Public debate needed on e-commerce tax puzzle

By KATHRYN ROBERTS*

Instead of announcing a Government inquiry into the tax system, it is time the Inland Revenue Department stated its position on e-commerce tax issues.

A Government inquiry will not provide answers that are needed right now. Countries such as the US, UK, Australia and Canada are conducting detailed studies of the income and consumption tax issues associated with e-commerce.

At the same time, the OECD is issuing various discussion reports and draft position papers, although the level of agreement achieved to date by the OECD is less than unanimous and a concern.

While the Inland Revenue is participating in the discussions at OECD level, it is not making its views known. Of more concern is the uncertainty facing New Zealand taxpayers who embrace electronic commerce as they seek to understand the tax treatment of income derived from e-commerce transactions involving locally sourced income.

The terms of reference of the Government's tax inquiry are deliberately broad. The need to modify the tax system and tax rates in light of new technology and international competition is only one of the questions to be examined.

The Minister of Revenue has stated that the taxpayer inquiry is intended to be architectural and will examine how the tax structure meets current and future needs.

Stage one, to be completed by the end of July, will involve designing a set of principles to guide tax policy and the structure of the tax system.

Where within this framework will an analysis of the position on certain key tax issues arising from e-commerce fit? Probably not at all, and even if there is the will to include such analysis, the timing is not right.

The OECD technical advisory groups are scheduled to complete their reviews by the end of this year, but New Zealand's tax inquiry will not complete stage one of its programme until seven months later.

Discussion is needed now on the position to be taken by New Zealand on the OECD's draft as well as:

The treaty characterisation of computer software.

Income characterisation issues arising from e-commerce.

The application of the permanent establishment definition in the context of e-commerce.

If, from business and economic perspectives, acquiring a digital version of a product is no different than acquiring the same product in a print or physical medium (newspapers, CD-Roms), the income tax characterisation of the transaction should be the same.

To reflect this view of tax neutrality, the OECD has recommended changes to the discussion on software payments included in a commentary on the royalty article of the Model Convention.

Before the character of income arising from a software transaction can be determined, the nature and extent of rights transferred need to be considered. A distinction is made between transfers involving rights in the underlying copyright and transfers involving only those rights necessary to operate the program.

The commentary states that a payment would be viewed as a royalty only if the right to copy and distribute the copyrighted software to others is transferred. The significance of characterisation as a royalty is that where the payment is to a non-resident, New Zealand and many other countries impose a withholding tax. If, on the other hand, the income is business profits, and the payment is to a resident of a country with which New Zealand has a tax treaty, no liability for tax in New Zealand exists unless the non-resident has a permanent establishment here.

New Zealand's position on the characterisation of software transactions remains unclear. Draft guidelines released in late 1997 have not been issued in final form. The only published commentary from the IRD is contained in an article available from its website - guidelines to taxation and the internet.

A comprehensive statement of the IRD's position is well overdue. To illustrate the conundrum facing New Zealand e-businesses: a draft report was issued by the OECD earlier this year on the characterisation of income generated from new types of internet-based transactions.

The report puts forth majority and minority positions for those income types on which consensus could not be reached. For most of the 26 types of transactions listed, the majority view is that income earned from e-commerce transactions should be classified as business profits. Consensus could not be reached on the following types of activities:

Electronic downloading of digital products and information.

Application hosting and application service provision (ASP).

Information and database access.

Customer support.

The minority view is that income from such activities should be taxed as royalty income.

Delivery models like application hosting, which consists of an enterprise running the software and providing its customers with access and application service provision, are gaining popularity. The majority view is that income carried from these activities is business profits. There is a minority view that the income may be taxed as a royalty where an expanded definition of royalty is adopted in a tax treaty which encompasses payments for the use of industrial, commercial or scientific equipment or payments for services of a technical nature.

New Zealand customers of application host arrangements based outside the country face uncertainty as to their liability to deduct withholding tax payments in the absence of any statement of position from the Inland Revenue.

One of the more difficult issues in relation to e-commerce and international tax is the determination of what constitutes a permanent establishment. This is the threshold an organisation must cross if its business profits sourced from another tax treaty country are to be liable for tax in that other country.

The OECD has issued two draft reports defining permanent establishments in an e-commerce context. It is considered that a server may constitute a permanent establishment if it meets the requirement of being a fixed place of business.

However, commentators from the US and UK, in particular, seem to be reluctant to accept that a server is sufficient of itself to constitute a permanent establishment of the business conducting e-commerce through a server.

New Zealand's position is further complicated by several of its tax treaties that provide for "substantial equipment" to be located and used in another state. What constitutes substantial equipment is not defined. Its scope is uncertain as interpretations of "substantial" can make reference to either size or value.

A policy debate initiated by the Inland Revenue is needed outside the forum of the tax inquiry.

At this time, broad support does not exist for developing a new tax, or tax regime, for e-commerce. Ultimately, an international consensus on the authority of countries to take income from e-commerce will have to emerge.

As the work undertaken by the OECD progresses, the Inland Revenue should be examining the tax implications in the New Zealand context and releasing its findings now for public debate.

*Kathryn Roberts is a newly appointed taxation partner at PricewaterhouseCoopers.