International Taxation of E-Commerce: A national approach to an international Problem
JULY 30, 2008
By Pallav Raghuvanshi & Suraj Narayan
THROUGH the gyre of inevitable and ever ongoing change we have entered into an era where the world, as we know, has been bifurcated by the revolution in Information Technology into the physical and the virtual world. Constant interaction between them makes these two seemingly different worlds unitary. More and more companies who have established themselves in physical world are entering into the realms of the virtual world. Another outcome of this revolution is the emergence of e-corporations which do not have any physical establishments or ‘brick-and-mortar' offices. This technological advancement brings with itself some novel questions, which have become difficult for law to answer; one such being the taxation of e-commerce.
The rise of the Internet has created a new market for companies to increase their sales, both domestically and internationally. Consumers benefit from such commerce because this grants companies an opportunity to sell their products and services at a cheaper rate due to the absence of taxes on such transactions. Also, the businessmen are saved of the traditional expenses of storage, warehousing and transportation. This in turn increases the volume or the number of commercial transactions that happen through the Internet, paving way for the erosion of the tax base of a country. If this persists, then supporting the massive economic and social infrastructure, designed to provide the citizens with the benefits of a modern society, for a developing country like ours will become a challenge. Therefore, it becomes important to identify the e-transactions that must be exposed to tax for the fiscal well-being of a country . However, such taxation should not stifle the growth of e-commerce. Striking a balance is thus crucial in order not to deter a person from entering the virtual world for business.
Another issue to be resolved by the government is whether it should introduce a new regime for taxing e-commerce or continue with the existing one by extending its provisions to the commercial transactions on the Internet. This needs to be addressed at the earliest otherwise the tax base might be eroded even before the government comes to know of its rapid erosion resulting from tax evasion.
The global impact of the Internet brings with itself the need to formulate methods to adapt existing tax policies, legislation, procedures and practices to overcome the difficulties that are posed by e-commerce, as distance and geographical borders vanish in the e-world. Therefore, it is important to understand the taxation -related problems, which are put forth by e-commerce and provide long-lasting solutions for the same.
E-commerce and International Taxation
It is indeed a cliché to say that our world has moved towards an information age but thanks to the coup d'état brought by the same, a businessman sitting in India can transact with a costumer in the United States through the Internet and avoid taxes; this if done through the channels of traditional commerce, brings the transaction under the purview of several taxes. Since such taxes are paid by the businessmen, the price of their goods and services will be more as compared to e-commerce businessmen. So, as a result he may be at a disadvantage, when competing with the online businessmen.
This situation strikes at the root of the principle of neutrality of taxation. As per this principle, same rates of taxation must apply to persons indulging in the same kind of business irrespective of the medium used to conduct the business itself. This principle has been so widely accepted that even Organization for Economic Co-operation and Development's ( OECD ) committee on fiscal affairs has proposed that “the taxation principles that guide the governments in relation to conventional commerce should also guide them on electronic commerce.”
Non-neutrality of taxation can affect the businessman in two ways: firstly, avoidance of taxes by e-businessman as compared to traditional businessman, secondly, disparity in taxation between e-business within and outside the geographical boundaries of a particular country. The example cited above clarifies the first. We can understand the other effect with the help of the following example. Two Web sites, one owned by a resident of the United States and the other by a resident of the United Kingdom , sell books. While the US-based Web site sells e-books, the UK-based Web site sells printed books, however, the essence of both the sales is same, i.e. sale of books. If an Indian costumer orders a book from both of them then he will have to pay more to the UK Web site, as hard copies of the books will be taxed and not the e-copy of the same. The other parallel issue that arises is that of collection and remission of taxes. Suppose the UK Web site collects the tax on the book sold, then whether it will remit the same to India remains a moot issue. This is one reason why source-based taxation is discouraged in e-commerce. Moreover, source-based taxation schemes along with residence-based taxation may lead to double taxation of the same income. In source-based taxation, the income is taxable in the country from where it is derived regardless of the place of residence of the person who earns it. In residence-based taxation the entire income of the person, who earns it, irrespective of its origin, is taxed in the country he is a resident of. Thus, one can imagine the hassle a person would have to suffer if he has to pay taxes based on both the schemes on the same income.
