Canada: Taxes in the E-Business Era: A Canadian Perspective

Last Updated: May 4 2000

This article reviews in detail the taxation issues faced by Canadian companies involved in E-business and non-residents transacting with Canadian residents. It includes commentary on the revised draft Organisation for Economic Co-operation and Development ("OECD") positions on permanent establishments and income characterization (both released March 2000) as well as the recommendations of the U.S. Advisory Commission on Electronic Commerce (released April 2000).

The following formed the basis of a presentation by Pierre Bourgeois of PricewaterhouseCoopers LLP to the Canadian Importers’ Association’s "Transfer Pricing 2000 for Importers and Exporters" conference in April 2000. Mr. Bourgeois can be contacted by E-mail at: or by phone at 1-514-205-4139.


The Organisation for Economic Co-operation and Development ("OECD") and its member countries have issued detailed discussion papers with respect to the impact of e-business on income and sales taxes. Various advisory groups have been set-up to pursue the analysis of the impact of e-business on taxation. In the course of this exercise, fundamental international tax principles are being discussed including residence vs. source taxation, income characterisation and the permanent establishment threshold. The particular issues and concerns with respect transfer pricing in a virtual world are also starting to be discussed.

Until an international consensus emerges, there will be a risk of incompatible treatment of revenue derived from electronic business where more than one jurisdiction is involved. Hence, a Canadian corporation that transacts cross-border using e-commerce, whether directly or through foreign affiliates, will be faced with a number of issues.

The issues that have been discussed are complex, however, a tenuous consensus is starting to emerge which respect to some critical matters:

  • Tax neutrality: Any changes that could be made should provide that taxpayers in similar situations entering into similar transactions should be taxed in the same manner.
  • Existing principles should be retained: Some alternative methods of taxation have been suggested such as a bit tax or the use of apportionment formulas to allocate income between jurisdictions. These alternatives have, for the moment, been rejected. To varying degrees, the majority view is that existing tax principles should be retained to deal with electronic business transactions.
  • International co-operation and consensus are essential: Given the global reach of electronic business, no one country can unilaterally make radical changes to existing principles. Hence, what is being sought at this time is a consensus as to how to adapt existing principles to the digital age. As we shall see, it will be very challenging to achieve a consensus.

The objective of this paper is to provide observations on the application of existing tax principles to electronic business in a cross-border context from a Canadian perspective. Given the level of uncertainty with respect to this area and the pace of technological change, it is not possible to provide definitive comments.

A number of characteristics of the Internet and electronic commerce have an impact on the way in which business is conducted and sales are made. Additionally, there are some technical characteristics of the electronic medium and related technologies which raise a number of interpretation issues and compliance concerns. Before discussing the international income tax issues, summarised below are some of these characteristics.1

1. Electronic business facilitates international trade as well as co-operation within an organisation. As a result, one can expect trade between countries will increase and that small and medium sized businesses may be more likely to trade across borders. These two factors could lead to an increased volume of international transactions where the value of the transactions is relatively small. Increased co-operation within an organisation may lead to situations where residents in various countries are involved in either service delivery (such as where consultants in various countries provide services to a client or where financial instruments are traded globally) or product development (consider, for example, a situation where a team of engineers composed of individuals in Canada and in other countries develop software).

2. The nature of the Internet is such that there is no necessary relationship between an Internet address, the residence of a party or its physical location. This ability to achieve anonymity on the Internet raises a number of fundamental concerns. For example, it can become difficult to determine which treaty applies to a given transaction and it could facilitate intentional non-reporting of transactions.

3. For some types of products, electronic commerce could reduce the number of intermediaries (disintermediation). An example is in the area of software. In the past, a commercial software application would have to be put onto a physical media (diskette or CD-ROM) and would likely be sold to a wholesaler who would in turn sell to a retailer before the software was acquired by the consumer. Electronic business will facilitate the direct sale of the software, in digital form, from the developer directly to the consumer. Intermediaries have traditionally played an important role vis-à-vis tax administration and compliance. Firstly, they provide an audit trail which is very useful to tax authorities and they are often mandated by taxation authorities to act as tax collectors. To the extent that resident intermediaries are not involved in a transaction, tax revenue collection is put at risk due to non-reporting and there is also the potential for tax base erosion due to disintermediation.

4. The fact that various information can be digitised increases the types of goods and products that can be transacted electronically. The nature of the items that are or can be digitised include software, written information (books, magazines, newspapers, encyclopaedias and databases), photographs, videos and music. The transformation of physical goods to digitised versions raises a number of issues with respect to the characterisation of the income and, by extension, the appropriate tax treatment under both domestic tax legislation and treaties.

5. The means by which certain products and services can be delivered will also likely change. Consider for example, the trend towards application service providers ("ASP"). An ASP will generally host various applications that are sold to its customers based on the amount of time that the application will be used. In such a business model, a customer could "rent" a given software application for a given period of time or number of uses rather than purchase the software under the traditional licensing arrangement.

6. Creation of a new electronic payment method, electronic cash (which has the characteristics of cash, specifically a very fungible nature), leads to a lack of tracing with respect to its use.

7. The Revenue Canada2 Advisory Committee has noted that financial institutions are potentially great beneficiaries of the electronic revolution as the transaction costs of electronic transactions is significantly lower than traditional methods.3 Assuming that the use of the Internet and private networks gains consumer acceptance, one can expect that financial institutions will embrace the new technologies. The increased use of such means for financial transactions, combined with increased access to tax-haven banking facilities, could create the potential for non-reporting.

8. The automation of various processes can yield significant savings. The most prevalent example of this at this is in the area of e-procurement. By automating the procurement process, the cost of processing transactions and the savings resulting from obtaining better terms with suppliers and stricter adherence to buying policies, can yield significant savings. For multinational enterprises, the ability to have the e-procurement activities for its non-Canadian procurement needs, carried-on by an entity located in the appropriate tax jurisdiction can magnify the savings obtained.

9. The valuations that are being given to e-business companies are very significant. Hence, there is a significant amount of value that can be created when a business transforms itself from the "traditional" model to an e-business model or where entirely new businesses are created. This creation of value and that fact that we are increasingly seeing co-operation between the various entities creates tremendous tax planning opportunities for companies.

Having outlined some of the basic characteristics of the new technologies, some of the more significant international income tax issues will now be addressed. Our comments are divided into five main headings:

  • Non-residents: a discussion of some of the income tax issues that non-residents who transact with Canadians could face (carrying on a business, services rendered in Canada and Part XIII withholding taxes);
  • Residents: a consideration of the impact of electronic business for Canadian residents who are involved in cross-border transactions (foreign tax credits and foreign accrual property income rules);
  • Tax treaties: a consideration of the application of treaties in the context of electronic business specifically with respect to the notion of permanent establishment, computer servers, web pages, mind and management as well as income characterisation;
  • Transfer pricing: an outline of some of the challenges faced in the transfer pricing area in the context of electronic business.
  • US developments: a review of recent US developments in the area of E-business.

Non-Residents transacting with Canadian residents

For non-residents that transact with Canadians, there are a number of taxes which could apply:

(i) a non-resident that carries on business in Canada could, subject to treaty protection, be subject to Canadian income tax and capital tax at the federal4 and provincial levels as well as branch tax under Part XIV of the Act;

(ii) a non-resident that receives an amount in respect of services rendered in Canada could be subject to a 15% withholding tax under Regulation5 105 of the Act.

(iii) payments made to non-residents could also be subject to withholding taxes pursuant to Part XIII of the Act.

Each one of these aspects is commented on below.

Carrying on a business

The first issue that has to be determined is whether a non-resident who is engaged in electronic business carried on via a Web page can be brought into the Canadian tax et by virtue of domestic legislation.6 Canadian tax law relies on the Common Law notion of what constitutes carrying on a business7 as well as providing for specific circumstances under which a non-resident is deemed to carry on business in Canada. In very general terms, a non-resident will be deemed to be carrying on a business in Canada if:

(i) the non-resident produces, creates, manufactures, improves, packs, preserves, or constructs, in whole or in part, anything in Canada; or

(ii) solicits orders or offers anything for sale in Canada through an agent or servant, whether the contract or transaction is to be completed inside or outside Canada or partly inside or outside Canada.8

Hence, in order to determine whether electronic business activities could be subject to Canadian income tax, the following determinations must be made:

(i) do the activities constitute carrying on business under Common Law principles?

