I thought I’d post an essay that I wrote a few months back for my Masters course on Australian International Taxation. I was pretty pleased to get an HD because my writing was a bit rushed and at times I felt like I had bitten off more than I could chew for a 4,000 word paper.
I haven’t included my footnotes here (because this is just a blog) but would be happy to share them. Please properly give me credit if using this article, ESPECIALLY, ESPECIALLY if it is for a university assignment.
So here it is;
Critically evaluate the following statement;
“As technological change weakens the link between economic activity and a particular location, traditional tax concepts such as residency and source become difficult to apply, if not unworkable. A new approach is needed.”
This paper evaluates the effect of technological developments, particularly the internet and associated communications technologies, on the core tax concepts of residency and source. It considers how these concepts can be applied in an environment where physical presence is less important. It starts by discussing the impact on residency (both individual and corporate) and permanent establishments before moving on to discuss source (focusing on digitised goods and services). Finally, it evaluates two alternate approaches but concludes that neither is an improvement on the current system. The paper argues that, fundamentally, the current rules remain workable, especially if a common-sense, substance-over-form approach is taken.
The concepts of residence and source are fundamental building blocks of Australia’s international tax system. Together they determine how tax is applied and which country has jurisdiction to tax. The core rules of these concepts were developed decades ago, long before the internet, video-conferencing and associated modern communications technologies were developed (or even imagined). Fundamentally based on a connection to physical, territorial locations, the rules of residency and source were intended for a very different world. Attempts to apply these rules to an electronic commerce environment pose significant difficulties. So much so that some have alleged a significantly new approach is needed. This paper seeks to identify the issues caused by the internet and associated technologies, evaluate their impact and potential solutions. It is argued that, while substantial challenges exists, the existing rules are fundamentally capable of responded to these challenges if authorities adopt a ‘substance-over-form’ approach.
Part one – the impact of technological change on residency and permanent establishments
This section of the paper will consider how new technologies have impacted the application of the residency and permanent establishment rules. In particular, it is interested in whether they have made those rules more difficult to apply or open to manipulation. It concludes that while technology creates substantial opportunities for taxpayers and difficulties for revenue authorities, the existing rules are largely workable, if authorities don’t lose sight of real, substantive ties to a territory instead of focusing on formal rules.
An individual will be resident of Australia under domestic tax law if they reside in Australia, are domiciled in Australia (and don’t have a permanent place of abode elsewhere), are present for more than half of the income year or pass the superannuation test. In the case of dual-residency, most Double Tax Agreement contain a tie-breaker provision that considers permanent home, personal and economic relations, habitual abode, nationality and finally mutual agreement. Some commentators have suggested that these rules can be manipulated by high-skilled, high-wealth taxpayers utilising communications technology. One suggested scenario involves an individual who sets up camp in a tax haven while continuing to operate in Australia via the internet. A more extreme version has the individual living on a yacht sailing the high seas.
Writing in 1996, Zak Muscovitch envisioned that residency would become “meaningless” in the internet age. In fact, traditional concepts of residency have remained largely intact because most people privilege lifestyle and social factors when deciding where to live. To satisfy himself that a permanent place of abode exists outside of Australia, the Commissioner will compare an individual’s presence overseas with their association with Australia. This presents a significant hurdle for most people. No matter how easy it becomes to conduct business on-line, physical presence will remain crucial to people in the social context. Thus the residency tests for individuals work well because they rely on real, substantive ties.
While a corporation cannot form social and emotional connections, it can also form real, substantive ties with a territory. The current residency rules don’t adequately reflect this and are therefore more susceptible to manipulation.
A company is resident if it is incorporated in Australia or it carries on business in Australia and has either its ‘central management and control’ in Australia or its voting power controlled by resident shareholders. It is broadly accepted (although not by the ATO) that the ‘carries on business’ element of the test is redundant if the central management and control of a company is situated in Australia (as this is where the “real business is carried on”). Furthermore, the Commissioner will generally accept that central management and control is in Australia if the majority of the board meetings are held in Australia.
