E-commerce occurs in various forms and between various entities in the market. One among the question faced by nations is how to tax it. As the internet crosses the boundaries the main challenges are how can the basic requirements of physical presence and substantial nexus criteria of taxation can be met. The article tries to analyse the key issues in the area of e-commerce taxation. Article alarms the nation that if it is left untaxed it will give rise to a parallet economy. Every industry contributes to the nations economic growth.
The communications industry has become very significant and is promising to grow enormously in the near future. Unlike other communication media, Internet is facilitating access to knowledge bank, in competitive market and rendering services of world class standard. E-commerce offers a new way of conducting, managing and executing business transactions using modern information technology. It has redesigned the traditional mode of business. As a whole, it is a business practice that involves use of computers, computer systems or computer networks1.
E-commerce occurs in various forms and between various entities in the market . The question is how to tax it. As the Internet has crossed borders (sovereignty) how can the requirements of physical presence and substantial nexus criteria of taxation be met. 2 Due to the uniqueness of e-commerce, taxation faces a number of problems. This articles tries to find out the key issues in the area of e-commerce taxation and tries to analyse the existing regime with regard to the e commerce taxation. It is also alarmed that if this is left untaxed , it will give rise to a parallel economy.
Definition of E-commerce According to Greenstein and Ferman3 “electronic commerce (e-commerce) is defined as the use of electronic transmission medium ( telecommunication) to engage in the exchange, including buying and selling of products and services requiring transportation either physically or digitally from location to location. ” E-commerce is any transaction completed over a computer-mediated network that involves the transfer of ownership or rights to use goods or services. According to European Commission4, e-commerce encompasses more than the purchase of goods online.
It includes a disparate set of loosely defined behaviours such as shopping, browsing in Internet for goods and defined behaviours, gathering information about items to purchase and completing the transaction like any other sustained business activity. It also means conducting consumer satisfaction surveys, capturing information about consumers and maintaining consumer databases for marketing promotion and other related activities. The first phase of e-commerce threw up a new business nomenclature using various combination of business and consumers5. It has its own advantages and disadvantages6 as in traditional business methods.
Thus, e-commerce has necessarily changed the world economy in a dynamic and interactive pattern. Taxation for Internet Transaction The Internet has changed many of the fundamental and long standing concepts of direct and indirect taxation. Governments all over the World are grappling with the various issues of taxation raised by e-commerce. This is because of lack of comprehensive understanding of: • The communication technologies • The complex nature of business offered through Internet business, etc. • The modus operandi of Internet business, etc.
has made the operation of tax legislations more difficult. The Information Technology Act, 2000, which is the first legislation to deal with e-commerce is quite silent about tax system. Substantial amount of state revenue which is generated through direct and indirect taxes is lost when Internet transaction remain untaxed7. A way is to be found to tackle this relevant problem. Basic Principles of Taxation Several basic principles form the foundation of taxation policy in any country. The most important of these principles are efficiency, equality, certainty and positive economic effect8.
If the tax system disregards these principles it is fatally defective. The efficiency principle encompasses notions of both fiscal and economic efficiency. An economically efficient tax system should be neutral and not influence one’s economic behaviour simply because of the manner in which the tax is levied. An ideal tax system is also equitable in its application. Not only does it treat taxpayers in similar economic circumstances9 similarly but also it makes suitable distinctions in its treatment of those in different economic situations.
It necessarily raises questions of “similar economic circumstances”, certainty in the tax laws is a fundamental principle in the establishment of ideal tax structure because predictability of tax consequences is an essential component of other basic tax principles. Finally, taxation has always been a mechanism for stabilisation and regulation of the economy10. Recognising this fact, legislature has emphasised the economic effects of the principle of taxation, with a particular focus on encouraging economic growth.
For the development of rational tax policy one should understand the nature of industry. Some of the peculiarities of Internet are”11. • It is a network of networks and it cannot be controlled or owned by one person. • This network of networks is capable of rapidly transmitting packets from one computer to another. • No human involvement is necessary to transmit data from one computer to another. • The Internet can re-route itself if one computer is connected to the net. Content wise the Internet is very rich. • The world-wide web environment provides a user friendly graphical interface.
