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TAXATION OF OFFSHORE E-COMMERCE

 

EXECUTIVE SUMMARY
This section is designed to present a basic outline of the taxation of e-commerce, and specifically offshore e-commerce, for those involved in it. The term 'e-commerce' is understood here to mean, commercial transactions taking place on the Internet.

E-commerce raises many new issues for governments, tax authorities, legislators and the courts, and of these by far the most challenging is the question of taxation. The growth of offshore e-commerce adds an extra layer of difficulty. So far, the volumes of taxable e-commerce transactions are relatively low, and taxpayers are only beginning to understand how they can be structured to avoid or reduce tax.

Despite low transaction volumes and bulging treasuries, rich-country (high-tax) Governments have begun to feel seriously threatened by tax leakage via e-commerce, especially the offshore variety. They tend to share a view that e-commerce undermines key concepts used in the existing structure of taxation, and they largely agree that any new initiatives are going to have to be taken in concert by all or most countries. There is no sign however that such a coherent approach is going to emerge any time soon.

The US has extended its moratorium on new e-commerce taxation for another 5 years, but individual states are seeking ways to impose existing taxes on electronic transactions. The EU however has unilaterally proposed to tax digital transactions, to the disapproval of the US. Both the EU and the US, along with other OECD countries, are attempting to limit the activities of offshore jurisdictions, partly in response to fears about the growth of offshore e-commerce.

Pending global legislation (and it may be a long wait) e-commerce is taking place under the law as it stands. Difficulties and ambiguities arise because many of the terms and concepts used in current tax law, such as 'source of supply' or 'permanent establishment', lose their clarity when applied to e-commerce. The two types of taxation that raise most issues for those doing business on the Internet are corporation tax, and VAT or sales tax.

Government attempts to limit the benefits to be gained from offshore e-commerce have so far been ineffective. As a general proposition, almost any business involved in e-commerce can gain from moving partly or wholly offshore, not just on a fiscal level but also through increased flexibility..

US SALES AND USE TAXES AND E-COMMERCE
The US and Canada are the main sales tax jurisdictions. The operation of such consumption taxes depends heavily on the ability of the taxing authority to find traces or records of transactions, thus motivating taxpayers to comply with the law because of the near-certainty that they will be found out if they don't. It is obvious that once an individual consumer can buy and receive digital but taxable goods or services through the Internet, then it is going to be hard to collect tax if the seller is outside the tax jurisdiction.

The taxing authority won't know and can't know about the transaction unless the consumer chooses to tell them, which history says is not likely! The supply of goods ordered and paid for from a distant seller and requiring physical delivery within the taxing jurisdiction is a simpler case, because a cross-border transit is necessary. Enforcement can be patchy, but Internet sales of this type are no different from existing mail-order catalogue sales. The case with businesses is more complex.

In sales tax jurisdictions, the key concept is 'nexus', meaning a sufficient presence in the taxing jurisdiction to justify collection of tax. In the US each State levies its own sales and use tax, so that an out-of-state supplier normally won't be caught by the tax unless they have physical presence (nexus), or habitual and substantial operational activity in the taxing State. In the latter case, the tax is very often collected from business purchasers in the taxing State through a 'reverse-charge' mechanism; but this doesn't work with individuals (although one or two states, notably Michigan, do require them to self-declare the tax) so that the taxing State must look to the out-of-state supplier for its tax, if it can.

A server probably does constitute nexus, but it is simple to put the server somewhere else, and then the taxing authority has the difficulty of finding transactions to evidence sales or use in the State. This difficulty can apply to businesses as well as to individuals; to a certain extent, and in certain business sectors, payment of use taxes, even perhaps sales taxes, would become optional for businesses with strongly Internet-centred activities.

The best place to put a server will often be offshore; an IOFC-based e-commerce company could probably do quite a substantial volume of business in a US State before being noticed by the taxing authority, which then has the difficulty of getting it to agree to pay tax; and how is the taxing authority to know where to find its taxable transactions if its counter parties don't keep their accounting records in the State?

The US Congress appointed the Advisory Commission on Electronic Commerce (ACEC) to study these and other issues connected with taxation of the Internet, and to report back with recommendations by April 2000. ACEC failed to reach the required two-thirds majority to make a binding recommendation, but it reported with some non-binding recommendations, and Congress has extended the current moratorium on Internet taxation until at least 2006.

