International Taxation of E-Commerce: Persistent Problems and Possible Developments
Lecturer in Information Technology & Law
School of law
Queens University, Belfast
This is a refereed article published on 24th October 2008.
Basu, S., “International Taxation of E-Commerce: Persistent Problems and Possible Developments”, JILT 2008(1)
Taxation of e-commerce is a major concern for international agencies and tax authorities worldwide. Taxation itself is a complex and controversial issue. Hence, it should not come as a surprise that there are so many arguments regarding taxation of e-commerce. The objective of the paper is to find out whether it is possible to tax e-commerce should it be desirable to do so.
Keywords: e-commerce, International taxation of e-commerce
The relationships between taxation and technological developments have always been interactive, dynamic and complex. The current debate over taxation of e-commerce has, to some extent, been little more than a rehash of a similarly inconclusive scholarly and legislative debate that raged over mail-order sales during the 1980s. However, in the case of e-commerce, the added question is how to reconcile national fiscal boundaries with the borderless world of the internet.
A government's authority to tax had always been based on territory and jurisdiction. These systems now face a serious challenge from development of e-commerce. The trade in goods and services over the Internet has fundamentally altered the accepted boundaries and conventions. Some of the concepts underlying the principles of international consensus on taxation were always flawed, but those flaws have become much more apparent with the advent of e-commerce. E-commerce makes the concepts of permanent establishment (to determine location of manufacture), point of sale (for the application of relevant tax rates), income classification (based on source of income), product classification (for preferred tax rates), etc. difficult to apply. Within the borderless world of the internet1, e-commerce effectively obliterates any footprints leading to the buyers and sellers’ locations. Governments are already losing millions in tax revenue through the penetration of e-commerce within their jurisdictions, and their tax authorities are finding it increasingly difficult to stem this haemorrhage.
The definition of “tax” is far from straight forward, even if conventional taxes are considered. However, in many countries, in addition to legally imposed taxes, there are also arbitrary and irregular tax-like levies imposed by the authorities. These are part of a larger phenomenon of the necessity to make extra payments when interacting with government officials in many countries, particularly at the local level and at lower levels of bureaucracy. These also form a part of the burden of taxation and have socio-economic consequences. In most countries, conventionally defined legal taxes and levies constitute a significant proportion of GDP, and finance major parts of government expenditure. It is therefore essential that these systems be designed to achieve the appropriate trade-offs among revenue generation, allocation efficiency, equity, and administration and compliance costs.
Taxation is not simply a matter of efficient economic management and functional governance, but serves to define, enable and constrain the historical meaning of the state and the possibility of society (Cameron, 2006). However, emergence of international and possibly global dimensions of taxation is a far more recent phenomenon. “As this implies, the institutional practices of taxation have been subject to continuous if not constant renegotiation throughout their history in response to the changing forms and functions of the societies they help to constitute” (Ibid). Much argument about the internet proceeds as if the problem were new, and thousands of years of political and legal thought simply irrelevant in light of the internet’s uniqueness. Some commentators have argued that this notion is manifestly false: many of the questions that apply to the Internet today arose in similar form during the popularization of other technologies, such as modern shipping, aviation, and telecommunications (to name only a few). The answers that human societies forged to those questions then can help us answer analogous questions today. Yet recognizing that the Internet lays on a historical continuum of transformative technologies leads us to ask two interrelated questions that merit attention before delving into others: What characteristics mark the Internet as a novel and genuinely disruptive technology? What about the Internet poses new challenges?
It is difficult to provide a comprehensive answer in this short article, however in response to the second; taxation is definitely one such area where internet and e-commerce have raised concerns. Five or ten years ago, it was fashionable in academic circles to make dire predictions about what Internet would do to the nation state. Nothing less than the very survival of the state seemed to be in question (Goldsmith & Wu, 2006). Today, probably in embarrassment at this former misjudgement, it is fashionable to doubt that cross-border e-commerce is of any consequence to the state’s main source of revenue, taxation. The truth, of course, lies somewhere, between these two extreme thoughts. The internet is neither fatal nor irrelevant for the nation state; it is one important factor in its continuous transformation.
