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TaxationWeb by Namita Chandra BA, LLB (Hons)

Namita Chandra BA, LLB (Hons), Lawyer, of Paras Kuhad And Associates, Advocates, Mumbai, India, considers taxation issues affecting e-commerce on a global basis.

I. Introduction

The nations of the world are entering a promising yet volatile E-Commerce realm. Traditional concepts and principles of taxation are proving to be inadequate. Principles of residence and source for taxation cannot be applied with certainty in the seamless, borderless and timeless market place of E-Commerce. For taxation purpose, the character of income is also important, but E-Commerce has the potential of blurring the character of income. Whether the income in these cases, be characterized as business income or royalty or service income is not very clear. In the absence of geographical nexus of a transaction, determination of a tax jurisdiction becomes difficult. Then there are enforcement- related problems revolving around identity and location of taxpayers, exchange of record -related information, recovery of tax, transfer-pricing issues etc.

II. Working of e-commerce through internet

Electronic commerce is conducted mainly through global computer networks. Generally, electronic commerce conducted through the Internet consists of three parties, namely the ISP, the trader and the customer. E-Commerce activities are classified in various categories, which become major sources of online revenues. However the issue still remains whether such revenue generated through E- commerce be taxed.

III. Should e-commerce be taxed?

The Information Technology (IT) sector has the distinctive characteristics of growth without state support. So, there is often a view that E-Commerce should in some sense be allowed to take place in a tax-free environment either by specific legislation or by continued government inaction. However in view of the author, profit arising out of E-Commerce should be taxed. The arguments as advanced below, would attempt to build a case for taxation of this new and potential area of revenue generation.

1. Benefit Theory Justification for Taxation of E-Commerce:

An important theory regarding a country’s right of taxation is the Benefit Theory. According to it, a state’s right to tax rests on the totality of benefits and state services provided to taxpayers that interact with a country. While in traditional commerce, services provided by the state like infrastructure, police and defense protection etc. are more visible, but benefits arising from conducive legal infrastructure, consumer base, stable exchange rates and economic stability are equally applicable to E-Commerce. So, the state needs to be compensated for the cost of providing public services, by income generating E-Commerce activities, too.

2. Principle of Neutrality:

Neutrality is a fundamental tax policy principle. Essentially, it requires that economic processes should not be affected by external influences such as taxation. In fact, whether a business is carried out through electronic medium or otherwise should not affect the tax liability. It cannot be a case that traditional bookshop owner pays tax on its profits while the e-tailer of books is exempted from paying tax on its profits.

3. Vertical inequity in exempting E-Commerce from tax

There is also vertical inequity in exempting E-Commerce from tax. It cuts cost of procurement, cost of processing transactions as also delivery costs for products and services delivered electronically, e.g., software financial services and music. Tax exemption for E-Commerce would, therefore, result in those conducting business in traditional manner and earning less profit being taxed whereas those switching over to E-Commerce and earning higher profit being exempt from tax.

4. Taxation of E-Commerce not a constraint:

Tax exemption could perhaps have been justified if taxation of E-Commerce would have proved a constraint in its healthy growth. But E-Commerce has achieved un-paralleled growth not only in the developed countries but also in a large number of developing countries including India. Taxation of E- Commerce transactions by no means act as a hurdle to its development and Growth.

5. Tax exemption for E-Commerce: Against the spirit of Current Reform process

Also ‘infant industries’ granted preferential tax treatment typically never grows up. Besides, tax exemption for E-Commerce would be totally against the spirit of current reform process, as also the recommendations of Raja Chelliah Committee on Tax Reforms in India during 1991, of reducing tax shelters and tax-rates. Business will modify themselves on the patterns of E-Commerce and thus will avoid tax, which will ultimately erode the revenue base.

On the basis of above discussion, it can be concluded that there is no case for exempting E-Commerce from direct taxation. Once it is established that transactions on the electronic medium are as much taxable as those in the physical medium, the focus should thus be to analyze the methods of taxation of Income arising from E-Commerce and the problems arising with the application of traditional principles of Taxation in this regard.

IV. Taxation problems posed by electronic transactions:

Taxation of income is the conclusive part of the tax-procedure. Initial steps include identification of taxpayer to whom the income belongs, determination of tax-jurisdiction (residence vs. source), characterization of income etc. After all these requirements are fulfilled comes the question of assessment of income and collection of tax.

1. Identification of taxpayer:

Income tax, to put it simply, is a tax on income. However, for income to be taxed it should belong to an identifiable person. Its ‘Domain Name’ generally identifies a business engaged in E-Commerce on the Internet. After identification of the taxpayer, we proceed to determination of jurisdiction of taxation, which is based on source or residence.

2. Determination of jurisdiction:

A country may tax an income on the ground that the person has been given protection of life and liberty and also that he is intimately connected to its social and economic life, that is, residence basis of taxation. It may also tax an income on the ground that the economic activity giving rise to the income was performed therein – the source basis of taxation. Thus, taxation depends upon the determination with some certainty, of the residence of a person or the place of a source of income.

