Sourcing income from Internet transactions.

EXECUTIVE SUMMARY

* The e-commerce revolution presents an unprecedented challenge to adapt rules that do not impede the growth of e-commerce, yet effectively and fairly collect tax revenue.

* The borderless nature of e-commerce presents a substantial challenge to the sourcing rule regime based on physical geographic links to a jurisdiction, so as to fit income into an existing category.

* The IRS has provided special sourcing rules for income produced from computer software transfers and the provision of services or know-how connected with a computer program.

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Internet technology has eliminated many geographical barriers to international trade. As a result of this increased ability to conduct e-commerce anywhere at any time, nations may claim inconsistent taxing jurisdiction over the same income. Existing income tax rules must take into account technological developments in e-commerce. This article describes how present interpretations of the sourcing rules for conventional commerce should apply to electronic transactions.

Electronic commerce (e-commerce) is the ability to perform commercial transactions involving the exchange of goods or services between two or more parties using electronic tools and techniques. (1) These new technologies (particularly communication technologies involving the Internet) have effectively eliminated geographic barriers to international trade.

The increased ability to conduct business anywhere at any time may lead nations to claim inconsistent taxing jurisdiction over the same income derived from electronic transactions, creating multiple (or at least impractical) taxation. (2) This economic revolution presents an unprecedented challenge to taxing authorities to adapt rules that do not impede the growth of e-commerce, yet effectively and fairly collect tax revenue from such transactions.

In a discussion paper titled "Selected Tax Policy Implications of Global Electronic Commerce," (3) Treasury set forth its position that e-commerce taxation must be based on principles of neutrality, with rules flexible enough to cope with, and adapt to, evolving technologies. Specifically, it proposes that income from economically similar transactions should be taxed similarly, whether earned electronically or through more conventional channels. Consequently, it rejected any new or additional taxes on e-commerce. (4)

To implement this neutrality policy without adopting new income tax principles requires a reexamination of existing income tax rules, taking into account their adaptability to technological developments in commerce. Among the existing tax principles that must be adapted are the determinations of whether income generated by cross-border e-commerce transactions is U.S.-source income, and whether such commerce constitutes a U.S. "permanent establishment" (PE) under U.S. income tax treaties.

This article describes how present interpretations of the sourcing rules to conventional commerce should apply to electronic transactions. An article in the May 2003 issue will discuss how the PE rules apply in Internet transactions and how fundamental principles of U.S. international taxation need to adapt to e-commerce.

U.S. Taxation of Cross-Border Income

The U.S. taxes its citizens, resident aliens and domestic corporations on their worldwide income; under Secs. 871,881 and 882, nonresident aliens (NRAs) and foreign corporations are generally taxed only on their U.S.-source fixed and determinable annual and periodic (FDAP) income (e.g., dividends and interest) and income effectively connected with a U.S. trade or business. Generally under Sec. 861, income is sourced in the U.S. when it is derived from an asset or activities located within the U.S.

When U.S. persons derive income from activities in another country, a double-taxation problem may arise if the U.S. and the foreign country claim taxing jurisdiction over the same income. Although the U.S. could alleviate this double tax simply by excluding from the tax base income derived from sources outside the U.S. (i.e., a territorial system of taxation), it instead adopted a credit system. Sec. 901 entities U.S. persons to credit foreign income taxes paid on foreign-source income, subject to a number of limits in Sec. 904 intended to confine the credit's effect to mitigation of double taxation.

Because the foreign tax credit (FTC) reduces only the U.S. tax on a U.S. person's foreign-source income, the source of any particular item of income and expense associated with that income is critical to the determination of the allowable credit (the greater the foreign source income, the greater the FTC potential). (5)

For NRAs and foreign corporations, the U.S. imposes a dual-track tax regime. Under Secs. 871(b) and 882, income effectively connected with the conduct of a trade or business in the U.S. is taxed on a net basis and subjected to the same graduated tax rates that apply to U.S. persons. In virtually all cases other than certain inventory sales arising outside of the U.S., Sec. 864(c)(4) provides that only U.S.-source income is effectively connected with a U.S. trade or business. U.S.-source FDAP income not effectively connected with a U.S. trade or business is subject to a flat tax generally collected through withholding under Secs. 871(a), 881 and 1441.

