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Cyberspace transactions present interesting international, state and local tax issues.


The 1990s have introduced the world to a vast array of commercial business opportunities that may forever change our lives and how we conduct business transactions. The opportunities center around electronic commerce and the World Wide Web, often called the "global information superhighway." This superhighway consists of a convergence of, among other things, telephone systems, cable and satellite communications, and computer networks. The primary introduction to this world -- the world of Cyberspace -- is through the Internet.

The Internet is a vast international network of networks that enables computers of all kinds to share services and communicate directly. Like a spider's web, the Internet has many avenues that may be followed to reach a particular destination. The Internet is frequently compared to a postal station with hundreds, if not thousands, of routes to deliver its mail.

To take advantage of this vast routing system, many businesses have established sites on the Worldwide Web (Web sites) to market, advertise, and sell their goods and services. Web sites can blend text, video images, and sound into a multimedia presentation of the site's contents. Through a Web site, potential customers may shop for consumer goods, software packages and licenses, tax and technical services, health care information and services, research libraries, stock transfers, banking services, and a wide variety of other goods and services.(1)

Access to the Internet is generally through an Internet service provider (ISP). ISPs are organizations (e.g., Compuserve and America On-Line) that provide individuals and businesses with access to the Internet, including commercial Web sites. These ISPs, who may be wholesalers or retailers, provide access to the customer either through hourly rate charges or flat fees. ISPs are typically accessed through local or 800 telephone numbers. Merchants and service companies establish Web sites on their own servers that can be accessed through ISPs. ISPs can be located anywhere in the world, because location of the ISP is meaningless to the ultimate transaction and transparent to the user.

The myriad transactions that can be effected through the Internet give rise to a host of international tax issues that must be addressed to determine which jurisdictions may tax the transaction, and what rules will govern the determination of the amount of tax. Among the issues are the characterization of the transaction as the sale of goods, licensing of intangibles, or rendering of services; the source of the transaction as domestic or foreign; whether the transaction has created a U.S. permanent establishment or U.S. trade or business; whether the income is "effectively connected" or fixed or determinable annual or periodic income; how are withholding tax obligations to be enforced; and whether the anti-deferral rules of Subpart F apply. This article surveys these issues.

Characterization of the Transaction

The starting point in determining the tax consequences of transactions in the electronic marketplace is proper characterization of the transaction based on its particular facts and circumstances. This determination is critical because differing characterizations could affect application of the source rules that could, in turn, trigger different withholding tax obligations. Further, characterizing the transaction influences the selection of the appropriate transfer pricing method, whether income must be included under Subpart F, application of customs duties (or VAT obligations), and application of various treaty provisions, including whether a permanent establishment exists. There is also a state taxation analog to these issues.

One of the more difficult characterization issues has recently been tackled by the Internal Revenue Service in proposed regulations relating to the sourcing of income from transactions involving computer software programs.(2) Although the proposed regulations are limited to transactions involving computer programs, they establish a framework that may be helpfully applied to other copyrighted information (e.g., digital information).(3)

The proposed regulations treat transactions involving computer programs as either (1) transfers of copyrights; (2) transfer of copyrighted articles; (3) the provision of services for developing or sublicensing the computer program; or (4) the provision of know-how regarding computer programming techniques. Copyrights are defined as the right to (1) make copies of the computer program for purposes of distribution to the public by sale, rental, lease, or lending; (2) prepare derivative programs based on the program; (3) make a public performance of the computer program; and (4) publicly display the program.(4)

If a user has obtained one or more of these four copyrighted rights, it is considered to have obtained an interest in the copyright, so that the transfer is treated as a license. If the user has not acquired a copyright, however, and the transaction does not involve the provision of services or the transfer of know-how, then the transfer is treated as a sale of tangible property. These provisions therefore attempt to answer the more difficult characterization issue involving shrink-wrapped software and functional equivalents, namely, whether they should be considered either the sale of tangible property or licensed copyrights. The proposals for the most part lean toward a characterization as the sale of tangible property.(5)

Characterization issues, however, are not solely limited to shrink-wrapped software. A white paper released by the U.S. Department of the Treasury in 1996, for example, highlights the ambiguity between the sale of goods and the provision of services where digital information, such as that contained in an encyclopedia, is sold over the Internet. The transaction may be accomplished either through the purchase of a CD-ROM disk or by simply downloading the software directly to the customer's computer. In either case, the purchase is effected through an electronic credit card purchase.

There is little practical difference between the electronic purchase of an encyclopedia and a direct bookstore purchase of a hard copy encyclopedia, so that treating this transaction, by analogy, as a sale of tangible goods may appear warranted. What is the result, however, if on-line services and updates are offered as part of a sale or, alternatively, if instead of purchasing a CD-ROM disk or downloading software, the purchaser acquires access to an on-line database library? These elements to the transaction begin to appear more like the rendition of services. In the former case, it arguably could make a difference if the use of the online service was infrequent or charged separately. In the latter case, however, the characterization may be completely shifted to one of service rendition.(6)

Along a similar vein, several companies offer direct online access to proprietary databases. These providers include credit rating bureaus, legal and tax professional firms (e.g. LEXIS/NEXIS, Big Six accounting firms(7)), physicians' healthnet, as well as many well known publishing houses. Classification of these items could fall under both the provisions for services and those for royalties -- that is, although payment may be made on an hourly or other time basis, copyrighted material may be provided to the user. By contrast, it could be argued that, if only selected data are derived from the database that is used for purposes of creating a report or separate document, a services paradigm is more appropriate. To reach these conclusions, of course, one should look past the actual mode of delivery of the product and focus on the underlying substance of the transaction.

