Managing E-Business

Group 7 - Term Paper

TAXATION AND LEGAL ISSUES IN CROSS BORDER ELECTRONIC COMMERCE

Managing E-Business

Group 7 - Term Paper

Table of Contents
Introduction ............................................................................................................................................. 3 Traditional Cross-Border Commerce ...................................................................................................... 3 Cross Border Electronic Commerce in Tangibles................................................................................... 4 Cross Border Electronic Commerce in Intangibles................................................................................. 4 The Pros and Cons of Taxation in Electronic Commerce ....................................................................... 5 OECD Guidelines for Taxing E-Commerce ........................................................................................... 5 OECD Definition of Place of Consumption ....................................................................................... 6 OECD Definition of Permanent Establishment (PE) .......................................................................... 6 Mechanisms for Tax Collection Proposed by OECD ......................................................................... 7 Conclusion .......................................................................................................................................... 8 References ............................................................................................................................................... 8

Managing E-Business

Group 7 - Term Paper

Introduction
Internet today enables a consumer to buy virtually any product from any seller anywhere in the world. This cross-border electronic commerce has created problems for revenue administrators to tax consumer goods and services. This has led to large scale erosion of consumption-tax (sales tax, VAT, etc.) revenue from the government. When electronic commerce was in its nascent stages, the debate on the taxation of electronic commerce was focused mainly on the sale of tangible products to businesses and consumers. Transaction of tangible goods still account for a large percentage of Internet sales. However, the sale of tangible products does not raise any fundamental taxation issues, because the proper destination-based consumption tax can be levied once the consignment passes through customs. However, if both the product delivery and payment method are electronic, (for example - downloaded software paid for with electronic cash) complicated tax enforcement issues arise because the origin and the destination of the transactions are not known. A question which then arises is: Can digitized transactions be taxed? Should they be taxed? To answer this question, it is necessary to weigh the efficiency and revenue gains from taxes on electronic transactions against the costs of compliance to consumers and the administrative costs to tax authorities.

Traditional Cross-Border Commerce

To understand cross-border electronic commerce in e-commerce, it is necessary to first understand the principles of traditional cross-border commerce. Destination based and Origin based principles are two basic principles of consumption based taxation which are discussed below: Destination Principle: In destination based principle, exports goods and services are exempt from consumption tax in the country of origin, but they are taxed in the importing country at the rate levied by the importing country. The taxation is basically at the place of consumption and the tax revenue accrues to the country in which the final sale occurs. In a world of perfect competition, the destination principle implies that all firms receive the same tax-exclusive price from selling in any location irrespective of their country of residence. Origin Principle: In origin based principle, Consumption tax is collected at source, that is, at the place where the goods are produced or exported from. Imported commodities are exempted from tax to avoid double taxation. The origin principle implies that consumer prices (or tax-inclusive prices), adjusted for transportation costs, are equated across countries. Origin-based taxation incentivizes firms to re-locate to low-tax countries, which it is feared will give rise to a race to the bottom in taxes, undermining countries ability to raise revenue. Taxation at the place of consumption promotes certainty and prevents double taxation or unintentional non-taxation where two jurisdictions employ non-compatible place of taxation rules (i.e. at source and at destination). Equally important is the fact that tax at the place of consumption creates a level playing field and is thus more neutral within and amongst conventional and electronic forms of commerce. Destination-based taxation is thus the international norm and is supported by the OECD (Organization for Economic Cooperation and Development), the European Union, and the

Managing E-Business

Group 7 - Term Paper

World Trade Organization (WTO). The origin principle is rarely applied in practice to trade, except for trade among the former members of the Soviet Union.

