United Nations ST/SG/AC.8/2001/L.3

Secretariat Distr.: Limited 30 August 2001 English Original: French

01-40063 (E) 040901

*0140063**0140063**0140063**0140063*

Ad Hoc Group of Experts on International Cooperation in Tax Matters Tenth meeting Geneva, 10-14 September 2001

Tax considerations for electronic-commerce companies*

“Where does the Internet rank with respect to strategic priorities? It’s number 1, 2, 3 and 4.”

Jack Welch, PDG, General Electric

Introduction**

The adoption of electronic commerce, and in some cases the changeover to an “electronic” company, are the great economic challenges of the new millennium. This situation has caused tax administrations everywhere to examine their fiscal policies and their administrative and collection procedures. The first detailed commentaries on these various issues came in a consultation document jointly prepared by Australia, Canada and the United States in 1996.1 Since then, each of

* This document was prepared by Pierre Bourgeois, member of the Advisory Committee of Revenue Canada and consultant to the Department of Economic and Social Affairs of the United Nations Secretariat. The views expressed are the author and do not necessarily reflect those of the United Nations.

** The author wishes to thank Me Pierre Gonthier, Director, Taxation Services, PricewaterhouseCoopers, for his cooperation in updating this text.

1 Organisation for Cooperation and Development (OECD), Implications of the Communications Revolution for Tax Policy and Administration, commentaries sent to OECD by Australia, Canada and the United States (Paris, OECD, 1996) (referred to below as “the OECD joint discussion document”).

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these countries and Japan has published other detailed commentaries.2 3 International organizations such as the Organisation for Cooperation and Development (OECD) and the Commission of the European Communities have also already submitted detailed commentaries.4 At the OECD ministerial conference on electronic commerce held at Ottawa in 1998, taxation was one of the aspects discussed.5 Despite the efforts of the various tax authorities, guidelines on basic issues, permanent establishment and income characterization remain uncertain.

2 Their views as of the preparation of this article may be found in the following documents:

CANADA, Ministry of National Revenue, Le commerce électronique et l’adminstration fiscal du Canada — Un rapport au Ministre du revenu national présenté par le Comité consultatif du Ministre sur le commerce électronique, Ottowa, Ministry of National Revenue, 30 April 1998 (referred to below as “the Revenue Canada Advisory Committee”), CANADA, Ministry of National Revenue, Le commerce électronique et l’administration fiscale du Canada — National Revenue reply to the report of its Advisory Committee on Electronic Commerce, Ottowa, Ministry of National Revenue, September 1998 (referred to below as “the Revenue Canada reply”); UNITED STATES, Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications of Global Electronic Commerce, Washington DC, Department of the Treasury, November 1966 (referred to below as “the US Treasury document”), available on the Treasury Department’s Internet home www.ustreas.gov/treasury/tax/html. Some parts of the document have been reproduced in Bruce COHEN, “Selected Tax Implications of Global Electronic Commerce” in 1996 Conference Report, Toronto, Canadian Tax Foundation, 1997, pp. 38:1-19; UNITED STATES, THE WHITE HOUSE, A Framework for Global Electronic Commerce, Washington DC, The White House, 1 July 1997, available on the Internet at www.whitehouse.gov/WH/New/Commerce; AUSTRALIAN TAXATION OFFICE, Tax and the Internet: Second report — December 1999, Second report of the Australian Taxation Office Electronic Commerce Project Team on the opportunities and challenges of electronic commerce for tax administration, Canberra, Australian Government Publishing Service, December 1999 (referred to below as “the ATO report”), available on the Internet at www.ato.gov.au/ecp; AUSTRALIAN TAXATION OFFICE, Tax and the Internet: Discussion Report of the ATO Electronic Commerce Project, Canberra, Australian Government Publishing Service, August 1997 (referred to below as “the 1997 ATO report”), available on the Internet at www.ato.gov.au/ content/businesses/downloads/ECOM/P1.rtf. A summary of the Japanese Government’s comments can be found in paragraph 3.2.4 of the report of the Revenue Canada Advisory Committee. See also chapter 3 of that report, which contains a summary of Canadian and foreign initiatives in the field of electronic commerce. For Revenue Canada’s viewpoint, see Walter SZYC, “Revenue Canada’s Perspective on Electronic Commerce” in the 1997 Conference report, Toronto, Canadian Tax Foundation, 1998, pp. 53:1-14. Readers should be advised that the URLs given in this text may not always contain the document referred to, as web sites may have been updated.

3 OECD, Commerce électronique: Les défis pour les autorités fiscales et les contribuables: Discussions informelles entre le secteur privé et les gouvernements, Paris, OECD, 1997 (referred to below as “the OECD Turku report”), para. 136. This document was submitted to the conference on electronic commerce held at Turku in November 1997 and sets out the views of the OECD Fiscal Affairs Committee at that time.

4 OECD, Commerce électronique: Opportunités et défis pour les gouvernements, Paris, OECD, 1997; “Taxation of Global Trading of Financial Instruments: A Discussion Draft”, 17 February 197, vol. 14 Tax Notes International 597-623 (referred to below as “the OECD report on global trading of financial instruments”). The Federal Republic of Germany and the Commission of the European Communities held a joint conference on international information networks at Bonn from 6 to 8 July 1997, at which many aspects of international information networks, including taxation, were discussed. The documents of the Bonn conference are available on the Internet at www2.echo.lu/bonn/conference.html.

5 Some decrees relating to this conference may be consulted on the Internet at www.ottawaoecdconference.org. Following the conference, OECD published several documents on taxation and electronic commerce. OECD, Conditions cadres pour l’imposition du commerce

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The matters discussed by these various organizations and countries are complex, but a consensus on certain fundamental parameters has emerged:

• Fiscal neutrality: Any change to tax laws would have to ensure that taxpayers in a similar situation and carrying out similar transactions are taxed in the same way.

• Retention of existing principles: Certain other taxation methods, such as a bit tax or the use of schemes for revenue-sharing by administrations, were suggested. These alternative solutions were rejected for the time being. It was generally felt, to a varying extent, that existing fiscal principles should apply to e-commerce transactions.

• Cooperation and consensus are essential at the international level: In view of the international scope of e-commerce, no country can unilaterally make radical changes to the existing principles. Efforts are therefore now being made to reach a consensus on how to adapt existing principles to the digital age.6

This text is aimed at presenting some observations on the application of existing principles to international electronic commerce from a Canadian perspective, at a time when OECD is preparing to prepare its revised commentaries on the concept of permanent establishment public, when it is attempting to formulate guidelines on the characterization of income from e-commerce, when the European Union (EU) intends to change the Value Added Tax (VAT) and while the United States seems paralysed in a moratorium. We do not intend to discuss consumption taxes7 or provincial taxes.8 In view of the uncertainty surrounding the issues and the speed of technological change, it is difficult to make any final comments on matters relating to international or Canadian taxation. A number of factors relating to the Internet and e-commerce influence the way in which business is done and sales are effected. There are also technical characteristics specific to the electronic medium and related technologies, which raise questions of interpretation and concerns regarding fiscal compliance. Before turning to specific matters concerning taxation, we wish to summarize some of these characteristics.9

électronique — Rapport du Comité des affaires fiscales, Paris, OECD, 1998; OECD, Problèmes fiscaux posés par le commerce électronique: mise en place d’un partenariat — Note du Comité des affaires fiscales, Paris, OECD, 1998; OECD, Commerce électronique: document de travail sur les questions fiscales — Document de travail du Comité des affaires fiscales, Paris, OECD, 1998 (referred to below as “the Ottawa working document”); OECD, Révision des commentaires au sujet des paiements concernant les logiciels, (referred to below as “Amendments to the commentaries on articles 12”), Paris, OECD, 1998. These texts are available on the Internet at www.oecd.org/daf/fa/E COM/Ottawa.htm.

6 United States Treasury document, op. cit. footnote 2, para. 7.1.1, and Revenue Canada Advisory Committee, op. cit. footnote 2, section 4.1.

7 Readers interested in this aspect are invited to consult Natalie ST-PIERRE, Les taxes à la consommation et le commerce électronique in Congrès 98, Montreal, Association de planification fiscale et financière, 1999, pp. 34: 1-10.

8 Readers interested in this aspect are invited to consult Geoffrey S. TURNER “Permanent Establishments and Interprovincial Income Allocation: Reflections on the Advisory Committee Report on Electronic Commerce” in Taxing Electronic Commerce: How E-Commerce Will Forever Change Taxation and Professional Tax Practice, Toronto, Strategy Institute, May 1998.

9 For more details see Pierre J. BOURGEOIS and Luc BLANCHETTE, “Income_taxes.ca.com: The Internet, Electronic Commerce, and Taxes — Some Reflections, Part I”, Canadian Tax

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1. Electronic commerce facilitates international trade and promotes cooperation within organizations. Trade between countries can therefore be expected to increase and small and medium-sized enterprises to be able to increase their volume of foreign business. These two factors could lead to an increase in the volume of international transactions of relatively low unit value. Increased cooperation within an organization may give rise to situations in which residents of different countries participate either in the provision of services (for example, where consultants in various countries provide services to a client or when dealings in financial instruments are at the global level) or in product development (for example, a team of engineers consisting of members from Canada and other countries developing software).

2. The nature of the Internet is such that an Internet address does not necessarily bear any relation to a party’s residence or physical location. This possibility offered by the Internet of remaining anonymous raises a number of basic concerns. For example, it may become difficult to know what tax treaty applies to a particular transaction and it might even be tempting intentionally not to declare certain transactions.

3. For some kinds of product, e-commerce could entail a reduction in the number of intermediaries (disintermediation). An example: in the past, a commercial software application had to be placed on a physical medium (diskette or CD-ROM) and would probably have been sold to a wholesaler, who then sold it on to a retail vendor from whom the consumer would have purchased it. Electronic commerce will facilitate direct selling of software, in digital form, from the developer to the consumer. Intermediaries have traditionally played an important role in administration of the tax regime and compliance. Firstly, they provide a verification track which is very useful to the tax authorities, and they are often mandated by the tax administration to act as tax collectors. Where resident intermediaries do not participate in a transaction, collection of tax revenue is exposed to certain risks resulting from non-disclosure, and disintermediation may erode the fiscal basis of assessment.

4. The fact that various items of information can be digitized leads to an increase in the kinds of goods and services that can be the subject of electronic transactions. Goods which are, or can be, digitized consist, depending on their nature, of software, written information (books, magazines, newspapers, encyclopaedias and databases), photographs, videos and music. The conversion of physical goods to digital versions raises a number of issues relating to revenue characterization and, by extension, to the appropriate tax treatment under both domestic tax laws and tax treaties. In addition, business models for trading in software, such as application service providers, change the way in which consumers use software.

5. The manner of sale can be changed. This is the case, especially, for application service providers (ASPs). A user of software could rent it for a specific time instead of signing a conventional licensing agreement. This new model affects income characterization.

Journal, 1997, vol. 45, no. 5, 1127-1149, pp. 1138-1143 (referred to below as “Income_taxes.ca.com Part 1”). See also the United States treasury document, op.cit. footnote 2, and Jeffrey OWENS, “The Tax Man Cometh to Cyberspace”, 2 June 1997, vol. 14 Tax Notes International 1833-1852.

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6. In the case of a new method of electronic payment, electronic currency (which has the characteristics of cash, especially high fungibility), it is not possible to trace the use to which it has been put.

7. The Revenue Canada Advisory Committee notes that financial institutions perhaps benefit most from the electronic revolution, because the cost of electronic operation is markedly less than that of conventional methods.10 Assuming that the public wants to use the Internet and private networks, financial institutions can be expected to opt for the new technologies. An increase in their use for financial transactions, combined with greater access to the banking installations of tax havens, could lead to possibilities for non-disclosure.

Having described some basic characteristics of the new technologies, we shall now turn to the major questions of international taxation. Our comments are divided into four main categories:

• Non-residents: a discussion of some of the fiscal problems that might apply to non-residents doing business with Canadians (carrying on a business, services rendered to Canada and taxes withheld under Part XIII of the Income Tax Act);11

• Residents: an assessment of the impact of e-commerce on Canadian residents participating in trans-border transactions (foreign tax credit and rules on accumulated foreign property income);

• Tax treaties: an analysis of the application of tax treaties in the context of e-commerce, principally in relation to the concept of permanent establishment, information servers, Web sites, mind and management and income characterization;

• Transfer prices: a review of some of the challenges that arise in the field of transfer prices in the context of e-commerce.

Lastly, we shall review recent developments in Europe, India, Quebec and the United States which may affect e-commerce companies.

