Sourcing income from Internet transactions.

• Author: Williamson, Donald T.

EXECUTIVE SUMMARY

* The e-commerce revolution presents an unprecedented challenge to adapt rules that do not impede the growth of e-commerce, yet effectively and fairly collect tax revenue.

* The borderless nature of e-commerce presents a substantial challenge to the sourcing rule regime based on physical geographic links to a jurisdiction, so as to fit income into an existing category.

* The IRS has provided special sourcing rules for income produced from computer software transfers and the provision of services or know-how connected with a computer program.

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Internet technology has eliminated many geographical barriers to international trade. As a result of this increased ability to conduct e-commerce anywhere at any time, nations may claim inconsistent taxing jurisdiction over the same income. Existing income tax rules must take into account technological developments in e-commerce. This article describes how present interpretations of the sourcing rules for conventional commerce should apply to electronic transactions.

Electronic commerce (e-commerce) is the ability to perform commercial transactions involving the exchange of goods or services between two or more parties using electronic tools and techniques. (1) These new technologies (particularly communication technologies involving the Internet) have effectively eliminated geographic barriers to international trade.

The increased ability to conduct business anywhere at any time may lead nations to claim inconsistent taxing jurisdiction over the same income derived from electronic transactions, creating multiple (or at least impractical) taxation. (2) This economic revolution presents an unprecedented challenge to taxing authorities to adapt rules that do not impede the growth of e-commerce, yet effectively and fairly collect tax revenue from such transactions.

In a discussion paper titled "Selected Tax Policy Implications of Global Electronic Commerce," (3) Treasury set forth its position that e-commerce taxation must be based on principles of neutrality, with rules flexible enough to cope with, and adapt to, evolving technologies. Specifically, it proposes that income from economically similar transactions should be taxed similarly, whether earned electronically or through more conventional channels. Consequently, it rejected any new or additional taxes on e-commerce. (4)

To implement this neutrality policy without adopting new income tax principles requires a reexamination of existing income tax rules, taking into account their adaptability to technological developments in commerce. Among the existing tax principles that must be adapted are the determinations of whether income generated by cross-border e-commerce transactions is U.S.-source income, and whether such commerce constitutes a U.S. "permanent establishment" (PE) under U.S. income tax treaties.

This article describes how present interpretations of the sourcing rules to conventional commerce should apply to electronic transactions. An article in the May 2003 issue will discuss how the PE rules apply in Internet transactions and how fundamental principles of U.S. international taxation need to adapt to e-commerce.

U.S. Taxation of Cross-Border Income

The U.S. taxes its citizens, resident aliens and domestic corporations on their worldwide income; under Secs. 871,881 and 882, nonresident aliens (NRAs) and foreign corporations are generally taxed only on their U.S.-source fixed and determinable annual and periodic (FDAP) income (e.g., dividends and interest) and income effectively connected with a U.S. trade or business. Generally under Sec. 861, income is sourced in the U.S. when it is derived from an asset or activities located within the U.S.

When U.S. persons derive income from activities in another country, a double-taxation problem may arise if the U.S. and the foreign country claim taxing jurisdiction over the same income. Although the U.S. could alleviate this double tax simply by excluding from the tax base income derived from sources outside the U.S. (i.e., a territorial system of taxation), it instead adopted a credit system. Sec. 901 entities U.S. persons to credit foreign income taxes paid on foreign-source income, subject to a number of limits in Sec. 904 intended to confine the credit's effect to mitigation of double taxation.

Because the foreign tax credit (FTC) reduces only the U.S. tax on a U.S. person's...