Draft Copy

INTERNATIONAL CONFERENCE ON ELECTRONIC

COMMERCE

ORGANISED BY

Infrastructure Leasing & Financial Services Limited

Global Information Infrastructure Commission

And

Confederation of Indian Industry

Tax Reforms to promote E-Commerce in

India
 Private & confidential

TABLE OF CONTENTS

I EXECUTIVE SUMMARY 3
II INTRODUCTION 5
2.01 The challenge posed by EC 5
2.02 Aspects of Internet Electronic Commerce relevant for Tax 5
Policy Makers
2.03 International Taxation – Treaty Law Regime 6
III INDIAN TAX LAWS 8
3.01 Direct Taxes 8
3.02 Indirect Taxes 9
IV ANALYSIS 11
4.01 Impact of EC on the Traditional Notions of Residence 11
4.02 Impact of EC on the definitions of PE 11
4.03 Impact of EC on the classification of Income 13
V THE INDIAN SCENARIO 15
5.01 Report of the Working Group 15
5.02 Illustrative Case Studies 16
VI THE CHALLENGE TO TRANSFER PRICING RULES 19
VII COMPARATIVE ANALYSIS OF POSITIONS ADOPTED BY 20
DIFFERENT COUNTRIES / AGENCIES
7.01 Australia 20
7.02 United States 20
7.03 United Kingdom 21
7.04 Canada 21
7.05 European Commission 22
7.06 OECD 22
VIII CONCLUSION 23

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 I : EXECUTIVE SUMMARY

The development of electronic commerce (EC) has revolutionised the way businesses
operate. It has also challenged the adequacy and fundamental validity of principles of
international taxation such as physical presence, place of establishment etc., that have formed
the basis for assessing tax liability.

With the advent of EC, even smaller corporations and individuals can aspire to have a global
presence. Correspondingly EC has also bridged the gap between developed and developing
countries. It has therefore become extremely essential to provide a legal and tax environment
that is conducive to the growth and development of these technologies.

This paper examines the implications of the growth of EC on domestic and international tax
systems. Considerable work on this subject has already been done by countries like U.S.,
U.K., Australia, Canada etc. They have identified the issues arising out of EC and have
attempted to lay down the fundamental principles of taxation of EC. Most countries have
advocated principles of neutrality, certainty, avoidance of double taxation and low
compliance cost. This paper has examined the positions taken by these countries and other
multilateral agencies like the Organization for Economic Co-operation and Development
(OECD) in order to identify the options available for Indian tax authorities.

A substantive issue raised by these technologies is identifying the country or countries, which
have the jurisdiction to tax such income. Whether a web server and an Internet Service
Provider (ISP) will constitute a Permanent Establishment (PE) or not are questions which
have been haunting policymakers.

The traditional concept of source-based taxation may lead to a global migration to low tax or
tax haven countries. Any attempt to artificially tax E-commerce will also accelerate such
migration. Therefore residence-based taxation is being advocated by many countries, with
the U.S. being one of its main proponents. However, determining residence itself is likely to
be problematic.

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Classification of income arising from transactions in digitized information, such as computer
programs, books, music, or images is also an issue that requires consideration. The distinction
between royalty, sale of goods, and services income must be refined in the light of the ease of
transmitting and reproducing digitized information.

Since the internet and global electronic commerce are going to revolutionize the way business
operates worldwide, the following recommendations may be considered by India while
formulating a tax policy for EC.

Recommendations:

(a) Existing taxation principles should not be changed in the short run. They may be
adapted to facilitate application to EC as it evolves.

(b) The levels and standards of identification of taxpayers applicable to conventional

commerce should also be applied to EC though different methods may be needed.

(c) Existing double tax treaty principles can continue to be applied, but their application
needs to be reviewed and clarified.

(d) The principles of neutrality, certainty, avoidance of double taxation and low
compliance cost should be kept in mind while formulating policies on EC.

(e) Modems, routers and other ancillary telecommunications equipment should not be
regarded as - PE as they do not form a significant part of the equipment carrying on
any business activity. Web server per se, should not be regarded as PE, especially
where it is used only for advertising or procurement of orders. ISPs should not be
regarded as agents and should not be deemed to constitute PE.

(f) The Indian states should commit to some form of moratorium to exempt EC from all
additional tariffs and taxes up to the year 2005.

