With the introduction of the internet and online purchasing, electronic commerce (ie. any form of transaction carried out in an electronic medium) provides a fundamentally new way of conducting commercial transactions. Its advent has caused accepted ways of doing business to be profoundly modified: traditional intermediaries can be replaced (the process being known as intermediation), new products and markets have been created, and new and more direct relationships will be forged between businesses and consumers. This may be particularly so where the product or service can itself be delivered online; knowledge information and financial services are classic examples.
Whilst still in its embryonic stage care must be exercised not to over-regulate electronic commerce. At the same time well publicised incidents of internet fraud, if left to persist, are likely to mean that mainstream consumers and businesses will not widely adopt e-commerce unless measures to promote confidence are introduced.
It was with these issues in mind that the Organisation for Economic Co-operation and Development (OECD) have, in the last couple of years, held several conferences to highlight the problems of electronic commerce and to suggested possible solutions. Amongst many issues raised two will be dealt with in this bulletin; the taxation of e-commerce, and the legal repercussions of e-commerce.
2. Taxation of E-commerce
The OECD has recognised that the assessment and collection of taxes on e-commerce transactions are an issue that concerns both government and business. The OECD feels that countries should be able to interpret and apply existing rules in an internationally consistent fashion to collect taxes from electronic commerce successfully. However, some issues do need to be resolved.
2.2 The nature of the income generated from e-commerce
The question as to whether income should be taxed in the country of residence or the country of source depends, in the first instance, on the character of the income involved (for example, is the income in the nature of sales of goods, provision of services or income from royalties). Any information that can be digitised e.g. computer programmes, books, music or images, can be transferred electronically between countries for a fee. The problem, however, is that a transaction involving, for example, a downloaded digital image, could be seen as either the equivalent of purchasing a physical photograph and results in business profits, or that it is a service and results in royalty income.
Currently the business sector supports e-commerce transactions being treated as a royalty as defined by Article 12 of the OECD Model Tax Convention and favours its application not only to software but to all digitised material like books, periodicals, videos etc.
However, if treated as royalty income, the OECD Model Convention does not allow source taxation of royalties, but a number of tax treaties allow source taxation, such as Spain and Australia.
In contrast to the business sector view, since the OECD conferences the Revenue Commissioners (the competent tax authority in the Republic of Ireland) have published a report entitled “Electronic Commerce and the Irish tax system” which categorically states that the Irish Revenue would treat the online supply of digitised product as the supply of a service.
If, as is suggested by the Irish, the income is treated as income from the sale of goods or the provision of services then under current tax laws the income is only subject to source taxation where the seller or provider has a permanent establishment in the source country. However within the context of e-commerce this issue of permanent establishment causes further problems.
2.3 Residence and permanent establishment
International tax conventions generally provide that business profits of non-resident enterprises may only be taxed in a country to the extent that they are attributable to a permanent establishment of the enterprise in that country.
Article 5 of the OECD Model Tax Convention defines “permanent establishment”, however the application of this definition raises a number of issues in regard to e-commerce:
a) The basic condition for the existence of a permanent establishment is that it constitutes a “fixed place of business through which the business of an enterprise is wholly or partly carried on”. (Article 5(1)). The issue for e-commerce is whether this condition is satisfied by a website on a server owned or used by a foreign enterprise, bearing in mind that there would not necessarily be any employees of the enterprise present in the country in which the website or server is located.
b) The permanent establishment rules allow business premises used for preparatory and auxiliary activities to escape classification as a permanent establishment (Article 5(4)). If the functions carried on at a website or server are such that they do not constitute a permanent establishment due to this rule, there is still a need to consider the tax implications of other activities carried on at that site (for example, how to tax profits arising on the lease of excess capacity on a server to allow another business to operate a website.)
c) If a foreign Internet Service Provider has established servers in a country (but carries on no other commercial activities in that country) then the mere presence of the equipment should not constitute a permanent establishment. It has also been pointed out that the mobility of the equipment means that the providers of electronic services can move equipment quite rapidly, if they see fit, and thereby avoid any attempt to apply the permanent establishment rules.
The US Department of the Treasury: Office of Tax Policy, published a White Paper on the issue in November 1996. It advocates the primacy of residence as a basis for taxation and as such would not regard a website or its computer server as a permanent establishment.
In support of this is a recent German case where the Regional Finance Office of Karlsruhe issued a decree on whether the installation of an internet server by a German resident entrepreneur in a foreign country creates a permanent establishment in that foreign country for German tax purposes. The decree stated that the “Foreign Tax Relations” section of the federal state and the Lander had decided that, for the time being, the installation of an Internet server is to be treated as a preparatory act under Art. 5(4) of the OECD Model Convention and not as a permanent establishment.
Clearly if there is an intention to adopt current tax laws then a decision must be made of how the income is to be recognised. Currently each appear to have its own pitfalls.
