E-Commerce and Tax TreatiesElectronic Commerce and OECD Reports

Michael J. McIntyreProfessor of Law

Wayne State University

(C) 2001 Slide 1 of 37

Definition of E-CommerceGeneral Description of Electronic Commerce

PTransactions over network of computers calledInternet, one part of which is World Wide Web.

PCommercial activities carried out over Internetincluding:< Sales of goods, services, and electronic products;< Electronic funds transfers;< On-line trading of stocks and other financial

instruments;< Electronic data sales, exchanges, research, etc.

(C) 2001 Slide 2 of 37

Examples of E-Commerce?Examples of E-Commerce Relevant to Tax Treaties

PSales of tangible goods ordered over theInternet. Buyer goes to web site and orders on-line, or orders by telephone after viewing on-linecatalogue. Buyer may be consumer (B2C) orbusiness (B2B).

POrder software, music, game, on-line anddelivery taken on line.

PAccess data on-line – general information database, proprietary information, technicalassistance.

(C) 2001 Slide 3 of 37

Tax Issues of E-CommerceImplications for Taxation

PSales tax (VAT).< Where is sale made for tax purposes?< Is there sufficient nexus in purchase country to tax?< How does the tax department find out about the sale,

especially in EU with no customs borders in mostcases?

P Income Tax.< Is income taxable under domestic law?< Is taxation prevented by tax treaty?< Can tax be enforced?

(C) 2001 Slide 4 of 37

Consumption TaxesGeneral Direction of OECD

PB2B (Business Inputs): Intangible servicesconsumed where recipient’s business is locatedand services provided.

PSelf-assessment for B2B

PB2C (Final Consumption): Place of consumptiondepends on information available. May be:< Place of consumer’s permanent address or residence< Consumer’s center of vital interests (how to know?)< Consumer’s country of nationality (how to know?)

PWithholding and clearing house for B2C(C) 2001 Slide 5 of 37

Major Tax Treaty IssuesIncome Tax Issues as Frame by OECD

PExistence of PE. Does the seller or provider havea PE in the source country?

PCharacter of Income. Is the income businessprofits or royalties or technical assistance fee?< Business income might be rental income for use of

intangible property.< Business income might be sales income.

PAttribution of Income. If a PE, how much incomeis attributed to the PE?

(C) 2001 Slide 6 of 37

OECD InitiativesRecent Actions By OECD

PFramework Agreement, Ottawa, 8 Oct. 1998

PModification of PE Commentary, 22 Dec. 2000

PReport of Business Profits TAG

PReport of Technology TAG

PReport of Consumption TAG

PReport of Working Party 9 on Consumption Taxes

PReport of Treaty Characterization TAG(C) 2001 Slide 7 of 37

Ottawa Framework PrinciplesOECD Framework Agreed on 8 Oct. 1998

PNeutrality – Various forms of e-commerce andother commerce treated same.

PEfficiency – Reasonable costs to business andconsumers for compliance.

PCertainty and simplicity – Rules clear andunderstandable.

PEffectiveness and fairness – properly payablewithout avoidance or evasion.

PFlexibility – Tax must keep up with changes.(C) 2001 Slide 8 of 37

Additional PrinciplesOperating Principles for TAGs

POld rules should be adapted – no need for newprinciples (e.g. the old PE concept should bepreserved).

PCharacterization of payments made by referenceto their purpose (e.g., payment is royalty only ifthe purpose as to obtain copyright interest).

PNo effort should be made to interpret languageof Model creatively to get a sensible result – ifresults are unacceptable, modify Model.

(C) 2001 Slide 9 of 37

PE IssuesPresence for E-Commerce as PE

PCan computer hardware, such as a server,constitute a PE?

PCan a Web site constitute a PE?

PCan an Internet Service Provider (ISP) constitutea PE?

(C) 2001 Slide 10 of 37

OECD’s Analytical FrameworkHow to Determine of E-Commerce Assets are PE

PPE definition, Article 5(1): “. . . a fixed place ofbusiness through which the business of anenterprise is wholly or partly carried on.”

