E-commerce is uncontestably a growing business model which enables businesses to deal across borders. Most international business already are already navigating the intricacies of the international taxation framework. And yes the use of the word “framework” is intentional rather than “system” because a proper and global set of uniform rules does not yet exist.
We previously covered intricacies in the global taxation system such as the application of GST or VAT, Tariffs and duties and the crucial importance for these businesses to develop internal capabilities responsible for understanding their tax and remittance obligations. We’ve also highlighted additional compliance challenges that e-commerce businesses face such as determining the jurisdiction(s) in which tax applies, verifying and evidencing the place of consumption, determining the parties of an e-commerce contract and the correct tax treatments and retaining and protecting customer data.
This article explores another set of challenges that e-commerce businesses face when ascertaining their tax obligations:
- Identifying the nature of the income they provide
- The important concept of “Transfer Pricing”, and
- Dealing with cash and electronic payments.
Identifying the nature of the income
The OECD has said that the proper characterisation of income derived from new business models is one of the “major tax challenges of the digital economy”.
Where products such as books, photos, music, videos or software can be digitised and delivered over the internet, the issue arises as to how the income from the transaction should be categorised, and therefore how it should be taxed.
For example, this consideration applies when a person uses a foreign website to download a computer program or digitised video in exchange for a fee. Depending on the facts and circumstances, some of these transactions may be viewed as the equivalent of the purchase of a physical copy of the video while others would result in royalty income because they involve payments for the use of copyrights.
That is because the purchaser’s rights could vary depending on the contract between the parties. The purchaser of a digitised video could obtain:
- the right to use, or
- the right to reproduce.
The significance of this is that if a purchase of goods is involved, the overseas seller would normally not be subject to Australian tax (unless it has a permanent establishment here), whereas a royalty may be subject to withholding tax. Good and services involved may also have GST, VAT or sales tax implications.
In Taxation Ruling TR 93/12, the Commissioner states that a payment for computer software will be considered to be a royalty where it is:
- Consideration for the granting of a licence to reproduce or modify the computer program in a manner that would otherwise constitute an infringement of copyright (for example, payments for the right to manufacture copies of a program for distribution), or
- Consideration for the supply of know-how (for example the supply of a program’s source code).
Payments would not be royalties where they are for:
- The transfer of all rights relating to copyright in the program
- The granting of a licence which allows only simple use of the software
- A sale of goods (for example where hardware and software are sold in an integrated form), or
- The provision of services in the modification or creation of software.
The above makes sense but in reality, a software licence agreement often covers both distribution rights as well as intellectual property rights and there often is a question as to whether withholding tax can be limited to the component relating to intellectual property rights.
In a few precedent cases, the court considered that the agreement often did not permit the components to be separated in this way, as the distribution rights were wholly subordinate to the intellectual property rights. Withholding tax was therefore payable on the whole amount payable under the agreement.
It is therefore crucial for tax accountants and legal advisors to be involved in the early stages of the product development agreement stages to draft a taxation proof instrument (clearly identifying and breaking up the nature of the agreement) before reaching any e-commerce platform.
Transfer pricing
The growth of e-commerce and the resulting globalisation of some businesses has led to an increase in transactions by Australian businesses with overseas parties. This has increased the scope for transfer pricing by enabling company groups to reduce overall tax by attributing more profit to an entity in the lower-tax country and attributing more deductible outgoings to the entity in the higher-tax country. Australia’s high corporate tax rate will always leave it vulnerable to profit-shifting.
In December last year, Google has settled its tax dispute with the Australian Taxation Office (ATO), paying an extra $481.5 million. Google is the latest tech giant to reach such a settlement, joining Microsoft, Apple and Facebook and according to the ATO, the result brings the increased collections made against taxpayers in the e-commerce industry to around $1.25 billion cash. The ATO’s transfer pricing and Tax Avoidance Taskforce is not limiting its attention to these corporate global giants. Smaller Australian e-commerce businesses will soon be subject to greater scrutiny under the recently introduced Multinational Anti-Avoidance Law which has already seen $7 billion in taxable sales being returned to Australia and the relevant profit of these activities being taxed.