The U.S. Treasury Department is clearly concerned that electronic commerce presents opportunities to evade U.S. taxation through the use of tax haven companies whose activities are entirely in the electronic commerce area.(8) This concern is more in the nature of a compliance concern -- which, admittedly, may be serious -- than a core problem with U.S. tax concepts. Nevertheless, there are possibilities. What if a U.S. company creates a controlled foreign corporation (CFC) in a no tax/low tax jurisdiction, and the CFC engages in the provision of interactive data retrieval and analysis? Arguably, the CFC is in a "services" business, and, if its data and servers are located in the country of its incorporation, its income will not be Subpart F foreign base services company income. By contrast, if the activities were considered to produce international telecommunications income, then the income would be Subpart F income -- specifically, Subpart F shipping income.(9)

Sourcing the Transaction

Once the character of the transaction is determined, the source of the transaction must be ascertained. Sourcing income from the sale of tangible property, income from the licensing of intangible property, and income from the provision of services can lea4 to different results including, for sales of tangible property, the application of the partly within and partly without rules of section 863(b) of the Internal Revenue Code.(10)

Generally, the United States imposes tax on both a source and a residence basis. Hence, U.S. citizens and residents and U.S. incorporated companies are taxed on their worldwide income. Taxpayers not subject to residence-based taxation, such as nonresident aliens or foreign corporations, are subject to tax on either income effectively connected to a U.S. trade or business or fixed or determinable annual or periodical income.(11) Bilateral tax treaties generally limit source-based taxation for nonresident taxpayers through the use of a "permanent establishment" provision which determines taxing jurisdiction based upon whether the nonresident taxpayer had a significant presence and business activity in the source country.

In addition to determining taxing jurisdiction, the sourcing rules are important for foreign tax credit, Subpart F, and withholding tax purposes. For foreign tax credit purposes, increasing foreign-source income may generally assist a taxpayer in efficiently utilizing excess foreign tax credits. Because services are sourced where performed but sales of inventory property are sourced where title passes, proper planning can assist in creating foreign-source income. For Subpart F income purposes, foreign base company services income may be established for services that "are performed outside the country under the laws of which the controlled foreign corporation is organized."(12) For withholding tax purposes, classification of a transaction as a license may produce a withholding tax obligations that would not exist for a sale of tangible property.

Because the source of income rules tend to be relatively uniform in their general classifications in most tax jurisdictions, there is a belief (and correctly so) that taxing authorities should seek to work with these established tax principles before seeking to promulgate new and special tax regimes to address Cyberspace issues.(13) Notwithstanding this belief, it is also recognized that some of these established tax principles do not address these new and unique transactions. Furthermore, it has been suggested that the application of these established principles could lead to potential abuses and enforcement difficulties.(14)

One difficulty lies with the sourcing of international communications income under section 863(e)(2) of the Code. This rule governs the sourcing of income from the transmission and reception of communications between the United States and a foreign country. Does this rule apply to electronic commerce transmitted over the Internet? If so, 50 percent of the income earned by the U.S. company would potentially be foreign source. Arguably, for this rule to apply, there must be both a transmission and a reception. Does this exist for the Internet? Can the actual reception be tracked? This provision may have limited effect for telecommunications operators where service is provided in a manner in which both the origin and destination of a particular communication is evident. Even though the result of this rule may be reasonable, is this the appropriate sourcing vehicle, especially where the characterization of the transaction may point to other potential sourcing rules such as for services or sales of tangible property? Clearly, the rule is sadly out of date in view of modern technology. For example, in the telecommunications industry, providers now frequently sell blocks of capacity rather than message-by-message interconnections, and have no way of knowing whether the user is using the capacity to call across the street or to Kathmandu.

Consider a U.S. company that transfers software over the Internet to a customer in a foreign country, and as part of the transfer, the foreign customer gains access to the U.S. company's proprietary database. If the income from the transfer is considered all royalty income, the source of income under sections 861 and 862 would be the place where the intangible is exploited, i.e., the customer's country. If, however, the income from the transfer is separated into two components, royalty income and services income, the services component would be sourced where the services are rendered. In this case, if the U.S. company developed and enhanced its software in the United States, the income from the enhancement would, by contrast to the royalty income, be considered to arise from U.S. sources. A further difficulty would arise in the course of attempting to allocate the customer's payments between the "royalty" component and the "services" component.

Electronic commerce presents the most profound challenge to traditional international tax concepts in the area of sourcing. Residence, as a criteria of tax jurisdiction, has been relatively simple to determine, especially for countries such as the United States that use straightforward criteria such as place of incorporation or the country under whose laws the entity is established.(15) By contrast, sourcing implicates a more factual concept -- the place where the relevant economic activity occurs. Electronic commerce, by its very nature, occurs in Cyberspace, a place without a nation, a mental construct of electrons and bits of data. Determining the place where economic activity occurs is difficult, at best, in the Cyberspace world. Attempts to use. the location of servers or ISPs to determine the requisite economic activity to provide a nexus for taxation are off the mark because the truly significant activity does not occur in those locations. Moreover, by their nature servers and ISPs may be relocated with almost as much ease as the old "tax haven" Subpart F-type activities. Although it may be inconvenient to abandon using servers within the country to carry a Web site aimed at that country's market, there is no reason -- other than the technical glitches and expense of long distance telephone connections -- to prefer a with-in-country situs to an offshore location.

All this has led the U.S. Treasury Department to suggest that source-based taxation may become passe in the world of electronic commerce.(16) In principle, this may be a reasonable solution. Residence-based taxation may be more administrable, and may reflect more accurately than traditional sourcing rules where, in fact, the real economic activity leading to the income occurs. If so, the global electronic superhighway may only be accelerating developments already underway. For example, countries increasingly prefer to rely on residence, rather than source, to impose taxation when negotiating their bilateral tax treaties. Hence, most U.S. tax treaties severely limit or eliminate withholding taxes on income earned by nonresidents, in exchange for obtaining sole or primary taxing authority over such income earned by U.S. residents from sources in the treaty partner. Moreover, there is some precedent in the area of international communications income and income from noninventory sales, where U.S. tax rules have opted for residence-based approaches to determining source. Beyond that, there is the undeniable simplification that would arise from abandoning source concepts.(17)

It is hard to predict how these issues will ultimately be resolved, either by the United States or by other countries. On the one hand, recognizing and embracing the "ascendency of residence-based taxation"(18) may be the best policy guideline. On the other hand, unilaterally moving to residence-based taxation would involve the surrender of significant taxing jurisdiction if there were no guarantee that most major trading countries would move in the same direction. In addition, many developing countries will likely be reluctant to abandon source-based taxation; indeed, it is precisely the abandonment of source-based taxation in the OECD Model Tax Treaty that distinguishes it from the U.N. Model Tax Treaty, and most developing countries continue to maintain significant withholding tax obligations even in their treaty arrangements.

