Original at: ftp://ftp.fedworld.gov/pub/tel/internet.wp (266 kb; WordPerfect 6.1 format). Published November 22, 1996.
November 1996
This paper provides an introduction to certain federal income tax policy
and administration issues presented by developments in communications technology
and electronic commerce. This paper is a discussion document, designed to
elicit views on the issues presented as well as suggestions as to solutions
for new problems. This paper is neither intended, nor should be taken as
an expression of the legal or policy views of the United States Government,
including the Department of the Treasury and the Internal Revenue Service.
In addition, no inference is intended as to current law.
Unless otherwise indicated, all section references are to the Internal Revenue
Code of 1986, as amended (the "Code").
This paper has also been posted on the Treasury Department's home page on
the World Wide Web at
http://www.ustreas.gov.
Comments on any of the issues raised by this paper should be addressed to:
Joseph H. Guttentag, International Tax Counsel, Department of the Treasury,
1500 Pennsylvania Avenue, NW., Washington, D.C. 20220. Comments may also
be submitted to Treasury via Internet e-mail to TAXPOLICY@treas.sprint.com,
with the subject line "technology issues." All comments will be available
for public inspection and copying.
2. An Overview of the Global Information Infrastructure or "Information Superhighway"
3. The World Wide Web and Electronic Commerce
6. Tax Policy and Administration Issues: General Considerations
8. Tax Administration and Compliance
Issues
9. Conclusion
New information and communications technologies such as the Internet are
creating exciting opportunities for workers, consumers, and businesses.
Information, services, and money may now be instantaneously transferred anywhere
in the world. Firms are increasing their imports and exports of goods, services,
and information as the costs associated with participating in global markets
plummet, and they are forming closer relationships with suppliers and customers
around the world. New markets and market mechanisms are emerging. Consumers
can choose from a much broader range of goods and services, and "intelligent
agent" software will soon give consumers an unprecedented ability to hunt
for bargains.
These new technologies, particularly communications technologies including
the Internet, have effectively eliminated national borders on the information
highway. As a result, cross-border transactions may run the risk that countries
will claim inconsistent taxing jurisdictions, and that taxpayers will be
subject to quixotic taxation. If these technologies are to achieve their
maximum potential, rules that provide certainty and prevent double taxation
are required.
In order to ensure that these new technologies not be impeded, the development
of substantive tax policy and administration in this area should be guided
by the principle of neutrality. Neutrality rejects the imposition of new
or additional taxes on electronic transactions and instead simply requires
that the tax system treat similar income equally, regardless of whether it
is earned through electronic means or through existing channels of commerce.
A major substantive issue raised by these new technologies is identifying
the country or countries which have the jurisdiction to tax such income.
It is necessary to clarify how existing concepts apply to persons engaged
in electronic commerce. In addition, transactions in cyberspace will likely
accelerate the current trend to de-emphasize traditional concepts of source-based
taxation, increasing the importance of residence-based taxation.
Another major category of issues involve the classification of income arising
from transactions in digitized information, such as computer programs, books,
music, or images. The distinction between royalty, sale of goods, and services
income must be refined in light of the ease of transmitting and reproducing
digitized information.
In the area of tax administration and compliance, electronic commerce may
create new variations on old issues as well as new categories of issues.
The major compliance issue posed by electronic commerce is the extent to
which electronic money is analogous to cash and thus creates the potential
for anonymous and untraceable transactions. Another significant category
of issues involves identifying parties to communications and transactions
utilizing these new technologies and verifying records when transactions
are conducted electronically. However, developments in the science of encryption
and related technologies may lead to systems that verify the identity of
persons online and ensure the veracity of electronic documents.
Treasury invites comments on the issues raised by this paper as well as any
other issues relating to electronic commerce.
Comments should be addressed to Joseph H. Guttentag, International Tax Counsel,
Department of the Treasury, 1500 Pennsylvania Avenue, NW., Washington, D.C.
20220. Comments may also be submitted via Internet e-mail to
TAXPOLICY@treas.sprint.com, with the subject line "technology issues." All
comments will be available for public inspection and copying.
It is by now a well-worn cliche to say that we live in an era of rapid
technological and social change. Technologies and businesses that were unknown
a few years ago are now widespread. Most recently, the explosive growth of
telecommunications technology, sometimes referred to as the "Global Information
Infrastructure," or the "Information Superhighway" which includes the Internet,
has enabled people to communicate and exchange information on an unprecedented
scale. These technologies present tremendous opportunities to enrich all
of our lives in so many ways, many of which we are likely not to have envisioned.
As President Clinton has said, "The day is coming when every home will be
connected to it, and it will be just as normal a part of our life as a telephone
and a television. It's becoming our new town square, changing the way we
relate to one another, the way we send mail, the way we hear news, the way
we play."
These new technologies bring with them social changes and new ways of doing
business. Services are an ever-growing sector of the economy. Modern
telecommunications allow information, services, and money to be instantaneously
transferred anywhere in the world. Some have even speculated that the traditional
corporation could itself become obsolete in certain cases as "virtual
corporations" bring together varying groups of consultants and independent
contractors on a project-by-project basis.
These technological advances may put particular pressure on the principles
governing the taxation of transnational transactions. It is the very nature
of these developments that they tend to blur national borders and the source
and character of income. Consequently, significant issues often arise regarding
how the income arising from transnational transactions utilizing these
technologies should be treated under current rules. As a result, it is possible
that countries will claim inconsistent taxing jurisdiction, with the attendant
possibility that taxpayers will be subject to international double taxation.
If these technologies are to achieve their maximum potential, this must be
avoided. Our overall tax policy goal in this area should emulate policy in
other areas -- maintain neutrality, fairness and simplicity -- a policy which
serves to encourage all desirable economic activity new and old.
These technological developments dictate that the Internal Revenue Code and
generally accepted principles of international tax policy be
reexamined.(1) It is in all parties' interests
to study the potential issues now, seek public comment, and develop rules
that accommodate evolving technologies and ways of doing business.
This paper is meant to be a step in this process of reexamination. It is
neither a treatise on taxation of technology nor a blueprint for future changes.
Instead, the purpose of this paper is to stimulate public discussion by raising
issues that currently exist or seem likely to arise. This paper is intended
to encourage interested taxpayers, practitioners, academics, and others to
comment on the issues identified herein and other similar tax issues that
they believe require resolution.
The modernization process of which this paper is an early step will proceed
on many fronts. Some of the issues identified in this paper can be resolved
through the administrative process. It is possible that other issues can
be resolved only through amendments to the Internal Revenue Code. Treasury
will work with the Ways and Means Committee, the Finance Committee, and the
Joint Committee on Taxation to study the statutory changes that may be required.
Finally, it may also be necessary to reach an international consensus on
certain issues. Treasury will be involved with the work of groups such as
the Organization for Economic Cooperation and Development and with our treaty
partners, to establish international standards to deal with these emerging
issues.
Treasury intends that the goal of this process is to develop a framework
for analysis that will not impede electronic commerce. The solutions that
emerge should be sufficiently general and flexible in order to deal with
developments in technology and ways of doing business that are currently
unforseen. In most cases, this will require that existing principles be adapted
and reinterpreted in the context of developments in technology. In extreme
cases, it may be necessary to develop new concepts.
The nature of the Global Information Infrastructure obviously has ramifications
beyond taxation, including national security, copyright, privacy, security,
financial trading systems, and even economic measurement. These issues are
outside the scope of this paper, although the Office of Tax Policy and the
Internal Revenue Service intend to coordinate their work with other branches
of the Treasury Department and the United States government.
2.1. The Information
Superhighway.(2) The Information
Superhighway or Global Information Infrastructure is not a single computer
network or means of communication but instead refers to the convergence of
previously separate communications and computing systems into an interoperable,
global network of networks.(3) Eventually,
this superhighway may transmit a wide spectrum of information, films, programs,
and services into every business and household, incorporating voice telephony
and cable television. This trend is driven in part by the fact that the cost
of communications is falling quickly. The Information Superhighway permits
its users to send and receive information around the world, at relatively
low cost.
2.2. Convergence of technologies. The distinct communications
systems that will converge to form the Information Superhighway include telephone
systems, cable and satellite communications, and computer networks. This
convergence has been in part driven by two major technological changes. In
telecommunications, transmission has evolved from copper wire, which has
a relatively limited data transmission capacity to fiber optic cable, which
has virtually limitless capacity. This increased capacity makes it practical
to rapidly transmit large amounts of information such as videos or x-rays.
The second technological development is "digitization," the conversion of
text, sound, images, video and other content into a common digital format.
Any type of information, including cash equivalents, which can be digitized
can be transmitted electronically.
2.3. Communications revolution is more than the Internet.
Although the Internet, which is discussed below, is the best known aspect
of the communications revolution, the Internet is only an example of these
developments. Many companies now operate extensive internal corporate networks,
or "intranets," and certain transactions, such as in the financial services
sector, are likely to occur on private networks for security reasons. For
tax considerations, it is generally immaterial whether parties communicate
over the Internet or over a private, proprietary network, such as an online
service or over an intra corporate network. It is also necessary to keep
in mind that the communications revolution is the result of a number of
technological and economic developments, such as relatively inexpensive computers
and telecommunications services and the growth of the service
sector.(4) The growth of the service sector
plays an important role because developments in communications allow services
to be instantaneously transmitted around the world. As a result, services
frequently no longer need to be produced at the place where they are consumed.
As developments in communications facilitate international trade in services,
there may be increasing pressure on the international tax rules that apply
to such services.
2.4. The Internet. The most widely publicized part of the
information superhighway is the Internet. While originally a system connecting
governmental and academic institutions, the Internet has expanded beyond
its initial participants to a world-wide network with user estimates ranging
from 30-60 million, and growing rapidly. The Internet has been described
as
a world-wide network of networks with gateways linking organizations in North and South America, Europe, the Pacific Basin and other countries . . . The organizations are administratively independent from one another. There is no central, worldwide, technical control point. Yet, working together, these organizations have created what to a user seems to be a virtual network that spans the globe.(5)
The Internet has no central computer or organizational structure. "Far from
being a hub with spokes, the Internet is more like a spider's web, with many
ways of getting from point A to point
B."(6) What links the Internet together and
allows its many disparate parts to communicate is the "TCP/IP" protocol
(Transmission Control Protocol/Internet Protocol), which is simply a means
of specifying how data is broken up in "packets" and assigned addresses to
be transferred over the Internet. It allows computers to communicate regardless
of differences in hardware and software, or communications
technology.(7)
Instead of a central computer, the Internet uses hundreds of thousands of
computers called "routers." Routers are like postal substations; they make
decisions about how to route "packets" of data just like a postal substation
decides how to route envelopes containing mail. Each router does not need
a connection to every other one. Instead, packets of data are sent in the
right general direction, using the best route available at the time, until
they finally arrive at their destination. In fact, the individual packets
making up a single message may end up taking different routes, to be recombined
when they reach their destination.
The packets are transmitted over existing telephone networks. However, since
the Internet is not tied to any communications technology, Internet traffic
can also travel over cable TV systems, satellite links, or fiber optic cables.
3.1. Background
3.1.1. The World Wide Web. The World Wide Web ("WWW" or
"Web") is one of the fastest growing applications of the
Internet.(8) What distinguishes the Web from
other components of the Internet is that it is a multimedia, hypertext system.