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 II : INTRODUCTION

2.01 The challenge posed by Electronic Commerce : Today, tax administrations

throughout the world face the formidable task of protecting their revenue bases
without hindering the development of new technologies. The challenges posed to tax
systems worldwide by EC are real. Numerous governments and fiscal organizations
and institutions (e.g. the OECD) are focusing on how to address them in a spirit of
collective co-operation. The allocation of taxing rights must be based on mutually
agreed principles and a common understanding of how these principles should be
applied. In addition to the need for consensus between governments, a need for co-
operation between governments and business has also been identified.

2.02 Aspects of Internet Electronic Commerce relevant for Tax Policy Makers :
Changes in business practice due to the advent of EC will affect taxation in the
following ways:

(i) Lack of any user control as to the location of activity : As the physical
location of an activity becomes less important, it becomes more difficult to
determine where an activity is carried out, and hence the source of income.

(ii) No means of identification of users : In general, proof of identity

requirements for internet use is very weak. The pieces of an internet address
(or “domain-name”) only indicate who is responsible for maintaining that
name. It has no relationship to the computer or user corresponding to that
address or even where the machine is located.

(iii) Reduced use of information reporting and withholding institutions :

Traditionally taxing statutes have imposed reporting and withholding
requirements on financial institutions which are easy to identify. In contrast,
one of the great commercial advantages of EC is that it often eliminates the
need for intermediary institutions. The potential loss of these intermediary
functions poses a problem for the tax administration.

E-commerce raises various questions. For instance, whether international trading by

an enterprise through EC will result in the enterprise creating a taxable PE in the
other countries in which customers are located. The most important aspect here will
typically be whether the existence of a web site and server in a country where no
employees are located is sufficient to create a taxable PE. A related question would
be whether an Internet service provider can be considered to be a dependent agent?

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 Similarly, if an enterprise provides excess server capacity to another business to
operate a web site, is equipment (the webserver) considered to have been leased?

If it is determined that an enterprise does have a PE in another country, another

important issue then arises: How to attribute profits to the PE?

Secondly, EC gives rise to new issues concerning the characterization of payments

under double tax treaties. It is often difficult to distinguish whether payments for
activities such as searching a computer database and downloading a document
represent payment for the sale or lease of property, payment for the provision of
services, or royalty payments. If double tax treaties strictly follow the OECD model
tax convention, the distinction may have little importance as taxing rights will be
allocated to the country of residence of the enterprise unless it has a PE in the other
country.

Moreover, though EC does not give rise to any fundamentally new issues relating to
transfer pricing, there may be some difficulties in applying traditional transaction
methods, establishing comparability, deciding the tax treatment of integrated
businesses and complying with documentation and information reporting
requirements.

2.03 International Taxation - Treaty Law Regime :

(a) Fundamental Principles : A taxpayer is generally taxed on its worldwide

income in the country of its residence (‘residence based taxation’). In the
case of a company, this is usually the place where the company is
incorporated, registered, or has its place of central management and control.
Where dual residence results from the application of domestic criteria, the
tax treaty tie-breaking rule is applied and the place of effective management
is decisive.

The company may also be taxed in another country if it has a recognized

source of income there (‘source based taxation’). Generally tax treaties
restrict the use of domestic source rules by requiring a certain minimum
nexus to allow taxation in that jurisdiction. Thus, taxation of business
income on the basis of the source rule requires the presence, in the country
of source, of a PE of the enterprise sought to be taxed. The country of source
also taxes income from immovable property, gains from alienation of such
property, income from activities of artists and sportsmen, director’s fees etc.
Where there is no physical presence, source country taxation is generally

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 only allowed in the form of withholding taxes on certain items of income,
such as royalties, interest and fees for technical services, etc.

Where the income or capital is taxed in the country of source, the country of
residence has the obligation to give relief from double taxation. Such relief
is granted either by exempting such income from taxation in the country of
residence or by giving credit for taxes paid in the source country.

(b) Permanent Establishment : Under the tax treaties1 based on the OECD
Model Tax Convention (OECD MC), an enterprise providing services
abroad is taxable in the country where it conducts business only if it has a
PE there. According to Article 5 para.1 of the OECD-MC, a PE presupposes
‘a fixed place of business’ (the basic rule PE) which may include premises,
facilities or installations. The characteristic ‘fixed’ demands a specific fixed
long-term connection between the place of business and a specific part of the
earth’s surface. This test excludes places of business that are mobile.

Secondly, if the services provided are part of a construction or installation

project that lasts for more than a particular period of time, a PE may be
constituted under article 5(3) i.e. construction PE. Thus, even if the
conditions for a basic rule PE are not met (e.g. lack of a fixed place of
business), a PE may still exist under the construction clause.