Most of the countries tax income on both the bases. Broadly, a resident is taxed on his global income with credit for taxes paid in source countries and the non-resident is taxed on the income arising in the country. Double taxation of same income may arise due to residence and source conflict and sometimes even due to conflict about the country of residence. Double Tax Avoidance Agreements between countries are aimed at avoiding such double taxation. OECD Model Tax Convention (hereinafter Model Convention) lays down the principles involved in taxation of cross-border commerce. Most of the countries follow this Model Convention.

3. Determination of residence in the context of the Internet:

Most of the countries including India determine residence of individuals on the basis of period of stay in the country. Section 6 of the Indian Income Tax Act 1961(hereinafter IT Act) provides 182-day test for determination of residence for individuals and Hindu Undivided Family.

4. Determination of the Place of Effective Management:

The problem gets all the more complicated in case of non-individual assessees. Both IT Act (sec 6) and the Model Convention (Art 4) rely on place of control and management to determine the residence of such assessee. However, this concept of effective management is not specifically defined in the Model Convention or the IT Act. So it is to be determined on the basis of fact and circumstances of the case. The only classification is that the effective place of management would be where key management and commercial decisions for conduct of the business of the enterprise are taken.

But in case of electronic space, it is almost impossible to determine the exact geographical location where the decision was taken. This makes the determination of the ‘place of effective management’ extremely complicated.

V. Digitization and Problem Of Characterization Of Income

Digitization is significant in terms of the way in which source is defined because the intangible nature of goods and services that may be bought and sold in electronic commerce will arguably exacerbate existing difficulties in characterizing income. As electronic commerce allows for an increasing number of goods and services to be delivered in an intangible way due to digitization it is likely to make it more difficult to determine, whether income represents sales income, or services income, or whether an intangible product has been licensed, there by giving rise to royalty income. Apart from taxing rights, it is also important to note that double taxation (or unintentional non-taxation) could result if classifications are not consistent between countries. Given that tax laws of different countries have developed different rules for the determination of both the character and source of income, there are numerous mismatches in the laws, which can result in either avoidance of tax in any country on a particular item of income or multiple taxation of the same income. Indeed there may be inherent conflicts between source and residence countries where, for example, source countries may want to widen their domestic withholding tax regimes to preserve their tax base, while residence countries may wish to adopt a different classification of an item of income to preserve their taxing rights.

To resolve the above-discussed issues the Model Convention has suggested some relevant principles and classifications of income in E-Commerce environment. Also based on relevant considerations, the Model Convention has classified passive E-Commerce income in 28 categories.

The principles and classification articulated in the OECD commentary are however, not universally accepted. Some countries articulate a broad standard of what constitutes a royalty so that negotiated withholding taxes may be applied to payments received by a non-resident that would not otherwise be taxable in the source country under Article 7 or Article 14.

Thus, with the above detailed discussion, it is clear that E-Commerce environment, though it is still in embryonic stage, has posed significant challenges for the traditional bases of taxation. So, the next part of our report analyses some of the policy approaches, which will help us in meeting the needs of E-Commerce taxation.

VI. Alternative approaches for taxation of e-commerce

1. Base–Erosion Approach

This approach advocated by professor Richard Doernberg seeks to redress some concerns created by E-Commerce. It seeks to maintain the PE principle, which modifying its application to allow for a sharing of the tax base generated by electronic commerce transactions between source and residence countries.

It suggests that withholding at a single rate would be permitted in a source country on any payment that has the effect of “eroding” the tax base of that country. A payment would be considered as eroding the tax base of a source country if it was either deductible by a source country purchaser, or alternatively, if it formed part of its cost of goods sold (as this would decrease the gain on the sale of goods). If either of these conditions applies, then withholding would occur under the base erosion approach irrespective of the category of income.

It represents a compromise approach and there are corresponding advantages for source and residence countries. For residence countries, full tax will be collected on dividends, as these are not subject to withholding due to their non-deductibility. Also, residence countries will be able to tax income arising from transactions with consumers in source countries, if no PE is maintained in those countries. Source countries also benefit as they can withhold tax on any base-eroding payment made by businesses to residence countries. Allowing a credit could accommodate relief from double taxation, and distortions and excessive tax burdens maybe accommodated through allowing for net basis return filing choice in source countries. Also, the system is administratively simple, as it operates within the existing international tax regime. It is based on an objective standard to determine the right to withhold tax.

The main difficulty is that it does not redefine the concepts of PE, and with existing principles of PE, allocation of profits to PE in active business income cases will be negligible. Also, the simultaneous existence of PE concept implies that the traditional commerce will get taxed differently as compared to E-Commerce.

2. Virtual Permanent Establishment Approach

The approach advocated by Professor Luc Heinekens has two main elements of this approach are: A lower withhold for a PE is intended to apply in the case of E-Commerce transaction and this will be achieved by deleting the requirement for a “fixed place of business’ to exist in the country of source from the existing principles for defining PE. Core or mainstream business activities will be subject to source country taxation under the approach, while ancillary activities will not be subject to source country taxation.