The passage of the moratorium bill did not stop some states and some pro-tax organisations from continuing to fight for Internet taxation, simply by applying existing legislation to the Internet (the moratorium applies only to new taxes). One clear conclusion from the Internet tax debate has been that the current muddle of more than 7,000 different sales and use taxes in the US makes it well nigh impossible to construct a coherent Internet taxation regime, and many states are combining in an attempt to tidy the up the existing situation as a step on the way towards a harmonised Internet sales tax system.

For instance, more than thirty states are participating in the Streamlined Sales Tax Project (SSTP). The essence of the Project is simplification of state sales tax systems, and the use of technology to make it easier for online companies and other remote sellers to collect sales tax.

Among the problems faced by the pro-tax brigade are that Federal and most state budgets are awash with cash, and that no-one has any idea how much tax, if any, is being lost due to the Internet. In July the General Accounting Office answered a query from the Senate by guessing that the losses are between $300m and $3.8bn. But the GAO admitted it had no evidence, and had used mathematical formulae to construct a figure.

The SSTP focuses on the development of standardised practices, including uniform definitions, sourcing rules and forms, centralised registration of sellers, and limitations on local rate changes (one of the most difficult aspects for an out-of-state seller).

How long will it take for such sanity to prevail? A long time perhaps, especially if a tax-cutting Republican administration has anything to do with it.

Meanwhile, most e-commerce sellers, and especially offshore ones, can avoid sales taxes without much difficulty.

US TAXATION OF FOREIGN E-COMMERCE TRANSACTIONS
There is little certainty about the effect of current US legislation on the taxation of sales made from non-US web-sites. Some indications given here are not definitive answers, and any trader should seek professional advice relevant to their own particular situation.

The existing rules are clear about sales of physical products delivered in the US: if the seller is in a country with which the US has a double tax treaty (almost all high-tax countries) then there is no sales tax unless the company has a 'permanent establishment' in the US; for other countries (including almost all offshore jurisdictions) products are taxed on arrival if the sale is 'effectively connected with the conduct of a U.S. trade or business'.

The location of the server in or on or with which a contract was concluded has an uncertain impact on taxability. It is thought unlikely that a server based in the US constitutes a 'permanent establishment', but it is wiser to avoid such if possible. Even if the server is not a problem, the server's host might be an 'agent', who can be deemed a 'permanent establishment'. A host who also provided transaction-processing, support and marketing functions would probably cross this line, especially if the host does not have many clients.

It is also unlikely that the positioning of a server in an offshore jurisdiction by a 'treaty' country business would change the origin of the sale, but no-one knows for sure. By the same token, it is unlikely that an offshore (non-treaty) company could avoid taxability by using a server in a high-tax (treaty) country.

So for physical products, the conclusion seems to be that e-commerce doesn't really change much, unless a company moves from a treaty to a non-treaty country. Usually this would happen in order to gain corporation tax benefit and that benefit would have to be set against the taxability of US B2B sales.

For digital products other than software there is the additional difficulty that it is not clear what is being sold. The rules for software say that it is delivered where it is downloaded, and taxed accordingly, as if it was a physical product (see above). Other types of download may be treated equivalently to software, but may instead be treated as generating royalty income, which would be taxable regardless of whether or not there is a permanent establishment in the US. There are as yet no rules. The normal rate of tax (to be withheld by the US buyer) would be 30% on royalties, which could be partly reclaimed by the seller if in a treaty jurisdiction. But it seems most improbable that a private buyer of, say, recorded music in the US is going to deduct and remit tax on purchases from a remote vendor, and only slightly less improbable that a business would do it unless they are buying on a large and noticeable scale.

The problem for a business selling downloadable product into the US, and not needing to allow for tax as things stand, is evidently that retrospective legislation may make it liable for large amounts of tax on past transactions. Businesses will have to make their own decisions about what to do. For a small business with occasional US sales, the danger can probably be disregarded, but for a larger business with a substantial Internet trade in the EU, there is a real chance that the IRS will come after them one day.