(ii) are the activities described in the extended definition of carrying on business in Canada?

(iii) are those activities carried on in Canada?

As one author has noted, in making the first determination, one must first ask the question whether the income that is being earned is income from property or income from business.9 Characterisation as business income would require, inter alia, a profit motive and an indication that time, attention and labour are being expended. Further, it has been noted that the determination of whether income is from business or property is not based on whether income is derived from the use of property but whether the income flows from a business or from property.10 Although one would expect that in most instances the income derived from an electronic business activity would, a priori, be income from business (consider for example that most Web sites are updated on a regular basis and that often the nature of the product that is sold is also updated frequently), there may be some fact patterns where the appropriate view is that such income is from property. In the latter case (and perhaps in the former as well), consideration would have to be given as to whether payments made are subject to withholdings under Part XIII of the Act (this matter is discussed in more detail later in this paper).

With the advent of electronic business, one of the results is the "digitisation" of products that were in the past sold in physical form. As a result of this change, the manner in which these products are sold has been modified - in the past, one purchased a subscription to a newspaper, today one enters into a licensing agreement to access the information. This transmogrification may also have an impact on the nature of income and the determination of whether the income can be viewed as income from a business or income from property. This matter is discussed in more detail below under the discussion dealing with treaties and income characterisation.

Assuming that the income derived from electronic business is business income, one must make the additional determination as to whether the non-resident is carrying on that business. To the extent that the electronic business activities can and are fully automated, this raises an interesting question: is the characterisation of the income and the notion of carrying on a business impacted?11 As commented upon below in the discussion regarding treaty issues, the OECD Model Convention12 considers whether gaming or vending machines located in a given jurisdiction could constitute a permanent establishment if a non-resident operates the machines for his own account or hires a dependent agent to do so. Query whether, by analogy, electronic commerce activities carried on by an automated process could be viewed in a similar manner?

The non-resident must now consider whether under the Common Law tests his activities are such that he is carrying on a business in Canada. The following are the factors that have been considered relevant by the courts:

  • place of delivery;
  • place of payment;
  • place where the purchases are made;
  • place of manufacture or production;
  • place from which the transactions are solicited;
  • location of inventory of goods;
  • location of bank accounts;
  • listing of the name and business in a directory;
  • location of employees or dependent agents;
  • location where the contract is concluded.

For each particular situation, a determination based on the facts will have to be made. In the common fact pattern where the Canadian presence of a non-resident is limited to Canadians viewing the enterprise's Web site and there is no physical presence in Canada, based on the factors outlined above, one would expect that the non-resident would not be considered to be carrying on business in Canada. Query however whether a different conclusion would be reached where, as a matter of contract law, the contract is considered to be concluded in Canada. As one author has noted, there is Canadian jurisprudence that could be referred to support the finding that a contract could be considered to be concluded in Canada in such situations.13 This is indeed an interesting question and one which will have to be monitored by tax practitioners. The Revenue Canada Advisory Committee has raised the issue but has not, understandably, taken a position.14 The question of which law is relevant to a transaction entered into via the Internet between parties residing in different states will likely be a topic of discussion in academic, international and legal for such as the World Trade Organisation and the OECD.

Consider also the situation where the digital product is stored on a server located in Canada: Is this tantamount to maintaining a stock of merchandise in Canada?

As noted above, the Act has an extended definition of carrying on business in Canada and a non-resident who is not considered to be carrying on business in Canada under the Common Law tests discussed above will have to consider this definition.

With respect to the first deeming rule, paragraph 253(a) of the Act, the Revenue Canada Advisory Committee raises the issue of whether the provision of electronic goods or services to Canadian customers by a non-resident could be considered goods or services that are produced, created or fabricated in Canada.15 This is certainly an interesting question. Consider the purchase of software that is downloaded to the consumer's computer. Generally, the software will be downloaded in a compressed form in order to reduce the download time. Does the act of decompressing the files that have been downloaded result in goods or services that have been produced, created or fabricated in Canada? As the act of decompression is being done by the consumer rather than the non-resident, the better view is that such an activity should not be within the purview of paragraph 253(a) of the Act.

Consider a situation where a US based computer engineer is providing services to Canadian corporations. For example, an engineer is provided with the code to software used by a Canadian corporation electronically and performs analysis with respect to the year 2000 bug. After having analysed the situation, she downloads the modified code to the Canadian client and performs some tests directly on the software by remote means. During the remote testing, she makes additional modifications to the code. Intuitively, in the first scenario, one would expect that paragraph 253(a) of the Act does not apply as there is no real value that has been added in Canada. The determination as to the application of this provision of the Act is somewhat less clear where modifications are made directly to the code that is physically situated in Canada. One of the activities that is enumerated in paragraph 253(a) of the Act is the improvement, in whole or in part, of anything in Canada. Could the view be taken that as the engineer accesses the code located in Canada and makes modifications that she has improved a thing in Canada? Again, the better view is that, as the actual activity is being carried on outside of Canada, paragraph 253(a) of the Act should not apply in this situation.

Under paragraph 253(b), a non-resident who solicits orders or offers almost anything for sale in Canada, through an agent or servant, will be deemed to be carrying on business in Canada. Would a non-resident that transacts with Canadians via his Web site be considered to be carrying on business in Canada under this deeming provision? Based on the Sudden Valley16 case, there is a distinction that has to be made between offering something for sale (which is limited to offers that if accepted would create a binding contract) and a mere "invitation to treat".17 In the latter case, paragraph 253(b) of the Act does not apply. Unless a Web page is a relatively passive instrument, providing only information and requesting that the viewer contact the enterprise for further information and/or to conclude the contract, it would appear difficult to make the argument that it would constitute a mere invitation to treat. Many Web pages contain much information and provide detailed description of products offered, pricing and shipping information as well as provide for electronic order forms from which the purchase is processed. This level of information is arguably such that the Web page goes beyond being a mere invitation to treat.18 However, this does not bring us, necessarily, to the conclusion that paragraph 253(b) of the Act applies as that provision requires that the solicitation or offering must be done through an agent or servant. In a typical electronic business scenario, this reasoning could imply that either the Web page or the Internet Service Provider ("ISP") is an agent of the non-resident. Initially, this was an area of great debate in international tax forums. As discussed in more detail below in our discussion of permanent establishment in the e-business context, the present consensus is that neither a Web page nor an ISP create taxable presence.

The Revenue Canada Advisory Committee has taken note of these difficult questions and has recommended that the Department issue an interpretation bulletin to clarify its position on the circumstances in which electronic business activities may constitute carrying on business in Canada. Additionally, the committee has recommended that the Department review whether the provisions of section 253 are appropriate for electronic business and convey its conclusions to the Department of Finance.19

Services rendered in Canada

In order to monitor the activities of non-residents within Canada and to provide for a collection mechanism, the Act provides that where a payment is made to a non-resident who has rendered services in Canada that is a fee, commission or other amount, a withholding of 15% must be made.20 A non-resident who suffers this withholding tax and is not taxable in Canada, due to treaty protection for example, can obtain a refund of the taxes withheld. Alternatively, a waiver can be obtained prior to the payment if the non-resident is not subject to Canadian income tax.21

The Revenue Canada Advisory Committee has indicated that the word "render" as it relates to services, signifies "to do".22 Hence, "an activity, an undertaking or some other action is required of the part of the [non-resident] provider in the delivery service" and there must be a physical connection in Canada23 (i.e., the activity must be done within Canada) for a withholding obligation under Regulation 105 to apply.

A number of issues arise where the Internet is used for service delivery. Due to the anonymity accorded by the Internet, the consumer of the services may not be aware he is dealing with a non-resident. Even if he is aware that the service provider is a non-resident, the consumer may not be able to determine whether the service is being provided within Canada or from abroad.24 Lastly, where the service in question is completely automated, it is difficult to determine the location of the service delivery.25

At present, there is little guidance that is available from Revenue Canada. In one technical interpretation, Revenue Canada considered the situation where a Canadian resident pays for a software hotline service and indicated that if the non-resident provider is not in Canada when the service is being rendered, no withholding under Regulation 105 is required.26 In the previous section, we considered a situation where a US-based engineer was providing program maintenance service to a Canadian corporation. Most of the services consumed were provided from the US and based on that fact, one would expect that no Regulation 105 withholdings would not be required. Query however, as a portion of the service was provided by accessing the Canadian mainframe whether that portion of the service is rendered in Canada. From a practical perspective, we would hope that in such a fact situation, no withholding would be required.