Cross Border Electronic Commerce in Tangibles

A consumer can purchase tangible goods (e.g. books, electronic items, clothing, etc.) through internet from virtually any online seller in the world. The place of consumption for the crossborder supply of such goods can be determined from the recipients address for delivery when the goods pass through the customs. Suppose an Indian customer purchases a book over the Internet from a seller in the United Kingdom, the proper destination-based consumption tax and applicable customs tariff can be levied when the consignment crosses customs control at the Indian border. Such a sale does not raise any fundamental taxation issues. Similarly for tangible services like hotel accommodation, transport, hairdressing services, etc. a location where the service is performed can be identified and the service therefore is said to be consumed at that location. However, as these types of transactions become more common, tax authorities will have a hard time handling significantly greater flows of small consignments. Thus the tax authorities will have to raise the bar of tax exemptions for small consignments from time to time, as the costs of inspection and tax collection exceed the revenue raised.

Cross Border Electronic Commerce in Intangibles

Intangible products (e.g. downloaded software, music, games, movies, books) are delivered electronically and thus they cannot be checked or recorded at the national border. Similarly intangible services (e.g. consultancy, accountancy, legal, banking and financial transactions, advertising) cannot be seen to be physically performed at a particular location and are often deemed to be consumed where the provider or customer is located. Jurisdictional and national boundaries thus become irrelevant for intangible products & services. The tax collectors need to know where the transaction takes place and whether the transaction involves a good or a service to be able to effectively tax a consumption transaction under traditional taxation principles. In addition, tax administrators generally rely on a paper trail of transactions for auditing purposes. Digital transactions typically do not generate such records. The vendors of intangible products often do not know and usually they do not need to know the physical location of their customers. Even determining the location of the vendor may be difficult for the tax authorities. A vendor may sell its products through a Web site on a server located in a country or jurisdiction other than the country in which the vendor is registered or where the purchaser is. Countries typically apply differential tax rates to goods and services. This necessitates a clear classification of digital products as either a product or a service. But technological developments have blurred the boundaries between goods and services. Is a downloaded movie a digital service, that is, the provision of information, or a good? Because of the difficulties discussed above most intangible services go untaxed in the United States, but not in the European Union. In Canada, digitized products are classified as intangible personal property, which is taxable under the federal Goods and Services Tax (GST). Countries thus differ in their tax policies, potentially giving rise to double taxation or no taxation at all of cross-border electronic trade.
4

Managing E-Business

Group 7 - Term Paper

The Pros and Cons of Taxation in Electronic Commerce

As discussed in the previous section, there are huge challenges when it comes to taxing transaction of intangible goods and services. So a natural question is: Can electronic commerce be taxed? And should it be taxed? Lets first at look at arguments in favour of taxing e-commerce. If e-commerce is not taxed then remote sellers (without a physical presence) will enjoy an unfair competitive advantage over local bricks-and-mortar retail stores. Retail transactions will thus shift from bricks-andmortar stores to the Internet based retailors. Exempting tax on Internet sales thus distorts consumer behaviour and thereby creates efficiency losses. Proponents of the taxation of electronic commerce also point to the revenue losses associated with a permanent exemption. Electronic commerce transactions are fiscal termites that gnaw away at the consumption tax base. Not only consumption tax revenues are at stake, but some countries levy customs duties on physical trade in digital media; that revenue would be lost if the products were imported electronically. Governments of developing countries, which depend heavily on import duties, would be hurt the most. Remote sellers, however, point to the shipping and handling fees charged on Web-based sales. They argue that such fees would offset any tax advantages that they currently enjoy. This may be true in the case of low-value purchases such as CDs; but consumers also buy more expensive items, such as DVD players and computers, from retailers that do not charge sales tax. Moreover, there are no shipping and handling fees on digital content such as downloaded software. Regarding loss in import duties, there is a broad support in the WTO for the exemption of electronically delivered products from customs duties. The rationale is that import tariffs cause larger by-product distortions than consumption taxes.