Unlike other Internet services, the Web blends text, images, video and audio
instead of displaying simple text. Web documents are hypertext documents
that can contain links to other documents which can be accessed by "clicking"
on these links. In fact, the links could be to any other "WWW" document on
any Internet server anywhere in the world. Accessing the Web requires a browser
program. The browser reads information accessed from the Web and presents
it to the user in a standard format. Internet search tools allow users to
locate Web pages containing the desired information.
3.1.2. Web pages and Web sites. A company's or individual's
collected Web documents are usually referred to as a "Web site." A uniform
addressing system allows users around the world to access information on
any Web site.(9) The information is stored
in the form of Web documents and pages on central computers called servers.
The location of a server is irrelevant since it can be accessed by users
around the world.
3.1.3. Exponential growth of the Web. Some indication of
the speed at which the World Wide Web has developed is given by the fact
that it was invented in 1989.(10) Graphical
browser programs, which made the Web easy to use and thus accessible to a
wide audience, were only invented in
1993.(11) By 1996, it was estimated that
there were over 250,000 commercial Web sites and a substantial number of
major companies, and countless small ones, have invested on a presence on
the Web.(12)
3.1.4. Technical barriers. Two factors that will be critical
to the growth of electronic commerce are bandwidth and improved payment
mechanisms. Bandwidth refers to the speed at which data can be transferred
over the system. Currently, at the transfer speeds available to most consumers,
it would take about two days to transfer the entire contents of a music CD
across the Internet. With higher speed connections likely to occur in a few
years, transfer time is likely to be drastically reduced, to about 10-15
minutes. Payment is also of course a critical factor. There is an emerging
consensus that electronic money (explained in Chapter 5 below) will accelerate
the growth of electronic commerce. If payments can be made by a mouse click
on an "electronic wallet" instead of transmitting credit card numbers, commerce
is likely to grow.(13)
3.2. Electronic Commerce
3.2.1. Generally. "Electronic commerce is the ability to
perform transactions involving the exchange of goods or services between
two or more parties using electronic tools and
techniques."(14) The growth of electronic
commerce will be driven in part by the fact that two of the present economy's
important products are software and recorded entertainment (both films and
music) which are particularly well suited to being distributed through computer
networks.
3.2.2. Retailing and wholesaling. Web pages are now
supplementing paper catalogs for many mail order companies and wholesalers.
These Web pages are similar to pages from a paper catalog, displaying images
of the goods and product information. Links to the vendor's inventory control
system can make it possible to verify whether the requested goods are in
stock. For example, one such Web site is a bookseller that allows customers
to search a database of over one million books, searching by either subject
or name. It is open twenty-four hours a day and has customers in over 60
countries. This Web site does not merely allow customers to select and order
books but also recommends related titles and will automatically notify customers
when a desired book is published.
3.2.3. Computer software. Computer software, which is created
and used in digital form, can be sold and delivered electronically. Software
may be transferred directly from the seller's computer to the purchaser's
computer without the need to deliver a floppy disk or CD-ROM. One such electronic
software vendor allows customers to select software, which is transmitted
and downloaded in encrypted format. Customers then enter credit card information,
which is verified over a private network via a toll-free number. After
authorization, a key that unlocks the software is sent to the customer.
Alternatively, the cost of the software may be charged to a pre-existing
account.
3.2.4. Photographs. Photographs can be
purchased over the Internet, and customers can select varying rights to utilize
the photograph. For example, stock photo agencies maintain large selections
of photographs on a wide range of topics, which are licensed to publishers
and advertising agencies who need a photograph on a given subject. Some stock
photograph agencies have established Web sites which allow customers to purchase
and download digitized images.
The price is based on the customer's intended use of the
photograph.(15) For example, one such arrangement
involves five, successively more expensive categories, beginning with consumers
who intended to make only personal use of an image, such as a student
illustrating a term paper, and increasing to commercial customers who might
want to distribute an unlimited number of copies.
3.2.5. On-line information. Electronic research databases
are in widespread use. Services such as Lexis, Nexis, and Dialog have created
vast computerized databases of reference information, such as legal materials
or newspaper and magazine articles. Customers can access these databases
and locate the desired information, which can be either read on-screen or
printed. The distinction between on-line research services and books is now
being blurred. Many publications, primarily reference works, are now being
created and distributed in digital form, generally via CD-ROMs. In addition,
once information has been digitized, it can also be transferred electronically.
Some encyclopedias, for example, are now available either on CD-ROM or through
an on-line service.(16) With a sufficiently
fast modem connection, a user might be indifferent as to whether she were
accessing a CD-ROM on her desktop computer or a mainframe computer located
at a distance. However, the latter, which can be easily and regularly updated,
can make time-sensitive databases much more valuable than traditional "hard
copies" or even CD-ROMs. In the future, the distinction between information
stored on a desktop computer and information retrieved from a network will
become increasing blurred as desktop software adopts Web style interfaces
which will seamlessly integrate desktop and Web
functions.(17)
3.2.6. Services. Services will be a fast-growing area of
electronic commerce. For example, at least one accounting firm is currently
offering consulting services electronically. For a yearly fee, subscribers
can obtain a password to visit the firm's Web site, where they can search
a database of information and monitor relevant news. Subscribers can also
submit questions, which are then routed to appropriate advisers from the
firm's tax, accounting and management consulting divisions.
3.2.7. Health Care. Health care is also an area in which
services can be provided
electronically.(18) Fiber optic telephone
links can now transmit high quality medical images to distant specialists
in minutes. For example, at the Massachusetts General Hospital, "a team of
70 radiologists has X-rays wired from their own telemedicine center in Riyadh,
Saudi Arabia."(19)
3.2.8. Videoconferencing. Videoconferencing also creates
expanded opportunities for distant persons to collaborate. Currently,
videoconferencing is primarily used by large businesses because it requires
expensive, dedicated equipment,(20) but it
is becoming more widespread. For example, videoconferencing is being used
by rural residents to obtain access to urban
specialists.(21) It is also being used by
coaches to train athletes(22) and by employers
to interview job applicants.(23)
Videoconferencing is expected to become more widespread with the introduction
of inexpensive desktop video cameras that can be connected to a personal
computer, coupled with higher speed Internet
connections.(24)
3.2.9. Gambling. Although Internet gambling may be illegal
in the United States,(25) Internet casinos
have been established offshore. These Internet casinos operate through Web
sites which are virtual replicas of casinos offering electronic slot machines,
black jack, poker and roulette.(26) Customers
pay for their wagers either by credit card or by establishing an account
with a bank associated with the casino and winnings are credited to either
the credit card or bank account. In the future, gamblers will presumably
be able to place their bets using electronic money.
3.2.10. Stock trading. Some stockbrokerages and mutual fund
companies have Web sites which allow customers to trade securities
electronically, including stocks, bonds, mutual funds, options, futures,
and commodities.(27) Customers can access
information regarding stock prices and company research and after researching
the desired stock, an investor can enter an order on-line, specifying the
stock, the number of shares and the price. Orders placed at the market price
are routinely completed and confirmed in less than a minute. The trade is
confirmed electronically and sometimes by mail as well. At present, trades
are still settled conventionally, although electronic money could be used
in the future. In addition to trading in the secondary market, securities
are now being offered on-line.(28)
3.2.11. Global dealing. "Global dealing" refers to the capacity
of financial intermediaries, mainly banks and securities firms, to execute
customers' orders and to take proprietary positions in financial products
in markets around the world and around the clock. For security reasons, global
dealing is conducted over private networks, instead of the Internet, although
as discussed above, the means of communication is not relevant for tax purposes.
Global dealing is impossible without modern computer and communications
technology, which allow orders to be transmitted around the world and a firm's
trading position to be continually transferred to locations where markets
are open.
3.2.12. Offshore banking and incorporation. Some Web sites
now offer offshore incorporation and banking services with the capacity for
payment by credit card. Customers complete questionnaires on their computer,
specifying the company name, desired jurisdiction, number of shares, etc.
and this information is transmitted to a service company, which prepares
and files the necessary forms. Although individuals and companies have always
been able to create offshore corporations and open offshore bank accounts,
these developments make it easier and less expensive to do so.
4.1. Security requirements for an open system. Security
issues pose a particular problem for Internet commerce because the Internet
is an "open" and inherently non-secure public system designed to facilitate
information exchange.(29) Therefore, the
security that is required for practical Internet commerce requires that security
procedures be applied at the level of individual commercial transactions
instead of being applied to the network as a whole. This involves the encryption
of transmissions, which is the first line of defense against interception,
duplication, and alteration of a confidential message, whether the message
represents an electronic payment or a
text.(30) Developments of systems requiring
security on the Internet generally rely on "public key" encryption. In addition
to keeping the contents of a message secret, these encryption procedures
may also be used to create a "digital signature" which can enable the recipient
of the message to independently verify the identity of the sender.
4.2. Public key encryption. Public key encryption, which
is based on complex formulae involving certain mathematical properties of
large prime numbers, is intended to allow someone to send a secure communication
to a person with whom they have never met, or previously
communicated.(31) If they operate as intended,
public key encryption techniques may play an important role in tax administration
of electronic commerce transactions.
Public key cryptosystems, involve two related complementary strings of numbers called keys, a publicly revealed key and a secret key (also frequently called a private key). Each key unlocks the code that the other key makes. Knowing a person's public key does not help you deduce the corresponding secret key. The public key can be published and widely disseminated across a communications network.
Anyone can use a recipient's public key to encrypt a message to that person, and that recipient uses her own corresponding secret key to decrypt that message. No one but the recipient can decrypt it, because no one else has access to that secret key. Not even the person who encrypted the message can decrypt it.
Message authentication is also provided. The sender's own secret key can be used to encrypt a message, thereby creating a digital signature. Alternatively, the sender could use a separate key solely for the purpose of creating his digital signature. The recipient can check the validity of this digital signature by using the sender's public key to "decrypt" it. This proves that the sender was the true originator of the message, and that the message has not been subsequently altered by anyone else, because the sender alone possesses the secret key that made that signature. It is not practically possible to forge a digitally signed message and the sender cannot later disavow his signature.
These two processes can be combined to provide both privacy and authentication by first signing a message with the sender's secret key, then encrypting the signed message with the recipient's public key. The recipient reverses these steps by first decrypting the message with her own secret key, then checking the enclosed signature with the sender's public key. These steps are done automatically by the recipient's software.(32)
5.1. Introduction. At present, a large portion of the money
supply already exists in "digital" form, as bank account balances and other
book entries with financial institutions, and is transferred in digital form
through wire transfers. Physical tokens or paper instruments are no longer
utilized for large-dollar payments in financial or foreign exchange transactions
and roughly 90 percent of financial transactions, by value, are now conducted
electronically. Conventional consumer transactions are also occurring
electronically as the use of automatic teller machine cards in retail outlets
continues to grow.
Electronic money, which is the focus of this chapter, involves consumer use
of electronic payment systems that may partially displace cash, checks, and
credit cards, which constitute about 90 percent, by volume, of financial
transactions. These electronic payment systems have the potential to create
new forms of money in which value is represented in digital form. "Electronic
money" encompasses a wide range of products, which are all still under
development. However, electronic money systems share certain similar features
and an understanding of these general features is a necessary step in developing
means to integrate these new payment systems into our system of tax
administration and compliance.(33)
5.2. Electronic debit and electronic credit. An electronic
debit system is a payment system based on funds stored in a deposit account
with a financial institution and subject to electronic payment orders to
transfer funds from one account to another. An existing example of such a
system is the use of automatic teller machine cards used at point of sale
terminals. However, emerging electronic debit systems allow consumers to
use an electronic checkbook, which can be either a hardware device or a software
program, to generate unique check identifiers, maintain a check register,
and create a digital signature. The electronic checks are sent via e-mail
over the Internet from the payor to the payee, who uses a digital signature
for endorsement and forwards it for deposit. Thus, consumers and retailers
can gather, transmit, and deposit electronic checks into their accounts without
physically going to a bank. If the electronic check is drawn on a bank account,
it is cleared and settled through the banking system similar to a paper check.