Sourcing of E-Commerce Income

The source of income arising from cross-border transactions is critically important to U.S. persons claiming a FTC and non-U.S. persons conducting transactions with U.S. persons. Generally, the source of an income item is based on the geographic location where the economic activity giving rise to that income took place. Secs. 861-865 identify such geographic locations by applying different rules for different income classifications. For example, under Secs. 861 and 862, interest and dividends generally are sourced based on the payor's residence; personal service income is sourced where the services are performed; rents and royalties are sourced where the property giving rise to the rent or royalty is used. Income from the sale of purchased inventory is sourced where the sale occurs; under Regs. Sec. 1.861-7(a), that place is generally deemed to be where the seller's right, title and interest in the property are transferred to the buyer. Consequently, the first step in sourcing retail e-commerce (e-tailing) income is to identity its character as service, royalty or sales income.

Character of E-Tail Operations

The borderless nature of e-tailing presents a substantial challenge to the sourcing rule regime based on physical geographic links to a jurisdiction, so as to fit income into an existing category. In characterizing a particular e-tail activity as a service, lease, license or sale, and then applying that source rule to the income, the electronic transaction giving rise to the income can take any of the following general forms:

1. Electronic order, payment and delivery. A customer browses a website and chooses to buy a product available in digitized form (e.g., computer software, music, films, video games, photographs or information databases (e.g., CCH, Lexis Nexis)). The customer places an order at the website, which receives the payment and immediately allows the customer to download the digitized product onto his or her computer.

2. Electronic order and payment with physical delivery. A customer browses a website and chooses to buy a tangible product. The customer places an order at the website, which receives the payment; the product is shipped to the customer via a conventional means of delivery.

3. Service activities. A customer obtains services electronically (e.g., videoconferencing). (6)

4. Physical ordering and electronic delivery. A customer places an order at a physical location; delivery is made electronically. (7)

In each of the above scenarios, the determination of the income source hinges on whether the parties structure the arrangement as a sale, lease, license arrangement or service contract. If a sale, the income would be sourced to the place where title to the property passes to the buyer. If the property were manufactured by the transferor and cast as a sale, the income source would then be determined under the labyrinth of Sec. 863(b) and its regulations. Regs. Sec. 1.863-3(b)(1)(i) generally sources one half of the income to the place where the property was produced and the other half to the place where the sale occured. However, if the property were licensed or leased, income is then sourced to the place where the property is used.

When nondigitized inventory (8) is sold electronically (e.g., books sold over the Internet) in cross-border transactions, conventional delivery methods invoke the long-established inventory sourcing rules; Secs. 861(a)(6) and 862(a)(6) source the income to the country where the property was sold. According to Regs. Sec. 1.861-7(c), inventory purchased for resale is sourced at the place where the title and risk of loss to the goods passes from the seller to the buyer under the sales contract as free on board (FOB) place of destination or FOB place of shipment. (9)

Although the title-passage rule generally applies to inventory sourcing by U.S. persons, an exception in Sec. 865(e)(2) prevents foreign persons who maintain a fixed place of business in the U.S. (10 from sourcing income attributable to that location outside the U.S., regardless of where the title to the goods passes. These rules are based on the notion that to expand geographically, a business must establish a physical presence in a new host market country, which is not the case for businesses that expand into markets electronically.

Computer Program Transactions

Applying the existing rules to characterize income from digitized products (software) may produce problematic results. Most products ordered electronically may not retain their character when delivered by electronic means, resulting in confusion as to the proper source rule.