Finally, the United States would encounter perhaps significant political fallout in advocating this approach. The United States, as the chief capital-exporting country in the world, arguably has the most to gain by abandoning source-based taxation. Because U.S. investment abroad is far larger than foreign investment in the United States, exchanging withholding taxes for the elimination of foreign tax credits on dividends, interest, and royalties could well prove a significant net revenue benefit for the United States. Even developed countries might resist an apparently reasonable change in the international norms if the revenue benefits of that change flow in only one direction.

Meanwhile, the difficulty of determining the proper characterization of income from electronic commerce, and the resulting ambiguity in the application of the sourcing rules, will generate more and more practical difficulties as the volume and scope of electronic commerce in Cyberspace expands.

Permanent Establishment Concepts in Cyberspace

Tax treaties have created the concept of a "permanent establishment" in order to establish a nexus for local country taxation. The OECD Model Treaty defines a permanent establishment in Article 5 as "a fixed place of business through which the business of an enterprise is wholly or partly carried on." There is a clear attempt to distinguish substantive economic activity, which creates a taxable presence, from mere "preparatory or ancillary" activity; the latter, although conducted through a "fixed place of business," does not create a taxable permanent establishment. Although not free from doubt, the permanent establishment concept, with its requirement of a fixed place of business, tends to lend some certainty to the circumstances in which a foreign person will be subject to tax in a host country. Moreover, as described in the business profits article, Article 7, of the OECD Model Treaty, the income that is sought to be taxed by the host country must be "attributable to" the economic activity of the permanent establishment.

Article 5 of the OECD Model Tax Treaty also distinguishes when, and under what circumstances, the activity within the host country of an agent of the foreign person will establish the requisite nexus to permit direct taxation of the foreign person's business activities by the host country where there is no "fixed place of business." A foreign person will not have a taxable presence solely by reason of using an agent, regardless of the type of activity carried out on behalf of the foreign principal. Rather, the agent must be "dependent," that is, dependent both legally and economically, on the foreign person.(19) Beyond that, the agent must be able to enter into contracts in the name of the foreign person, which, at least, means that the agent must be able to bind the foreign person to a contract as a matter of local law. If these indicia are not present, the OECD Model Treaty takes the view that the agent is one of independent status and the principal cannot be taxed by reason of using the agent. In such a case, the host country, in effect, is conceding that the taxation of the agent's income is an appropriate amount of taxing jurisdiction for it to have in the context of the overall transaction.

As noted, no "fixed place" of business is required if the foreign person is using a dependent agent. By requiring that the agent be dependent and conclude contracts in the name of the foreign principle, the dependent agency concept is trying to link taxing jurisdiction to the notion of significant economic activity occurring in the host country in relation to the transaction under scrutiny.

Because of its insistence on a "fixed place" of business, the permanent establishment rule should not create taxation for those taxpayers planning electronic commerce transactions with customers in countries where they have no other business activity. For example, selling widgets over the Internet should not, in and of itself, result in a U.S. company having a permanent establishment in another country; the economic functions creating the income simply would not have occurred in that country.

Nevertheless, there can be no assurance that contemporary international taxation principles lead, inevitably, to such a result. As a practical matter, it can be expected that taxing authorities of net consumers of products and services marketed through Cyberspace will seek out ways in which to tax these transactions. In view of the fact that prior to electronic commerce, most of those transactions would have been readily taxable by the purchaser's country, at least to some extent, under traditional principles, because the seller would need to have distributors within the country to market and sell its products or services there.(20)

Reaching for such a position, taxing authorities will seek to develop analogies and analyses that relate electronic commerce transaction flows to fixed places of business that can be found "in-country." In this regard, attention needs to be drawn to two potential "hooks" upon which a finding of permanent establishment existence could be supported. First, there is the issue whether the geographic presence of a server with the relevant Web site is adequate to create a permanent establishment. Second, there is the issue whether the ISP creates a dependent agency permanent establishment for the foreign merchant.

The Commentary to the permanent establishment article of the OECD Model Treaty has something arguably applicable to this subject. Paragraph 10 of the Commentary on Article 5 discusses the circumstances under which activities conducted through automatic equipment such as "gaming and vending machines and the like" may constitute a permanent establishment. In these cases, a permanent establishment may exist if "the business of the enterprise is carried on mainly through automatic equipment, the activities of the personnel being restricted to setting up, operating, controlling, and maintaining such equipment." The key factor, according to the Commentary, is "whether or not the enterprise carries on a business activity other than the initial setting up of the machines." The Commentary suggests a facts-and-circumstances approach:

A permanent establishment does not exist if the enterprise

merely sets up the machines and then leases the machines to

other enterprises. A permanent establishment may exist,

however, if the enterprise which sets up the machines also operates

and maintains them for its own account. This also

applies if the machines are operated and maintained

by an agent dependent on the enterprise.

By contrast, the Treasury Department, without explicitly adopting the position, seems to wish to insulate electronic commerce from taxation under permanent establishment principles under those circumstances. In its White Paper, the Treasury muses about whether traditional exceptions to permanent establishment treatment of what is otherwise a "fixed place" might apply:

For a business which sells information instead of goods, a

computer server might be considered the equivalent of a

warehouse. Examination and interpretation of the

permanent establishment concept in the context of

electronic commerce may well result in an extension of the

policies and the resulting exceptions [from permanent

establishment status] to electronic commerce.(21)

Clearly, as the nation most likely to be selling to foreign customers through servers based abroad, the United States would likely maximize its taxing jurisdiction by adopting a policy that a server physically present in a country does not create a permanent establishment. It is also possible to see how other countries, whose tax revenues may be perceived to be threatened, could look to the OECD Commentary for some support, at least by analogy. Nevertheless, an attempt to treat a server as a taxable permanent establishment must ultimately fail given the ease with which the server with the Web site can be relocated offshore.