Electronic credit systems use conventional credit card numbers to make payments
over the Internet. Consumers transmit their credit card details to merchants,
generally in encrypted form, who process transactions using the existing
credit card payment infrastructure. In some cases third parties are used
to approve and execute payments in order to eliminate the need to send a
credit card number over the Internet.
Electronic debit and electronic credit systems should not raise any fundamental
tax policy or administration issues because they essentially represent new
ways of executing traditional bank or credit card transactions. Since an
independent third party maintains records of the identity of the parties
to a transaction and the amounts involved, these transactions are fully
auditable. Moreover, unlike the electronic money systems described below,
they do not involve new payment systems.
5.3. Electronic money. Electronic money involves tokens
of value expressed in digital form, in the same sense that a casino chip
is a token of value expressed in physical form. In contrast, the electric
debit and credit card systems described above are the functional equivalent
of conventional check and credit card transactions and do not involve the
creation of new tokens of value. The digital form of electronic money allows
it to be processed inexpensively and instantaneously transferred around the
world. All electronic money systems function as payment systems or payment
system components and all depend upon application of high-speed communication
and information analysis.(34) Although no
commonly accepted general definition of electronic money exists, some
generalizations can be made.
The loading of funds involves the exchange of cash or deposits for digital
value backed by an issuer. This could occur, for example, at an ATM, where
a consumer loads a smart card with electronic cash and has a bank account
debited for the same amount, or over the Internet by downloading electronic
money onto a PC hard drive.
5.4. Distinctions between electronic money systems. Electronic
money systems differ in a number of basic ways. The primary differences include:
These distinctions are discussed in more detail below. They are important
because the way in which any particular electronic money system implements
these distinctions will be the primary factors in determining how the system
should fit into our system of tax administration and compliance and the concerns
that the system poses for our system of tax administration and compliance.
5.5. Identity of the issuer. One distinction among electronic
money systems is the identity of the issuer or sponsor. At present, electronic
money can be issued by either a bank, a nonbank financial services company,
or a non-financial company.
5.6. Whether transactions are fully accounted for by the
issuer. The second distinction is whether electronic money transactions
are fully accounted for by the issuer. There are both accounted and unaccounted
systems. In an accounted system, the e-money issuer maintains a complete
or partial audit trail of transactions, and can identify the person to whom
the electronic money is issued as well as the people and businesses receiving
the electronic money as it flows through the economy. In an unaccounted system,
the e-money is issued and passes through the economy without a transaction
trail. Unaccounted e-money may operate much like paper currency, moving through
the economy anonymously.
There are advantages and disadvantages to both accounted and unaccounted
electronic systems and they are likely to operate in tandem. Unaccounted
systems may pose risks to the issuer because there are no records to rectify
any problems that might arise. However, consumers may not feel comfortable
using accounted electronic money for some transactions which they can currently
conduct anonymously with cash. In addition an accounted system may impose
costs on merchants and e-money issuers that would be passed on to consumers.
These costs may be excessive relative to the benefits that consumers receive
if electronic money is used for only small value transactions. In contrast,
consumers may prefer accounted systems when they wish to have an independent
record of the transaction.
5.7. Where the value resides. The third important distinction
is whether the electronic money is stored on a ledger maintained by a third
party ("notational electronic money") or is stored on a token which is maintained
by the consumer ("token electronic money"). A notational electronic money
system stores value as a notation in the ledger of a third party and is exchanged
by subtracting amounts from one entry and adding it to another. The third
party serves as an off-site control point which verifies and authorizes
transactions. Token electronic money is represented by value stored on a
"smart card," computer disk drive, or other storage device and the value
is directly exchanged between payor and payee like currency.
5.8. Card vs. PC. Finally, a distinction can be drawn between
PC-based systems and card based
systems.(35) In PC-based systems, value is
transferred to and held in a personal computer and transferred electronically
from one computer to another. The PC acts as both a storehouse of value and
a device to access that value.
PC-based systems usually:
In contrast, card-based systems employ so-called "smart-cards" which are
plastic cards containing microchips which can process and store any type
of digital information, including electronic
cash.(36) Customers load value onto their
cards from their bank accounts by using automated teller machines or specially
equipped telephones in their homes, and eventually, over the
Internet.(37) In order to utilize the stored
value a separate access device is needed which might be included in a vending
machine or attached to a cash register. Similar to the farecards used on
many subway systems, the stored-value card is inserted into the access device
which debits value from the card and transfers the value to the merchant's
account. Card-based systems also differ from PC-based systems in that PC-based
systems are designed to be used remotely, whereas card-based systems are
designed for face-to-face commerce in retail transactions. This is not a
rigid distinction because a PC or telephone could be used as an access device
for a smart-card, which would enable the card to be used remotely.
Smart card systems can be further distinguished based by whether they are
"open" or "closed" systems. In a "closed" system there is generally only
one card issuer and one vendor that accepts the card for payments; usually
the issuer and the accepting vendor are the same entity. Common examples
of closed systems are public transportation farecards, prepaid telephone
cards, and prepaid copier cards. In contrast, open systems involve single
or multiple issuers which provide cards that can be used with multiple vendors.
Card-based systems can also permit personal transfers of value between
individuals, rather than just commercial transactions, provided that the
individuals have the appropriate equipment.
5.9. Example of a PC-based system. One
PC-based system, for example, permits customers to purchase electronic money
from a bank, generally by debiting an existing bank account. As consumers
browse various Web sites which sell goods and services, their electronic
money software is active in the background. The program senses when payment
is required and pops up a dialog box that prompts the buyer to approve the
transaction. The software removes the digital "coins" from the buyer's hard
disk and transfers the serial numbers representing the electronic money to
the seller's computer. The seller's computer contacts the issuing bank, which
verifies that the serial numbers representing the electronic money have not
been used and notifies the seller that the electronic money is valid. At
that point, the seller sends the electronic goods to buyer. The seller will
eventually deposit the electronic money in a bank.
In the context of the analytical framework discussed above, such
a system is a nonbank, token, unaccounted, pc-based system. Although the
electronic money was issued by a bank, it is a nonbank system because a bank
is not required. It is a token system because the strings of numbers representing
"digital coins" are stored on the customer's computer, not a central ledger.
Finally, it is an unaccounted system because the issuer does not maintain
any records of how the electronic money is used until it is presented for
conversion into conventional funds.
6.1. General. Any consideration of the substantive tax policy,
and tax administration and compliance issues that arise in this area must
be guided by basic tax policy principles and must also take into account
the technical and scientific characteristics of the Global Information
Infrastructure, including the Internet.
6.2. Neutrality. A fundamental guiding principle should
be neutrality. Neutrality requires that the tax system treat economically
similar income equally, regardless of whether earned through electronic means
or through more conventional channels of commerce. Ideally, tax rules would
not affect economic choices about the structure of markets and commercial
activities. This will ensure that market forces alone determine the success
or failure of new commercial methods. The best means by which neutrality
can be achieved is through an approach which adopts and adapts existing
principles -- in lieu of imposing new or additional taxes.
Recent technological developments may appear to be radical innovations primarily
because they have evolved within a relatively short period of time. However,
careful examination may very well reveal that few, if any, of these emerging
issues will be so intractable that their resolution will not be found using
existing principles, appropriately adjusted.
6.3. Impact of technical features of the Internet. The
policies and rules governing the taxation of electronic commerce cannot be
developed without an understanding of the underlying technical features.
Although chapter three presented a sampling of current means of electronic
commerce, the basic technical structure of the Internet has some important
implications for tax policy and administration. These aspects are restated
here.
6.3.1. Radically decentralized; no central control. The
Internet has no physical location. Users of the Internet have no control
and in general no knowledge of the path traveled by the information they
seek or publish. Many participants in the system are administrators or
intermediaries who have no control over what type of information travels
over their computers; rather they offer interconnectivity which enables the
system to operate. In practical terms, it would therefore be difficult to
monitor or prevent transmissions of information or electronic cash across
the Internet. From a technical perspective, in principle and generally in
practice, it makes no difference whether the information or electronic money
sought to be transmitted are within one jurisdiction or between several,
as the Internet pays little or no regard to national boundaries.
6.3.2. Disintermediation. In general, tax compliance is
facilitated by identifying key "taxing points:" for example, reporting
requirements can be imposed on financial institutions which are easy to identify.
In contrast, one of the great commercial advantages of electronic commerce
is that it often eliminates the need for intermediating institutions.
6.3.3. Weak correspondence between computer domain name and reality.
The pieces of an Internet address (or "domain-style name") tell
you who is responsible for maintaining that name. It may not tell you anything
about the computer corresponding to the actual Internet address, or even
where that machine is located. Even if an e-mail address is clearly associated
with a certain person and computer, that person and her computer could be
located anywhere in the world. This makes it difficult to determine a person's
location and identity, which is often important for tax purposes.
6.3.4. Lack of central control / Registration. It is not
difficult to introduce a new computer to the Internet. Registration requirements
are not difficult to satisfy, and there is little to prevent transfer of
the site to new controllers. In general, proof of identity requirements for
Internet use are very weak.
6.3.5. Auditability / Remote control. Untraceable use of
an Internet site, with the permission of the site's controllers, is quite
easy to arrange. For example, if Anne, who lives in Australia, is running
a commercial site on the Internet for U.S. customers, using a computer located
in Canada, Anne can control the Canadian computer from Australia through
a series of computer programs which can be configured to leave no audit trail.
Moreover, if the need arises, operations can be shifted to somewhere else
on the Internet.
6.3.6. Detection of contents. Since all electronic
communication consists of streams of binary digits, it is difficult, if not
impossible, to determine the contents until converted. At present, a personal
letter appears indistinguishable from a message transmitting electronic money.
Even if the nature of the contents is determined, the use of encryption could
preclude comprehension.
7.1. Introduction
7.1.1. General. This section discusses the impact of electronic
commerce on substantive principles of
taxation.(38) Current tax concepts, such
as the U.S. trade or business, permanent establishment, and source of income
concepts, were developed in a different technological era. However, the principle
of neutrality between physical and electronic commerce requires that existing
principles of taxation be adapted to electronic commerce, taking into account
the borderless world of cyberspace. An advantage of an approach based on
existing principles, in addition to neutrality, is that such an approach
is suitable for adaptation as an international standard. Existing principles
are, in broad outline, common to most countries' tax laws.
7.1.2. Bases for taxation. The United States taxes income
on the basis of both the source of the income and the residence of the person
earning that income. U.S. source income is subject to
tax(39) when earned by foreign persons as
is the worldwide income of U.S. citizens, residents, and
corporations.(40) Although U.S. persons are
subject to net basis taxation on their worldwide income, the foreign tax
credit provisions avoid double taxation of foreign source
income.(41) Our international tax treaty
network, while attempting to minimize taxation at source, also protects against
double taxation.
