Sinc e193 7

TAX In' taw-FOUN DATION

A Primer on theTaxation of

Electronic Commerce

BY CLAIRE M. HINTZSENIOR ECONOMIST

TAX FOUNDATION NOVEMBER 1998

BACKGROUND PAPER I N0.28

About the Tax FoundationIn 1937, civic-minded businessmen envisioned an independent group of researchers who, by

gathering data and publishing information on the public sector in an objective, unbiased fashion ,could counsel government, industry and the citizenry on public finance .

Six decades later, in a radically different public arena, the Tax Foundation continues to fulfil lthe mission set out by its founders . Through newspapers, radio, television, and mass distributio nof its own publications, the Foundation supplies objective fiscal information and analysis t opolicymakers, business leaders, and the general public .

The Tax Foundation's research record has made it an oft-quoted source in Washington an dstate capitals, not as the voice of left or right, not as the voice of an industry or even of busines sin general, but as an advocate of a principled approach to tax policy, based on years of profes-sional research .

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Since_u 1937

TAXFOUNDATION

A Primer on theTaxation of

Electronic Commerce

BY CLAIRE M. HINTZSENIOR ECONOMIST

TAX FOUNDATION NOVEMBER 199 8

BACKGROUND PAPER I NO .28

O 1998 Tax Foundation

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Table of Contents

Introduction 1

State and Local Tax Issues 3

Internet Access Fees 3

Sales and Use Taxes 3

Nexus for Sales Tax Purposes 4

Digital Goods 5

State Corporate Income Taxes 6

National Tax Issues 7

International Issues 8

The Jurisdiction to Tax and Sourcing of Income 8

Indirect Taxes: Value Added Taxes 8

Transfer Pricing Issues 9

Digital Products 9

Administration and Compliance Issues 9

Conclusion 10

Endnotes 11

IntroductionThe rapid growth in Internet access and

usage has opened up a 24-hour virtual glo -bal marketplace for goods and services tha tis creating a revolution in the way busi-nesses operate . This swiftly changing tech-nology has the potential to fundamentallyalter the nature of marketing, ordering, in -voicing, billing, and customer service . Be-cause the costs of entry into this new mar-ket are relatively low, it is accessible t ovirtually any business with the desire andcreativity to exploit it .

How big is electronic commerce? Elec-tronic commerce is in its infancy and harddata is difficult to come by. Industry esti-

mates vary widely. According to a survey b yNielson Media Research and CommerceNet ,almost seventy-nine million people over th eage of sixteen used the Internet in the firs tsix months of 1998, up 58 million from th e

previous nine months . Of those users, 2 0

million made online purchases—double thefigure from the previous nine months .' Glo-bally, there were more than four hundred

thousand active commercial websites at thebeginning of 1998, more than double theamount at the beginning of 1997 . 2

By far the largest component of elec-tronic commerce is business-to-busines strade. In the United States, business-to-busi-ness electronic commerce is expected t otop $17 billion in 1998, more than doublethe amount in 1997 . By 2002, U.S . business-to-business sales of goods using the Interne tare expected to exceed $300 billion . 3

U .S. online retail sales were about $ 2billion in 1997 . In 1998, they are expecte dto reach $4 .8 billion . The Commerce De-partment reports that a conservative esti-mate of the growth of retailing on th eInternet put revenue from online commerc eat $7 billion in the year 2000 while otherestimates have it reaching as high as $11 5billion in five to eight years.

Global projections for online commerc eand commerce generated by an online pres -ence range from about $1 trillion to more

than $3 trillion shortly after the turn of the

century.° This potential for growth in th euse of the Internet to advertise, sell, an ddeliver goods and services has caused ta xadministrators worldwide to consider th eramifications of these new business meth-ods on income and sales tax bases and o ncompliance and the administration of tax

law.Existing tax policy was written for a

world in which most commerce consisted

of the sale of tangible manufactured goods .

This raises a number of issues in its appli-cation to electronic commerce :

♦ The fundamental issue concernin g

electronic commerce is which jurisdiction

has the right to tax . The growth of mail or -

der has increased the fraction of commerc e

performed by remote merchants rather than

local vendors . Because states are legally

prohibited from compelling out-of-state ven -

dors without sufficient connection with

their states from collecting sales and usetaxes on products and services sold to theirresidents, local merchants are at a competi -tive disadvantage vis-a-vis remote vendorsof all kinds, including Internet merchants .