The third element for a PE is article 5(5) and (6) under which an ‘agency
PE’ may be constituted. This is the case if a provider of services in a country
has a dependent agent there who involves his principal in business by
regularly concluding contracts on behalf of the principal.

1
When reference is made to ‘tax treaties’ it means the treaties based on the latest OECD model treaty.

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 III : INDIAN TAX LAWS

3.01 Direct Taxes :

Indian residents are taxed on their worldwide income. Non-residents are taxed on
their Indian-source income.

(a) Residence: A company is considered resident in India in any previous year,

if it is an Indian Company; or during that year, the control and management
of its affairs is situated wholly in India2. Every Indian company is deemed to
be resident in India even if its control and management is situated wholly or
partly abroad, while a non-Indian company is deemed to be resident only if
its control and management is situated wholly in India. Thus, most foreign
companies fall under the non-resident category.

(b) The Source Rule in India : Section 9 of the Income Tax Act, 1961 (ITA)
specifies various types of income which would be regarded as deemed to
accrue or arise in India and therefore become taxable in India. The income is
covered under this section when it is not chargeable on the basis of its
receipt. This principle is applicable to both residents as well as non-
residents.

Any income, though directly or indirectly, which is derived through or from

• any property in India, or

• business connection in India, or
• any asset or source of income in India, or
• transfer of a capital asset situated in India,

is deemed to accrue or arise in India.

However, in case of a business of which not all operations are carried out in
India, only such part of income as is attributable to Indian operations would
be regarded as income accrued or arisen in India.

Business connection : The expression ‘business connection’ has a wide but

uncertain meaning. It has no precise definition. A business connection
involves a relation between a business carried on by a non-resident which
yields profits or gains and some activity in India, which contributes directly

2
Section 6(3) of the Income Tax Act, 1961.

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 or indirectly to the earning of those profits or gains. Thus, to establish a
business connection, there should exist an element of continuity between the
business of the non-resident and the activity in India. The concept of
‘business connection’ is similar to but much wider in meaning as compared
to PE.

If it were established that a non-resident has a business connection in India,

then his income would be subject to Indian taxation under section 9 of the
ITA. However, the tax would apply only on such income which is
attributable to business in India.

Royalty / Fee for technical services : Section 9(vi) of the ITA deals with the
source rule in respect of royalty income. Royalty income is deemed to
accrue or arise in India if it is paid either by a resident or a non-resident in
respect of any right, property, information or services utilized for carrying
on a business in India. Similarly, Section 9(1) (vii) lays down the source
rule in respect of fees for technical services. Once again, such fees is
deemed to accrue or arise in India if it is paid either by a resident or a non-
resident in respect of any services utilized for carrying on a business in
India.

(c) Withholding provisions : Any person responsible for making any payment to
a non-resident of a sum chargeable to tax in India, is required to deduct
income-tax at source. This can be done at the time of credit of such income
to the account of the payee or at the time of payment, whichever is earlier3.

(d) The Treaty - Domestic Law Interface : Section 90 (2) of the ITA provides
that Act will apply to an assessee only to the extent that it is more beneficial
to the assessee as compared to the relevant Double Taxation Avoidance
Agreement (DTAA). In the case of a conflict, the more beneficial provision
will prevail.

3.02 Indirect Taxes :

(a) Sales Tax : In India, sales tax is levied by the respective states under the
state Sales Tax laws and also by the centre under the Central Sales Tax Act,
1956. A state levies sales tax on the sales that take place inside the state.
Sales in the course of inter-state trade and commerce are taxed by the centre
under the Central Sales Tax Act, 1956. The state from which movement of

3
Section 195 of the ITA.

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 goods commences collects these taxes on behalf of the centre and retains the
proceeds of the taxes. Where the sale takes place in the course of import into
India, or export out of India, no tax is leviable under the Central Sales Tax
Act or the state Sales Tax Laws.

The specific issue that EC would give rise to is situs of a sale. In the case of
corporeal or tangible goods, which are specific or ascertained, their sale is
deemed to take place in the state in which they are at the time the contract of
sale is made. In the case of unascertained or future goods, the sale is
deemed to take place in the state in which the goods are at the time of their
appropriation to the contract of sale by the seller or by the buyer (Section 4
(2) of the Central Sales Tax). Therefore, the time of conclusion of the
contract is of critical importance to the question of situs. The issues in
respect of time of conclusion are addressed in the paper titled “Legal and
Policy Framework for e-commerce in India”. The situs of intangibles
depends on where the contract of sale can be said to be concluded. Such
sales cannot be in the course of inter-state trade or commerce or in the
course of import or export as there is no movement of goods from one state
to another or from one country to another. The issues in respect of the place
of contract have been discussed in “Legal and Policy Framework for e-
commerce in India”.