7.1.3. Source of income. Source of income concepts play
a central role in international taxation since the country of source generally
has a right to tax income and residence countries generally avoid double
taxation through either a credit system or an exemption system. Source of
income principles are generally similar worldwide. In general, the source
of income is located where the economic activities creating the income occur.
For example, income derived from the use of intellectual property has its
source in the location where the intellectual property is
utilized.(42) Compensation for labor or personal
services has its source in the location where the labor or personal services
are performed.(43) Furthermore, residence-based
source rules have been adopted for certain types of income such as capital
gains and swap income because the country of residence represents the location
where the economic activity that produces the income
occurs.(44) Generally, the nature of an item
of income is important for determining source because the source of income
flows from its nature.(45)
7.1.4. Role of tax treaties. The United States currently
has comprehensive income tax treaties with 48 countries.
The rules embodied in these tax treaties generally give the residence country
an unlimited right to tax income while limiting or eliminating the source
country's right to tax. One of the most important concepts in tax treaties
is that of a "permanent establishment." Source countries tend to give up
their source-based taxing rights over business profits if they are not
attributable to a "permanent establishment" or "fixed base" in their
jurisdiction. Treaties generally limit the rate of taxation at source that
can be applied to interest, dividends, and royalties paid to a resident of
a treaty partner.
7.1.5. The ascendancy of residence-based taxation. The United
States, as do most countries, asserts jurisdiction to tax based on principles
of both source and residence. If double taxation is to be avoided, however,
one principle must yield to the other. Therefore, through tax treaties, countries
tend to restrict their source-based taxing rights with respect to foreign
taxpayers in order to exercise more fully their residence-based taxing rights.
This occurs in a number of ways. The permanent establishment concept represents
a preference for residence-based taxation by setting an appropriate threshold
for source-based taxation of active business income. By setting a threshold,
in most cases it is not necessary to identify the source of active business
income and the income is only subject to tax in the country of residence.
In the case of interest, dividends, and royalties, the income is still
potentially subject to source-based taxation but in many cases is effectively
subject to only residence-based taxation because of a nil rate of withholding.
The country of residence also agrees to take appropriate steps to ameliorate
any possible double taxation resulting from the limited source-based taxation.
The growth of new communications technologies and electronic commerce will
likely require that principles of residence-based taxation assume even greater
importance. In the world of cyberspace, it is often difficult, if not impossible,
to apply traditional source concepts to link an item of income with a specific
geographical location. Therefore, source based taxation could lose its rationale
and be rendered obsolete by electronic commerce. By contrast, almost all
taxpayers are resident somewhere. An individual is almost always a citizen
or resident of a given country and, at least under U.S. law, all corporations
must be established under the laws of a given jurisdiction. However, a review
of current residency definitions and taxation rules may be appropriate.
In situations where traditional source concepts have already been rendered
too difficult to apply effectively, the residence of the taxpayer has been
the most likely means to identify the jurisdiction where the economic activities
that created the income took place, and thus the jurisdiction that should
have the primary right to tax such income. For example, in the Tax Reform
Act of 1986, Congress adopted residence-based sourcing rules for sales of
noninventory property. This reflected Congress' belief "that source rules
for sales of personal property should generally reflect the location of the
economic activity generating the income, taking into account the jurisdiction
in which those activities are
performed."(46) In the case of certain sales
of personal property, the residence of the seller was thought to best represent
the location where the underlying economic activity
occurred.(47) Similar rules were adopted
for certain space and ocean
activities.(48) Therefore, United States
tax policy has already recognized that as traditional source principles lose
their significance, residence-based taxation can step in and take their place.
This trend will be accelerated by developments in electronic commerce where
principles of residence-based taxation will also play a major role.
7.2. U.S. Trade or Business and Permanent Establishment
7.2.1. Taxation of non-resident aliens and foreign
corporations. Non-resident aliens and foreign corporations are generally
only subject to tax on their U.S. source income, including income derived
from the performance of personal services in the United States, and certain
foreign source income that is attributable to a U.S. trade or business. Unless
a treaty applies, non-resident aliens and foreign corporations are taxed
at ordinary graduated rates on their net income effectively connected with
a trade or business in the United
States,(49) and are taxed at a flat rate
on the gross amount of their U.S. source "fixed or determinable annual or
periodical gains, profits and
income."(50) A U.S. trade or business includes
the performance of personal services within the United
States.(51) Therefore being engaged in a
trade or business in the United States is a threshold requirement
for the taxation of active business income earned by foreign persons.
7.2.1.1. "In the United States." In many cases, it is clear
that a foreign person is engaged in a trade or business but it is not clear
whether they are so engaged "in the United
States."(52) However, a foreign person not
physically present in the United States who merely solicits orders from within
the United States only through advertising and then sends tangible goods
to the United States in satisfaction of the orders is unlikely to be engaged
in a trade or business in the United States even though such a person is
clearly engaged in a trade or
business.(53) A person who is not directly
engaged in a U.S. trade or business may nevertheless be deemed to be engaged
in a U.S. trade or business as the result of the activities of an agent.
7.2.2. Impact of tax treaties: Permanent establishment
concept. Tax treaties adopt a different and generally higher threshold
for source basis taxation of active income. U.S. source active income ("business
profits") of non-resident aliens and foreign corporations who are entitled
to benefits under a U.S. income tax treaty is only subject to U.S. tax if
the income is attributable to a permanent establishment located in the United
States. A permanent establishment is a fixed place of business through which
the business of an enterprise is wholly or partly carried on.
(54) "[I]t has come to be accepted in
international fiscal matters that until an enterprise of one State sets up
a permanent establishment in another State it should not properly be regarded
as participating in the economic life of that other State to such an extent
that it comes within the jurisdiction of that other State's taxing
rights."(55) Therefore, a foreign person
who is entitled to benefits under a tax treaty with the United States will
not be subject to U.S. tax on the income arising from a trade or business
in the United States if the income is not attributable to a permanent
establishment in the United States.
7.2.3. U.S. tax jurisdiction in the context of electronic
commerce.
7.2.3.1. U.S. trade or business. The concept of a U.S. trade
or business was developed in the context of conventional types of commerce,
which generally are conducted through identifiable physical locations. Electronic
commerce, on the other hand, may be conducted without regard to national
boundaries and may dissolve the link between an income-producing activity
and a specific location. From a certain perspective, electronic commerce
doesn't seem to occur in any physical location but instead takes place in
the nebulous world of "cyberspace." Persons engaged in electronic commerce
could be located anywhere in the world and their customers will be ignorant
of, or indifferent to, their location. Indeed, this is an important advantage
of electronic commerce in that it gives small businesses the potential to
reach customers all over the world.
Electronic commerce permits a foreign person to engage in extensive transactions
with U.S. customers without entering the United States. Although such a person
is clearly engaged in a trade or business, questions will arise as to whether
he is engaged in a trade or business in the United States or has a permanent
establishment in the United States. Therefore, it is necessary to clarify
the application of the U.S. trade or business and permanent establishment
concepts to persons engaged in electronic commerce. In developing principles
to classify these activities, it will be important to consider the extent
to which electronic commerce simply represents an extension of current means
of doing business, the tax consequences of which are understood. For example,
to the extent that the activities of a person engaged in electronic commerce
are equivalent to the mere solicitation of orders from U.S. customers, without
any other U.S. activity, it may not be appropriate to treat such activities
as a U.S. trade or business. It will also be necessary to consider whether
it is appropriate or practical to treat foreign persons engaged in electronic
commerce with U.S. customers as being engaged in a U.S. trade or business
if they are physically located outside the United States.
Another example is the treatment of foreign persons who maintain or utilize
a computer server in the United States. Computer servers can be located anywhere
in the world and their users are indifferent to their location. It is possible
that such a server, or similar equipment, is not a sufficiently significant
element in the creation of certain types of income to be taken into account
for purposes of determining whether a U.S. trade or business exists. It is
also possible that if the existence of a U.S.-based server is taken into
account for this purpose, foreign persons will simply utilize servers located
outside the United States since the server's location is irrelevant.
Finally, consideration may also be given to the role other activities should
play in determining whether a U.S. trade or business exists. For example,
it may ultimately be decided that a foreign person who operates a computerized
research service through computers located outside of the United States might
not be engaged in a U.S. trade or business unless other U.S. situs activities
exist. However, U.S.-based individuals engaged in providing marketing and
support services for a foreign-based provider of computerized research may
create a U.S. trade or business for the foreign person even if the computer
servers and other activities are located outside the United States.
7.2.4. Permanent Establishment. To the extent that a foreign
person is not engaged in a U.S. trade or business, then the absence of a
permanent establishment is irrelevant since the United States will not tax
that person's active business income. However, some persons entitled to benefits
under a U.S. income tax treaty will not be subject to U.S. tax due to the
lack of a permanent establishment, notwithstanding the fact that they may
be engaged in a U.S. trade or business. A U.S. permanent establishment generally
requires a fixed place of business in the United States although a permanent
establishment can also arise by imputation from the activities of an
agent.(56) Therefore, persons engaged in
electronic commerce may not have a U.S. permanent establishment because they
do not have a fixed place of business in the United States, unless a permanent
establishment is created by imputation, as discussed in section 7.2.5 below.
Telecommunications or computer equipment owned or used by a foreign person
engaged in electronic commerce raises a question as to whether this equipment
could constitute a fixed place of business of the foreign person in the United
States, taking into account that there would not necessarily be any employees
present.(57) It will be necessary to consider
whether a foreign person who owns or utilizes a computer server located in
the United States should be deemed to have a U.S. permanent establishment.
Again, it is useful to review the treatment of existing, traditional commercial
activities and consider whether any existing exclusions from permanent
establishment treatment should apply in this situation. For example, a permanent
establishment generally does not include the use of facilities solely for
the purpose of storage, display, or delivery of goods or merchandise. . .
."(58) For a business which sells information
instead of goods, a computer server might be considered the equivalent of
a warehouse.(59) Examination and interpretation
of the permanent establishment concept in the context of electronic commerce
may well result in an extension of the policies and the resulting exceptions
to electronic commerce.
7.2.5. U.S. trade or business or permanent establishment by imputation:
telecommunications and Internet service providers. A U.S. trade
or business or permanent establishment can also arise by imputation from
an agent's activities.(60) Agency issues
arise from the relationship between a foreign person and a computer online
service or telecommunications service provider. Even if a person engaged
in electronic commerce does not maintain a computer server or similar equipment
in the United States, issues of U.S. trade or business or permanent establishment
would also arise. In most cases, information will be transmitted to the
customer's computer through telephone lines. For example, a foreign person
who operated a computerized research service might contract with a U.S.
telecommunications company to provide local dial access service so that the
foreign person's U.S. customers can access its computerized databases.
Alternatively, the U.S. customers might access the foreign information seller's
Web site using a U.S.-based Internet service provider. Presumably, the foreign
person's relationship with a local telecommunications service provider is
such that the telecommunications service provider would not even be considered
an agent of the foreign person. Even if an agency relationship were deemed
to exist, the service provider would likely be considered an independent
agent, with the result that a U.S. trade or business or permanent establishment
would not arise.(61) Nevertheless, it may
be necessary to further clarify the applicable principles in this area and
seek to create an international consensus on this issue.