• A simple click is sufficient to obtain vast information anywhere in the World. • It encompasses all territorial and geographical limitations Keeping these unique qualities of the Internet in mind one should try to visualise the issues concerning the taxes on the net. E-business for taxation is an intriguing concept. It crosses nine trillions12. In these circumstances, it seems an imperative for revenue authorities to examine the approach and policy towards taxation of e-commerce more comprehensively than they have to date.
However, this examinations should not be confined to the conventional topics like whether an e-merchant has a permanent establishment, how income from one line transaction should be characterised and where consumption of goods and services delivered electronically takes place, etc. These topics should be considered in the context of broader study evaluating the total impact of e-transformation on business productivity, supply chain , economic cycles and sector differences.
To put it in another way, revenue authorities should not simply focus upon taxation of e-commerce per se (such as B2C sale and purchase of goods by Amazon.com the downloading of Norton anti-virus program), where attention is typically focused upon the location and function of servers, characterisation of income and place of consumption. Instead, the analysis should extend more broadly to ensure a deeper understanding of the nature of e-business as it is today and as it will develop tomorrow. In this regard, it is tempting to argue that business function will simply and suddenly disappear into cyberspace and that virtual companies will be able to operate with little presence anywhere except a site hosted by an Internet service provider in a tax-free jurisdiction.
Primarily, Internet activities are divided into two parts . One is “access service” and other is “content service13”. In the former, access to the Internet will be provided to the individuals whereas, in latter, content consisting of information are delivered electronically. To distinguish further Internet service provider is one who provides the service of accessing Internet whereas, online service provider (OSP) is one who provides service through Internet. The service is rendered by them in return for the payment of subscription and usage fees. These are subjected to tax.
The Internet as discussed earlier encompasses content/material service, traditional retail transaction to an electronic medium, electronic commerce involving digital products. This would eventually create so many intellectual property problems. Offline Transactions The offline transactions describe any transaction where goods and service are ordered and possibly paid for electronically, but delivered by other means. The bulk of e 14. commerce is currently found in offline transactions14. In contrast to the normal transactions, these offline transactions came by disintermediation.
The practicalities of enforcing sales tax, customs duty differ between online and offline transactions. The tax authorities will need to re-think their current methods of tax collection, simplifying or streamlining procedure without threatening any revenue and other cross-frontier controls15. OnLine Transactions The term online is used to describe any transaction that is delivered online. For tax authorities, these transactions are very difficult to handle. The problems with online transactions, as perceived by tax collecting authorities16 include: • Inability to identify a transaction.
• Encryption of transaction • Collecting the tax from millions of end-users rather than a small number of intermediaries. • Difficulties in determining where a product is produced or consumed. • Definition of goods and services and • Distinctions between types of services17 Tax collecting authorities will be virtually powerless in identifying transaction between Indian consumers and overseas suppliers, where all of the transaction has been performed electronically including paying the money through electronic cash.
Encryption of Transaction Powerful encryption technologies are now available to everyday Internet user and are expected to become commonly used in the next two to three years. These technologies allow users to encrypt all of the transaction so that only the parties involved can decrypt the information. This means that if the income tax officer or other tax authority is able to interrupt a transaction, he will not be able to read it or understand its content in order to identify whether the transaction involves accessible goods or not.
The use of encryption technologies will not only be conducted by tax evaders but also by the most honest citizen who just wishes for his transaction to be secure collecting the tax from end users. Another important problem in e-taxation is collection of tax from millions of individuals rather than intermediaries. This will increase the cost of tax collection. Internet makes the physical location of the seller’s business irrelevant. Whereas, the conventional notions of the sales tax law are based on the location of sellers business itself.
Making use of the unique feature of the Internet, the seller may operate his market in a state effectively from far beyond the state’s borders where it may be immune to the states taxing jurisdiction. The VAT systems currently is place in 30 OECD countries are credit invoice tax systems. This method has a basis that relies on a number of rules and one of these rules is the “place of supply rule”18. This rule tries to ensure that appropriate goods and services are subject to taxation only once.
The OECD has recommended that the place of supply rules be called the place of taxation rules so as to minimise any prospect of misunderstanding about the extent and implication for countries arising from any consensus reached on the place of taxation19. E-Commerce Taxation The well -planned tax system in India with the authority to levy taxes is divided between the Central and State Governments. • Central Government collects direct taxes like personal income tax, corporate tax • State Governments collect local and state sales tax.