Although Treasury contends that the source of e-tail income can be characterized under the existing rules, the IRS has provided special sourcing rules for income produced from computer software transfers, as well as the provision of services or know-how connected with a computer program. These regulations recognize that the use and transmission of the intangible property interests reflected in the digitized products require additional guidance to fit transactions into the existing source rules. Thus, they look to the rights transferred from the seller to the buyer (rather than to the form of the product) to characterize the transaction as a sale, license or royalty arrangement. Under Regs. Sec. 1.861-18(b)(1), treatment of the income as a sale, lease or license is based on whether it is derived from a transfer of a "copyright right" in a computer program or a transfer of a copy of the program (a "copyrighted article"). (11)

Transfer of Copyright Rights

According to Regs. Sec. 1.861-18(c)(2), a transfer of a computer program is classified as a transfer of a copyright right if a person acquires one or more of the following rights:

* To make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental lease or lending.

* To prepare a derivative computer program based on the copyrighted computer program.

* To make a public performance of the computer program.

* To publicly display the computer program.

Once a transfer of a computer program is classified as a transfer of a copyright right, the income-source determination is made on the basis of whether (taking into account all facts and circumstances) there has been a transfer of "substantially all rights" in the copyright. If substantially all rights have been transferred, the transaction is a sale and the income is sourced as such. (12) If substantially all the rights have not been transferred, Regs. Sec. 1.861-18(f)(1) deems the transfer a license generating royalty income, sourced to the location where the property is used. As stated in Regs. Sec. 1.861-18(g)(2), the regulations ignore the medium (physical or electronic) used to deliver the product, adopting Treasury's neutrality policy. (13)

Transfer of Copyrighted Articles

If the transfer of a computer program does not entail the transfer of any of the above rights, it is deemed a transfer of a "copyrighted article." This is normally the case when the seller grants a "license" for the nonexclusive use of a standardized product to an end-user. (14) In such cases, Regs. Sec. 1.861-18(f)(2) uses a "benefits and burdens of ownership" test to determine if the transaction is a sale or exchange, rather than a lease. If, taking into account all the facts and circumstances, the benefits and burdens of ownership have been transferred to the buyer, the transaction is a sale. Absent a shift in "the benefits and burdens" from the buyer to the seller, the transaction is deemed a lease of a copyrighted article and the income is sourced as a royalty.

If a transaction could be both a copyright right and a copyrighted article, Regs. Sec. 1.861-18(b)(2) provides for the bifurcation of income, so as to place appropriate portions in the pertinent categories. However, any de minimis portion is ignored for purposes of being classified as a separate category and is included in the overall transaction.

Example 1: S, a software-developing company, is a resident of country Y. USCo is a U.S. corporation engaged in retailing software through its retail stores in the U.S. There is no treaty between Y and the U.S. and S has no taxable presence in the U.S. S develops software X, which is recorded on CDs and packaged with a disclosure statement as to the buyer's rights. A certain number of copies of this shrink-wrap software are sold to USCo for resale to end-users. (15) The CDs are shipped to USCo by conventional means; title to the goods passes to USCo outside the U.S. USCo acquires no copyright rights to reproduce or prepare derivative programs or publicly perform or display the software. Under Regs. Sec. 1.861-18(f)(2), the transaction is a sale of inventory from S to USCo generating foreign-source income not taxable in the U.S.

Example 2: As the demand for X increases, USCo and S agree to make the software available on USCo's website, so that U.S. customers download the software for the same price as when purchased at USCo's retail stores. Packaging and shipping costs are eliminated and delivery time is significantly reduced. USCo uploads copies of X onto its server. As digitized products can be replicated perfectly, without deterioration in quality, the decision as to how many copies to duplicate and upload is based strictly on online customer volume. USCo is entitled to sell an unlimited number of copies of X to its online customers and pays S the same amount per copy as it did while selling the copies through its retail stores. USCo produces only the number of copies of X that it actually sells to its U.S. customers, as it has S's consent to reproduce the software rather than physical product. USCo's uploading of copies of X is the transfer of a "copyright right" from S to USCo; the payments from USO to S are U.S.-source royalties taxable in the U.S. under Regs. Sec. 1.861-18(f)(1). (16)

Thus, conducting essentially the same transaction via physical product sales or by an electronic transfer can result in a significant difference in the rights transferred from buyer to seller, and very different sourcing results. These different outcomes offer planning opportunities to maximize U.S. taxpayers' FTCs and to minimize U.S. taxation of foreign taxpayers.

