Revisiting nexus standards: establishing U.S. jurisdiction to tax cross-border commerce.

• Author: De Sellier, Brianne N.
• Position: Tax Law

In 1789, Benjamin Franklin famously observed, "[I]n this world, nothing can be said to be certain, except death and taxes." Franklin might have been correct about death, but in this modern era of electronic commerce and virtual retailing, the international tax environment has become uncertain at best. The emergence of electronic commerce has challenged the U.S. tax system to re-evaluate jurisdictional nexus standards in order to adapt to the realities of the modern business climate. In particular, questions have been raised as to whether traditional international tax principles continue to be a viable approach to establishing U.S. jurisdiction to tax cross-border commerce.

Traditional U.S. International Tax Principles

When a foreign taxpayer generates income in the United States, both the United States (the source country) and the foreign taxpayer's country of residence (the residence country) generally have jurisdiction to tax that income. The overriding objective of the U.S. system of international taxation is to equitably resolve these competing claims in a way that stimulates global commerce while simultaneously mitigating risks of multiple taxation and tax avoidance. (1) In this respect, there are two fundamental approaches to resolving competing claims to tax the same income: 1) residence-based taxation; and 2) source-based taxation. (2)

Under principles of residence-based taxation, income is taxed in the taxpayer's country of residence, regardless of where the income is earned. (3) Under principles of source-based taxation, by contrast, income is taxed in the country in which it is earned, regardless of the taxpayer's residence. (4) The United States employs a hybrid approach under which jurisdiction to tax cross-border income is predicated on principles of both residence-based taxation and source-based taxation. (5) U.S. citizens, resident aliens, and domestic corporations are subject to U.S. taxation on worldwide income in accordance with principles of residence based taxation. (6) Foreign taxpayers, on the other hand, generally are taxed in accordance with principles of source based taxation. (7)

The Internal Revenue Code (IRC) provides that foreign taxpayers engaged in a trade or business within the United States are subject to U.S. taxation on income that is "effectively connected" to the conduct of trade or business within the United States. (8) The treaty counterpart is that a foreign taxpayer is subject to U.S. taxation only on business profits attributable to a U.S. permanent establishment. (9) The majority of inbound business activity that occurs in the United States involves foreign companies domiciled in countries with which the United States has a bilateral income tax treaty. Therefore, the U.S. generally must establish its jurisdiction to tax the business profits of a foreign enterprise under treaty principles, which typically limit the scope of U.S. taxing jurisdiction to situations in which the foreign enterprise has a "permanent establishment" within the United States.

The Permanent Establishment Concept

The term "permanent establishment" is defined as "a fixed place of business through which the business of an enterprise is wholly or partly carried on." (10) Traditional examples of permanent establishments include stores, offices, branches, and factories. (11) In addition, the activities of an agent acting on behalf of a foreign enterprise in the United States may create a permanent establishment for the foreign enterprise. (12) Some tax treaties have even extended the definition of permanent establishment to deem a permanent establishment to exist when a foreign enterprise performs services within a jurisdiction for more than a specified length of time. (13) In essence, the permanent establishment concept demands an integral and ongoing physical presence within the United States as a prerequisite to U.S. taxation.

Historically, the permanent establishment concept emerged in the early 20th century as a byproduct of the second Industrial Revolution. (14) The second Industrial Revolution facilitated innovations in transportation which, in turn, enhanced business mobility and created unprecedented opportunities for foreign businesses to enter previously inaccessible U.S. markets. (15) As a result, there was an influx of foreign capital into American markets. (16) Of course, with foreign exploitation of American markets came U.S. taxation of foreign businesses. At the same time, however, these foreign based businesses remained subject to taxation in their residence countries based on principles of residence-based taxation. As a result, double taxation of cross-border business profits became an issue, and the permanent establishment concept...