Moreover, there is the issue whether the ISP providing a server creates a "dependent agent." Where the Web site accepts orders after establishing all the terms of the sales or services contract with the customer through interactive, but pre-programmed, decision software, and then, again automatically, directs the shipment of the goods or the provision of the services, a basis may exist for analogizing the ISP's server to an agent of the nonresident seller. Arguably, however, the ISP should be an "independent agent." In the typical case, the ISP will be analogous to an independent broker with myriads of "principals" for any one of whom it is not dependent either legally or economically. Beyond that, the computer programs that operate to engage in the transaction probably have been created and installed on the Web site (and thus the server) by the foreign merchant itself and not by the ISP; accordingly, it cannot be said that it is the ISP that is entering into contracts in the name of the foreign merchant, although it may provide the equipment -- the server -- that enables this to occur.

ISPs providing online or database services in their own right may themselves be treated as having a permanent establishment where they actively provide such services, e.g., America On-Line's extensive organization of electronic information and provision of "front end" entry into the Internet, particularly if those activities are classified as "services" for tax purposes. By contrast, if the activities are treated as the sale of property, the ISP can argue that it does not have a permanent establishment, but merely a facility used "solely for the purpose of storage, display or delivery of goods."(22) Here it is assumed that data constitute goods and the ISP acts as a warehouse, following the suggestion contained in the Treasury White Paper.(23)

A Web site alone seems unlikely A qualify as a "fixed place of business." It is, by its nature, ephemeral, a collection of electrons organized into bits of data. It can be moved from one server to another with great ease. Thus, it does not have the "permanence" envisioned by the concept of a "fixed place of business."

One is tempted to apply the analogy of the tax treatment of sales through a mail-order catalog to electronic commerce transactions through a Web site. At first blush, this seems an extremely apt analogy; some Web sites do not consist of much more than a listing of products coupled with an order form. In those cases, the Web site is not much more than an electronic catalog, advertising products and soliciting sales. As electronic commerce becomes more interactive, however, customers will inquire about specific products and terms of sale, and the transaction will looks less and less like a purchase from a mail-order catalog. As one commentary has put it:

[Computers and telecommunications] equipment at

present, and in the future, may do more than routinely

execute commands. This equipment may perform credit

checks, enter into purchase and sales agreements and

perform other functions that, if performed by individuals

located in the United States, would be found to comprise a

U.S. trade or business and permanent establishment.(24)

Of course, the provision of services on an interactive basis bears very little resemblance to mail order catalogs either.

Clearly, the technology and the marketplace that takes advantage of it are going to present challenges to the simple adaptation of traditional permanent establishment concepts to the world of electronic commerce.

U.S. Trade or Business

Where there is no applicable tax treaty, domestic tax law must be applied instead of tax treaty principles. In the United States, the Internal Revenue Code focuses on whether the seller of tangible property or provider of services is engaged in a U.S. trade or business. If so, sections 871(b) and 882(e) impose a tax on income that is effectively connected to the conduct of that U.S. trade or business. While the concept of "permanent establishment" is similar in many respects to the Code's concept of a "U.S. trade or business," differences exist. Therefore, it is possible that an activity may be a U.S. trade or business, yet not be considered a permanent establishment.(25)

While the definition of a U.S. trade or business has varied from case to case, and is indeed ultimately a facts-and-circumstances determination, generally it is assumed that "continuous, considerable and regular" activities of a foreign company or its agents in the United States will give rise to a U.S. trade or business.(26) Accordingly, if a foreign company establishes a Web site through an ISP, and merely advertises and solicits orders for its products, the activity may not rise to the level of a U.S. trade or business. Some cases have held that mere solicitation of business or advertising is not sufficient to give rise to a "U.S. trade or business."(27) By contrast, some cases have attempted to apply a quantitative and qualitative analysis to the "continuous, considerable and regular" activities of a foreign company in the United States that could give rise to a U.S. trade or business.(28) Thus, the case law provides no tangible guidance except that each fact pattern must be separately addressed.

The issues raised in this context are similar to those discussed above in relation to application of the permanent establishment concept to electronic commerce, although the resolution of these issues may at times differ. This difference can exist because the tests for significant activities under the Code requirements are less clear than in the permanent establishment area. For example, the Code's quantitative and qualitative requirements as articulated in the "considerable, continuous, and regular" activity test appear to be more activity-focused than the "fixed place of business" test, which looks more toward a physical location. The de Amodio case illustrates this point where a nonresident alien owning U.S. real estate was deemed engaged in a U.S. trade or business because of the continuous and regular activity of her management agents, yet this activity was not considered to be conducted through a fixed place business for purposes of the permanent establishment requirement under the current U.S.-Swiss Income Tax Treaty. More appropriate to electronic commerce is whether "continuous, considerable, and regular" solicitation on a Web site would be considered sufficient activity for a U.S. trade or business.(29) If there is, in addition, "continuous, considerable, and regular" regular transacting of sales through the ISP on behalf of the foreign company, would this increase the potential for the existence of a U.S. trade or business?

Once it is concluded that a U.S. trade or business exists, U.S. tax can only be applied against income that is "effectively connected" with that business.(30) Section 864 provides that effectively connected income includes income derived from a sale or exchange of inventory that takes place outside the United States if it is attributable to an office or other fixed place of business within the United States. The income will be attributable to a U.S. office or other place of business if that office or fixed place of business (1) is a material factor in the production of that income and (2) regularly carries on activities of the type from which the income is derived. The office or fixed place of business of a dependent agent is disregarded if that agent does not have authority to negotiate and conclude contracts in the name of the foreign company or does not have inventory of the foreign company from which orders are regularly filled.(31)

To avoid any potential issue of an ISP providing the requisite office to which foreign-source sales income could be attributed, the foreign company could use ISPs located outside the United States, with title passing outside the United States. Because ISPs can be reached through various means, this should not be difficult.

