E-commerce has almost no barriers to entry. Electronic commerce allows the smallest company to gain access to national and international markets. A software company operated out of the corner of a bedroom can easily sell its products to customers anywhere in the world, as long as those customers have Internet access. For sellers of digital products (i.e., products that can be delivered electronically in digitized format), there are no geographical barriers to entry for any world market. A sale made on the other side of the world is made as easily as a sale to a buyer next door.
Sellers of tangible goods can also use electronic commerce to make sales, with no greater market barriers than sellers of digital products. These vendors, however, have to deal with shipment of the goods. This is not a problem in the United States, where products can be delivered by common carrier. Outside the United States the vendor, however, must deal with foreign import and export rules, customs, and the vagaries of foreign delivery infrastructures. In most cases, however, a foreign shipment of tangible goods is not too difficult.
This ease of selling to national and international markets, once territories limited to large companies, presents smaller companies with problems they are ill-equipped to handle. A small vendor does not have staff to deal with the tax rules of 50 different states, over 30,000 different United States taxing jurisdictions, and an untold number of foreign tax authorities. Many smaller companies will transact business on such a small scale that they are unlikely to be noticed. Nevertheless, once noticed, they will face all the same issues as their larger competitors.
Larger companies, who will clearly not escape scrutiny by the tax authorities, will have to devote substantial resources to compliance with the myriad state and international tax rules that affect their e-commerce activities. The difficulty lies in the fact that these companies must attempt to comply with tax rules that do not easily interpret electronic commerce transactions. Thus far, tax authorities have not moved quickly to provide guidance in this area. For example, a majority of states in the United States have sales tax rules relating to out-of-state mail order companies that pre-date the U.S. Supreme Court's decision in Quill Corp. v. North Dakota. The failure to respond to this decision will add greater complexity to electronic commerce state tax issues.
Companies engaged in electronic commerce face uncertainty regarding the taxability of new, Internet-related services. In testimony before the U.S. Senate, an Internet service provider based in Tennessee told this story. This individual operated an online bulletin board service for several years. It was expanded in 1995 to include full Internet access. He testified that he had 1994 and 1996 letters from Tennessee stating that his online charges were not subject to sales tax. A 1996 audit of his business by Tennessee resulted in an unpleasant surprise. The auditors concluded that he owed sales tax, retroactive to January 1993, on his online and Internet access charges. The State did not assess interest and penalties because he had letters stating that the charges were not taxable.
Another bittersweet success story was told to the U.S. Senate by another taxpayer. In this case, a representative of a major Oregon-based mail order company, with a substantial presence on the Internet, challenged an assessment by a state, and won. The cost to challenge the state laws, which were ultimately found unconstitutional, was several hundred thousand dollars.
Basic Issues in E-Commerce Taxation
There are at least six unique aspects of e-commerce that make taxation of electronic commerce enterprises difficult under existing rules:
- Worldwide sales
- Even the smallest e-commerce enterprise sells into a national and international marketplace.
- Remote operation of a Web server
- The ability to operate an entire Web-based company remotely.
- Anonymity
- A marketplace where buyers and sellers do not see each other and don't need to know anything about each other to open or close transactions.
- Digital products
- Products that can be delivered electronically, including software, recorded music, videos, books, reports, and services.
- Intangibles
- The creation and operation of businesses whose value rests primarily in software, data, and other intangibles.
- Fast changing rules
- The rules for taxation of electronic commerce are in their infancy now, but the body of law in this area will grow quickly.
E-Commerce and the Internet
Most analysts believe electronic commerce will grow rapidly. The taxation of electronic commerce depends in some cases on how transactions are accomplished, and on the infrastructure of the Internet. Clearly, it is necessary to understand the terminology involved in electronic commerce to properly assess the impact of existing rules on Internet-based transactions. For instance an Internet service provider may be subject to tax in a state when it locates routers, modems, and other equipment in that state to accommodate local dial-up access from subscribers. The same dial-up connection may be accomplished through the local telephone company without the Internet service provider having to physically locate its equipment in the state. In analyzing an ISP's potential tax liability, the tax advisor must understand the ISP's business.