In light of the little guidance available, the recommendation by the Revenue Canada Advisory Committee that the Department issue an interpretation bulletin is very welcome.27

Part XIII Withholding Taxes

Paragraph 212(1)(d) of the Act provides for withholdings on a very broad nature and type of payments. As previously noted, electronic commerce and the Internet will have the impact of changing the nature of goods. As goods become more digitised and can be sold via licensing agreements through the information highway and access to on-line databases increases, the scope of payments made by Canadian residents to non-residents that could potentially be subject to a withholding obligation under paragraph 212(1)(d) of the Act will likely increase.28

For the Canadian taxpayer that is making a payment that is subject to a withholding obligation, this can pose a number of problems. Firstly, it will be difficult to determine the appropriate withholding rate (assuming that a treaty applies) as the Internet provides a certain degree of anonymity and, as a result, a Canadian taxpayer could, in good faith, assume that the Canada-Australia Income Tax Convention applies due to the suffix of the Web site address (.au) in a situation where the beneficiary of the payment is resident in a non-treaty jurisdiction. Such a problem will likely only be solved when an international consensus on the verification of country of residence is arrived at.29 Secondly, the Revenue Canada Advisory Committee has made an interesting observation that if Canadian residents are subject to withholding taxes resulting from the recharacterisation of an activity, this could increase the cost to Canadian business30 and reduce their competitiveness.

As has been noted by one author, a Canadian resident making a payment to a non-resident for the use of an on-line database could be subject to Part XIII withholding tax pursuant to either subparagraph 212(1)(d)(ii) of the Act (if the payment is viewed as being for information) or subparagraph 212(1)(d)(iii) (if the payment is viewed as being for services).31 Revenue Canada’s position with respect to this area is not clear. In a technical interpretation, Revenue Canada was asked to opine on whether withholding taxes applied to fees to access a US situs database via telephone or satellite. The Department was unable to provide its position.32

With the increase of licensing and sales of digitised products electronically, there is perhaps an analogy that can be made with the Canadian position on software. Canada has in the past taken a position with respect to software that differed with that of other members of the OECD.33 Specifically, Canada has indicated that "payments by a user of a computer software pursuant to a contract that requires [that] the source code be kept confidential, are payments for the use of a secret formula or process and thus royalties". This position is clearly evolving. Firstly, Canada has reduced or eliminated withholding tax on some computer software payments in recent treaty negotiations.34 Secondly, the Revenue Canada Advisory Committee appears to be sympathetic to the emerging consensus that goods that were previously sold in physical form should be treated in the same manner for income tax and withholding tax purposes independent of the form of delivery (electronic or hard copy).35 The committee has recommended that Revenue Canada, in conjunction with the Department of Finance, examine the appropriateness of revising Part XIII of the Act with respect to payments for electronic subscriptions and similar transactions.

Transactions entered into by a Canadian corporation

To date, there is little definitive guidance available with respect to the positions that various countries are taking with respect to electronic commerce. Hence, in situations where Canadians are transacting with non-residents, there is increasing risk of incompatible international tax treatment being given.

The Revenue Canada Advisory Committee has commented upon this situation indicating that there are situations where Canada could consider income to be business income whereas the other jurisdiction would take the view that the income is subject to withholding taxes. The committee notes that in such a situation, the Canadian taxpayer would be unable to claim a foreign tax credit with respect to the foreign taxes withheld as the credit is limited to the Canadian taxes that would otherwise apply to the foreign source income. In such a situation, the Act allows for a deduction of the taxes that are not otherwise creditable.36 This produces only partial relief from double taxation and the committee has recommended that the Department of Finance monitor this situation to ensure that appropriate relief is obtained by Canadian taxpayers. As discussed later, there are indications that the risk of incompatible income characterisation could arise in a cross-border context.

To the extent that an international consensus is attained with respect to the characterisation and sourcing of income derived from electronic business, these problems could be, in large part, mitigated and it is likely that this is why the committee recommended monitoring of the situation rather than legislative change.37

Foreign Accrual Property Income Rules

A concern of Canadian taxation authorities, taxpayers and their advisors is whether the FAPI rules for foreign affiliates are effective vis-à-vis electronic business conducted by a CFA.

Income characterisation for FAPI purposes

Our comments assume activities such as the sale of digitised products via the Internet or the sale of services via this medium are carried on by a CFA.38 In order for income that is earned by a CFA to escape FAPI characterisation, it must be carrying on a business. Carrying on a business requires a certain level of effort. Hence, to the extent that the activities of the CFA are fully automated, one can query whether it can be said that the entity in which the activities are occurring is really carrying on a business.39 It has been suggested that in such situations, it would be useful to avoid fully automating the process.40 Although this is an interesting line of inquiry, the related question is, to the extent that the activities are automated, what will be the impact on the appropriate transfer price? This is a complex determination requiring, inter alia, a detailed analysis of the ownership of the intangibles and their contribution to profit generation.

Investment Income Definition

To the extent that products become digitised and the income derived from their sale can be viewed as royalty income or transfers subject to royalty, consideration has to be given to the application of the "investment income" definition. Income from an investment business is deemed to be income from property and therefore FAPI unless a provision of paragraph 95(2)(a) of the Act deems the income to be active business income. An investment business is one whose principal purpose is deriving income from property, including royalties and similar returns. Query whether, in certain circumstances, an income stream earned by a CFA could be considered to be income that is not from property.

As the investment income definition is, in large part, inspired by the "specified investment business"41 definition, reference can be made to jurisprudence and Revenue Canada positions with respect to this provision.

In making a determination of what constitutes the principal purpose of a corporation for the purpose of the "specified investment business" definition, Revenue Canada has indicated that the following factors have to be taken into account:

"(a) the purpose for which the business was originally commenced;

(b) the history and evolution of its operations, including changes in the mode of operation and purpose of existence; and

(c) the manner in which the business is conducted."42

Applying these criteria to an electronic business scenario is difficult and likely inconclusive.

Revenue Canada has provided more specific guidance in two technical interpretations that considered types of revenue which are somewhat relevant to electronic business. The first considered whether royalties from copyrighted music could be income from property or from business:

"Although royalty income is generally from a source that is property, where it can be established that the royalty income is related to an active business carried on by the recipient corporation in the year, or the recipient corporation is, in the year, in the business of originating property from which the royalties are received, such income will be considered to be income from an active business. Therefore, if a company is in the business of composing music, the income it earns with respect to its copyrighted music would generally be considered active business income. The fact that such income is in the form of royalties is not, in and by itself, sufficient to conclude that it is property income."43 [emphasis added]

Revenue Canada has also commented upon the qualification of income from licensing and has noted the following:

"As a general rule, income from a licensing agreement would not be income from an active business because it would be income from a source that is property or income from a specified investment business. In a situation where it could be established that the licensing income is related to an active business carried on by the recipient corporation or the recipient corporation is in the business of dealing in or originating the property from which the licensing income is received, such income could be considered to be income from an active business."44 [emphasis added]

Needless to say, it will be challenging to determine, based on the particular activities of a CFA, whether the position can be taken that the income it derives is business income and therefore not subject to FAPI characterisation under the "investment income" definition. Interestingly in both technical interpretations quoted above, the Department has alluded to the situation where the taxpayer is the originator of the "property" in determining the character of the income. This may be particularly relevant in an electronic business context and difficult to apply. Consider for example where the product is "originated" in Canada but where a CFA or a number of CFAs is involved in service delivery? Does the fact that the originator was in Canada have an impact? What if the CFAs and the Canadian taxpayer engage in bona fide cost sharing arrangements such that the Canadian taxpayer and the CFAs all contribute to the ongoing development of the digital product?

Assuming that a particular CFA engaged in electronic business is deriving income from property, its business must be carried on by it with the principal purpose of deriving income from property, including royalties and similar returns to come within the ambit of the "investment business" definition. The use of the term royalty is not problematic as reference can be made to the definitions of the term. Consider however the situation where the income that is earned is not a royalty. In such a situation, the analysis must consider whether the income earned is a "similar return". Such a determination could be difficult in the context of electronic business.

