Under U.S. tax law, domestic corporations are taxable on their worldwide income. However, U.S. corporations can be taxed as residents of other countries as well. Such dual residence results in tax problems, such as taxability on worldwide income by more than one country and the loss of certain treaty benefits.
Residence of an e-commerce enterprise, for tax purposes, depends on the laws of individual countries and on tax treaties. A country may consider an enterprise to be a resident of that country by reason of incorporation in that country or based on other factors, including the enterprise's place of control or management. Where a company is determined, under local law, to be a resident of two different countries, there is a significant potential for double taxation. Tax treaties are intended to mitigate this double tax potential.
Where, under local law, a company is a resident of two countries, the U.S. Model Income Tax Convention provides that a company is deemed to be a resident of the country in which it is incorporated if that country is one in which local law says it is a resident. However, individual U.S. tax treaties may provide rules for defining residents that differ from those of the U.S. Model Income Tax Convention.
The OECD Model Income Tax Convention, on the other hand, provides that if a company is deemed under local law to be a resident of more than one country, it will be considered under the treaty to be a resident of the country in which its place of effective management is situated.
Place of Effective Management: Many countries seek to tax the worldwide income of a corporation if the place of "effective management" is located within their borders.
The location of effective management is a question of fact and is often attributed to the place where boards of directors and management meet to make top-level decisions. If these individuals are located in different countries and collaborate online in the decision-making process, there may be no easily identifiable place of effective management. In such circumstances, it has been suggested that the company's residence should be (1) the country with which its economic relations are closer, (2) the country in which its business activities are primarily carried on or (3) the country in which its senior executive decisions are primarily made. These three options are currently under discussion within the OECD.
Fiscal Sovereignty: The sovereign rights of countries that are net importers of e-commerce goods and services to impose taxes may be called into question because e-commerce offers a business the ability to earn substantial revenues without having to maintain any physical presence in the country where its customers reside.
If businesses take advantage of these possibilities and choose to operate with no physical presence in the country where their customers are located, remaining with the current international tax regime may allow for a shift in tax revenue from countries that are net importers of electronic goods and services to countries that are net exporters of such goods and services. This would be contrary to the objective of achieving a sharing of tax revenues derived from e-commerce.
Physical Presence: Physical presence is and probably will remain the key concept in determining whether source-based tax liability is triggered in the context of e-commerce—with or without the protection of a bilateral double tax treaty. Therefore, what constitutes physical presence and the resultant fiscal effects of such determination are examined below.
Under the OECD model treaty, business profits of a nonresident company may be taxed only if they are attributed to a PE the company maintains in the taxing country. The treaty provides for two circumstances in which business operations of the company will constitute a PE in the local country:
- When the company has a fixed place of business through which the business of an enterprise is wholly or partly undertaken and
- When a person—other than an agent of an independent status—is acting on behalf of an enterprise and has, and habitually exercises, in a contracting state an authority to conclude contracts that are binding on the enterprise.
Fixed-Place-of-Business Test: The OECD commentary concerning PEs states that "fixed place of business" contains the following three conditions:
- There must be a distinct place, such as premises, or in certain instances, machinery or equipment ("place-of-business test").
- It must be established with a certain degree of permanence ("permanence test").
- Business must be carried on through the place, usually by personnel of the enterprise ("business-activities test").
Note: Although human beings can be a "place of business" for tax purposes, customers would qualify only if they could be classified as agents. However, because they are not representatives of the company in any way, they cannot be agents. In addition, unless the company laid its own cables and set up its own computers for customers to use in the foreign country, these would not qualify as a place of business. A web page may satisfy this part of the analysis if the actual purchase and sale were considered to have taken place through the web site.
PE by Agency: An agent will not constitute a PE for the enterprise on whose behalf it is acting, provided the agent is both legally and economically independent of the enterprise and acts in the ordinary course of business when acting on behalf of the enterprise. Agents cannot be said to act in the ordinary course of business if, on behalf of the enterprise, they perform activities that economically belong to the enterprise rather than to their own business operations.
U.S. Taxation Considerations and Issues: U.S. domestic tax law does not use the PE concept. Instead, foreign companies are subject to U.S. taxation for activities in the U.S. that are "effectively connected" with a U.S. trade or business. U.S. e-commerce creates the opportunity for foreign persons to limit or eliminate their presence in the U.S. and still transact a significant amount of business with local customers. This aspect of e-commerce will make it more difficult for the U.S. to invoke tax jurisdiction over foreign persons applying the current U.S. trade-or-business standard. The U.S. response to this potential loss in tax revenue remains to be seen.
Foreign persons engaged in e-commerce but not engaged in a U.S. trade or business still might be subject to tax in the U.S. Even absent a U.S. trade or business, the U.S. asserts the right to tax U.S.-source FDAP income. U.S. payers of FDAP income must collect this flat-rate withholding tax (usually 30 percent of gross income subject to the tax unless a lower treaty-designated rate applies) by deducting it from foreign persons.
e-Commerce and Foreign Retail Distribution Activities: U.S. tax law encourages the manufacture and sale of U.S. products by facilitating foreign retail distribution. Treasury regulations contain taxpayer favorable retail-oriented provisions for property that is "sold for use, consumption, or disposition" at specified locations. The tax result depends on whether the destination of the property is located inside or outside a specified country. Technological changes are increasing the importance and viability of these long-dormant foreign retail provisions.
William P. Elliot is partner and firm director of international tax at Cherry, Bekaert & Holland specializing in audit, tax and consulting services.