7.2.6. Taxation of telecommunications service providers.
The principles used to determine whether a person is engaged in a U.S. trade
or business or maintains a U.S. permanent establishment might differ if the
person is primarily engaged in providing telecommunications services, in
contrast to a business which is primarily engaged in selling goods or services
for whom the telecommunications services are merely
incidental.(62) A distinction is generally
recognized between activities that "contribute to the productivity of the
enterprise" and activities that involve the "actual realization of
profits."(63) In the case of a foreign
telecommunications service provider, the operation of a computer server in
the United States or the sale of computing services and Internet access to
U.S. and foreign customers is clearly integral to the realization of its
profits, in contrast to the case of a foreign person who is primarily engaged
in selling data which is stored on a U.S.-based server.
7.3. Digitized Information: Classification of Income
7.3.1. Transactions in digitized information. Any type
of information that can be digitized, such as computer programs, books, music,
or images, can be transferred electronically. For example, a U.S. person
could, via the Internet, communicate with a computer located in a foreign
country and download a computer program or digitized image or video in exchange
for a fee. The purchaser's rights in the information transferred could vary
depending on the contract between the parties.
The purchaser of a digitized image could obtain the right to use a single
copy of the image, the right to reproduce ten copies of the image for use
in a corporate report, the right to reproduce the image for use in an academic
work that is expected to have a limited press run, or the right to reproduce
the image in a mass-circulation
magazine.(64) Depending on the facts and
circumstances, some of these transactions may be viewed as the equivalent
of the purchase of a physical copy or copies of the photograph, which would
probably not subject the seller to U.S. taxation, while other of these
transactions would result in royalty income because they involve payments
for the use of or the privilege of using copyrights or similar property in
the United States, which could be taxable in the United
States.(65)
Technological developments have necessitated a reexamination of existing
income classification principles in light of the ease of perfectly reproducing
and disseminating digitized information. Classifying transactions involving
digitized information may require a more complex analysis that disregards
the form of the transaction -- without regard to whether tangible property
is involved -- in favor an analysis of the rights transferred. This is necessary
to ensure neutrality between the taxation of transactions in digitized
information and transactions in traditional forms of information, such as
hard copy books and movies, so that decisions regarding the form in which
information is distributed are not affected by tax considerations.
7.3.2. Classification of income issues. Information that
can be digitized is generally protected by copyright law. Payments made for
the use of or for the privilege of using copyrights are considered
royalties.(66) Similarly the U.S. Model Tax
Convention defines "royalties" as "payments of any kind received as consideration
for the use of, or the right to use, any copyright of literary, artistic
or scientific work including cinematograph films . . .
."(67) It is not always clear how this definition
applies to the sale of digitized information. Yet, it is clear that some
of these transactions, such as the electronic purchase of computer programs,
are merely substitutes for conventional transactions involving physical objects.
Digitized information also presents unique issues because it can be perfectly
reproduced, often by the purchaser. Although someone desiring to purchase
ten copies of a bound book will generally purchase ten copies from a publisher,
someone wishing to purchase ten copies of an electronic book may simply purchase
one copy and acquire the right to make nine additional copies. This transaction
might literally be considered to create royalty income, at least in part,
since the right to make reproductions is a right reserved to the copyright
holder and by allowing a third party to make reproductions, the payment is,
at least in part, in consideration for the use of the copyright. However,
this transaction may also be viewed as merely a substitute for the purchase
of ten copies from the publisher in which the purchaser has undertaken to
make the copies, a process which would not be feasible were the information
not digitized. Therefore, it is necessary to apply the definition of "royalties"
in a manner that takes into account the unique characteristics of digitized
information.
7.3.3. Proposed regulations on computer program transactions.
The proposed regulations on the classification of income from transactions
involving computer programs represent an initial attempt to resolve this
issue.(68) The regulations invite comments
prior to finalization. Although these regulations are proposed to be limited
to transactions involving computer programs they may establish a framework
applicable to any type of digitized information, at least to the extent it
is protectable by copyright. Treasury requests comments on this issue.
These proposed regulations do not seek to make determinations based on whether
property is "tangible" or "intangible" because those concepts do not properly
capture the unique features of digitized information. For example, when a
computer disk containing a program is transferred, that would appear, on
its face, to be a transaction in a tangible object. When the same program
is transferred by means of electronic impulses transmitted over a telephone
line, it would seem to be an intangible. Both of these classifications, however,
ignore the substance of the transactions and the analysis of the proposed
regulations avoids this confusion, in part by treating the means of transfer
as irrelevant.
The proposed regulations treat transactions involving computer programs as
being either: (1) transfers of copyright rights, (2) transfers of copies
of the copyrighted program, (3) the provision of services for the development
or modification of a computer program; or (4) the provision of know-how regarding
computer programming techniques.(69) Because
computer programs are protected under copyright law and the rights that
transferees of computer programs obtain are primarily rights created by copyright
law, the proposed regulations take copyright law rights as the starting point
for the analysis. They demonstrate that an understanding of these rights
makes it possible to analyze computer program transactions in the framework
of existing principles of tax analysis.
The primary distinction established by the proposed regulations is between
transfers of copyright rights and transfers of copyrighted articles. The
proposed regulations use copyright law principles to determine whether the
rights transferred are rights in the underlying copyright or are rights in
a copyrighted work. However, the proposed regulations depart from copyright
law when appropriate to take into account the special characteristics of
computer programs. Tax law principles are then applied to determine whether
or not there has been a partial or complete transfer of these rights, which
will determine the tax classification of the resulting income. If a transaction
is considered to involve copyright rights, it is either a sale or exchange
of the copyright, or a license, depending on whether "all substantial rights"
in the copyright have been transferred. If the transaction is a transfer
of a copyrighted article, then it is either a sale or exchange, or a lease
of the copyrighted article, based on an application of the "benefits and
burdens" test. Because this comprehensive framework is based on an analysis
of the underlying rights, it may be flexible enough to handle transactions
in computer programs and other types of digitized information that are yet
to be invented.
These concepts and distinctions can, of course, be found in existing law.
The novel aspect of the proposed regulations is that they take into account
the unique characteristics of digitized information. For example, for copyright
law reasons, computer programs are generally sold pursuant to "license"
agreements. Software developers transfer rights in computer programs to
individual users through licenses, rather than sales, to prevent transferees
from claiming the rights that would be provided under copyright law to purchasers
of copies of the program. Therefore, the proposed regulations seek to determine
whether the rights obtained by a "licensee" are copyright rights or are
substantially equivalent to the rights that would have been obtained had
the transferee acquired a program
copy.(70)
As indicated above, the proposed regulations take the unique characteristics
of digitized information into account in departing from a strict copyright
law analysis. For example, computer programs are frequently distributed through
site licenses. Under a site license, a "licensee" might obtain only one disk
containing the program but also obtains the right to make a certain number
of copies for internal use. Notwithstanding the term applied to the transaction
or the grant of a copyright right under U.S. copyright law, the regulations
propose to treat this transaction as a sale of goods for tax
purposes.(71) Although the right to reproduce
a computer program is a right granted to the owner of the copyright, which
would make the transaction a license (resulting in royalties) under a pure
copyright law analysis, the proposed regulations recognize that the bare
right to copy a program is not relevant for purposes of this analysis. Since
digitized information can be perfectly copied at little cost, the bare right
to reproduce is disregarded for tax purposes. The proposed regulations provide
that the right to reproduce is only relevant when it is coupled with the
right to sell the copies so made to the public. This is a case where existing
tax principles have been adapted to take into account the unique features
of electronic commerce.
7.3.4. Definition of services income. Digitized information
may also further complicate existing difficulties in defining services income,
as distinguished from sales of goods income or
royalties.(72) This distinction is important
for purposes of determining the source of income, and for the application
of various Code provisions including the Subpart F rules. Under subpart F,
the definition of foreign base company sales income differs from the definition
of foreign base company services
income.(73) Therefore, whether a transaction
is deemed to result in sale of goods income, as distinguished from services
income, may affect whether such income will be Subpart F income that will
be subject to current tax.
The distinction between services income and other types of income is a pervasive
issue throughout the Code. For example, in many cases, the distinction between
service contracts and other arrangements is
unclear.(74) Although many commercial
transactions involve elements of both the provision of tangible property
and the performance of services, these transactions are generally classified
in accordance with their predominant characteristic. For example, a transaction
involving the performance of professional services may result in the provision
of a letter or other document. The aspect of the transaction consisting of
the provision of the tangible property is treated as incidental to the
performance of the services.(75) In contrast,
if a retail establishment sells a suit to a customer but agrees to make slight
alterations as part of the purchase price, the performance of services would
be viewed as an integral part of a transaction consisting of the sale of
goods.(76)
In the proposed regulations regarding the classification of computer program
transactions, an attempt is made to clarify the distinction between the sale
of goods and the provision of services in the context of computer programs.
For example, if a software developer agrees to provide upgrades of a computer
program when they become available, the proposed regulations provide that
the developer is not treated as having provided services to its
customers.(77) In contrast, if the person
commissioning the creation of the program bears all of the risk of loss
associated with its creation and will own all of the copyright rights in
the underlying program when it is completed, the proposed regulations provide
that the developer is treated as providing
services.(78) The proposed regulations clarify
that, even if a transaction involving a computer program has a de
minimis service component, it may nevertheless be classified as the
transfer of copyright rights or copyrighted
articles.(79)
A further example of where new technologies will blur these distinctions
involve transactions in digitized information over the Internet. For example,
a reference work, such as an encyclopedia, would previously have been sold
only as a set of bound volumes and the sale of the bound volumes would have
resulted in sale of goods income, notwithstanding the fact that the cost
of printing and binding represented only a fraction of the encyclopedia's
value. Now, instead of purchasing a bound volume, a potential purchaser might
be able to choose between a set of CD-ROMs and a computer on-line service
through which the encyclopedia's content can be accessed. If the customer
has a sufficiently fast modem connection, there may be little practical
difference between accessing the on-line service and the CD-ROMs on the
customer's personal computer. The sale of the CD-ROMs may result in sale
of goods income(80) while the classification
of the income arising from the on-line service is not clear. The on-line
service may result in services income although in some circumstances it could
be characterized as a means of distributing copies of copyrighted works.
However, a distinction between sales of goods and services income may still
be appropriate in this area taking into account the frequency at which the
on-line service will be updated and the fact that the user of the online
service must continue to make periodic payments, as contrasted with the fact
that the purchaser of the CD-ROM may acquire the right to use the disk in
perpetuity for a single payment.(81) It will
be necessary to consider the principles to be applied in these situations
that will best implement the policy behind the underlying Code provisions.
7.3.5. Effect on controlled foreign corporation rules. The
ability of taxpayers to electronically sell digitized information and services
may have an effect on existing rules regarding the controlled foreign corporation
provisions of Subpart F.(82) Subpart F limits
the use of tax deferral through controlled foreign corporations (CFCs) by
currently taxing certain types of highly mobile income to the CFC's "United
States shareholders." If CFCs can engage in extensive commerce in information
and services through Web sites or computer networks located in a tax haven,
it may become increasingly difficult to enforce Subpart F. Some persons engaged
in electronic commerce may already be locating their businesses
offshore.(83) As discussed in Chapter 8 below,
this presents enforcement problems because it may be difficult to verify
the identity of the taxpayer to whom foreign base company sales income accrues
and the amount of such income. It may be necessary to revise Subpart F or
the regulations thereunder to take these new types of transactions into account.
7.4. Source of Services Income
7.4.1. Geographic basis. Income derived from the performance
of labor or personal services only constitutes U.S. source income if the
person performing the services is physically present in the United
States.(84) This is also a generally accepted
international principle.(85) This requirement
is based on the view that there is generally an independent, substantial
significance to the location where the person rendering the services is located
with the result that it is reasonable for that country to tax such services.
