The development of electronic commerce (herein after referred to as EC) can be
said to be the greatest event in the history of mankind, next only to the
Industrial Revolution of the early 20th century. Whereas Europe and United
States were the main beneficiaries of the industrial revolution, there are clear
indications that India along with United States and China would be the major
beneficiaries of the EC Revolution. The huge pool of technological manpower is
at the basis of this indication.
The development of EC modifies the way of
doing business. For centuries, traditional business around the world has been
based on two concepts:-
1. Physical presence; and 2. Physical delivery of goods
Today physical presence is no longer
necessary to perform activities (i.e., commercial transactions are no longer
defined by geographical boundaries) and physical transactions are replaced by
bytes of data. Since EC can be conducted virtually instantaneously around the
globe and around the clock, the question where the profits should be taxed
Taxing the Internet is a topic that makes global headlines, everyday. The lure
of setting out national tariffs for every byte of data that follows and taxing
every product traded hopes to herald a new economy for the taxman. Most
governments are alarmed at the extreme growth of the internet, and they should
be, as the Net is the largest free information system the world has ever seen.
The task of taxing commerce on the Net is
daunting, since the data flowing through the vast annals of the Internet is
intangible and the network on which it is built is spread over the space of the
Earth. The peculiarity of Net stems from the kind of
"traffic" that flows through it- World Wide Web (WWW) pages, e-mail,
internet relay chat, video conferencing, internet telephony, streaming audio and
video file transfer and so on--- and each of this data is just a meaningless
string of zeros and ones.
The Need To Tax
The development of EC has revolutionized the way business operates. It has also
challenged the adequacy and fundamental validity of principles of international
taxation such as physical presence, place of establishment etc. that has formed
the basis of asserting tax liability.
Business conducted through the internet
caters to globally located customers. This raises cross border legal issues.
Transactions that may be legal and valid in one jurisdiction may not be
enforceable in others. Creation of wealth through cyber space would also entail
the use of "offshore" financial institutions to store this wealth. This would
constitute an elaborate and often untraceable form of tax avoidance. This is not
only a threat to national sovereignty but also overrides traditional principles
of taxation- a transgression of traditional notion of political and monetary
autonomy. As wealth is generated through the means of cyber space, accounting
mechanisms and monetary control would become difficult. Taxes on cyberspace
would be one method of getting some amount of monetary control.
The allocation of taxing rights must be
based on mutually agreed principles and a common man understanding of how these
principles should be applied. In addition to the need for consensus between
governments and business, a need for co-operation between them has also been
Aspects Of Internet Electronic Commerce
Relevant For Tax Policy Makers
Changes in the business practice due to the advent of the EC will affect
taxation in the following ways: -
(i) Lack of any user control to the location of activity: As the physical
location of an activity becomes less important, it becomes more difficult to
determine where an activity is carried out and hence the source of income.
(ii) No means of identification of users: In general, proof of identity
requirements for Internet use is very weak. The pieces of an internet address
(or domain name) only indicate who is responsible for maintaining that name.
It has no relationship with the computer or user corresponding to that address
or even where the machine is located.
(iii) Reduced use of information reporting and withholding institutions:
Traditionally taxing statutes have imposed reporting and withholding
requirements on financial institutions that are easy to identity. In contrast,
one of the greatest commercial advantages of EC is that it often eliminates the
need for intermediary institutions. The potential loss of these intermediary
functions poses a problem for the tax administration.
Some of the fundamental tax related issues raised by the evolution of EC
transactions may be summarized as follows: -
* Whether international trading by an enterprise through EC will result in the
enterprise creating a taxable PE in other countries in which customers are
* Is there a need to create new definition and meaning of permanent
establishment (Hereinafter referred to as “PE”)?
* Is there a need to change the basis of taxation (for example, residence based
* While considering taxation of EC transactions, should principles of tax
neutrality be adhered to?
* If it is determined that an enterprise does have a PE in another country,
another important issue than arises: How to attribute profits to PE?
EC also gives rise to new issues concerning the characterization of payments
under the double tax treaties. Moreover, though EC does not give rise to any
fundamentally new issues relating to transfer pricing, there may be some
difficulties in applying traditional transaction methods, establishing
comparability, deciding the tax treatment of integrated businesses and complying
with documentation and information reporting requirements. Unless these issues
are addressed, an erosion of the tax base may result, especially for developing
and under developed countries.