In India the tax policies should be carefully formulated based on a policy that is clear and transparent and is consistent with the international norm of characterisation of revenues. The Government should honour the principle of neutrality as laid down by the OECD in characterisation of income from e-commerce transactions. India has signed tax treaties with various countries. These are mainly based on OECD. These treaties are making it mandatory to reduce the loss of income due to double taxation20 and also to give relief to Indian Assesses from double taxation.
Taxation of e-commerce has become a major concern for international agencies and tax authorities worldwide. In Europe, North America and Australia and in many Asian countries substantial research has been conducted on the impact of e-commerce on taxation21. Among the plethora of book reports, articles and papers produced on the topic, the work of OECD stands out as the most significant. The theme underlying throughout OECD work done till now is, that the Government has to successfully meet the challenges posed by e-commerce for taxation systems, and a global coordinated approach is required to tax a truly global phenomenon.
OECD Report The recent report of OECD paved way for a statement of broad taxation principles that should apply to e-commerce as reported in “The Economic Times” dated, 3rd June, 2000. “All double taxation avoidance treaties to be reviewed”. In sum and substance, same principles of conventional taxation should apply to e-commerce. Neutrality – Taxation should be neutral and equitable between different forms of e-commerce and thus, avoiding double taxation or international non-taxation. Efficiency – Compliance costs for business and administration costs for the Governments should be minimised as far as possible.
Certainty and Simplicity-Tax rules should be clear and simple to understand so that tax payers know where they stand. Effectiveness and fairness – Taxation should produce the right amount of tax at the right time, and the potential for evasion and avoidance should be minimised. Flexibility – Taxation system should be flexible and dynamic to ensure that they keep pace with technological and commercial developments. These principles can be applied through existing tax rules and there should be no discriminatory tax treatment of e-commerce.
The OECD ministerial conference held in Ottawa in October 1998 endorsed the principles summarised above. They proceeded to implement these taxation frame work conditions by establishing five technical assistance groups (TAGS). These comprise government officials from OECD as well as non-OECD states and representatives of the international business community. The work carried out by TAGs focused upon three major areas : 1. Consumption Tax Issues22 TAG has examined the principle of taxation at the place of consumption and the collection mechanisms that best serve to ensure the effective operation of this principle.
The consumption Tax TAG’S report proposes guidelines defining the place of taxation for cross border services and intangible property by reference to the recipients business establishment for (B2B transactions) and by reference to the recipient’s usual jurisdiction of residence for (B2C transaction) 2. International Direct Tax Issues TAG has found upon the definition of royalties in the OECD Model Tax Convention in the context of a wide range of payments made in e-commerce transactions.
This work mainly involves questions of characterising income arising from different types of e-commerce transactions. In two independent exercises, changes have been made to the commentary on Art. 23 of OECD model tax convention, clarifying the application of the permanent establishment’s definition of e-commerce and reports have been issued concerning profit attribution to a permanent establishment, both generally and specifically relating to permanent establishments involved in e-comerce transactions.
Permanent Establishments -The revised commentary to Art 5 of OECP Model Tax Convention clearly states that a non-resident enterprise with an Internet website alone would not be regarded as having permanent establishment in the country in which the website is located. This concept is of course crucial to the assessment of business profits under Article 724 of the OECD Model Tax Convention Article 5(1)25 defines a permanent establishment and Article 5(2)26 provides what it means.
The revised commentary explores various challenges posed by e-commerce to the wording of permanent establishment concept detailed in Art . 5. The revised commentary classifies that a website cannot by itself be considered a permanent establishment. Similarly, an ISP normally will not constitute a dependent agent of another enterprise so as to constitute a permanent establishment of that enterprise. 3. Income Characterisation This issue concerns the classification of various types of e-commerce income as either royalties or income from the sale of goods or income from the provision of services.
This will decide the extent to which tax jurisdiction will benefit and this, in turn, may depend upon whether the home and source jurisdiction are net exporters or importers of technology. TAG formulated its conclusion by insisting on neutrality of taxation between traditional commerce and e-commerce. For instance, buying virtual books, by downloading the content and the right to read without the right to reproduce is similar to buying a paperback. Therefore, it seems logical that taxation treatment on Internet need not be different from conventional tax system. Transfer Pricing.
The OECD recognises that transfer pricing issues will be increasingly important in the e-commerce age27. E-commerce is more collaborative and dispersed than traditional forms of commerce and its supply chain is intrinsically connected. It facilitates connectivity both intra-group and inter-group. Examining the totality of existing arena, it will be difficult in terms of determining appropriate transfer pricing to decide which business functions should carry greater weight particularly given that e-commerce has changed the way of intermediation and distribution of business flows to a significant extent.