EUROPEAN UNION VAT AND E-COMMERCE
All but three of the 28 OECD countries apply VAT, and as with sales taxes, operation of VAT depends heavily on the ability of the taxing authority to find traces or records of transactions, thus motivating taxpayers to comply with the law because of the near-certainty that they will be found out if they don't. It is obvious that once an individual consumer can buy and receive digital but taxable goods or services through the Internet, then it is going to be hard to collect tax if the seller is outside the tax jurisdiction. The taxing authority won't know and can't know about the transaction unless the consumer chooses to tell them, which history says is not likely!

The supply of goods ordered and paid for from a distant seller and requiring physical delivery within the taxing jurisdiction is a simpler case, because a cross-border transit is necessary. Enforcement can be patchy, but Internet sales of this type are no different from existing mail-order catalogue sales. The case with businesses is more complex.

The most important VAT area is the EU, and the application of the tax is more sophisticated there than in other countries. This discussion concentrates on the situation in the EU.

At present there is a clear distinction between goods and services: for goods, VAT is charged on an origin basis within member states (countries), while for a supply between member states the supplier does not charge VAT and the buyer has to pay it by a reverse-charge mechanism (and can offset it against output tax). Individuals and non-registered traders buying goods across borders will pay the origin tax concerned. Imports of goods from outside the EU are charged with destination VAT at the time of importation.

For services, there is also an origin basis for trading within member states, but for intra-Union cross-border trading the rules become complex. Most services are taxed where delivered, and the supplier has to set up a local office or agent to account for the tax, ie to become a registered trader, once turnover is over a low level (depending on the member state). Services delivered from outside the EU to a registered trader will normally give rise to a reverse-charge tax liability, again deductible for the importer. Services delivered from outside the EU to a non-registered person (individual or company) are not taxed, but if the non-EU supplier has a fixed establishment in any member state, then it is liable for tax in that State. E-commerce naturally assists suppliers to avoid the need for a fixed establishment in a member state, as we have seen.

The distinction between goods and services causes problems in connection with e-commerce, since what is clearly a good in a shop (a compact disc) is considered to become a service when it is in digital form. In practice, this avoids a compliance problem, since a consumer buying digital information from a vendor outside the EU is not likely to account for VAT on it; but the tax is lost. The problems for VAT collection authorities, as for corporation tax collectors, are first that suppliers of services via e-commerce can increasingly avoid a fixed establishment in the EU by placing their servers elsewhere, and second that digitising goods turns them into services, which then escape taxation in many situations.

It is fairly clear therefore that there is an incentive for suppliers of services to non-registered traders (meaning in practice, small traders in addition to individuals) to be based outside the EU, if they can manage it. On the other hand, at first sight location should make little difference to an EU supplier of services to EU registered traders, since in theory they can reclaim the tax paid; but in practice the procedure for reclaiming VAT across borders is complex and seldom-used. Therefore, even registered traders would prefer to import services from outside the EU (and be able to use the reverse-charge mechanism) rather than having to pay origin VAT which they can't offset and which they can't easily get refunded.

All in all then, both types of taxation offer many possibilities to e-commerce traders to reduce their own and their customers' taxes, usually by trading from without the taxing jurisdiction; and a logical extension of this for a trading company is to base itself in an IOFC.

The EU made proposals in June, 2000 to tax sales of electronic (downloadable) products.

If the proposal passes into law, any non-EU supplier with sales to EU consumers (ie non-VAT-registered buyers) exceeding Euros 100,000 will have to register for VAT in one EU member state (any one) and channel its EU supplies through that member state in a fiscal sense, charging VAT at the rate obtaining in its chosen member state, and paying the VAT collected to that state.

The member state most likely to be used is Luxembourg, whose VAT rate is 15% (the lowest in the Union except for Madeira, which has been allowed a 12% rate and might offer competition to Luxembourg). It would be very tempting for the Isle of Man to reduce its rate from the current 17.5% to 15% to attract more e-commerce, if the UK would allow this. Whichever state got the business, would reap a rich reward. Would it have to give some of its gains to other member states? Not under current legislation. But the proposals are likely to remain just that: proposals.

First they have to be agreed unanimously by all 15 member states, and countries charging close to 30% VAT could see the rules as the thin end of a very damaging wedge which would tend to drive incoming e-commerce business into the arms of lower-tax competitors. Second, any foreign company falling under the rule cannot easily be obliged to fall into line unless foreign countries legislate accordingly, which seems an extremely remote possibility.