With modern technology (e.g. the development of video conferencing facilities and the increasing affordability of air travel) it is relatively easy to move the location of board meetings and therefore to manipulate the residence of a company. The central management and control test does not adequately reflect the realities and complexities of the modern business environment. This has led to increasing uncertainty and opportunities for shrewd tax planning. To date there has been scant guidance from the ATO and few cases to suggest that, as the ATO has suggested, the courts are open to modifying the test to the electronic communications environment. Where directors are dispersed throughout the world and ‘meet’ via videoconferencing facilities or where they are constantly on the move and arrange to meet in different places throughout the year the residency of the company becomes difficult to determine at best and purely a matter of convenience at worst.
In the case of dual-residency, most of Australia’s Double Tax Agreements allocate residency to the ‘place of effective management’. Though similar to the concept of central management of control, this concept appears to focus more on where decisions are made and less on where meetings are held. It is arguably also more interested in the day-to-day management of the company than the major policy decisions. For these reasons, while it is conceivable to envisage a situation where the managing director of a company is constantly on the move and making decisions across numerous countries (and perhaps even while flying over the ocean), ‘place of effective management’ is certainly more difficult to manipulate than ‘central management and control’.
However, a better approach would be one that draws on the strengths of the individual residency tests discussed above. As Lord Loreburn wrote; “in applying the conception of residence to a company, we ought, I think to proceed as nearly as we can upon the analogy of an individual”. Mathew Collett has argued that, like an individual, one may consider than a multi-national corporation resides where it has the closest economic, political, financial, cultural and legal links. Similarly Uta Kohl has advocated a broad-based control test that looks for a substantive rather than formal nexus. This real, substantive approach to corporate residency would be a significant improvement to the current rules, and certainly better than the (admittedly simple and certain) sole incorporation test that business groups appear to advocate. However, as more businesses become decentralised and less tied to physical assets (itself a development made possible by modern technology), even this approach may become difficult to apply in some circumstances. Whether or not this means that the whole concept of residency should be jettisoned is something that will be considered in part three of this paper.
Where an entities’ presence in Australia is insufficient to create residency, the concept of a permanent establishment is important in establishing Australia’s right to tax that entity, especially in regards to its business profits. Article 7(1) of the OECD model, upon which Australia’s tax treaties are based, provides that a resident of a contracting state shall be taxable only in that state unless it carries on an enterprise in the other state through a permanent establishment. If such a permanent establishment exists, the profits that are attributable to it may be taxed in the other state. Article 5 defines a permanent establishment as “a fixed place of business through which the business of an enterprise is wholly or partly carried on”. Writing about the similar s6(1) definition of permanent establishment, the Commissioner considers that there must be an element of permanence, both geographic and temporal. The model treaty deems certain specific locations to be permanent establishments, a physical presence of some permanence being common to all, and others not to be. Included among the latter category are facilities used solely for storage, display or delivery of goods or merchandise and solely for activities of a preparatory or auxiliary character.
An important question in international taxation is how and whether, the concept of permanent establishment can be applied to electronic commerce. Can a computer server constitute a permanent establishment and if so, how can profit be attributed to it? The majority (but not unanimous) view is that the mere presence of a server in a particular jurisdiction is usually not sufficient to create a permanent establishment. An analogy has been drawn between a server and a warehouse or mail-order activities, both of which have traditionally not been held to be permanent establishments. The correct treatment may depend on the functions performed on the server. For example, a server that is used merely for advertising will not be held to be a permanent establishment, consistent with the exclusion of preparatory and auxiliary activities. However, where the server is also used for taking orders and accepting payment, it may, according to some, be a permanent establishment. Where it is also used for digitised delivery of goods there is an even stronger case. However, multiple servers, each performing particular functions in different locations, cannot be cumulated into a single permanent establishment.
A server should rarely, if ever, be treated as a permanent establishment since its location is largely arbitrary and has little or no connection to where the real economic activity takes place. However, even if justified on theoretical grounds, there are many practical obstacles to servers as permanent establishments. A server is highly mobile and therefore, if it can constitute a permanent establishment, the likely taxpayer response will simply be to relocate them to a tax haven. There are also problems of how profit would be attributed to it. Article 7(2) provides for attribution based on what it might be expected to make, “if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions”. This deceptively simple article belies the tremendous complexity which could arise in regards to the allocation of income between competing jurisdictions. These issues demonstrate the difficulties of applying traditional tax concepts in an electronic commerce environment.