PTo constitute a PE, the electronic assets must:< Constitute a “place of business”.< This place of business must be “fixed”< Business of the enterprise must be “carried on”

through this fixed place of business

(C) 2001 Slide 11 of 37

Server as PEWhen Can Computer Hardware Be a PE?

PComputer hardware has a “physical location” andthat “location” may constitute a fixed place ofbusiness (PE). UK think server is never a PE.

PServer must be “fixed” – “ server will need to belocated at a certain place for a sufficient periodof time so as to become fixed. . . .”

PWhether business is “carried on” through serverdepends of facts and circumstances – the issueis whether it has facilities at its disposal wherebusiness functions are performed.

(C) 2001 Slide 12 of 37

Quotation: Server Possibly a PEOECD Commentary to Article 5

Para. 42.3. . . . the server on which the web site isstored and through which it is accessible is a piece ofequipment having a physical location and such locationmay thus constitute a “fixed place of business” of theenterprise that operates that server.

Para. 42.4. In order to constitute a fixed place ofbusiness, a server will need to be located at a certainplace for a sufficient period of time so as to become fixedwithin the meaning of paragraph 1.

(C) 2001 Slide 13 of 37

Web Site as PEIs a Web site in a Country a Fixed Place of Business?

PKey is whether the Web site that appears on theuser's computer is the provider’s “place ofbusiness”.

POECD Commentary long stated that “the term‘place of business’ covers any premises, facilitiesor instillations used for carrying on the businessof the enterprise....”

(C) 2001 Slide 14 of 37

OECD Defines Premises NarrowlyHardware Can be PE but Software Cannot

PNew OECD Commentary says that Web site cannotconstitute a “facility”.

P “. . . an Internet web site, which is acombination of software and electronic data,does not in itself constitute tangible property. Ittherefore does not have a location that canconstitute a ‘place of business’.

PSpain and Portugal do not consider that physicalpresence is needed in context of e-commerce.

(C) 2001 Slide 15 of 37

New Business Facility RulesOECD Introduces Two New Obstacles to Taxation

PClaims, without support in language of Model,that business enterprise must have a “physicalpresence” to have a PE.

PClaims that Web site is not “physical” because itis a combination of software and electronic data.< In fact, a Web site requires a physical presence to

exist – it is not “intangible” like stock or copyright.

PTo diffuse opposition, OECD promises toreconsider Model’s definition of PE.

(C) 2001 Slide 16 of 37

Quotation: Web Site Not a PEOECD Commentary to Art. 5 para 42.2

For instance, an Internet web site, which is acombination of software and electronic data, doesnot in itself constitute tangible property. Ittherefore does not have a location that canconstitute a “place of business” as there is no“facility such as premises or, in certain instances,machinery or equipment” (see paragraph 2 above)as far as the software and data constituting thatweb site is concerned.

(C) 2001 Slide 17 of 37

ISP as PEIs an Independent Service Provider a PE?

P ISP acts as agent for enterprise in providingInternet access and hosting a Web site.

P Issue is whether ISP is agent for enterprise thatconstitutes a PE under Art. 5(5).

POECD Says “Almost Always No”:< ISP usually is independent agent acting in the

ordinary course of its business.< ISP does not have and habitually exercise right to

conclude contracts for enterprise.< Web site itself is not agent because not a person.

(C) 2001 Slide 18 of 37

Quotation: ISP Not a PE of EnterpriseArt. 5 Commentary: Independent Service Provider is not a PE

Para. 42.10. The issue may then arise as to whether paragraph 5may apply to deem such ISPs to constitute permanent establish-ments of the enterprises that carry on electronic commerce throughweb sites operated through the servers owned and operated bythese ISP. While this could be the case in very unusual circum-stances, paragraph 5 will generally not be applicable because theISPs will not constitute an agent of the enterprise to which theweb sites belong, because they will not have authority to concludecontracts in the name of these enterprises and will not regularlyconclude such contracts or because they will constituteindependent agents acting in the ordinary course of their business,as evidenced by the fact that they host the web sites of manydifferent enterprises.

