Carving Taxes Out of the Information Highway - PricewaterhouseCoopers LLP

Cybertax, information highway, electronic commerce, new millennium, global economy - what does all this mean to your business? What will be the tax cost of the new way you are conducting business? What are the risks and opportunities?

Electronic commerce is changing the way the world is conducting business. Tax administrations around the world and the Organisation for Economic Co-operation and Development (OECD) have embarked upon a review of their fiscal policies and collection procedures in contemplation of the likely effect of these changes.

Canada's Personal Information Protection and Electronic Documents Act (Bill C-54) is currently before Parliament. It establishes a framework for privacy protection that will cover all commercial activities conducted on the Internet and sets rules for the use of electronic documents, including the practical development and implementation of secure electronic signatures.

On the US legislative front the Internet Tax Freedom Act was signed as part of the October 21, 1998 omnibus appropriations bill. The legislation imposes a three-year moratorium on state and local taxes on Internet access fees charged by Internet service providers and on "multiple" or "discriminatory" taxes on electronic commerce. The legislation also grants states that currently have taxes on Internet access that are generally imposed and actually enforced as of October 1, 1998, the right to continue to levy these taxes.

Until recently, electronic commerce referred primarily to electronic data interchange (EDI) offerings and electronic messaging technologies that facilitated the exchange of information between businesses and organizations. During the past two years, the term "electronic commerce" has broadened to encompass business-to-business and business-to-consumer transactions conducted over the Internet and the World Wide Web. The Internet and Web browsers have created an easy-to-use, standardized infrastructure for conducting business and have made new products and ways of conducting business possible. The use of electronic commerce for business transactions is expected to grow dramatically over the next several years, fuelled by the availability of sophisticated Internet and Web technology and tighter security mechanisms.

The repercussions are significant. The adequacy of tax systems is being brought into question. Existing legislation must be interpreted in today's electronic age in a consistent and predictable manner. Concerns arise because tax legislation and tax treaties were drafted when the presence of bricks and mortar were necessary to conduct business. New technologies significantly reduce the need for a physical presence in a jurisdiction, and reduce the number of intermediaries needed to complete a transaction. The pace of change will only heighten, creating further issues, risks and opportunities.

In a global economy, the issues are complex, spanning a multitude of taxing regimes, philosophies and cultures. Nevertheless, a consensus is starting to emerge on some broad principles:

  • Tax neutrality: Any changes should provide for different taxpayers to be taxed in the same manner when entering into similar transactions in similar situations.
  • Retention of existing principles: For the moment, suggestions that a unique basis of taxation be developed to tax electronic commerce have been rejected. For example, a "bit tax" on the number of bits transmitted and the use of formulae to allocate income among jurisdictions have been advanced. To varying degrees, most countries that have taken a position want existing tax principles to be retained and adapted, if necessary, to deal with electronic commerce.
  • Cooperation and consensus are essential: Given the global reach of electronic business, countries recognize that a particular jurisdiction cannot make unilateral changes without hurting their residents and their tax bases. A consensus is being sought on how to adapt existing principles.


A number of characteristics of electronic commerce affect how business is conducted and the interpretation of existing tax principles. For example:

  • Electronic commerce facilitates international trade and cross-border cooperation within an organization, as well as joint ventures between businesses. Consider, for example, the collaborative development of software by a team of engineers located in Canada and other countries. Barriers of entry are significantly reduced, resulting in an increase in the number of international transactions, most notably among small- and medium-sized businesses with lower-value transactions.
  • Products that have been sold in physical form can now be sold in digital form from computer to computer. These include software, music, videos, books and other written material. The transformation of physical goods to digital versions raises issues with respect to the characterization of income and the appropriate tax treatment for domestic, international and sales and customs purposes. Compliance and documentation issues also arise.
  • Access to new technologies may also reduce the number of intermediaries in a given transaction, an effect known as "disintermediation." For example, shrink-wrapped software sold through traditional distribution channels (developer(r)manufacturer(r) wholesaler(r)retailer(r)consumer) may now be sold directly from the developer to the consumer via the Internet.

Disintermediation raises important concerns, because intermediaries have traditionally acted as tax collectors and provided tax authorities with an audit trail. In addition, the lack of intermediaries may erode a local tax base, especially for a jurisdiction that is a net importer of goods and services transacted electronically. On the other hand, the tax base of a country that is a net exporter likely would not suffer, and may even expand. Clearly, there are competing interests among governments.

There is no necessary relationship between an Internet address or a Web site, the residence of a party or its physical location. Such anonymity may make it difficult to determine which tax treaty applies to a given transaction and has governments concerned about intentional non-reporting of transactions.


Just as electronic commerce is clearly a global issue, so are the tax issues raised by conducting business electronically. Until an international consensus emerges, there will be a risk of incompatible treatment of revenue derived from electronic commerce when more than one jurisdiction is involved.

Underlying all the issues that are discussed below is one of today's greatest concerns for governments: transfer pricing. Although transfer pricing issues that must be considered in the context of electronic commerce are not new, they are particularly complex. For example, the creation, ownership, valuation and transfer pricing methods relating to intangibles raise difficult issues for businesses transacting globally. The use of a branch or a subsidiary can have vastly different results when intangibles are involved.


Canadian taxpayers that transact electronically across borders face these issues:

  • With the emergence of a computer server and Web site as vehicles for conducting business, the level of activity necessary to constitute a permanent establishment, and thus be subject to income tax, is uncertain. Various US states, in particular, have taken a rather aggressive stance in this regard.
  • When income derived from electronic commerce is considered business income by Canada, but subject to withholding taxes in a foreign jurisdiction, the current foreign tax credit mechanism fails to provide adequate relief.