This approach helps in achieving a neutral international tax system, where by the competitors within the same market face the same tax burden and thus derive the same relative net advantage from the infrastructure of the country. This approach helps in preservation of fiscal sovereignty and sharing of the tax-base in the source country. Also, this basis of tax- nexus provides a more reliable jurisdictional criterion than the place of incorporation or establishment of an E-Commerce business as it seeks to apply taxing nexus based on economic activity. Thus, it provides a more stable and less manipulability basis for establishing taxing authority in source countries.

However, the biggest disadvantage of this approach is the problems associated with establishing an internationally acceptable standard for determining nexus under this approach, which detracts it from successful implementation. Also, there are difficulties in attributing profits to a virtual PE.

3. Refundable Withholding Approach:

It is a hybrid approach, which draws upon elements of other two approaches, to reconceptualize the way source are currently defined for both active and passive income.

Under this approach all income from international transactions involving goods or services that are either provided electronically (e.g. Computer software) or purchased via electronic means (e.g. flowers purchased over the Internet) would be treated as “withholding income”, which would then be subject to a uniform rate of withholding by source countries irrespective of the category of income involved. In most of the cases, they are taxed in residence countries, though consistent with current practices, they may continued to be taxed on a withholding basis by source countries that withhold tax on such income.

Conversely, if a seller’s total gross sales into a jurisdiction for the period exceeded the threshold, then the vendor would be subject to source country taxation and amounts withheld would not be refunded. At the same time, the later ones will have a choice to file a return in the source country and be taxed on net basis.

This approach redefines the source for active business income by putting forward an alternative to the PE threshold for determining source country tax nexus. Also, it simplifies the way source is defined for passive income by seeking to apply withholding at a standard rate to all income covered by the proposal irrespective of the character of income.

In sum, it is submitted that the proposed refundable withholding approach could provide a more stable and appropriate basis for source-based taxation of international E-Commerce transaction than the current international tax system. Indian E-Commerce committee report also, favors the adoption of this approach.

Now after defining the jurisdiction and characterizing the income, the next step in tax procedure is ‘enforcement’ i.e. fixing tax-liability and its collection and recovery.

Vii. Enforcement issues

The effect of Internet on enforcement of tax laws has raised fears of governments being unable to meet legitimate demands of their citizens for public service. Some of those challenges along with possible solutions have been discussed below:

1. Identity and location of parties:

One of the significant perceived threats associated with the advent of Internet is anonymity offered by it to the customer does not know where the server is located and the server cannot identify where the customer is stationed. In fact, with E-Commerce and use of private intranets, it may be difficult to know who is doing what. However, the experience in Australia, as presented in IFA Asia Regional Conference on E-Commerce and International Taxation, reflected the possibility of tracing the correct identity and location.

2. Anonymity of transactions and accounts:

In the conventional commercial environment, the tax authorities were able to collect information by means of books and records in order to support the assessment of tax. However, in the electronic environment, electronic books and records could easily be concealed, or stored in foreign jurisdiction, thus denying the tax authorities access to records. Even the traditional third party information may be curtailed as the Internet encourages the process of disinter mediation.

3. Transfer pricing:

Transfer pricing issues though not created by E-Commerce will become more complex with Internet. The use of the new information and communication technologies in business increases the speed and borderless mobility of the transactions making it difficult for tax-administrators to identify and measure contributions and functions of the single participating undertakings to the unitary business or contract performance. In such situations how one state would determine the arm’s length price is not very clear. In this regard, discussions need to be initiated at international /forum/ through OECD etc. to formulate specific guidelines in this direction.

4. On-Line Delivery and e-cash:

The real problem for enforcement in an E-Commerce situation arises in transactions involving online delivery and payment, which is growing at a fast pace. In these transactions where the supplier is from a foreign tax jurisdiction it becomes difficult to charge or collect direct as well as indirect taxes. Withholding of tax through a large number of small consumers for direct tax purposes or realizing indirect taxes from them is administratively impossible. The development of e-cash is an even more serious challenge for tax administrators.

5. Identification of taxing jurisdiction:

The place of execution of contract and the place where title to the goods or services passes are important in determining where the income accrue or can be deemed to accrue and, therefore taxed. In E-Commerce, with offer and acceptance on the networks, the place where the contract is executed will not be known under laws and rules applicable to traditional commerce.

Viii. Conclusion:

E-Commerce, still in its infancy, is not currently a major economic force but in all likelihood, will become the future of international commerce. The concrete tax rules applying specifically to the direct taxation of E-Commerce is few. There is little in the way of new rules or new laws to address the proper taxation of E-Commerce. At the institutional level, OECD is working in this direction. But there is a need for a more comprehensive, multilateral /forum/ that is similar to the World Trade Organization

June 2005

Namita Chandra BA, LLB (Hons)
Paras Kuhad And Associates, Advocates
903 Peninsula Towers
Peninsula Corporate Park
Ganapatrao Kadam Marg
Lower Parel
Mumbai -400 013
India