I. Non-Residents carrying out transactions with Canadian residents

Non-residents carrying out transactions with Canadians could be taxed in various ways:

(i) Subject to the protection provided for in a tax treaty, a non-resident carrying on a business in Canada could be liable to federal12 and provincial income tax and to branch tax under Part XIV of the Act;

(ii) A non-resident receiving a sum of money for services provided in Canada could be liable to a 15 per cent withholding tax under article 105 of the Income Tax Regulations;13

10 Revenue Canada Advisory Committee, op. cit. footnote 2, section 1.2.1, table 1. 11 L.R.C. (1985), 5th suppl., c.1 and amend. (referred to below as “the Act”). 12 Para. 2(3)(b) of the Act. 13 C.R.C., 1978, c.945 and amend. (referred to below as “the Regulations”).

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(iii) Payments to non-residents could also be subject to withholding tax under Part XIII of the Act.

Each of these is discussed below.

Carrying on a business

First of all, a determination has to be made as to whether a non-resident engaging in e-commerce through a Web site can be caught in the Canadian tax administration’s net under domestic law.14 Taxation of non-residents in Canada under Canadian tax law is partly based on principles of business operation taken from Common Law.15 The Act also envisages specific circumstances in which a non-resident is deemed to be carrying on a business in Canada. In very general terms, this is the case if:

(i) The non-resident produces, creates, manufactures, makes, conserves, improves, packages or builds anything, wholly or partially, in Canada; or

(ii) Solicits orders or offers anything for sale in Canada through an agent or appointee, whether the transaction or contract had to be completed in Canada or abroad or partly in Canada and partly abroad.16

Hence, in order to ascertain whether the e-commerce activities undertaken by a non-resident could be liable to Canadian income tax, the following would have to be determined:

(i) Do the activities represent carrying on a business under Common Law principles?

(ii) Are the activities described in the expanded definition of carrying on a business in Canada?

(iii) Are these activities undertaken in Canada through a permanent establishment?17

As one writer has already stated, to determine the first point, the question must first be asked whether the income acquired is business income or property income.18 Characterization as income would require, inter alia, a desire for profitability and an indication that time, attention and manpower are being devoted to the activities. It has also been noted that a determination of whether income is business income or property income, a determination has to be made not of whether it derives from the use of a good but rather whether it comes from a business or a good.19 In most cases, income from an e-commerce activity could be expected to be business income

14 In this section we shall ignore the impact of tax treaties. 15 For a detailed analysis of the concept of company operation in a Canadian context, see

Constantine A. KYRES, “Carrying on a business in Canada”, 1995, vol. 43, no. 5, Canadian Tax Review, 1672-1718.

16 Paras. 253(a) and (b) of the Act. 17 It is interesting to note that a similar approach is taken in Australia. Common Law is generally

the basis for the rules of liability, but it is supplemented by certain legal assumptions specific to certain kinds of income (such as dividends, royalties and income from natural resources).

18 Charles T. ORMROD, “Income Tax Issues Arising out of Electronic Commerce”, in 1997 Conference Report, Toronto, Canadian Tax Foundation, 1998, pp. 51: 1-20 p. 51: 6. See also the discussion below concerning the definition of “investment income”.

19 C.T. ORMROD, id.

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(for example, most Web sites are updated regularly and, frequently, the products sold are also changed). In other circumstances, the facts could justify characterization as property income. In this latter case, (and perhaps also in the first one), an assessment would have to be made of whether the payments made are liable to withholding under Part XIII of the Act (this issue will be discussed in greater detail later). One of the results of the emergence of e-commerce has been the “digitization” of products which were previously sold on a physical medium. The way in which goods are sold has therefore changed: in the past, a newspaper subscription was taken out to obtain access to information, today a licence contract is signed. This change may also affect the nature of the income and its characterization as business income or property income. This question is dealt with in greater detail below, in the section on tax treaties and income characterization.

Assuming that the revenue obtained by a company engaged in e-commerce is business income, the question must also be asked whether the non-resident is carrying on a business. To the extent that e-commerce activities are fully automated, an interesting question arises: are characterization of the income and the concept of carrying on a business affected?20 As mentioned later in the section on tax treaties, Working Party No. 1 and the Technical Advisory Group (referred to below as “TAG”) are studying the matter in relation to the updating of the commentaries on the OECD model tax convention.21

Non-residents must now determine whether, under Common Law, their activities are such as to constitute carrying on a business in Canada.22 These are the factors which the courts have deemed to be relevant in determining the place of business of a company:

• place where services are provided;

• place of payment;

• place where purchases are made;

• place of manufacture or production;

• place of solicitation;

• location of product stocks;

• location of bank accounts;

• inclusion of the company’s name in a directory;

• location of employees or dependent agents;

• place of signature of the contract.23

20 Id., pp. 51: 7-8. 21 OECD, Model Tax Convention on Income and Assets, Paris, OECD, loose-leaf (referred to below

as “the OECD Model Convention”). 22 Cf. the following distinction drawn by the House of Lords in Grainger & Son v. Gough, [1896]

AC 325: “In the first place, I think there is a broad distinction between trading with a country and carrying on trade within a country. Many merchants and manufacturers export their goods to all parts of the world, yet I do not suppose any one of them would dream of saying that they exercise or carry on their trade in every country in which their goods find customers”.

23 For its part, Australia applies a central criterion: determination of what constitutes the essence of the business and identification of its location. Secondary criteria used by the courts include the

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This determination will have to be made in each case. In a typical situation in which a non-resident’s presence in Canada is limited to viewing of his Web site by Canadian residents without any physical presence, and in the light of the factors listed above, it could be expected that the non-resident would not be regarded as carrying on a business in Canada.24 The question arises, however, whether the conclusion would be different if, under contract law, the contract was deemed to have been concluded in Canada. As one writer has pointed out, there is Canadian case law which could be cited in support of the conclusion that, in such circumstances, a contract could be regarded as having been concluded in Canada.25 This is an interesting question and one which tax specialists should follow closely. The Revenue Canada Advisory Committee has raised the matter but, as was to be expected, has not expressed a view.26 The ATO report draws the dividing line in terms of the nature of solicitation. If it is merely an invitation to negotiate, the contract will be drawn up wherever the consumer is situated. If, on the other hand, the offer is irrevocable, the contract will be drawn up at the site’s domicile.27 The question of the law applicable to a transaction effected on the Internet between parties residing in different countries will probably give rise to a debate in university, international and legal forums and in organizations such as the World Trade Organization and OECD. In addition, the relevant provisions of the Quebec Civil Code28 concerning the preparation of a contract will have to be taken into account in Quebec.

We can also imagine the case of a digital product stored on a server situated in Canada. Does this mean that an “inventory” of products is kept in Canada? If so, the problem could be expected to be solved relatively simply by using a server situated elsewhere.

As noted above, the Act contains an expanded definition of the term “carrying on a business” in Canada, and a non-resident who is not regarded as carrying on a business in Canada according to the principles of Common Law will have to take that definition into account.

With respect to the first defining rule, subparagraph 253(a) of the Act, the Revenue Canada Advisory Committee raised the question whether electronic products or services provided to Canadians by a non-resident could be regarded as products or services produced, made or manufactured in Canada.29 This is clearly an interesting point. Let us take the example of the purchase of a non-resident supplier’s software by downloading onto the client’s computer in Canada. In general, the software is downloaded in compressed form in order to reduce the

place where the contract is negotiated or concluded, the place where the contract is executed, the law applicable to the contract, the currency used for the transaction and the place of payment. See the ATO report, op. cit. footnote 2, section 5.2.9.

24 The ATO report comes to the same conclusion, op. cit. footnote 2, section 5.2.21. 25 Quebec Pharmaceutical Association v. T. Eaton Co. Ltd. 56 CCC 172 KB and London Life

Assurance Co. v. R. [1990] CTC 43 (C.A.F.). See the detailed discussion in C. T. ORMROD, op. cit. footnote 18, p. 51: 7-9.

26 Revenue Canada Advisory Committee, op. cit. footnote 2, section 4.2.2.2. 27 ATO report, op. cit. footnote 2, section 5.2.28. It should be noted that under Australian law the

place of contract does not necessarily determine the question of liability, see section 5.2.32 on this point.

28 L.Q. 1991, c.64, chiefly arts. 1385-1397. 29 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.2.

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download time. Does the decompression of downloaded files result in goods or services that have been produced, made or manufactured in Canada? We believe that, as the decompression was carried out not by the non-resident but by the client, this should not make the non-resident liable to tax in Canada.

Let us now consider the situation of a computer engineer in the United States providing services to Canadian companies. For example, an engineer obtains the user code of a Canadian company’s software by electronic means and carries out analyses. Following these, he downloads an amended code for the Canadian client and carries out certain checks directly on the software by remote processing. In the second stage of service provision, he makes further changes to the code. Intuitively, in the first example, it could be expected that subparagraph 253(a) of the Act does not apply, since there has not been any real value added in Canada. The issue of the application of this provision of the Act is, however, less clear in the second example, since changes are made to the software when it is physically on the Canadian company’s computer. One of the actions listed in subparagraph 253(a) of the Act is improvement, wholly or partially, of anything in Canada. Could it not be said that, if the engineer has access to the user code, which is situated in Canada, and makes changes to it, he has improved something in Canada? We consider that since the improvement occurs at the place where the programmer carries out his work, subparagraph 253(a) should not be applicable. The opposite position could, however, be argued.

Under subparagraph 253(b), a non-resident soliciting orders or offering anything for sale in Canada, through an agent or appointee, is deemed to be carrying on a business in Canada. Would a non-resident carrying out transactions with Canadians through his Web site be regarded as operating a business in Canada under this defining provision?

According to the judgement in Sudden Valley vs. MNR,30 a distinction must be drawn between offering something for sale (confined to offers which, if accepted, would give rise to a binding contract) and a simple “invitation to negotiate”.31 In the latter case, subparagraph 253(b) of the Act does not apply. Unless the Web site is a relatively passive instrument providing only general information, and where visitors are asked to contact the company for further information or to conclude the contract, it would seem difficult to assert that the Web site is merely an invitation to negotiate. Many Web sites contain much more information and provide a detailed description of the products offered, prices and delivery methods, as well as electronic order forms used to process the purchase. In addition, a site visited by a particular client can be personalized in terms of past purchases and information obtained from “cookies”. The amount of information is therefore such that we can state that the Web site is much more than a simple invitation to negotiate.32 This does not, however, necessarily lead to the conclusion that paragraph 253(b) of the Act applies, since it requires that the solicitation or offer must be made through an agent or appointee. In a typical e-commerce scenario, this reasoning would assume that either the Web site or the Internet service provider (ISP) is an agent of the non-

30 [1976] CTC 297 (CF, first instance), confirmed in [1976] 775 CTC (C.A.F.) 31 For a more detailed analysis, see Pierre J. BOURGEOIS and Luc BLANCHETTE,

“Income_taxes.ca.com: The Internet, Electronic Commerce and Taxes — Some Reflections: Part 2”, (1997), vol. 45, no. 6, Canadian Tax Journal, 1379-1415, pp. 1384-1385 (referred to below as “Income_taxes.ca.com Part 2”).

32 See C.T. ORMROD, loc. cit., footnote 18, p. 51: 9-10 for a more detailed discussion.

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resident. The initial views expressed on the subject are somewhat contradictory. In the joint OECD discussion document, it is stated that a Web site may be a dependent agent if contracts are habitually concluded through it for the account of its principal.33 The United States Treasury document also notes that, even if there is a relationship of representation between a local service provider and a non-resident operating the database, the local service provider would probably be considered as an independent agent.34

In its latest draft document on the permanent establishment concept in the context of electronic commerce, OECD states the following on the concept of agent and ISP:

“the ISPs will not constitute an agent of the enterprises to which the Web site belongs, because they will not have the authority to conclude contracts in the name of these enterprises and will not regularly conclude such contracts or because they constitute independent agents acting in the ordinary course of their business.”35

As to the question whether a Web site can, in and of itself, be a fixed place, the answer seems to be “no”.36 Thus, the current provisional consensus appears to be that an ISP or a Web site cannot, in and of themselves, constitute agents.

The Revenue Canada Advisory Committee has taken note of these complex issues and recommended that the Ministry should publish an interpretation bulletin to define its position on the circumstances in which activities carried out through electronic commerce may constitute operation of a business in Canada. The Committee also recommended that the Agency should determine whether the present provisions of paragraph 253 are appropriate in the context of electronic commerce and should, if necessary, inform the Ministry of Finance of its concerns.37

Services provided in Canada

In order to monitor the activities of non-residents in Canada and to provide a means of taxation, the Act stipulates that when a payment is made to a non-resident having rendered services in Canada, constituting fees, commissions or other sums, 15 per cent should be withheld.38 A non-resident liable to this withholding tax but not taxable in Canada, for example under a tax treaty, can obtain a refund of the amount deducted. In addition, an advance waiver can be obtained if the non-resident is not taxable on his Canadian income.39

33 Joint OECD discussion document, op. cit., footnote 1, para. 8.2.4. 34 United States treasury document, op. cit., footnote 2, para. 7.2.5. 35 OECD, 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 Convention, Paris, OECD, 2000, available on the Internet at www.oecd.org/daf/fa/treaties/ art5rd/3march.pdf. Referred to below as “the OECD revised commentaries on the permanent establishment concept”.