Part two – the impact of technological change on source
Having discussed the impact of new technologies on the residency rules, this section will now apply a similar evaluation to the source rules. Traditional source rules were developed for a physical world and therefore rely on physical presence or economic connection to a physical location. However, as the physical location of an activity becomes less important to certain types of transactions, it becomes more difficult to determine where an activity is carried out and hence the source of income. Furthermore, the hybrid nature of digital products blurs income categories and makes income characterisation significantly more difficult to determine. This is of fundamental importance because the characterisation of income affects how source is determined and how the income is taxed. For example, the rules applying to royalties (such as copyright and know-how) are significantly different to the rules applying to business income (such as the sale of intangible goods and the provision of professional services).
When digitised products are viewed or downloaded it can be difficult to determine how to characterise the income. New types of products and methods of delivery are challenging traditional tax distinctions. Take for a book for example – previously it could only be bought in physical form. Today, it is possible to download on electronic version to a computer or mobile device, to subscribe to an online database that includes the book and even to receive online updates of the book. Similar possibilities (and thus issues) also arise with software, images, movies, music, newspapers and other documents. As Jinyan Li has said, digital transactions “defy the pigeon-hole approach of characterisation because of the hybrid nature of digital products, the modes of delivery and the fact that digital products may be simply, accurately and cheaply reproduced”. The application of traditional tax principles to digital products could potentially lead to impractical and unreasonable results, with minor differences in the nature or mode of delivery of a product leading to significantly different tax results.
An important issue in e-commerce is whether the payment for the supply of the book (or similar product) is consideration for the supply of goods or for the copyright to reproduce a digitised product. A royalty includes an amount paid for “the use of, or the right to use any copyright… or other like property or right”. From a strictly technical perspective, many transactions in digitised products meet this definition because they involve creating an electronic copy. Therefore some have argued that payments for such transactions should be (whether fully or partially) classified as royalties. However, it seems that this is a minority position within the OECD. A majority take the more common-sense approach that that consideration is to acquire digital products for the acquirer’s own use and enjoyment does not give rise to a royalty payment. To the extent that it constitutes the use of copyright under the relevant law, this is merely an incidental part of the process. This approach, which focuses on the true economic substance of the transaction, is far better than one that focuses on strict legal form. The mere fact that a digital product is delivered electronically should not change its classification. To treat it differently for tax purposes would offend the principle of neutrality. While the ATO has provided very little guidance on its approach, Tax Ruling TR93/12 (which addresses computer software and royalties) suggests that they are willing to take a pragmatic approach. The ruling recognises that while amounts attributable to the right to load a program onto the user’s computer would strictly be a royalty, that the amount, if quantifiable, is likely to be minimal.
Services and know-how
Another area of difficulty arises in the provision of services. Historically, the person performing and receiving the service would be in the same jurisdiction. Today, modern communications technology enables services to be provided entirely on-line, across jurisdictions and without a fixed base in the other country. Typically it is consulting services, such as advice provided by a lawyer, accountant, doctor, engineer or other professional that is most commonly provided online. In the case of dependent personal services, the source of the income is generally the place where the services are performed. The technology used to conduct the transaction may be new but it should not pose a significant problem for the determination of source. However, where creative talents or specialised skills are exercised, or where the services are furnished an independent contractor, other factors become important. These factors include the place of contracting and the place of payment. This potentially opens the door to difficulties and manipulation where services are contracted, provided and paid over the internet. It should be remembered, however, that where Double-Tax Agreements are in place the issue is of less importance. This is because the independent personal services article will generally require a resident of one of the contracting states to have a fixed base regularly available to them in the other contracting state before they can be taxed n that other state.
Like the provision of services, the supply of know-how is now frequently made on-line and across borders. However, it can be frequently be difficult to distinguish between the two. Examples of the type of payments where this issue arises include payments made for preparing or developing designs, models, plans or drawing, or for performing engineering, research, testing, experimental or other similar services. The correct characterisation is important as the tax treatment varies considerably between the two. Payment for the transfer of know-how is often included as part of the royalty article in bilateral tax treaties and is also included in the definition of royalties for domestic tax purposes. Payments for services will generally be covered by the business profits article. The Tax Office has stated its view on the distinction between royalties and payments for services rendered in IT 2660. It explains that the main distinctive feature of know-how is that it is an asset and, as such, is something which is already in existence. By contrast a contract involving the performance of services results in the creation, development or bringing into existence of a product. The OECD Commentary makes very similar distinctions. Where standard advice based on inputted data is supplied, some have argued that the tax treatment is unclear. In such cases it would be helpful to remember that the necessary knowledge base must have been created by human input.