"The fundamental issueconcerning electroniccommerce is whichjurisdiction has the righ tto tax."

Should remote commerce be subject to sal e

and use tax collection requirements ?

♦ Current sales and use taxes at thestate and local level in the United State sapply primarily to tangible products . The yare selectively applied to services on a

widely varying basis . Services are a grow-

ing fraction of consumer expenditures . The

growth of electronic commerce will only

increase the fraction of commerce that es -

capes sales and use taxation as more con-sumers go online to purchase services and

intangible products . Should services andintangibles (digital goods) be included i nthe sales tax base? And if so, how ?

♦ In addition to blurring the distinc-tion between tangible and intangible com-modities, the hiternet blurs the links be-tween economic activity and location .When commerce is concluded or facilitatedby the Internet, it is often not clear wherethe income producing activity occurred . Inthe borderless world of the Internet, wher e

"There is widespreadagreement that taxpolicy as applied to elec-tronic commerce shouldsatisfy the fundamentalprinciples of taxation:neutrality, simplicity,and fairness. . . . Marketforces should determinewhat is produced, how itis produced, and whereis produced; tax policyshould not."

does a transaction take place? Is it at th ecustomer's computer? At the company' swebsite? The server that houses thewebsite? The seller's computer ?

♦ Since the source of income and th elocation of the sale are important to thedetermination of which jurisdiction has theauthority to tax a transaction or the incom eresulting from a transaction, it is crucial tha tthere is agreement among taxing authori-ties worldwide on how to source incom eand sales to prevent potentially stifling mul -tiple layers of taxation .

Tax administration and compliance ar emajor concerns to all levels of government .

If electronic commerce increases non-com-pliance, it will erode all manner of tax bases ,thereby depriving government of expectedrevenue and shifting the tax burden ontoactivities unrelated to electronic com-merce .

♦ Capital engaged in electronic com-merce is highly mobile and may respon dquite elastically to changes in tax policyamong jurisdictions .

♦ The name and location of a buye rmay not be known or knowable to the ven-dor, making the attribution of sales or in-come to a particular location practically im-possible . Rules for identifying the taxpayeror siting the sale would become necessary .

♦ Since businesses engaged in elec-tronic commerce may be known only bytheir domain names, their income and sale smay avoid taxation altogether.

♦ The growth of electronic cash an dencryption raises issues of compliance an dtax evasion for all levels of governments a sno records of transactions or income mayexist .

Efforts at addressing these and other is-sues regarding the taxation of electroniccommerce are underway globally at all lev-els of government. The OECD has recentlyconcluded a conference that addressed (i npart) the global tax issues connected withelectronic commerce . The United State sgovernment has issued a white paper con-taining its primary concerns regarding elec -tronic commerce . ? And a compromise ver-sion of the Internet Tax Freedom Act (ITFA)was signed into law on October 21, 199 8as part of the omnibus budget reconcilia-tion package .

This paper outlines the basic tax issue sthat have arisen with respect to the growt hof electronic commerce . In general, the is-sues are not new, but are extensions of ex-isting issues in tax policy—the erosion oftax bases due to changing methods of do-ing business and increasing globalization oftrade, and compliance and administratio nissues arising from these same sources .

There is widespread agreement that taxpolicy as applied to electronic commerce

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should satisfy the fundamental principles oftaxation: neutrality, simplicity, and fairness .Economically equivalent transactions and in-

come should be taxed equally. Marke tforces should determine what is produced ,how it is produced, and where is produced ;tax policy should not .

State and LocalTax Issues

Internet Access FeesEleven states and the District of Colum-

bia tax Internet access fees . The rational fortaxing Internet access varies from state tostate : in Texas Internet access is consideredan information service and in Wisconsin itis considered a telecommunication service .`The remainder of the states are prohibite dfrom levying taxes on Internet access for thenext three years by the recently enacte dInternet Tax Freedom Act . Under this legis-lation, only states that had imposed and en -forced such taxes prior to October 1, 199 8may collect them .

Sales and Use TaxesForty-five of the fifty states impose sale s

taxes on the purchase of tangible personalproperty. (Many states include some selec tservices in their sales tax bases as well) . Thetax base for each states sales tax is unique .What is taxable in one state may be untaxedin another. Aggregate state general sales anduse tax collections amounted to more tha n$147 billion and comprised one third of th etotal tax revenue raised by state govern-ments in 1997 . State sales tax revenue grewby 5.5 percent between 1996 and 1997 andover the last ten years has exhibited an av-erage annual growth rate of 6 .4 percent (i nnominal terms) .