36 Id. 37 Revenue Canada Advisory Committee, op. cit., footnote 2, section 6.3.2.2. 38 Under article 153(1)(g) of the Act and article 105 of the Regulations. Except in Quebec, there is

no obligation on provinces to withhold a sum. The Taxation Act, L.R.Q., c.1-3 and amend. provides for a withholding tax of 9%. See article 1015 and associated article 1015R9 of the Tax Regulations, R.R.Q., 1981, c.1-3, r.1 and amend.

39 Because of the nature of electronic commerce, there are several situations in which it is unlikely

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The Revenue Canada Advisory Committee stated that the term “rendered”, in the context of a service, means, “carried out”.40 Consequently, “an activity, operation or other action on the part of the [non-resident] supplier must occur for there to be a provision of service” and the supplier must have a physical link to Canada41 (i.e. the activity must take place in Canada) for the tax withholding obligation under article 105 of the Regulations to apply.

A number of questions arise when the services are provided over the Internet. Because of the anonymity of the Internet, the consumer of the services may not know that he is dealing with a non-resident. Even if he knows that the provider of the services is a non-resident, he may not be in a position to determine whether the service provided originates in Canada or from outside it. 42 Lastly, when the relevant service is fully automated, it is difficult to determine where it was performed.43

For the moment, there are very few details about this point from Revenue Canada. In a technical interpretation, it examined the situation of a Canadian resident who is paying for a software hotline service, and stated that if the non-resident supplier is not in Canada when the service is rendered, no deduction under article 105 of the Regulations is applicable.44 In the preceding section, we considered the case of an engineer providing software maintenance services to a Canadian company. Most of the services originate in the United States. In this case, therefore, it could be expected that no deductions under article 105 of the Regulations would be required. On this point, we believe that it would be appropriate to consider that no service has been performed in Canada because the provider (engineer) is outside Canada.

In view of the paucity of details available, the recommendation made by the Revenue Canada Advisory Committee that the Ministry of Income should publish an interpretation bulletin is highly appreciated.45 However, if Revenue Canada were to come to the opposite conclusion, it appears likely that a waiver could be obtained for deductions under article 105 of the Regulations on the grounds that the engineer has no permanent establishment in terms of the tax treaty.

that a waiver can be processed in time. For a detailed discussion of Revenue Canada’s administrative policies, for refund requests, see Shannon L. BAKER and Dale S. MEISTER, “Non-Residents Rendering Services in Canada: Regulation 105 and Other Issues”, Canadian Tax Journal, vol. 47, no. 5 (1999), 1321-1341.

40 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.3.3. 41 Id. 42 Returning to the example of the United States engineer providing services to a Canadian

company, let us assume that he is in Seattle. For a contract with a Canadian client, the entire work is done in Seattle. In this case, it would seem right to say that, as no service has been provided in Canada, no withholding under article 105 of the Regulations is required. Let us then suppose that the engineer spends one week in Vancouver to visit friends and, during this time, carries out certain remote work for a Canadian client on his laptop computer fitted with a modem. In this case, the conclusion would be different because the services were physically carried out in Canada and the withholding tax under article 105 of the Regulation would apply. In both cases it could be said that the consumer of the service (the Canadian company) has no way of knowing where the services were provided.

43 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.3.3. 44 Revenue Canada, technical interpretation 5-3857, 20 November 1987. 45 Revenue Canada, Advisory Committee, op. cit., footnote 2, section 4.2.3.3.

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Withholding tax under Part XIII

Subparagraph 212(1)(d) of the Act provides for tax withholding from various payments made to non-residents. As noted earlier, e-commerce and the Internet may result in a change in the nature of products. Because of increased digitization of products sold on the information highway through licence contracts and greater access to online databases, the number of payments made by Canadian residents to non-residents liable to withholding under subparagraph 212(1)(d) of the Act is likely to increase.

For Canadian taxpayers making a payment subject to a tax deduction, this may give rise to a number of problems. Firstly, it will be difficult to determine the appropriate rate of withholding (assuming that there is a treaty) because of the anonymity associated with the Internet. Thus, a bona fide Canadian taxpayer could assume that the tax treaty between Canada and France applies because of the suffix of the Web site address (.fr), whereas in fact the payee resides in a country that has not concluded a tax treaty with Canada. This is a problem that will not be solved until countries agree on a method of determining the country of residence for e-commerce.46 Second, the Revenue Canada Advisory Committee has made an interesting comment that the liability of Canadian residents to tax withholding because of the new characterization of an activity or a product could lead to an increase in costs for Canadian companies47 and contribute to a reduction in their competitiveness.

As one author states, a Canadian resident making a payment to a non-resident for the use of an online database could be liable to a Part XIII tax withholding under subparagraph 212(1)(d)(ii) of the Act (if the payment is deemed to be made for information), or under subparagraph 212(1)(d)(iii) (if the payment is deemed to be made for services).48 Revenue Canada’s position on this point is not clear. In a technical interpretation, it was requested to rule on the question whether tax deductions applied to charges for telephone or satellite access to a database situated in the United States. The Ministry was unable to set out a final position.49

With the increase in licences granted and sales of digital products, an analogy may perhaps be drawn with the position adopted by Canada on software. In the past, Canada adopted a different position on software to that of other members of OECD.50 More specifically, it took the view that “payments made by a user of computer software under a contract stipulating that the source language or programme must remain confidential are payments intended for the use of a secret formula or process and thus constitute royalties”. It seems, however, that this position is undergoing change. Firstly, Canada has reduced, and even eliminated, tax deductions on certain payments relating to computer software in the context of recent negotiations on treaties.51 Second, the Revenue Canada Advisory Committee

46 C.T. ORMROD, op. cit., footnote 18, pp. 51: 13-14. When the Web site address suffix is .com or

.net, it is usually impossible to determine the country of residence. 47 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.3.1. The Committee cites

the example of additional interest charged for purposes of Canadian withholding tax deductions. 48 C.T. ORMROD, op. cit., footnote 18, pp. 51: 13-16. 49 Revenue Canada, technical interpretation 9613820, 30 April 1996. 50 Income_taxes.ca.com Part 2, loc. cit., footnote 31, p.1399. 51 See, for example, the recent amendments concluded with the United States, France and the

Netherlands.

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seems receptive to the consensus emerging in OECD that products formerly sold on a physical medium should be entitled to the same treatment for income tax and withholding tax, the method of delivery (electronic version or paper version) being unimportant.52 This approach would be desirable for Canadian companies. The Committee recommended that Revenue Canada, in consultation with the Ministry of Finances, should assess the relevance of revising Part XIII of the Act with respect to payments made for electronic subscriptions and similar operations.

II. Canadian residents

We shall now turn to the impact of electronic commerce for Canadian residents participating in international operations.

In the absence of a global consensus, there will be a risk of incompatibility in the tax treatment of income arising from e-commerce when more than one administration is involved and this could, ultimately, give rise to double taxation. Canadian companies engaging in electronic commerce abroad, directly or through affiliated foreign companies, will therefore have to face a number of problems.

Operations carried out by a Canadian company

So far there are few indications of the positions adopted by various countries regarding the new forms of e-commerce. The United States Treasury document suggests that under United States domestic law, it is unlikely that an alien selling products in the United States and whose presence in that country is limited to the use of a server situated there will be deemed to be carrying on a business or trading in the United States.53 It is, however, far from clear that individual states would arrive at the same conclusion.54 The Australian Taxation Office, on the other hand,

52 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.3.1. The Committee

specifically mentions electronic subscriptions and similar operations. The range of products of the kind considered by the Committee seems narrower than that envisaged by OECD in the recommendations put forward at the Turku and Ottawa conferences. According to our discussions with some members of the Committee, they intended to endorse the OECD recommendations at Turku and in their report. As discussed below, OECD has just drawn up a consultation paper which contains comments on the characterization of several types of income.

53 United States treasury document, op. cit., footnote 2, section 7.2.1.1. See also Income_taxes.ca.com Part 2, op. cit., footnote 26, 1385-1386; Reuven S. AVI-YONAH, “Keynote Address: The Challenge of e-Commerce to Income and Consumption Taxes”, in Taxing Electronic Commerce: How E-Commerce Will Forever Change Taxation and Professional Tax Practice, Toronto, Strategy Institute, May 1998 and Salvador M. BORRACIA, “Lessons on Taxing Nexus in the USA: State Competition for Jurisdictional Authority to Tax”, in Taxing Electronic Commerce: How E-Commerce Will Forever Change Taxation and Professional Tax Practice, Toronto, Strategy Institute, May 1998.

54 Individual states are not bound by United States tax treaties. See also INTERACTIVE SERVICES ASSOCIATION TASK FORCE, Logging On to Cyberspace Tax Policy: White Paper, Silver springs, MD: ISA, 1997. Companies which were represented in the working group included America Online Inc., AT&T Company, CompuServe Inc., GE Information Services, Inc., IBM, Microsoft Corporation and NETCOM Online Communication Services, Inc. The white paper was prepared by Ernst & Young, LLP for the working group and in collaboration with it. It is available at www.isa.net/about/release/taxwhpap.html. See also INFORMATION TECHNOLOGY ASSOCIATION OF AMERICA, Straight Talk: Internet, Tax and Interstate Commerce, Arlington, VA: ITAA, 1997, available at www.itaa.org/p.7.html and Vertex Inc. at www.vertexinc.com/taxcybrary20/taxchannel70/taxchannel_70.html. Following the 1998

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has not stated in its report whether a non-resident engaged in a similar level of activity would come within its competence.55

As mentioned above in the discussion on Part XIII taxes, Canada may consider that certain kinds of income are liable to withholding, while other administrations may feel that they are, rather, business income. Canadian companies engaged in electronic operations with other countries may face similar situations. The Revenue Canada Advisory Committee has commented on such a scenario, stating that it is possible for Canada to consider the income as business income while the other country might regard it as income subject to withholding tax. The Committee points out that, in such circumstances, the Canadian taxpayer would not be able to request a refund of foreign tax with regard to foreign deductions made, since the refund is limited to Canadian taxes payable on income arising abroad. In this case, the Act provides for a deduction of taxes which do not otherwise give rise to a refund.56 This is only a partial alleviation of double taxation, and the Committee recommended that the Ministry of Finance should monitor the situation in order to ensure that Canadian taxpayers obtain appropriate relief.

If and when there is an international consensus on the characterization and provenance of income arising from electronic commerce, the difficulties could, to a large extent, be mitigated and this is probably why the Committee recommended that the situation should be monitored rather than any legislative changes.57

Accrued foreign property income

The Canadian tax administration, taxpayers and their advisers are preoccupied with the question whether the rules on accrued foreign property income (AFPI) for foreign affiliated companies are applicable to the e-commerce activities carried out by a controlled foreign affiliated company (CFAC).58

Characterization of income for the purposes of the regulations on AFPI

For the purposes of these commentaries, it has been assumed that the CFAC is engaged in activities such as the sale of digital products or services over the Internet.59 If the income obtained by a CFAC is not to be characterized as AFPI it must carry on a business.60 Carrying on a business requires a certain level of effort and activity. Thus, if the CFAC’s activities are fully computerized, can it be said that the entity at which the activities are being performed is really carrying on a business? It has been suggested in a similar case that it would be sensible (though perhaps not feasible) not to computerize the process entirely.61 The argument is

Congress, the Internet Tax Freedom Act, which proposes a moratorium on new taxes on Internet operations, was adopted. See Doug SHEPPARD, Internet Legislation Becomes Law With U.S. Omnibus Appropriations Act, Tax Analysts (electronic database), document no. 98 TI 205-6, 22 October 1998.

55 See Income_taxes.ca.com Part 2, loc. cit., footnote 31, 1386-1387 for a brief comment on this question.

56 Para. 20(12) of the Act. 57 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.5. 58 As defined in paragraph 95(1) of the Act. 59 The discussion that follows is a summary of the issues raised in C.T. ORMROD, loc. cit.,

footnote 18, and in Internet-taxes.ca.com Part 2, loc. cit., footnote 31, 1405-1408. 60 According to the definition of an actively operated company in paragraph 95(1) of the Act. 61 C.T. ORMROD, loc. cit., footnote 31, 1405-1408.

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interesting, but the associated question is: what is the effect of full computerization of activities on the determination of an appropriate transfer price? This is likely to be difficult to assess and will require an analysis of the ownership and use of intangibles.

Definition of investment income

As products become digitized and income arising from their sale can be regarded as royalty income or where transfers subject to royalties are made, an assessment has to be made as to whether the definition of “investment income” applies. Income from an investment business is deemed to be property income and, consequently, AFPI unless, under a provision of subparagraph 95(2)(a) of the Act, it is deemed to be the income from an actively operated business. An investment business is a company whose principle aim is to derive property income, including royalties and similar earnings. In some circumstances, could a royalty received by a CFAC be considered as income that is not property income? As the definition of investment income is based mostly on that of “specific investment business”62 for purposes of the small business deduction, the matter can be left to the jurisprudence and the positions of Revenue Canada on this concept.