Tom Magney has advocated, albeit not with the communications revolution in mind, a ‘factor approach’ to determining source. This would give emphasis to the actions taken by the taxpayer, and in particular the decision making, in determining the source of income. Other, more formal factors such as the place of making the contract would be of less significance. This section has demonstrated how traditional tax concepts such as source can be difficult to apply in an electronic commerce environment. However, if Magney’s approach is followed and the focus remains on the activities being conducted and the value being added, the existing rules are flexible enough to remain workable. Unfortunately, as Magney’s 1997 paper illustrates, too often judges pay lip-service to such an approach, whilst simultaneously ignoring it. Time will tell how the challenge of electronic commerce will be addressed.
Part three – possible new approaches
Parts one and two of this paper have demonstrated that technological changes have made traditional tax concepts such as residency and source significantly more difficult to apply. Some have even suggested that a completely new approach to international taxation is needed. Part three now evaluates the case for two of the more radical approaches that have been put forward; exclusive residence- and exclusive source-based taxation. Any proposal to alter the tax system is typically evaluated on the grounds of equity, efficiency and simplicity and therefore it is these factors that will form the basis of the succeeding discussion.
In the international tax context an important aspect of equity involves determining how tax revenues should be divided between countries. For some, equity (or fairness) means taxes collected should reflect the benefits received from those taxes. The ‘benefits theory’ applies this thinking to the international context, viewing taxes as consideration for benefits provided by the state. Under this approach, the country that makes the greater contribution to the income-earning activities should receive a greater share of the tax revenue flowing from these activities. As we shall see below, determining which state makes the greater contribution, especially in an electronic commerce environment, can be problematic.
Efficiency is concerned with maximising economic growth. Conventional wisdom holds that growth is maximised when taxes (and also, it can be argued, government benefits) don’t influence the attractiveness of alternate goods, investments or activities. That is, efficiency is maximised when government policies are neutral. In the international context Peggy Musgrave is credited with identifying two aspects of neutrality; capital-export and capital-import neutrality. Both these objectives can only be achieved if taxes are the same in all countries. Since this is a practical impossibility, the two criteria are often in conflict. Whether one supports residence- or source-taxation depends in large part on their preference for capital-import or expert neutrality.
Exclusive residence-based taxation
The United States Treasury Department has been a prominent advocate for residence-based taxation, arguing that “as traditional source principles lose their significance, residence-based taxation can step in and take their place”.
Residence taxation has been justified under the benefits principle since residents enjoy the benefits of the social, economic, physical and legal infrastructure of the state in which they reside. This infrastructure contributes to their ability to earn income and therefore it is considered just for residents to contribute to the tax revenue that finances it. However, a traditional, bricks-and-mortar store avails itself of government infrastructure to a significantly greater degree than online businesses and it has therefore been argued that this justification of residence taxation is weaker in an e-commerce environment. Georg Von Schanz argues that residence not a valid criterion for establishing tax liability because it would “lead to taxing people who get no benefit or who at best get only a partial benefit from a State’s activities”.
Residence taxation has also been supported on the grounds that it is consistent with capital-export neutrality. Export neutrality means that income earned by a resident of a given country is taxed at the same rate, regardless of where it was sourced. This is achieved via a combination of residence taxation and fully-refundable foreign tax credits. The case for capital-export neutrality rests on the proposition that, in order to secure efficiency in capital allocation, the choice of investment location should not be affected by tax considerations. Capital-export neutrality achieves this while capital-import neutrality leaves capital allocation decisions open to tax differentials between countries of residence and source. Capital is thus attracted to low-tax countries and the international allocation of capital is distorted. For this reason, Charles McLure, and indeed most economists, shows a preference for capital-export neutrality (and thus residence taxation).
