Cyberspace transactions present interesting international, state and local tax issues.

• Author: Levey, Marc M.

Introduction

The 1990s have introduced the world to a vast array of commercial business opportunities that may forever change our lives and how we conduct business transactions. The opportunities center around electronic commerce and the World Wide Web, often called the "global information superhighway." This superhighway consists of a convergence of, among other things, telephone systems, cable and satellite communications, and computer networks. The primary introduction to this world -- the world of Cyberspace -- is through the Internet.

The Internet is a vast international network of networks that enables computers of all kinds to share services and communicate directly. Like a spider's web, the Internet has many avenues that may be followed to reach a particular destination. The Internet is frequently compared to a postal station with hundreds, if not thousands, of routes to deliver its mail.

To take advantage of this vast routing system, many businesses have established sites on the Worldwide Web (Web sites) to market, advertise, and sell their goods and services. Web sites can blend text, video images, and sound into a multimedia presentation of the site's contents. Through a Web site, potential customers may shop for consumer goods, software packages and licenses, tax and technical services, health care information and services, research libraries, stock transfers, banking services, and a wide variety of other goods and services.(1)

Access to the Internet is generally through an Internet service provider (ISP). ISPs are organizations (e.g., Compuserve and America On-Line) that provide individuals and businesses with access to the Internet, including commercial Web sites. These ISPs, who may be wholesalers or retailers, provide access to the customer either through hourly rate charges or flat fees. ISPs are typically accessed through local or 800 telephone numbers. Merchants and service companies establish Web sites on their own servers that can be accessed through ISPs. ISPs can be located anywhere in the world, because location of the ISP is meaningless to the ultimate transaction and transparent to the user.

The myriad transactions that can be effected through the Internet give rise to a host of international tax issues that must be addressed to determine which jurisdictions may tax the transaction, and what rules will govern the determination of the amount of tax. Among the issues are the characterization of the transaction as the sale of goods, licensing of intangibles, or rendering of services; the source of the transaction as domestic or foreign; whether the transaction has created a U.S. permanent establishment or U.S. trade or business; whether the income is "effectively connected" or fixed or determinable annual or periodic income; how are withholding tax obligations to be enforced; and whether the anti-deferral rules of Subpart F apply. This article surveys these issues.

Characterization of the Transaction

The starting point in determining the tax consequences of transactions in the electronic marketplace is proper characterization of the transaction based on its particular facts and circumstances. This determination is critical because differing characterizations could affect application of the source rules that could, in turn, trigger different withholding tax obligations. Further, characterizing the transaction influences the selection of the appropriate transfer pricing method, whether income must be included under Subpart F, application of customs duties (or VAT obligations), and application of various treaty provisions, including whether a permanent establishment exists. There is also a state taxation analog to these issues.

One of the more difficult characterization issues has recently been tackled by the Internal Revenue Service in proposed regulations relating to the sourcing of income from transactions involving computer software programs.(2) Although the proposed regulations are limited to transactions involving computer programs, they establish a framework that may be helpfully applied to other copyrighted information (e.g., digital information).(3)

The proposed regulations treat transactions involving computer programs as either (1) transfers of copyrights; (2) transfer of copyrighted articles; (3) the provision of services for developing or sublicensing the computer program; or (4) the provision of know-how regarding computer programming techniques. Copyrights are defined as the right to (1) make copies of the computer program for purposes of distribution to the public by sale, rental, lease, or lending; (2) prepare derivative programs based on the program; (3) make a public performance of the computer program; and (4) publicly display the program.(4)

If a user has obtained one or more of these four copyrighted rights, it is considered to have obtained an interest in the copyright, so that the transfer is treated as a license. If the user has not acquired a copyright, however, and the transaction does not involve the provision of services or the transfer of know-how, then the transfer is treated as a sale of tangible property. These provisions therefore attempt to answer the more difficult characterization issue involving shrink-wrapped software and functional equivalents, namely, whether they should be considered either the sale of tangible property or licensed copyrights. The proposals for the most part lean toward a characterization as the sale of tangible property.(5)

Characterization issues, however, are not solely limited to shrink-wrapped software. A white paper released by the U.S. Department of the Treasury in 1996, for example, highlights the ambiguity between the sale of goods and the provision of services where digital information, such as that contained in an encyclopedia, is sold over the Internet. The transaction may be accomplished either through the purchase of a CD-ROM disk or by simply downloading the software directly to the customer's computer. In either case, the purchase is effected through an electronic credit card purchase.

There is little practical difference between the electronic purchase of an encyclopedia and a direct bookstore purchase of a hard copy encyclopedia, so that treating this transaction, by analogy, as a sale of tangible goods may appear warranted. What is the result, however, if on-line services and updates are offered as part of a sale or, alternatively, if instead of purchasing a CD-ROM disk or downloading software, the purchaser acquires access to an on-line database library? These elements to the transaction begin to appear more like the rendition of services. In the former case, it arguably could make a difference if the use of the online service was infrequent or charged separately. In the latter case, however, the characterization may be completely shifted to one of service rendition.(6)

Along a similar vein, several companies offer direct online access to proprietary databases. These providers include credit rating bureaus, legal and tax professional firms (e.g. LEXIS/NEXIS, Big Six accounting firms(7)), physicians' healthnet, as well as many well known publishing houses. Classification of these items could fall under both the provisions for services and those for royalties -- that is, although payment may be made on an hourly or other time basis, copyrighted material may be provided to the user. By contrast, it could be argued that, if only selected data are derived from the database that is used for purposes of creating a report or separate document, a services paradigm is more appropriate. To reach these conclusions, of course, one should look past the actual mode of delivery of the product and focus on the underlying substance of the transaction.

The U.S. Treasury Department is clearly concerned that electronic commerce presents opportunities to evade U.S. taxation through the use of tax haven companies whose activities are entirely in the electronic commerce area.(8) This concern is more in the nature of a compliance concern -- which, admittedly, may be serious -- than a core problem with U.S. tax concepts. Nevertheless, there are possibilities. What if a U.S. company creates a controlled foreign corporation (CFC) in a no tax/low tax jurisdiction, and the CFC engages in the provision of interactive data retrieval and analysis? Arguably, the CFC is in a "services" business, and, if its data and servers are located in the country of its incorporation, its income will not be Subpart F foreign base services company income. By contrast, if the activities were considered to produce international telecommunications income, then the income would be Subpart F income -- specifically, Subpart F shipping income.(9)

Sourcing the Transaction

Once the character of the transaction is determined, the source of the transaction must be ascertained. Sourcing income from the sale of tangible property, income from the licensing of intangible property, and income from the provision of services can lea4 to different results including, for sales of tangible property, the application of the partly within and partly without rules of section 863(b) of the Internal Revenue Code.(10)

Generally, the United States imposes tax on both a source and a residence basis. Hence, U.S. citizens and residents and U.S. incorporated companies are taxed on their worldwide income. Taxpayers not subject to residence-based taxation, such as nonresident aliens or foreign corporations, are subject to tax on either income effectively connected to a U.S. trade or business or fixed or determinable annual or periodical income.(11) Bilateral tax treaties generally limit source-based taxation for nonresident taxpayers through the use of a "permanent establishment" provision which determines taxing jurisdiction based upon whether the nonresident taxpayer had a significant presence and business activity in the source country.

In addition to determining taxing...