It is of no wonder therefore, that tax payers and tax collectors alike are struggling to determine which business functions are significant and then agree upon a suitable allocation of profits thereto. Administration of Tax – Technological Challenges It is a fine balancing act to legislate on the basis of an intellectual and equitable framework on the one hand and to take proper consideration of enforcement barriers and administrative particularities on the other. In action on the part of taxation authorities in today’s e-business environment.
is simply not an option. Taxation authorities worldwide appreciate that obtaining information from taxpayers and related parties and ensuring tax compliance in an e-commerce world will be a mushrooming problem. Numerous questions arise in this regard: 1. How should transaction be kept and where? 2. What is the appropriate record keeping standard and how detailed should this be? 3. How should the constraints under various privacy and personal data laws be balanced with the need to ensure tax co mpliance? 4.
It is feasible or appropriate to require an e-merchant to obtain a business registration in every place in which sales are made or services provided. 5. How parity treatment should be ensured between new e-merchants and old style catalogue houses that export goods from a remote location? These are some of the many questions to be considered in the course of time. The revenue authorities should not simply focus upon taxation of e-commerce per se. Rather, their analysis should extend more broadly to ensure a deeper understanding of the nature of e-business as it is today and as it will develop tomorrow28.
It is increasingly evident that enterprise of the old and new economics are managing to create an extended line of viable business platforms. Click and Mortar operation which offers products and services in both a physical and virtual context. Application service providers delivers application and software services over the Internet. Remote network management and IT services provide -helps co-operation maintain and monitor their owes networks. Aggregate provide back and services to merchants or banks on a regional basis.
All online credit card transactions within a region can be aggregate by one single payment processor who then handles the authentication, verification, fraud screening and authorisation request before clearing with a card issues such as visual meter card. Challenges Before Tax authorities The general perceived wisdom to which tax authorities universally appear to subscribe, is that their major challenges regarding e-commerce are : (i) Identifying the tax payer, especially when an Internet user is involved. (ii) Identifying audit risks and developing audit trials to ensure compliance.
(iii) Obtaining access to verifiable information and documents. (iv) Obtaining access to encrypted data (v) Developing a response to the advent of electronic money (e-cash) and ensuring efficient mechanism for collecting tax especially from non-resident tax payers. There is a need for initial inter-government and multi-jurisdictional co-operation and agreement to synchronize the taxation treatment. Taxation authorities need to modernise their operation radically. There is a need to monitor cross-border business activities on the Internet. Authorities need to upgrade their technological knowledge.
Tax authorities need better data mining techniques database management took and an audit policy indeed towards thoroughly examining the various models of e-business. Tax treatment need to match electronic reality. Privileges such an extended filing dates for tax returns could be granted to tax payers who conduct their dealings with the tax authorities electronically. Many tax authorities urgently need to co-ordinate better with other Government departments to obtain information on matters such as customs duty clearances. General legislations and domain registration requirements and investment attraction.
Tax policy makers need to strike a balance between providing incentives to promote the new e-business economy. Simplicity of rules and case of compliance are obvious legislative and administrative goals yet these must be balanced by regulatory controls preventing crime and tax fraud ensuring personal data protection. Judicial Approach to Taxation Issues The judiciary is caught in the middle of the tray, burdened with responsibility of interpreting the different types of software and bringing Order to their inherently conflicting treatment.
They lack guidance from precedent or legislature. Rather in US, the state and federal taxing entities have not relied on consent policies of relations in their approach to software taxation, each entity has construed and classified software in the manner most advantages to its own safe. This results in the incompatiable standards of tax treatment. Even in India, almost all states have their own taxing policies therefore, to reconcile them into a comprehensive legislation is a very difficult task. Courts generally relied upon two principles in classifying software as intangible.