The Treasury Department, a s well, seems to have reached the conclusion that continuing utilization of the "U.S. trade or business" standard may present difficulties in the context of electronic commerce. A footnote in the Treasury White Paper states:

The difficulties in determining whether a foreign person is

engaged in a trade or business in the United States may be

a reason to consider replacing the Code's U.S. trade or

business concept with the permanent establishment

concept found in both U.S. tax treaties and the domestic

laws of many of our trading partners.(32)

If brought to fruition, this somewhat startling thought (considering the source) would be a substantial change in U.S. tax jurisdiction concepts.

Transfer Pricing

Although the previously discussed substantive international tax issues for Cyberspace can be difficult and raise significant ambiguities, transfer pricing issues become even more unwieldy in the context of electronic commerce and the globalization it permits. The starting point for intercompany pricing purposes is determining the proper characterization of the transaction. In the United States, that characterization will dictate which set of transfer pricing methods is available -- those covering sales of tangible or intangible property; the licensing of intangible property, or the provision of services.(33)

In some instances, establishing an arm's-length transfer price may not be significantly different from the process in traditional transactions. For example, in the case of the sale of tangible personal property through a Web site, a traditional buy-sell distributor paradigm may be created using either the resale-price method or the comparable-profits method. The same may be true for either licensing software that may be purchased through, or downloaded from, the Web site or establishing fees for database usage.

Complexity, however, arises with global banking, telecommunications, or technology projects where global collaboration functions to take positions in financial products in markets around the world, where data, software, and other products are collected and developed globally through a variety of participants and transmitted through telecommunications to worldwide customers, and where scientific and engineering projects are carried out by laboratories around the world.

The goal of transfer pricing in these cases is to allocate the income from the end product of the collective effort to the individual legal entities involved. Under basic transfer pricing tax and economic principles, this allocation must be commensurate with the functions performed, risks taken, and assets committed by each participant in the process.

As evidenced in the area of global trading in the financial industry, traditional transfer pricing rules do not lend themselves to practical application and implementation in these cases. Recognizing this, the Internal Revenue Service issued Notice 94-40,(34) which established a profit-split formula using factually based weighted factors to allocate profit among the various participants trading on a global book of financial instruments. Similar profit-split formulae (or cost-sharing arrangements) may be the wave of the future in dealing with these global products. Of course, where capital is a material factor in the process, or valuable intangibles largely contribute to global profitability, those factors must be incorporated into the formula or separately compensated prior to any profit-split analysis. Aside from Notice 94-40, the IRS publicly announced any conclusions regarding appropriate allocations among a global group, or even mused about issues or requested comments. The IRS could, if it chose, issue notices on additional types of transactions, or make public at least the general concepts underlying Advanced Pricing Agreements that have been reached with taxpayers on those matters. Meanwhile, taxpayers will be left to make informed guesses based upon Notice 94-40, and whatever may be reported in the gossip columns of the tax press.


The Treasury White Paper expressed great caution and skepticism regarding the ability of the Internal Revenue Service's compliance techniques to catch up with the technology of electronic commerce.(35) The focus of Treasury's concern was for (1) electronic money, (2) identity verification, (3) recordkeeping and transaction verification for electronic transactions, and (4) disintermediation and its effect on information.(36)

While electronic money and identity verification appear to pose the greatest concern for tax evasion, especially when dealing with jurisdictions where bank secrecy rules are applicable, the causes of Treasury's concerns do not appear to be any more serious for electronic commerce than for any other transactions. In fact, electronic transfers of money may actually create more ascertainable documentation than other forms of payment. This documentation may take the form of a centralized computer record of transactions that may be more orderly than manual transfers by check. Similarly, computerized records should exist for purchase and shipping invoices regarding the sale of goods or transfers of intangibles over the Internet. These records should be available to match up against any withholding tax obligations that may be due. Moreover, merchants conducting their businesses via electronic commerce have every incentive to agitate for the development of technologies that will permit them to identify their customers and verify their creditworthiness.

Nevertheless, the ability of those highly literate in the new technologies offers the potential that transactions can be conducted in a manner that is virtually untraceable. There is little question that taxing authorities will remain concerned about this aspect of the electronic commerce revolution.

On the other side of the coin, there has been much concern expressed over the potential for governments to impede the development of electronic commerce by the establishment of "toll booths" on the global information superhighway that would be used not only for the purpose of imposing new taxation on electronic commerce, but also for the purpose of assuring compliance with existing tax laws by the participants in the new Cyberspace marketplace.(37) While Treasury may be considering those concepts to assure compliance, it is surprising that in our world of over papering each transaction, as well as sophisticated accounting software used for tracking transactions, that alternative and less costly procedures may be used. As our learning experience matures within this area, one would think these issues would disappear.

State Tax Issues

In addition to federal and international tax issues, electronic commerce also raises many state tax issues. Many of the state issues are analogues to the previously discussed federal and international issues. For example, issues of permanent establishment or what constitutes being engaged in U.S. trade or business are replaced with questions of "nexus." Questions of characterization of income and source of income remain key considerations in the state context. Nevertheless, various overlays of constitutional law and federalism frame these issues in the state context. To date, most developments have occurred at the state level. If electronic commerce has stimulated commentary and speculation at the federal level, it has also stimulated at least as much commentary and speculation at the state level.

In addition, however, electronic commerce has also provoked, at the state level, legislative action as well as cases and controversies. To date, comparatively more of the action (as distinguished from talk) has probably taken place at the state level. This concentration of activity at the state level is probably attributable to several factors, including greater reliance on transactional taxes (e.g., sales and use tax), frequently shorter audit cycles, and involvement of taxing authorities from more states. Also, and perhaps most important, the Internet and electronic commerce have probably developed faster in the United States than elsewhere. As might be expected, states have not adopted a uniform policy and the approaches taken by the different states are, to use an expression, all over the map.