To determine what constitutes the principle purpose of a company for the purpose of the definition of a “specific investment business”, Revenue Canada has stated that the following factors should 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 its mode of operation and purpose of existence; and

(c) the manner in which the business is conducted.”63

It is difficult to apply these criteria to an e-commerce scenario and the exercise may not be very conclusive.

Revenue Canada has laid down more specific guidelines in technical interpretations on the types of income that are most relevant to electronic commerce. The first related to whether royalties on a musical work protected by copyright constituted property income or business income:

“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

62 Para. 125(7) of the Act. The Revenue Canada Advisory Committee has commented on the

application of the definition of a specified investment business to electronic commerce. See Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.3.2. The comments are identical to those made on questions of international taxation.

63 Revenue Canada, Interpretation Bulletin IT-73R5 — Deduction for small businesses, 5 February 1997, para. 14.

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in the form of royalties is not, in and by itself, sufficient to conclude that it is property income.”64 [our bold characters]

Revenue Canada also commented on the characterization of income from a licensing agreement and stated:

“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.”65 [our bold characters]

It goes without saying that it will be complicated to determine, from the particular activities of a CFAC, if the position can be adopted that the income it earns is business income which consequently is not subject to characterization as AFPI in accordance with the definition of “investment income”. It is interesting to note that in the two interpretations quoted earlier, the Ministry referred to a situation in which the taxpayer originates the “property” in order to characterize the income. This is something which can prove especially relevant in the context of e-commerce and which is difficult to apply. Let us take the example of a product that “originates” in Canada (i.e. is designed and developed in Canada), where one or more CFACs participate in the provision of service or subsequent updating. Does the Canadian origin have any impact? What happens if the CFAC and the Canadian taxpayer agree to share costs in good faith so that both parties contribute to the origin of the digital product?

It is assumed that a particular CFAC carrying on an e-commerce business earns property income and that it has to operate that business whose principle purpose is to earn property income, including royalties and similar earnings, in order to meet the definition of an “investment business”. The use of the term “royalties” does not give rise to any particular difficulty because the term is defined. Let us look, however, at a situation in which the income earned is not a royalty. One would then have to determine whether the income received constituted “similar earning” under paragraph 95(1) of the Act. Such a determination could be difficult to make in the context of e-commerce.

If a CFAC is carrying on an investment business, an assessment must be made of whether its activities consist in selling on or granting licences for property. This determination is important because the Act defines the expression “grant licences” as including the authorized use or production or reproduction of property including information or anything else.66 A CFAC whose activities fall within the definition and:

(i) Whose business is operated principally with persons with whom the affiliated company does not have a relationship of dependency; and

64 Revenue Canada, technical interpretation 972215, 26 September 1997. A similar comment was

made on royalties in general in technical interpretation 9520295 of 8 August 1995. 65 Revenue Canada, technical interpretation 9507915, 14 September 1997. 66 In accordance with the definition of “investment business” in paragraph 95(1) of the Act.

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(ii) Which employs more than five persons full-time throughout the year (including an equal number of persons outside Canada employed by associated persons and certain personal associations);

will not be considered to be carrying on an investment business and will therefore not generate any AFPI.

The Revenue Canada Advisory Committee mentioned these issues in its report and stated that it would be appropriate to change the definitions contained in the Act so as to exclude passive income from the operation of intellectual property earned by a CFAC engaged in e-commerce.67 It also questions the relevance of the threshold of five employees, noting that, because of the level of computerization in e-commerce, this criterion is perhaps inappropriate. In addition, the Committee pointed out that there should be a gradual application of the present rule concerning the number of employees by stipulating, for example, that the rule does not apply to start-up companies (for example, during the first 24 months).68

Defining provisions of AFPI

Another concern relating to the AFPI regime concerns the application of the various rules under which income that would otherwise be considered as income from actively operated business is deemed to be AFPI. Brief comments on the most relevant defining provisions are set out below.

Under subparagraph 95(2)(a.1) of the Act, a foreign affiliated company’s income from the sale of goods is deemed to be business income other than income from an actively operated business when it is reasonable to consider the cost of the good is included in the calculation of income from a business operated by the taxpayer or a person resident in Canada with whom the person has a relationship of dependence. This defining rule also applies to the provision of services as an agent in relation to the purchase or sale of goods. It does not apply in either of the following circumstances:

(i) If the good was manufactured, produced, grown, mined or processed69 in the country under whose laws the foreign affiliated company was set up or organized and in which its business has been mainly carried on;70

(ii) If more than 90 per cent of the foreign affiliated company’s gross income arises from the sale of goods to persons with whom the foreign affiliated company has no relationship of dependence.

In certain special circumstances, a foreign affiliated company engaged in e-commerce may be subject to this rule if it earns agency commission. This should not give rise to any difficulty where the foreign affiliated company’s sales are exclusively to persons with whom the foreign affiliated company has no relationship of dependency. It could, however, be more complicated to apply the first exception in the context of e-commerce.

67 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.5.2. 68 Id., section 4.2.5.3. 69 How should the concepts “manufactured, produced, grown, mined or processed” be applied in

the context of e-commerce? Can digital products be regarded as being manufactured, produced or processed in Canada?

70 In the context of e-commerce, a business may be operated in various places and, consequently, it may be difficult to meet the condition that the business must be operated in a particular place.

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Under subparagraph 95(2)(b)(ii) of the Act, when a CFAC provides services and the amount of the consideration paid or payable is deductible in calculating the income from a business operated in Canada by a person with respect to whom the affiliated company is a CFAC or by a person associated with that person, the provision of services is deemed to constitute a business separate from a business actively operated by the CFAC. Let us consider the case of a CFAC engaged in e-commerce which invoices technical support charges to the parent Canadian company. In this case, these services will be regarded as a business separate from an actively operated business and the related costs will be regarded as business income other than actively operated business income.

In very general terms, subparagraphs 95(2)(a.3) and (a.4) stipulate that the income arising from debts or liabilities resulting from the leases of persons residing in Canada is deemed to constitute business income other than actively operated business income (i.e. AFPI) unless more than 90 per cent of the gross income from such activities arises from non-residents with whom the affiliated foreign company has no relationship of dependency. It is a matter for concern that, since the definition of “liability resulting from a lease” includes a “liability provided for by a treaty permitting the use, production or reproduction of a good, including information or anything else”,71 the defining rules may be applied to a CFAC engaged in e-commerce. As these provisions were intended to cover dealing in certain financial instruments, we do not think that it would be appropriate, in the context of fiscal policy, to apply them to e-commerce.

As noted above, a number of issues relating to the application of the AFPI regime to e-commerce will have to be discussed. Electronic commerce may result in a change in the nature and type of income earned by CFACs in Canada. This is not surprising, given that the AFPI regime was set up before the electronic era, so that the provisions of the Act generally relate to transactions which concern goods, financial instruments and physical products, as well as the provision of traditional services. As e-commerce can markedly change the nature of income and the manner in which it is obtained, it will be interesting to see the reaction of the legislator in Canada. Two reactions are possible. The Canadian legislator could decide that existing laws were adequate and draw up a series of administrative positions on e-commerce. Conversely, he might propose legislative changes to target specific problems to which e-commerce gives, and will give, rise in the manner of doing business. Canadian companies and their advisers hope to obtain very specific guidelines and particular issues, and they want them very soon. The fact the Revenue Canada Advisory Committee has firmly supported the principle that it is very important for Canadian businesses to be consulted so as to assist the Government in formulating appropriate solutions to these highly complex problems is greatly appreciated, because it will probably result in the adoption of appropriate measures.

III. Tax treaties

Tax treaties are an important tool for settling various problems which may arise from the activities of a business in various administrations. The treaty lays

71 Para. 95(1) of the Act.

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down the taxation authority of each contracting State and the distribution of revenue between the administrations, and helps the contracting States to prevent tax evasion.

The detailed comments set out in this section do not take the last-named aim into account. We should, however, like to stress that tax administrations are increasingly emphasizing this aspect in assessing the impact of e-commerce. In its report, the Australian Taxation Office stated that it would examine the scope of exchanges of information under its treaties.72 A similar recommendation was put forward by the Revenue Canada Advisory Committee, which stated that “Revenue Canada and the Ministry of Finance should try to exchange information more spontaneously with foreign tax administrations in order to ensure that Canadian residents declare their income from foreign sources correctly”.73 Lastly, at the OECD Ottawa conference, several recommendations on cooperation between countries to combat tax evasion were put forward, including:

• Adding an article in the OECD model tax convention to enable a contracting State to assist another contracting State to collect tax;

• Improving the use of bilateral and multilateral agreements in administrative assistance (OECD and Council of Europe multilateral treaties).

The distribution of revenue among various administrations is based on two concepts: (i) residence; and (ii) source. Under the former, the country of residence of the business has the first power of taxation. Under the latter, the country of origin of the income generally has the right to tax it. When the two concepts are applied at the same time to active and passive income (according to the characterization of the income given by each country) it may happen that income tax is levied in two administrations (as is the case when the company’s income is attributable to a permanent establishment situated in the country of which the company is not a resident or when passive income is subject to a withholding tax in the country of origin). In this case, the country of residence usually grants a credit or exemption or both.

Although various Governments, international organizations and practitioners have started to analyse the application of the treaties to e-commerce, it has become clear that the application of the basic principles set out in these international treaties (the permanent establishment concept, origin of income from the sale of a computer programme over the Internet or from the provision of services by persons physically present in different administrations, for example) constitutes a challenge, mainly because these basic principles were formulated in an age when physical presence (of individuals, immovable property, etc.) was important, and not in the era of e-commerce and integrated digitization. As we shall see, the international community, through OECD, has begun to identify the issues which will have to be addressed and some initial recommendations are very encouraging. However, a consensus seems elusive for the time being.

72 1997 ATO report, op. cit., footnote 2, section 7.7.7. 73 See Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.4.2, for a detailed

discussion of administration and collection issues. See also Income-taxes.ca.com Part I, loc. cit., footnote 9, 1142-1148, and Rob WEIL, “Fostering Tax Compliance in a Global Electronic Environment”, in Taxing Electronic Commerce: How E-Commerce will Forever Change Taxation and Professional Tax Practice, Toronto, Strategy Institute, May 1998, and Walter SCYC, op. cit., footnote 2.

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Income characterization74

The conversion of the manner of distribution to digital versions raises the fundamental question whether electronic distribution givers rise to business income or royalty income (which could incur tax on the amount paid). At the Ottawa conference, an amendment was proposed to the commentaries on article 12 of the OECD Model Convention. Subsequently, OECD published a revised draft study on the characterization of income from e-commerce. This document, the result of the labours of the Technical Advisory Group on Treaty Characterization Issues Arising from Electronic Commerce (TAG),75 was made public in the original version on 24 March 2000 and in a revised version on 1 September 2000. The Group is composed of representatives of various countries and some taxpayers.76 Its mandate is to examine the characterization of various types of payments made in e-commerce in the light of the tax treaties in order to submit clarifications to the commentaries to the OECD Model Convention. Seemingly unable to reach a consensus on a set of characterizations for adoption, TAG set out its disagreements in the form of a series of positions that are sometimes majority, sometimes minority and rarely unanimous. Although the most recent version of the draft received the support of many commentaries and there has been progress towards consensus on various aspects, some discussions have still to be completed. To this end, TAG again invited the international community to submit its comments by 13 October 2000 so that it could take them into account at its last meeting scheduled for the beginning of November 2000. TAG should then be in a position to send its report to the Committee on Fiscal Affairs before the end of 2000.

The approach adopted by TAG was to identify 27 typical e-commerce transactions. After summarizing the main comments received to its first draft, it offers general conclusions on the characterization of income from e-commerce and then applies them to each of the transactions identified. Unfortunately, we are not told which member supported which cause. Informed observers of the international tax scene will, however, be able to make some educated guesses about the identity of these persons, given the positions adopted by some speakers.

The table below shows both the transactions identified by TAG and the proposed characterizations, with the degree of consensus obtained. To facilitate its reading, the table lists only 25 transactions, the second and the sixth having been incorporated into similar transactions.

74 For a more detailed analysis of this question, see Income-taxes.ca.com Part 2, op. cit., footnote

27, 1396-1400 and Income_taxes.ca.com: An Update, to appear in the Tax Review in 2000. 75 OECD, Technical Advisory Group on Treaty Characterization Issues Arising from Electronic

Commerce, Revised Document for Comments, Paris, 1 September 2000 (“TAG report”). The document is available in English only at www.oecd.org/daf/fa/treaties/treatychar_4Sept.pdf.

76 The countries represented are Australia, Chile, India, Israel, Japan, Norway, Philippines, United Kingdom and United States. A notable absentee is Canada. The non-governmental bodies are IBM, NTT Data, Reed Elsevier, The Software Coalition and Walt Disney Corporation.