Assuming that a CFA is involved in an investment business, consideration has to be given to whether its business involves the resale or licensing of property. This determination is important as the Act defines the "licensing of property" to include "authorising the use of or production or reproduction of property including information or any other thing".45 A CFA whose activities meet this definition will, provided that:

its business is conducted principally with persons with whom the affiliate deals at arm’s length; and,

it employs throughout the year more than five full-time employees (including employee equivalents outside Canada employed by related persons and certain partnerships);

not be considered to have an investment business and consequently will not generate FAPI.

The Revenue Canada Advisory Committee has mentioned these issues in its report and indicated that consideration should be given to amending the definitions of the Act to exclude passive income receipts derived from the exploitation of intellectual property by a CFA engaged in electronic business.46 Furthermore, it has also questioned the relevance of the more than five full-time employee threshold indicating that, due to the level of automation that is possible in electronic business, such a test may not be appropriate. Alternatively, the Revenue Canada Advisory Committee has indicated that consideration could be given to providing a phase-in of the existing number of employee threshold by providing, for example, that it would not apply to start-up scenarios (for e.g., for the first 24 months).47

FAPI Deeming Provisions

Another concern with respect to the ambit of the FAPI regime to electronic business is the application of the various specific rules that deem what would otherwise be active business income to be FAPI. Some of the more relevant deeming provisions are briefly commented on below.

Paragraph 95(2)(a.1) of the Act deems income of a foreign affiliate from the sale of property to be income from a business other than an active business where it is reasonable to conclude that the cost of such property is relevant in computing the income from a business carried on by the taxpayer or non-arm’s length persons in Canada. This rule applies to income derived from services as an agent provided in relation to a purchase or sale of property. This deeming rule does not apply in either of the following circumstances:

the property was manufactured, produced, grown, extracted or processed48 in the country under whose laws the foreign affiliate was formed or organised and in which the business was principally carried on49; or,

more than 90% of the gross income of the foreign affiliate is from sales of property that deal at arm’s length with the foreign affiliate.

In some particular circumstances, a foreign affiliate engaged in electronic business may be subject to this rule if it earns an agency commission. This should not be a concern where the foreign affiliate’s sales are exclusively with non-arm’s length persons. However, it may be difficult to apply the first exception to a context of electronic business.

Under subparagraph 95(2)(b)(ii) of the Act, where a CFA provides services and the amount of consideration paid or payable therefor is deductible in computing the income from a business carried on in Canada, either by a person in relation to which the foreign affiliate is a CFA or by a person related to that person, the provision of services is deemed to be a separate business other than an active business carried on by the CFA. Consider a situation where a CFA engaged in electronic business charges a fee to its Canadian parent for technical assistance. In such a scenario, the technical fee will be considered a separate business whose income is income other than income from an active business.

In very general terms, paragraphs 95(2)(a.3) and (a.4) provide that income derived from indebtedness or lease obligations of persons resident in Canada will be deemed to be income from a separate business other than an active business (i.e., FAPI) unless more than 90 percent of the gross revenues from such activities is derived from arm’s-length non-residents. There is a concern, given that the definition of "lease obligation" "includes an obligation under an agreement that authorises the use of or the production of property including information and any other thing"50 that these deeming rules could apply to a CFA engaged in electronic business. Given that these provisions were designed to address dealing in certain financial instruments, it would not appear appropriate to apply them to electronic business from a tax policy perspective.

As demonstrated above, a number of issues will have to be considered in applying the FAPI regime to a Canadian-based e-business conducting part of its business through CFAs.

Electronic business has the potential of changing the nature and character of income that is generated in Canada and by CFAs. This result is not surprising as the underpinning of the FAPI regime was established in a pre-electronic era and, as a result, the provisions of the Act generally consider transactions involving physical goods and products as well as the provision of traditional services. Given that electronic business results in changing the nature of income and its delivery, it will be interesting to see the reaction of Canadian legislative authorities. One can contemplate two potential reactions. Canadian tax authorities could decide that existing legislation is adequate and develop a series of administrative positions to deal with electronic business. Alternatively, legislative amendments could be put forth that consider the very specific issues that electronic business has brought and will bring, to the way business is transacted. Canadian businesses and their advisors will be looking for very specific guidance with respect to these particular issues in the very short term. The fact that the Revenue Canada Advisory Committee has strongly endorsed the principle that it is very important that Canadian businesses be consulted to assist the government in providing appropriate solutions to these very difficult issues, is very welcome as it will likely result in appropriate legislative initiatives.

Tax Treaties

Income tax treaties are an important mechanism to deal with the various issues and conflicts that may arise where an enterprise conducts activities in various jurisdictions. A treaty sets out each contracting state's taxing prerogative, provides for income allocation between jurisdictions and assists contracting states in preventing tax avoidance and evasion. Our comments in this section do not consider the latter objective. We would note however that taxation authorities are increasingly focusing on this aspect when they are considering the impact of electronic business. In the Australian Report, the Australian Taxation Office noted that it would explore the possibility of examining the scope of exchanges of information under its treaties.51 This is also a recommendation of the Revenue Canada Advisory Committee which has indicated that: "Revenue Canada and the Department of Finance should seek to achieve more spontaneous exchanges of information with foreign tax authorities in order to ensure that Canadian residents properly report their foreign source income."52 Additionally, the OECD indicated during the Ottawa Conference that it would pursue the development on a new article to the Model Convention to provide for mutual assistance in the area of tax collection by treaty countries.53 This is also one of the OECD’s recommendations in its harmful tax practices report.54

Two concepts are drawn upon to effect an allocation of income between jurisdictions: (i) residence; and, (ii) source. The residence concept grants the primary taxing prerogative to the country in which the enterprise is resident. The source concept generally permits the country to tax the income that is sourced to its jurisdiction. When these two concepts are applied to business income and passive income, it may result in income being taxed in two jurisdictions, (such as where there is business income is attributable to a permanent establishment sis in the country in which the enterprise does not reside or where passive income is subject to a withholding tax in the source jurisdiction). In such situations, the country of residence will generally provide relief either through a credit system, an exemption system or a combination of these mechanisms.

As various governments, international bodies and practitioners have started to analyse the application of treaties to electronic business, it has become clear that applying the basic principles embodied in these international agreements (the notion of permanent establishment, the sourcing of income from the sale of a computer program over the Internet or income from services performed by persons physically present in different jurisdictions, for example) is challenging chiefly because these basic principles were developed in an era of bricks and mortar rather than the seamless digital world of electronic business. As we shall see, the international community, via the OECD, has started to outline the issues that have to be considered and has put forth some initial recommendations.

Income Characterisation55

The transformation of the manner in which information is delivered from physical media (book, magazine, newspaper, CD-ROM, diskette, video, picture or cassette) to digitised versions that can be transacted via the Internet or private networks, as well the delivery of financial and other services via such media, raises the fundamental question of whether the electronic delivery of the product or service generates business income (which in the case where a treaty applies will generally only be taxed in the foreign jurisdiction to the extent that there is a permanent establishment and the income is attributable to that permanent establishment) or royalty income subject to withholding at the treaty rate on the gross amount paid.

There appears to be a consensus emerging whereby if, from a business and economic perspective, the acquisition of the digital version of a product is fundamentally no different from the acquisition of the "hard copy" (newspapers and magazines) or other physical media (on diskette or CD-ROM with respect to software for example), then the income tax implications and results should be the same. In order to reflect this view, the OECD Committee on fiscal affairs has recommended changes to the commentary to the royalty article of the Model Convention.56 The change to the commentary of the royalty article for purposes of the Model Convention considers the unique characteristics of software and likely other digitised information and, more importantly, recognise that they can be distributed in digital or physical means. In order to determine the character of income earned, (business vs. royalty), the nature and extent of the rights transferred would be considered. In this regard, reference would be made to copyright law to distinguish between rights in the underlying copyright and rights usually conferred in the course of a sale of software. In situations where a transferee acquires only those rights necessary to operate the program (i.e., where essentially the transferee is in the same position as if he had acquired a diskette or CD-ROM of the software), the income that is derived from the sale would be considered business income. This position would be extended to situations where the rights are only marginally greater such as a site license. However, where the right to copy and distribute the copyright software is transferred (essentially a payment for a restrictive right), the payment stream that would be earned would be viewed as a royalty.57 The comments of the Committee on fiscal affairs are limited, at this time, to software. One can perhaps extrapolate these views to other situations where copyright exists (music, videos and photographs).

