Cyprus: E-commerce Taxation Treaty Characterization Issues: Direct Taxation

Last Updated: 29 January 2010
Article by Christiana Aristidou


There is no internationally accepted definition of e-commerce. The department of trade and industry have proposed to the OECD the following definition:

"Using an electronic network to simplify and speed up all stages of the business process, from designed and making to buying, selling and delivery e-commerce is the exchange of information across electronic networks, at any stage in the supply chain, whether within an organisation, between business, between business and consumers, or between the public and the private sectors, whether paid or unpaid".

It seems from the above definition that, internet is used not just as a marketing tool but it is also used to simplify and speed up all stages of the business process.

Nowadays, companies use internet technology to streamline other business functions (such as production, delivery of services and administrative and accounting functions) over the internet.

For instance, internet may be used to increase purchase efficiencies and to minimize their costs (e-procurement). In this way, the value added chain becomes value added network, which in fact increases the profitability of the companies. This, in effect, creates great competition between companies, which, with the advancement of internet technology is getting bigger and bigger every day.

The continuous advancement of internet technology and the great competition between companies has created a new style of doing business, new business models.

New business models

  • Outsourcing (new communication technologies allow enterprise to outsource thus achieving reduction of costs)
  • Commodity suppliers (web-based systems that streamline the ordering, selling and payment for raw materials supply)
  • Manufacturing (new information technologies allow manufacturers to reduce procurement costs and their suppliers to access new customers or markets and reduce their transaction costs and also enable manufactures to increase their direct sales to consumers)
  • Retail distribution (websites which provide low cost products with much convenience and customization for their customers. Many functions are now automated, e.g procurement, inventory management, warehousing, shipping etc. Electronic marketplaces like online auctions, electronic marketplaces operated by content aggregators or online shopping portals, allow consumers new ways to buy products or compare prices.)
  • Delivery (Shipping Enterprises benefit from new technologies like online parcel order and tracking systems which allow quicker and more accurate deliveries. This allows their business customers to outsource order fulfillment functions in order to concentrate on core activities.)
  • Marketing, Advertising and customer support (enterprises can present information about their products or services to a larger audience in a more efficient and cost effective manner. In this way, small and remote businesses are allowed to enter new markets.)
  • Information (Internet allows worldwide and almost instantaneous delivery of information in various forms to individuals and enterprises. Costs for accessing and searching information are substantially reduced. Everyone can benefit from E-learning and interactive training. The treatment of information is generally facilitated through data processing, information storage systems and application service providers.)
  • Financial services ( such as banking, brokerage and life insurance are now offered through internet, either from traditional financial institutions or New businesses. Further, financial institutions can now offer new functions related to the security of e-commerce transactions.)
  • Digital products ( software, music, video, games, news, e-books, etc. can be marketed and distributed through web-based systems in direct purchase, rental, or pay per use transactions.
  • Other services ( other types of services such as services in the areas of travel and health care have greatly benefitted from web-based network)

Threats on Taxation

Tax Systems were designed with different business models in mind

With the technological advancement, companies straddle national boundaries, competition flourishes and tax authorities struggle to follow the modern ways of doing business. An international business transaction will find two and even more "applicants" alleging a taxing right on the particular income. This can expose businesses to double taxation risk and also challenge unpleasant competition between governments.

Apparently, e-commerce seems to create new challenges in the area of direct taxation, questioning the conformation of existing tax regulation.

Nature of cross-border transactions:

The character of any payment depends on the nature of the transaction that gives rise to the payment.

Depending on the right or property transferred, transactions may be for the

  • Sale of goods
  • Sale of services
  • Licensing of copyright or other intangible property right
  • Sale of intangible property

However, plethora of transactions involve products that are a hybrid of tangible goods, services, copyright and know-how.

E-commerce and income taxation

In cross-border transactions, once it is determined that the taxpayer is in fact subject to tax, the character of a transaction, in most cases determines its taxability.

Income Tax Treaties and the domestic source rules of almost every country rely upon the proper characterization of income in order to determine the appropriate tax treatment.

The cross-boarder sale of a product, such as a pair of shoes or a bag, is ordinarily subject to income tax in the customer's country ONLY when the seller has a permanent establishment in that country.(provided a tax treaty based on MTC does exist between the countries involved in the transaction)

Where a cross-border royalty is paid, the recipient of the payment is ordinarily subject to tax in the country in which the customer is located, regardless of whether the recipient has a permanent establishment in that country. Ordinarily, the customer must withhold tax on the royalty payment.