Sales and Use Tax
The e-commerce taxation issue that has gained the most attention is sales and use tax. Pressing questions in this area revolve around whether a Web-based sale is taxable, and, if so, whether the state has the right to the tax. For instance, are Internet access services taxable? Is software taxable when delivered electronically? If a sale to a customer in Kansas is made from a Web site in Texas, which is owned by a vendor in Utah, what state, if any, may collect the tax?
Sales and use tax is more important than income tax for many electronic commerce enterprises. This is because currently many of these companies are running losses and are therefore indifferent to income tax--at least for now. However, sales and use tax is immediate. Because e-commerce enterprises have worldwide sales they are potentially required to collect sales and use tax in over 30,000 taxing jurisdictions in the United States. But, many of these companies are small, with no staff capable of filing hundreds of tax returns. As will be discussed, luckily, most smaller electronic commerce enterprises are subject to tax in only a few jurisdictions.
The taxability of companies engaged in electronic commerce depends on nexus in the taxing state. The nexus of out-of-state vendors has been a hotly contended issue for decades. Traditional mail-order companies have fought many battles with state tax authorities in this area. The U.S. Supreme Court's 1992 decision in Quill Corp. v. North Dakota apparently settled the issue. However, many state tax rules relating to the nexus of out-of-state vendors do not comply with the decision, and it is unclear whether states will attempt to enforce rules that may be unconstitutional.
In most cases, where a sale is made to a customer in a state where the seller is not required to collect sales and use tax, the customer must voluntarily pay a use tax. However, this requirement is universally ignored by consumers on small purchases. Only on large purchases and on purchases by some businesses is the requirement to remit use tax complied with. Where the seller is not required to collect the tax, and where the buyer does not voluntarily pay the tax, the sale is, as a practical matter, tax free. With the rapid increase in mail order and Web-based sales, an increasing number of purchases are made free of tax, causing an increasing strain on state tax revenues.
An e-commerce enterprise is required to collect sales and use tax on sales to customers in any state in which it has nexus. Nexus means a seller's presence in a state is substantial enough that the state has the right to subject the seller to its tax laws.
For sales and use tax, the most important factor in determining whether a seller has nexus in another state is physical presence. According to the Supreme Court, in Quill Corp. v. North Dakota, an out-of-state seller must have physical presence in a state before it has nexus, and before that state can require it to collect sales and use tax. The questions that arise are what activities of an e-commerce enterprise results in physical presence in a state, and how physical presence can be avoided.
One of the current hot key issues in determining whether an e-commerce enterprise has physical presence, and is therefore required to collect sales and use tax in a state, is the remote operation of a Web server. A Web server is a computer, connected to the Internet, that contains the software and data needed to operate a Web site. A single server may host one Web site or a thousand Web sites. For a variety of reasons, a company's Web server may be located far from the company. However, a Web site, hosted on a remote Web server, may be operated as easily as if the server is next door.
Whether a Web site on a Web server located in another state causes an e-commerce enterprise to be subject to tax in that state is a question to which there is no firm answer.
In the context of sales and use tax, the anonymity of buyers is a serious issue. Anonymity comes into play when a Web site delivers services or digital products. In either case, a company needs only a name and a credit card number to complete an online transaction. In the future, when anonymous digital cash is used, sellers will not need to know anything about buyers. Anonymity will make it difficult for sellers to comply with tax laws, which depend in large part on the locations of buyers.
Digital products are unique to e-commerce, and present difficulties in applying sales and use tax rules that were written when these products did not exist. Currently, the primary digital product is software downloaded from the Internet. However, a product that is quickly moving to electronic delivery is recorded music.
The following are estimates for future Internet-based sales of software, books, music, and videos, all of which are easily delivered electronically. These estimates are for all Internet-based sales, and include products delivered both electronically and physically. However, it is likely that a significant amount of these sales will be electronic (i.e., digital). What is most important about these estimates is the growth rate. Music sales, for instance, has an expected growth rate of over 150 percent per year.
Millions Millions
1997 2002
Software 85 2,379
Books 152 3,661
Music 37 1,591
Videos 15 575Source: Zona Research, Inc.
