Clicks and Mortar: Taxing Multinational Business Profits in the Digital Age

• Publication year: 2003

SEATTLE UNIVERSITY LAW REVIEWVolume 26, No. 4SPRING 2003

Clicks and Mortar: Taxing Multinational Business Profits in the Digital Age

Aldo Forgione(fn*)

International tax treaties generally provide for the business profits of multinational enterprises to be taxed in the jurisdiction where the enterprise has a fixed base or "bricks and mortar" establishment. Technological developments have contributed to the deterioration of the tax base in many countries. Digital technologies, such as the Internet, challenge international norms that rely upon physical presence as the basis for jurisdictional income taxation. The growth of electronic commerce and the increasing use of tax havens have spurred pleas for international tax reforms.

International tax reforms must satisfy accepted tax policies, including the principles of neutrality and inter-nation equity. Income from e-commerce ("clicks") should be treated in a similar manner to traditional business income ("mortar"). Equity concerns question whether the permanent establishment rule for taxation of multinational business income unfairly impacts the treasuries of less developed countries. Treaty rules typically preclude countries from taxing business profits derived from activities within their jurisdiction, unless these activities can be connected to a physical establishment located within the jurisdiction. The country where the buyer resides foregoes tax jurisdiction in favor of the nation that is home to the business enterprise. These treaty rules effectively represent a mechanism of reverse foreign aid-potential tax revenues flow from the treasuries of poor countries to the treasuries of wealthy or developed nations.

The current imbalance in the distribution of tax revenues and other inadequacies of the prevailing international tax regime could be ameliorated through the adoption of treaty rules that replicate the domestic tax rules adopted by most countries, including the United States. In other words, international tax reforms should restore the primacy of "market country taxation" of multinational business profits by abandonment of the treaty concept of permanent establishment.

Introduction

The emergence of electronic commerce (e-commerce) casts a daunting specter over the current regime of international income taxation. Existing tax rules were established to handle transfers of physical goods and services across borders. Globalization, e-commerce and the increasing use of tax havens have created a fiscal crisis that threatens the security of the tax base of most industrialized nations.(fn1) As a result, many of the world's national tax authorities are struggling to utilize unstable mechanisms and outdated tax rules to identify and collect crucial revenues.(fn2)

Numerous governments ponder the potential impact that the Internet and electronic commerce would have on prevailing tax rules.(fn3) The approaches favored by domestic tax authorities vary considerably. The United States (U.S.) and other industrial nations generally recommend ad hoc modifications to existing international tax laws and norms to deal with e-commerce.(fn4) In contrast, tax authorities from developing countries tend to propose the abandonment of the traditional tax treaty principle of "permanent establishment" and the adoption of international tax norms that could apply to electronic commerce as well as to traditional cross-border business activities.(fn5) One of the few points of agreement is that the application of prevailing tax treaty rules will lead to unsustainable inequities and distortions in the taxation of international business profits.

This Article argues that governments should abandon the treaty concept of permanent establishment and adopt international tax reforms that restore the primacy of "market country"(fn6) taxation of multinational business profits promoted by domestic tax laws. Part I explores several emerging e-commerce issues that demonstrate the tension of introducing traditional tax norms to a digital environment. Part II reviews historical and recent developments in the international taxation of business profits and looks at the underlying trends and sentiments for reform of the existing system of global taxation of business income. Part III canvasses several prominent international tax reform alternatives proposed by governments, multilateral organizations and tax commentators around the world. Finally, Part IV proposes the adoption of tax rules and norms that allow each nation unfettered jurisdiction over business income, including e-commerce profits, derived from transactions completed within that country's borders.

I. TECHNOLOGY AND THE CHALLENGE TO GLOBAL TAX

REVENUES

A. Types of Electronic Commerce

The quintessential electronic commerce transaction involves the sale and delivery of intangible products and services through computer networks. E-magazines, music, video games, software and travel services are all intangible items that can be procured over the Internet without ever manifesting themselves outside of a computer. The process of marketing, distribution, payment and delivery of an intangible good or service may be completed electronically without the need for physical delivery of the product or service. It is the intangible nature of electronic commerce that fundamentally challenges traditional international tax concepts and practices.(fn7) The distinction between the sale of a digital good and the delivery of a service over the Internet can be obscured to suit the commercial intentions of the parties. The online purchase and delivery of an intangible good or service is distinguishable from the purchase of physical products using the Internet.

Consumers can purchase tangible goods and services such as books, groceries, clothing, and travel tickets by merely interfacing with a vendor's web site. The major distinction between these two types of e-commerce is that most tangible products and services require physical delivery even if marketed or purchased through a digital medium. E-commerce transactions involving the sale and delivery of physical goods and services are similar in many respects to traditional modes of commerce. When a tangible product is purchased online, the Internet acts as a modern communication device, similar to a telephone or facsimile machine, for the promotion and sale of goods and services in the marketplace. While the increasing popularity of online purchases of tangible goods and services presents several challenges to international tax authorities, such transactions are less problematic than their purely electronic counterpart.

B. Emerging Issues: Taxation and the Digital Economy

The growth of electronic commerce raises important issues for the taxation of international income. The following sections outline several aspects of e-commerce that present difficulties for the collection of taxes in a digital environment.

1. Elimination of Intermediates and the Threat to Tax Collection

Current rules and practices cannot resolve the difficulties of collecting taxes in a digital environment. At present, tax authorities rely upon various intermediaries as crucial sources of information as well as for the collection and remittance of taxes. E-commerce circumvents traditional audit and collection points by eliminating or redefining the role of intermediaries.(fn8) The absence of traditional intermediaries in the electronic world constitutes a serious problem for tax authorities because governments have been unable to devise an efficient system to handle the due and timely processing of e-commerce tax revenues.(fn9) The loss of crucial audit or verification points will eventually undermine the administrative efficacy of the entire income tax system.(fn10)

While tax authorities are seriously concerned about the impact that e-commerce will have on the income tax system, the collection and remittance of sales and other indirect taxes on electronic transactions represents an even greater problem for many tax jurisdictions.(fn11) The laws of most jurisdictions conscript traditional retailers to collect and remit taxes on behalf of the national treasury. It is difficult to apply collection obligations to the digital forum due to inconsistencies in the tax base and the absence of verification controls. Tax authorities recognize that the potential for lost revenue is particularly acute in respect of a state's collection of value-added taxes and other sales taxes.(fn12) Discrepancies between the tax treatment of e-commerce goods and traditional products also serve to distort or unduly influence market behavior.(fn13) The absence of any effective regulatory controls on the Internet restricts the ability of tax authorities to monitor taxable transactions. E-commerce vendors can bypass tax collection mechanisms with relative impunity because of the absence of any stringent governmental verification mechanisms. In so far as the Internet eliminates the use of traditional intermediaries, it exposes deficiencies inherent in a self-reporting tax system. The pitfalls in existing collection, administration and enforcement mechanisms will necessarily correspond to reduced national tax revenues.

2. Challenges to the Present System: Identification of Taxpayers and

Taxable Transactions

Tax authorities must be able to identify and monitor e-commerce...