The initial changes that were announced by the OECD in this area are very encouraging as a very pragmatic approach has been taken that most certainly meets the tax neutrality objective that is being sought. Furthermore, a certain degree of certainty is achieved.

Recently, the OECD Technical Advisory Group ("TAG") that is considering income characterisation in the e-business context, issued a draft document outlining its preliminary views on the whether certain typical e-business type fall into the business income category (in which case the permanent establishment threshold is relevant) or royalty income.58 As we shall see, the level of consensus that appeared to have been achieved by the OECD in the area of income characterisation is much less than one could have hoped for when the various types of e-business revenue are commented upon.

The table below summarises the types of income and the positions that are being taken by the OECD member countries:


The table indicates that the OECD TAG has put forth "majority" and "minority" positions. In most instances, the majority position is that most of the income61 that can be earned in a e-business context is income from business, subject to the permanent establishment threshold. Notable exceptions to this characterisation are where there is a right to exploit copyright.62 Interestingly, the comments in the OECD TAG’s report indicated that some member countries are not in agreement with the changes to the royalty commentary that were discussed previously. For example, the countries that are part of the "minority position" clearly make a distinction based on the medium that is used for the information or code;63 this is clearly in contradiction with the principle of tax neutrality and the revised Article 12 commentary. Furthermore, the minority position views the income earned with respect to certain types of information delivery64 and short term licensing arrangements65 as being in the nature of royalty-type income rather than business income.

The fact that the OECD was not able to reach a consensus is a concern, as taxpayers that are using the new technologies will be faced with countries taking divergent positions, i.e., that the amounts paid are royalties (and therefore potentially subject to withholding taxes) by some countries whereas other countries will take the view that the profits are subject to a higher threshold, that of business income and the notion of permanent establishment. As previously noted, this could result in a cost to Canadian taxpayers transacting directly with non-residents as the foreign tax credit mechanism may only provide partial relief. Countries that are taking the minority view could also be creating a situation their residents will not have access to certain web-based services and products as businesses may not be willing to transact with jurisdictions that impose withholding taxes on income that is considered business profits by the jurisdiction of residence.

Permanent Establishment

As noted earlier, a taxpayer earning business income via operations in a foreign country with which Canada has an income tax convention, will be subject to tax in the foreign jurisdiction if the presence meets the permanent establishment (PE) threshold.

The definition of permanent establishment considers a factory, a branch, a place of management or some other physical presence.66 Electronic business is such that a physical presence as presently contemplated by existing treaties is likely not necessary or is significantly altered.

One of the more difficult issues with respect to e-business and international tax is what constitutes a PE? Does a Web page or a server represent a PE for an enterprise conducting its business electronically? The OECD’s Committee on fiscal affairs has issued two draft proposals defining PEs in an e-business context. The committee had tentatively concluded that a Web page, whether hosted on a local Internet Service Provider or not, cannot represent a PE. Furthermore, the committee has indicated that a web site cannot be considered an "agent" for treaty purposes due to the fact that it cannot be considered a person.

With respect to a server, the Committee on fiscal affairs has indicated that it may constitute a PE if it meets the requirement of being a fixed place of business. Hence for a server located in a given jurisdiction to be considered a PE, it will have to be located in a certain place for a sufficient amount of time. The Committee on fiscal affairs has also noted that the preparatory and auxiliary PE exception can also apply to a server. As one industry group has noted, the existence of a server should not, by itself, be viewed as creating a permanent establishment in a jurisdiction. Rather, the existence of a server should be considered, in light of other relevant facts and circumstances.67 This is also the view of Revenue Canada, which has indicated that it will review permanent establishment issues on a case-by-case basis rather than issue an interpretation bulletin.68

On March 3, 2000, the OECD issued a revised draft of proposed clarification of the commentary on article 5 of the OECD Model Convention dealing with the application of the permanent establishment definition in the context of electronic. The revised draft69 is much more extensive than the initial draft.

The revised draft discusses the various perspectives that member countries are putting forth. Unlike the initial draft, there is no attempt to outline a consensus view. The revised draft puts forth the position that a computer server can constitute a permanent establishment provided that it meets the requirement of being fixed. In this regard, the OECD does not provide any indications of the length of period of time necessary for a computer server to be considered fixed.

Some of the OECD member countries appear to be taking the view that a computer server can represent a self-contained automated permanent establishment. This perspective is supported by the existing model convention commentary in paragraph 10 that recognises that a business can be carried on through automatic equipment (gaming or vending machines) and German jurisprudence with respect to the use of a pipeline in the natural resource sector. Other OECD member countries are taking a different position, that a retailer conducting business using the Internet is carrying on its business not through the server, but through its bricks and mortar facilities (offices, warehouses, research facilities, etc.) in which its income-generating activities take place.

There is also discussion of whether there is a need for human intervention, i.e., for a computer server to constitute a fixed place of business is it necessary to have actual human intervention. In this regard, the revised draft discusses whether the human intervention has to occur at the location of the server or whether it can be done remotely (via a modem connection for e.g); whether the intervention has to be carried-out by employees of the enterprise or sub-contractors and what level of human intervention is necessary.

There are also some significant nuances in the positions put forth. For example, in the context of e-tailing, the draft report notes that "[t]he e-tailer's business is carried on, not through the server, but through the enterprise's offices, warehouses, research facilities and other locations in which its income-generating activities take place." On the other hand, the draft report also notes that: "Thus, only in exceptional cases do these countries see a possible permanent establishment for this category, for example if the relevant transaction (the conclusion of a contract, the payment and the delivery of the goods) is handled fully (automatically) by the server itself". These positions demonstrate that a server will could have different PE consequences depending upon whether it is a transactional server used for traditional tangible property transactions (i.e., sale of music CD's via the Internet) vs. a transactional server used in the sale of digital goods (music sold in digital "downloadable" format).

Lastly, the revised draft outlines some preliminary views on the application of the preparatory or auxiliary treaty exception to e-commerce scenarios. Although the draft indicates that this determination has to be done on a case-by-case basis, it has indicated that the following activities would generally be regarded as being preparatory or auxiliary in nature unless they represent core functions70 of the e-business:

  • Supplying information;
  • Gathering market data;
  • Advertising of goods and services;
  • Mirror servers used for efficiency and security purposes; and,
  • Providing a communications link between suppliers and customers.

The OECD has indicated that it anticipates finalising its views on this issue by September 2000. Given the divergent views expressed in the revised draft, it appears, at this time, that a consensus may be difficult to achieve.

Transfer pricing

Electronic business is a relatively recent development and is evolving. The complexity of the technical language and the different technological functions that are necessary to perform electronic business can be very closely integrated such that it may be difficult to evaluate its components. Additionally, increased global collaboration is facilitated by modern communication means and the increased interaction between entities creates opportunities to shift income between jurisdictions. These factors make the traditional transaction-by-transaction analysis71 as well as the allocation of income between jurisdictions difficult. As Canadian taxation authorities prefer transaction-based methods (especially comparable uncontrolled price) over profit-based methods72, this could pose significant problems for Canadian taxpayers especially in light of the requirement to have contemporaneous documentation and the related penalties for non-compliance with these requirements.73

The Revenue Canada Advisory Committee has identified the issues that it considers important vis-à-vis electronic commerce and transfer pricing:

  • identification of appropriate comparable uncontrolled prices;
  • establishment of appropriate economic return for each type of activity that can be identified;
  • allocation issues with respect to transactions, activities, profits and expenses to different jurisdictions; and
  • impact on Canadian tax base.74

The issues that are faced by a company engaged in electronic business with respect to transfer pricing that have been identified by taxation authorities are not unique75, they do however bring to the table some of the more complex transfer pricing questions that can be faced.

