Electronic Commerce Taxation and United States Bi-Lateral Treaties

Taxation of electronic commerce from offshore has two main aspects, the United States tax regime from an international perspective and the effect of bi-lateral treaties upon that regime.  A previous writing addressed the first consideration, the general dynamics of the United States tax regime for entry taxation of a non-resident alien or foreign corporation. (1)  The United States is engaged in more than fifty bi-lateral income tax treaties with other sovereigns.  In a general statement, those treaties are designed to mitigate the effects of double taxation.

Income that is generated by a foreign party from activity in the United States can be taxed from the source country, the United States in that case, and the residence foreign country, creating risks of multiple taxation.  Treaties are designed to alleviate that conflict.  The appropriate place of beginning in exploring bi-lateral treaty application is to establish the United States taxation and then over-lay the treaty ramifications.  Electronic commerce integrated with the United States taxing regime poses different challenges.  The concept of a trade or business used in the taxing regime is in some ways interchangeable with the treaty terminology of permanent establishment.

United States Taxation Treatment and Treaties.

To allow for a natural flow of treaty principles, it is necessary to digress to previous United States taxing concepts.  Basic rules governing normal business commerce that flows from a foreign person focuses upon whether it is sourced from the United States and contemplates the principles of conducting a trade or business within the United States.  Foreign persons are taxed upon United States sourced income in the event that a trade or business is carried on in the United States. (2)

Income of foreign persons that is effectively connected with the conduct of a trade or business is subject to United States graduated tax rates. (3)  As a general proposition, the only income that is to be treated as effectively connected with a United States trade or business is United States sourced income. (4)  If the income is determined to be in contrast as fixed or determinable annual or periodic gross income that is not effectively connected with a United States trade or business, it is taxed at a flat rate of thirty percent.  (5).

The effectively connected concept of income is based upon whether the foreign person is engaged in a trade or business in the United States.  (6)  Foreign sourced income is only effectively connected with a United States trade or business if deemed attributable to an office or fixed place of business in the United States as a general rule.  Where the requisite factors that an office or fixed place of business in the United States is established, the question then is of the sourcing of income link. (7)

The significance of the basic United States taxation of the foreign person or entity is to apply a treaty application of the residence country enterprise that is deriving income from the source country.  The perimeters of establishing this tax treatment is prefaced upon income that is effectively connect to the conducting of a trade or business in the United States. (8)  Where there is an applicable treaty between the sourced and residence taxpayer, the foreign person is taxable, not upon the fleeting concepts of a trade or business presence, rather the concept set down in the United States Model Tax Treaty, where there is determined to be a permanent establishment.  That term for treaty purposes defines when a nonresident has sufficient presence in a jurisdiction to validate a taxation of the business profits in the source country. (9)

The condition to a validly defined permanent establishment as opposed to conducting a trade or business is a certain fixed place of business through which business of an enterprise is wholly or partially carried on. (10).  The permanent establishment of the United States income tax treaties is very much a jurisdictional approach.  Generally, a foreign person will be deemed to have sufficient nexus to be subject to United States taxation as to business activities.  The treaty perimeters generally state that in absence of physical presence, a foreign person can be deemed to satisfy the elements of permanent establishment of the United States if activities of its agents in the United States satisfy a threshold that can be ascribed to a foreign association acting on their behalf.

The concept of an absence of physical presence still being sufficient derives from language in the bi-lateral model treaty.  Though a fixed place of business shall not exist, if a person is acting on behalf of an enterprise and has the authority to conclude contracts as binding authority, that foreign enterprise shall be deemed to have a permanent establishment in that state in respect of any activities which is undertaken for the enterprise. (11)  A foreign enterprise would not be deemed to have a permanent establishment in a contracting state because it has carried on business in that state through a broker, general commission agent or any other agent of an independent status along as they are acting in the ordinary course of their business as independent agents. (12)

The purpose of the exact term of permanent establishment is important because it defines at what point a foreign person establishes requisite presence in a jurisdiction to subject it to taxation.  If a taxpayer’s presence is not established to the degree where it is to be termed a permanent establishment, the sourced-based taxation falls in favor of residence-based taxation.  Where tax planning is implemented and a bi-lateral treaty controls, an otherwise taxable foreign person by virtue of the United States tax regime is sheltered by the treaty; a treaty party relinquishes jurisdiction to tax.

Electronic Commerce and Permanent Establishment.

In the United States taxation regime a foreign person contemplating the effects of being deemed as doing business in the United States, and therefore taxable upon income effectively connected, designs its business model often availing itself of a bi-lateral treaty.  This prompts a two-prong business analysis.  First as seen in Piedras Negras Broadcasting Co. v. Comr. (13)  It is often cited for the general proposition of what the parameters are in distinguishing whether there is a United States presence with respect to a foreign person that conducts business into the United States.  This of course was for the purpose the actively conducting a trade or business as opposed to determining permanent establishment, but the concepts are very similar.

There it was determined that income being collected from the United States was not defining as to the source of income inquiry.  But the factual pattern provided a useful analogy to Electronic Commerce.  In that instance it was radio frequency for the purpose of advertising from Mexico into the United States.  For purpose of Electronic Commerce analysis, noted commentary have set those facts against the hypothetical of a Web server and its location rather than a broadcasting facility.