The basic question is how e-commerce interacts with traditional principles of taxation. While some authors debate that e-commerce has not transformed the fundamentals of taxation, others argue that there is a need for dramatic change (Westberg, 2002, p.53). Those opposing taxation assert that introduction of an e-commerce tax would do irreparable harm to the growth of the e-commerce, as consumers will return to main-street shops. However, this perception is not accepted without argument. Those who favour taxation of e-commerce cite concerns of lower government revenues due to increasing e-commerce sales, the resulting decrease in public good provision, and issues regarding equity. The concern is for potential revenue loss and the uncertainties created for tax authorities. A provocative and interesting thought is submitted by Krever, who states that “a more sober study will reveal that in many respects much of the hyperbole about e-commerce and tax is just that and in the overall scheme of things the impact of e-commerce on tax system may be limited” (2000, p.151). Li (2003) has also commented that there is nothing absolutely new under that sun. Governments and tax authorities continue to struggle with the same old problems, such as determining, what is the appropriate nexus that permits the exertion of tax jurisdiction over cross-border sales. However, Li (Ibid) maintains that the current international tax regime does not properly address the many vexing challenges faced by tax authorities and multinational firms today. These challenges include increasing regional and global trade and capital market integration, and the movement toward more service-oriented economic activities for many countries. Cockfield (2004a) categorized this broader discourse among tax commentators as ‘Doubting Thomases’, ‘Purists’, and ‘Pragmatists’.
Concerns have been expressed that e-commerce could result in the erosion of tax bases. Consumption taxes are levied on the principle of taxation at the place of consumption and according to rates set in individual countries, or in individual states in the case of federal nations. E-commerce, however, has the potential to undermine the application of domestic and national tax rules. Tax planning for an e-business differs from tax planning for a traditional bricks-and-mortar company. Historically, the generation of income depended on the physical presence of assets and activities. This physical presence, or permanent establishment, generally determined by which jurisdiction had the primary right to tax the income generated. Because of the growth of electronic commerce, new e-business models (including digital marketplaces, online catalogues, virtual communities, subscription based information services, online auctions, and portals) have emerged. Each allows taxpayers to conduct business and generate income in a country with little or no physical presence in that country. The separation of assets and activities from the source of the income represents a significant departure from historic business models. This change creates new tax planning challenges and opportunities.
There are several issues relevant to the current e-commerce tax debate in relation to direct and indirect taxation. The main concern is how to enforce taxes in the digital environment and how to apply the traditional concepts of taxation to new environment. There are three kinds of problem: enforcement problems; application problems; principal problems.
The enforcement problems are obvious. These are the problems that have been most thoroughly analysed. They are also the problems most urgently needing to be solved. The application problems have also been recognised, and received their due share of attention. The principal problems, those concerning the fundamental principles and assumptions of tax law, have not been thoroughly analysed. In fact they are not recognised as problems. It is believed that these problems are more alarming than the problems of enforcement and the problems of application, but they tend to be overshadowed by these more easily grasped problems. This conservative approach may be justified from the point of view that one should not jump to conclusions. In the long run, however, it will not be tenable. The strain on traditional tax concepts will eventually result in the breakdown of the tax system. If we do not address the fundamental questions, but wait and see, we may wake up one day and find that the tax system has been so alienated from the economic and technological reality, that applying the rules is not just hard but downright impossible. The tax system will lose its legitimacy, which will benefit nobody. Such a breakdown could be avoided if the problems are recognised as problems and included in discussions among legislators.
The concern of new businesses is understandably with markets, growth and profit and not with paying taxes. Any solutions therefore will need to balance the need to maintain the revenue yield without placing unrealistic compliance burdens on these new businesses. It is therefore immediately evident that it is crucial for the online entrepreneur to be aware of and fully understand all the implications of such means of taxation. In the light of this, legislators are increasingly concerned about their responsibility to bring forward, as quickly as possible, solutions to solve the problems introduced by e-commerce. Without workable rules, there will be a stronger incentive, particularly for smaller businesses, simply to ignore indirect tax requirements.2
Obviously if a country wants a competitive taxation regime and a decent level of social services then it needs a taxation base to sustain it. To stay competitive the weight must be kept off direct tax - income tax and company tax - and the indirect tax base must carry the burden of funding social services.3 A narrow base indirect tax cannot do it. To re-weight the tax system out of indirect tax and, by definition, into direct tax is a reverse direction. With the competitive challenges we face we cannot afford errors. Narrowing our indirect tax base, and its consequence of higher direct taxes, could do us great damage.4 The changes in technology and communication have brought means that bad-decision making is more evident and reaction to it faster and more severe.5 The advantage is greater than ever. The benefits can be greater than before but the margins for error are much smaller.
