions.

Although the U.S. participated in drafting the change to the Commentary and ultimately voted to adopt that change, the Model Treaty and the

Commentary are not binding on the IRS or Treasury. Although the Commentary offers a persuasive interpretation of applying the PE concept to e-commerce transactions, the U.S. is unlikely to insist that the language of its treaties be changed to adopt the Commentary's position. At the same time, however, the U.S. has not invoked its right to make a formal reservation to the Commentary, leading to the conclusion that it acquiesces to the new language. In any event, the Commentary's language is only "persuasive" authority, not binding on any court.

Conclusion

The challenges of determining the source of e-commerce income and whether it is effectively connected with a U.S. trade or business or attributable to a PE under U.S. income tax treaties are daunting and imperative. The U.S. needs to be cognizant of what other countries are doing and to discuss the taxation of the Internet and e-commerce with them. The U.S.'s participation in the OECD's activities is an important step. As the global economy marches forward, the U.S. tax system will continually be faced with adapting and clarifying the existing tax rules.

EXECUTIVE SUMMARY

* Under U.S. income tax treaties, a foreign person's income would be subject to U.S. tax if it is attributable to a PE in the U.S.

* Foreign-source income earned by a foreign seller using a website maintained by an independent U.S. ISP should not be taxable in the U.S.

* OECD Model Treaty changes make clear that a website alone does not necessarily constitute a U.S. PE.

For more information about this article, contact Prof. Williamson at [phone].

(1) See Williamson, Naveed and Nakamoto, "Sourcing Income from Internet Transactions," 34 The Tax Adviser 206 (April 2003).

(2) If such U.S.-source income is fixed or determinable, annual or periodic and not effectively connected to a U.S. trade or business, Secs. 871 (a) and 881 (a) tax it at a flat rate of 30%, subject to reduction by treaty.

(3) See U.S. Model Income Tax Convention, Article 7 (9/20/96); Organisation for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital, Article 7 (6/30/98).

(4) See U.S. Model Income Tax Convention, Article 5 (9/20)/96); OECD Model Tax Convention on Income and on Capital, Article 5 (6/30/98).

(5) See Sec. 864(b) for rules on the performance of per-sonal services constituting a U.S. trade or business.

(6) Inez de Amodio, 34 TC 894 (1960), aff'd, 299 F2d 623 (3d Cir. 1962).

(7) Piedras Negras Broadcasting Co., 43 BTA 297 (1941), aff'd, 127 F2d 260 (5th Cir. 1942), nonacq., 1941-1 CB 18.

(8) See U.S. Treasury Department, Discussion Paper, "Selected Tax Policy Implications of Global Electronic Commerce," Sec. III, 7.2.1.1 (11/21/96).

(9) Kegs. Sec. 1.864-7(d)(3)(i) states that an "independent agent means a general commission agent, broker or other agent of an independent status acting in the ordinary course of his business in that capacity...."

(10) A related party can be an independent agent. Regs. Sec. 1.864-7(d)(3)(i) states, "[t]he determination of whether an agent is an independent agent ... shall be made without regard to facts indicating that either the agent or the principal own or control directly or indirectly both. For example, a wholly owned domestic subsidiary corporation of a foreign corporation which acts as an agent for the foreign parent corporation may be treated as acting in the capacity of independent agent for the foreign parent corporation."

(11) Regs. Sec. 1.864-7(b)(1) provides "... for this purpose, an office or other fixed place of business shall include, but shall not be limited to, a factory; a store or other sales outlet; a workshop; or a mine, quarry, or other place of extraction of natural resources. A fixed facility may be considered an office or other fixed place of business whether or not the facility is continuously used by a nonresident alien individual or foreign corporation."

(12) Although the foreign person's "sporadic or infrequent" use of a U.S. ISP would not result in income effectively connected with a U.S. trade or business under Regs. Sec. 1.864-7(12)(2), this exception does not appear applicable to businesses conducted substantially over the Internet.

(13) Alternatively, an agent of a foreign person would constitute a U.S. fixed place of business if the agent carries a stock of merchandise belonging to the foreign person from which it regularly fills orders on the foreign person's behalf. However, it is simply impractical for an ISP to carry nondigitized goods for customers.

(14) See Clarification on the Application of the Permanent Establishment Definition in E-Commerce: Changes to the OECD Commentary on the Model Tax Convention on Article 5 (12/22/00).

(15) Id., at Sections 42.2 and 42.3.

(16) Id., at Sections 42.5 and 42.6.

(17) Id., at Section 42.4.

(18) Id., at Section 42.7.

(19) Id., at Sections 42.7-42.9.

(20) See Taisei Fire and Manne Insurance Co., Ltd., 104 TC 535 (1995), acq., 1995-2 CB 1.

Donald T. Williamson, LL.M., CPA Professor and Director Graduate Tax Program Kogod School of Business American University Washington, DC

Faro Naveed, MST, CPA Senior Tax Specialist KPMG LLP Tysons Corner, VA

Kelly Nakamoto, MST, CPA Senior Tax Manager PricewaterhouseCoopers LLP McLean,VA