For sales and use tax, another critical question is whether digital products are subject to tax. Most states tax only tangible personal property and selected services. Few states have rules to determine if digital products are tangible personal property subject to tax. In fact, in 1999, less then twenty states had rules for downloaded (electronically delivered) software, and no states had rules for downloaded books, music, or videos. For the states with rules related to downloaded software, a little more than half subject these sales to sales and use tax. The others have ruled that such transactions are not taxable. This demonstrates a near complete lack of agreement among the states, and presents software vendors with a real dilemma when sales are made in states with no rules (the last we heard, flipping a coin was not "substantial authority"). Vendors of digital products other than software face greater uncertainties because there are no rules at all.
The taxability of Internet access services is also an issue. Most states have not ruled on the taxability of such services. However, as mentioned earlier, a state may decide to impose a levy on ISP services retroactively if the state determines that such services are subject to sales tax or some other type of transactions tax. Considering the marginal profitability of ISP services in the United States, such retroactive taxation can create devastating discrepancies between projected and actual business net income.
Sales and use tax in general is a battleground in e-commerce. The new millenium will bring with it major tax changes in tax laws because state tax administrators are keenly aware of the drain on state and local sales that e-commerce can represent. The debate surrounding the recently enacted Internet Tax Freedom Act rang with warnings by local tax administrators of the "death of Main Street."
The most important result of the Internet Tax Freedom Act is the creation of the Advisory Commission on Electronic Commerce. This Commission has a mandate to make recommendations relating to a panoply of e-commerce tax issues. However, the Commission's focus is likely to be sales and use tax, and the ability of states to require out-of-state vendors to collect sales and use tax. This is a power that Congress and the Supreme Court have, so far, withheld from the States. However, according to the Supreme Court, Congress may grant the States this power any time it wishes. If the Commission makes recommendations favoring the States, Congress may decide to grant the States this power. If it does, the economics of e-commerce, and of remote sales (e.g., mail order sales), will shift dramatically.
International Taxation
International taxation of electronic commerce is probably the second most talked about issue after sales and use tax. Here, the main problem is determining the country with the right to impose an income tax on a transaction. For instance, if a French vendor sells products to U.S. customers from a French Web site, are those sales taxable in the United States? What if the Web server is in the United States? What if the product is delivered electronically?
U.S. companies engaged in electronic commerce can easily make international sales. These companies are taxable in the United States on their income regardless of where those sales occur. Where the company is a U.S. company its main concern is taxability in foreign countries, and whether there is a United States foreign tax credit available to offset foreign taxes paid.
Foreign corporations engaged in electronic commerce with customers in the United States are concerned with whether they will be taxable in the United States. Taxability of foreign corporations depends on the extent of activities in the United States.
Electronic commerce enterprises all have worldwide sales, and are potentially subject to tax all over the world. This can be a serious problem for companies that are not equipped to deal with the complexities of foreign country tax rules, U.S. international tax rules, tax treaties, and the like. Current rules affecting cross-border transactions were written in an era when most cross-border business was done by relatively large companies. Today, the smallest e-commerce company can have customers all over the world.
One example of the difficulty in applying old laws to e-commerce is illustrated in the cross-boarder licensing of intangibles. In the United States, a person that pays a royalty to a person in another country must withhold a 30 percent tax (assuming no rate reduction or elimination by an applicable treaty) on the royalty payment, and remit that tax to the IRS. Similar rules exist in other countries. In e-commerce, certain small transactions will be considered royalties. While these small transactions do not, individually, warrant the administrative burden of withholding and remitting royalty payments, cumulatively they may add to a lot of money.
Example:
ForeignWebSite creates content that is licensed and used in other Web sites. The average U.S. customer pays ForeignWebSite $50 per month for the content. ForeignWebSite has 2,000 U.S. customers and earns $100,000 per month in U.S.-source royalties. Withholding on each $50 is only $15, and this small amount does not warrant, in economic terms, the time and effort required by either the taxpayer or the IRS to comply with withholding requirements. Cumulatively, however, the withholding is $30,000 per month, a very respectable sum.
In the world of paper transactions and "snail mail," companies would not engage in a large number of small licensing arrangements, such as in the example above, because the cost of doing the transaction exceeds the amount earned. International tax rules are predicated on transactions large enough to be economically justified. E-commerce has dramatically lowered transaction costs to the point where "micro-transactions," such as the one above, make sense. However, the international tax rules do not account for the impracticality of dealing with tax compliance relating to these small transactions.