In four states, the revenue raised by thesales tax accounts for more than fifty per-cent of tax revenue raised . In another six ,it accounts for more than forty percent ofthe taxes raised at the state level . In addi-tion thirty-one states authorize local govern-ments (cities and counties) to levy loca lsales taxes . In total, there are at least 7,00 0jurisdictions in the United States that cur-rently levy sales and use taxes .`' Local sale sand use taxes add another layer to the com-plexity of sales and use taxes . In additionstate and local sales taxes are in a constant

state of flux. According to Vertex Inc ., 634taxing jurisdictions changed their rates oradded new sales taxes in 1997 . Since 1990 ,the number of jurisdictions that change dtheir rates or added new sales taxes totals5,277 . 1 0

Sales taxes are generally collected byretailers on the gross price of a sale . In gen-eral, a retailer is not liable for collecting sale stax on an out-of-state sale unless the retaile ris determined to have "nexus" (defined be-low) with the taxing state . This prohibitiongives remote sellers an advantage over lo-cal retailers whether they use traditiona lmail order or the Internet to market thei rgoods .

`Applying nexus standards rooted inphysical presence to remote commerce,whether it is conducted by mail orde rwith catalogs or over the Internet, ex-empts most of these vendors from th eresponsibility to collect sales or us etaxes on behalf of the states . This givesremote vendors of all types, not jus tInternet merchants, an advantag erelative to local sellers."

To prevent sales to residents from out-of-state businesses from escaping taxation ,states that levy sales taxes also impose us etaxes on their residents . A use tax is im-posed on the value of tangible personalproperty (and sometimes services depend-ing on the jurisdiction) that is used or con-sumed in a state and that has not been taxedelsewhere . Most consumers do not knowthat they are liable for use taxes and, as aresult, most use taxes go uncollected .

Because the base of the sales tax varie sfrom state to state and rates can vary locally,multi-state corporations that are obligatedto collect sales taxes from their customers

over multiple jurisdictions face a complexweb of rates and bases that adds to theircosts of compliance . Even for large multi -state corporations with large legal and taxdepartments, the wide variance in state andlocal sales taxes impose high complianc ecosts. As small and medium-sized busi-nesses expand their reach into new state sand localities, they may face the burden ofcomplying with these myriad regulations .

Nexus for Sales Tax PurposesPrecisely because of the heavy burden

that would result from collecting sales taxe sfor so many different jurisdictions with dif-fering and continuously evolving statutes ,states have been prohibited by the SupremeCourt from compelling most businesses thatdo not have "nexus," that is, sufficient con-nection with the state, to collect sales taxeson sales of products in their states .

This constraint on the ability of statesto impose collection and remittance on out -of-state sellers of tangible goods is basedupon the Due Process and CommerceClauses in the Constitution .

To satisfy the Due Process Clause con-straint on a state's ability to tax a remoteseller, there need only be a minimum con-nection between that state and the person ,property or transaction that it seeks to tax .It does not require the physical presenceon the part of the taxpayer.

The Commerce Clause imposes a moreprohibitive standard on states that wish t otax out-of-state businesses . The seller mus thave "substantial nexus" with the taxingstate . The standard for substantial nexus wasmost recently established by the SupremeCourt in 1992 in the case of Quill v. NorthDakota . The Court ruled that the contac tthat the Quill Corporation had with NorthDakota—licensed software and common car -rier delivery of merchandise—were insuffi-cient to establish nexus . For the purpose ofplacing collection responsibility for sales anduse taxes on an out-of-state business unde rthe Commerce Clause, substantial nexus re -quires some physical presence on the par tof the seller in the taxing jurisdiction .

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This nexus standard was developed fo ran era of commerce in physical manufac-tured goods . But the fundamental featureof electronic commerce is that no physica lcontact of the seller with the taxing state isrequired. If the delivery of a physical goo dresults, the seller may ship the product viacommon carrier and remain outside th ebounds of nexus requirements .

