Formulating international tax laws in the age of electronic commerce: the possible ascendancy of residence-based taxation in an era of eroding traditional income tax principles.

• Author: Sweet, John K.

INTRODUCTION

In recent years, the number of Internet participants around the world has expanded dramatically, "with user estimates [in 1996] ranging from 30-60 million, and growing rapidly."(1) This growing user base has resulted in a significant increase in the amount of business conducted over the Internet.(2) In 1996, income from Internet transactions grew immensely, topping the one billion dollar mark for the first time.(3) The growth-to-date of electronic commerce ("E-commerce"), though substantial, pales in comparison to the anticipated increase in electronically conducted business over the next few years. One research group predicts annual Internet sales of $327 billion by the year 2002.(4)

As the trend toward E-commerce gains momentum, fewer transactions will conform to conventional means of doing business. This increasing reliance on the Internet for conducting transactions has already created challenging and novel questions in several areas of law.(5) The impact that technological developments have had on existing legal principles "has provoked some scholars to argue that cyberspace needs laws of its own."(6) In the area of international taxation, the changing business landscape caused by the surge in E-commerce at the very least warrants a review of existing principles in light of new technologies.(7) Certain long-standing international tax concepts evolved in a simpler economic era when easily traceable, "physical" transactions dominated the business world.(8) The tendency of E-commerce to eliminate geographical boundaries and "to blur ... the source and character of income"(9) may threaten the continued viability of such concepts, which include: (1) source-based taxation; (2) the tax treaty concept of "permanent establishment" ("PE"); and (3) the Internal Revenue Code (the "Code") concept of "U.S. trade or business."(10)

The amount of attention and resources that international taxing authorities are devoting to E-commerce taxation issues underscores the importance of addressing these issues sooner rather than later.(11) One commentator stresses that "[t]he international tax issues surrounding intangibles, electronic commerce, and communications technologies ... strike at the heart of change and uncertainty in international tax."(12) In formulating tax policy to deal with the new business technologies, tax authorities should strive to avoid impeding the development of E-commerce.(13) Achieving this goal will require an international consensus regarding the taxation of E-commerce.(14)

A consistent, internationally accepted approach to the taxation of electronic transactions will provide certainty to the growing number of taxpayers engaged in E-commerce. More importantly, a unified approach will mitigate the potential for double taxation (as well as tax evasion) which arises when tax authorities adopt inconsistent methods of taxing similar electronic transactions. Double taxation would artificially inflate the cost of cross-border electronic transactions relative to domestic E-commerce transactions.(15) Failure to deal effectively with the possibility of double taxation, therefore, could prevent worldwide E-commerce from realizing its full potential.(16) Concededly, the policy of pursuing international agreement on the taxation of cross-border flows of income--in order to provide certainty and prevent double taxation--is also applicable to conventional modes of commerce. The ability of E-commerce, however, to remove physical barriers to international trade and thus permit cross-border transactions to take place with increasing frequency reveals the greater need for an internationally coordinated approach to the taxation of E-commerce.

Barriers to international agreement may arise because the residents of one country might be situated differently in relation to E-commerce than the residents of another country. For example, a major exporter of electronic goods and services like the United States might desire to tax E-commerce on a residence basis. Another country whose residents are primarily importers and users of electronic goods and services might prefer a "source-of-payment" tax rule. Consequently, it would be unrealistic to expect all international taxing authorities to agree on a single, unified approach to the taxation of E-commerce. Nonetheless, a common approach, if agreed upon by a significant number of nations, could go a long way toward alleviating the problem of double taxation.

Good policy also dictates that taxing authorities pursue the application of the neutrality principle wherever possible. The Treasury Department strongly advocates the neutrality principle, which "requires that the tax system treat economically similar income equally, regardless of whether earned through electronic means or through more conventional channels of commerce."(17) Under a successfully operating "neutral" tax system, "tax rules would not affect economic choices about ... commercial activities," ensuring that "market forces alone determine the success or failure of new commercial methods."(18) The Treasury Department believes that the best way to achieve neutrality "is through an approach which adopts and adapts existing principle--in lieu of imposing new or additional taxes."(19) This Comment periodically analyzes the principle of neutrality as it relates to the taxation of E-commerce. In general, I agree with the Treasury Department's position that neutral tax policy, for economic reasons, should be implemented to the extent possible. However, I will also express doubt that pursuing the neutrality principle is possible in certain instances or that doing so will yield a positive outcome.

Although I do not seek to de-emphasize the importance of policy decisions in the formulation of tax laws, I will focus more on substantive tax matters in this Comment. I will undertake the task of reevaluating traditional international tax principles in an effort to determine their adaptability to the constantly evolving electronic age of business. Part I will consider the potential impact of E-commerce on the principle of source-based taxation. Since income classification is essential to the proper sourcing of income, Part I will initially assess the feasibility of current classification principles in the context of E-commerce. I will conclude that although classification of income from Interact transactions is possible, the source-based taxation principle is seriously threatened by modern day E-commerce. Part II will analyze the analogous tax threshold concepts of "U.S. trade or business" and "permanent establishment" in the context of today's global electronic economy, concluding that these concepts will likely lose their relevance in cyberspace. Part Ill will consider the possibility of an increased role for residence-based taxation in the future of international taxation, and conclude with certain reservations that a move toward residence-based taxation is desirable.

1. THE IMPACT OF E-COMMERCE ON SOURCE-BASED TAXATION

   1. Overview of Source-Based and Residence-Based Taxation Principles

      The international tax environment has relied on the principles of source- and residence-based taxation for over seventy years.(20) A source-based approach (sometimes referred to as a territorial approach)(21) entitles the "source" country to tax the income of nonresidents that is earned within its borders.(22) In contrast, under a residence-based system, a country asserts jurisdiction to tax the worldwide income of its residents, regardless of source.(23) Most countries, including the United States, "assert[] jurisdiction to tax based on principles of both source and residence."(24)

      The policies of the various countries--whose constituents engage in international trade--regarding source- and residence-based taxation may create the potential for the double taxation of certain cross-border flows of income. Double taxation comes in three basic forms: (1) residence-residence double taxation; (2) residence-source double taxation; and (3) source-source double taxation.(25) Residence-residence double taxation occurs when a taxpayer "is deemed a resident of more than one [nation]" and each asserts the right to tax on a residence basis.(26) Residence-source double taxation arises when one nation seeks to tax income on a residence basis and another country asserts the right to tax the same flow of income on a source basis.(27) Finally, source-source double taxation exists when each of two nations that tax on a source basis considers a particular flow of income to have a domestic source.(28)

      To avoid double taxation, "one principle must yield to the other."(29) A common bilateral tax treaty involving the United States solves the double taxation problem by restricting the taxing rights of the source country, which correspondingly increases the taxing jurisdiction of the residence country.(30) Where a source country retains its rights to tax a particular flow of income, the country of residence may avoid double taxation on that income in one of two ways: (1) by granting a credit to its resident taxpayers for taxes paid to the foreign jurisdiction;(31) or (2) by exempting the foreign source income from the taxable income base of its taxpayers.(32)

      Foreign tax credits, however, do not always alleviate the burden of double taxation. The United States, for example, will not allow a tax credit in a source-source double taxation situation, where both the United States and another country deem a certain item of income to have a domestic source. In such a situation, the taxpayer, for U.S. tax purposes, does not derive any foreign source income. Since the existence of foreign source in come is essential to generating a foreign tax credit for U.S. tax purposes,(33) double taxation will persist in such a case.

      The source-source situation also carries with it the risk of tax evasion. A tax avoidance opportunity could arise when each of two...