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Characterization of e-commerce in the light of the OECD commentaries

TYPE OF INCOME PROPOSED

CHARACTERIZATION MAJORITY MINORITY

1. Electronic order processing of tangible products i. Software

a. General

ii. Other

Business income 2. Electronic ordering and

downloading of digital products b. With copyright Royalties

a. Supplied on a physical medium

i. Software

3. Updates and add-ons

b. Supplied electronically ii. Other Royalties a. Supplied on a physical medium

i. Software

4. Limited-duration software and other digital information licences b. Supply

electronically ii. Other

Business income

Royalties 5. Single-use software or other digital product Services or royalties

a. Separate licence 6. Applications hosting b. Bundled contract

7. Applications service provider (ASP) 8. ASP licence fees 9. Web site hosting

Business income

10. Software maintenance Mixed contracts 11. Data warehousing 12. Customer support over a computer network

13. Data retrieval 14. Delivery of exclusive or high-value data Royalties

15. Advertising 16. Electronic access to professional advisory services

Business income

17. Technical information Royalties 18. Information delivery 19. Subscription access to an interactive Web site 20. Online shopping 21. Online auctions 22. Sales referral service

Business income

a. To obtain the right to post documents protected by copyright

Royalties

23. Content acquisition transactions

b. To create new content 24. Streamed (real time) Web-based broadcasting 25. Broadcasting rights

Business income

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Summary of TAG discussions

Although the table clearly shows the variety of characterizations proposed for the various transactions considered, it does not really reflect the fact that the divergences or convergences of opinion among members of TAG resulted from a relatively limited number of arguments. For example, we have detected three major trends in TAG’s preliminary conclusions. Firstly, there is a set of income types for which there is a consensus that they are business profits. Second, there is a consensus that another set of income types should be characterized as royalties. Lastly, there is a set of income types for which no consensus has yet been reached but within which two distinct approaches can be seen. Our comments on these trends are set out below.

Income types constituting business profits

It may seem encouraging that TAG reached this characterization for these items, which account for 2277 of the 27 income types considered. For most of them, the underlying commercial operation either corresponds to a traditional type of transaction such as the sale of a movable tangible product, one of the aspects of which, for example payment, is administered electronically, or else is a type of service which constitutes or can be assimilated to a traditional type of service but one which is also administered, wholly or partially, electronically. Examples here are data storage services or online auctions.

An attentive reading of the table reveals that some operations cannot be assimilated to operations in the real world. These are applications hosting on a Web site and supplying access to applications (or the right to use them). If, for example, hosting of an Internet site can be compared to the operation of a commercial lease, the analogy is much less evident in the case of applications hosting, since logic would dictate that what is involved is royalties or rent, as the charges for use would appear at first sight to cover the use of an intangible — the software.

This is not, however, the position adopted by TAG. It came to the conclusion that in these cases the user is in the same situation as if he had acquired the software and chosen to install it on the host’s server rather than on his own computer. We are thus back at the analogy of the commercial depot or premises where the purchaser would use his own equipment. Here, too, some members of TAG expressed reservations because in some tax treaties the definition of royalties includes “payments for the use, or the right to use, industrial, commercial or scientific equipment”, TAG thus based its view on the criteria set out in article 7701(e) of the

77 Although 27 operations were identified, the distinctions made by TAG mean that we actually

have to distinguish 33 such categories. They are as follows: 1 Electronic order processing of tangible products, 2ai Electronic ordering and downloading of general software, 3a Software updates and add-ons if supplied on a physical medium or 3b if supplied electronically, 4a Limited-duration software and other digital information licences if supplied on a physical medium or 4b software if supplied electronically, 6a Applications hosting under separate licence and 6b bundled contract, 7 Applications service provider (ASP), 8 ASP licence fees, 9 Web site hosting, 11 Data retrieval, 15 Advertising, 16 Electronic access to professional advisory services, 19 Subscription access to an interactive Web site, 20 Online shopping, 21 Online auctions, 22 Sales referral service, 23b Content acquisition transactions if intended to create new content, 24 Streamed (real time) Web-based broadcasting, 25 Broadcasting rights.

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United States Internal Revenue Code,78 concluding that such payments were remuneration for services rendered rather than rental payments.

Income types constituting royalties

There are three of these,79 and it may be said that TAG chose for this characterization only more or less indisputable cases involving the use, against monetary payment, of intellectual property.

Income types on which there is no consensus

It goes without saying that this is the heart of the debate. These are products and services which either are delivered in entirely digital form or provided entirely over the Internet. Six80 of the 27 income types are covered by this discussion. As mentioned earlier, these divergences revolve around two categories which result from two distinct approaches. They may be described as follows:

• Downloading of products other than software

• Services providing access to databases and information

The cause of the divergence between the majority and minority positions on income from these types of operation lies in the fact that the minority position has changed since the distribution of the first report, and it now agrees to accept the revised commentaries on article 12 of the Model Convention covering software.81 In so doing, it accepts the idea that software should be treated in the same way, whether it is downloaded or supplied on a physical medium. More specifically, the fact that downloaded software implies the transfer of limited reproduction rights in order to use it does not result in characterization as royalties, since the consideration attaching to this right is minimal and is, moreover, only an accessory to the principal service. The latter typically consists of contractual rights such as usage or service rights, and in any event rights other than copyright.82

Strangely, the minority takes a different view when considering a digital product other than software. Here it sees a source of royalties mainly because the product exists for the user only from the time when it is copied onto one of his memory units.

In more specific terms, this approach considers that the downloading of a digital product does not provide the purchaser with a copy of that product, because at that moment he is not in possession of movable tangible containing the file. This

78 TAG report, op. cit., footnote 75, para. 36. 79 They are: 2b Ordering and downloading of digital products with copyright, 17 Technical

information, 23a Content acquisition transactions if intended to acquire the right to post documents protected by copyright.

80 As explained in footnote 77, there are actually 33 sub-categories of transactions among the 27 main categories. They concern the following income types: 2aii Ordering and downloading of digital products other than general software, 3bii Updates and add-ons for products other than software if supplied electronically, 4bii Limited-duration software and other digital information licences, except software, if supplied electronically, 13 Data retrieval, 14 Delivery of exclusive or high-value data, 18 Information delivery.

81 OECD, Revised commentaries on article 12 concerning payments for software (Paris, OECD, 1998). The reference is to commentary 14.1 to article 12. The document is available at www.oecd.org/daf/fa/treaties/art.12_f.pdf.

82 TAG report, op. cit., footnote 75, para. 21.

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does not occur until the time when the file is transcribed onto a hard disk or any other physical medium. Consequently, the argument is that what is being paid for is not ownership of a file copy but the right to make a file copy on a physical medium. According to this approach, the fact of copying is a central element in the transaction and therefore gives rise to royalties, because the price relates to the right of reproduction and not any other right.83

Fortunately, there are many critics of this line of argument. One of the basic precepts of the revision of the commentaries to the Model Convention is fiscal neutrality, i.e. identical tax treatment of transactions which are fundamentally identical. The question does indeed arise as to what is the difference between the sale of software and the sale of an MP3 music file.

A counter-argument to that put forward by the minority is the fact that the scope of reproduction rights agreed by the seller84 is so small, compared with the right to use the product, that the proportion o the payment relating to reproduction rights is infinitesimal.85 The object of the transaction is therefore considered to be the transfer of the right to use a copy rather than the right to reproduce an original subject of intellectual property, since the method of transmission chosen by the seller serves only to increase efficiency and cut contribution costs.86 Another argument put forward by the majority is that the economic substance of the transaction lies in the acquisition of a digital product for personal use or the user’s entertainment and that, in this sense, the sale of a piece of music, a text or a picture cannot be dissociated from that of software.87

It can thus be seen that the path taken by TAG is strewn with pitfalls. Although a majority of members do not hesitate to characterize as business income payments resulting from most of the transactions identified, a minority nevertheless refuse to support this analysis. Even more worrying is the almost obstinate inclination expressed by this minority to question the validity of the principle of fiscal neutrality by making the distinction relate not to the method of transmission of the digital product (physical medium or downloading) but to the type of file transferred (for example, an .exe file rather than a .mpg, .txt or .tif file).

These conclusions were echoed in the commentaries of the Electronic Commerce Tax Study Group,88 which recommends the adoption of a simple criterion to distinguish between royalties and business profits: the criterion of commercial exploitation. If a product is digitized to enable it either to be incorporated into a new product or to be commercially exploited directly, the

83 Id., para. 24. 84 Typically, as for software, the right to make copies for personal use and not for resale. 85 This is the position taken by Australia in its report, see ATO report, op. cit., footnote 2, section

5.4.50. 86 TAG report, op. cit., footnote 75, para. 23. 87 Id., para. 22. 88 This group consists of representatives of industry. It was formed in 1996 to study international

taxation issues relating to electronic commerce and to promote dialogue between industry and tax authorities throughout the world. Member companies include: Agilent Technologies, Inc., America Online, Inc., Cisco Systems, Inc., Electronic Data Systems Corporation, Hewlett-Packard Company, Intel Corporation, International Business Machines Corporation, J. D. Edwards & Company, MasterCard International, Microsoft Corporation, NCR Corporation, Sun Microsystems Inc., The Thomson Corporation, The Walt Disney Company and Time Warner Inc. PricewaterhouseCoopers acts as adviser to the group.

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payments relating to its provision will be royalties. If not, they will be business profits. This solution is the same as that developed by OECD in its revised commentaries to article 12, mentioned above. It is to be hoped that this is the solution that will ultimately be adopted by TAG, because so far it is the only one that both is simple to apply and respects the principle of neutrality.

Permanent establishment

As we have emphasized above, a taxpayer earning an income from a business through establishments situated in a country with which Canada has signed a tax treaty is liable to tax in the foreign administration if its presence meets the criterion of permanent establishment.

The definition of permanent establishment covers factories, branches, headquarters and other forms of physical presence.89 In the context of electronic commerce, physical presence as currently set out in the existing treaties is probably not necessary.

A communications server or Web site is sometimes the only “physical presence” in a country. The emphasis in relation to permanent establishment for e-commerce is therefore on these factors.

On 3 March 2000, OECD published its revised commentaries on the permanent establishment concept in the context of electronic commerce. This document is one of reflection in which the sometimes contradictory positions of member countries are put forward.90 The revised draft asked for commentaries to be sent to the Working Party by 15 June 2000 to enable it to formulate a final position for its next meeting, scheduled for September 2000.

As a first step, OECD states that a Web site and the algorithms that lie at its heart cannot, in and of themselves, constitute a place of business. However, a server, which has a physical presence, could be considered a place of business in certain circumstances. For example, as the server is fixed, it could constitute a permanent establishment. On this point, OECD mentions that, for a server to be considered as a fixed place of business, it must in fact be situated in a fixed place for a given period. Thus, if the server can be, but is not, moved, it could be regarded as a permanent establishment in the light if that particular situation. OECD did not specify the period of time needed to characterize a server as a fixed place: is it one year, six months…?91

In a situation in which, in accordance with the guidelines set out above, a server could be considered to be a fixed place, it would subsequently be necessary to determine whether a business was operated, wholly or partially, by means of the server. On this question, several important principles are being discussed, including:

• Can there be an independent computerized permanent establishment?

• Does the level of human intervention have to be considered?

89 See, for example, article 7 of the OECD Model Convention. 90 Revised commentaries on the permanent establishment concept, op. cit., footnote 34. 91 For its part, the ATO report, op. cit., footnote 2, section 5.3.18, supports the idea that a period of

six months is sufficient to make a presence fixed. This period is often the threshold from which tax treaties consider that certain building or installation activities can constitute a permanent establishment.

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• In what situations are the activities of an electronic business preparatory or auxiliary in terms of the definition of permanent establishment?

Independent computerized permanent establishment

Some member countries believe that the first question has already been dealt with adequately in the OECD Model Convention, in which certain computerized procedures are regarded as being capable of constituting a permanent establishment. In the commentaries to article 5 of the OECD Model Convention, the case of automatic vending machines and gaming slot machines is considered, and it is stated that “if the activities of the business are carried out principally by means of automatic machinery, while the activities of the staff are limited to assembling, starting, monitoring and maintaining that machinery”,92 they would constitute a permanent establishment unless the vending machines were simply assembled for subsequent rental. The application of this principle to a communications server hosting software that carries out certain functions could therefore lead us to conclude that a permanent establishment does exist, the level of activities sometimes being broad enough93 for more than the sale, for example, of a bar of chocolate by a vending machine. For other member countries, the situs of a server for an electronic business is not relevant. An example is the situation of the sale of goods on the Internet. In this case, the place where the business is carried on is not the place where the server is situated, but rather where its offices, depots, research centres, etc. are located. It is, however, also pointed out that when the server carries out all economic activities (accepting the contract, payment and delivery of products or services), it would seem that the company is carrying on its business by means of the server. In our view, this approach to e-commerce activities shows some contradiction, and the question arises whether the principle of fiscal neutrality is being respected. An electronic business selling tangibles (for example music CDs) would not be regarded as carrying on a business through its transactional server, whereas one selling the same “product” in digital and downloadable form (for example music in MP3 form) would be regarded as doing so.94 Moreover, this approach appears to suggest that a server must both be a transactional server and store the digital product, a situation which, in our experience, will hardly be frequent.