If the product is intangible/digital i nnature—information services, music, books ,or downloaded computer software—nophysical contact with the taxing state oc-curs at all . Applying nexus standards tha tare rooted in physical presence to remot ecommerce, whether it is conducted by mai lorder with catalogs or over the Internet, ex-empts most of these vendors from the re-sponsibility to collect sales or use taxes o nbehalf of the states . This gives remote ven-dors of all types, not just Internet merchants ,

an advantage relative to local sellers .States and localities have been attempt-

ing to apply standards of contact that do no trely on physical presence, including notionsof attributional nexus (attributing the pres-ence or activity of another person or entityto a corporation or business) and transac-tional nexus (a business would have nexuswith a taxing jurisdiction if a transactionoccurred within that jurisdiction) . Underattributional nexus the location of a webserver in a state could generate nexus . At-tempts to extend nexus have been and con -tinue to be extensively litigated .

The recently passed Internet Tax Free-dom Act offers a forum for businesses en-gaged in electronic commerce to discusshow to resolve the nexus issue without pro-tracted litigation. If the goal is to maintainneutrality in the taxation of commerce, i thas been suggested that all sellers, remot eand local, be required to collect sales an duse taxes in the jurisdictions where they d obusiness . The trade-off on the part of thestates would be a simplification of the ex-isting plethora of rates and bases .

The issue of the sourcing of sales wil lalso need resolution. Because electroniccommerce is borderless both nationally and

globally, the precise location of a sale wil lhave to be determined . In the case of physi -cal goods, the tax can be determined by thelocation of the delivery. Intangibles—prod-ucts that are digital or are services—pose alarger problem. For such goods, the sellerneed not know the location of the buyerand the buyer may use the product any-where . If the point of contact for electronictransactions (i .e ., location of a website or

"Under attributionalnexus the location of aweb server in a statecould generate nexus.Attempts to extendnexus have been andcontinue to be exten-sively litigated."

server) were determined to be the site ofthe sale for tax purposes, businesses woul dsimply relocate their servers to more tax -friendly locations . Such sales may have t obe subject to throwback rules and source dat the location of the seller for tax pur-poses. Alternatively, as electronic com-merce develops, sellers may require someform of digital verification that locates thebuyer for the purpose of taxation .

Digital GoodsDigital goods are a problem for th e

sourcing of sales, but they also present an -other challenge . The sales and use tax basesof most states consist primarily of tangibl egoods . Most states include some service sbut this varies widely." There is no wide -spread agreement on how intangibles anddigital products should be classified for taxpurposes .

Some digital products that have physi-cal analogs, computer software for example ,can often either be purchased in boxed

5

form or, increasingly, they can be down -loaded from a manufacturer's website . Neu -trality would require that both are taxed orthat both are exempt . States vary in their

current treatment of downloadable informa -tion and software . Of the 45 states that havesales and use taxes, 27 tax software down -loaded from the Internet . 12 The growingnumber of products that will be availabl eto be downloaded from the Internet in digi-tal form will require some proper treatmen tto maintain neutrality among traditional andelectronic commerce .

State Corporate Income TaxesEach of the fifty states has a unique set

of corporate income tax rules . While notas large as the potential burden of the salestax, these rules involve high compliancecosts for both small and large businesses .When a company has sales in multiplestates, its income will be taxable in the state swhere it has nexus . The company's incomeis then divided among the states where ithas sufficient nexus and each state taxes it sshare .

Nexus rules for income taxation de -scribe the amount of business activity thatmust occur before a business must pay in-come tax in that state . In general, nexus i screated for income tax purposes in a stateif it earns income from sources within thestate, owns or leases property in the state ,has employees in the state that do morethan seek orders for the company, or hasphysical property in the state . This is quitea broad definition and in practice differentstates impose different thresholds of activ-ity before they require an out-of-state com-pany to pay income tax .

Under federal law there is a minimumthreshold for the degree of business activ -ity that is required before a business can besubject to a state's income tax . Under thislaw, states are prohibited from imposing atax on or measured by net income whenthe only connection that a business has withthe state is the solicitation of sales or order sfor tangible personal property. As the lawwas enacted in 1959, it does not protect the

solicitation of sales of intangible propertyor services .

A business's income is apportionedamong the states with which it has nexusby a formula . Many states follow or bas etheir rules of apportionment on the Uni-form Division of Income for Tax Purpose sAct . UDITPA uses a three-factor formula toapportion income : sales, payroll, and prop-erty are apportioned to the state in whic hthey are located for tax purposes . Incomefrom intangibles such as bonds is taxedwhere the company is headquartered . Moststates also have throwback rules that requir ethat sales to states where a company has no testablished nexus be apportioned to a busi -ness or corporation's home state .