Let us consider the situation of mail order vendors. Mail Order transactions involve companies that use catalogues, television or direct marketing to make retail sales via shipping. Now catalogue sales combined with internet sales though increase the magnitude of retail sales but at the same time escape most state and local taxes. Suppose there is a Web site, whose server is in the United States , which sells printed and published books. An Indian customer purchases the book online and the vendor delivers it. In this situation if tax is levied by India on the income earned by the sale of that book and the United States taxes the entire income of the vendor, being its resident, the businessman ends up paying taxes twice on the same income. In order to curtail the negative consequences of double taxation most countries have concluded double-taxation avoidance agreements for prevention of the same. Generally tax treaties restrict the use of domestic source rules by requiring a certain minimum nexus to allow taxation in that jurisdiction. Thus, taxation of business income on the basis of the source rule requires the presence, in the country of source, of a Permanent Establishment (PE) of the enterprise sought to be taxed.
But using only residence-based taxation could sometimes be unfavourable for the ‘not-so' developed countries that do not have, or have a handful of e-businessmen, as it might lose out on the money that goes out of its economy. The approval for residence-based taxation is supported by the treasury of the countries, with high concentration of the Internet companies. Those countries do this in order to further their own economic interest at the cost of the other ‘not-so' developed countries. Moreover, residence-based taxation would open the door for wide-spread tax avoidance resulting from the movement of their servers from the taxing jurisdictions to the tax havens. Keeping this in mind, the United Nations came up with the model for double taxation avoidance agreement, which was based on source-based taxation and tax relief for the resident e-businessmen in the form of tax credits, tax deductions and tax exemptions. Out of the above three breathers given by the tax authorities of a country, resident e-businessmen favour tax exemption the most.
Therefore, a PE is crucial to verify the existence of a tax liability. According to the OECD model convention, business profits are taxable only in the country of residence of the enterprise and not in the source country, unless the profit is attributed to a PE in the source country.
Consequently, source-based taxation of e-commerce is given a thumbs-down. PE presupposes the fixed place of business, which may include premises, facilities and installations. This definition excludes the places of business that are mobile. The basis underlying this definition is that one will not have a PE in another country unless he has a “brick and mortar” office and employees in that country. Therefore, it would be very hard to conceive how an e-businessman can have a PE in another country.
The logical question that arises now is whether a server or a Web site or an ISP will constitute a PE. As per the reasoning specified by the OECD Tax Convention, the server is not the “place” from where the business is transacted, but it is merely a “warehouse” where information to be sold is kept. And as we know, a PE does not include the use of facilities for the purpose of storage, display or delivery of goods or merchandise. Then, is a server a sufficiently significant element for generating income? The answer to this, in all probabilities, is negative. This is mainly because a particular server is just incidental to the creation of income and can be changed at the convenience of the Web site owner. Therefore, there is nothing permanent about this server. Then, can a Web site be a PE? In case of a Web site, it is always based on a server and it cannot be the place of business as goods and/or services are not delivered through it but independently of it. Again, the Web site may be permanent, but it is difficult to trace the residence of the owner of the Web site.
On the other hand, it would also depend on the activities that a person can do in it. For example, if a Web site offers a software-upgradation service and requires online submission of credit card numbers for payment, then it may amount to a PE (in the analysis of ‘activity test' as discussed below).Understanding the meaning of PE is simple, however, to determine the existence of PE stays a tight spot. There are three tests to determine the presence of a PE in a country. They are as follows:
1. The Assets Test – If the tangible and/or intangible assets of an e-business are in a country, then it can be construed as PE. But this is a very objective test and is difficult to relate to the e-commerce activities, as the latter involve transactions that are carried out electronically and goods and services are transferred through the electronic media.
2. The Agency Test – A PE will be present if a non-resident employs a dependant agent having contracting ability in the taxing jurisdiction. This is a reason why the Internet service provider is not an agent as he does not have the ability to close contracts on behalf of the Web site owner. Therefore, merely providing telecommunication services will not amount to agency for the purpose of the existence of PE. Thus, the effectiveness of taxation connected to the Internet service providers is debatable, since the providers can be changed at the will of the Web site owner.
3. The Activity Test – Certain activities can result into the presence of a PE while others may not. For this, the object of the transaction must be looked into and not the method of doing the transaction. Here, it is important to differentiate between activities that “contribute to the productivity of the enterprise” and activities that “involve actual realization of profits”.
These three tests have been designed to ensure whether PE of an e-business exists or not in a particular country so as to expose the businessman to tax liabilities.