(C) 2001 Slide 19 of 37

Are E-Commerce Activities Auxiliary?Application of Article 5(4) to ISPs, Web Sites, Hardware

P In general, new OECD Commentary takes positionthat E-Commerce activities are often exemptunder Art. 5(4) as preparatory or auxiliary.< Use of server to advertise, display a catalogue of

products, provide information to potential customersall auxiliary.

< If equipment used to conclude sale, process payment,or deliver product, then exception for preparatory orauxiliary activities does not apply.

P ISP is a PE for itself because hosting Web site isa “core” function of its business.

(C) 2001 Slide 20 of 37

Quotation: Server not a PE if AuxiliaryException for Auxiliary Activities

Para. 42.7. Another issue relates to the fact thatno permanent establishment may be considered toexist where the electronic commerce operationscarried on through computer equipment at a givenlocation in a country are restricted to thepreparatory or auxiliary activities covered byparagraph 4.

(C) 2001 Slide 21 of 37

Characterizing E-Commerce IncomeIs Income Business Profits, Royalty, or /Technical Fee?

P If income is business income, it is only taxable ifthere is a PE (and PE hard to get under new OECDCommentary).

P If income is royalty (payment with respect tocopyright), then taxable under Article 12.< Under OECD Model, royalty rate is zero.< Under UN Model, rate subject to negotiations —

usually a substantial rate (10% to 30%)

PSome treaties allow for source taxation oftechnical fees whether or not a royalty.(C) 2001 Slide 22 of 37

Categories of E-CommerceFrom OECD TAG Report 1 Feb. 2001

POECD Established 28 Categories of Transactionsinvolving e-commerce.

PFor each category, it suggested whether incomegenerated by it would be business profits,royalty, or “technical fees” taxable as royalty.

PMost income characterized as business income.

(C) 2001 Slide 23 of 37

Electronic Order of Tangible ProductsOrdering Goods over the Internet: TAG #1

PDefinition. “The customer selects an item from anonline catalogue of tangible goods and ordersthe item electronically directly from acommercial provider. . . . The product isphysically delivered to the customer by acommon carrier.”

POECD Analysis. Business income, taxable inSource Country only if PE.

(C) 2001 Slide 24 of 37

Downloading of Digital ProductsPurchase of Product and Delivery over Internet: TAG #2

PDefinition. “The customer selects an item from anonline catalogue of . . . digital products andorders the product electronically directly from acommercial provider. . . . The digital product isdownloaded onto the customer's hard disk. . . .”

POECD Analysis. [T]ransactions that permit thecustomer to electronically download digitisedproducts (such as software, images, sounds ortext) for the customer's own use or enjoyment . . . cannot be considered as royalties.

(C) 2001 Slide 25 of 37

Downloading for ExploitationAcquiring Copyright to Reproduce Image: TAG #3

PDefinition. “The customer orders the productelectronically directly from a commercialprovider . . . [and] acquires the right tocommercially exploit the copyright in the digitalproduct (e.g. a book publisher acquires acopyrighted picture to be included on the coverof a book that it is producing).”

POECD Analysis. [T]he payment qualifies as aroyalty. . . .

(C) 2001 Slide 26 of 37

Updates and Add-onsCustomer Pays for Right to Updates, Etc.: TAG #4

PDefinition. “The provider of software or otherdigital product agrees to provide the customerwith updates and add-ons to the digital product.There is no agreement to produce updates oradd-ons specifically for a given customer.”

POECD Analysis. Business profits. Like #1 ifdelivered on tangible medium; like #2 ifdownloaded.

(C) 2001 Slide 27 of 37

Limited Duration SoftwareRight of Consumer to Use for Limited Period: TAG #5

PDefinition. “The customer receives the right touse software or other digital products for aperiod of time that is less than the useful life ofthe product. The product is either downloadedelectronically or delivered on a tangible mediumsuch as a CD. All copies of the digital product aredeleted or become unusable upon termination ofthe license.”

POECD Analysis. Business profits, like TAG #1 or#2.