International Taxation - Treaty Law Regime
Fundamental Principles: A taxpayer is generally taxed on its worldwide income in
the country of its residence (residence based taxation). In the case of a
company, this is usually the place where the company is incorporated,
registered, or has its place of central management and control.
The company may also be taxed in another country if it has a recognized source
of income there (source based taxation). Generally tax treaties restrict the use
of domestic source rules by requiring a 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 PE of the enterprise
sought to be taxed.
Where the income or capital is taxed in the country of source, the country of
residence has the obligation to give relief from double taxation. Such relief is
granted either by exempting such income from taxation in the country of
residence or by giving credit for taxes paid in the country of source.
Permanent Establishment: Under the tax treaties based on OECD Tax Convention, an
enterprise providing services abroad is taxable in the country where it conducts
business only if it has PE there. For most tax treaty purposes, a ‘PE’ is a
“fixed place of business through which an enterprise carries on business. A PE
presupposes ‘a fixed place of business’ (the basic rule of PE) which may include
premises, facilities or installations . The characteristic ‘fixed’ demands a
specific fixed long-term connection between the place of business and a specific
part of the earth’s surface.
Secondly, if the services provided are the part of a construction or
installation project that lasts for more than a particular period of time, a PE
may be constituted under article 5(3), i.e., construction PE.
The third element of PE is article 5(5) and (6) under which an ‘Agency PE’ may
be constituted. This is the case if a provider of services in a country has a
dependant agent there who involves his principal in business by regularly
concluding contracts on behalf of the principal. Typically, however, tax
treaties exclude from the definition of a fixed place of business any offices
and facilities that are used merely for promotional activities or for the
storage, display or delivery of goods and facilities.
Background To E-Commerce
Electronic commerce is a broad concept that covers any commercial transaction
that is effected via electronic means and would include such means as facsimile,
telex, EDI, Internet and telephone. For the purposes of this report the term is
limited to those trade and commercial transactions involving
computer-to-computer communications whether utilising an open or closed network.
In addition it has also been said that:
Electronic commerce could be said to comprise commercial transactions, whether
between private individuals or commercial entities, which take place in or over
electronic networks. The matters dealt with in the transactions could be
intangibles, data products or tangible goods. The only important factor is that
the communication transactions take place over an electronic medium
With the rapid growth of the Internet, the process by which EC is conducted has
magnified. An understanding as to the mechanisms involved in the operation of
the Internet is necessary.
All machines connected to a Network are generally identified by their Internet
Protocol (IP) numbers. Devices communicate with each other through this IP
number system, acting much like two conventional telephones. Further, specific
IP numbers denoting a computer is given a domain name. The communication takes
place in the form of packets which can traverse through several networks
before reaching their destinations. Data packets are of specific size and if
their content exceeds this size, it is split up and transmitted. The data
portion of the packet can be encrypted for better security.
International tax issues in the area of e-commerce are manifold and include
nexus of the vendor and tax enforcement agencies. Taxing authorities may have
great difficulty collecting revenue form vendors conducting commerce through
foreign Internet addresses. The foremost problem associated with Internet based
commerce is fixing the place of transaction. The place where a web-server is
located, the place where the user initializes the transaction and the server
where payment is collected may be different. Electronic transfer of funds
heightens the risk of money being sent to tax havens. Further, many
jurisdictions rely on the taxpayer to voluntarily identify himself, herself or
itself as falling within its tax system. Tax authorities may not be able to
effectively enforce their rights to collect tax in such an environment,
especially if a business does not consider itself to be within a tax
jurisdiction and simply choose not to disclose its activities to the relevant
Underlying any discussions as to whether a website, server, telecommunication
equipment, local access numbers, etc. constitute a permanent establishment or
not is the source or residency based taxation.
Not surprisingly, certain technology exporting countries are in favour of a move
away from a source-based tax. The United States made a clear statement to this
effect in the treasury paper. Treasury maintains that it is difficult to apply
traditional concepts of source to link an electronic transaction with a
particular country. This view has been re-affirmed by the USD and supported by
Japan at the G8 meetings in Birmigham.
