UK: Direct Tax Considerations Of Offshore E-Commerce

Last Updated: 27 March 2001
Article by Miles Dean

Existing Principles

Factors such as source and character of income, and whether a permanent establishment exists, are the principles of international taxation and must still apply to e-commerce in the absence of other specific laws. It is relatively straightforward to ascertain whether a permanent establishment has been created or whether a company is deemed to be trading within a given country if the business in question is a traditional trading entity. It is not so easy, however, for tax authorities to establish where the tax nexus of a cyber company lies. The existing concepts such as management and control, permanent establishments etc have been confused to the extent that it has become increasingly more difficult to pinpoint the tax "nexus" of a particular business operating, in whole or part, across the world-wide web. Under existing principles taxing rights will be established using the source of the income as the basis, income is thus allocated to particular countries when a business has a substantial presence there, i.e. a permanent establishment.

The benefit of e-commerce is that a business offering services such as gambling and computer software products may be able to operate just as well via the Internet without the need to have a substantial presence in any one country. Even businesses that sell physical products such as CD’s and books are able to benefit and reach a massive audience relatively easily without having the overheads normally associated with such as business. However, this benefit is also a huge problem for tax administrations because a business conducting its affairs over the internet may well be able to function normally without ever creating a substantial presence in a particular country, the result of which is that a permanent establishment is not created, thus denying taxing rights under a double tax treaty.

The Concept Of Trading With And Trading Within

The concept of trading with and trading within a country is equally important and relevant to Internet transactions. Where a foreign company trades within the UK for example, the Inland Revenue are able to assess the profits from that trade to income tax. If however the trade is with the UK then no such power exists. It is a well-established principle of common law that merely soliciting orders by advertising does not amount to trading within; it is therefore possible for a computer server located in the UK to advertise products without it creating a taxable presence.

Caution must be exercised lest the basic principles of international tax are forgotten. E-commerce can and has been likened to mail order, and at the heart of any transaction is the contract. For a legally binding contract to exist there must be three elements: offer, acceptance and consideration, and without these constituent parts a contract cannot exist. Not only is it vital that they exist but where they actually take place is of fundamental importance and the following questions may be asked:

  • Where is the offer and where is the acceptance?
  • Is the customer accepting an offer, which, if offered repeatedly in a particular country, could create a trade, and only the existence of a double tax treaty could afford protection in the absence of a permanent establishment?

If a company is to be deemed trading within the UK it is the formation of the contract which is the important factor, and in particular where the contract is executed. In the case of e-commerce transactions (assuming that e-mail is an instantaneous method of communication, in the same way as telex is) the contract will be formed in the place where notification of the acceptance is received. Thus, where a CD for example is advertised on a website and a consumer, via the Internet places an order for the CD (the offer) the contract is formed when the customer receives notice of acceptance from the e-business. This being the case, provided the server which sends confirmation of acceptance is located in a tax free jurisdiction and has not created a permanent establishment in the web-users country of residence, it is very unlikely for there to be a threat to taxation.

Transfer Pricing

Another aspect which is in need of clarification is that of Transfer Pricing, featured in a separate IFS Tax Briefing on the subject. The use of Intranets, that is inter-company trading networks, is becoming a common feature in large multinational companies and so the potential for transfer pricing arrangements becomes apparent. Again, opinion is divided as to how transfer prices should be dealt with in the context of the internet, the debate centering around which method to use to adjust the prices since there will more often than not rarely be any comparable method to choose from.

One major problem with the new technology is tracing the source of the income since an e-commerce business may have mirror sites in several different locations around the world and will therefore become extremely difficult to regulate. To this end it would not be surprising to see an increase in the exchange of information powers Revenue authorities are granted to assist them in tax collection and audit enquiries.

