Taxation of income generated by cross-border digital transactions
by Andrea Moriggi
Summary: Introduction: The e-commerce market. – 1. Legal framework. – 2 The OECD Model. – 3. Types of transactions: business profits or royalties? – 4. Problems related to the Taxation of Digital Transactions – 5. Conclusion
Introduction: The e-commerce market
“It is difficult to apply the existing rules to the digital transactions since the digital economy blurred the traditional distinction between the form of delivery and the substance of what is delivered”
(Jinyan Li[1])
In 2017 the e-commerce market accounted for the 10.2% of the worldwide total retail sales[2]. In 2021, almost two goods out of ten will be sold online, resulting in a volume of 4.8 trillion dollars of financial transactions. The world of online commerce goes by definition beyond national borders and brings complex tax implications to the table, mostly related to the need to deal with different jurisdictions. The way the e-commerce market is developing around the world, however is far to be uniform. If in Asian countries online shopping accounts for more than 12% of the total retail sales, in Middle East and Africa just one purchase out of 100 is done on e-commerce platforms[3]. This is one of the reason why countries have developed different sensibilities for tax-issues online, and many of them do not have a dedicated tax regime for e-commerce platforms. In Europe, for instance, the EU Commission has recently made two proposals related to the so-called “Web Tax”. The first initiative aims to reform corporate tax rules so that profits are registered and taxed where businesses have significant interaction with users through digital channels. The second proposal calls for an interim tax which covers the main digital activities that currently escape tax altogether in the EU[4]. The e-commerce is therefore challenging the current international tax regime and in this context «political leaders, media outlets, and civil society around the world have expressed growing concern about tax planning by multinational enterprises that makes use of gaps in the interaction of different tax systems to artificially reduce taxable income or shift profits to low-tax jurisdictions»[5]. In this paper I address the most debated taxation issues related to cross-border digital transactions and I will try to explain how regulations are facing them.
1. Legal Framework
The two principal sources of international tax rules are treaty law and domestic law[6]. While domestic tax law generally provides rules for determining who’s liable to tax in a particular jurisdiction, treaty law goes in the direction of mitigating the risks of double taxation and under-taxation, imposing limits on the taxation power of the treaty partners[7]. The OECD Model is used as a guideline by states when negotiating the terms of a treaty[8] and will be further analyzed in the following paragraph.
Before introducing the Model, however, is important to mention the two criteria that states are using to determine whether an income should be subject to taxation in their jurisdiction or not. These criteria are (i) residence and (ii) source.
Under the residence criteria, countries exercise residence-based jurisdiction over individuals (determined by reference on citizenship, domicile, presence in the country or maintenance of an abode in the country) and companies (determined by reference on place of incorporation, location of corporate headquarters, commercial domicile, or place of effective management), as a basis to tax their worldwide income.
Source jurisdiction, on the other hand, is asserted with respect to items of income connected with the territory of the state concerned. Tax treaties use the concept of “permanent establishment” to determine the source of business income that article 5 of the OECD Model Tax Convention, defines as the «fixed place of business through which the business of an enterprise is wholly or partly carried on»
2. The OECD Model
The OECD Model is the most relevant guideline on which treaty and domestic tax rules are based. The Model also applies in the context of e-commerce and digital transactions[9]. In 1999 the OECD set up a Technical Advisory Group (TAG) with the aim of examining the characterization of various types of digital payments under tax treaties. In 2000, the TAG released a final report finally adopted by the OECD Council in 2002, where it identified a number of typical digital transactions and the various treaty characterization that could arise from them[10]. The TAG assumed that for tax treaty purposes, cross-border digital transactions may be classified either as (i) business profits or (ii) royalties.
- Business profits: Business profits are not clearly defined by article 7, but the latter describes when business profits shall be taxable in the residence or source State.
«The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. … Where profits include items of income which are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article».
Article 7 allocates the right to tax the profits of an enterprise of a contracting state (residence State) only in that State unless the enterprise carries on business in the other contracting state (source State) through a permanent establishment situated therein[11].
- Royalties: according to article 12, royalties are
«payments of any kind received as a consideration for the use of or the right to use any copyright or literary, artistic, or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience».
The above provision grants the exclusive taxing authority only to residence State. However, if the royalties are attributable to a permanent establishment in the State in which the royalties arise, Article 7 will apply.