(b) Customs Duties : The only significant change introduced by e-commerce

would be taxation on the on-line transfer of goods. Where the transaction is
concluded on-line, and the goods are delivered physically, there is no issue
regarding the tracing and taxation of such transactions. However, when the
goods are delivered on-line, tracing of the delivery of such goods for the
imposition of tax continues to be a significant issue facing tax authorities,
and remains to be sorted out. The present taxation regime is not wholly
equipped to face such challenges and is dependant on voluntary disclosures
by the persons engaged in these transactions.

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 IV : ANALYSIS

4.01 Impact of EC on the Traditional Notions of Residence : As it stands today, in the

context of international EC activities on the internet, residence-based taxation
currently is more important than source-based taxation. The US Treasury Paper
mentions ‘… transactions in cyberspace are likely to accelerate the trend to de-
emphasize traditional concepts of source-based taxation, increasing the importance
of residence-based taxation’.

If the focus is towards a residence-based taxation, the question that emerges is

whether the traditional residency concepts can be applied to EC without amendment.

(a) Concepts of Residence : A globalized company will mean one with

management scattered around the globe, communicating by telephone, fax,
e-mail or video conferencing. It would be difficult to confine the result of
such management to one location. In the case of management elements
scattered over more than one jurisdiction, under the traditional residency
concept, one of those locations has to be nominated as the main management
location. Under those concepts, it should be investigated whether the other
locations are to be considered PEs. The issue of how to allocate global profit
would then arise.

More concrete criteria for the determination of the main place of effective
management may need to be developed. Consideration could be given to
applying additional tiebreaker rules, similar to those applicable for private
individuals. If the place of effective management cannot be determined, one
could consider more of the mentioned criteria and determine whether there is
one place to which the majority of these criteria point. If that would not lead
to a clear conclusion, more formal criteria may be applied as the final
tiebreaker. It may be that in the case of truly global companies, the
incorporation criterion may be the only available clear criterion.

4.02 Impact of EC on the definitions of PE :

The common issues that may arise in the context of application of the
existing definitions of PE to EC transactions may be as follows:

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 (a) Will a server constitute a PE? : Does a web server located in a jurisdiction
other than the country of residence of the person owing or controlling such a
server, form a PE?

This issue can be analyzed under four sets of circumstances :

(i) where the server is used merely for advertising

(ii) where the server is used for advertising and taking orders
(iii) where the server is used for advertising, taking orders and accepting
payments; and
(iv) where the server is used for advertising taking orders and accepting
payments and for digitized delivery of goods

In the first case, a server will not be held to be PE. Exception 5(4) (a) of the
OECD MC will be attracted in this case where the use of a facility solely for
the purpose of storage, display or delivery of goods or merchandise
belonging to the enterprise will not amount to the existence of a PE. It could
also be exempt under Article 5(4) (e) of the OECD MC, which exempts the
maintenance of a fixed place of business solely for the purpose of carrying
on, for the enterprise, any activity of a preparatory or auxiliary character
from the ambit of PE. In the second and the third case, it may possibly be
held that the server is a PE. In the last case, there is an even stronger case to
hold the server to be a PE. However, an attempt to tax the server as PE will
not serve any purpose as it is very easy to shift the server to a tax haven or to
a low tax country. Further, difficulties will arise where a number of mirror
web sites on different servers located in different countries are used so that a
customer could be directed to any one of these sites.

(b) Does the presence of communication channels constitute a PE? : The

German Supreme Tax Court has ruled that a Dutch Corporation that supplied
oil and oil products thought underground pipelines in Germany constituted a
German PE for the purpose of German Net Worth Tax Act. German oil
companies maintained delivery stations that supplied the companies with oil.
The necessary oil pressure for transportation of the oil was supplied in the
Netherlands. The Dutch company had no employees in Germany.
Independent contractors did all maintenance and repairs of the pipelines in
Germany. The court held that fully automated equipment would constitute a
PE4. However, this case was based on the old Germany-Netherlands treaty,

4
The Pipeline Decision, European Taxation, Feb, 1999, 67.

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 which had presence of an asset as one of the PE tests. Such a test does not
exist in the new Germany-Netherlands treaty.