Therefore, characterization of revenue as either ordinary business income or as royalty will result in significant different tax treatment.


OECD has been dealing with these challenges posed in the area of E-commerce Taxation for several years now. It has established 5 Technical Assistance Groups (TAGs) to analyse the problems and propose technological and legal solutions. The work carried out has focused upon three major areas:

  1. International direct tax issues
  2. Consumption Taxes
  3. Tax administration issues

The Treaty Characterization TAG

The Technical Advisory Group on Treaty Characterization Issues was set up with the general mandate to "to examine the characterization of various types of electronic commerce payments under tax conventions with a view to provide the necessary clarifications in the commentary".


One of the most important issues in the area of e-commerce taxation is the characterization of income derived from the sale or transfer of certain intangible goods or services.

Digitization makes it difficult and complex to determine whether income represents sales income or services income or whether intangible product has been licensed.

Being able to distinguish between the above and eventually classify the type of income is of crucial importance


Article 12 (2) of the OECD Model Tax Convention provides the following definition of royalties:

"The term "royalties"...means payment of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience."

In the 1977 Double Taxation Convention, that definition also included "payments [...] for the use, or the right to use, industrial or commercial or scientific equipment" and some bilateral conventions still include this previous definition of royalties.

Business profit or royalty? (payments for the use or right to use, a copyright)

The main question to be addressed: Is the essential consideration for the payment, the use or the right to use a copyright?

So, what is important is:

The identification of the consideration for the payment.

The delivery means (over the internet or by physical means) should not have any incidence in the characterization of income.

The identification of the consideration

Where the essential consideration is for something other than the use or the right to use, rights in the copyright (such as to acquire other types of contractual rights, data or services), and the use of copyright is limited to such rights as are required to enable downloading, storage and operation on the customer's computer, network, or other storage performance or display device, such use of copyright should be disregarded in or should not affect the analysis of the character of the payment for the purposes of applying the definition of "royalties".

Depending on the relevant copyright law and contractual arrangements of, to electronically download a computer program, a software or other digital content may give rise to use of copyright by the user/customer, e.g because a right to make one or more copies of the digital content is granted under the contract. To the extent that the act of copying the digital signal onto the customer's hard disk or other non-temporary media constitutes the use of a copyright by the customer under the relevant law and contractual arrangements, this is merely an incidental part of the process of capturing and storing the digital signal. This incidental part is not important for classification purposes because it does not correspond to the essential consideration for the payment (i.e to acquire data transmitted in the form of a digital signal), which is the determining factor for the purposes of the definition of royalties.

Relevant Transactions

Type A Transaction

Electronic ordering and downloading of digital products (software or images or sounds or text) from internet or other sources for the customer's own use.

Type B Transaction

Electronic ordering and downloading of digital products (software or images or sounds or text) from internet or other sources for distribution, modification or reproduction (for purposes of commercial exploitation of the copyright).

Example of Type A Transaction

A student selects an anti-virus computer program from an online catalogue of software and orders it electronically directly from a commercial provider. The computer program is downloaded onto the student's hard disk or other non-temporary media.

Example of Type A Transaction

Type A Transaction

Transactions that permit the customer to electronically download digital products such as software, music, text, images or pictures for the customer's own use or enjoyment does not constitute royalty but are business profits and falls within Article 7 or Article 13 as the case may be.

In the above case the payment is made to acquire data transmitted in the form of a digital signal for the own use or enjoyment of the acquiror, the student in this case.This constitutes the essential consideration for the payment.

Example of Type B Transaction

A publisher, buys the right to reproduce a copyrighted picture that, will be included in a book it is publishing. The publisher will be buying the right to use the copyright in the digital product he is producing. He acquires the right to reproduce and distribute the digital product it bought.

Example of Type B Transaction

Type B Transaction

In transactions where the customer electronically downloads digital products such as software, music, text, images or pictures for distribution, modification or reproduction, it can be said that the essential consideration is the granting of the right to use a copyright in the particular digital product and therefore the payment will give rise to royalties.

The essential consideration for the payment is the granting of the right to use a copyright that is electronically downloaded for that purpose.

Relevant Transactions

Type C Transactions

Transactions relating to "limiting duration software and other digital information licenses" ( those in which the customer receives the right to use the software or other digital products for a period of time that is less than the useful life of a product.)

Example (Limited duration software)

The customer receives the right to use software or other digital products for a period of time that is less than the useful life of a product. The product is either downloaded electronically or delivered on a tangible medium such as a CD. All copies of the digital product are deleted or become unusable upon termination of the license.