Moving to an exclusively residence-based system would represent a fundamental shift in taxing rights and is therefore unlikely to receive broad international support. Taxation of internet transactions on the basis of residency would tend to favour net exporters of internet products and services (which are typically developed countries) and disadvantage net importing countries (which are typically developing countries). The United States is the world’s largest exporter in e-commerce so its position is easy to understand. Without a wide international consensus there is a risk of double-taxation as net importers try to preserve their tax base. No country which levies an income tax forgoes taxing domestic source income, irrespective of who has derived it. In contrast there a number of exceptions and qualification to the general practice of taxing foreign source income. Perhaps this suggests that there is a stronger case for source taxation.
Exclusive source-based taxation
Earlier it was noted that residence taxation has been justified under the benefit principle. However, Klaus Vogel and Georg Von Schanz amongst others have argued that it the source country, i.e. the place of income-generating activity, which makes the greater contribution to the production of income, and is therefore deserving of a greater share of tax revenue. Schanz argued that where a taxpayer has an ‘economic allegiance’ to both a residence and source state, both countries should receive a share of tax revenue. However, the allegiance to the source-state is the greater allegiance and therefore it should receive the greater share. Schanz proposed that three-quarters of the income be taxed in the source state and only one-quarter in the residence state. Vogel, approving of Schanz’s novel suggestion, takes things a step further and argues that if the state of residence levies a significant quota of indirect taxes, these taxes are sufficient to entirely compensate the residence state for the benefits it provides and therefore exclusive income taxation by the source state would be justified.
Vogel and Von Schanz formulated their positions before the advent of electronic commerce. Where trade is less tangible and no presence in the source country is needed to derive income from it, the only contribution of a source country may be its customer base and the telecommunications infrastructure to reach them. Of course this sill is a significant contribution – it would be impossible to earn income without a market to earn it in. Furthermore, as Arvid Skaar and others have noted, there are numerous other benefits that a source country provides, even in the absence of a physical presence. These benefits include a legal system that enforces payment for transactions, protects consumers (which builds necessary trust) and upholds intellectual property rights. The protection of intellectual property rights is especially critical to vendors of intangible products and digitised services. They also include a political and economic system that maintain a stable and competitive business environment (e.g. keeping exchange rates stable and interest rates low) and even an education system which ensures consumers have the required level of competency in computers to purchase their products.
Source-based taxation has also been justified on the grounds that it is consistent with capital-import neutrality. Capital-import neutrality exists when the same taxation scheme applies to all income earned within a given territory, regardless of the where the investor resides. Proponents of capital import neutrality hold that firms, when competing in foreign markets, should not be handicapped (as they would be under capital-export neutrality) because their residence lies in a higher-tax country. Such a situation would be inefficient and, from the perspective of the firm, unfair. The preference for capital-export neutrality mentioned above has been challenged in recent times and on the basis of these challenges source taxation has been put forward as superior. Otto Gandenberger critiqued capital-export neutrality on two grounds. Firstly, if residence taxation is employed and the rate of tax in the residence country is higher than in the source country, an enterprise would face a higher overall tax burden than its competitors and be less likely to finance new investment in the source country. Secondly, Gandenberger argued that the level of taxation in a country is likely to correspond to the level of public goods provided. A country providing fewer public goods will typically have a lower tax rate than one providing more public goods. If true, an enterprise’s decision whether to invest in a lower-taxed country could be affected since it would receive less public goods in the source country than in the country of residence, yet it would still be residence country’s higher tax rate.
There are numerous practical obstacles to adopting source as the exclusive basis for taxation. Modern technology makes it easier to trade in a source country without a physical presence, but without such a presence (i.e. something that could operate as a tax withholding agent or as security for the tax liability) it is difficult for the source country to enforce tax rules. Secondly, and as noted above, source taxation benefits e-commerce importing countries to the detriment of exporting countries and therefore an international consensus would be difficult to build. It would also be extremely difficult to reach an agreement regarding how taxing-rights would be apportioned among jurisdictions which claim that income is sourced in their territory. Without such an agreement double taxation could result.
This section has evaluated two significantly new approaches to international taxation. Each approach has strong theoretical grounds but also significant problems. Overall, neither approach has clearly established itself as a necessary solution to the difficulties established in parts one and two, or a significant improvement to the current system. Therefore neither can be recommended. Overall, residency and source remain workable, and a new approach is unnecessary.