When a customer downloads a digital product and saves a copy of such work on his hard disk, that activity is incidental part of the essential nature of the transaction. According to the TAG report, since the definition of royalties applies to “payments for” any of the various items listed in that definition, the main question to be addressed in any given transaction is the identification of the consideration for the payment.
Where the essential consideration is for something other than the use of, or right to use, rights in the copyright (such as to acquire other types of contractual rights, data or services), and the use of copyright is limited to such rights as are required to enable downloading, storage and operation on the customer’s computer, network or other storage, performance or display device, such use of copyright should be disregarded in the analysis of the character of the payment for treaty purposes. This would be the case, for instance, where a payment is made by a person for the downloading and the operation of a copy of a computer program. Whilst electronic downloading of the program may or may not constitute the use of a copyright by the user (as opposed to by the provider) depending on the relevant copyright law and contractual arrangements, the essential consideration for the payment is not that possible use of a copyright. In the case of transactions that permit the customer to electronically download digital products (such as software, images, sounds or text), the payment is made to acquire data transmitted in the form of a digital signal for the own use or enjoyment of the acquirer. This constitutes the essential consideration for the payment. To the extent that the act of copying the digital signal onto the customer’s hard disk or other non-temporary media (including transfers to other storage, performance or display devices) constitutes the use of a copyright by the customer under the relevant law and contractual arrangements, this is merely an incidental part of the process of capturing and storing the digital signal. This incidental part is not important for classification purposes because it does not correspond to the essential consideration for the payment (i.e., to acquire data transmitted in the form of a digital signal), which is the determining factor for the purposes of the treaty definition of royalties[12].
Another important characterization issues related to royalties is related to the payments for the provision of know-how, and it is applied very similarly to the previous one.
- Mixed payments: what happens when the transaction involves a hybrid of tangible and intangible goods, copyright, services and know-how? The general principle set up by the TAG provides that “if … one part of what is being provided constitutes by far the principal purpose of the contract and the other parts stipulated therein are only of an ancillary and largely unimportant character, then the treatment applicable to the principal part should generally be applied to the whole amount of the consideration”. The reason why they are not separated is because the transaction is regarded as a single transaction, and an obligation to break down the payments would impose an unreasonable compliance burden on taxpayers, especially for consumer transactions that involve relatively small amounts of money[13].
3. Types of transactions: business profits or royalties?
Digital transactions are mostly considered business profits. Out of the 28 typical digital transactions developed by the TAG, only 4 fall (under certain conditions) within the current definition of royalties. An online transaction can refer either to a tangible or an intangible good or asset. According to the TAG classification, a transaction is related to a tangible good when «the customer selects an item from an online catalogue … and orders the item electronically directly from a commercial provider. There is no separate charge to the customer for using the online catalogue. The product is physically delivered to the customer by a common carrier»[14].
Such transactions don’t give rise to any particular issue, since this income comes from the sale of tangible goods and both the domestic and treaty law apply. When a transaction is related to an intangible asset transaction, on the other hand, «the customer selects a … software or other digital products and orders the product electronically directly from a commercial provider … The digital product is downloaded onto the customer’s hard disk»[15]. The digital economy is characterized by an unparalleled reliance on the latter category of intangible assets, the massive use of data and a widespread adoption of multi-sided business models that capture value from externalities generated by free products.