Importing countries will not necessarily take the same view and here is a danger
that in the absence of clear guidelines that are universally accepted we will
find some jurisdictions ‘straining’ the traditional concept of permanent
establishment to catch electronic trade and preserve local taxing rights or (and
potentially more alarming) seeking to apply ‘royalty’ treatment especially where
treaties allow for a withholding tax on gross receipts.
Where a foreign enterprise is considered to be carrying on business in a
particular country, it will generally be subject to tax in that country on that
source of business income. However, it may be exempted from tax on the business
income in the particular country if certain provisions are in a bilateral tax
treaty. Tax treaties will generally restrict the ability of a country to tax a
non-resident on its business income sourced to that country unless the income is
attributable to a “permanent establishment” in that country. Thus, a foreign
corporation that is resident in a country with which its home country has a
double tax treaty is liable for tax in the former only if it has a permanent
OECD definition of a permanent establishment
Business profits are taxable in the State of the residence of the enterprise
even if the business is carried on in the State of source, unless they are
attributable to a permanent establishment is generally defined as ‘a fixed place
of business through which the affairs of an enterprise are carried on’ .
This definition contains the following conditions:-
* The existence of a ‘place of business’, i.e., a facility such as premises or,
in certain cases, machinery or equipment;
* The place must be fixed, i.e., it must be established at a distinct place with
a certain degree of permanence;
* The carrying on of the business of the enterprise through this fixed place of
The conduct of a business usually implies that certain persons run the
enterprise’s affairs from the fixed place. However, the OECD comments concerning
automatic equipment make it clear that it is not necessary for personnel or any
other human being to be present performing particular activities in order for
there to be a PE.
A PE will also be deemed to exist ‘where a person other than an agent of an
independent status is acting on behalf of the enterprise and has, and habitually
exercises an authority to conclude contracts in the name of the enterprise .
Most treaties list a number of business activities which are not considered as
PE. The common feature of these activities is that they are, in general,
preparatory or auxiliary in nature.
What constitutes PE for the purposes of electronic commerce?
EC may pose problems for the definition of permanent establishments that
existing tax treaties do not address. While as yet unforeseen questions are
bound to arise, the current debate over what constitutes PE can be broadly
summarized in the following questions:
* Whether a mere accessibility of a website from within a particular
jurisdiction subjects the site-owners to income tax in that jurisdiction?
* Whether the presence of a server would constitute a PE?
* Whether a consumer’s computer constitutes a PE?
* Whether the provision of services by an Internet Service Provider (ISP) would
constitute a PE?
Treaty negotiators will have to examine these questions to see how treaty
concepts can be applied to new ways of doing business.
A web - Site
The most obvious question concusses the ability to access a website from within
a particular taxing jurisdiction. In OECD countries, a mere existence of
technical equipment is insufficient for creating a PE. Article 7 of the OECD
Model Treaty provides that an enterprise of a contracting state is generally
exempt from tax on its profits derived from business carried on in the other
contracting state unless these profits are attributable to a PE located in that
other contracting State. Article 5 defines a PE. The Model Treaty also lists
business premises which constitute PE and if we were to characterize these
examples, it is likely that we would conclude that a physical presence of some
permanence is common to all. Does a website or home page have a physical
presence of some permanence?
A website has no actual physical presence, but rather is highly mobile,
borrowing only the presence of the server where it happens to reside at the
moment. No employees need be present in the country to maintain the site. To the
extent that advertising and ordering functions are perforated, the website is
analogous to mail order catalogue or a television advertisement,
or home shopping channel. Mere solicitation, without more, does not create a PE
under existing principles, and it should not, when effectuated through EC. To
the extent that a customer can view stack or data, the website is analogous to a
location being maintained solely for the purposes of storage, display or
Moreover under existing principles, electronic content that resides on a server
only temporarily should not be a PE. For example, the construction rules reflect
this concept of duration and require the presence of project activities,
including he presence of a workforce, in-country for twelve consecutive months .