There it is suggested that the location of a Web server in the United States along with collective functions accomplished through the server could result in a sufficient United States presence to constitute a trade or business.   That is if a sale was conducted through an online United States based Web server, the activity might constitute a United States trade or business.  On the other hand the distinction might be made that if the activities are limited to displaying goods for sale, that limited activity may not constitute a United States trade or business. (14)

The issues that are projected regarding whether a Web server could be a permanent establishment has been touched upon by an OECD Committee on Fiscal Affairs. (15)  Therein the consensus was that a Web site would not be a permanent establishment because it does not have a location that can constitute a place of business.  Additionally the OECD Committee concluded that though a Web server might be a permanent establishment, which determination could only be made upon what was deemed the facts and circumstances test.  It elaborated on this clarification by confirming that a Web site that is hosted by an Internet provider is the server that actually hosts the Web site and is not the physical location of an enterprise that maintains the Web site.

On the other hand, if the server is at the disposal of the foreign vendor and the vendee manages the server, that could be construed as a permanent establishment for treaty purposes if its presence is fixed at a location for what it termed a sufficient period of time. (16)  The Committee determined that if the activities performed by the server were preparatory activities such as advertising, as opposed to core activities, that would not constitute a permanent establishment. (17)

It further enunciated that it was not material whether personnel were required at the server, provided however, the presence of personnel might be material in a determination of what portion of sale proceeds, profits could be attributable to a Web server that constituted a permanent establishment. (18)  The United Kingdom, at least with respect to clarification regarding the Model Tax Convention as reviewed by the OECD Committee on Fiscal Affairs, has taken an official position that servers do not alone or with Web sites constitute permanent establishments of Electronic Commerce. (19)

In a summary and basic traditional tests approach, the factors of geographic location of capital and labor that produce the income continues to have sound fundamentals.   Those basic principles normally conclude that a taxpayer does not have a permanent establishment in a particular jurisdiction for treaty purposes without substantial physical presence.  Jurisdiction to tax does not come by virtue of the presence of customers in a particular jurisdiction.  Just as in Piedras Negras Broadcasting Co. v. Comr. (20) it was concluded that customer contact by telecommunications did not necessarily give rise to a taxable nexus; like wise there is not a foundational reason for the use of the Internet to alter this premise.  Access to a Web site from a particular jurisdiction does not formulate the fundamental to create a permanent establishment for a business that owns and maintains the site unless it was deemed fixed and business carried on through the fixed location.  That view from the OECD commentary stated that servers were not equipment of the type that facilitated the carrying on of business.  The emphasis was directed to the location and activities of the employees and other dependent agents of a business as opposed to its communications equipment. (21)

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Footnotes

1.  See TaxConnections, United States Taxation of Foreign Electronic Commerce. July 29, 2014, William Richards.

2.  Id. at 1.  See subheading, Linkage of Trade or Business and Effectively Connected.

3.  IRC Sections 871(b) and 882 (1986).

4.  IRC Section 864(c)(4) (1986).

5.  IRC Sections 871(a) and 881 (1986).

6.  Supra at note 1, subheading, Electronic Commerce and Trade or Business.

7.  IRC Section 864(c)(4)(B)(iii) (1986).  The general rule is that income, gain, or loss from sources without the United States is to be treated as effectively connected with the conduct of a trade or business within the United States by a nonresident alien individual or a foreign corporation if such person has an office or other fixed place of business within the United States to which such income, gain, or loss is attributable and the gain or loss … is derived from the sale or exchange (outside the United States) through such office or other fixed place of business of personal property described in Section 1221(a)(1).

8.  Supra at note 2, see subheading, Linkage of Trade or Business and Effectively Connected.

9.  U.S. Model Income Tax Convention (November 15, 2006), Art. 7.

10.  U.S. Model Income Tax Convention (November 15, 2006), Art. 5.

11.  U.S. Model Income Tax Convention (November 15, 2006), Sections 5 and 6 of Art. 5.

12.  U.S. Model Income Tax Convention (November 15, 2006), Section 6 of Art. 5.  For the purposes of this Tax Convention, the term permanent establishment means a fixed place of business through which business of an enterprise is wholly or partly carried on.  Section 1, Art. 5.  The term  permanent establishment includes especially, a) place of management; b) a branch; c) an office; d) a factory; e) a workshop; and f) a mine, an oil or gas well, a quarry, or any other place place of extraction of natural resources. Section 2, Art. 5.

13.  43 B.T.A 297 (1941), aff’d, 127 F2d 260 (Cir. 1942).

14.  Llewellyn, U. S. Tax Regime for Taxing Foreign Persons Conducting E-tail Operations with U.S. Customers, Tax Management International Journal, Vol. 30, No. 7, July 13, 2001.

15.See Working Party No. 1 on Tax Conventions and Related Questions, Changes to the Commentary of Article 5 (Dec. 23, 2000).

16.  Supra at note 14.

17.  Supra at note 14.  The Working Party 1 of the OECD addressed the type of functions related to sale and determined that preparatory activities or auxiliary activities; conclusion of a contract with the customer, the processing of payment, and delivery of the product.  See par. 42.6, page 5 of note 15, supra.

18.  Supra at note 15.

19.  Supra at note 15.

20.  Supra at note 13.

21.  Note that in previous treaty Commentary to  Art. 5 of the OECD Model Treaty, it stated that there are circumstances where machinery and equipment could constitute a place of business, stating specifically that: a permanent establishment may exist if the business of the enterprise was carried on mainly through automatic equipment, with the activities of the personnel being restricted to setting up, operating, controlling and maintaining the equipment.

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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