Transactions of e-commerce involve either sale of articles or transfer of copyrights or upgradation and information services. Sale of article is easy to understand as it normally involves sale, but transfer of copyrights is a bit complicated. For the same purpose, the OECD has also formed a Technical Advisory Group (TAG) to advice on the treaty characterization of payments related to electronic commerce. The main problem is determining whether certain revenue is a business profit, a royalty or yet another treaty qualification needs to be applied. TAG also helps in determining how to tax payments for electronic order processing, downloading, licenses, updates and add-ons, application hosting, Web site hosting etc. under the treaty. Mostly, the preference seems to be inclined towards taxation of income as business profits than royalties, as the rate of taxation is more in the former. Another method for determining whether the income be taxed as royalty or business profit would involve the analysis of the e-contract that is entered into by the customer who buys the goods or services that are sold online. Let's take the example of software sold on the Internet. In this case, it is difficult to determine whether it is sale of software or license of its copyrights, because on the face of it, sale occurs but the user is also forced to enter into a standard form of agreement called EULA (End User License Agreement) as he cannot use the software unless he clicks on the “I Accept” button during the installation of the software. One inference that we can draw is that it depends on this EULA whether it is a sale of the software or transfer of the copyright on the software. If the EULA permits the user to reproduce the software and sell the copies so made, then it is a transfer of copyrights otherwise it is a sale. Therefore, the income can be taxed accordingly as royalties or business profits. However, nowadays, technology has gone one step further. Today, the softwares are made in such a manner that they cannot be copied or installed more than once in a computer. This is a welcome innovation as it keeps the copyright on the software intact and reduces the infringement to minimum. Therefore, tax administrators can easily identify through the EULA whether the income should be taxed as royalties or business profits.
Each country has its own individual tax policies and principles. Therefore, it is very difficult to harmonize the tax policies of all the countries to meet a global standard. This is one of the biggest obstacles that come in the way of addressing the issue of international taxation of e-commerce. The double taxation avoidance agreements might look like a possible solution but they may sometimes amount to added bedlam. Let us assume that there are 210 countries in the world out of which only 150 have an ‘active role' to play in e-commerce. If, among these 150 countries each one has a double taxation avoidance agreement with all the others, then it may result into the existence of a plethora of confusing and useless double taxation avoidance agreements and this may influence the decision of an e-businessman to conduct e-business or not in a particular country. Therefore, an e-businessman in a country will have to consider the rates of taxation in all the countries separately and analyze the tax consequences of his business if he decides to transact with costumers in those countries separately. This is against the principle of taxation, according to which the tax policy should not influence a businessman in making a decision whether to conduct a business or not in a particular manner or in particular country.
In harmonizing the tax policies of each country, the OECD tax convention and the UN model of double taxation avoidance agreement offer a helping hand, though both of them point at diametrically opposite directions. The OECD tax convention talks of residence-based taxation and discourages source-based taxation. The UN model takes the opposite stand. But problems may be solved by taking a pooled approach. The definition of PE can be retained with certain amendments (as suggested below) from the OECD tax convention and source based taxation can be retained from the UN model. But, before actually deciding whether the tax should be levied on the country of source or the country of residence, all possible boons and banes of both, with regard to the protection of tax base of ‘not-so' developed countries, must be understood.
SUGGESTION
It is imperative to tax e-commerce to avoid an adverse effect on the competition, as non-taxation of e-commerce would lead to the situation where the prices of goods and services offered by the traditional commerce men will be more and as a result, the traditional businessmen will avoid these taxes by converting themselves into e-commerce businessmen. This development on a wide scale would cause significantly high base erosion, which will become a very difficult problem for the nations, as taxes are one of the main sources of revenue with the help of which the government is able to run the country smoothly.
This brings us to the next point of discussion, whether uniqueness of the Internet commerce requires a new approach to tax or can the existing tax regimes' principles be applied with certain amendments.
By now, it is quite clear that there can be no universal law that can be uniformly applied to all countries for taxing e-commerce, as the world is divided into developed and ‘not-so' developed countries, where taxes are high, and the tax haven countries. However, an international convention can be made in this regard which would be applicable to the different categories differently. OECD backed by most of developed nations prefer residence based taxation over source-based taxation, which on the other hand is baleful for the developing countries as it amounts to the loss of revenue to those countries. So, one suggestion in this regard could be the application of source-based taxation made by the less developed countries. Determining whether a country is less developed or not would obviously depend upon its per capita income. When the transactions are made with developed countries there should be a strict application of this source-based taxation scheme by the ‘not-so' developed countries, and the taxpayers must get relief in the form of some concessions, which would be reserved for the developed country's residents by way of tax credits, deductions and exemptions by the developed countries.
Though taxation of the Internet commerce does not seem to be a big problem now, but, as mentioned before, it may lead to tax base erosion in near future. The current tax policies and principles are not at all equipped to tackle the complex legal problems brought along by e-commerce. Therefore, it is proposed that there should be legislation at both the levels; national and the international.