A necessary first step is to determine whether there are comparables available. In light of the fact that electronic business is a recent phenomenon, it may be very difficult to find reliable third party data. Additionally, the seamless nature of electronic commerce and the fact that the various risks and activities can be split in a multitude of ways, may make obtaining relevant data difficult. As a consequence, the information available will likely not meet the standard of comparability that is generally required.76 In such situations, the best source of information would likely be within the organisation itself. This would be the case where, for example, there has been an evolution from "traditional" commerce to electronic commerce. Additionally, we would note that the lack of available information may be short-lived. If the projections with respect to the quantum of electronic business are realised totally or even partially, it is likely that electronic business will become so widespread and the availability of comparables will increase commensurately.

There are various methods that can be used in order to develop and support an enterprise's transfer pricing methodology. At present, due to the previously enumerated reasons, the transactional approaches are viewed as being deficient with respect to electronic business. In this regard, it was noted during the 1997 OECD Turku conference that profit split methods would likely have wider application in the context of electronic commerce.77

At the Ottawa Conference, the OECD indicated that transactional methods are preferred but that in many instances they cannot be relied upon due to the fact that there is insufficient data on uncontrolled transactions, such data is not sufficiently reliable or due to the highly integrated nature of the business operation. In these situations, the transactional profit methods should be used.78

Interestingly, the Revenue Canada Advisory Committee has noted that Canadian taxpayers face significant difficulties arising from the inconsistent use and acceptance of the comparable profits method between Canada and the United States and that there is a need to resolve this inconsistency.79 Although the committee has not fully endorsed the use of profit-based methods, this may be an indication that Revenue Canada is receptive to the fact that, as Canada and the United States have differing positions with respect to transfer pricing methodologies, this increases the compliance burden for Canadian taxpayers.


As discussed previously, it is possible that, depending upon the consensus that emerges, corporations engaged in electronic business may find themselves with permanent establishments in the jurisdictions in which they have servers. In an electronic commerce environment, the use and creation of various intangibles will likely be significant. Should there be a proliferation of "electronic branches", the result could be surprising. As the OECD position is that intangibles are not recognised at the branch level (other than cost contributions) for transfer pricing purposes, this could give rise to a number of difficult issues. This particular issue was highlighted in the OECD Global Trading Paper as follows:

"With respect to intangible rights, the commentary to the OECD model convention states that "the rules concerning the relations between enterprises of the same group (e.g., payment of royalties …) cannot be applied in respect of the relations between parts of the same enterprise". This is because legal ownership of the intangible cannot be attributed to any particular part of the enterprise. Accordingly, the costs of creating intangible rights are regarded as attributable to all parts of the enterprise making use of the intangible. Therefore, the current view reflected in the OECD model convention and its commentary is that internal or intra-entity payments made by a permanent establishment in consideration for the use of intangibles (as opposed to a contribution towards the cost of developing an intangible) are not recognised."80 [emphasis added]

As in some instances, the value of the intangible could be significant to the income producing activity of the permanent establishment81, applying the above principles to an electronic commerce branch could result in significant levels of net income at the branch level which, at least from an economic perspective, would appear to be inappropriate. In this regard, it was noted in the Turku conference that:

"[t]he tax treatment of permanent establishments, where they can be identified in the context of electronic commerce, may be different from that of subsidiaries carrying similar activities. This raises the issue as to whether it is appropriate to treat permanent establishments and subsidiaries differently for tax purposes if they are undertaking economically similar activities."82

Hence, if the permanent establishment threshold is set at a relatively low level for electronic commerce, consideration will have to be given by the international community to the appropriate manner to consider intangibles. This is of course a very difficult issue as the use of intangibles will increase and it becomes even more difficult to quantify the effect of such assets where more than one type of them is involved.83

Global Trading

In its discussion of transfer pricing during the Turku conference, the OECD noted that the principles that were developed in the OECD Global Trading Paper could have application to electronic business.

Briefly, global trading consists of a financial institution's global customer business and its proprietary trading activities in physical securities. The characteristics of global trading that create issues similar to electronic business are the following:

  • Global trading is conducted internationally and around the clock. This results in situations where a dealer may delegate authority (trading or marketing) to affiliates (subsidiaries or branches).
  • The nature of global trading is such that it is conducted in an integrated manner and as a result, profit allocation is a challenge. This area is made somewhat more difficult by the fact that different jurisdictions may follow different income recognition approaches.
  • As capital is increasingly mobile, expected profits or losses can be transferred from one jurisdiction to another. Due to the complexity of financial products, the audit of such transactions is inherently difficult.84

The report considers whether advance pricing agreements ("APAs") could be one solution. Not surprisingly, the report concludes that APAs are probably inadequate as they are voluntary and it is likely that few taxpayers will consider them as a viable solution given the direct and indirect (disclosure of information to taxation authorities) costs of doing so.85 Taxpayers involved in electronic business would likely take a similar view.

The location where a transaction is recorded is noted as not necessarily being the appropriate indication of where the profit should be recorded.86 Similar concerns arise in an e-business context, for example, where server array technology is used.87

Based on the nature of global trading, it is felt that profit split methods are likely the most appropriate solution and that, given the broad divergence in the manner in which such activities are conducted, each situation would likely have to be dealt with on a case by case basis. In order for a profit split method to be used, two conditions must be met:

  • apportionment must be customary in the jurisdictions involved (i.e., domestic rules must provide for such a method); and
  • the results obtained from the apportionment must be in accordance with the arm's length principle of article 7 of the OECD Model Convention.88

The difficulties in applying such an approach are twofold. Firstly, with respect to the first condition, it is likely that many jurisdictions do not, at present, provide for apportionment methods and consequently, a concerted legislative effort by various countries would be necessary. Secondly, it may be difficult to conclude that the results obtained using an apportionment method result in an arm's length result.

With respect to the issues that have to be considered in allocating income and expenses, the report makes a number of interesting observations:

  • revenues should be allocated in the profit split?
  • how should activities that have a remote connection with the global trading activities share in the profits?
  • which should expenses be allocated (on the same basis of gross or net income, should a distinction be made between global and local expenses)?89

Similar questions will undoubtedly arise when analysing electronic commerce. The report then considers and comments on the various factors (volume, capital, location of management, trading risk, compensation paid to traders) that could be used to affect the profit split. The report indicates that the identification, choice and weighting of factors are always difficult and that each situation has to be considered on its own merits.90 The application of profit split methods to an electronic business will certainly be no less difficult.

As previously noted, the transfer pricing issues faced by an enterprise conducting electronic business are not new, they are however situations where more complex issues will be brought forth.

Taxpayers, tax advisers and taxation authorities will obtain experience with these issues in the next few years which will allow a clear consensus to emerge. Nonetheless, it is likely that taxpayers and their advisers will be looking to tax authorities to provide some guidelines in the near future. Further, it is hoped that countries will collaborate on these guidelines and their interpretation so as to minimise the situations where double taxation arises.

Recent US Developments

The US has in many respects lead the debate with respect to the taxation of the Internet. In 1998, Congress passed the Internet Tax Freedom Act ("ITFA") which imposed a three year moratorium on new or discriminatory taxes on the e-commerce and Internet access. The ITFA also called for the creation of a commission, the Advisory Commission on Electronic Commerce ("ACEC") that had a broad mandate to study the various taxes that e-commerce is subject to and provide its recommendations to Congress. The ACEC has completed its mandate and has prepared its final report.

The results of the ACEC are somewhat disappointing. The only significant recommendation (i.e., that received two-thirds support of the members and therefore represent recommendations to Congress) deals with tariffs. The ACEC has also made recommendations (i.e., positions that received majority support but fell short of the two-thirds threshold for Congressional recommendations) on the following:91

  • Extending the present moratorium for 5 years and expanding its ambit to prohibit taxation of sales of digitised goods and services and their non-digital counterparts;
  • Request clarification of nexus issues for state income tax and sales and use tax purposes;
  • Encourage uniform and simplified sales and use tax reform;
  • Extend the moratorium on Internet access taxes;
  • Elimination of certain taxes of telecommunication and Internet providers.

As the ACEC was not able to reach the required two thirds threshold to make recommendations to Congress, it does not appear that there will be any substantive changes in the near term in the US.