This concept is also relevant for purposes of Subpart F since foreign base
company services income only includes services which "are performed outside
the country under the laws of which the controlled foreign corporation is
organized."(86) As travel and communications
have become more efficient and less expensive, the relationship between the
service provider's location and the service consumer's location has weakened.
For example, it is now possible for physicians to remotely diagnose certain
diseases through telecommunications links and videoconferencing has eliminated
the need for many face-to-face meetings.
7.4.2. Role of existing concepts. These technological
developments are generally extensions of existing communications devices.
For example, a video conference is likely to be a substitute for a conference
telephone call. Although these communications developments may pose some
base erosion potential since service providers will find it easier to relocate
to low-tax jurisdictions, it may be the case that the base erosion potential
is not so significant as to require review of the current general principles
of residence-based taxation applicable to services. In devising rules to
source this type of income, it may also be necessary to consider the relationship
between the service-provider's physical location and other potential indicia
of source, such as the location of a computer server or communications link.
Furthermore, to the extent the source of this income is becoming both less
meaningful and increasingly difficult to determine, residence-based taxation
should necessarily play a larger role.
7.5. Global Services: Allocation Of Income And Expenses
7.5.1. Global collaboration. The foregoing section discussed
the problem of determining the source of income derived from the performance
of services. A related issue arises from increases in global collaboration
arising from modern telecommunications. One example is global dealing. As
discussed above, global dealing refers to the capacity of financial
intermediaries, mainly banks and securities firms, to execute customers'
orders and to take propriety positions in financial products in markets around
the world and around the clock. Global dealing could not take place without
modern computers and communications, which permit a firm's trading position
to be transferred around the world as markets open and close. Similarly,
certain scientific and engineering projects are now being worked on twenty-four
hours a day as laboratories in one region electronically hand-off the project
at the end of the day to a laboratory where the day is
beginning.(87) This type of global collaboration
is expected to increase.(88)
7.5.2. General principles of allocation. Global collaboration
is not a new concept. When goods are manufactured in one country and marketed
and distributed in another, the overall transaction could be characterized
as global collaboration in the sale of goods. Global collaboration requires
transfer pricing and source of income principles, to correctly allocate the
resulting income between the countries involved. Current transfer pricing
principles are focused on global collaboration in the manufacture and sale
of goods and the creation and transfer of
intangibles.(89) The cost sharing regulations
under section 482 apply to allocate the results of certain global research
and development efforts, but only when intangibles are
created.(90)
By contrast, global dealing income has been allocated through case-by-case
negotiations between the competent authorities involved, although a guidance
project on global dealing is currently developing rules of general
application.(91) As the ways in which companies
collaborate globally to provide services continue to grow, it may be appropriate
to consider the creation of general principles for the arm's length allocation
of broader categories of services income based on each situation's particular
facts. These rules could be implemented through Treasury Regulations and
international consensus. To the extent that capital is not a material
income-producing factor in this situation, it would be expected that the
place where the component services were performed would be of primary importance
in allocating such income.
8.1. General. In the area of tax administration and compliance,
electronic commerce may create new variations on old issues as well as new
categories of issues. These developments require that practical techniques
be developed to deal with these technological innovations. As discussed in
this chapter, these technological developments touch on a wide range of issues
affecting the administration of our tax
laws.(92) In many cases, the products and
techniques that will be required cannot be developed or implemented by Treasury
or the IRS on a unilateral basis. Private sector and international cooperation
is likely to be necessary to develop and implement appropriate software and
hardware technologies.
Electronic commerce is still developing and no electronic money system has
yet achieved widespread usage. Nevertheless, it is important to consider
these issues now since some issues may require that the needs of tax
administration be addressed while electronic commerce systems are still under
development. Others issues may not require immediate action and decisions
can be delayed while Treasury and the IRS obtain more experience with these
systems.
8.2. Categories of issues. These technological developments
create issues under many different sections of the Code. Instead of dealing
with these issues with respect to particular Code sections, they will instead
be approached on the basis of their technological features. This is both
a more useful means of categorizing these issues and is also more likely
to identify potential solutions since solutions must be tailored to the
technology. These broad categories of issues, which are discussed in detail
below, are:
8.3. Electronic money. As discussed in chapter 5, developments
in electronic payment systems have the potential to create "electronic money."
Electronic money is a broad term, and just as electronic money systems differ
in their technical features, they also differ in the extent to which they
create issues for tax administrators. Depending on the type of system used,
electronic money can be either an advantage or a disadvantage for tax
administrators.
As discussed below, electronic money poses a tax evasion potential similar
to that created by paper money. This raises the issue of whether the evasion
potential is manageable and what must be done to manage it. As discussed
below, it is possible that the techniques that have been developed over time
to combat evasion using paper money can be adapted and expanded to combat
evasion through electronic money. In particular, it may be necessary to consider
the role that issuers of electronic money can play in this effort, since
they represent the interface between the physical economy and the electronic
economy. In general, however, the extent to which electronic cash will be
a problem will likely depend on the extent to which it results in an extensive
payment system outside of normal banking channels.
Treasury intends to study, and requests comments on these issues, including
the extent to which (i) current techniques can be adapted to combat tax evasion
using electronic cash, (ii) new audit techniques will be necessary, and (iii)
information reporting and similar requirements can and should be imposed
on issuers of electronic money.(93)
8.3.1. Accounted systems. Chapter five distinguished electronic
money systems in part based on whether they are accounted or unaccounted
systems. In accounted systems, the electronic money issuer maintains a central
record of the flow of its electronic money through the economy. In unaccounted
systems no such central record exists. Accounted systems are unlikely to
present substantial tax administration concerns because the central record
of transactions, if it is available for examination on audit, will permit
tax administrators to match payments and receipts to specific taxpayers.
In fact, the growth of accounted systems will be an advantage for both taxpayers
and tax administrators since the central records maintained by an accounted
system could be used by taxpayers and auditors to verify payments. Some taxpayers
may therefore choose to use accounted systems when a record of the transaction
is necessary for tax or other purposes.
Treasury intends to study, and requests comments on, how the records maintained
by accounted systems can be integrated into the system of tax administration
and the standards that should be applied to determine whether the records
maintained by an accounted system are acceptable for tax purposes.
8.3.2. Unaccounted systems. In contrast to accounted systems,
problems may arise with unaccounted systems, which maintain no such central
record and are therefore analogous to cash. The extent of this problem will
be measured by the extent to which unaccounted systems are used instead of
accounted systems. It may be that unaccounted systems will be used primarily
for certain types of small transactions, just as cash is used primarily for
certain types of transactions. In many cases consumers will prefer existing
payment mechanisms, such as credit cards, for the payment terms and the consumer
protection that they provide. In other situations, consumers will use electronic
money but will use accounted systems in order to have a central record in
case a dispute arises with the merchant. While unaccounted electronic systems
are unlikely to completely displace other payment systems, the tax evasion
potential they create could be substantial.
Transactions using unaccounted electronic money create the opportunity for
both not reporting or underreporting the resulting income because detection
of these transactions is difficult. For example, a taxpayer might sell physical
goods in exchange for unaccounted electronic money, which might be transferred
via a card-based system. This problem currently exists for paper currency-based
businesses. However, it has been historically possible to examine a business'
flow of inventory and similar physical indicia of the magnitude of the taxpayer's
business. This may not be possible for a taxpayer who sells electronic goods
or services; there is unlikely to be any physical indicia of the amount of
the taxpayer's receipts.(94)
8.3.3. Bank secrecy. Finally, electronic money creates increased
opportunities to deposit unreported income in a bank or other financial
institution. As a result of electronic money's advantage in transmitting
large amounts of money with relative ease, combined with the continued use
of cash, the problem of an underground, unaccounted for economy is likely
to be exacerbated.
Electronic money and the Internet substantially increase the ease and safety
with which bank accounts can be opened abroad, letterbox companies and trust
accounts can be established abroad, and funds transferred anonymously. Unlike
paper currency, electronic money can be securely and instantaneously transmitted
anywhere in the world. It is now possible to open a bank account over the
Internet in a bank secrecy jurisdiction, without actually traveling to the
bank's location.(95) Electronic money could
be instantaneously and anonymously transferred to such an account, thereby
eliminating the risks and reporting requirements involved in transferring
cash. Alternatively, a smart card encoded with a large amount of unaccounted
electronic money could be slipped into a pocket and taken anywhere in the
world without the bulk and weight of cash. However, in the case of a bank
or financial institution located in the United States or a country with which
the United States has a tax treaty or Tax Information Exchange Agreement,
it may be possible in most cases to gain access to the taxpayer's bank records
or records of the funds' transmittal.
8.4. Identity verification. A New Yorker cartoon
once featured two dogs sitting in front of a computer with a caption that
read "[O]n the Internet, nobody knows you're a dog." Tax administrators face
a similar issue. On the Internet it is possible to use a false identity and
it is not currently possible to independently verify a party's identity.
This raises a number of issues because the identity of a counterparty is
important for numerous tax provisions. For example, if securities are purchased
electronically, the issuer is still subject to information reporting and
record keeping requirements. If the purchasers are nonresident aliens or
foreign corporations, payments of interest and dividends are subject to
withholding and reporting. This withholding may be reduced or eliminated
by a tax treaty if the beneficial owner is entitled to treaty benefits. Claiming
an expense deduction requires proof of the payee and the transaction. Under
Subpart F, the identity of the purchaser of goods is relevant in determining
whether the sale creates foreign base company sales income. For example,
a U.S. seller of electronic goods could route sales through a Web site maintained
by a base company and claim that the purchases were for use within the base
company's country of incorporation.(96)
Therefore, it will be necessary to develop techniques to verify that the
purchases were indeed for use within that country. Finally, if tax returns
and other documents are to be electronically filed, an acceptable form of
digital signature will be required.
Verification of identity is also a problem for consumers, who want to be
assured that the persons with whom they do business are who they claim to
be.(97) As a result, companies engaged in
electronic commerce are developing "digital certificates" or "digital IDs"
that can be used to verify a person's identity over the
Internet.(98) "Digital certificates" are
issued by a trusted intermediary who verifies the identity of a person and
performs appropriate background checks, depending on the level of assurance
to be granted.(99) Once a person's identity
has been verified, he is issued a digital ID, which is the on-line equivalent
of a driver's license or passport which can be transmitted to a potential
customer. The certificate is created using public key encryption techniques,
which makes it independently verifiable by the recipient and immune from
tampering.(100)
If they operate as designed, these digital IDs are likely to represent an
important means by which taxpayers and tax administrators can prove the identity
of electronic counter parties. For example, if it were necessary for tax
purposes to prove the identity of an electronic counter party or comply with
an information reporting requirement, a taxpayer could be required to obtain
a digital ID from the counterparty and maintain a record of that ID which
could be examined on audit. However, because some issuers of digital IDs
may not perform sufficiently thorough identity checks prior to issuing a
digital ID, the IRS may be required to develop standards for issuers of digital
IDs and certify issuers. In order to do so, the IRS may be required to issue
its own digital IDs to issuers of digital IDs so that they can electronically
prove that they have received IRS certification. Treasury requests comments
on the extent to which digital IDs can be utilized for tax purposes, including
the extent to which they can serve as signatures on electronically filed
documents, the extent to which their use should be required for certain purposes,
and the role that the IRS should play in certifying issuers of digital IDs.