A related question is that of the passive use of an asset for operational

reasons. The European Court of Justice had occasion to consider whether
such use would amount to a PE in a judgement of July 4, 19855. The
European Court held that the definition of a fixed place of business
presupposes both physical resources as well as personnel who assist the
entrepreneur in the use and implementation of the physical resources. The
court stated that a fixed place of business can be a piece of equipment (such
as a vending machine), but subject to the proviso that it is permanently
installed at a specific location and that it requires the employment of human
energy for its operation.

The commentary on the OECD-MC has also discussed entrepreneurial

activities existing in the operation of automatic equipment, for e.g., vending
machines. The mere setting up of the machines for lease to an operator does
not constitute a PE. However, if the machines are operated by the enterprise
itself or by a dependent agent for its own account, then a PE can be assumed.
The assumption of a PE does presuppose that employees or dependent
agents must carry on a business in the country of source.

(c) Can the services of an ISP constitute a PE? : The ISP merely acts as an
intermediary between a non-resident seller and the customers in the source
country. Therefore, the ISP will not qualify as the agent of the non-resident
seller. Since the ISP acts on behalf of several web site owners, even if it is
treated as an agent, it would be an independent agent and not a dependant
agent. Therefore, it will not constitute a PE. Even if it acts for only one web
site owner, it does not have the authority to conclude contracts on behalf of
the web site owner, which is an essential pre-requisite before it can be
considered to be the owner’s PE.

4.03 Impact of EC on the classification of income :

Owing to developments in technology, it is possible to sell books, music, software,

etc. electronically as well as physically. This raises significant issues of
classification of income. It is possible to view these transactions in terms of the sale
of the said items or, as permission for the use of royalty. In case of the former, the
income earned will amount to business income and the country of source cannot tax

5
Judgements of the European Tax Court 1985, p. 2251 Berkholz case168/84

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the same in the absence of a PE of the seller. In the latter case, the income will be
royalty and taxable even in the absence of a PE.

While analyzing the transactions involving digitized information, the US Treasury

report suggests that the form of transaction may have to be disregarded. For
example, where computer software is sold on internet with a right to make a copy,
mere right to copy may be disregarded in view of the ease with which number of
copies can be made. However, if such a right to make copies is accompanied by a
right to sell to public, royalty will arise. While analyzing a service transaction, its
predominant characteristics have to be considered, to determine where the services
will be taxable.

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 V : THE INDIAN SCENARIO

5.01 Report of the Working Group :

(a) Background : The Income Tax Department in India had set up a working
group to examine the tax implications of EC transactions. The Group was
set up by Mr. V.M. Muthuramalingam, the then Chief Commissioner of
Income Tax, Mumbai and has recently submitted its report. Its
recommendations have not yet been implemented and a formal stand is yet
to be taken. The report has concluded from its study that the existing tax
laws are inadequate to cover EC transactions and has suggested that the Tax
Planing and Legislation (TPL) section of the Central Board of Direct Taxes
undertake a study on the issues arising out of taxation of EC transactions.

(b) PE : The report also states that a computer terminal used to receive and send
information across national boundaries, should be regarded as PE. The same
has been said of the web site used in EC. No reasons are given in support of
this stand. It also considered the imposition of a presumptive tax in the form
of a fixed portion of billings or a “bit” tax. However, this approach was
dismissed as being too simplistic. The report also considers a home page on
a web site, observing that it is analogous to an advertisement in a magazine.
No tax implications can be said to arise on the placing of advertisements on
the Net under the existing laws. However, a view can be taken that when the
seller’s home page is downloaded on the user’s computer, a fixed place of
business is created at that physical site. If the webpage is downloaded often
enough, the activity may be considered regular enough for it to be treated as
a fixed place of business. However, as Article 5 stands today, requirements
of a place of business in physical space at a particular geographical location
would not permit such an interpretation

(c) Sale of software : In the case of sale of software through internet, the report
notes, it will be necessary to examine whether supply of software was an
isolated transaction or whether there is an element of continuity involved.
This can be an indication of the presence of a business connection. However,
to conform to the requirements of a business connection, there should be a
real and intimate connection and commonness of interest between the
trading activity carried on outside India and the trading activity carried on
inside India. The commonness of interest may be by way of management
control or financial control or by way of sharing of profits. Further, mere
purchases from abroad on principal to principal basis do not establish a

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 business connection. In case of a sale transaction over the Internet, the
transaction shall primarily be one that can be regarded as being on principal
to principal basis and in that case, there would be no business connection.
The report also examines the case of an Indian software vendor obtaining
software on the Internet from a foreign software vendor selling the same to
Indian buyers and remitting a mutually agreed amount of the sale proceeds
to the foreign vendor. In such a case, since no activity is carried out by the
foreign vendor in India, apart from transmitting the software to India from
abroad, no portion of the remittance can be brought to tax in India under
Section 9.