OECD Guidelines for Taxing E-Commerce

OECD (Organization for Economic Cooperation and Development) has given guidelines and framework for taxing cross border e-commerce, which is followed by its 34 member countries. In 1998, a report- A Borderless World: Realising the Potential of Electronic Commerce was presented to the Conference of the Ministers of the OECD. The main conclusions of the report were: 1. The taxation principles which guide governments in relation to conventional commerce should also guide them in relation to electronic commerce with appropriate modifications. 2. The taxation principles should be structured to maintain the fiscal sovereignty of countries, to achieve a fair sharing of the tax base from electronic commerce between countries and to avoid double taxation and unintentional non taxation. 3. Rules for the consumption taxation of cross-border trade should result in taxation in the jurisdiction where consumption takes place and an international consensus should be sought on the circumstances under which supplies are held to be consumed in a jurisdiction. 4. Countries should examine the use of reverse charge, self-assessment or other equivalent mechanisms, where business and other organisations within a country acquire services and intangible property from suppliers outside the country.

Managing E-Business

Group 7 - Term Paper

OECD Definition of Place of Consumption

Definition of place of consumption in case of intangibles is a big point of contention. OECD has given the following guidelines for place of consumption B2B Transactions: For B2B transactions, intangible services are assumed to be consumed where the recipient has located its business presence. Where there is a choice of locations, such as a headquarters in one country and a branch in another, the business presence should be considered as the establishment (for example, headquarters, registered office or branch of the business) of the recipient to which the supply is made. In certain circumstances, revenue authorities may use a different criterion to determine the actual place of consumption to ensure that the business structure or the mobility of communications is not used to avoid taxes by routing services through temporary establishments in non-tax or low-tax jurisdictions. B2C Transactions: For B2C transactions the jurisdiction in which the customer has his/her usual place of residence is the most practicable definition of place of consumption. Where a consumer has more than one country of residence the place of consumption should be the jurisdiction in which they spend the majority of their time. However, significant problems exist in identifying the jurisdiction of a virtual customer. In long term, technology will likely be able to determine a consumers location accurately.

OECD Definition of Permanent Establishment (PE)

Only those business profits of a non-resident business can be taxed by a country that are attributable to a permanent establishment of the business in that country. Permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on. This definition incorporates both a geographical requirement (i.e. that a fixed physical location be identified as a permanent establishment) as well as a time requirement (i.e. the presence of the enterprise at that location must be more than merely temporary). Also a non-resident is deemed to have a permanent establishment in a country if another person acts in that country as an agent of the non-resident and habitually exercises an authority to conclude contracts in the name of the non-resident. Following rules also apply in defining a Server-PE: A web site cannot, in itself, constitute a PE A web site hosting arrangements typically do not result in a PE for the enterprise that carries on business through the hosted web site Except in very unusual circumstances, an Internet service provider will not be deemed (under the agent/permanent establishment rule described above) to constitute a permanent establishment for the enterprises to which it provides services Whilst a place where computer equipment, such as a server, is located may in certain circumstances constitute a permanent establishment, this requires that the functions performed at that place be such as to go beyond what is preparatory or auxiliary

OECD has analysed various scenarios related to the definition of a PE: 1. A stand-alone computer server performing automated functions (in particular, online processing of transactions and transmission of digitised products) without the presence of personnel in the permanent establishment: In such a scenario the permanent establishment is performing only routine functions and is reliant on other parts of the enterprise to provide the intangible assets. Accordingly, the activities of the permanent establishment are very unlikely to warrant it being attributed with a substantial share of the profit
6

Managing E-Business

Group 7 - Term Paper

associated with the distribution activities of the enterprise conducted through the server. This is similar to a contract service provider type arrangement where all substantial assets and risks would be left with the head office 2. Where personnel are present in the permanent establishment to perform maintenance and online services tasks, the quantum of the profit attributable to the permanent establishment would be commensurate with what independent service providers would be expected to earn in a similar situation. 3. In-house development of server and web site is likely to produce a more substantial attribution of profit to the permanent establishment, as it assumes sufficient development risks to be considered as the economic owner of the intangible property developed to operate the server and the web site and, therefore, is entitled to the profit associated with the exploitation of such property.