So does the fact that consumers can place orders through a foreign firm’s
website subject that firm to income taxes in the country where the customer
lives? The answer to that question, in my opinion, is certainly “no”. To say
that the ability to access a website, without some other more substantial
contact, is sufficient to constitute a PE is to say that online businesses are
liable for income taxes in every country where their customers happen to reside.
A website cannot be considered as a PE and such a principle is also virtually
It would be more useful to tie the presence of a homepage to some physical
equipment, namely its host computer. And that takes us to the second debate,
namely whether a serer constitutes a PE.
A second, more complex, question arises regarding the location of computer file
servers: should the mere presence of a server in a particular taxing
jurisdiction be considered sufficient contact to constitute a PE? In most cases,
the existence of a foreign owned server does not require employees to be present
in the host country – traditionally a prerequisite for PE. This issue can be
analyzed under four sets of circumstances:
* Where a server is used merely for advertising.
* Where the server is used for advertising and taking orders.
* Where the server is used for advertising taking orders and accepting payment;
* Where the server is used for advertising, taking orders and accepting payments
and for digitized delivery of goods.
In the first case, a server will not be held to be a PE. Exception 5(4)(a) of
the OECD MC will be attracted in this case where the use of a facility solely
for the purpose of storage, display or delivery of goods or merchandise
belonging to the enterprise will not amount t the existence of a PE. It could
also be exempt under Article 5(4)(c) of the OECD MC, which exempts the
maintenance of a fixed place of business solely for the purpose of carrying on,
for the enterprise, any activity of a preparatory or auxiliary character from
the ambit of PE. In the second and third case, it may possibly be held that the
server is a PE. In the last case, there is an even stronger cause to hold the
server to be a PE. However, an attempt to tax the server as PE will not serve
any purpose as it is very easy to shift the server to a tax haven or to a low
tax country. Further, difficulty will arise where a number of mirror websites on
different servers located in different countries are used so that a customer can
be directed to any one of these sites. Yahoo, for example, uses a number of
mirror sites so that the users can have better access to its very heavily
The User’s Computer As Pe
A view could be taken that the location of a computer who initiates the contract
from his computer would constitute a PE for the non-resident. However, that
place is only a location from which one logs on and is unlikely to be fixed. For
example, a customer may access a web site through a mobile computer. This may
even be outside the country.
Thus, the question of whether by simply accessing a website, a computer
transforms itself into a PE of the owner of the website, is unlikely to be
answered in the affirmative. It would lead to a situation where everyone with a
web page would have a PE in every country. Further, the question of enforcement
would remain unanswered.
Can The Services Of An Isp Constitute A Pe?
Agency issues may also be clarified as they relate to the conduct of e-commerce.
For example, some national governments will likely argue that a domestic ISP, by
connecting consumers to a foreign business’s website, acts as an agent for the
purposes of determining the existence of PE.
The ISP merely acts an intermediary between a non-resident seller and the
customers in the source country. Therefore, the ISP will not qualify as the
agent of the non-resident seller. Since the ISP acts on behalf of several
website owners, even if it is treated as an agent, it would be an independent
agent. Therefore, it will not constitute a PE. Even if it acts for only one
website owner, it does not have the authority to conclude contracts on behalf of
the website owner, which is an essential pre-requisite before it can be
considered to be the owner’s PE.
The phenomenal rate of the Internet will force us redefine our concepts of the
world and recreate the rules and regulations that apply it. Because conducting
business through EC is fast becoming the norm of the day, the rate of knots at
which the international institutions and families of nations are evolving
strategies to catch up with the challenges posed by EC is too slow.
The existing canons of income tax based on
source rules seem to be getting outdated. There is an immediate need for
international institutions, such as OECD and International Fiscal Association,
to evolve more equitable tenets for cross-border EC transactions so that there
can be more equitable distribution of tax revenues among nations. Countries that
are feeling an erosion of the taxes shouldn’t be forced to adopt desperate
measures that may be short term and hence, likely to adversely affect the growth
EC has rendered geological precincts
redundant and converted the world into a global community. Procedural and
administrative hurdles must not interrupt the development of EC. Of particular
importance is the avoidance of dissonance among nations on sharing the proceeds
of taxation of EC transactions. Nations must make a coordinated effort to evolve
principles of taxation of these activities through a body comprising of
representatives of all nations.
This is the challenge for the future.