Tax Treaties

Tax treaties will in certain circumstances play a large part in successful low tax e-commerce trading, and the following example explains what I mean. If a company incorporated in Panama for example (which does not have a network of double tax treaties), is deemed by virtue of its e-commerce activities to be trading within say France, then its profits will be subject to French tax. However, where for instance the computer server which initiates and concludes the Internet sales is resident in Holland, which has concluded a tax treaty with France, it is unlikely that the profits generated will be subject to French tax. The reason for this is because in the absence of a permanent establishment in France the taxing rights belong solely to the Netherlands as a result of the treaty. Therefore, in many e-commerce situations it is unlikely that a threat to tax in the source country would arise since the necessary elements of a permanent establishment would not exist.

The Netherlands has suggested that a moratorium be imposed on the introduction of tax regimes for e-commerce until the OECD has made its recommendations, one of which may be to include computer equipment in the definition of a permanent establishment, which would obviously have far reaching effects. The US Treasury also issued some form of guideline in a Treasury Paper where it was stated that a computer does not constitute a permanent establishment but is more like a warehouse. The Australian Tax Office takes the opposite view and both Germany and Austria have not ruled out the existence of a permanent establishment where computers are concerned.

One thing is for certain: that the OECD in conjunction with the US perhaps, need to formulise a standard Article to be used in all double tax treaties if the problems in allocating taxing rights in e-commerce transactions are to be overcome.

Does A Server Create A Permanent Establishment?

Would a server based in the US which was owned by a Jersey company create a taxable presence in the US for that Jersey company. One of the main reasons why music is yet to be fully available for download off the Internet (apart from the copyright issues) is that download times are quite slow. Bandwidth issues are less of a problem in the US, so it may be preferable to have a server in the US from which software or games for example can be downloaded rather than from a Jersey server which may be restricted by available bandwidth.

Generally, a non-US company is taxable in the United States on US sales of inventory in two cases:

  1. If the company is a resident of a country with which the United States has a tax treaty (this includes all of the major trading partners of the United States), the company must have a "permanent establishment" (p/e) in the United States before it is subject to US tax. This usually means the company must have a place of business in the United States, or must have agents in the United States.
  2. If the country is not a resident of a "treaty" country, sales are taxable in the US if the sales are "effectively connected with the conduct of a US trade or business." Foreign companies are also taxable in the United States on "non-business" income, whether or not there is a permanent establishment.

For instance, foreign companies earning royalties in the United States are subject to tax in the United States regardless of whether there is a permanent establishment in the United States.

US Treaties

A typical US treaty excludes from p/e status the use of facilities or maintaining a stock of goods or merchandise solely for the purpose of storage, display, or delivery of the goods or merchandise; maintaining a stock of goods solely for the purpose of processing by another enterprise; or maintaining a fixed place of business solely to carry on any other activity of a "preparatory or auxiliary" character.

US treaties also generally provide that an enterprise will not be deemed to have a p/e as a result of carrying on a business through brokers, general commission agents, or other independent agents acting in the ordinary course of their business. Conversely, a dependent agent who has, and who habitually exercises, the authority to conclude contracts in the name of an enterprise will create a p/e for the enterprise on whose behalf he is acting.

Whether a foreign seller has a US p/e as a result of sales activities generated by or through a US depends on a number of issues such as:

  • whether the location of a home page, on a US based webserver is a "particular site" and, with sufficient permanence to be a fixed place of business under a treaty
  • whether the website can be considered as an exempt display of goods?
  • whether a home page is the tax equivalent of a mail order catalogue or, whether it is analogous with an entire US based sales outlet
  • whether the standard for a website should be greater than, equal to, or less than that for a physical catalogue mailed into the US?
  • whether having sales approval and other administrative functions such as credit checks, outside the US is sufficient to avoid a p/e being formed?

If for example the Jersey company has its web pages hosted by a US based server which allows the browser to view the goods and also place orders then it could be argued that a fixed place of business exists. If the Jersey company has no other physical presence in the US, i.e. there are no individuals making decisions about the business of the company in the US it could be argued that the webserver is not a fixed place of business irrespective of the fact that sales-related software is located in the US.

The Commentaries in paragraph 10 to Article 5(4) of the 1992 OECD Model Convention state that a p/e may exist if the business of the enterprise is carried on "mainly through automatic equipment," with the activities of personnel restricted to setting up, operating, controlling, and maintaining such equipment. However, this relates more to gaming and vending machines (which would require direct interaction with the machine) rather than Internet-based transactions which generally require limited user input.