The policy debate with respect to taxes and e-business raise issues that are effectively twofold. The first major issue is the tax leakage that can occur when business is transacted electronically. The compliance and administrative concerns will undoubtedly have an impact on the policy debate. The second major issue deals with the jurisdiction to tax, and more specifically, whether the principles that are now in place are adequate for electronic commerce. At the present time, there does not appear to be broad support for developing a specific tax (or tax regime) for electronic commerce.92 Hence, the OECD and its member countries continue to explore the approach of using existing tax legislation and principles to tax electronic commerce and this is not likely to change in the medium term. Such an approach appears to be appropriate, especially in the area of transfer pricing, as the issues that have been identified are not really new or unique. They are however among the more complex as they deal with area of intangibles and, as e-business becomes more pervasive (i.e., "e-business is business"), the issues should become demystified. This effect, along with the increased data that will be available, should reduce the burden of dealing with these complex issues.

Ultimately, an international consensus regarding the determination of jurisdiction to tax income from electronic commerce and key related issues is essential. In wording toward an international consensus, tax administrations will have to consider their federal tax systems as well as subnational and sales tax issues. A single electronic transaction may potentially be subject to multiple taxes, both direct and indirect, imposed at both the national and subnational level.93 Taxation authorities must work together to develop a consistent cross-border approach. Only an approach that transcends national boundaries will ensure that electronic commerce and the associated technologies are not inhibited by various tax regimes. As we have seen in the review of the recent OECD TAG’s report on income characterisation and the last draft commentary on permanent establishments in a e-business context, the required consensus appears to be elusive at this time. Given the nature of the issues to be resolved, it is unlikely that a consensus will be reached in the near term. This will likely lead to an environment where uncertainly will exist. This situation will create some tax and sales tax pitfalls for some taxpayers and planning opportunities for others. Taxpayers who can optimise their income tax and sales tax position with respect to their electronic business activities will have a competitive edge in the digital era.

E-business presents threats and opportunities as companies compete in a changing world. The drive to improve business performance and increase efficiency will lead to new models of business based on radically changed processes. Tax costs will have to be managed to protect net benefits. There are tax pitfalls to be avoided and new tax planning challenges. Companies will have to judge risks and benefits in assessing proposals. It will not be easy weighing up the options to ensure proper reflection of tax technical issues and uncertainties; e-business commercial aspects; technological factors and particular industry trends. Adopting a holistic approach, using a technical framework and planning tools, will facilitate the development of a practical plan for managing the tax issues successfully.

The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.

While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers LLP advisor.

PricewaterhouseCoopers refers to the Canadian firm of PricewaterhouseCoopers LLP and other members of the worldwide PricewaterhouseCoopers organization.

* The author is a member of the Canada Customs and Revenue Agency’s Technical Advisory Group dealing with tax policy for e-commerce. The opinions expressed in this paper are the author’s.

The commercialisation of the Web is a recent event. Taxation authorities have issued numerous discussion papers with respect to the application of their tax legislation and tax treaty concepts to sales carried on using this new medium. To-date, there is no definitive guidance available and the taxation authorities of significant economies and the Organisation for Economic Co-operation and Development are conducting detailed studies of the issues. Hence, in analyzing the tax issues relevant to an e-business setting, existing taxation principles must be interpreted. Such analysis is difficult given that domestic and international tax rules (treaties) were conceived in a pre-electronic era. Additionally, it is possible that countries will, after having studied the impact of electronic commerce, develop policies and/or legislation that could significantly impact the comments in this paper.


1 For more detailed commentary on this issue see Pierre J. Bourgeois and Luc Blanchette, " The Internet, Electronic Commerce and Taxes-Some Reflections: Part 1," International Tax Planning feature, vol. 45 no. 5, Canadian Tax Journal, (Toronto, Canadian Tax Foundation, 1997), pp. 1127-49, pp. 1138-1143, (hereinafter " Part 1").

2 Revenue Canada is now known as Canada Customs and Revenue Agency. Given that Revenue Canada is more familiar to most readers, we will use the "old" name in this paper.

3 Canada, Minister of National Revenue, Electronic Commerce and Canada's Tax Administration – A Report to the Minister of National Revenue from the Minister's Advisory Committee on Electronic Commerce, April 30, 1998 (hereinafter "Revenue Canada Advisory Committee"), at section 1.2.1, Figure 1.

4 Paragraph 2(3)(b) of the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended, herein referred to as "the Act".

5 Income Tax Regulations, Consolidated Regulations of Canada, c. 945, as amended, herein referred to as "Regulation".

6 In this section, we ignore the impact of treaties.

7 For a very detailed analysis of the notion of carrying on a business in a Canadian context, see Constantine A. Kyres, "Carrying On a Business in Canada", vol. 43, no. 5, Canadian Tax Journal, (Toronto: Canadian Tax Foundation, 1995), pp. 1629-71.

8 Paragraphs 253(a) and 253(b) of the Act.

9 Charles T. Ormrod, "Income Tax Issues Arising out of Electronic Commerce", Report of the Proceedings of the Forty-Ninth Tax Conference, 1997 Conference Report, (Toronto: Canadian Tax Foundation, 1998), pp. 51:1-51, p. 51:6. See also discussion, infra, under the heading Investment Income definition.

10 Ibid.

11 Ibid, at pp. 51:7-51:8.

12 Organisation for Economic Co-operation and Development, Model Tax Convention on Income and on Capital (Paris: OECD) (looseleaf) (herein referred to as "the OECD Model Convention"), commentary on article 5 at paragraph 10.

13 Quebec Pharmaceutical Association v. T. Eaton Co. Ltd. 56 CCC 172. and London Life Assurance Co. v. R. [1990] CTC 43. See detailed discussion in Ormrod, supra note 9, at p. 51:7-9.

14 Revenue Canada Advisory Committee, supra note 3, section

15 Ibid.

16 Sudden Valley v. MNR [1976] CTC 297 (FCTD), aff'd. [1976] 775 CTC (FCA).

17 For a more detailed analysis, see Pierre J. Bourgeois and Luc Blanchette, " The Internet, Electronic Commerce and Taxes-Some Reflections: Part 2," International Tax Planning feature vol. 45 no. 6, Canadian Tax Journal, (Toronto, Canadian Tax Foundation, 1997), pp. 1379-1415, pp. 1384-5. (hereinafter " Part 2").

18 For a more detailed analysis, see Pierre J. Bourgeois and Luc Blanchette, " The Internet, Electronic Commerce and Taxes-Some Reflections: Part 2," International Tax Planning feature vol. 45 no. 6, Canadian Tax Journal, (Toronto, Canadian Tax Foundation, 1997), pp. 1379-1415, pp. 1384-5. (hereinafter " Part 2").

19 Ibid.

20 Pursuant to paragraph 153(1)(g) of the Act and Regulation 105. Apart from Québec, there is no requirement to withhold an amount for provincial purposes. The Québec Taxation Act L.R.Q., c. I-3, as amended, provides for a 9% withholding tax. See section 1015 and the related regulation, 1015R9.

21 Due to the nature of electronic business, it is unlikely that a waiver could be processed on a timely basis.

22 Revenue Canada Advisory Committee, supra note 3, section

23 Ibid.

24 Consider the example of the US engineer providing services with respect to the year 2000 bug which we discussed previously. Assume that the engineer is based in Seattle. For one contract with a Canadian customer, all of the work is done from Seattle. In this situation, the appropriate view would appear to be that as no services were provided in Canada, no Regulation 105 withholdings are required. Assume that the engineer spends a week in Vancouver visiting friends and during that time she does some work for a Canadian based client remotely using her laptop. In this scenario, the conclusion would be different as the services were physically performed in Canada and Regulation 105 withholdings would be required. The consumer of the service (the Canadian corporation) arguably has no way of knowing from where the services were provided in these scenarios.

25 Revenue Canada Advisory Committee, supra note 3, section

26 Revenue Canada Technical Interpretation 5-3857 dated November 20, 1987.

27 Revenue Canada Advisory Committee, supra note 3, section

28 For a detailed discussion of the current views being put forth with respect to the characterization of various types of e-business type income, see discussion below under the heading "Income Characterization".

29 Ormrod, supra note 9, at pp. 51:13-14. Where the address suffix is either .com or .net, it is virtually impossible to determine the country of origin.

30 Revenue Canada Advisory Committee, supra note 3, at section 4.3.1. The committee gives the example of interest that is grossed-up for Canadian withholding taxes.