92 Para. 10 of the commentary to article 5 of the OECD Model Convention. 93 For example, software used in e-commerce can reach a level of computerization such that it

would be able to carry out all the functions listed below: • solicit orders from target recipients using e-mail; • provide detailed information on the digital products or services on offer; • provide an electronic order form; • obtain the digital product and transmit it to the client; • register the sale and transmit the necessary information to head office; • process the payment (credit card or electronic currency) and transmit the deposit to the

appropriate financial institution; • periodically provide registered clients with updates and information on the product or service.

94 Since the MP3 business could store digital versions on a transactional server which would carry out the sale cycle.

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In response to the Working Party’s commentaries, a New Zealand author, Mrs. Mara Fischer,95 proposed a different approach. As article 5 was drafted at a time when the emergence of electronic commerce had not been foreseen, it is wrong to try and apply its principles literally. In this sense, she considers that extending the scope of article 5 to the mere physical presence of a server runs counter to the article’s purpose. A teleological approach is therefore proposed, under which article 5 does more than identify a source of income and attribute it to a physical presence. It sets a notional tax threshold in a country. The author deduces that to go beyond this threshold, the physical presence must also be a centre of economic activity, and not merely an extension of the parent company. A server is not a place of business, but rather a conduit; the profit is created at the place where the server’s software was designed, while the income is obtained where the client is situated.96 The author therefore concludes that, fore the purposes of the Model Convention, a server is not an independent centre of economic activity but merely an automated machine which, unlike a vending machine, does not have be situated in the jurisdiction of the consumer. The Swiss business community expressed similar views in a letter to the Working Party.97 It concluded that in no case could a server used to carry on electronic business constitute a permanent establishment.

Human intervention

For some member countries, intervention is not necessary to conclude that a server is a permanent establishment. On this point, an analogy is drawn with the situation of a pipeline not requiring any human intervention, which is regarded in German jurisprudence as a permanent establishment for the purposes of a tax treaty,98 and reference is made to the commentaries discussed above concerning the case of automatic vending machines and gaming slot machines.

According to other member countries, a level of human intervention is necessary with respect to a server for a permanent establishment to exist. These countries therefore reject jurisprudence over pipelines and the OECD position on automatic vending machines and gaming slot machines. Although they agree on the concept of human intervention, several associated questions remain to be discussed:

• What level of intervention is necessary?

• Must the intervention be that of employees of the business or other persons (for example sub-contractors)?

• Must the intervention be by persons situated in the country where the server is situated or can it be remote (for example by modem)?

95 A summary of her comments can be found in New Zealand: Comments on Revised Draft of PE

Definition, Tax Planning International e-commerce, vol. 2, No. 7, p. 17, July 2000, BNA International Inc., London, United Kingdom.

96 There is therefore no correlation between the place where the server is situated, the place where the business is carried on or the place where there is an economic presence.

97 Switzerland: Comments on Revised Draft of PE Definition, Tax Planning International e-commerce, vol. 2, No. 7, p. 18, July 2, BNA International Inc., London, United Kingdom.

98 See the decision of the Federal Finance Ministry, 30 October 1996 (IT.R 12-92), published in Betriebs-Berater 1997, p. 138.

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• What type of intervention should be taken into account: at the time of establishment or at the time of regular activities such as the updating of files and databases?

The Swiss comments99 considered that the discussion of human intervention was not relevant because, in their view, intervention is not a determining criterion concerning permanent establishment with respect to a server.

Preparatory or auxiliary activities

Under the usual definition of permanent establishment, an establishment carrying on so-called “preparatory or auxiliary” activities is not deemed to be a permanent establishment. Thus, a server could be regarded as a fixed place of business without constituting a permanent establishment. In the OECD revised commentaries on the permanent establishment concept, it is stated that the determination of whether a given activity is preparatory or auxiliary in nature must be made in each individual case. However, some particular activities have been identified as being, in most cases, preparatory or auxiliary:

• Information-gathering;

• Provision of market information;

• Advertising of goods or services;

• Use of a “mirror” server for efficiency (for example, server array technology) or security;

• Provision of a communication link between suppliers and clients in a context of e-procurement.

Although the above activities are, a priori, regarded as being preparatory or auxiliary, the OECD revised commentaries on the permanent establishment concept state that, if the activities represent the very essence of the business, they could nevertheless be deemed not to be preparatory or auxiliary. Let us take the example of an electronic auction business. In this type of business, the gathering and provision of information, like advertising, represent the very essence of the economic activities of the business, and such a business would be considered to have a permanent establishment from a threshold different to another business selling tangible and digital property.

The first three activities listed above merely repeat ideas already found in the exception for preparatory or auxiliary activities in the OECD Model Convention.

With regard to the use of a mirror server for efficiency or security, we believe it appropriate to consider it as auxiliary since the extent of the activity is not the essence of the business (i.e. this exception is aimed at activities such as “back-up”).

The last activity listed above appears to relate to a server used in the context of e-procurement activities, one of the most important activities for businesses moving towards e-commerce. In our experience, computerization of procurement activities over the Internet produces substantial savings for businesses. For example, a multinational group could plan e-procurement activities in a controlled foreign

99 Op. cit., footnote 97.

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affiliated company in order to reduce its tax charge,100 attributing procurement savings to it.101 Thus, in the light of the principles advanced in the OECD revised commentaries on the permanent establishment concept, we believe that such a company would have to have a level of human intervention in the country in which the company is situated in order to achieve its planning objectives.

Lastly, it is stated that some countries consider that using the Internet for transactions is merely a means of communication, i.e. that this method of doing business is no different to telephone or postal selling. Other countries, basing their view on the recent changes concerning royalties (article 12 of the Model Convention), conclude that a server may constitute a permanent establishment if it is responsible for an economic activity.

The positions put forward by the OECD revised commentaries on the permanent establishment concept represent a significant advance over the first OECD discussion draft on this issue. On the one hand, the European positions (independent computerized permanent establishment) can be seen to have been included in this revision. However, the hesitation of some other member countries to endorse that position is also evident. The discussion on permanent establishment in the context of e-commerce will therefore have to face considerable challenges because of the contradictions to be found in the present draft.

The Swiss business community102 has stated its view that no attempt should be made to ascertain the capabilities or functionalities of a server to establish whether there is a permanent establishment. It expresses its disagreement with paragraph 13(12) of the revised commentaries on article 5 of the Model Convention,103 which suggests that a case-by-case study is needed to resolve the matter. In its view, the presence of a server can be seen, at most, as a preparatory or auxiliary activity, even where the server enables fully automated transactions to take place. For its part, the United Kingdom104 has declared in a public statement that a Web site or the hosting of a Web site on a server is a presence that is insufficient in itself to constitute a permanent establishment. In addition, the fact that the server is owned directly, rented or otherwise made available to a business has no effect on the determination.

Central management105

The improvements made to various communication technologies (videoconferencing and electronic communications, including the Internet) have increased the frequency of meetings of governing boards in which the directors are physically located in different jurisdictions. The new technologies also help to facilitate the monitoring of operations abroad and, in some cases, their execution in another administration. It then becomes difficult for tax authorities to apply the traditional criterion of central management to determine the residence of a company.

100 Clearly, in a Canadian context, consideration must be given to the application of the determining

rule to subparagraph 95(2)(a)(i) of the Act with respect to procurement for Canadian operations. 101 An analysis of transfer prices would of course have to support the level of profit attributed to the

e-procurement business. 102 Op. cit., footnote 97. 103 OECD revised commentaries on the permanent establishment concept, op. cit., footnote 35, p. 6. 104 United Kingdom: Tax Status of Web Sites and Servers, International e-commerce, vol. 2, No. 4,

p.28, April 2000, BNA International Inc., London, United Kingdom. 105 For a more detailed discussion of this question, see Income-taxes.ca.com Part 2, loc. cit.,

footnote 31, 1395-1396.

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Similarly, taxpayers with CFACs could find it difficult to prove that the central management is not in Canada.

Some have suggested that a new residence criterion is needed for companies with only a “virtual” existence (a criterion which would apply to the country of residence of the auctor intellectualis of the product, idea or concept106), but it would not seem appropriate to make such a fundamental change to a basic principle of international taxation.

The Revenue Canada Advisory Committee has noted the difficulties of applying the traditional criterion of central management resulting from the new technologies, and has indicated that there will probably be an increase in the number of companies with dual residence. It makes two recommendations on the subject. Firstly, it recommends the publication of an interpretation bulletin on the factors to be taken into consideration in determining the central management of a business, which would presumably take account of complex matters such as the impact of teleconferencing and videoconferencing. Secondly, as reference to the competent authority process enables cases of dual residence to be resolved (there is a notable exception in the Tax Treaty between Canada and the United States, where it is the country of incorporation of a company that is the decisive factor), it is recommended that Canada, in cooperation with its tax partners, should try to find ways of shortening the process of appealing to the competent authority, especially for medium-sized enterprises.107

In its report, the Revenue Canada Advisory Committee went into some detail on the main questions of international taxation relating to treaties. It does not arrive at any final conclusion, but it nevertheless makes a recommendation that Canada should not abandon the existing principles without examining alternative or new concepts.108 According to the United States Treasury document, changing taxation by source to taxation by place of residence is both desirable and inevitable because of the changes made in electronic commerce and telecommunications.109 One would expect the United States to be a net exporter of digital goods and services and to continue to have a favourable trade balance in this area in the short term. A change to taxation by place of residence would probably be advantageous to the United States Treasury. It will come as no surprise that the Revenue Canada Advisory Committee has recommended that more information should be obtained in order to assess the impact of any change in the balance existing between source-based taxation and taxation based on place of residence.110

106 Machiel LAMBOOIJ, “Rethinking Corporate Residence”, available at

www.lovotax.nl/ondrwerp5. 107 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.1. We believe that it

would be appropriate to shorten the competent authority process for all the taxpayers concerned. On the first recommendation, Revenue Canada stated in the Reply of Revenue Canada, op. cit., footnote 2, section 6.3.2.1, that it would not start an interpretation bulletin on the concept of residence. This position of the Canadian tax authority is in accordance with that of OECD as announced in Ottawa in October 1998. See Ottawa working document, op. cit., footnote 2, para. 52.

108 Revenue Canada Advisory Committee, id., section 4.2.2.4. 109 United States Treasury document, op. cit., footnote 2, section 7.2.5. 110 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.4.

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Transfer prices

Electronic commerce is a relatively recent and constantly changing phenomenon. The complexity of the technical language and the various technological functions needed to carry on e-commerce activities can be so closely integrated that it may become difficult to asses their components. In addition, modern means of communication facilitate greater international cooperation, and the growing interaction between entities opens up possibilities for moving revenue among administrations. Because of these factors, the traditional case-by-case approach111 and the distribution of revenue among administrations become difficult. The Canadian administration’s preference for transaction-based methods of determining transfer prices (particularly the method of comparable price on the free market) over profit-based methods112 could cause problems for Canadian taxpayers, especially in view of the requirement for meticulous documentation and the penalties for non-compliance.113

The Revenue Canada Advisory Committee has singled out the issues which it considers important with respect to electronic commerce and transfer prices:

• Determination of comparable market prices;

• Establishment of the appropriate economic yield for each type of activity which can be identified;

• Attribution of operations, profits and expenditure to the various administrations;

• Impact on the Canadian tax base.114

The problems which a company carrying on e-commerce activities must face in respect of transfer prices, and which our tax administration has singled out, are not peculiar to this sector,115 but they raise certain issues on transfer prices which are the most complex ones that could arise.

As in any other situation relating to transfer prices, the first stage in determining a transfer price consists in obtaining information on the main economic variables and the manner of doing business which may influence the distribution of income and profits between the businesses concerned. It is therefore necessary to determine which affiliated companies (or branches) carry out or support the following activities and are the owners of certain active elements:

1. who is the owner of intangible goods? (trade name or trademark, clients’ database, right to digital product source code and right of distribution);

2. who bears the financial risks with regard to collection?116

111 OECD Turku report, op.cit., footnote 3, para. 123. 112 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.7. 113 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 ”, (1997), vol. 45, no. 6, Canadian Tax Journal, 1243-1275.

114 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.7. 115 For example, similar questions to those which arise for businesses specialized in technology also

arise for financial institutions trading at the global level. 116 This may be a factor of minor importance if a business deals exclusively in electronic currency,

the equivalent in reality of a business where the credit risk is nil or almost nil.

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3. what is the level of computerization of the activities and what are they?