(d) Detection : The report also suggests the formation of an international

organization to detect any transaction on the Internet. The Articles on
‘Mutual Agreement Procedures’ and ‘Exchange of Information’ can also
form the basis of a system of dissemination of the information on Internet
Transactions to the Competent Authorities in various countries.

(e) Tax jurisdiction : Another suggestion examined is the imposition of a tax on

the person who gets the receipts and which have resulted in the creation of
assets in the form of movable / immovable property. The identification of
such property could also be undertaken by the International Organization to
be set up as per the preceding paragraphs. The jurisdiction to tax could be
assigned to the country of the person receiving such payments. The sharing
of tax proceeds could be in the form of a new Article in the Double Tax
Avoidance Agreements.

5.02 Illustrative Case Studies :

In India, the tax department has identified electronic transactions carried on by

MNCs, such as credit card and airline reservations businesses, as a major source of
revenue. A perusal of taxation of the CRS activities in India will prove to be a useful
case study for the purpose of this analysis. This case will bring about clearly, some of
the issues regarding the challenges posed to the prevalent definitions of PE by EC.

(a) Taxation of CRS companies :

The CRS companies facilitate the global reservation of air tickets by travel
agents world over. The business of the CRS companies is to make airline
reservations on behalf of the participating airlines that enter into contractual
relationships with the CRS company. For this purpose, the CRS company
uses the “CRS Host System’ located in Country A, a country outside India
which may or may not be the country of residence of the CRS company. The

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 participating airlines provide the necessary information, which is displayed
to the travel agents throughout the world so that they can guide their
customers who make the necessary requests through the CRS system.
The stepwise transaction is explained in the following diagram:

Country B Country A India

AT&T Router
Network VSNL
Network owned
by the
CRS co.
Router
owned by
the CRS
company
Travel
Agents
Airline
CRS
Host
Host

SITA SITA
Network Network

The Indian income tax authorities have sought to tax the booking fees which
have originated in India as income of the CRS companies accruing and
arising in India. This has been justified on the ground that the presence in
India of the routers owned by the CRS companies will constitute a PE of the
CRS companies in India. Therefore, the booking fees are taxable as the
business income of the CRS companies in India

This is a very bold attempt to tax EC. The position adopted by the Income
Tax Authorities can be countered on the ground that mere presence of
routers should not constitute a PE. As is clear from the definition of PE
above, the mere presence of equipment will not constitute a PE unless some
business activity is carried on through the equipment. In addition, the routers
do not form a significant part of the equipment used for conducting the
business. Whatever activity is carried out through the routers is auxiliary in
nature and therefore may not constitute a PE. However, CRS companies
have tightened their belts for a long legal battle. Also, some of the CRS
companies are invoking the Mutual Agreement Procedure under the DTAA.

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 (b) Advance Ruling on the taxation of Credit Card Companies in India:
The Indian Authority for Advance Ruling (AAR) recently delivered an
important advance ruling6 on the taxability of income of foreign companies
engaged in the operation of credit cards and travelers’ cheques. The
payments made by the Indian company for accessing the foreign company’s
computer system in the USA has been held to be royalty income and
therefore taxable in India.

The Indian company in this case was a subsidiary company of a US

subsidiary of the Applicant US company. The central processing unit (CPU)
of the applicant in the USA had its own software and was operated by its
own personnel in the USA. The Indian company was retrieving the
processed data of its customers from the CPU and making payments to the
Applicant for gaining access to the data and use of the computer system. The
software used in the CPU was that of the Applicant who had in turn allowed
the Indian company to use it.

AAR held the following to be the main ingredients for characterizing any
payment as royalty payment:
1. It is a payment made in return for a right to exercise a beneficial
privilege or right.
2. The payment is made to the person who owns the right.
3. The consideration payable is determined on the basis of the amount
of use.

