E-Commerce: The Challenges it Poses to the …

1 E- commerce : The Challenges it Poses to the concept permanent Establishment1 I. Introduction II. Infrastructure of the Internet and E- commerce & the Internet s Regulatory OrganizationsA. Infrastructure of the InternetB. Organizations Regulating the InternetC. What is E- commerce ? III. Overview of the Current Taxing SystemA. Trade or BusinessB. permanent EstablishmentC. Fixed or Determinable Annual or Periodic Gross Income IV. Current Taxing Law & the Infrastructure of the Internet: The Conflict with the concept ofPermanent Establishment V. Analysis of the Recommendations and Suggestions by the United States and theOrganization for Economic Cooperation and Development: Application of the permanent EstablishmentConcept in E-CommerceA. United StatesB. Organization for Economic Cooperation and Development VI.

2 Recommendation: Application of the concept Place of Effective Management as aTie-Breaker in E- commerce as a Viable SolutionA. The Traditional concept of Place of Effective Management B. Finding a Solution: Application of the concept of Place of Effective Management in E- commerce VII. Conclusion I. Introduction It is without question that the advent of the Internet and electronic commerce ( e- commerce ) Poses achallenge to the manner in which countries around the world tax business profits generated frome- commerce transactions. The primary reason why e- commerce , the sales of goods and services on-line, Poses a challenge to the already established concepts of the taxation of foreign income is twofold. First,the established sourcing rules do not always provide a clear-cut answer as to where goods sold andservices provided on-line are to be sourced.

3 Secondly, since the sale and purchase of goods and theE- commerce : The Challenges it Poses to the concept permanent Establishment1 file:///C|/Documents and Settings/abc/ - Emerging Trends and Legal (1 of 23) [6/8/2006 12:10:56 PM]rendering of services on-line make it virtually impossible to establish a fixed place of business, it isdifficult to determine the residence of an e- commerce business, and as such, it is difficult to establishwhether that business has a permanent establishment. As a result of the international community s fearsthat e- commerce will erode their tax bases, the Organization for Economic Cooperation andDevelopment (OECD), as well as OECD countries and non-OECD countries have begun to explore themanner in which a jurisdiction can establish that it has the right to subject the business profits of ane- commerce business to taxation in its jurisdiction.

4 Although there is still much debate surrounding theissue of how e- commerce will be taxed, there appears to be a general consensus among most countries,including the OECD, that the existing principles of taxation, particularly the concept of permanentestablishment, are adaptable to the new e- commerce business model. The scope of this paper is limited to determining whether the concept of permanent establishment canbe modified to apply to e- commerce or whether a new concept needs to be developed in determiningwhen and how business profits derived from e- commerce transactions are taxed. Part II of this articlewill examine the infrastructure of the Internet, and in turn, reveal what technological capabilities made e- commerce part of the global economy. Furthermore, since this paper seeks to demonstrate that theorganizations regulating and monitoring the Internet may prove to be part of the solution, in determiningwhich jurisdiction has the right to tax e- commerce business profits, Part II will also provide an overviewof those organizations and the regulations which have been established.

5 Part III will describe the currenttax rules in the United States and the treaty concept of permanent establishment. Part IV willdemonstrate that the current tax rules in the United States and the concept of permanent establishment are no longer meaningful in attempting to tax the business profits generated from e-commercetransactions. Part V will discuss and provide a critical analysis of the most recent proposedrecommendations and solutions offered by the United States and the OECD as to how they believee- commerce business profits should be taxed. Part VI will recommend that since the proposedrecommendations and solutions discussed in Part V are not viable, due to the infrastructure of theInternet, the application of the place of effective management as a tie-breaker warrants furtherconsideration for the purposes of determining how the taxation of e- commerce should be resolved.

6 II. Infrastructure of the Internet and E- commerce & the Internet s Regulatory OrganizationsAlthough it may be true that the Internet is not owned by any particular entity or person, this does notmean that the Internet is not regulated and monitored to ensure that the procedures and mechanismdeveloped for its proper use are abided This section will describe the infrastructure of the Internetwhich makes e- commerce a reality, as well as examine the various organizations and agencies currentlyregulating and monitoring the Internet. Whereas a general2 understanding of the Internet sinfrastructure3 may be helpful in assisting the OECD and countries around the world determine how theInternet may constitute a permanent establishment, it is equally important to fully understand how theInternet is organized and regulated when making this determination. When analyzing the regulations andstandards which these organizations have developed, this paper will specifically focus on the manner inwhich an entity or individual registers for a domain name, as well as the regulations and proceduresregulating domain names.