The sales factor will be the most af-fected by a firm's engagement in electroni ccommerce . Sales of tangible personal prop-erty are sourced where the customer is lo-cated. If the business has no nexus in th ecustomer's state, sales of tangible goods ar cgenerally subject to throwback rules (the yare assigned to the business's home state) .Intangible products are even more difficultto source . The treatment of intangibles i snot uniform, and jurisdictions apply varyingsourcing rules to such sales. The majoritywill source them to the seller's state, bas-ing them where the income-producing ac-tivity occurs . The rest source them to theconsumer's location . Online businesses sell-ing digital products have no way of know-ing where their customers are located andthus, in most cases, will have to source thei ronline sales in their home state .

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National Tax Issues

There is currently no national excise taxon Internet access or usage and no such ta xis contemplated . And in the United States ,unlike many of its trading partners, there i sno national sales or consumption tax . At thenational level, government authorities areprimarily concerned with how to providea level and non-restricted playing field fo rthis new method of doing business at thestate and local and international levels .

The White House set out its position oneconomic issues concerning electroniccommerce in its white paper : "A Frame -work for Global Electronic Commerce ." 1 3The federal government has declared thatthe Internet should be a"tariff free environ-ment whenever it is used to deliver prod-ucts and services ." It has also asserted thatno new taxes should be levied on electroniccommerce but rather that existing taxpolicy should be applied neutrally and con-sistently at both the national and interna-tional levels . In addition, the Framework en -courages state and local governments todevelop a uniform and simple system to ta xelectronic commerce based on current ta xprinciples .

The Internet Tax Freedom Act (ITFA) ,recently enacted as part of the omnibu sbudget bill, is meant to address the inter -state issues regarding electronic commerce .The Act specifically provides for a three-yearmoratorium during which states or subdi-visions thereof are prohibited from levying :

♦ Taxes on Internet access, unless th etax was generally imposed and actually en -forced prior to October 1, 1998 ; and

♦ Multiple and discriminatory taxe son electronic commerce .

The ITFA does not prohibit any consti-tutional forms of taxation that can currentlybe imposed by the state . States and locali-ties may still require remote vendors (in-cluding those who use the Internet) to col-

lect sales and use taxes if they meet theestablished nexus requirements. States andlocal governments may also continue to

impose income and franchise taxes on busi -nesses over which they have jurisdiction .

More important than the moratorium i sthe creation of an Advisory Committee o nElectronic Commerce . The Committee wil lbe composed of nineteen members: theSecretaries of Commerce and Treasury an dthe United States Trade Representative (ortheir respective delegates), eight member sof state and local governments, and eightmembers of the electronic commerce busi-ness community.

The Committee has an eighteen-monthmandate to study federal, state and local, andinternational tax and tariff issues related t o

The Internet Tax Free-dom Act offers a foru mfor businesses engagedin electronic commerceto discuss how to resolvethe nexus issue withou tprotracted litigation.electronic commerce. Importantly, it is di-rected in particular to study the most con-tentious issue at the state and local level —the issue of sales and use taxes . Specifically,the Committee is to study model state leg-islation that would simplify the sales and us etaxes by providing for a uniform base forthese taxes and it is to review the efforts ofstate and local governments to compel re-mote sellers to collect sales and use taxe son sales made to their residents .

At the end of its eighteen-month tenure ,the Committee will pass its legislative recom -mendations, if any, to Congress . Hence, theITFA opens up the issue of nexus at the con-gressional level . Because only Congress hasthe authority to regulate interstate commerce ,the ITFA may prompt Congress to overrulethe traditional nexus requirements and re-quire all remote sellers—including Internet -based vendors—to collect sales and use taxe sin all jurisdictions where they do business .

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International Issues

There is general international agree-ment that existing international tax prin-ciples can be applied successfully to elec-tronic commerce in ways that satisfy th e

principles of neutrality, efficiency, and sim-

plicity. Issues that require international con-

sensus are: the sourcing of income andtransactions and the characterization of digi-tal products . International authorities ar e

"Electronic commerce allows both firmsand individuals to easily reach acrossborders to conduct transactions. Inlight of this, both the OECD and theUnited States government recognize th eneed to re-examine existing principlesgoverning the jurisdiction to tax."

also very concerned with issues of tax

avoidance and compliance . While many of

these issues will be familiar to large multi -

national corporations, they will be new t o

smaller business which, through the globa l

reach of the Internet, may be selling to th eworld for the first time .