The legislation at the national level, inter alia , may include the following:
1. Server to be attributed as PE –
According to OECD, a warehouse is not a PE and the server is treated as a warehouse. Thus, the residence-based taxation is avoided. It is proposed that if the server is attributed as a PE then this avoidance can be curtailed. The advent of the Internet has reduced the geographical distance to such an extent that a person sitting in a country can sell an article to a person in another country in matter of minutes. Therefore, instead of considering the server as a warehouse, we should consider it as warehouse that is connected to the “place of business”. This means that we are comparing this with a business where in the same building the goods are sold on the first floor, which are warehoused at the second floor. In the e-world, even if the ‘place of business' or the computer from which actual sale is made is elsewhere, the ‘distance' between it and the server is negligent. Therefore the server could be construed as PE in this sense.
It is argued by many authors that a server is too mobile to be permanent. We would like to rebut this proposition by pointing out that it is not of much relevance whether a server is mobile or not but what is more relevant is a fact whether it is actually moved or not. After all a server is also a computer and its movement can be checked by registering it with a Government authority. If the server has not been moved out of the country, for say 6 months, then it can become a PE. But this should not stop a businessman from moving his server to other country within or after that period. He should be allowed to do so after levying certain taxes for the winding up. Thus we are proposing that if a server is not moved for a fixed period of time in the previous year then it should be treated as a PE for that following assessment year.
2. No bit tax -
The concept of bit tax has its origin from the Australian tax regime where each bit which is transmitted to the user or the server is taxed. This means that if a user browses a web page then he will be taxed for each bit that is delivered to his computer to make the Web site accessible and if he downloads any material even that will be taxed bit wise.
This concept of taxing at the bit rate is highly criticized on the grounds that:
a. It can lead to double taxation as the user and server both are taxed for the same amount of bits transferred. To understand this better we take the following example. A Web site is loaded when a user types its domain name in the address bar of his browser. After he does this a request is sent from his computer to the server in the form of packets which can be expressed in terms of bits. After receiving these packets the server responds by sending “the packets” of its Web site to the user. Now if bit tax is imposed here then the server will be charged for the bits that it receives in the form of requests that is sent by the user and the user will be charged for every packet of the Web site that he receives.
b. It is difficult to count the actual number of bits transferred and the same can be hidden by encryption. Sometimes counting the bits can be costlier than the revenue generated by taxing them.
c. It can lead to tax avoidance by compression of data which is being sent by keeping the data in analog form. This could actually reverse the process of development of the technology.
3. Law for one common forum or market –
How to determine which transactions are commercial and which are non-commercial? The law can allow the government to run a Web site, which would act as a marketplace for all the sellers in India . The law could also provide that the foreign sellers must also sell their goods and services through this web site. By doing this, the government can maintain a record of the sales made and therefore, it would be convenient for it to decide what kind of taxes must be levied on the transaction.
On the face of it, this ‘common forum' or ‘e-market' appears to abridge the right conferred by article 19(1)(g) of Indian Constitution which talks of freedom of carrying on any trade, business or profession. It is submitted that this ‘common forum' or ‘e-market' would only regulate the practice of the trade, business or profession in the Internet and in no way does it violate the fundamental right. But this does not ensure tracking and stopping people from using their own web sites to sell. To check this violation the government can levy extra taxation on those e-businessmen who do not sell their products and services through this e-market. This, in a way would ensure tax compliance and at the same time the government may also generate some extra revenue.
This ‘common forum' or ‘e-market' has other advantages too. One of which would be that the consumers will have and know all the options or alternatives that are available to them. This will also boost the competition amongst the e-businessmen.
4. The Internet Service Provider to have a record of the Web sites it hosts -
The law should provide that the ISP must maintain a record of the Web sites it hosts, in the sense, whether the sites engage in e-commerce or not. The ISP must also maintain a record of the contact details of the Web site owners and such records must be furnished to the tax authorities, as and when required.
CONCLUSION
As technological advancement has made the world so compact, with no geographical demarcations, it has posed new questions concerning the application of rules of international taxation. As these questions have no certain answers, it is important to consider and draw a synthesis of all probabilities, in order to get some of the solutions. A nation is always a green-eyed monster when it comes to the protection of its own tax base. So it would never allow the other countries to extract money out of its own economy. Whether such suggestions, as mentioned above, are implemented through the legislation at a national or international level is a separate moot issue, which our paper does not seek to answer. However, the focus of this paper is to point out, that if these suggestions are implemented, then e-commerce may be taxed without any arbitrariness.
(The authors are 4th year students of B BA LLB of Symbiosis Society's Law College)