Federal Influence on State Taxation

Consistent with its policies of tax neutrality for electronic commerce and of allowing development of electronic commerce without new or unique fiscal barriers, the Clinton Administration endorsed the "no new taxes" approach for electronic commerce at the state level:

The Administration believes that the same broad principles applicable to international taxation, such as not hindering the growth of electronic commerce and neutrality between conventional and electronic commerce should be applied to sub-federal taxation. No new taxes should be applied to electronic commerce, and states should coordinate their allocations of income derived from electronic commerce.(38)

Cox-Wyden Bill -- The Internet Tax Freedom Act

Representative Chris Cox, a Republican from California, and Senator Ron Wyden, a Democrat from Oregon, introduced companion bills (H.R. 1054 and S. 442) to place moratorium on new taxes on electronic commerce and to direct federal officials to work with state and local officials to develop a coordinated national policy for taxing electronic commerce. This legislation became a lightening rod for the debate on state taxation of electronic commerce. The Multistate Tax Commission (MTC) staff reportedly sought support from the states to oppose the ITFA. In response, the California Board of Equalization, continuing its recent trend of independence in the face of MTC efforts to direct tax administrator initiatives, voted unanimously to support the legislation. The MTC staff quickly moved to deny that it had tried to engineer opposition to the ITFA. At a meeting in August 1997, the members states in the MTC voted neither to support nor oppose the ITFA, but to adopt a resolution acknowledging that the Act is "of great concern to the members" of the MTC. This resolution was adopted because the ITFA has been subject to continual revision, and therefore it was not possible to determine the effect of the ITFA on the member states.

Activity at the State Level

In addition to the policy issues framed by federal legislation like the ITFA, taxation of electronic commerce at the state level is also bound up in existing legal and constitutional considerations and restrictions. Often the policy arguments influence and are influenced by these legal considerations. Perhaps more so at the state level than at the federal or international levels, the theoretical discussion sometimes takes place in the shadow of the need to apply existing laws, file tax returns, and raise revenues.

States have taken widely different approaches to taxation of electronic commerce. Representing the two opposite ends of the spectrum are California and Texas.


In California, a bill was introduced to enact a state version of the ITFA, known as the California Internet Tax Freedom Act. This bill would preclude state and local government agencies from enacting special taxes on the Internet, interactive computer services, and the use of the Internet or any interactive computer services. Generally, applicable income, business license, property taxes and sales and use taxes would be unaffected.

In addition, the California Board of Equalization is considering amendments to a regulation dealing with collection of use tax to specify explicitly that maintaining a Web site would not constitute being "engaged in business in California." The proposed amendment would also clarify that use of an independent (and unrelated) contractor to perform warranty and repair services in California would not cause a retailer to be engaged in business in California.


Texas is an example of a state that has taken an aggressive stance on taxing the Internet. Texas imposes a multitude of taxes on different aspects of the Internet. Previously, Texas imposed taxes on telecommunication services, data processing and information services. The creation and posting of a Web page on a Texas server is subject to tax as data processing because the creation and posting requires data input and manipulations. Access charges are taxed as information services. Based on a report from the Texas Comptroller's Tax Policy Director, Texas will continue to take an aggressive stance on taxing the Internet, but the state is willing to work with industry leaders to come to a compromise.

Application of Telecommunications Taxes

Internet access providers may face imposition of a sales tax on telecommunications or information services or a separate telecommunications excise tax in certain jurisdictions. Approximately 40 states and the District of Columbia impose sales taxes or telecommunications excise taxes on telecommunication services transactions. Of these states, about half impose one or more of these taxes on both intrastate and interstate transactions, and about half impose tax only on intrastate or local transactions. States are beginning to address application of these taxes to Internet services.

In states that only impose sales or telecommunications excise taxes on intrastate transactions, a crucial issue for the provider is determining the jurisdiction in which the services should be considered performed. This may hinge on how the provider structures its Internet access services and where the telephone lines and computer hardware providing such access are physically located.


In 1995, the Florida Department of Revenue (DOR) issued a series of rulings holding that Internet access charges were subject to the Florida telecommunications sales tax and gross receipts utilities tax as a computer exchange service. The DOR cited New York, Ohio, Texas, Tennessee, Louisiana, West Virginia, South Carolina, Washington, and Illinois as imposing some form of taxation on Internet access, electronic mail or bulletin board services, and cited California and Virginia as states that do not tax those items on grounds that they are non-taxable services. The rulings were made prospective to allow legislative consideration. Governor Lawton Chiles appointed a task force to review the issue in conjunction with rewriting Florida's telecommunications tax. The task force recommended replacing all current Florida non-income taxes on telecommunications providers (e.g., municipal utilities taxes and franchise fees, state, and local [option] sales taxes and gross receipts taxes) with a tax (at a revenue neutral rate) on customers for all telecommunications service regardless of the provider (thus covering telecommunications provided by cable companies) but specifically exempting Internet access, e-mail, two-way game playing, computer exchange services and related on-line services, along with exemptions for equipment rental, 900 service, line maintenance, yellow pages listings, and pay phone calls. That proposal would have applied (with a tax threshold) to residential services currently exempt from various Florida telecommunications taxes. Revenue would have been shared with local governments by formula. The recommended legislation failed to pass, but a specific prohibition against taxation of Internet access, e-mail, and other Internet services was enacted.


Currently Tennessee includes Internet access and e-mail services in the definition of taxable telecommunications services. In October 1996, the Information Technology Association of America (ITAA) requested the Tennessee DOR not to include Internet access in Tennessee's definition of taxable telecommunications services, stating that the Tennessee telecommunications tax should not include Internet access because the current law does not extend to value added or enhanced information services.


Senate Bill 5763 (SB 5763) was passed by the Washington legislature during the last few days of the 1997 legislative session and delivered to Governor Gary Locke for final action. SB 5763 prohibits the taxation of Internet service providers as network telephone service providers. The bill provides that the Internet services will continue to be taxed under the Business and Occupation tax classification of selected business services. The current rate is 2 percent until July 1, 1998, when it will drop to 1.5 percent.