4. who bears the guarantee costs (for example, the cost of software updates and alterations)?

5. who provides technical support for users (helpline for users, drafting of FAQs117, etc.)?

6. who performs accounting and financial tasks such as updates of sales data, registration of transactions?

7. where are “stocks” held?

8. what is the nature and type of transactions between affiliated companies (or branches)?

The next stage is the choice of method for determining the most appropriate transfer price in the light of the elements listed above and the economic and functional analyses carried out.

Firstly, it is necessary to determine whether comparable data exist. As e-commerce is a recent phenomenon, it may be difficult to find reliable data from third parties. Moreover, the integrated nature of e-commerce and the fact that various risks and activities can be distributed in many different ways may make it very difficult to obtain relevant data. Consequently, it is probable that the available information does not meet the comparability standard generally required.118 In these circumstances, the business itself may well be the best source of information. This would be the case, for example, when the organization has moved on from “conventional” trading to e-commerce. In addition, the non-availability of information could be short-lived. If forecasts of the volume of e-commerce activities prove wholly or partially correct, there would be strong growth in e-commerce and available comparable data would increase accordingly. Businesses and tax administrations will, however, probably not wish to wait until information becomes available, since the absence of guidelines could have an important impact on maintaining existing fiscal bases of assessment.119 In addition, the possibility that different administrations could prepare incompatible guidelines could increase the risk of double taxation. The premature adoption of strict guidelines, on the other hand, could harm the development of e-commerce.

There are several ways of formulating and supporting a policy for establishing a business’s transfer prices. At present, and as mentioned above, transaction-based methods may be regarded as inadequate with respect to e-commerce. In this connection, it was pointed out at the OECD Turku conference in 1997 that methods based on profit-sharing could well be applied more broadly in the context of e-commerce.120 Interestingly, the Revenue Canada Advisory Committee considers that Canadian taxpayers may encounter major difficulties as a result of the incoherent application and acceptance of the method of comparable profits in Canada and the United States, and that the problem must be solved.121 The committee did not wholly endorse the use of methods based on profit margin, but Revenue Canada

117 Frequently asked questions. 118 See the OECD Turku report, op. cit., footnote 3, para. 125 119 Id. para. 135. 120 Id. para. 134. 121 Revenue Canada Advisory Committee, op. cit., footnote 2, section 4.2.2.7.

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seems to be aware of the heavy burden of compliance on the shoulders of Canadian taxpayers because of the fact that Canada and the United States have different positions concerning methods of establishing transfer prices. These are harbingers of possible changes in the positions adopted by the Canadian administration that are likely to be well received and could facilitate the task of businesses working in e-commerce and struggling with transfer-price problems.

We shall now turn to some more specific aspects of e-commerce, particularly intangibles and global trading of financial instruments, which could be considerably facilitated by the new technologies.

Intangibles

As stated earlier, it is possible that, in the light of a consensus that might emerge, companies engaged in e-commerce activities could find themselves with permanent establishments in the administrations in which they have servers. In the context of e-commerce, the use and creation of various intangible elements may well be important. If there is a proliferation of “electronic branches”, the results could be surprising. The fact that OECD believes that intangibles are not taken into account at the branch level (except their contribution to costs) could raise a number of complex problems. The question was brought to light 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.”122 [our bold characters]

In some cases, the value of intangibles could be important for the income-generating activity of the permanent establishment. The application of the above principles to an electronic branch could result in substantial net income at the level of the branch which, at least in an economic perspective, would seem inappropriate. In this connection, the following appears in the Turku report:

“The tax treatment of permanent establishments, when their existence can be shown to be in the context of e-commerce, may well be different from that of branches engaged in similar activities. This raises the problem of knowing whether permanent establishments and branches should be treated differently with respect to taxation when they are engaged in economically similar activities.”123

122 OECD, “Taxation of Global Trading of Financial…”, loc. cit., footnote 4, para. 138. 123 OECD Turku report, op. cit., footnote 3, para. 131. This position on intangibles will probably be

adopted by the Canadian tax administration as a result of Cudd Pressure Control Inc. v. Canada [1999] 1 C.T.C. 1 (C.A.F.).

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Thus, if the threshold for a permanent establishment is set at a relatively low level for e-commerce, the international community should reflect on the most appropriate way of taking the intangibles into account. This is clearly a very complex question at a time when intangibles are being used more and more and it is becoming even more difficult to quantify their effect when several kinds of intangibles are involved.124

Global trading of financial instruments

In its discussion of transfer prices at the Turku conference, OECD noted that the principles put forward in its Global Trading Paper could be applied to e-commerce. The extent to which its commentaries could be relevant to a business engaged in e-commerce should be examined.

Briefly, activities for the global trading of financial instruments concern the international investment activities of a financial institution’s client and the institution’s own global trading activities. The inherent characteristics of these activities, which raise problems similar to those encountered by e-commerce, are:

• Global trading activities go on everywhere in the world, 24 hours a day. A trader may therefore have to delegate its powers (to negotiate, buy or sell) to affiliated entities (subsidiaries or branches).

• Global trading activities are integrated. The distribution of profits is therefore a challenge. The issue is made palpably more complex by the fact that different administrations may apply different methods of income assessment.

• Since capital is increasingly mobile, anticipated profits or losses may be transferred from one administration to another. Because of the complexity of financial instruments, verification of transactions is in itself difficult.125

The reports assesses whether advance transfer price agreements might be a solution. It concludes, quite rightly, that such agreements are probably insufficient because they are voluntary and few taxpayers consider them to be a viable solution in view of the direct and indirect costs (informing the tax administration) involved.126 It is also possible that taxpayers engaged in e-commerce activities feel the same way.

The place where the transaction is effected is not necessarily an appropriate indication of the place where the profit should be entered in the accounts.127 This is a consideration similar to that mentioned previously in the context of the use of servers.

In view of the nature of global trading in financial instruments, it is considered that profit-sharing methods are probably the best solution and that, because of the great variety of ways in which these activities are carried out, each situation should probably be considered separately. Two conditions need to be met for a profit-sharing method to be used:

124 OECD Turku report, id., para. 132. 125 Id., paras. 95-97. 126 Id., paras. 103-107. 127 Id., para. 133.

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• Sharing must be common practice in the administrations concerned (i.e. internal regulations should lay down relevant procedures);

• The results must be compatible with the principle of full competition set out in article 7 of the OECD Model Convention.128

There are two difficulties in the application of this approach. Firstly, with respect to the first condition, most administrations probably do not provide for any profit-sharing methods at present and a concerted effort by various countries to change their domestic tax laws would therefore be needed. Second, it may prove difficult to conclude that the results of applying a profit-sharing method comply with full competition.

The report contains a number of interesting observations regarding the factors which have to be taken into account in income and expenditure sharing:

• Should activities with only a remote link to global trading of financial instruments be entitled to a part of the profits?

• Which income should be attributed under profit-sharing?

• How should expenditure be broken down (on the same basis as gross or net income; should a distinction be drawn between international and local expenditure?)129

Similar questions will inevitably arise when e-commerce activities are analysed. The report then considers and comments on the various factors (volume, capital, head office, negotiation risk, remuneration paid to negotiators) that may have an effect on profit-sharing. It states that the identification, choice and weighting of these factors are always difficult and that each situation should be examined in all objectivity.130 The application of profit-sharing methods to a business engaged in e-commerce activities will certainly be no less arduous.

As noted earlier, the transfer-price issues which a business engaged in e-commerce has to face are not new, but they are certainly among the most complex. Taxpayers, tax advisers and tax administrations will become more familiar with them over the next few years, and this will help a consensus to emerge. It is nevertheless probable that in the near future taxpayers and their advisers will ask their tax administration for guidelines. It is also to be hoped that countries will cooperate in preparing and interpreting guidelines in order to minimize cases of double taxation.

Review of other recent developments

OECD

In addition to the amendments made to article 12 of the OECD Model Convention and the positions taken on the permanent establishment concept, the Ottawa conference highlighted what is at stake in e-commerce and the problems to which it gives rise, without putting forward any recommendations. OECD thus gave itself the means to study the issues in greater detail and consult those involved,

128 Id., para. 134. 129 Id., paras. 156-160. 130 Id., para. 195.

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namely, OECD member countries, OECD non-member countries and taxpayers. Five technical advisory groups (TAGs) were established in January 1999 to study the issues. They will have two years to gather all the necessary information. The five TAGs and their mandates are:131

• Income characterization

To examine the characterization of various sources of e-commerce income for purposes of tax treaties and, where necessary, to formulate recommendations for changes to the commentaries on the Model Convention.

• Taxation of business profits

To examine how the current standards will apply to e-commerce and analyse proposals for alternative rules (for example bit tax, distribution by formula, etc.) in order to make recommendations.

• Consumption taxes

To examine the feasibility of mechanisms, such as the use of self-liquidation, self-assessment or equivalent mechanisms for the sale of digital products to businesses. To examine ways of simplifying registration and payment obligations.

• Technology

To list and evaluate Internet developments to identifying the challenges and opportunities for tax administrations: taxpayer identification, verification of taxpayer information and facilitating tax collection.

• Data access

To review the methods used by business to verify the reliability, identity and completeness of data with a view to adapting these procedures and methods for tax administrations.

Lastly, it is possible to join a discussion group on the matters raised above and obtain some of the documents used by the TAGs. All that is needed is to go to the OECD Internet site and register.132

United States

A very important piece of legislation, the Internet Tax Freedom Act (IFTA),133 has been adopted in the United States. Under it, a moratorium of three years has been imposed on state, county and urban taxes on internet access, except those which were in force on 1 October 1998, and all multiple or discriminatory taxes on electronic commerce. “Discriminatory tax” means, inter alia:

• A tax levied by a state, county or town which is not generally levied or may not be payable for transactions relating to products, goods, information or similar services;

131 The mandates of the TAGs may be consulted at oecd.org/daf/fa/e-com/tag.htm. 132 At oecd.org/daf/fa/e_com/e_com.htm. 133 Internet Tax Freedom Act, Title XI of P.1. 105-27, Omnibus Appropriations Act of 1998. These

laws may be consulted at ecommercecommission.org/IFTA.htm.

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• A different rate of tax for transactions relating to products, goods, information or similar services; or

• A tax liability which is different from that for transactions relating to products, goods, information or similar services.134

IFTA set up an Advisory Commission on Electronic Commerce (ACEC), which has studied issues relation to the taxation of e-commerce and access to the Internet. In its report to Congress submitted in April 2000,135 the Commission did not arrive at any meaningful consensus on most of the matters entrusted to it, as a two-thirds majority was needed under its statutes for its recommendations to be submitted to Congress. Since this was not achieved on most cases, new United States legislative measures cannot be expected in the near future. The renewal of the moratorium for a further three or five years is at most uncertain. Although the House of Representatives has adopted a bill to this end, it is far from clear that the Senate will wish to do likewise. Mention may be made in this connection of the bill tabled by Senator Dorgan entitled “Internet Tax Moratorium and Equity Act”. Although it has not yet been adopted, this bill has received the support of the Multistate Tax Commission and proposes an extension to the moratorium of four years, together with the establishment of a system for levying state sales tax on all taxable sales made on the Internet. It goes without saying that this bill is diametrically opposed to that adopted by the House of Representatives, which provides for the continued exclusion of Internet sales from sales tax.

Lastly, the United States Treasury Department has announced in a communiqué136 that it would publish a report on the regime of controlled affiliated foreign companies, particularly their e-commerce activities. No news has been published on that study.

Canada

Like OECD and the United States, Revenue Canada has set up technical advisory groups. Their mandates are quite similar to those of the OECD TAGs and are as follows:

• Improvement of services to taxpayers

• Tax assessment and administration

• Consumption taxes

• Interpretation and international cooperation.

Each technical advisory group is chaired by a representative of Revenue Canada and the members come from business and tax professionals. The groups work together and in cooperation with the OECD TAGs. Lastly, we understand that an advisory group of provincial representatives will be established to ensure that infra-national concerns are taken into account.

The term of the technical advisory groups’ mandates is two years. It is therefore unlikely that tax professionals in Canada will have any indication of the positions taken by Revenue Canada before 2001.

134 Id., art. 1134(2). 135 The document is available in pdf format at www.ecommercecommission.org/acecreport.pdf. 136 Dated 10 December 1999, available in pdf format at www.ustreas/gov/press/releases/ps289.htm.

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Quebec

On 11 May 2000 the Quebec Government announced the establishment of Electronic Commerce City.137 It is modelled rather closely on the tax credit programme for companies in the multimedia city,138 and establishes tax incentives for employment in the form of reimbursable tax credits granted on condition that the Quebec Ministry of Finance issues a visa.

For eligible companies, a reimbursable tax credit, equal to 25 per cent of the wages agreed and paid to eligible employees, will be available until 2010. There is, however, a ceiling of $10,000 per year and employee. Eligible companies must obtain a certificate of eligibility, for which they must be able to show that they have at least signed a lease for premises within Electronic Commerce City and at least 75 per cent of its activities are eligible.