The Jurisdiction to Tax an dSourcing of Income

The primary issue at the internationa l

level is the division of the jurisdiction to tax

income from electronic commerce . Like

nexus standards, international treaties andbilateral agreements were written for a

world where commerce consisted primarily

of tangible manufactured goods . Often the

determination of whether a governmen t

may tax an individual or business turns onnotions of physical presence within tha tcountry's borders. Electronic commerce al-lows both firms and individuals to easilyreach across borders to conduct transac -

tions . In light of this, both the OECD an d

the United States government recognize th e

need to re-examine existing principles gov -

erning the jurisdiction to tax .The apportionment of income for tax

purposes is complicated by the wedge thatelectronic commerce drives between thesource of income and its location . Withouta consensus among nations on how t osource income for tax purposes, there is ahigh probability that either income will betaxed in more than one jurisdiction or tha tit will escape taxation altogether. Thesource rules governing international taxagreements were also developed whe nmost global commerce consisted of themanufacture and export of physical goods .

Income is usually sourced where th eeconomic activity creating the income oc-

curred. Electronic commerce can obscureboth the source of income and the nature

of income . Businesses engaged in elec-tronic commerce can be located anywherein the world and their customers will be in-different and often unaware of the seller' sphysical location . Because of this weaken-ing of the links between a type of incomeand its physical location, the Treasury De-partment advocates moving toward resi-dence-based taxation (basing the jurisdic-tion to tax on the residence of the taxpaye r

rather than the source of the income) be-

cause "almost all taxpayers are residentsomewhere?'

Indirect Taxes: Value Added TaxesUnlike the United States, many other

nations impose Value Added Taxes (VAT) ora national sales tax . Similar issues arise be -tween the application of VATs to electroni c

commerce as arise with sales taxes at thestate and local level in the United States . I f

a transaction occurs on the Internet, wha tjurisdiction has the right to levy a sales taxor a VAT? Who is liable to pay—the pur-chaser or the seller? Where does the trans -action occur?

There is no general consensus o n

whether a digital product should be treated

for the sake of neutrality like its physica l

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analog, if one exists, or not . The seller of a

digital product will have to remit either VATor sales tax depending on the identity of th ecustomer, the seller's location, th ecustomer's location, and the nature of th eproduct .

The OECD has proposed that transac-tions should be taxed in the country wher econsumption takes place . This, as it notes ,

would require an international consensus

on the definition of the place of consump-tion. The OECD has also proposed that digi -tized products not be treated as goods fo rthe purposes of consumption taxes like th eVAT.

Digital ProductsAt the state and local level in the United

States, sales of digital products can escapetaxation as sales and use tax statutes werewritten for a world of tangible goods . Digi-tal products also pose challenges at the in -ternational level for much the same reason .

There is not yet a consensus on how to clas -

sify digital products for tax purposes . In-formation that can be transformed into adigital format is, in general, protected bycopyright law. Payments made for the us eof copyrights are royalties . Yet, many digi-tized products have physical analogs, i .e . ,

digital books v. tangible books, and neutral -

ity would have them taxed equally regard -less of their form . The OECD proposal to

treat digitized products differently fro m

their physical analogs would eliminate thisneutrality.

Administration and Complianc eIssues

Soon, electronic forms of money may b e

fairly common for conducting transactions

over the Internet . Electronic money maypose many of the same problems for ta xadministration and compliance as does cashcurrently. To the extent that non-traceable

"Electronic money may pose many of thesame problems for tax administratio nand compliance as does cash currently "

electronic cash is used for transactions ,there will be opportunities for tax evasionand avoidance through under-reporting or

non-reporting of income . As encryption

technology improves, it may be possible t otransfer large amounts of electronic moneywithout a trace throughout the world . How-ever, technological constraints may limit thegrowth of electronic cash for many consum-ers who may desire the consumer protec-tion and payment terms present in mor e

conventional payments .Tax administration and compliance de-

pends in large part on record keeping and

Transfer Pricing Issue sThe cross-border sale of goods and ser-

vices between related elements of a com-pany creates some of the most perplexin gproblems in international taxation . Assur-ing that prices for these internal sales areestablished according to arms-length prin-ciples is essential to the measurement o fincome and expense . Electronic commerceadds to this already complex process . Cur-rently, to apportion income and expense samong the constituent companies in a mul -tinational corporation, tax authorities apply arms-length-pricing rules . Prices for inter-company transactions are generally set a tthe price of a comparable transaction be-tween unrelated firms .