The Massachusetts DOR recently decided to apply a five-percent telecommunications service tax on online services retroactively to 1990, when the tax was first enacted. Legislation (H.4608) has been introduced in the Massachusetts legislature, however, that would eliminate application of this tax, also retroactively. Along with other groups, the ITAA is lobbying the legislature to revoke application of this law, using the arguments about enhanced services also raised in Tennessee.

Merchants' Use of the Internet

In addition to questions about state taxation of Internet service providers, questions of state taxation of purveyors of merchandise and services over the Internet are becoming increasingly important. The questions involve both liability for collection and remittance of sales and use taxes and liability for income and franchise taxes.

Sales and Use Taxes

In some states, the tax authorities or legislative have adopted specific clarifications of the application of sales and use tax to various aspects of electronic commerce. For example, in California retailers who accept orders through a telecommunications network, and who have no other presence in California, are not required to collect California sales and use tax provided the retailer does not directly or indirectly own the network and the network primarily provides on-line communication services rather than the electronic display of and taking of orders for products.(39)

Where on-line sales are not specifically exempt, the threshold issue is whether the merchant's nexus with the taxing jurisdiction is sufficiently substantial to satisfy the physical presence threshold of Quill Corp. v. North Dakota.(40) Where the merchant is an out-of-state taxpayer whose only contact with a state is via the Internet, the merchant should fall within Quill's safe harbor and not be subject to sales tax or a use tax collection obligation in that state.

Where a merchant does not fall within the safe harbor, sales and use tax may apply. Private software companies are developing products that track on-line sales to assist in compliance. For example, Netscape has announced the development of software that would enable merchants to track the incidence and location of on-line sales for purposes of determining sales and use tax compliance obligations.

Sales of Software and Information Services via Electronic Transmission

Some states expressly exempt the sale of software from sales tax where the software is transmitted to the customer electronically. For example, the South Carolina taxing authority has ruled that the electronic delivery of computer software is not subject to South Carolina sales and use tax, although sale of packaged software on a tangible medium, such as a diskette, is taxable.(41) The same rule applies in California.

The Texas Comptroller has adopted a different approach for information services: Sales tax applies to online sales of information where the information is downloaded from the Internet (apparently where the taxpayer's server is located in Texas) by customers after their credit card information has been accepted. Interestingly, the Comptroller stated that sales tax would not apply where the information is contained on a diskette that is shipped to an out-of-state customer who sent a check or money order.(42)

To the extent that a state applies its sales tax only to the transfer of tangible personal property, the sale or license of a packaged program should not be a taxable transaction if the program is transferred by remote telecommunications from the seller's place of business to the purchaser's computer and the purchaser does not obtain possession of any tangible personal property, such as storage media, in the transaction. If a separate charge is made for any documentation or manuals provided, then sales tax would likely apply to the separate charge.

State Income Tax Ramifications of Electronic Commerce

To withstand constitutional challenge, a state tax must satisfy tests under both the Commerce Clause and the Due Process Clauses of the Constitution. This requirement is true for income as well as transactional taxes such as sales and use tax, although the considerations raised by electronic commerce in the context of state income tax may differ from those raised in the context of sales and use tax. The U.S. Supreme Court in Quill held that some form of physical presence in a state was required before the state could constitutionally impose a sales or use tax. This constitutional limitation on state tax authorities does not expressly apply to taxation based on net income.

In 1993, the South Carolina Supreme Court ruled in Geoffrey, Inc. v. South Carolina Tax Commission(43) that a Delaware holding company was subject to South Carolina's income tax where the company merely licensed intangible property rights to a licensee in South Carolina and had no physical presence in the state. The court side-stepped Quill's physical presence requirement by interpreting the requirement as limited to the sales and use tax context. As such, the court concluded that by merely licensing intangibles for use in South Carolina, Geoffrey had the requisite nexus for Commerce Clause purposes and income tax could properly be imposed.

Taking the Geoffrey theory to its extreme, almost any material economic penetration into a state could trigger income tax nexus. In that case, merchants selling goods via the Internet would have nexus wherever the Internet reaches -- all 50 states and the District of Columbia. Many believe that such an expansive reach is not permitted by the Commerce Clause of the Constitution, but rather requires enabling federal legislation. Some commentators argue, however, this expansive view may not survive a challenge under the Due Process Clause.

In the last few years, various courts have dealt with non-tax aspects of when communications and contacts are sufficient to subject an out-of-state taxpayer to jurisdiction in the state.(44) These cases, however involve only Due Process limitations on jurisdiction and not the Commerce Clause limitations. Unless Congress acts to change the result, the Commerce Clause provides a higher barrier to state taxation than does the Due Process clause.

Congress has previously acted to restrict the states from impose income taxes on certain types of businesses. Although this legislation was adopted long before anyone thought of electronic commerce, it will restrict states from imposing income tax on merchants meeting the requirements set forth in the law. Public Law 86-272, which was enacted in 1959, prohibits states from assessing a corporate income tax against an out-of-state corporation that limits itself merely to soliciting orders for sales of tangible personal property where the orders are approved and filled outside of the state. As a result, merchants who sell tangible goods via the Internet and meet the requirements of Public Law 86-272 would escape state tax nexus in states where their customers are located (assuming they had no other contacts with the states). Public Law 86-272 does not, however, apply to taxpayers who sell services, intangible property, or real estate.


In summary, the theoretical debate about taxation of electronic commerce is probably as active and varied at the state level as it is at the international level. The debate at the state levels presents similar issues of jurisdiction to tax and characterization of transactions as arise at the international level. Unlike the international level, at the state level there are no tax treaties to deal with. At the state level, however, there are constitutional and federal law issues, both actual (e.g., Public Law 86-272) and proposed (e.g., the internet Tax Freedom Act), that set a special framework for analyzing the potential tax issues arising from electronic commerce. Unlike the international level, the state level has experienced significant legislative, administrative, and judicial developments. It may well be that some of these developments presage developments in international taxation of cyberspace transactions, or may provide laboratories that provide insight on what will, and what will not, be effective means of approaching international tax issues in this area.(45)


Our knowledge of cyberspace and the issues inherent in the commercial international transactions utilizing it will continue to evolve and mature. As it does, the tax issues and compliance problems highlighted by these transactions should become more manageable. As the U.S. Treasury Department and numerous commentators have recognized, established tax principle are susceptible to application to these issues. Having said this, it is important to realize that electronic commerce, if it becomes a significant portion of global commerce, will place pressure on the previously developed international consensuses on taxation of international transactions and investments. Traditional understanding of how income should be sourced are less satisfying in the electronic marketplace. Beyond this, the logic of traditional international tax principles may lead to significant alterations in distributions of tax revenues among countries. Beyond this, too, there is no guarantee that further developments in the technology could render much of the current thinking and speculation largely irrelevant. Enacting special provisions to deal with gaps in the law or perceived abuses could therefore be in the offing. In the meantime, businesses and their tax advisers must become familiar with the new business medium and cognizant of the issues it raises and the ambiguities surrounding them.