31 Ormrod, supra note 9.

32 Revenue Canada Technical Interpretation 9613820, April 30, 1996.

33 Part 2, supra note 17, p. 1399.

34 Consider for example, the recent protocols entered into with the United States, France and the Netherlands.

35 Revenue Canada Advisory Committee Report, supra note 3, at section The committee refers specifically to electronic subscriptions and similar transactions. The scope of the type of products considered by the committee appears to be somewhat narrower than that considered by the OECD in its recommendations during the Turku conference. In discussions with members of the committee, it was indicated that it was their intention to recommend full support with the Turku conference recommendations.

36 Subsection 20(12) of the Act.

37 Revenue Canada Advisory Committee, supra note 3, section 4.2.5.

38 The discussion below is a summary of the issues that have been raised by Ormrod, supra note 9, 51:7-8 and Part 2, supra note 17, 1405-8.

39 Per the definition of active business at subsection 95(1) of the Act.

40 Ormrod, supra note 9. To-date, we have not encountered any situations where the process is fully automated. Hence, this concern is likely not relevant at the present time. However, with the level and velocity of technological change, one can foresee that such a situation could arise in the future.

41 Subsection 125(7) of the Act. The Revenue Canada Advisory Committee has made comments with respect to the application of the specified investment business definition to electronic business. See Revenue Canada Advisory Committee, supra note 3, section The comments effectively mirror those made with respect to the international tax issues.

42 Revenue Canada, Interpretation Bulletin IT-73R5 - The Small Business Deduction, February 5, 1997, at paragraph 14.

43 Revenue Canada Technical Interpretation 972215, September 26, 1997. A similar comment was made with respect to royalties in general in Revenue Canada Technical Interpretation 9520295, August 8, 1995.

44 Revenue Canada Technical Interpretation 9507915, September 14, 1997.

45 Per the definition of "investment business" at subsection 95(1) of the Act.

46 Revenue Canada Advisory Committee, supra note 3, section

47 Ibid., section

48 Query how to apply the concepts of "manufactured, produced, grown or processed" in an electronic business environment? Can digitised products be considered manufactured, produced or processed in Canada?

49 In the context of electronic business operations, business can be carried on in various places and consequently, it may difficult to meet the "principally carried" on condition.

50 Subsection 95(1) of the Act.

51 Australian Taxation Office, Tax and the Internet: Discussion Report of the Australian Taxation Office Electronic Commerce Project, Canberra: Australian Government Publishing Service, August, 1997, (hereinafter the "Australian Report), paragraph 7.7.7.

52 Revenue Canada Advisory Committee, supra note 3, at For a detailed discussion of administration and collection issues see Part 1, supra note 1, 1142-1148.

53 Organisation for Economic Development and Co-operation, Electronic Commerce: A Discussion Paper on Taxation Issues, Paris: OECD, 1998, (hereinafter the "Ottawa Discussion Paper"), paragraph 57, p. 29.

54 Organisation for Economic Co-operation and Development, "Harmful Tax Competition An Emerging Global Issue", (Paris: OECD, 1998), recommendation 14, at page 51.

55 For a more detailed analysis of this question, see Part 2, supra note 17, 1396-1400.

56 Organisation for Economic Co-operation and Development, Commentary on Article 12 concerning Software (Paris, OECD, 1998).

57 The approach taken is very similar conceptually to the one that has been legislated in the US with respect to the characterization of software. For an excellent discussion of the US legislation, see C. Andrew McAskile, "The Characterization of Computer Software: Canada, the United States, and the OECD Model Tax Convention", International Tax Planning feature, vol. 47, no. 6, Canadian Tax Journal, (Toronto: Canadian Tax Foundation, 1999), pp. 1505-1524.

58 Organisation for Economic Co-operation and Development, Treaty Characterization Issues Arising From Electronic Commerce, (Paris: OCED, 2000).

59 Items shown in light grey denote revenue types for which the positions of the majority and minority differ.

60 Only if electronic downloading and copying of technical documentation on a non-temporary medium is a substantial part of the consideration for the payment. If information downloaded solely for viewing purposes, the minority position is the same as the majority position.

61 Twenty-one of the twenty-six revenue types that were analysed were considered to be business profits by the members of the majority position.

62 See revenue types 3 and 25.

63 See revenue types 2, 4 and 5 in the table.

64 See revenue types 14, 15 and 16 in the table.

65 See revenue types 8, 9 and 10 in the table. This would have a very important impact on ASP providers especially in an open operating system architecture environment such as Linux.

66 See for example, OECD Model Convention, supra note 12, article 7.

67 Tax Executives Institute (Canadian branch), TEI provides comments on Electronic Commerce and Canada’s Tax Administration letter to the Honourable Herb Dhaliwal dated September 17, 1998, reproduced by Tax Analysts (on-line database), September 17, 1998, 98 TNI 291-02.

68 Canada, Minister of National Revenue, Electronic Commerce and Canada's Tax Administration – A Response by the Minister of National Revenue to his Advisory Committee's Report on Electronic Commerce, Ottawa, Minister of National Revenue, September, 1998, (hereinafter "Revenue Canada Response"), section

69 Organisation for Economic Co-operation and Development, The Application of the Permanent Establishment Definition in the Context of Electronic Commerce: Proposed Clarification of the Commentary on Article 5 of the OECD Model Tax Convention – Revised Draft for Comments, (Paris: OECD, 2000).

70 An example where some of the activities that are a priori considered preparatory and auxiliary would be considered core functions could be, for example, an auction site.

71 Organisation for Economic Co-operation and Development, Electronic Commerce: The Challenges to Tax Authorities and Taxpayers: An Informal Discusssion Between Business and Government, Paris, OECD, 1997, (hereinafter the "OECD Turku Report") at paragraph 123.

72 Revenue Canada Advisory Committee, supra note 3, at section

73 For a detailed discussion of these rules, see François Vincent and Ian M. Freedman, "Transfer Pricing in Canada: The Arm’s Length Principle and the New Rules", Canadian Tax Journal, vol. 45 no. 6, (Toronto, Canadian Tax Foundation, 1997), 1213-1242.

74 Revenue Canada Advisory Committee, supra note 3, at section

75 For example, similar issues are faced by technology companies as well as financial institutions that deal in global trading. The application of the OECD’s analysis on transfer pricing and global trading is discussed further below.

76 See OECD Turku Report, supra note 71, at paragraph 125.

77 Ibid., at paragraph 134.

78 Ottawa Discussion Paper, supra note 53, paragraph 56, pp. 28-29.

79 Revenue Canada Advisory Committee, supra note 3, at section

80 Organisation for Economic Co-operation and Development, Taxation of Global Trading of Financial Instruments: A Discussion Draft, February 17, 1997, 14 Tax Notes International, 597-623, (hereinafter the "OECD Global Trading Report") at paragraph 138.

81 In a typical e-business scenario, the intangibles relate to, inter alia, the "brand", customer lists and data and process delivery.

82 OECD Turku Report, supra note 71, at paragraph 131. Based on Cudd Pressure Control Inc. v. Canada [1996] 2 CTC 2382 (TCC), aff’d. by Cudd v. R. 1998 CarswelNat 1933 (FCA), this view with respect to intangibles would likely be taken by Canadian taxation authorities.

83 OECD Turku Report, supra note 71, at paragraph 132.

84 OECD Global Trading Report, supra note 80, paragraphs 95-97.

85 Ibid., paragraphs 103-107.

86 Ibid., paragraph 133.

87 Server array technology is used in situations where the digital information is available on multiple servers. In such a situation, where a download occurs, the user is directed to the server with the least traffic in order to minimize download time. As noted in the discussion, infra, regarding permanent establishments, such a type of server activity would generally not represent a permanent establishment due to the preparatory and auxiliary exception.

88 OECD Global Trading Report, supra note 80, paragraph 134.

89 Ibid., paragraphs 156-160.

90 Ibid., paragraph 195.

91 Advisory Commission on Electronic Commerce, Report to Congress, April 2000. Available at

92 For a contrary view and an excellent analysis of the source issues relevant to e-commerce, see Jinyan Li, "Rethinking Canada’s Source Rules in the Age of Electronic Commerce: Part 2", vol. 47, no. 6, Canadian Tax Journal, (Toronto: Canadian Tax Foundation, 1999), pp. 1411-1478.

93 One of the groups that presented a paper to the Advisory Committee on Electronic Commerce in the US noted that a company transacting with the Internet could be subject to over 40,000 taxes and levies.

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