Taxation – Cyberspace’s new conundrum

In October, the OECD Conference in Ottawa looked at how to tax electronic commerce. Governments were remarkably relaxed about prospects for their tax revenues. They thought that existing tax concepts will be perfectly adequate to cope with the brave new world of Internet trading, and that tax revenues will not just run away into the ether. I do not share their optimism.

I am more worried about the taxation of profits than the taxation of sales.

VAT is a robust sales tax, at least in theory. The reason is that VAT is a tax on the consumer, and most consumers will not move to another country simply in order to reduce their tax bills. So long as the sale can be tracked down to the consumer and VAT can be levied in this country, that country can get its money.

This is not quite as easy as it seems, as sales of products, like music or software, over the Internet do not lead to any packages passing through Customs; VAT cannot simply be collected at the point of import. But along with advances in Internet technology, we may expect advances in the monitoring of transactions. Customs & Excise should be able to track down what you have spent and collect the money straight off your credit card.

The problem with the taxation of profits is not a practical one, but a theoretical one. Even the basic conceptual framework is put under strain by the growth of electronic commerce. It is not that we cannot work out who has made what profit; the difficulty is in deciding which country should get to tax a given profit.

The traditional method has been to look for a permanent establishment.

Basically, this is a business establishment that is important enough to make contracts with customers. Merely advertising or warehousing goods for sale, does not count. Once there is a permanent establishment in a country, that country gets first bite at taxing its profits.

Selling on the Internet presents a big challenge to the concept of a permanent establishment. To buy something, a customer contacts a website and gives it their credit card details. The website is the nearest thing to a permanent establishment. But in which country is it? The only option seems to be to find the server computer that holds the website; the country with the computer gets to tax the profits.

What a tangled website we weave

But new difficulties spring up straightaway. What if the same website exists on several different computers, and it is entirely a matter of luck as to which computer a customer gets through to? What if the server is on a satellite and not in any country? What if pieces of the website are held on several different computers and they all work together to construct the complete site?

If there is a tax advantage to be had out of running websites in such complicated ways, we can be sure that people will do it.

In any case, since websites can easily be moved around the world from one computer to another, why should the location of the computer matter?

It no longer reflects any economic reality. The presence of an old-fashioned branch office in a country does mean something, as the office becomes part of the local economy. It makes sense for the country to tax the branch’s profits. But the Internet destroys the links between businesses and countries.

So what comes next? What are countries to do if they lose their claim to some of the profits they now tax? The rich ones could actually make a tidy living out of VAT, as they have consumers who spend lots of money.

But the poorer ones will need something else. The obvious temptation is to take a slice out of any money that leaves the country.

Developing countries will, therefore, be very tempted to increase their withholding taxes on royalties and interest as a way of getting extra money out of the businesses that do still physically exist within their borders. Such taxes might be justified when royalties and interest are abused as a way to siphon out profits. But a better reaction to that tactic is a decent transfer pricing regime.

I do not relish an increase in withholding taxes; they are economically ‘distortive’ and they put investors off. So, we urgently need to work out how to allocate profits made on the Internet to countries.

Richard Baron is deputy head of the Policy Unit at the Institute of Directors.

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