(C) 2001 Slide 28 of 37

Application HostingPerpetual License to Use Software: TAG #7

PDefinition. “The user enters into a contract . . .whereby the host entity loads the software copyon servers owned and operated by the host. Thehost provides technical support to protectagainst failures of the system. . . .” Example –“financial management, inventory control,human resource management or other enterpriseresource management software applications.”

POECD Analysis. Business Income. And NotTechnical Fee.

(C) 2001 Slide 29 of 37

Application Service Provider ("ASP")ASP Provides Use of Software and Support: TAG #9

PDefinition. The ASP makes a software applicationhosted on its computer servers available to itscustomers. The software automates a particularback-office business function for the customer– automate sourcing, ordering, payment, anddelivery of goods or services used in thecustomer's business, such as office supplies.

POECD Analysis. Part business income and parttechnical fee for support (if special treaty rulefor technical fees).

(C) 2001 Slide 30 of 37

Software maintenanceContract for Updates and Technical Support: TAG #12

PDefinition. “Software maintenance contractstypically bundle software updates together withtechnical support. A single annual fee is chargedfor both updates and technical support. In mostcases, the principal object of the contract is thesoftware updates.”

POECD Analysis. Mixed income. Business incomefor updates but perhaps technical fee forsupport.

(C) 2001 Slide 31 of 37

On-Line Customer SupportCustomer support over a computer network: TAG #14

PDefinition. The provider provides the customerwith online technical support, includinginstallation advice and trouble-shootinginformation. This support can take the form ofonline technical documentation, a trouble-shooting database, and communications (e.g. bye-mail) with human technicians.

POECD Analysis. Business income.

(C) 2001 Slide 32 of 37

Data RetrievalAccess to On-Line Data Base: TAG #15

PDefinition. “The provider makes a repository ofinformation available for customers to searchand retrieve. The principal value to customers isthe ability to search and extract a specific itemof data from amongst a vast collection of widelyavailable data.”

POECD Analysis. Business income, either serviceincome or “sales” of information.

(C) 2001 Slide 33 of 37

Technical InformationProvision of Proprietary Information: TAG #19

PDefinition. “The customer is provided withundivulged technical information concerning aproduct or process (e.g. narrative descriptionand diagrams of a secret manufacturing process).

POECD Analysis. “The Group agrees that paymentsarising from this category of transactionsconstitute royalties as they are made for thesupply of know-how, i.e. ‘for informationconcerning industrial, commercial or scientificexperience.’”

(C) 2001 Slide 34 of 37

Other TAG CategoriesAll Produce Business Income

P#20: Information delivery

P#21: Access of users to an interactive web site

P#22: Online shopping portals

P#23: Online auctions

P#24: Sales referral programs

P#26: Streamed (real time) web basedbroadcasting

P#27: Carriage fees – fee to have contentdisplayed(C) 2001 Slide 35 of 37

Revision of PE RuleOECD Study of PE Rule

The Committee wishes to stress that the changes includedin this document deal exclusively with the permanentestablishment definition as it currently appears in Article5 of the OECD Model Tax Convention. The TechnicalAdvisory Group (TAG) on Monitoring the Application ofExisting Treaty Norms for the Taxation of Business Profitsin the Context of Electronic Commerce has been given thegeneral mandate “to examine how the current treaty rulesfor the taxation of business profits apply in the contextof electronic commerce and examine proposals foralternative rules.”

(C) 2001 Slide 36 of 37

Possible PE RevisionsSuggestions for OECD or UN Model

P Article 5(5) may be amended by the removal of therequirement that the agent be a “person.” Enterprisesthat carry on a business in a country through a“thing,” whether tangible or not, that satisfy the otherrequirements of article 5(5) set out above will have aPE and be taxed on the profits attributable to that“thing.” See “Clicks vs. Bricks: the Interaction Betweenthe OECD PE Concept and Web Sites,” 22 Tax Notes Int'l1821 (Apr. 9, 2001) by Niv Tadmore

P Other Ideas?????

(C) 2001 Slide 37 of 37