They are : (i) Software as knowledge and (ii) Software encompasses an array of services. Knowledge of Principle It states that sale of software is the sale of knowledge and acknowledged intangible. Under this theory the tangible means, of transmitting this knowledge is merely incidental to the transaction . Therefore, the more separable the content is from the container the more transaction looks like a sale of intangible knowledge. The Transaction Test Courts have cited the following factors in support of the knowledge principle. (i)
The Tangible product is discardable , (ii) The disk is a mere conduct or container for the knowledge and (iii) Alternative methods of conveying the information exist. These factors comprise the “essence of the transaction” test. In different cases, Court applied this principle to address the issue of software intangibility. District of Columbia v. Universal computer Assocs29 was one of the first case. The Court relied upon the knowledge principle to conclude that two programs at issue in the case-one custom and other canned-constituted intangible knowledge not subject to tax. This decision was followed in Commerce Union Bank v.
Tidwell. 30 In this case, Court held that tangible magnetic tapes were only conduits for transmitting the intellectual creations. The case of First National Bank of Fort worth v. Bullock31 followed in the wake of universal and Tidwell and focused upon seperability of information from its container in the essence of the transaction test. The Court concluded that the primary object of the transaction test. The Court concluded that the primary object of the transaction, the sale of particular process coded on the software was intangible, therefore the sale was not subject to sales tax.
Personal Services Principle Characterising software as a personal service is another commonly used justification for not applying sales/use tax to software. As sales tax apply only to the sale of tangible properly personal services traditionally have been exempt from sales taxation. Thus, if a software sale can be classified as a sale of services32 then transaction will not be subject to sales taxation. The proponents of this view arranges that the consumer of software actually buys the programmer’s service knowledge and labour in solving a particular problem.
It is a narrower justification for intangible. Indian Judicial Approach In Tata Consultancy services v. State of Andrapradesh33, there arose a question whether branded software which is an intangible intellectual property being a product of thought creativity and intellect be classified as “goods” for the purpose of Andra Pradesh General Sales Tax Act. They held that when a person goes to buy a CD containing the software he does not pay for the mere CD but for the software contained in the CD.
The contention that software is merely “knowledge or intelligence” and such is not corporeal and thus, not taxable is erroneous. Once the information or knowledge is transformed into physical existence and recorded in physical form, it is no longer in intangible form but a corporeal property and hence taxable. Legislative Approach The Government of India had set up a committee to go into the various questions regarding taxation of e-commerce. The Kanwarjit Singh committee , submitted its report to the Central Board of Direct Taxes and it has made certain recommendations on e-commerce and taxation .
Government is making effort to create a balance between economic growth and generation of revenue in the InfoTech global environment. The issues raised by e-commerce taxation are complex and the subject is controversial in nature because it has created serious conflict of interest between developed and developing nations. Unique features of interest also add to the existing confusion. Income Tax Act, 1961 and Finance Act, 2003 etc. are silent about e-commerce taxation. The only existing agreements in this area are OECD Model Treaty and United Nations Model Treaty.
Thus, India has got no legislation to deal with e-commerce taxation. Tax Evasion and the Internet Some of the Conventional tax evasion measures undertaken by companies are • Shifting of profits to low tax Countries by transfer pricing. Thin capitalisation • Allocation of costs operation artificially either against domestic profits or foreign profits depending on where the rates of tax are less favourable . • Setting up conduit or intermediary companies outside the home country to process and channelise income from different foreign source. • Establishing base companies in tax havens or legal domicle.
The problem of the Internet is that all of these become much easier with location being quite irrelevant in the borderless world. Need for Consensus In this context, considering the unique characteristics of the medium , consensus is necessary at an international level if countries are to ensure the effective application of taxes, direct and indirect, to e-commerce that : • Protects tax revenue generally ; • Does not increase the opportunity for avoidance evasion or fraud ; • Minimise the cost of compliance for business ; • Does not hinder the development of electronic trade. This is the challenge for the future.
Conclusion The structure of software industry involves transnational transactions, which attract transactions provisions of more than one country thereby, leading to double taxation of companies involved in such transactions . The Government World over tries to avoid such double taxation by entering in to DTAAS. However, there is still a need on the part of all countries to come together and form an internationally accepted uniform model for tax reforms. In order to bring Indian tax system in line with the International Tax System some big changes are required. India has already seen transformation in its tax structure.
There is a lot more to be done to make sure that Indian IT industry is not hindered by tax related issues. On a larger perspective, the base of tax system should be broadened . It should also be simple within the administrative capacity of the Government. The Government tries to enhance its revenue while tax payers oppose any increase in tax rates. Therefore, there has to be a line of demarcation which the Government will have to follow because exclusive taxes do not reflect positive indications for the growth of any economy and may act as deterent for the people entering the Indian market.