Internet-Based Sales to the United States

General Approach to Taxation of E-Commerce
The general approach taken by the U.S. government, and the governments of countries that are members of the OECD, is to tax Internet-based transactions under existing rules. For many Internet-based transactions this approach works well. For instance, where a sale to the U.S. results in the physical delivery of goods, conventional and Internet-based transactions are taxed in the same way.

If the company is a resident of a country with which the United States has a tax treaty (this includes all of the major trading partners of the United States), the company must have a "permanent establishment" in the United States before it is subject to U.S. tax. This usually means the company must have a place of business in the United States, or must have agents in the United States.

Foreign companies are also taxable in the United States on "non-business" income, whether or not there is a permanent establishment. For instance, foreign companies earning royalties in the United States are subject to tax in the United States regardless of whether there is a permanent establishment in the United States.

Effect of Remote Operation of a Web Site An Internet-based business can usually be operated from anywhere in the world without affecting its activities. Business transactions take place on a server, which may be located in the country of the seller, the buyer, or in some other country. Sales may take place on several different servers located in different countries. The effect of server location is unknown under existing U.S. tax law.

Example ForeignWebCo is a foreign corporation that sells software through its Web site. The site is run from a Web server based in California. The company has no agents in the United States, and has no other physical presence in the United States. However, the company makes substantial sales to U.S. customers. Is the company taxable in the United States on sales to U.S. customers?

The issue is the effect of a Web server in the United States. While the weight of opinion seems to be that server location is not relevant, there is still great uncertainty. In this article we focus on companies from treaty countries, so the issue we are concerned with is whether the Web server is a permanent establishment in the United States.

Permanent Establishment
A permanent establishment is usually a fixed place of business. For instance, the term is defined in U.S. tax treaties to mean a fixed place of business in the United States through which the business of an enterprise is carried on. Does a Web server meet the definition of a permanent establishment? No one knows. While there are good arguments that say a Web server does not, until we have certain rules we advise the following:

Example
Same as above, except that ForeignWebCo uses a "turnkey" merchant system in the U.S. The system provides complete transaction processing on a U.S.-based Web server. For a single monthly fee, the host provides credit card processing, transaction record keeping, Web site programming (but not content and design), software installation, and other services. Web site design, creation of content, and changes to the Web pages are handled by company personnel. Do the services performed by the U.S. hosting service create an agency relationship, which causes the foreign company to be taxable in the U.S.?

Agency Relationships
A foreign company can be found to have a permanent establishment in the United States if it employs agents in the United States. This can result if the company employs a "dependent agent" in the United States, but will not result from the activities of an "independent agent." Generally, an "independent agent" is one that operates in an independent status. Some of the most important characteristics of an independent agent are that the agent has many clients, and that the agent does not have the authority to act on behalf of the foreign company.

A U.S.-based Web hosting company's activities may include Web hosting, transaction processing, and record keeping. The company may also be engaged in marketing and promotion of a Web site. At what point does the U.S. company go from being an independent to a dependent agent?

The hosting of a Web site, by itself, probably does not create an agency relationship that results in a U.S. trade or business for a foreign corporation. ISPs and hosting services, by themselves, are mechanical services that do not give one the sense of an agency relationship. Even if an agency relationship exists, the ISP or host would surely be an independent agent. However, the determination of agency relationships is based on facts and circumstances, and the IRS has discretion in applying the regulations that define dependent and independent agents.

Where U.S.-based e-commerce support services are involved, the issue of agency is much more difficult to resolve. These types of services are not mechanical, and there is more direct involvement between the U.S. and foreign company. If a foreign corporation employs a U.S.-based company to provide hosting services for a U.S.-based Web server, in addition to performing marketing and support functions, the possibility of an agency relationship is more likely.

A key question is whether a U.S. agent of a foreign company exercises the authority to conclude contracts on behalf of the foreign company. If it does, the agent will surely cause the foreign company to be taxable in the United States. If the foreign company must use service providers in the United States, their activities and authority must be severely limited to avoid an agency relationship that creates a permanent establishment.

Uncertain Character of Digital Products
A foreign company that sells digital products faces the problem that, for tax purposes, it is uncertain what is being sold. This uncertainty has a direct effect on taxation because the character of what is being sold affects how it is taxed. Digital products include any products that are sold and delivered electronically. The most commonly sold digital product is software downloaded from the Internet. However, in the future, recorded music and videos will be sold and delivered electronically in vast quantities.

The sale of a digital product can be a sale of inventory-type property, taxable in the United States only if there is a permanent establishment in the United States (assuming the seller is in a treaty country). Alternatively, the digital product may result in royalty income in the United States, subjecting the foreign company to U.S. tax regardless of whether there is a permanent establishment. The digital product may also result in some form of services income. Services income is ordinarily taxed where the services are performed, which, in this case, is likely to be the foreign company's own country.

How does one tell what type of income the digital product generates? If the digital product is software, the United States has fairly well-developed regulations. These regulations will need to be consulted to determine the type of income. The general view of the regulations is that the form of delivery of a product does not determine its character. Accordingly, where the software is downloaded from an Internet Web site, the analysis of taxability in the United States will be the same as if the software was delivered in a box.

If the digital product is anything other than software, there are no rules. When the IRS issued the regulations related to software it specifically said that no other digital products are covered by the rules. What can a company do? The best advice is to look to the software rules for guidance, since it is likely future rules related to other digital products will closely follow these rules.

Anonymous Transactions
Where products are sold and delivered electronically, there is no commercial need to know the identity or location of the buyer. However, in most cases, tax compliance requires some minimum amount of information. In cross-border transactions, a foreign vendor that is taxable in the United States must know the extent of its sales to U.S. customers to properly determine its U.S. tax.

Even where the information is not necessary to complete a transaction, we recommend that sellers obtain information regarding the identities and locations of buyers that is sufficient for tax compliance.

Conclusions
The ability to operate and sell from a remote Web site, the uncertain character of digital products, and anonymous buyers and sellers make Web-based sales to U.S. customers difficult. This article only introduces some of the issues foreign sellers must deal with. For a complete treatment of these issues look for the upcoming book, Electronic Commerce: Taxation and Planning.