While examining the impact of e-commerce on taxation, there is always the danger of jumping into a conclusion without adequately understanding the nature of the problem raised by rules that evolved before the dawn of internet or e-commerce. E-commerce is a classic case of economic and technological change which forces us to consider how overlapping sources of national and trans-national law can be shaped to cope with the challenge of rapid and unpredictable market developments. Taxation of e-commerce, then, is fascinating in its own right from the global perspective but, on a broader scale, it offers an intriguing case of limitations and possibilities for moulding an effective tax administrative regime involving national and trans-national, public and private, which is designed to regulate but not to damage the growth of e-commerce. If the Internet and e-commerce are threatening a crisis for global tax administration because of the dangers they create for existing tax regimes, they have created opportunities as well. Some of the long-standing problems in taxing cross-border income flows will require new forms of international fiscal cooperation and an inevitable reduction in national fiscal sovereignty. Internally, the concept of individual privacy may be severely tested as governments struggle to maintain their revenues in the face of new pressures to expand the underground economy, with its concomitant tax evasion. When it comes to the implications of e-commerce for taxation, we may perhaps be at the end of the beginning, but we are still a long way from the end. An interesting irony of e-commerce, in fact, is that both consumption and income taxation seem to be equally threatened (Bird, 2003).
2. Is E-Commerce Taxable?
In order to find out whether it is possible to tax e-commerce, we should consider the problems that arise because of e-commerce for taxation. This section, deals with the problems; it will consider the issues of classification and jurisdiction. However as I have explained before there could be many challenges for enforcement of transactions related to e-commerce. These are anonymity of identity and location of parties, anonymity of transactions and accounts, disintermediation, transfer pricing issues, online delivery and digital cash, easy access to tax havens and low tax jurisdictions, identification of taxing jurisdiction, new evasion opportunities, recovery of tax, and exchange of information. The general opinion seems to be that existing tax rules are applicable and should be applied in a digital environment. The problems caused by new forms of communication are not seen as new problems, only as bigger ones.
2.1 Issue of Classification
The problem of classifying digital products has been a subject of attention for several decades, and has become more important with the arrival of e-commerce. In taxation, it is often necessary to classify a transaction or the object of a transaction. Transactions are classified, for example, as income from employment or from royalties, and the objects of the transactions are classified, e.g. as products or services. I will focus here on the classification of products and services. Traditionally, distribution of information has depended on the distribution of the media. When the information has been fixed, e.g. on a CD, the information has been distributed in fixed form. These transactions have traditionally been taxed as transactions in goods, without regard to the fact that the actual object of the transaction is the information contained in the physical product. In these cases, the information product is an object that exists and can be observed in the physical world.
The classification problems connected to e-commerce are primarily related to the principle of neutrality. An information product, e.g. a music album, can be delivered either physically, in the form of a record, or digitally. According to current tax law, the same information product will be taxed differently depending on how it is delivered. It is hard to find a way to classify information deliveries within the framework of current tax law, which at the same time satisfies fundamental taxation principles and considers the characteristics of information. Classification problems occurred in the traditional physical environment. As long as information was distributed mainly in physical form, these problems were of little importance. As production and distribution move out into the networks, the problems grow more pressing.
In the end, the problem of neutrality may seriously endanger the legitimacy of the tax system. The dominant view among the tax subjects is or will be that the two forms of delivery are just that: different forms of delivery of the same product. The law, which treats them as different products, will then seem out of touch with the real world. These problems may to some extent be problems of terminology. However, underlying them there are more fundamental assumptions related to tax law. These assumptions are deeply rooted in the history of tax law and its connection to trade in goods. The discussion regarding classification can contribute to the discussion of information taxation mainly by highlighting the fact that products in networks are neither good nor services in a traditional sense. Information simply does not fit into tax law, because tax law is rooted in the production and distribution of physical products, and not services, still less information. This is even more evident from the discussion of localisation problems.
2.2 Issue of Jurisdiction
The key issue that the Internet poses for tax policy is not so much its potential to create a world without borders but rather to create a world of only borders – a world in which everyone is as responsive to local taxation as people who live on geographic borders (Goolsbee, 2000). In legal terminology, ‘jurisdiction’ describes the legal authority of the state. The scope of that authority is manifest either in terms of a “prescriptive jurisdiction, the power to legislate or otherwise prescribe legal rules; or enforcement jurisdiction, the power to apply such rules through judicial or executive action” (Ott, 1987, p.137 cited in Gordon, 2001). The state exerts its legal sovereignty over physical and conceptual spaces. The application of state law requires that a territorial connection can be made between the legal question and this physical or conceptual state place. That connection is an imperative of international law, and is necessary to distinguish the applicability of one state’s laws from another’s. Even when expressed in terms of “prescription” and “enforcement”, the concept of jurisdiction evokes certain geography, one that articulates the scope of state sovereignty in territorial terms (Gordon, 2001). There are two aspects that disconnect between geographic jurisdiction and Internet (Kobrin, 2001). First, enforcement of law or regulation based on territorial jurisdiction may become problematic in the e-commerce environment. As Dryden (2000) notes, internet is not a lawless frontier; the issue is not the absence of law and regulation, but rather problems of enforcement through territorial jurisdiction. Second, and perhaps more important, there are serious questions about whether territorial jurisdiction provides a legitimate conceptual basis for the governance of internet (Kobrin, op. cit.).