8.5. Record keeping and transaction verification. Taxpayers
are required to keep accurate books and records, which are subject to examination
by the IRS in order to verify the income and expenses reported on the taxpayer's
return.(101) Although many taxpayers rely
on computerized record keeping systems to a large extent, many transactions
still originate as paper records which can be used to verify the accuracy
of the electronic records. However, for taxpayers engaged in the sale of
electronic goods or services, no paper records are likely to be created because
customer orders are placed and fulfilled electronically and therefore the
only record that exists of these transactions could be an electronic one.
As all users of computers know, this creates the possibility for tax evasion
and fraud because computerized records can be altered without a
trace.(102) Even taxpayers engaged in the
sale of physical, as opposed to electronic, goods may soon receive orders
and issue invoices electronically. Electronic "documents" must be verifiable
in order to minimize the potential for tax evasion.
This is also an issue for non-tax businesses reasons. For example, a recipient
of an electronic order needs to verify both that the order was sent by the
proper person, and also needs to verify that the order was not altered in
transit. Public key encryption techniques, which are used to create digital
identity certificates, can also be used to verify that electronic documents
and records have not been tampered with. For example, "digital notarization"
systems have been developed which are intended to make it possible to verify
that electronic documents and records have not been altered. One such system
purports to provide the digital equivalent of a notary stamp which can be
used to certify and seal digital records in content and time so that it can
later be proved that the electronic record was created when claimed and was
not altered after the fact.(103)
Treasury requests comments on the extent to which such technologies can,
in fact, be used to verify the authenticity of electronic transactions and
on the role that Treasury should play in the development of these systems.
8.6. Disintermediation and information reporting. Tax reporting
and compliance relies in part on the use of centralized institutions and
intermediaries that can be used to comply with information reporting and
withholding requirements. For example, withholding on payments to foreign
persons relies on the use of "withholding agents" who will generally be
sophisticated persons who understand their obligations and can be identified,
and the ability of the IRS to audit them. As discussed above, it is now possible
for individual and relatively unsophisticated taxpayers to engage in cross-border
investment and licensing transactions that previously would have taken place
through traditional intermediaries, if at all. Disintermediation refers to
the elimination of these traditional intermediaries. For example, a payment
made for the right to download and reproduce a digitized image may be a royalty,
depending on the transferee's
rights.(104) The parties to these transactions
may be unfamiliar with their withholding obligations and current technology
does not yet provide a means for computing and paying such taxes electronically.
Such a system is, presumably, technically feasible but may not be accepted
by electronic merchants and consumers. The small amounts involved will also
complicate tax administration. In addition, the parties may be unfamiliar
with their information reporting requirements. Information reporting plays
an important role in tax administration and it may also be necessary to integrate
these transactions into our system of information reporting.
Treasury requests comments on how the tax system can be adapted to deal with
such disintermediated micro-transactions, and the role of information reporting
in such transactions.
As the communications revolution continues to sweep through the world economy,
tax principles and systems of tax administration will have to adapt. This
paper represents an attempt to further that process. It is not intended to
resolve the tax policy and administration issues posed by the communications
revolution but is intended to identify and assess some of these issues. Certain
issues may initially appear to be so complex that they cannot be dealt with
by existing principles. Further study is likely to result in the conclusion
that one or more existing principles are more flexible than they may seem
and they remain relevant notwithstanding technological developments. However,
some of these technological developments, such as the potential growth of
extensive anonymous transactions involving electronic cash, do raise certain
existing administration and compliance issues to new levels of concern.
Treasury looks forward to receiving comments from, and working with taxpayers
and their advisors, including both tax law specialists and computer technology
specialists, academics, and foreign tax policy makers and administrators,
to better understand these technologies and develop rational and enforceable
tax rules. This can play an important role in fostering the growth of these
technologies and transactions. Clear and rational principles will ensure
that the tax law will not be an impediment to the growth of these exciting
technologies that have such a great potential to improve our lives.
Comments on any of the issues raised by this paper should be addressed to:
Joseph H. Guttentag, International Tax Counsel, Department of the Treasury,
1500 Pennsylvania Avenue, NW., Washington, D.C. 20220. Comments may also
be submitted to Treasury via Internet e-mail to TAXPOLICY@treas.sprint.com,
with the subject line "technology issues." All comments will be available
for public inspection and copying.
Bandwidth: (Also known as "capacity") In simple terms, how
much information or traffic can be carried on the Internet in a given amount
of time. The simple rule is that the greater the bandwidth, the greater the
opportunities for commerce. As a specific example: with low bandwidth,
transferring the contents of a music CD via the Internet is not feasible;
with higher bandwidth, it is entirely feasible.
Browser: A program used to access the World Wide Web.
Bit: A contraction of the term "binary digit;" a unit of
information represented by a zero or one. The speed of information transmission
is measured in bits per second.
CD-ROM: Compact Disc with Read Only Memory; compatible with
computers, compact discs are inexpensive, high-capacity storage devices for
data, text and video.
Commercial Web Site: A computer site, attached to the Internet,
which sells Internet merchandise.
Convergence: The "coming together" of formerly
distinct technologies, industries or activities; the most common usage refers
to the convergence of computing, communications and broadcasting technologies.
Cyberspace: The three-dimensional expanse of computer networks
in which all audio and video electronic signals travel and users can, with
the proper addresses and codes, explore and download information.
Digital: Information expressed in binary patterns of ones
and zeros.
Digital Signature: Data appended to a part of a message
that enables a recipient to verify the integrity and origin of a message.
Digitization: The conversion of an analog or continuous
signal into a series of ones and zeros, i.e., into a digital format.
Electronic Commerce: Consumer and business transactions
conducted over a network, using computers and telecommunications.
Encryption: The coding of data for privacy protection or
security considerations when transmitted over telecommunications links, so
that only the person to whom it is sent can read it.
Fiber Optic: A modern transmission technology using lasers
to produce a beam of light that can be modulated to carry large amounts of
information through fine glass or acrylic fibers.
Global Information Infrastructure or GII:
The convergence of previously separate communications and computing systems
into a single global network of networks.
Hypermedia: Use of data, text, graphics, video and voice
as elements in a hypertext system. All the forms of information are linked
together, so that a user can easily move from one form to another.
Hypertext: Text that contains embedded links to other documents
or information.
Information Superhighway: See Global Information Infrastructure.
Intellectual Property: A collective term used to refer to
new ideas, inventions, designs, writings, films and others; protected by
copyright, patents, trade-marks, etc.
Internet: A vast international network of networks that
enables computers of all kinds to share services and communicate directly.
Internet Merchandise: Goods, services or other property
(typically property in which intellectual property rights subsist, such as
music, software etc.) sold via commercial web sites. A distinction
can be drawn between those cases where delivery is effected via the Internet
itself (e.g. downloaded software) and where delivery is effected via conventional
means.
Internet Service Providers (ISPs): Organizations which provide
individuals and businesses with access to the Internet (including
commercial web sites). ISPs may be wholesalers or retailers or both.
A wholesaler normally resells bandwidth and certain other services to smaller
ISPs who act as retailers. The most significant component of the sale price
is the amount of bandwidth purchased.
Modem: A contraction of "mo(dulator)" and "dem(odulator),"
an accessory that allows computers and terminal equipment to communicate
through telephone lines or cable; it converts analog data into the digital
language of computers.
Protocol: A standard procedure for regulating data transmission
between computers.
Server: Computers which store information for access by
users of a network, including the Internet.
Virtual Reality: An interactive, simultaneous electronic
representation of a real or imaginary world where, through sight, sound and
even touch, the user is given the impression of becoming part of what is
represented.
World Wide Web, Web, or WWW: The graphical, hypertext portion
of the Internet. The World Wide Web is described in chapter 3.
1. This paper is limited to federal income taxation issues. These technological developments also raise other issues, such as the effect on subfederal taxation, which are outside the scope of this paper. Nevertheless, Treasury believes that these new technologies should not be used to justify new taxes. Accordingly, Treasury is not considering any type of value added tax (VAT), "bit tax," or other new excise tax on electronic commerce.
2. The information contained in this paper, which is current as of November 1996, is only intended to provide a general summary. It does not purport to be a complete description of the new technologies.
3. See generally, http://nii.nist.gov.
4. In 1994, 74 percent of total U.S. employment was in the service sector, as compared to 67 percent in 1980.
5. M. Meeker & C. Depuy, The Internet Report 1-9 (1996).
6. Survey: The Internet, The Economist, July 1, 1995, at 6.
7. Id.
8. At the end of 1995, the Web accounted for an estimated 40 percent of Internet traffic. G. Kessler, Serving the Internet, Lan Magazine, Sept. 1996, at 43.
9. Web servers and Web browsers communicate using the HyperText Transfer Protocol, a special protocol created to transfer hypertext documents over the Web, which accounts for the ubiquitous "http" prefix in Web addresses.
10. J. Markoff, A Free and Simple Computer Link, N.Y. Times, Dec. 8, 1993, at D1.
11. Id.
12. K. Debello, Making Money on the Net, Business Week, Sept. 23, 1996, at 104.
13. Such developments appear to be on the horizon. See e.g. P. Lewis, A Technology for the Cyber-Marketing Age, N. Y. Times, Sept. 18, 1996, at D1; M. Jerome and W. Taylor, Mint a Million, PC/Computing, Oct. 1996, at 73.
14. XIWT Cross-Industry Working Team, Electronic Commerce in the NII, at 1.0 (1995)(available at http://www.cnri.reston.va.us:3000/xiwt/documents/ EComm_doc/ECommTOC2.htm); See also, http://192.216.71/iw/center/hotweco.htm (collection of links to other electronic commerce sites).
15. As discussed in chapter 7.3 infra, a customer's intended use of the photograph may affect the classification, and thus the taxation, of the payment.
16. Encyclopedias on CD-ROM. 32 into 1 will go, The Economist, Feb. 17, 1996, at R11.
17. See e.g., S. Rupley, Half Open or Half Closed, PC Magazine, Dec. 3, 1996, at 28; A. Cortese, The Software Revolution, Business Week, Dec. 4, 1995, at 78.
18. The Doctor Will See You Now -- Just Not In Person, Business Week, Oct. 3, 1994, at 117.
19. Id.
20. B. Gates, The Road Ahead, 149-50 (1995).
21. The Doctor Will See You Now, supra note 18.
22. See, F. Matheny, Mail Order Coach, Bicycling, Jan. 1996, at 50 ("Using only a telephone, a fax machine and perhaps a video camera, an isolated cyclist in Kansas can get personal coaching from a cycling guru in California.")
23. E. Wee, Computers Give Firms a Window to College Prospects, The Washington Post, Nov. 19, 1996, at B1.
24. The Road Ahead, supra note 20, at 149-150, and 178-179. For a different perspective on videoconferencing, see C. Levin and S. Rupley, Collaboration on Call, PC Magazine, Sept. 10, 1996, at 31.
25. See 18 U.S.C. 1084 (prohibiting transmission of wagering information and wagers by wire).
26. See e.g., J. Sterngold, A One-Armed Bandit Makes a House Call, N. Y. Times, Oct. 28, 1996, at D1.
27. Getting Wired, Barrons, May 6, 1996, at 37.
28. L. Eaton, Wall Street Without Walls, N. Y. Times, Nov. 11, 1996, at A1; L. Eaton, Initial Public Offerings, Coming Your Way over the Internet, N.Y. Times, Oct. 23, 1996, at D10. This has obvious securities law implications which are outside the scope of this paper.