In the following table it is provided the taxation treatment that the TAG finds more suitable for each category of typical digital transactions:
| Category number | Name | Business profit (art. 7) or royalty (art. 12) |
| 1 | Electronic order processing of tangible products | Business profit |
| 2 | Electronic ordering and downloading of digital products | Business profit |
| 3 | Electronic ordering and downloading of digital products for purposes of commercial exploitation of the copyright | Royalty |
| 4 | Updates and add-ons | Business profits |
| 5 | Limited duration software and other digital information licenses | Business profit |
| 6 | Single-use software or other digital product | Business profit |
| 7 | Application Hosting – Separate License | Business profit |
| 8 | Application Hosting – Bundled Contract | Business profit |
| 9 | Application Service Provider (“ASP”) | Business profit |
| 10 | ASP License Fees | Business profit |
| 11 | Web site hosting | Business profit |
| 12 | Software maintenance | Either business profit or royalty |
| 13 | Data warehousing | Business profit |
| 14 | Customer support over a computer network | Business profit |
| 15 | Data retrieval | Business profit |
| 16 | Delivery of exclusive or other high-value data | Business profit |
| 17 | Advertising | Business profit |
| 18 | Electronic access to professional advice (e.g. consultancy) | Business profit |
| 19 | Technical information (undivulged technical information concerning a product or process – know-how) | Royalty |
| 20 | Information delivery | Business profit |
| 21 | Access to an interactive web site | Royalty |
| 22 | Online shopping portals | Business profit |
| 23 | Online auctions | Business profit |
| 24 | Sales referral programs | Business profit |
| 25 | Content acquisition transactions | Either business profit or royalty[16] |
| 26 | Streamed (real time) web based broadcasting | Business profit |
| 27 | Carriage fees | Business profit |
| 28 | Subscription to a web site allowing the downloading of digital products | Business profit |
4. Problems related to Digital transactions
Although the TRIPS and national regulators provide a clear taxation framework, some problems related to the correct application of taxation principles and their enforcement remain unclear. One of these, for instance, is the difficulty encountered in determining the jurisdiction in which value creation occurs, especially in cases where the transaction is related to intangible goods.
Another question which remains unresolved is on whether the income arising from cross-border transactions should be allocated among or between the jurisdictions where the transaction occurs.
Criteria for deciding whether a transaction is taxable under article 7 or article 12 is just based on normal contractual arrangements. The distinction between different types of income, particularly at the margin between closely related categories (e.g., the sale of a digital good, the provision of services and the licensing of an intangible) can be artificial, and can result in “creative” business arrangements to take advantage of each difference. The Internet, in fact, does not easily fit into the existing general international tax framework and tax authorities are still unsure on how to tax income effectively[17].
5. Conclusion
Even the OECD acknowledged that the current income characterization is uncertain and ambiguous for most of the transactions of the digital economy. Non-digital world taxation criteria, in fact, have proven weak in preventing base erosion and profit shifting in the web economy business.
The same regulators and governments which are often reluctant to participate in tax information exchanges, should instead work together in creating an appropriate tax framework that deals with the changes brought by the digital economy.
[1] Jinyan Li, International Taxation in the Age of Electronic Commerce: A Comparative Study, Canadian Tax Foundation, p. 513
[2] E-Commerce Worldwide Dossier, Statista, 2018, available at: https://www.statista.com/topics/871/online-shopping/
[3] Ibid.
[4] European Commission Proposal for a Council Directive laying down rules relating to the corporate taxation of a significant digital presence, 2018/0072
[5] OECD, BEPS action 1: address the tax challenges of a digital economy, 2014
[6] A. Cockfield – W. Hellerstein – R. Millar – C. Waerzeggers, Taxing Global Digital Commerce, Wolters Kluwer, 2013
[7] Ibid.
[8] There are now over 2000 bilateral tax treaties primarily related to income tax, Ibid., p. 40
[9] L. Ohm, Issues Regarding the Characterization of Income Derived by Digital Enterprises, in I. Kershkner – M. Somare, Taxation in a Global Digital Economy, Linde, 2017
[10] Ibid.
[11] L. Ohm, Issues Regarding the Characterization of Income Derived by Digital Enterprises, supra note 9
[12] OECD, Model Tax Convention on Income and on Capital: Condensed Version 2014, Commentary to Article 12
[13] OECD, Tax Treaty Characterization Issues Arising from E-Commerce: Report to Working Party No. 1 of the OECD Committee of Fiscal Affairs, Annex 2, p. 16
[14] OECD, Tax Treaty Characterization Issues Arising from E-Commerce: Report to Working Party No. 1 of the OECD Committee of Fiscal Affairs, Annex 2, p. 20
[15] Ibid.
[16] If the site operator pays a content provider for the right to display copyrighted material, the payment would fall under the definition of royalties. Where the operator pays for the creation of new content and, as a result of the relevant contractual arrangements, becomes the owner of the copyright in the content so created, the payment constitutes a business profit.
[17] B. Schaefer, International Taxation of Electronic Commerce Income: A Proposal to Utilize Software Agents for Source-Based Taxation, Santa Clara High Technology Law Journal, 2000
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