The ability to remotely operate a Web server presents issues for international taxation similar to those it raises for state taxation. For example, does a Web server located in another country cause an e-commerce enterprise to be taxable in that country? For countries with which the United States does not have a tax treaty, a trade or business in the United States will cause a foreign e-commerce enterprise to be taxable in the United States. For countries with which the United States does not have a tax treaty, the question is whether a Web server constitutes a "permanent establishment." For purposes of taxation in the United States and the treaty partner, only companies with a permanent establishment are subject to tax in the foreign country.
Whether a Web server in a country constitutes a trade or business or a permanent establishment is not answered under current U.S. tax law. Neither is it answered by the tax laws of other countries. For countries with which the United States has tax treaties, the treaties must be applied to resolve this question. For countries where there are no treaties, the question may remain unclear for some time.
As in state taxation, anonymity is a serious issue in cross-border transactions. Where products and services are sold the identity and location of the buyer is often the key to taxability. Obviously, in a marketplace where buyers and sellers do not see each other, and often know nothing about each other, tax compliance is very difficult. The problem of anonymity will be exacerbated as anonymous electronic money comes into common usage. Certainly, anonymous cross-border transactions, especially those involving digital products, will raise the level of international tax evasion. However, even honest taxpayers will find it difficult to cope with international tax compliance where they engage in anonymous transactions.
Digital products will be the easiest products to sell internationally. There are no shipping or customs problems to inhibit these transactions. And, as electronic money comes into common usage, there will be no currency issues to deal with. The sale of a digital product is usually taxable in the seller's country if characterized as the sale of an intangible or the sale of a service, whereas the buyer's country will tax the transaction if the sale is considered a royalty. On the other hand, if the transaction is a product sale, it may be taxable partly in the seller's country and partly in the buyer's country.
Some rules exist to characterize digital products under U.S. tax law. Regulations relating to cross-border software transactions have recently been finalized. These rules deal specifically with electronically delivered software. Unfortunately, the U.S. rules relate only to software transactions. Transfers of other digital products await further rule making.
Rules relating to electronically delivered software exist in other countries as well. Recently, commentaries to the OECD Model Tax Treaty have been rewritten to include rules for electronically delivered software. In addition, the OECD has recently issued proposed rules relating to the characterization of all digital products for transactions taxes, such as value added tax (VAT), and goods and services tax (GST).
The rules for digital product transfers are more complete for international taxation than for state taxation. However, the rules still have sizable holes in them. As discussed above, the U.S. rules do not cover digital products other than software. We can expect to see a large number of new rules written in the future.
A phenomenon in international e-commerce is the growing use of offshore Web servers. These are Web servers based in offshore tax havens. U.S. taxpayers, for instance, can easily set up a Web server owned by a Cayman Islands corporation to sell products and services all over the world. The rules for these controlled foreign corporations are important because of the ease of opening a foreign bank account, forming a foreign corporation, and engaging in sales through the foreign corporation. How can offshore corporations work to defer U.S. taxes. What are the many pitfalls that can result in taxes and penalties in the United States.
The IRS and foreign tax authorities are disturbed about the growth of offshore Web servers. The IRS rightly sees in this a potential for tax evasion on a huge scale. We can expect to see many new rules aimed at curbing illicit use of offshore Web servers, both from the IRS and from other tax authorities.
Digital Products
A substantial amount of transactions involving digital products and services will take place over the Internet. Digital products and services are those that can be delivered over the Internet without anything being sent to the buyer on physical media. The most common of digital products today is software. Other products include digital magazines and newspapers. Digital services include research services, Java-based software programs, and other digital offerings.
In many areas of tax law, especially state tax law, the characterization of an item as either a tangible or an intangible product, or as a service, is important for determining taxability. The rules regarding the characterization of sales of digital products and services are not settled. For instance, most states subject tangible personal property to sales tax, but do not have rules that characterize software delivered electronically.