In the instant case, it was held that these tests cover the charges payable by
the Indian company to the Applicant Company. On facts, it was held that
the Indian company utilizes the CPU of the applicant as equipment. Also,
the Applicant Company specifically developed the software used under the
agreement entered into between the two. The software is customized and
kept secret. The facilities provided by the Applicant to the Indian company
are in the nature of online analytical data processing. In light of these facts it
was held that the payment had been received as “consideration for use of, or
the right to use the design or model, plan, secret formula or process…”
within the meaning of the term ‘royalties’ in article 12(3)(a) of the DTAA
and therefore, would be taxable at the rate of 20% for the first five years
from the date of the DTAA coming into effect and thereafter at the rate of
15%.

6
This ruling has not been published yet.

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 VI : THE CHALLENGE TO TRANSFER PRICING RULES

New businesses focussing on electronic products or the electronic provision of services

(software development, electronic books, newspapers, distribution of music, database
services, electronic banking, securities trading, internet services, consultancy services,
entertainment, betting and lottery services), can be easily moved around. A sales and
distribution company could be set up in a convenient low tax location. Assuming the effective
management of this company is really located there, in the absence of new source rules there
is little tax authorities can do to tax these profits. The moment at which they can tax the
proceeds of such a product, idea or concept is the moment the author or developer of the
product transfers it to the sales and distribution company. This is a transfer pricing issue.

Under the current European transfer pricing rules, the value of the product, idea or concept
will have to be estimated at the moment of the transfer and the tax will be due at that moment.
Normally this price is not influenced by the actual proceeds of the future sales. The authors or
developers of the product, idea or concept, realize their profit at the moment of transfer and
any further profits are then for the risk and account of the sales company.

The key issue in this type of situation is whether the exploitation and distribution company is
really resident, in the sense of effectively controlled and managed, in the low tax jurisdiction.
If it is properly set up, the exploitation and distribution function in reality could be totally
independent from the development phase, so that the challenge could prove to be difficult.
Therefore this situation has triggered discussion for a new source-based criteria. In the Indian
context, transfer pricing is not yet a big issue. However, it is soon likely to follow and hence,
the need for discussion on the subject.

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 VII : COMPARATIVE ANALYSIS OF POSITIONS ADOPTED BY DIFFERENT
COUNTRIES/AGENCIES

This section discusses the positions adopted by different countries and a comparative analysis
of the same:

7.01 Australia: The Australian Taxation Office’s (ATO) position is that use of Internet
for delivery is no different from physical delivery from the sales tax perspective.
Availability of audit trail is crucial for adequacy of existing law. In the absence of
audit trail, it would be very difficult to identify the parties executing an EC
transaction and to ensure tax compliance and tax collection. Cryptography has a lot
of potential in maintaining security and assisting in setting up audit trail. The
following recommendations were made by the ATO:

• ATO should use Internet to hold and collect information and records of tax
payers;
• Internet should be used for collection of transaction tax;
• ATO should work with the OECD to limit influence of tax havens on EC;
• Multilateral co-operation is a must to access audit trails for payments for EC
transactions;
• One should be sensitive to the nascent EC industry; and
• Webshops should be licensed.

7.02 United States: The U.S. Department of Treasury has published a report titled
“Selected Tax Policy Implications of Global Electronic Commerce” 7as far back as in
November 1996. The US treasury has not considered any type of value-added tax
(VAT), ‘bit tax’ or other new excise tax on EC and defines EC as “the ability to
perform transactions involving the exchange of goods or services between two or
more parties using electronic tools and techniques.”

It has followed the fundamental principles of neutrality, fairness and simplicity.

As per the report, neutrality requires that the tax system treat economically similar
income equally.

Source-based taxation could lose its rationale and be rendered obsolete by EC. All
taxpayers, however, are likely to be resident in some country. The U.S. tax policy has
already recognized that as traditional source principles lose their significance,

7
http://www.ustreas.gov

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 residence-based taxation can step in and take their place. However, the definition of
residence may need to be reviewed. This is because in case of a corporation, where
residence is established, where central control and management of the corporation
lies, EC may pose some problem.

The United States Framework for Global Electronic Commerce states that “The
Internet should be declared a tariff-free environment whenever it is used to deliver
products or services”. The U.S. has introduced Internet Tax Freedom Act (ITFA),
which lays a moratorium up to year 2005 on internal taxes by states on Internet. The
U.S. senator Bob Smith had proposed that the moratorium on the imposition of taxes
on the Internet should be made permanent.