Payments for such use of digital products cannot be considered as payments "for the use, or the right to use, industrial commercial or scientific equipment" because

  1. Digital products cannot be considered as "equipment",
  2. Such product cannot be viewed as "industrial, commercial or scientific"
  3. The payments involved cannot be considered to be "for the use, or the right to use" the product since it is designed to have a short useful life

Total alienation of a copyright

As regards software, difficulties can arise in the case of a transfer of rights that could be considered to form part of an element of property referred to in the definition where these rights are transferred in a way that is presented as an alienation. For example, this could involve the exclusive granting of all rights to an intellectual property for a limited period or all rights to the property in a limited geographical area in a transaction structured as a sale.


Where a payment is in consideration for the transfer of the full ownership of an element of property referred to in the definition, the payment is not in consideration "for the use of, or the right to use" that property and cannot therefore represent a royalty, but rather such payments are likely to be commercial income (Art. 7 MTC) or a capital gains matter (Art. 13 MTC).

Example of a total alienation of a copyright

An example of such a payment would be that of a distributor of clothes resident in one Contracting State who pays a certain sum of money to a manufacturer of branded shirts, who is a resident of the other Contracting State, as consideration for the exclusive right to sell in the first State the branded shirts manufactured abroad by that manufacturer. In that example, the resident distributor does not pay for the right to use the trade name or trade mark under which the shirts are sold; he merely obtains the exclusive right to sell in his State of residence shirts that he will buy from the manufacturer.

Business profits and Payments for "Know-how"

In some transactions it is necessary to distinguish whether the consideration for the payment is the provision of services or the provision of know-how (i.e information concerning industrial, commercial or scientific experience)

Various definitions have been formulated by special bodies:

According to the ANBPPI ( Association des Bureaux pour la Protection e la Propriete Industrielle), "Know-how is all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions inasmuch as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique."

In the know-how contract, one of the parties agrees to impart to the other so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. It is recognised that the grantor is not required to play any part himself in the application of the formulas granted to the licensee and that he does not guarantee the result thereof.

Payments for the provision of services or the supply of Know-how?

In a typical contract for the provision of services, one of the parties undertakes to use the customary skills of his calling to execute work himself for the other party. Payments involved in this kind of contracts generally fall under Article 7 of the MTC

The following criteria are relevant for the purpose of making the above distinction:

Contracts for the supply of know-how concern information that already exists or concern the supply of information after its development or creation and include provisions concerning the confidentiality of that information.

In the case of contract for the provision of services, the supplier undertakes to perform services which may require the use, by that supplier of special knowledge, skill and expertise but not the transfer of such special knowledge, skill or expertise to the other party.

In the supply of know-how contacts, the supplier supplies existing information or reproduce existing material. Contracts for the performance of services involve greater level of expenditure by the supplier (may have to incur salaries, wages or payments to subcontractors for the performance of similar services.)


In a contract for the provision of information concerning computer programming, know-how is only supplied where information constituting ideas and principles underlying the program such as logic, algorithms or programming languages or techniques, subject to trade secret protection, are supplied under the condition that the customer will not disclose it without authorisation.

Examples of payments which should not be considered as provision of services:

  • Payments obtained as consideration for after sales service,
  • payments for services rendered by a seller to the purchaser under a guarantee,
  • Payments for pure technical assistance
  • Payments for an opinion given by an engineer, an advocate or an accountant, and
  • Payments for advice provided electronically, for electronic communications with technicians or for accessing, through computer networks, a trouble-shooting database.

Concluding remarks

It seems from the above that most of the transactions are considered to be transactions for the provision of services and fall under the business profits classification.

The OECD classified the characterization of 28 types of e-commerce transactions- the income derived from most of them = business income

However, many transactions gave rise to conflicting opinions between the participants. This supports the view that, although there is some degree of international consensus, consensus is far from complete. It is possible that a transaction (digital) will be characterized in more than one ways. ( competition between capital-importing and capital exporting countries)

The risk of Double Taxation or tax avoidance exist. (both can hamper growth of e-commerce.

Characterization is an issue that must be resolved within and between each taxing jurisdiction.

Royalty definition

Behind the times?

E-commerce is generating countless transactions and it is true to say that numerous income characterization issues are raised, whose resolution is uncertain under existing categories of income. (regarding domain names, topographies, semiconductor products)

Adapting the definition of royalties is maybe a step towards achieving consensus among several states.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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