Electronic Commerce: Taxation of Services Provided via the Internet

by Sanford H. Goldberg, Howard J. Levine, Ellen Seiler Brody
Published: October 01, 1997
Source: R & H Newsletter -- Tax Insights

Do your competitors have a hidden cost advantage in the way they use the Internet? To the extent that an Internet activity generates income, have you considered the extent to which the income tax result can be impacted by:

  • the provider’s domicile?
  • the user’s location?
  • location of warehouses?
  • relationships with distributors?
  • the situs of a computer server, or a parallel server at another location?
  • the place where the service or knowledge being accessed was created?

These are just a few of the perplexing questions whose answers may determine the extent and situs of taxation imposed on your electronic activities. State and local taxing authorities have been trying aggressively to resolve questions like these in their favor, and Congress may have to step in to referee a reasonable outcome.

In our June 1996 Journal of Taxation article, International Sales Pose International Tax Challenges, we addressed a number of issues that our international clients had encountered with international sales of products via the Internet. One basic question is whether sales of products should be taxed differently because they are concluded over electronic networks, rather than through physical stores or mail order catalogues. More difficult questions are raised by products that can be delivered electronically, like software that can be "downloaded" on-line. When there is virtually no physical connection between the seller and the buyer, the tax authorities have a much more difficult time applying long-standing tax concepts to collect tax revenue. The Treasury Department’s recent White Paper on electronic commerce touched on many of these issues, as well as other issues raised by electronic money transfers.

Because many electronic transactions could be categorized as "services," we also felt it was time to look at the tax aspects of electronic services from a fresh perspective. In our recent article, Electronic Services: Suggesting a Man-Machine Distinction, which appeared in the August 1997 Journal of Taxation, we present the rather radical view that, for tax purposes, the category of personal services is not really expanding, it is contracting. At the same time, a new category of economic activity, arising from the exploitation of what is an expanding classification of intellectual property, is emerging. In this light, the fundamental framework of the U.S. income tax system still appears to provide workable rules for application in domestic and international operations involving electronic services.

Although interfacing with an electronic network can be viewed as involving new and different "services," a closer look reveals that in many cases, these electronic interactions merely involve more efficient communication. For example, the Internet may facilitate the delivery of professional services of an architect, attorney, or engineer, which traditionally have been provided through face-to-face meetings, telephone conferences, telexes, faxes, and "hard copies." Such traditional personal services are classified in our article as "Type I" services. Those services require that some significant service be provided directly by a "human being."

The second category of electronic services, referred to as "Type II" services, generally involves the use of electronically accessed data bases, or more sophisticated machines. These "services" are largely, or entirely, mechanized and do not require any significant, ongoing direct human input. An example would be accessing an on-line telephone-listing data base instead of using a printed telephone directory. We believe it should not matter that the on-line directory is "interactive," where no human being is rendering any direct services.

Overall, it is suggested that where mechanical (including software) systems, rather than human beings, provide the electronic "service," the developing tax rules applicable to the exploitation of intellectual property should apply.

The issues that are addressed in this article include the following:

  • Is a whole new set of rules needed or is existing international tax law adequate to deal with all the issues that can arise through the expanded use of the Internet?
  • Can income attributable to personal services be distinguished from the licensing of intangibles or the exploitation or disposition of property?
  • How can taxpayers take advantage of the different rules in the U.S. and elsewhere for planning purposes?
  • What factors should govern the sourcing of income?
  • What are the implications for the Tax Treaty network?

The authors believe that the current international tax rules for personal services (i.e., the place of performance rules) should apply to only Type I services, whether or not rendered or delivered in whole or in part electronically. Type II services should be treated as a license, royalty, or purchase of property, whichever is appropriate.

As long as distinctions continue to be drawn between the taxation of services and the taxation of sales of intangible and tangible products, however, tax tensions (meaning planning opportunity and the risk of double taxation) will continue to exist in "cyberspace," as elsewhere. This article merely attempts to draw the line at some discernible point between "man and machine," and to explain how such a distinction can and should be useful to tax planners, administrators, and policymakers.