Difficult jurisdictional issues arise when the world’s principal tax systems begin to collide with the emerging world of global e-commerce. Several taxation concepts relate to the physical or geographical location of a person, a company, or a transaction. This is because taxes are national. Tax jurisdictions are very much dependent on the territorial nexus principle and the status of a tax payer.6 It is therefore always necessary to attribute a transaction to a certain geographic location. The aim is always that the creation of value should be taxed where the value is actually created. The connection can be formal, e.g. connected to where an organisation is registered. It can also be based on where a transaction is regarded as taking place. Whether or not the physical location of an Internet user can be determined with any degree of accuracy is still controversial. An IP address is a network organizational construct only loosely related to a geographical location. The question is whether and how geography can be inferred from the available data (Kobrin, op. cit). Kobrin (2001) argues that the idea of territorial jurisdiction is compromised if it is not possible to describe a transaction in cyberspace vectorially, in terms of two-dimensional geographic coordinates. Given the lack of clarity about the meaning of a virtual presence, there may well be circumstances when it is difficult, if not impossible, to locate a transaction geographically. If the parties to a transaction cannot be located geographically with any degree of certainty and if regulatory authorities are unaware of the transaction, enforcement becomes difficult.
Conceptually, there are two distinct issues. The first is the issue of when it is appropriate for a state to subject persons outside its borders to the economic burden (as opposed to the administrative burden) of a particular tax because of contacts with that state, which are in whole or part electronic in nature. The second significant issue is to determine when a state can legitimately ask that a foreign person be asked to assist in the collection of a tax on others, where those others are within the state’s legitimate taxing jurisdiction. The distinction made here, between jurisdiction to impose the burden of a tax and jurisdiction to impose a duty to help collect a tax, is not one that is reflected in the actual law of jurisdiction that has developed, but in a more global and technologically sophisticated economy it may become increasingly important to make this distinction. However, governmental entities should be cautious about imposing jurisdictional oversight and protections that will have extra-jurisdictional implications.
When an online purchase is made, either directly or through the intervention of an electronic agent, programmed with the background, assets, and preferences of its human principal/buyer, has the buyer stepped into a new place or simply used a different means of communication, much like a phone, fax or satellite link, to affect that purchase? More specifically, if I order a book online from my home in Belfast from a seller physically located in California, is it as if the bookseller boarded a plane and delivered the book to me in Belfast, or is it as if I flew to California to purchase the book off his shelf? Does the ‘push’ and ‘pull’ of technology make a difference in how the law should be applied?
The Internet penetrates deeply into domestic economic, political and cultural structures; tax issues go to the heart of a wide range of social issues from beliefs about social spending and the role of government to the distribution of income and wealth. Tax codes are used to discourage activities deemed undesirable by society. They are the basis of attempts to redistribute wealth and income through a graduated income tax or inheritance taxes. What is seen as an appropriate rate of taxation reflects social views about the role of government and collective versus individual solutions to social problems (Kobrin, op. cit). Although the principle of formal sovereignty, in theory, remains the underpinning of international taxation, developments such as economic integration and global e-commerce challenge the state’s ability to adhere to or invoke this principle. It is beyond any argument that e-commerce particularly digital e-commerce has impaired the State’s ability to tax the income generated by confusing traditional source rules thus making it more difficult to characterize income. If a state cannot characterize income according to traditional source rules, it cannot effectively determine whether it has a right to tax that income. This could result either in double taxation or non- taxation, thus inhibiting the growth of e-commerce or allowing these transactions to go completely untaxed (Basu, 2003).
The autonomy and the anonymity with which people are able to move through the electronic world prevent any legitimate chance of effective self-governance. The virtual identity of a person most of the times has no relation to their actual identity. It is possible to govern cyberspace with set of norms, which could banish a user from a community electronically (Basu & Jones, 2008). However, the technology is not yet developed enough to prevent them from wreaking havoc under a new identity. Even if it were possible to virtually govern online activity, such governance ignores the impact that virtual activity has on the physical world. Jurisdiction is the area of law that deals most directly with the contact between the two worlds. “It is more important that the applicable rule of law be settled than that it be settled right”.7 The question is then how to settle this point of law with the bounds of the traditional legal framework. It is my submission that incremental and conservative change in jurisdiction law is right because it is the best choice. This means that the defined parameters of the law should be applied to the new factual situations. Governments should take steps to align “enforcement jurisdiction” with “substantive jurisdiction” to ensure that technological developments do not undermine sound tax policy (Hellerstein, 2003).