A major use of the Internet is, and will continue to be, the sale of digitised products since these are capable of being downloaded onto the browsers own PC. The fact that telecommunications are becoming more advanced means that download times are getting faster by the day which means more users will turn to web-based software sales rather than physical delivery of a CD-ROM, for example (many software companies now do not publish manuals that accompany software but make these available on their internet sites, such is the growing acceptance of digitised products). Taking the sale of digitised software as an example the server from which the product is downloaded may be fully capable of accepting orders, "delivering" the software and issuing an invoice or receipt. Even in this case it is still unclear that the seller would have a p/e in the country where the server is located, because the server might be considered to be no more than an (exempt) instrument for delivery.

Effectively Connected Income

When the US does not have a tax treaty with a foreign country, the p/e concept is replaced by the domestic law concept of "engaged in the conduct of a US trade or business" under Sections 871(b) and 882. A non-resident alien or a foreign corporation will be taxable at the graduated US tax rate on its net income that is "effectively connected" with its US trade or business.

It is possible that an enterprise that is located in a country with which the US has no tax treaty and that engages a US service provider to place advertisements on the Internet and to handle orders and credit checks may be deemed to have a US trade or business, even if the US provider is an independent agent. Such an argument might be advanced based on several old court cases holding that a US trade or business exists when a foreign enterprise is carrying on activities in the US for the production of income where the activities are active, substantial, and continuous or regular.

The Code focuses on whether the seller of tangible personal property is engaged in a US trade or business. Sections 871(b) and 882(a) impose tax on income that is "effectively connected" with a trade or business within the US. If the foreign seller is not engaged in a US trade or business, its sale into the US via the Internet will not attract US tax, regardless of where title passes. Therefore, if a foreign seller has its website hosted by a US-based webserver will this cause the seller to be engaged in a US trade or business?

Selling goods and services over the internet can be, and has been likened to mail order in many respects but should the standard for a website be greater than, equal to, or less than that for a physical catalogue mailed into the US? In general terms whether a foreign seller is engaged in a trade or business in the US is a question of fact, depending on the continuity and regularity of its economic activities. The courts have held that where goods are regularly purchased and sold in the US, the seller is engaged in a trade or business in the US. By way of contrast an isolated sale, for example, should not amount to a US trade or business. In Continental Trading Inc., 265 F.2d 40 (CA-9, 1959), the court held, taking into account the companies activities as a whole, the US sales were "casual or incidental transactions" and as such did not constitute a trade or business.

Under Section 864(c) effectively connected income includes income derived from a sale or exchange of inventory that takes place outside of the US if it is attributable to an office or other fixed place of business within the US. The income will be attributable to a US office or other fixed place of business only if that office or fixed place of business

  1. is a material factor in the production of such income and
  2. regularly carries on activities of the type from which that income is derived.

For this purpose, a store or sales outlet of an independent agent is not considered an office or other fixed place of business of a foreign seller, irrespective of whether such agent has authority to negotiate and conclude contracts in the name of the foreign seller, and regularly exercises that authority, or maintains a stock of goods from which he regularly fills orders on behalf of his principal.

Reg. 1.864-7(d) provides that the office or other fixed place of business of an agent who is not an independent agent is disregarded only if such agent:

  1. does not have or does not regularly exercise the authority to negotiate and conclude contracts in the name of the non-resident alien or
  2. does not have a stock of merchandise belonging to the non-resident alien from which orders are regularly filled on behalf of such alien.

Under these standards, it should be possible to make a strong argument that a properly structured foreign-source sale over the Internet does not give rise to effectively connected income.

Solicitation Activity.