The most important foreign country, the US, is strongly opposed to the tax. Virginia Governor and Chairman of the Advisory Commission on E-commerce (ACEC) Jim Gilmore said: "Europeans tax everything and they're good at it. The Internet should be allowed to grow without burdensome tax regulations." EU officials admit privately that the proposed rules are unenforceable, but of course, in the Alice In Wonderland world of the EU, that won't stop armies of legislators, translators, interpreters and bureaucrats from wasting oceans of time and paper over them, only to see them struck down when they reach the Council some time in 2001.

The US has expressed its opposition to the proposed EU tax regime a number of times since it was announced, most notably in July 2000 when Treasury Secretary Lawrence Summers explicitly said that the EU was wrong to introduce an Internet tax unilaterally, and that such plans should be discussed in the OECD, which he saw as the correct forum.

As with US sales taxes, it just isn't likely that there will be any short-term resolution of the problem, so that the existing regime will continue in force for the foreseeable future.

CORPORATION TAX AND E-COMMERCE
Corporation tax (income tax) is levied on the profits of an incorporated business. Some countries tax companies based on place of incorporation (legal establishment), but more usually tax applies to a 'permanent establishment'. As with individuals, the taxing country will normally attempt to tax a company's world-wide income once it has demonstrated permanent establishment. Income arising in other countries is often subjected to local withholding taxes before remittance; or of course it can easily happen that more than one country will assert permanent establishment, leading to double taxation. These situations are sorted out through the network of double taxation treaties which most high-tax countries have entered into.

IOFCs, International Offshore Financial Centres, by and large do not have double tax treaties, not least because they usually have very low or no corporation tax. Companies have often attempted to escape tax by earning profits in subsidiary companies in IOFCs and not remitting it to the mother company; almost all high-tax countries have anti-avoidance 'controlled foreign company' laws which attribute such income to the mother company.

Within this (highly over-simplified!) framework, what is the effect of e-commerce? Whereas previously, in order to trade in a country, it was necessary to have some or all of staff, an office, a warehouse, and means of delivery, these things can be to some degree avoided with e-commerce. A customer can inspect and buy goods or services on a company's Internet site (no local record of the sale is created), using money from an offshore account or an electronic credit card (no local trace of the transaction is created), and delivery of the goods can be outsourced to a third party. In fact, in most countries, a simple warehouse and delivery operation does not constitute a permanent establishment so that the outsourcing may not be necessary.

The placing of the Internet server from which (on which, if you like) the e-commerce transaction happens, is probably important: some cases have already suggested that a server may constitute a permanent establishment; others suggest that it doesn't. Of course, the server can be anywhere, and specifically, it can be offshore. If the goods or services are deliverable digitally (eg music or software) then there is no physical trace whatsoever of a transaction in the jurisdiction which would like to tax it.

The OECD has established a working party to study the question of web servers and the possible need to re-define the concept of the permanent establishment. It has conducted two rounds of consultation, the second having closed in June 2000, and is expected to bring forward recommendations at its meeting in September 2000. Its interim report seemed to be moving in the direction of agreeing that servers would not constitute permanent establishments.

As well as 'dematerialising' transactions, the Internet allows a company to have its various departments scattered almost anywhere, but permanently connected through the web. It will become increasingly difficult to say exactly where a company has its 'main' base, because it often won't have one. In an extreme case, a company can base itself entirely in one or more IOFCs, outsourcing all those elements of its business which require physicality. For this reason, the OECD's agenda includes the question of whether the concept of the permanent establishment is now outmoded.

Governments, which haven't so far been much affected by e-commerce, are nonetheless very concerned about the future. How can a Government collect tax on profits resulting from transactions which it can't see or measure, carried out by a company which doesn't exist physically on its soil? Intrusive and heavy-handed attempts to 'police' the Internet or its use have already been quickly seen off, and most Governments seem to understand that such behaviour will simply result in the isolation of their countries from the rest of the world.

Of course, eventually a solution will be found to tax Internet transactions in a fair way, and it is no doubt correct that this should be the case; but while the search continues there are going to be multiple, completely legal ways for companies to take advantage of the confusion in order to reduce their tax bills.

 

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