7 The main goal of this paper is to demonstrate that already establishedprocedures, standards, and mechanism currently used to monitor and regulate the Internet may assist theOECD and other countries in finding a viable solution as to how to deal with the Challenges that theInternet and e- commerce pose to the concept of permanent establishment, especially if it is concludedthat the concept of permanent establishment is not conducive within the context of e- commerce . E- commerce : The Challenges it Poses to the concept permanent Establishment1 file:///C|/Documents and Settings/abc/ - Emerging Trends and Legal (2 of 23) [6/8/2006 12:10:56 PM]A. Infrastructure of the Internet The word Internet refers to a hierarchy of networks that are interconnected throughout the world;4therefore, the word Internet encompasses the connection between a particular computer, such as one ina person s home or office, with numerous phone cables and various networks or computers locatedthroughout the The two most common ways in which a personal computer is able to establish aconnection to the Internet by way of an Internet Service Provider (ISP) are as follows.

8 6 One way is through the use of a modem which serves to connect a user s personal computer to atelephone cable, thus establishing a connection with the user s It is also possible to connectthrough a high speed digital phone line, known as a Local Area Network (LAN), in which case amodem is not Once the user is connected to his ISP, but before he has access to theInternet, there are several intermediate steps or connections which must be First, ISP shave Points of Presence (POP) in each region where their service is In other words, whena user dials into his ISP, he is accessing a POP which is a merely a rack of modems that the user smodem dials into by way of high speed telephone Once the user has established a connectionwith the his ISP s POP, yet another connection needs to be established to a Network Access Point (NAP).12 NAP s are located both in the United States, as well as all over the world to enable InternetService Providers, and other commercial, international and federal POP s to connect with each Peering agreements provide the mechanism which allow a particular ISP to exchange their user sdemands and information with other ISP s, thus enabling all of the ISPs users throughout the world tointercommunicate with each specialized computers which allow users to connect from a POP to a NAP and finally to the Internet,all in a matter of seconds, are called routers.

9 15 In essence, routers serve to pass information from onecomputer to another and ensure that the information or messages from users reach their When finally connected to the Internet, the user will want to either send an e-mail or navigate through theWorld Wide Web (WWW).17 The WWW is a navigation tool for locating and accessing informationpresented in graphic form available on the hard drives and other storage facilities of computers know as Web Servers on the Internet. 18 The WWW works by allowing users to navigate through the Internetby clicking on links such as words or pictures, but in order to use the WWW, the user must have theappropriate web browser software installed in his Alternatively, the user may have aspecific website s address which he is interested in visiting. So, how does a user get to a specificwebsite? Each computer has an assigned unique Internet Protocol Address (IP Address) which isnothing more than a string of numbers;20 the Internet Protocol is the language which computers use tocommunicate with each other over the To enable users to remember the IP Address of websites, domain names were example, is a domain name, but the IP Address for is really astring of numbers.

10 Needless to say, since each IP Address or domain name is assigned to a particularwebsite, it is crucial that they be When a user types in a domain name into the web browser, a Domain Name Server (DNS) will translate the domain name into its IP Address, and providing that itis a valid domain name, the user s DNS will connect through multiple DNSs until it establishes aE- commerce : The Challenges it Poses to the concept permanent Establishment1 file:///C|/Documents and Settings/abc/ - Emerging Trends and Legal (3 of 23) [6/8/2006 12:10:56 PM]connection to the DNS s IP Address the user has In essence, a DNS maps the humanreadable names of a website to the IP In sum, the web browser, once instructed that the userwants to access , will form a connection with yahoo s web server and the page willappear on the user s Organizations Regulating the InternetThe Internet, originally consisting of only four host computers, was developed in 1969 to allow the Department s network, ARPANET,27 to connect to radios and Initially, theobjective was to create a system of communication and research that could operate and remainunaffected during a military In the 1980s, the National Science Foundation (NSF) developedthe National ScienceFoundation Network (NSFNET)