Canadian withholding obligations also need to be considered, as Canadians increasingly make payments to non-residents with respect to electronic commerce. These withholding requirements apply to payments to non-residents for services rendered in Canada (raising issues such as where a service is performed and whether a Canadian recipient will even know the residency of a service provider over the Internet) and for information, licenses and sales of digitized products.

One way to view business conducted electronically is that only the method of delivery is changing, not the purchaser's underlying rights. The delivery of a product by land, sea or air does not affect its taxation; why should the purchase of a digital product be taxed differently from the purchase of a physical newspaper or CD-ROM, if in both cases the purchaser effectively obtains the same bundle of rights?

Canadians that conduct business through controlled foreign affiliates must be alert to the possibility that income earned by those affiliates may be considered foreign accrual property income (FAPI). FAPI is generally passive income from property, as opposed to income from an active business. FAPI is subject to immediate taxation in Canada, with compensation for foreign tax paid by the controlled foreign affiliate. Issues include:

  • To the extent that processes become more and more automated, activities that once were considered the carrying on of business now might be considered to give rise to FAPI.
  • Many companies within an international organization will likely be earning royalty and similar income. These types of income are generally considered passive, and are subject to the FAPI rules unless earned by the originator of the intellectual property.
  • The FAPI rules also have a number of provisions that deem active business income to be FAPI. Depending on how these provisions are interpreted, electronic business has the potential of changing the nature and character of income generated by controlled foreign affiliates. Given that the FAPI regime was developed in a pre-electronic era of physical goods and traditional services, previous interpretations may no longer be appropriate.


Non-residents transacting electronically with Canadians will have to consider whether their activities constitute carrying on a business in Canada which, subject to treaty protection, would make the non-resident taxable in Canada. Issues include:

  • Could viewing a non-resident's Web page from a computer located in Canada constitute carrying on business? Although it is generally agreed that such activity alone should not constitute carrying on business, the degree of activity that will constitute carrying on business in the electronic age is less than clear.
  • Where is a contract concluded when entered into by a Canadian with a non-resident via a Web page? Offer and acceptance rules will need to be examined carefully, as the place of contract is one of the factors in the determination of whether business is being carried on in Canada.
  • Would a computer consultant performing diagnostic analysis on computer code stored on a Canadian-based computer be considered to have improved something in Canada? Such an improvement is considered to result in the carrying on of a business under domestic tax legislation.
  • Can a Canadian Internet Service Provider (ISP) be considered to be acting as an agent for a non-resident when it hosts a non-resident's Web page? Current views suggest that the ISP may, at most, be an independent agent; however, a number of factors must be considered in such a determination.
  • Is the storing by a non-resident of digital product on a computer situated in Canada tantamount to maintaining a stock of merchandise in Canada ? This is another factor in the determination of the carrying on of a business. Given the ease with which such inventory can be moved to any jurisdiction, is this criterion even relevant for electronic commerce?

The same issues must also be kept in mind regarding foreign jurisdictions when Canadians are transacting abroad.

Application of traditional interpretations will lead to unsatisfactory results in many cases. To avoid an onslaught of new legislation that is unlikely to keep up with the pace of technological change, governments will have to interpret existing legislation in a fair and pragmatic manner, keeping in mind their underlying policy objectives.


The traditional method of avoiding double taxation, tax treaties between nations, will also require new interpretations to implement the underlying principles upon which they were drafted.

Issues that arise in a treaty context are similar to those raised domestically: the characterization of income; the existence of a permanent establishment; residency of a corporation and the location of "mind and management"; and, more fundamentally, the determination of which countries are even involved in a particular electronic transaction.


Many issues that arise with respect to sales tax are similar to those raised above for income tax. For example, the "carrying on business in Canada" and "place of supply" rules are critical for application of the goods and services tax to both Canadian residents and non-residents. Businesses also need to be aware of registration, collection and filing requirements. Similar concerns arise with respect to provincial sales taxes, state sales and use taxes and European value-added taxes.

At a recent Ottawa OECD conference there was agreement that consumption taxes should be levied in the country where consumption takes place, and that for the purpose of these taxes, the supply of digitized products should be treated as a supply of goods.

Customs duties are levied on tangible goods. Electronic commerce may transform some tangible goods into electronic products, eroding duties and taxes.

Depending on the reaction of governments to the income tax issues, sales and consumption taxes may become increasingly important sources of revenue.


Until some consensus is reached between taxing jurisdictions, it will be essential for companies to monitor the tax implications of how they conduct business. Businesses that are able to minimize major problem areas and, indeed, maximize planning opportunities, are the ones that will have a competitive advantage in the digital age.

While many questions with respect to the taxation of electronic commerce remain unanswered, opportunities exist for taxpayers to optimize their tax structures by reviewing existing and proposed transactions, as well as approaches to such key areas as income classification, source of income, permanent establishment and transfer pricing. PricewaterhouseCoopers LLP has assembled a team of tax practitioners who can help you minimize the risks and optimize the benefits for your electronic business.

The foregoing article is based on one that appeared in "Emerging Tax Topics for 1998 and Beyond", a PricewaterhouseCoopers LLP (Canada) Tax Memo.

The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.

While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers LLP advisor, or:

David W. Steele
PricewaterhouseCoopers LLP
145 King Street West
Toronto, Ontario  M5H 1V8


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