As most electronic commerce is cur-rently conducted between businesses usingboth the Internet and via private, company-run Intranets, it will become increasinglydifficult to apply standards like arms-lengt hpricing to transactions between divisions o fmultinational corporations . This is becauseit becomes more difficult for tax authoritie sto determine exactly what transactions oc-curred. Further, to the extent tax authori-ties are aware of the transaction and ca ncategorize it, it may not be possible to de-termine if there is a comparable transactio namong non-related enterprises .

9

the ability of tax authorities to verify trans -actions . Although records are currentlykept on computer files by most companies ,there is still often a corresponding alternat epaper record of transactions which ca nverify the authenticity of electronicallystored data . In transactions using theInternet, independent paper trails such a sinvoices and orders will not exist—agai ncreating the potential for tax evasion . Thedevelopment of encryption technology willadd greatly to the difficulty that tax authori-ties may face in obtaining this information .

And finally, companies engaged in elec-tronic commerce may only be known to taxauthorities by their domain names . If theirphysical location and income can not b eascertained they may be able to evade al ltaxation. With the ease and low cost of en -try for businesses conducting electroniccommerce, web-based enterprises may b eable to arise and disappear before comin gto the attention of tax authorities .

Conclusion

The potential of electronic commerc eto transform the ways in which busines stakes place is enormous . Its exponentialgrowth is evidence of its efficacy. The chal-lenges it poses for tax policy at all levels ofgovernment are not, for the most part newor unique . They largely stem from the needto apply tax policy rules that were devel-oped for a world where transactions wer elargely in physical goods to a world of glo-bal trade assisted by and sometimes con-ducted over the Internet . With care and na-tional and international consensus, existin gtax policy can be applied to global elec-tronic commerce in ways that avoid mul-tiple layers of taxation and yet preserve neu -trality between electronic and traditiona lforms of commerce .

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Endnotes

' Press Release, Nielson Media Researchand CommerceNet,August 24, 1998, http ://commerce .net/news/press/19980824 .html ,Internet usage is based on projections fromsurvey answers of individuals who wer eonline in the month before the survey andwho still had access to the Internet at th etime of the survey.

2 "Real Numbers Behind 'Net Profits 98,"ActivMedia, http ://www.activmedia .com/index.html .

5 Edwin Blaine et al ., "Sizing Intercom-pany Commerce," Forrester Research, July1997, http://www.forrester.com .

4 Kate Delhagen et al .,"Retail Revs Up,"Forrester Research, October 1997, http ://www.forrester.com .

5 Lyn Margherio et al ., "The EmergingDigital Economy," U .S . Department of Com-merce, 1996, p . 38 ., http://ecommerce .gov.

6 Press Release, "Forrester EstimatesWorldwide Internet Commerce Will Reachas High As $3 .2 Trillion in 2003," ForresterResearch, November 5, 1998, http ://www.forrester.com and "The Real NumbersBehind `Net Profits 98 .",ActivMedia, http ://www.activmedia .com/index.html .

7 "Selected Tax Policy Implications o fGlobal Electronic Commerce," Departmen tof the Treasury, Office ofTax Policy, Novem -ber 1996 .

8 For a detailed description of state taxpolicy with regard to Internet access see"Internet Taxation : State Summaries, "Vertex Inc ., http://www.vertexinc .com/taxcybrary20/Cybertax_Channel /taxtable72.html .

9 Vertex Inc . http://www.vertexinc .com/taxcybrary20/SalesTax_Chronicle /taxtrends_taxfacts .html .

1° Ibid .11 The Federation of Tax Administrator s

tracks the taxation of services . In its 1996study it reported that all but one state taxedsome of the 160 services it tracks, with hal ftaxing less than 50 of these . Tax Adminis-trators News, Federation of Tax Administra -

tors, December 1996 .12 For some states the software must be

identical to prepackaged software .For a detailed description of state taxpolicy with regard to downloaded softwareand information see "Internet Taxation :State Summaries," Vertex Inc ., http ://www .vertexinc .com/taxcybrary20 /Cybertax_Channel/taxtable_72 .html .

' 3 This information can be found athttp://www.ecommerce .gov/framewrk .html .

11

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