Tax compliance
The Internet is a vehicle for worldwide sales. Worldwide sales means worldwide tax compliance, which is a problem for any taxpayer but can be an especially big problem for small companies used to filing tax returns in a limited number of jurisdictions. In addition, the Internet is particularly suited to anonymous transactions. These are transactions where buyers and sellers do not meet each other and may know nothing about each other. Web sites can also be operated remotely, as from, for instance, offshore tax havens. Finally, the future currency of the Internet will be, in part, untraceable electronic money. All of these characteristics make it difficult for honest taxpayers to maintain accurate records and to determine and comply with filing requirements. For dishonest taxpayers, the Internet is a new tax-free haven, where untraceable cash, anonymous buyers and sellers, and offshore Web sites make tax evasion easy.
Even the smallest e-commerce enterprise has the potential for worldwide sales of products and services. As discussed above, the potential liability for tax in over 30,000 U.S. tax jurisdictions, and an untold number of foreign jurisdictions, can make tax compliance an unmanageable burden. The likelihood is there will be substantial noncompliance until the rules are rationalized to take into account the unique nature of e-commerce. Much noncompliance will stem from application of rules that make no sense in a virtual world and the sheer inability to cope with the multitudes of conflicting tax rules in the various jurisdictions.
Even where existing tax rules make sense in a virtual world and taxpayers can comply without undue effort, there will be noncompliance. This is because the ease of tax evasion and avoidance will tempt many taxpayers.
The ability to remotely operate a Web server will allow an e-commerce enterprise to put its Web server in an offshore tax haven that maintains bank secrecy and which does not share tax records with the owner's home country. The Web server may process sales only, receiving a substantial commission for its services. Or, it may operate an entire business, such as where the business involves Web-based services, or Web-based sales of digital products.
Transactions in digital products will be hard to audit. Classic IRS audit techniques will not be as effective in the virtual world as they are in the real world. For example, one method of auditing sales is to relate the raw materials purchased by the taxpayer to expected sales. For instance, if a bagel maker buys a certain number of sacks of flour, the number of bagels that can be made and sold can be estimated. This is a valid way of auditing sales. Where digital products are sold this audit technique does not work. One software master, for instance, can be copied and sold one time or a million times without the taxpayer's consumption of any raw materials.
Anonymity will make it easy to hide records from tax authorities, where the taxpayer is bent on evasion. For honest taxpayers, as mentioned above, anonymity will make it difficult to determine where a sale is taxable (i.e., the state or country in which the buyer is located). The problem will be to identify parties to transactions. The Internet makes it possible to sell goods and services without either the buyer or seller being identified. Our tax system, as well as the tax systems of our major trading partners, requires the parties to transactions to be known in order to properly tax transactions.
Federal, state, and foreign tax authorities have all expressed their concerns regarding the effect of anonymous transactions. What we can expect to see in the future are rules aimed at insuring tax compliance. No firm plans have been put forward by tax authorities. However, considering the potential for tax evasion presented by anonymous Internet-based transactions we can expect a series of initiatives from the IRS and other tax authorities. Some of these may be quite invasive.
One solution to the problem of anonymity is the expected use of digital signatures to verify the identities of parties to transactions. It is possible that digital signatures will be required so that all parties to a transaction will be identified. Currently, no such requirements exist.
Electronic money is a great concern of the U.S. Treasury, especially "unaccounted" money. Unaccounted money is digital cash that can be spent without any record being kept of the person spending the money. The potential for tax avoidance where unaccounted cash is used is enormous. On this issue the U.S. Treasury has said:
The major compliance issue posed by electronic commerce is the extent to which electronic money is analogous to cash and thus creates the potential for anonymous and untraceable transactions.
Another issue impacting tax compliance is the mobility of electronic commerce enterprises. A vendor in a jurisdiction that is unfriendly to e-commerce can easily move its entire operation to another jurisdiction. Customers will not notice any difference. In addition, mobility may allow a business to locate in a jurisdiction where it can escape tax by playing on the inconsistencies of country-to-country tax rules. This will lead to unexpected consequences as states and countries begin to adjust to these vendors.
Certain transactions require withholding at source when a sale is made. For instance, royalty payments made to foreign persons require a 30 percent withholding in most cases. Electronic commerce presents two difficulties. The first is identifying when withholding is required. This is made especially difficult when the character of electronic transactions is uncertain. It is also made difficult when the identity of the company to whom a royalty is paid is uncertain.