New wine may not fair as well in old bottles, and, at least, the cork must be replaced regularly.


(1) See U.S. DEPARTMENT OF TREASURY, OFFICE OF TAX POLICY, SELECTED TAX POLICY IMPLICATIONS OF GLOBAL ELECTRONIC COMMERCE (Nov. 21, 1996) (Treasury White Paper) (general overview of the world of electronic commerce); Dell, Guide to Proposed Regs Classifying Transfers of Computer Programs, TAX NOTES 83 (Jan. 6, 1997).

(2) Prop. Reg. [sections] 1.861-18, 61 Fed Reg. 58, 151 (Nov. 13, 1996).

(3) See generally Shapiro, Lost in CYBERSPACE: Transfer Pricing Aspects of Proposed [sections] 861 Computer Software Regulations, 5 TAX MGMT TRANSFER PRICING REP. 495 (Dec. 11, 1996).

(4) Treas. Reg. [subsections] 1.861-18(b)(1) and (h).

(5) Compare Treasury White Paper [sections] 7.3.3 at 23.

(6) To further complicate issues, some tax authorities view the license or sale of software as neither a good nor an intangible, but rather the provision of intellectual services. See Cigler, Burritt & Stinnett, CYBERSPACE: The Final Frontier for International Tax Concepts, 7 J. INT'L TAX'N 340, 342 n.2 (1996).

(7) See Cottrell & Worham, Internet Resources for International Tax Practitioners Are Emerging and Expanding, 8 J. INT'L TAX'N 10 (1997).

(8) See Treasury White Paper [sections] 7.3.5 at 25.

(9) I.R.C. [sections] 954(f).

(10) All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

(11) See I.R.C. [subsections] 871(b) and 882(a).

(12) I.R.C. [sections] 954(e).

(13) Treasury White Paper [sections] 7. 1. 1 at 15.

(14) Treasury White Paper [sections] 7.3.5 at 25.

(15) Even for jurisdictions that use concepts such as siege sociale or "place of management and control," residence determinations are usually not difficult.

(16) Treasury White Paper [sections] 7.4 at 22-23.

(17) Utilization of "qualified resident"-type concepts would have to be increased, however, in order to avoid taxpayers establishing themselves under the laws of a tax haven to avoid taxation anywhere.

(18) Treasury White Paper [sections] 7.4.1 at 23.

(19) See Taisei Fire & Marine Ins. Co. v. Commissioner, 104 T.C. 107 (1995).

(20) It is not particularly relevant whether the distributor is owned by the foreign seller or is independent; some profit would be available for the distributor's country to tax in the normal course.

(21) Treasury White Paper [sections] 7.2.4.

(22) See OECD Model Treaty, Art. 5(4).

(23) See Cigler, Burritt & Stinnett, supra.

(24) Pridjian, et al., Comments to Department of Treasury Discussion Paper, at [paragraph] 16, 97 TNT 176-43 (Tax Analysts Reference) (May 15, 1997).

(25) de Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd. 299 F.2d 623 (3d Cir. 1962).

(26) Id.

(27) See Piedras Negras Broadcasting Co. v. Commissioner, 43 B. T. A. 297 (1941), aff'd, 127 F.2d 260 (5th Cir. 1942), nonacq. 1941-1 C.B.18.

(28) See de Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd, 299 F.2d 623 (3d Cir. 1962).; Spermacet Whaling & Shipping Co. v. Commissioner, 281 F.2d 646 (6th Cir. 1960), aff'g 30 T.C. 618 (1950).

(29) See Rev. Rul. 56-165, 1956-1 C.B. 849; Handfield v. Commissioner, 23 T.C. 633 (1955).

(30) I.R.C. [sections] 864.

(31) Treas. Reg. [sections] 1.864-7(d).

(32) Treasury White Paper [sections] 7.2.1 n.52.

(33) See generally Treas. Reg. [subsections] 1.482-1, et seq.

(34) 1994-1 C.B. 351.

(35) Treasury White Paper 8.1 at 26-28.

(36) Id. at 27.

(37) See Cigler, Burritt & Stinnett, supra.

(38) White House Report, A Framework for Global Electronic Commerce (July 1, 1997).

(39) Cal. Rev. & Tax. Code [sections] 62030).

(40) 112 S. Ct. 1904 (1992).

(41) S.C. Rev. Rul. 96-3 (1996).

(42) Comptroller Ruling, 8 January 1996, Microfiche No. 9601L1389G04.

(43) 437 S.E. 2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993).

(44) See, e.g., Bensusan Restaurant Corp. v. King, 96 Civ. 3992 (S.D.N.Y. 1996); Hall v. LaRonde, 97 C.D.O.S. 6345 (Cal.2d App. Dist. 1997).

(45) Recall that state income tax formula apportionment schemes have led some politicians and commentators to advocate similar approaches to international transfer pricing problems.

MARC M. LEVEY is a partner in the New York office of Baker & McKenzie, THOMAS A. O'DONNELL is a partner in the Washington office of Baker & McKenzie, and J. PAT POWERS is a partner in the Palo Alto office of Baker & McKenzie. Copyright 1997 Marc M. Levey, Thomas A. O'Donnell, and J. Pat Powers. All rights reserved.
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Date:Nov 1, 1997
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