The ITFA also provides that no taxes should be imposed on ISPs and the WTO and
other multilateral agreements should ensure that none of the countries tax Internet
transactions. Acting through WTO, 39 nations signed a global pact on March 26,
1997 in Geneva to free the $ 500 billion Information Technology trade from virtually
all tariffs by the year 2000. India is a signatory to WTO and has already started
moving towards this by reducing tariffs on IT products.

7.03 United Kingdom: The United Kingdom Inland Revenue and HM Customs and
Excise issued a joint paper on UK tax policy on EC on October 6, 1998. It states that
the taxation principles that the U.K. will follow include neutrality, certainty,
effectiveness and efficiency. The aim should be for tax rules and tax compliance to
be neutral between EC and more traditional forms of commerce. According to this
report, current taxes are sufficiently robust to mean that at this stage, it is not
necessary to make any major changes to existing tax rules. However, some changes
may be required to ensure the effective and consistent operation of VAT systems. It
also states that international co-operation between revenue authorities is essential.

7.04 Canada: “Electronic Commerce and Canada’s Tax Administration – A Report to the
Minister of National Revenue Commerce” was released in April 1998. In general, the
Committee recommends that Canada’s tax policy should be neutral, equitable,
efficient and easy to administer, and that it should avoid multiple taxation.

The committee rejects a bit tax on the ground that such tax will be an impediment to
the growth of EC. It recommends against the adoption of a global formulary
appointment system. It feels that the existing tax legislation is capable of
encompassing EC.

7.05 European Commission: The European Commission has presented an electronic

commerce directive to ensure that Internet trade enjoys all the common market

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 guarantees, such as free movement of services and freedom of establishment, that are
enjoyed by other forms of commerce8. The directive proposes to define the place of
establishment as the place where an operator actually pursues an economic activity
through a fixed establishment, irrespective of where web sites or servers are situated
or where the operator may have a mailbox.

7.06 OECD: The OECD through its Committee of Fiscal Affairs (‘CFA’) has undertaken
a lot of work to develop a co-ordinated international approach to address the tax
issues in EC. The CFA had organized two conferences in Finland in November 1997
and in Canada on October 1998 to discuss these issues.

CFA, which is the main tax policy body of OECD, has published a paper titled
“Electronic Commerce: The Challenges to Tax Authorities and Tax payers” for an
informal round table discussion between business and Government in Finland, on
November 18, 1997. It summarizes that Governments will need to develop a
common approach on how to respond to challenges posed to tax systems by the
Internet and global EC.

The committee emphasizes that maintaining an international consensus is the key to

enabling the Internet to develop to its full capacity and at the same time enabling tax
authorities to protect their revenue base.

8
1999 WTD 6-27 TNI citation – IP/98/999 (November 18, 1998)

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 VIII CONCLUSION

8.01 A common sub-set of international tax principles emerges on comparison of the tax
policies announced by various countries and agencies. These principles are:
neutrality, fairness, efficiency, certainty, avoidance of double taxation, simplicity of
compliance and international consensus. Most countries have adopted the strategy of
wait and watch. They want to see how EC evolves and what are its full ramifications,
before coming forward to tax it. Most countries have also taken the stand that the
existing tax laws should be adapted and applied to EC to the extent possible.
Changes should be considered only under inevitable circumstances. There is also
recognition of the need for co-operation and common policy for taxation of Internet.
On the PE concept, the consensus seems to be that a web server should not be
regarded as a PE per se, especially where it is used only for advertising and soliciting
orders. Routers and switches should not be regarded as PE as they are not significant
parts of assets performing business activity. Internet service providers should also not
be regarded as agents.

8.02 Only payments for the use of non-standardized software or for specific know-how
should be classified as royalty payments. Although some countries may try to extend
the scope of this type of taxation, current Internet activities may not qualify for
taxation on this basis.

8.03 In India, the tax authorities have come up with some sort of presumptive tax
mechanism relating to the taxation of foreign telecasting companies. The Report of
the Working Group has in fact considered the imposition of such a presumptive tax
on EC activities in India. However, the application of such tax may generate various
problems not merely on the international tax front regarding incompatibility with
existing tax practices but also in its administration. How much tax should be charged,
how to collect tax, how to assess taxable income etc. are some of the questions that
need to be addressed.

8.04 EC has rendered geographical boundaries redundant and converted the world into a
global village. The development of EC must not be interrupted by procedural and
administrative hurdles. Of particular importance is the avoidance of discord among
nations on sharing the proceeds of taxation of EC transactions. Nations must make a
coordinated effort to evolve principles of taxation of these activities through a body
comprising of representatives of all nations.

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