The activities targeted by this measure fall into two categories. Firstly, there are advisory services associated with technology and electronic business solutions and activities relating to the development and integration of information systems and technological infrastructures. The second category consists of activities associated with the operation of electronic business solutions. It is not the advisory service that is specified here but the performance of the activity itself, such as, for example, the maintenance or management of systems or applications. Activities associated with “equipment”, such as maintenance, manufacture or assembly of installations, are excluded.

From an international taxation standpoint, this measure is not intended merely to simplify the problems of multiple taxation which can result from e-commerce activities, as we have seen. The idea might have been to establish a tax-free zone such as that established for international financial centres,139 but it seems that the Government has taken a different view. It remains to be seen whether the evolution or divergence of discussions on the adoption of joint international tax measures on the taxation of electronic commerce will favour the adoption of incentive or compensatory tax measures with respect to the multiple taxation of income.

Europe

The Commission of the European Communities recently submitted a draft Council Directive140 amending the rules governing liability to Value Added Tax (VAT). At present, if a service provider is situated outside the European Union (EU), its services rendered inside the EU do not incur VAT. This naturally creates a competitive advantage for providers abroad, since the same service would be liable for VAT if provided by a business inside the EU. The proposals put forward

137 C.N.W., “Cabinet du vice-premier minister et ministre d’Etat à l’Economie et aux Finances et

minister des Finances — LA CITE DU COMMERCE ELECTRONIQUE A MONTREAL: 20,000 EMPLOIS D’ICI DIX ANS”, Quebec, 11 May 2000.

138 Loi sur les impôts, L.R.Q., c. 1-3, art. 1029.8.36.0.3.28 and ff. and 1129.4.3.13 and ff. 139 For a general presentation of what constitutes an international financial centre, see the text by

Bernard Barsalo entitled Congé fiscal accordé aux nouvelles societés, in APFF, Colloque 68: Colloque 68 — Déductions, Crédits d’impôts et Aides Gouvernementales.

140 Draft Council Directive amending CEC directive 77/388/CEE concerning the value added tax regime applicable to certain services provided electronically, available in pdf format at http://europa.eu.int/eur-lex/fr/com/pdf/2000/fr_500PC0349_02.pdf.

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therefore seek to remedy these distortions and to establish a simplified system for administering VAT. There are two sets of measures, depending on their purpose.

Measures concerning the rules governing liability:

In accordance with the guiding principles adopted by the Council,141 deliveries of digital products are deemed to be services for the purposes of VAT and services consumed on EU territory are thus liable to VAT. The rules proposed can be summarized as follows:

• Services provided by an operator established outside the EU to an EU client will be deemed to be rendered in the EU and will now be subject to VAT.

• In the opposite case, when services are rendered by an EU operator to a foreign client, the place of taxation will be the client’s place of establishment.

• If an EU operator provides services to a person who is liable (one who is TPS/TVQ-registered), the place of provision and hence the rate of taxation will be determined by the place of establishment of the person liable.

• If the same operator provides a service to a (non-registered) individual established in the EU, it is once again the place of establishment that determines the place of provision and the applicable rate.

Measures to facilitate administration:

• Commercial clients are liable to VAT for services (taxable supplies) rendered to them. It will therefore be necessary to register only if the services are provided to private clients.

• Small tradesmen: a threshold of 100,000 euros will be established for sales to individuals.

• A single registration venue is provided for in the case of businesses that are not established in the EU. They will thereby be able to fulfil all their obligations through one tax authority and will thus be on an equal footing with EU operators.

• Possibility of carrying out all VAT registration formalities and submitting declarations electronically.

• Establishment of permanent mechanisms enabling operators to verify the status of their clients (EU establishment, registered for VAT).

Canadian businesses interested in trading electronically with the EU should note that they will have to register in the first member State in which they provide a service. It should be pointed out that it is then to their advantage to choose an EU member State which has a low VAT rate, because this will subsequently be in their favour in relation to their EU competitors.

141 The ECOFIN council, at its meeting of 6 July 1998 following the Ottawa conference.

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This point was also raised by the European e-Business Tax Group142 in its preliminary comments on the draft Council Directive.143 While this measure provides an advantage to foreign businesses wishing to engage in e-commerce on EU territory, it will disadvantage European businesses already established in member States whose VAT rate is higher. Moreover, the proposed “small trader” threshold is higher than that for business established in the EU. EeTG therefore emphasizes here a potential distortion in competitiveness on the European market. In addition, EeTG suggests that the final Directive should be clearer as to the interpretation of “place where a service is consumed” and “residence”, so as to ensure uniformity in their application by member States and thus to avoid cases of double taxation.

More generally, although these measures show a healthy desire to integrate VAT into the realities of e-commerce, they have certain weaknesses with respect to means of monitoring conformity. Knowing the anonymity of the Internet and the virtual impossibility of tracing the source of communications, we can guess the technological challenges that the solutions put forward by the Commission lay down. A suffix such as “.ca” does not in itself guarantee that the owner of that address is a Canadian resident, and it is even less of an indication of where that person is at the time when he or she decides to access online services or to order a digital product. As in many other cases, we see that the integration of the taxation of electronic commerce is as much a question of principle as one of technological feasibility. In the final analysis, the declared political will to arrive at a fiscally neutral solution requires that the usual rules governing liability should be applied in the context of e-commerce. As basic premises of these rules such as the client’s situs or nationality are virtually irrelevant governing liability may need to be adjusted to the new reality if they are not to fail. Moreover, if other jurisdictions react to the European proposal and oblige non-residents to register for the purposes of their consumption taxes, a heavy burden of compliance may well arise.

Other developments

Indian advance ruling: increase in source-based taxation?

In April 1999, the counterpart of Revenue Canada’s Department of Decisions, the Indian Authority for Advanced Ruling (AAR), published an advance ruling on tax which raises interesting problems for companies using the new technologies.

The facts considered in the advance ruling were as follows:144

• An Indian company, “IndiaCo”, was providing technical services (data management, data analyses, etc.) to a group of companies, the ABC Group,

142 Referred to below as “EeTG”. This is a European discussion group made up of representatives of

important players in electronic commerce. The firms represented are: ABB, ICL, KPN, Microsoft, Omnitel, Proctor & Gamble, Sony and TNT Post Group. PricewaterhouseCoopers is responsible for support and administration of the EeTG secretariat.

143 EeTG, Indirect tax treatment of electronic commerce: Preliminary comments on the European Commission’s draft Directive, 4 July 2000.

144 Shreya PANDIT and Shefalia GORADIA, Indian AAR Issues Landmark Ruling on E-Commerce Taxation Under U.S.-India Tax Treaty, Tax Analyst (database), 1 June 1999, 1999 WTD 128-5.

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which was carrying on a credit-card business in Asia, Europe and elsewhere.145

• A United States company, “UsCo”, was operating a telecommunications processing centre located in the United States. To this end, UsCo had supercomputers in the United States which were used by its clients for very- high-speed data storage and processing. UsCo’s clients used the supercomputers to process certain payments. IndiaCo used UsCo’s supercomputers to complete some of the data processing which it was carrying out. UsCo was also using supercomputers located in Hong Kong through a dedicated very-high-speed network. IndiaCo had access to this network also in order to obtain certain information and process data.

• IndiaCo signed a contract with UsCo providing that it should pay for access to and use of the supercomputers and access to the network. That access enabled it to use certain software. The contract provided that the sum to be paid could, if appropriate, be reduced by the applicable withholding tax.

• When a credit-card or traveller’s-cheque holder performed a transaction, it was transmitted to a computer in the country concerned. When the transaction took place in India, it was carried out by IndiaCo when the information had been channelled to it by modem or microwave. This information was then sent to UsCo and, once processed, sent back to IndiaCo by a satellite connection.

According to UsCo, the sums it received from IndiaCo were business profits and, for the purposes of the tax treaty between the United States and India, no withholding tax was payable. In addition, the sums in question could not be taxed in India because UsCo did not have any permanent establishment there; the processing activities were carried out by supercomputers in the United States and Hong Kong.

The Indian tax authority maintained that the sums paid by IndiaCo were royalties under the tax treaty between the United States and India and, consequently, a deduction at source was payable.

AAR upheld the position of its colleagues, stating that the characteristics which categorized a payment of royalties were:

• the payment is made in consideration of the acquisition of a right;

• the payment is made to the owner of that right;

• the consideration payable is determined in terms of use.

In the case of the payments made to UsCo, AAR determined that, in view of the nature of the business and the type of service provided, especially the fact that the confidential nature of the information processed requires the use of UsCo’s sophisticated software (inter alia, encryption), the payments in question were made “for granting the use of a secret design or model, plan or formula or process”. AAR thus upheld its colleague’s position and a withholding tax was payable under Indian law, as amended by the relevant tax treaty.

This advance ruling raises significant questions for electronic commerce. For example, where an Internet surfer pays a sum of money to play an interactive game

145 Id. According to the authors, the advance ruling could also apply to a flight reservation system

such as SABRE.

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with other surfers, the sum paid is for a single use of the game software. In this case, the question arises whether AAR’s reasoning can be applied to make the surfer’s payment for use liable to withholding tax under domestic laws. On this point, the Ministry of Revenue has dealt with a similar question in which it had to consider whether the charges for telephone or satellite access to a database situated in the United States were covered by the withholding tax provided for in subparagraph 212(1)(d) of the Act. The Ministry was unable, when asked for a technical interpretation, to adopt a final position.

Thus, depending on the nature of the business carried on over the Internet, withholding taxes could apply at source. For the recipient of the payments, it is possible that the sum withheld might not be recovered under a country’s current system for reimbursing foreign taxes.

Doernberg study

The International Fiscal Association (IFA) recently published a detailed analysis of electronic commerce and international taxation.146 The Doernberg Study will no doubt be a reference tool for tax experts and tax administrations, since it considers the various alternatives available for taxing electronic commerce and sets out their advantages and disadvantages. The authors make no final recommendation in the study concerning the optimum method of taxing e-commerce. They do, however, highlight the fact that e-commerce considerably reduces physical presence in the source jurisdictions and could therefore cause a significant erosion of those countries’ tax bases. In an earlier work, Mr. Doernberg stated that the use of a standard rate of withholding tax for e-commerce activities would potentially be the only solution for taxing e-commerce. This approach is recommended for two reasons: it constitutes an acceptable solution for countries that are importers of technology and digital products, and difficult questions of income characterization are avoided. On this last point, Mr. Doernberg believes that income characterization as between products for sale, royalties, services, interest and dividends is not necessary provided that a mechanism for reimbursement of the withholding tax deducted is put in place by countries of residence.147

The Doernberg approach is a revolution in the taxation principles of both domestic legislations and tax treaties. An extraordinary consensus among the various jurisdictions, as well as a mechanism for amending tax treaties in a timely and appropriate manner, would therefore be needed to implement such a proposal. In addition, the United States would probably oppose such a move.148 We find it difficult to imagine that such a consensus can be achieved.

Conclusion

For an electronic business, tax matters are clearly highly complex. Moreover, the task is colossal in many respects, because tax administrations have to take

146 Richard L. DOERNBERG and Luc HINNIKENS, Electronic Commerce and International

Taxation, The Hague, Netherlands, Kluwer Law International, 1999, referred to below as “the Doernberg Study”.

147 Richard L. DOERNBERG, “Electronic Commerce and International Tax Sharing”, Tax Notes International, 30 March 1998, pp. 1013-1022.

148 See para. 7.1.5 of the United States Treasury document, op. cit., footnote 2.

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account of a range of administrative subjects (tracking and risk of non-disclosure), national and infra-national taxation concerns, transfer-price issues and, lastly, consumption taxes. In view of the expected current importance of the “new knowledge economy”, several countries want to make sure that their decisions with respect to fiscal policy will not give rise to a competitive disadvantage for their businesses. Lastly, it may well be difficult to reach a consensus because the various countries might have irreconcilable concerns. For example, countries that are importers of the new technologies will prefer source-based taxation in order to maintain their tax assessment base (income tax, withholding tax and sales tax). For their part, countries that are exporters of the new technologies will find residence-based taxation more interesting. Lastly, any solution must be feasible and take account of the burden of conformity for businesses. It is hard to imagine that a business selling digital products on the Internet that has no presence in several jurisdictions would want to register for VAT in all those jurisdictions and pay its taxes there! So it is not surprising that OECD and its members have not succeeded in finding a consensus to reach a fair and feasible conclusion.

For the tax expert advising e-commerce, it is unlikely that any final positions will be taken by the tax authorities in the near future. He will therefore have to come to terms with the current tax laws, which do not contain any detailed consideration of the characteristics peculiar to e-commerce. In this context, of course, he will have to cope with a high level of uncertainty. This means that taxpayers face risks. Tax advisers who can avoid or lessen the risks and exploit structures optimised for their clients will give them a competitive advantage.