The same source and residence issues are just as important for VAT purposes, though there is the added issue of rating. Electronic commerce raises particularly difficult questions for VAT, as the vast majority of the services concerned are normally taxed at a positive rate of VAT when supplied for domestic consumption and at a zero rate for export.
The OECD has suggested a possible solution is that “goods” or services delivered electronically should be considered as transactions taking place in a tariff-free zone (ie. free of customs duties). This appears, at first, to be consistent with current law. For computer software, for example, tariffs are imposed on the value of the media (e.g. the value of the computer disk or tape) but not on the value of the software contained on it. In an electronic transaction the medium no longer exists and logically therefore such tariffs should not be applied.
However, in the UK, the purchase of a book on-line in a digitised form is treated as a service and, under current rules, subject to VAT at a standard rate of 17.5%. In contrast, the same book ordered online but delivered physically would be zero-rated for VAT.
2.5 Use of Tax Certificates
A possible solution to these issues may be the use of certificates issued by a certification authority to inform the seller and buyer of the jurisdiction applicable to that transaction. While potentially feasible, there is some question about the practicality of such solutions. They could place a large administrative burden on merchants to calculate, collect and transfer taxes on what often are low-value, high volume products (such as CD`s). Other technology solutions may be found to help with the identity problem and administrative procedures, and there is already software available for calculating multi-jurisdictional tax obligations.
3. Legal consequences of E-commerce
With the need for contracts to be signed, the growing use of e-commerce has raised the issue of how electronic contracts are to be made legally binding. This is an issue that has been raised in connection with transactions in and for financial services such as life assurance.
The need for secure technologies, most notably cryptography, and a predictable regulatory environment to support them will be required for building business and consumer trust in electronic transactions. Digital signatures, electronic signatures, and electronic representations that link individuals and entities to operations in the electronic environment are less meaningful without accompanying certification mechanisms, ie. means of independently verifying information about transactions and transacting parties.
As mentioned earlier the OECD has suggested the introduction of a certification authority (CA) that can act as an independent trusted means of determining that factual information is verifiably connected to a transacting party. It could certify at least six types of information to provide a basis for confidence in electronic transactions: identification and registration, user attributes, compliance with standards, authorisation to act, transactional information, or applicable laws.
A number of issues need to be considered when developing policies for certification mechanisms and certification authorities. Due attention should be paid to clarifying the responsibilities and the liability of entities that certify information. Also, because certification processes can generate vast quantities of data, issues related to the protection of privacy and personal data also need to be considered. Finally, a framework for supporting the international interoperability of certification mechanisms and the mutual recognition of certification authorities needs to be developed.
To this end the European Council of Ministers has tried to address this issue with a recent directive. The directive states that, “Member states shall ensure that their legislation allows contracts to be concluded electronically” by introducing a framework for electronic signatures. Under the directive, “certification-service-providers” will be able to issue certificates, defined as “an electronic attestation which links signature-verification data to a person and confirms the identity of that person”. The certification-service-providers cannot be made subject to prior authorisation, but member states will be able to introduce or maintain voluntary accreditation schemes aimed at enhanced levels of certification-service provision. Member states will not be able to restrict the provision of such services by providers in other member states.
The directive also contains an article on the legal effects of electronic signatures, stating that members states are to ensure that electronic signatures based on a qualified certificate and which are created by a secure signature-creation device satisfy the legal requirements of a signature in the same way as handwritten signatures and that they are admissible as evidence in legal proceedings. In addition, member states are to ensure that an electronic signature is not denied legal effectiveness and admissibility as evidence in legal proceedings solely on the grounds that it is in electronic form, is not based on a qualified certificate or is not created by a secure signature-creation device.
3.2 Legal disputes
For international electronic commerce, the usefulness of courts for resolving problem transactions may be limited, and appropriate dispute settlement mechanisms will therefore have to be found. The most promising appears to be the financial intermediary, because it can, in many cases, reverse the financial portion of a transaction under appropriate circumstances (e.g. mistake, non-delivery, delivery of the wrong item) and therefore arbitrate disputes efficiently. This ability to “charge back” a transaction also gives merchants a strong incentive to ensure high levels of consumer satisfaction at the outset: payment card associations can and do drop merchants with too frequent charge backs.
In the United States the chargeback mechanisms are partly responsible for high confidence in telephone shopping among consumers and its enormous growth. Extensions of chargeback principles to international electronic commerce will be important for developing similar levels of confidence in this new medium.
The legal issues raised by electronic commerce do not appear as insurmountable as those raised by its taxation.
Although the OECD believe that it is possible to adapt current tax laws to e-commerce, it can be seen that even the most fundamental issues of current tax law are “stumbling blocks” for e-commerce. Whilst e-commerce is in its embryonic stage one must wonder whether it is more prudent to start afresh and create a completely new basis of taxation to be adopted by all countries, rather than to homogenise current, often conflicting laws already in existence. Either way what one must realise is that significant time must be spent on deciding the best course of action for such issues. With a basis of taxation that can affect world wide commerce rather than just national dealings any mistakes or loopholes will become far more difficult to deal with.