Mechanisms for Tax Collection Proposed by OECD

Since it is difficult to accurately identify the location of a virtual customer, OECD has proposed the following mechanisms for tax collection: Self-assessment / Reverse Charge: Under this system recipients would be required to determine the tax owing on imports of services and intangible property, and to remit this amount to the domestic tax authority. This system is being currently used for B2B transactions in most OECD Member countries and the system has proven feasible, effective, and carries a low compliance and administrative burden. Self-assessment/reverse charge, however, has not been effective in ensuring the collection of tax on transactions involving private recipients (B2C). Registration: Under this system, non-resident businesses would be obliged to register in a jurisdiction and to charge, collect and remit the consumption tax to that country. Difficulties however arise in terms of identifying non-resident suppliers, as well as in imposing registration requirements and enforcing obligations on non-residents. This option could increase the cost of tax administration (e.g. registering, auditing, collections, etc.). Registration would also impose significant compliance costs on non-resident suppliers, particularly for those making supplies in multiple jurisdictions with relatively few sales in each jurisdiction. Therefore, there should be a certain thresholds to ensure that the compliance burden is eliminated where it would reduce or negate the incentive to carry on business activity, e.g. for small and medium-sized enterprises (SMEs). Tax at Source and Transfer: Under this system a business would collect consumption tax on exports to non-residents and remit the amount to their domestic revenue authority from where it would be forwarded to the revenue authority in the country of consumption. This would reduce the significant compliance costs associated with the registration option. However significant increase in the cost of administration, in addition to the need for international agreements regarding enforcement, collection and revenue transfers, places the feasibility of this option in question. Collection by Third Parties: Under this system third parties (such as financial intermediaries) would be enlisted to collect consumption taxes on payments between recipients and suppliers of digital supplies. The third party would then remit the tax to the country of consumption. A question however remains on feasibility of shifting the onus of collection onto the third party. According to OECD, any such third party participation should be voluntary and based upon market-driven commercial viability. Such a model could be successful if third parties were provided with appropriate incentives.
7

Managing E-Business

Group 7 - Term Paper

Technology-based Options: Use of tamper-proof software, which would automatically calculate the tax due on a transaction and remit (through a financial intermediary or a trusted third party) the tax to the destination jurisdiction. Bilateral agreements would provide for the verification by the tax authority in the supplying jurisdiction (on behalf of the consuming jurisdiction) of the installation and operation of such software. After exploring various tax collection mechanisms, the OECD recommended that in case of B2B transactions if a non-resident business is not registered then a reverse charge or selfassessment system should be followed. In case of B2C transactions a system of simplified registration for non-resident suppliers should be pursued, which ensures that the potential compliance burden is minimised.

Conclusion
Although OECD has given elaborate guidelines and frameworks for taxing cross-border ecommerce transaction, only a small part of this is actually implemented by various OECD member nations. Implementation of these guidelines requires compliance at a national level which nations are reluctant to do. This non-compliance of OECD guidelines can be observed from the fact that nearly 53% of Googles revenue comes from international sources and its effective tax rate on this international income is just 2.4%. Google does not really pay taxes to non-US governments.

References
1. A Borderless World: Realising the Potential of Electronic Commerce, A Report by the Committee on Fiscal Affairs, as presented to Ministers at the OECD Ministerial Conference, on 8 October 1998. 2. Are the current Treaty Rules for Taxing Business Profits Appropriate for ECommerce?, OECD Report 3. Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transactions, a OECD discussion paper 4. Consumption Taxation In A Digital World: A Primer, J.E. Ligthart, Sept 2004 5. Consumption Tax Aspects Of Electronic Commerce, a OECD report 6. Global Taxation Of Cross-Border Ecommerce Income, Rifat Azam 7. Facilitating Collection of Consumption Taxes on Business-To-Consumer Cross Border E-Commerce Transactions , OECD Report 8. Electronic Commerce Commentary on Place of Consumption for Business-to-Business Supplies, OECD Paper