Although the Treasury's neutrality principle appears compromised at first by this disparate treatment, the result may nevertheless be correct; the transactions are somewhat economically different, because the rights transferred in the examples do differ. In Example 1, when title to the goods passes from S to USCo, the risk of loss from failure to resell lies with USCo. However, such risk-shifting is absent in Example 2, because the marginal cost of duplicating the software is minimal to both corporations; advance payments by USCo to S to purchase a few copies for uploading and duplication are de minimis.

In any event, the regulations emphasize that the distinction between a sale of a copyrighted article and the use of a copyright right hinges first on which rights have been transferred and second on whether there has been a transfer of substantially all of the rights. Regardless of the transaction's form (i.e., "brick-and-mortar" store sale, Internet sale or a combination of physical and electronic order and delivery systems), an analysis of who holds rights in the property transferred via e-commerce should result in income sourcing consistent with the approach adopted by the Code and regulations.

Conclusion

The Code provisions governing the source of income in international transactions were created when U.S. businesses did not confront aggressive competition from other countries and international trade consisted of physical items crossing physical borders. The difficulties in determining the source of e-commerce income are daunting and imperative. Similar problems are presented in connection with PE. An article in the May 2003 issue will discuss how current PE rules apply to electronic transactions and how the fundamental principles of U.S. international taxation need to adapt to e-commerce.

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

(1) Statement by the Cross Industry Working Team of the Corporation for National Research Initiatives; see www.cnri.reston.va.us.

(2) U.S. Treasury Department, Discussion Paper, "Selected Tax Policy Implications of Global Electronic Commerce," Section I (11/21/96).

(3) Id. at Section III, 6.2.

(4) See note 2, supra.

(5) Income source is also relevant in determining the extent of a U.S. individual's foreign-earned income exclusion under Sec. 911 and the allowable deductions attributable to a foreign sales corporation or a domestic international sales corporation.

(6) See, e.g., "The Doctor Will See You Now--Just Not in Person," Business Week 117 (10/3/94).

(7) In fact, the Organisation for Economic Cooperation and Development's (OECD's) Technical Advisory Group on Treaty Characterization of Electronic Commerce Payments, identified no less than 26 common e-commerce transactions; see "OECD Technical Advisory Group Issues Final Report on E-Commerce Taxation," 2001 TNT25-7 (2/5/01).

(8) "Inventory" includes personal property held by a taxpayer primarily for sale to customers in the ordinary course of business, according to Secs. 865(i)(1) and 1221(1).

(9) This assumes that tax avoidance was not the primary purpose for arranging title passage in a particular jurisdiction, in which case all factors of the transaction are taken into account; the sale is treated as having been consummated where the substance of the sale occurs.

(10) Sec. 864(c) provides some guidance as to a fixed place of business for Sec. 865(e)(2) purposes.

(11) Regs. Sec. 1.861-18(b)(1)(iii) and (iv) also provide sourcing rules for the provision of (1) services to develop or modify the computer program and (2) know-how as to computer programming techniques. These rules are not discussed, because they are less relevant to the determination of sourcing e-commerce transactions.

(12) Under Secs. 861 (a)(6) and 862(a)(6), income from the sale of inventory is sourced to the jurisdiction where title passes to the transferred property. Under Sec. 865, the sale of tangible personal property is sourced according to the seller's "residence."

(13)See note 2 supra, at Section III, 6.2.

(14) Rights to use such a product are referred to as "shrink-wrap license;" the product is "canned software."

(15) None of the rights enumerated in Regs. Sec. 1.861-18(c)(2)(i)-(iv) are transferred to the buyer, thereby making the transaction a transfer of a copyrighted article under Regs. Sec. 1.861-18(f)(2).

(16) This assumes all substantial rights in the copyright have not been transferred. Absent any treaty provisions, Secs. 861(a)(4) and 862(a)(4) apply, making the royalties U.S.-source income, because the copyrighted article will be used in the U.S.

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