Another problem involves the actual mechanics of withholding. Some transactions may be characterized as royalties, but may be very small transactions. It may be difficult to create mechanisms to handle withholding on very small transactions.
Tax compliance in cyberspace is "Item 1" on the agendas of the IRS and other tax authorities. In a recent speech, an official of the U.S. Treasury expressed concern over the rapid growth and development of international electronic commerce, and its potential for tax fraud and tax evasion. This official said the United States is working with its major trading partners to prevent these activities. He said, "We must not allow the Internet to become a tax haven that erodes the tax base."
Because of the concerns expressed by the United States and other tax officials, taxpayers should expect major initiatives aimed at curbing Internet-based fraud and tax evasion. These rules will likely capture unwary innocents, along with the intended abusers. For this reason, taxpayers engaged in electronic commerce must pay particular attention to tax developments in this area.
Privacy and security
Privacy and security in electronic commerce are at the top of the list of concerns about e-commerce for most users, and for most Web site operators. When users are questioned about the Web, they consistently express concerns about their private information being exposed. Web-based vendors are concerned about transaction security, about hackers, and about making customers feel comfortable when doing business on the Internet. In business-to-business transactions, companies are concerned about transaction integrity.
The biggest issue to be addressed before electronic commerce can become widespread is the security of online transactions. Encryption technology exists which will allow commercial transactions to be completely secure. However, this technology will also allow transactions and communications involving criminal activity to take place with complete security. Therein lies the dilemma. The government wants legitimate commercial activity to take place in complete security, but also wants the ability to monitor transactions and communications that may involve criminal or terrorist activity.
In addition to issues posed by the security of transactions, there are questions concerning the security of Web sites and the security of data. Where vendors are selling digital products, there is always a danger that someone can gain unauthorized access to a Web site and download products or information. Web sites are frequently used to answer customer account inquiries. Customers can check the status of orders, check account balances, and perform many of the activities of a traditional order processing system. Unauthorized access to this information by competitors or individuals bent on mischief is a major concern.
As a consequence of these concerns, major efforts are underway to make transactions secure, both in business-to-consumer transactions and business-to-business transactions, through the use of technologies such as anonymous electronic money, digital signatures, and encryption.
As transactions undertaken by businesses and consumers become more secure, the IRS will have a more difficult time monitoring these transactions. This sets up a classic conflict between the needs of citizens for privacy and security and the legitimate need of the government for access to information.
Looking forward to possible issues relating to tax compliance in electronic commerce, two issues are obvious. The first issue is the privacy and security of information moving over the Internet. It may be relatively easy to intercept email and transactions moving over the Internet because all traffic moves through a relatively limited number of channels. If the government has the ability to decipher encrypted information, it may be able to gather unprecedented amounts of information. What are the rules regarding the ability of the Internal Revenue Service to use that information against a taxpayer?
Another issue relates to the subpoena power of the IRS. Taxpayer information relating to transactions may be lodged on the taxpayer's own computers, as well as on computers owned by other parties. Information may also be on another party's computer when that computer hosts the taxpayer's Web site. What are the rights of the IRS to access information contained in these host computers? What if the computers are located outside the United States?
Can taxpayers protect their rights of to be secure in their electronic transactions from government intrusion. For instance, can the IRS can legally intercept taxpayer email or "hack" a taxpayer's Web site to gain access to transaction and other financial records and use the contents of that email or of that web site against the taxpayer?
Future direction of rules
One thing that is certain about the taxation of electronic commerce is that the rules will change dramatically. While governments in the United States and elsewhere claim that current tax rules can be adapted to meet the challenges of e-commerce, this is not true. There are far too many e-commerce transactions that are not covered by existing rules.
One indication of the potential for rapidly changing rules is the newly formed Advisory Commission on Electronic Commerce. This commission, formed by the Internet Tax Freedom Act (enacted in October 1998), will meet for eighteen months from the date of formation with a mandate to review most tax laws affecting e-commerce. The Commission may recommend far reaching changes, especially in the area of state sales and use tax. Taxpayers must keep an eye on this Commission to see where it wants to lead us.
CYBERTAX HOME