Using the same example of a foreign company selling goods over the internet and having its website hosted by a US-based webserver does this constitute solicitation activities? If so, is solicitation alone sufficient to cause the foreign seller to be engaged in a trade or business in the US? There are a number of cases that may be referred to in this respect:

Piedras Negras Broadcasting Co., 43 BTA 297 (1941)

A foreign corporation that executed contracts abroad relating to broadcasts designed to be heard by listeners in the US was not subject to US income tax on the income from those contracts. It was held by the Fifth Circuit that the taxpayer's source of income was outside the US, however the Board of Tax Appeals also found that the foreign corporation was not engaged in a trade or business in the US. Previous case law had held that the mere solicitation of business, where goods were shipped from outside the jurisdiction, was not sufficient to create a tax nexus. The Board concluded that if a sale of merchandise or a solicitation of a sale by a foreign publisher was not the transaction of business in a State, then broadcasting could not be considered as creating a tax nexus. In this particular case it should be noted that the taxpayer had no physical presence in the US.

Northwestern States Portland Cement Co. v. Minnesota, 358 US. 450 (1959).

The taxpayer solicited orders and had a physical presence in the form of an office in the State. The Court held that these two elements created a nexus and allowed the state to impose an income tax. Pursuant to this case there were several instances where State courts held that mere solicitation was sufficient contact to allow the imposition of tax. These cases prompted Congress to act and by passing P.L. 86-672, section 101 no State now has the power to tax the net income derived within that State by a non-resident if the only business within the State during the tax year is the solicitation of orders for sales of tangible personal property where the order is approved outside that State.

State Taxes

Will a home page situated on a computer server located in the US. cause the seller to be engaged in a trade or business in the US?

Quill Corp. v. North Dakota, 504 US. 298 (1992)

This is a recent and well reported case in which the Court held that it was unconstitutional for North Dakota to impose State "use tax" on an out of state mail order company that had no physical presence in the State itself. Interestingly the taxpayer did have licensed software in the State which allowed a customer direct access to the taxpayers stocklist and price guide, and this was held to be insufficient to create a tax nexus. Whilst this is not an e-commerce case it is unlikely that if it were the Court would have found any differently on the basis that an internet transaction could well have even less contact with the State

Conclusion

It would seem that in order to be certain that a p/e will not be created, or that the income is not effectively connected with the US, the foreign company should locate all the sales software on servers located outside the US. If effective, it would seem that the US will not be able to tax income from these sales under the current law. Similarly, the use by the Jersey company of a mirror server located outside the US may make international sales difficult or impossible for the US to reach for tax purposes. Indeed, if a buyer cannot tell where the seller's server is located, this may prevent the tax authorities from effectively auditing international Internet sales activities.

Nevertheless, if the sales software is located on the Jersey servers and hence outside the US, there is still a possibility that the US would try to assess the company if the "warehouse" site was located on a US server. Facts and circumstances dictate how the IRS would determine whether there is a p/e in the US, or whether the sales income is effectively connected with a US presence.

There have been commentators who believe that e-mail acceptances of orders over the Internet are analogous to posting an acceptance in a letterbox, where the contract is deemed to be concluded where posting takes place. However, with the advent of e-commerce, it would seem impossible to take this line of argument to permit countries all over the world to carve up say the Jersey company’s profits to be taxed in each country. A system similar to VAT may certainly be introduced where each transaction carries a tax charge, although implementing and policing these transactions may prove difficult.

In the meantime, in the above scenario, it is suggested that e-commerce be taxed as follows:

  1. If there is only one server in Jersey where both solicitation of goods and services and acceptance of orders takes place, the sole taxing authority should be Jersey.
  2. If there is also a server in the US which displays the products of a company, but all orders are sent to the Jersey server which processes them as to credit card checking and acceptance of all orders, then the US courts have established that mere solicitation does not amount to the conduct of a trade or business in the US. The absence of a double tax treaty between Jersey and the US would not appear to jeopardise this position, although clearly the permanent establishment clause of a double tax treaty provides additional protection against US taxation.
  3. If the US server permits downloading of digitised product, which may be done for bandwidth preservation of the Jersey based transactions, it is suggested that this may constitute such an important part of the total sales process that, if done with regularity, a US trade or business will be created.
  4. If the US server permits sales to take place thereon, then there definitely exists a US trade or business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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