29. "By its very nature the Internet is an insecure channel. Packets of data consist of plain text with address information in the headers and are routed seemingly at random; even a modestly talented hacker can spoof an Internet address to intercept, read, and even alter those packets." E. Bott, Online Security, PC/Computing, Sept. 1996, at 344. Private networks, such as inter-corporate networks, are considerably more secure since access to these networks is strictly controlled and the path that information can travel is circumscribed.
30. This paper does not address, and is not intended to create any inferences regarding, any non-taxation issues relating to encryption.
31. The Road Ahead, supra note 20, at 107; J. Prosise, Digital Signatures: How They Work, PC Magazine, Apr. 9, 1996, at 237.
32. Adapted from, Philip Zimmerman, PGP™ Users Guide Volume I (distributed with the computer program PGP™, available from http://www.pgp.com and many other Web sites).
33. The Treasury Department is also considering the implications of electronic money systems in a number of other areas outside the scope of this paper, including bank regulation, consumer protection, and law enforcement. See e.g., Department of the Treasury, An Introduction to Electronic Money Issues, Sept. 19, 1996 (available from Comptroller of the Currency, Communications Division, Washington, D.C. 20219).
34. See generally, Department of the Treasury, Financial Crimes Enforcement Network, Exploring the World of Cyberpayments: An Introductory Survey, Sept. 27, 1995 (available from Financial Crimes Enforcement Network, Department of the Treasury, 2070 Chain Bridge Road, Vienna, VA 22182)[hereinafter Cyberpayments].
35. See generally, Cyberpayments, supra note 34, at 8-9.
36. "The memory lets it store about 80 times as much information as the typical magnetic stripe on a credit card or fare card, and the processor makes possible the use of cryptographic methods to secure the data." J. Gleick, Dead as a Dollar, N. Y. Times, June 16, 1996, Section 6 at 29. In the future, as the memory of these cards is expanded, they will be able to store more information, such as medical or other personal information. This raises certain privacy concerns that are outside the scope of this paper.
37. Sophisticated telephones with smart-card slots will soon be available. Smart Phones: The Highest I.Q.'s Yet, N. Y. Times, Sept. 5, 1996, at C2; See also, Telephone Bill, The Economist, Nov. 16, 1996, at 76.
38. This chapter is focused on certain broad themes arising under United States international tax rules. However, certain specific provisions of the Code and Regulations may relate quite directly to technological developments and the growing role of intangibles in the modern economy. For example, U.S. persons are increasingly engaging in joint ventures in which intangibles play a major role and U.S. companies frequently provide intangibles to international joint ventures. If the transferred property is an intangible, section 367(d) may apply to treat the U.S. transferor as having licensed the intangible property to a related foreign corporation in exchange for an arm's length royalty. In addition, sections 863(d) and (e) provide source rules for income arising from space and certain ocean activities and international telecommunications. Regulations have not been issued under either subsection. Treasury invites comments with respect to the relationship between the evolving issues described in this paper and these Code provisions and related interpretative guidance.
39. Sections 871, 881 and 882.
40. Sections 1 and 11.
41. Section 901 et seq.
42. Section 861(a)(4).
43. See section 861(a)(3).
44. See section 865, and Rev. Rul. 87-5, 1987-1 C.B. 180.
45. Sections 861 through 865.
46. Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong. 1st Sess, (May 7, 1987) at 917. [hereinafter 1986 Bluebook.]
47. Id.
48. Code section 863(e); See also, 1986 Bluebook, supra note 46, at 932.
49. Section 871(b) and 882(a); See also, section 864(c).
50. Section 871(a) and 881(a); See also, section 894.
51. Section 864(b).
52. The difficulties in determining whether a foreign person is engaged in a trade or business in the United States may be a reason to consider replacing the Code's U.S. trade or business concept with the permanent establishment concept found in both U.S. tax treaties and the domestic laws of many of our trading partners. Treasury invites comments on this issue.
53. See, Piedras Negras Broadcasting Co. v. United States, 43 B.T.A. 297 (1941) aff'd, 127 F.2d 260 (5th Cir. 1942).
54. United States Model Income Tax Convention of September 20, 1996, Article 5, paragraph 1 [hereinafter U.S. Model Tax Convention].
55. Model Tax Convention on Income and Capital, OECD Committee on Fiscal Affairs (1995), Commentary to Article 7, at paragraph 3 [hereinafter OECD Model Tax Convention].
56. U.S. Model Tax Convention, supra note 54, Article 5, paragraph 5.
57. See e.g. OECD Model Tax Convention, supra note 55, Commentary to Article 5, at paragraph 10 (circumstances under which a vending machine could constitute a permanent establishment).
58. See U.S. Model Tax Convention, supra note 54, Article 5, paragraph 4(a); OECD Model Convention, supra note 55, Article 5, paragraph 4(a).
59. Some very large-scale servers are colloquially referred to as "data warehouses." See e.g., L. Gomes, Let's Share, Wall Street Journal, Nov. 18, 1996, at R23.
60. U.S. Model Tax Convention, supra note 54, Article 5, paragraph 5.
61. Id. at Article 5, paragraph 6; See also, OECD Model Tax Convention, supra note 55, Article 5, paragraph 5.
62. OECD Model Tax Convention, supra note 55, Commentary to Article 5, at paragraph 23.
63. Id.
64. See section 3.2.5. supra.
65. See, section 861(a)(4) and sections 871(a)(1) and 881(a)(1); Compare, U.S. Model Tax Convention, supra note 54, Article 12.
66. Section 861(a)(4); Treas. Reg. 1.861-5.
67. U.S. Model Tax Convention, supra note 54, Article 12, paragraph 2.
68. Prop. Treas. Reg. §1.861-18, 61 Fed. Reg. 58, 152 (Nov. 13, 1996).
69. Prop. Treas. Reg. §1.861-18(b)(1).
70. "In the field of taxation, administrators of the laws, and the courts, are concerned with substance and realities and formal written documents are not rigidly binding." Helvering v. Lazarus & Co., 308 U.S. 252, 255 (1939). On the subject of computer program licenses, see generally, Rice, Licensing the Use of Computer Program Copies and the Copyright Act First Sale Doctrine, 30 Jurimetrics 157 (1990).
71. Prop. Treas. Reg. §1.861-18(h), Example 10.
72. See e.g., Karrer v. U.S., 152 F.Supp. 66 (Ct. Cl. 1957).
73. Compare sections 954(d) and 954(e).
74. See e.g. section 7701(e). (Factors for use in determining whether a transaction should properly be treated as a lease of property or the performance of services.)
75. See e.g. Rev. Proc. 71-21, 1971-2 C.B. 549. (Circumstances under which an accrual method taxpayer may defer the recognition of advance payments for the performance of services.)
76. See e.g. Treas. Reg. §1.451-5. (Circumstances under which an accrual method taxpayer may defer the recognition of advance payments for the sale or other disposition of goods held primarily for sale to customers in the ordinary course of a trade or business.)
77. Prop. Treas. Reg. §1.861-18(h), Example 12.
78. Prop. Treas. Reg. §1.861-18(h), Example 15.
79. Prop. Treas. Reg. §1.861-18(b)(2).
80. See PLR 9633005 (Aug. 19, 1996).
81. The fact patterns could be reversed with possibly different results. While the CD-ROM purchaser may make periodic payments and receive regular updates, the online service might charge an initial lump sum fee which includes updates. It may be necessary to consider whether this difference in payment mechanisms is relevant.
82. Sections 951-964.
83. M. Murphy, Cooling the Net Hype, Wired, Sept. 1996, at 86. ("Companies selling information over the Internet can call any place home, and the savvy ones are choosing jurisdictions with low or no taxes, financial privacy, governmental stability, and decent communications systems. (Warm water and sandy beaches are also a plus.)")
84. Section 861(a)(3); Section 862(a)(3).
85. OECD Model Tax Convention, supra note 55, Commentary to Article 15, at paragraph 1.
86. Section 954(e).
87. See, O. Suris, Behind the Wheel, Wall Street Journal, Nov. 18, 1996, at R14.
88. See, C. Levin and S. Rupley, Collaboration on Call, PC Magazine, Sept. 10, 1996, at 31; Will Habanero be the Next Big Thing?, Wall Street Journal, May 30, 1996, at B6.
89. Treas. Reg. §1.482-1 through -8.
90. Treas. Reg. §1.482-7. ("A cost sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement." Treas. Reg. §1.482-7(a)(1).)
91. Intl 070-90; See also, Notice 94-40; 1994-1 C.B. 351.
92. These developments also raise issues under the criminal provisions of the Internal Revenue Code, sections 7201-7344, and under the Bank Secrecy Act, 12 U.S.C. §§1829b, 1951- 1959, and 31 U.S.C.§§ 5311-5330. However, these issues are outside the scope of this study.
93. It may also be necessary to consider how section 6103, which provides rules governing confidentiality and disclosure of returns and return information, should apply in this context.
94. For example, if a taxpayer sells computer software imprinted on floppy disks, the taxpayer's purchases of blank disks could be used to approximate his gross sales. If the taxpayer sells the same software electronically, a copy is simply transmitted to the purchaser at the moment of sale and no such guidepost exists.
95. A Web site exists which allows the user to open an account with a bank in Antigua. The bank offers multi-currency current and time deposit accounts, numbered accounts, international wire transfers, portfolio management, and "tax protection." Bank secrecy is assured. Such accounts are, of course, subject to the reporting requirements for foreign financial accounts. See 31 C.F.R. §103.24.
96. See section 954 and Treas. Reg. §1.954-3.
97. See e.g., Digital Signatures Expected to be Necessary for Online Shopping, Interactive Marketing News, Sept. 13, 1996.
98. See e.g., http://www.verisign.com. The Postal Service is also testing an "Electronic Postmarking Service." 61 Fed. Reg. 42,219 (1996); See also, http://www.usps.org. The Federal Government has adopted a Digital Signature Standard (DSS), 59 Fed. Reg. 26,208 (1994), and a Secure Hash Standard (SHS), 58 Fed. Reg. 27,712 (1993).
99. For example, one digital signature provider offers three levels of certification. The simplest level verifies that a an e-mail message was sent from an indicated address. The next level verifies the digital ID holder through online identity verification against a consumer database. The highest level requires that the holder personally appear before a notary public to have a digital ID application notarized.
100. The theory of digital signatures is discussed in Chapter 4, supra.
101. Section 6001; See also, Notice 96-10, 96 - 7 I.R.B. 47 (electronic imaging of taxpayer records).
102. Public key encryption (as well as other encryption methods) also permits a taxpayer to encrypt his financial records to prevent their examination on audit. It would seem that this should be treated no differently from failing to keep or destroying paper records.
103. For example, one such system is based on a mathematical method called "one-way hashing" which creates a nearly unique "hash value" for each document, based on the arrangement of the characters and graphics elements within it. The hash value is generated using a "hash algorithm" which makes it easy to input the text of a document and generate a unique number, but it is virtually impossible to use the resulting hash value to recreate the original document. (In one system, there are 2228 possible hash values, while in contrast the Universe is estimated to contain 2280 molecules.) Therefore, it is virtually impossible to create a second document that would yield the same hash value. The hash value is transmitted electronically to a local server, which digitally time-stamps it and stores it. Any document's hash value can be re- calculated and compared with the original one. Since even the smallest change creates a different hash value, it can be determined whether a document's contents or time-stamp have been changed. See, http://www.surety.com.
104. See section 3.2.4, supra.
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