Under the tax rules for regulation of transfer pricing, businesses are required for tax purposes to observe and document “arm’s length” principles in many overseas transactions. There are various methods for determining an arm’s length price:
- The traditional “transaction” methods such as CUP (Comparable Uncontrolled Price), RPM (Resale Price Method) and CPM (Cost Plus Method). These methods rely on third party comparisons, but also rely on the data being available. All these transaction methods create difficulties in dealing with transactions involving services or intellectual property.
- the “profit” methods. These include profit splits or Profit Comparison Method (PCM) determined by assessing how the profit arising from a particular transaction would have been divided between the independent business units involved in the transaction.
In order to avoid the shift of the burden of proof, all businesses transacting across borders need to prepare a formal Transfer Pricing Documentation which substantiates their respective arm’s length transfer price. This may include proper intercompany agreements, relevant correspondence, invoices and receipts.
The importance of preparing proper Transfer Pricing Documentation is regularly underestimated by small- to medium-sized businesses who often pay an heftier compliance and taxation price down the track than had they properly embedded transfer pricing considerations and documentation requirements in the early stages of their e-commercialisation strategies.
Dealing with cash and electronic payment
Existing problems of tax enforcement in relation to cash dealings (also known as the “black economy”) are likely to be increased with the development of electronic payment systems such as ‘Money Network” which may not have an audit trail and may be more convenient than physical cash.
Under the Financial Transaction Reports Act, cash dealers, such as banks and financial institutions, must report currency transactions of at least $10,000 to the Australian Transactions Reporting and Analysis Centre (AUSTRAC). These reports are used by the ATO to check compliance with tax laws. However, their scope is limited as “cash dealers” is not properly defined and “currency” is defined as coin or paper money, and would not cover various electronic payment systems, such as network money or crypto currencies like “Bitcoin”.
Bitcoin allows users to transfer money on the internet without using a bank, credit card issuer or a third party like PayPal. The network is controlled by those using it, on a platform of encrypted software, maintaining security and anonymity. A user installs a bitcoin “wallet” on their computer or mobile device and like a bank account, the wallet is used to store bitcoins and transact with other users.
The ATO treats transacting with bitcoins as akin to a barter arrangement, with similar tax consequences. As a matter of fact, Bitcoin is neither money nor a foreign currency but rather trading stock. Therefore, it does not fall within the rules for recognising foreign currency gains and losses.
The status of trading stock does not only apply to a taxpayer carrying on a business of mining and selling bitcoin but also for businesses receiving bitcoins as a method of payment for goods sold in the ordinary course of their business.
But unlike any other forms of trading stock, Bitcoins is also treated as a CGT asset and this applies for consumers purchasing goods and services using crypto currencies. However, there are no income tax or GST implications if a taxpayer is not in business or carrying on an enterprise and simply pays for personal goods or services in bitcoin. That is because the current CGT legislation provides that any capital gain or loss from disposal of the bitcoin will be disregarded (as a personal use asset) provided the cost of the bitcoin is $10,000 or less.
Conclusion
While the OECD and various international tax bodies are concentrating their efforts on providing clarity and simplifying the e-commerce taxation framework to avoid double or non-taxation, the distinguishing features of electronic commerce — greater anonymity and speed, increased cross-border transactions and product integration — all currently still pose problems for tax administrations and global businesses in applying taxation and transfer pricing rules.
Over the last six months, our series of articles have touched on the following five major intricacies:
- Difficulties in identifying the transactions and the parties involved;
- Difficulties in classifying the type of income involved and the nature of the product, particularly where it has been digitised (for documentation requirements in transfer pricing situations);
- Dealing with cash payment and crypto currencies, and
- Obtaining reliable data to assess arm’s length standards or simply obtaining data overseas;
- Assessing the respective contributions of the related entities to the development of the product, particularly where electronic products are involved, and the production process has been deliberately spread.
E-commerce business strategists should embrace these issues in the early stages of their planning and internationalisation strategies. Breaking down their processes and documenting the arms-length nature of their transactions with the assistance of experts is essential for ongoing compliance to taxation and legal requirements.
Obviously, this area of the legislation and international frameworks integration is rapidly evolving and once again, businesses who are not geared for agile decision-making will not be able to adapt and/or comply. This becomes more and more of a challenge for small-to-medium sized e-commerce businesses who do not have the internal capabilities or resources to devote to these considerations. These businesses should hire, and/or partner with experts such as William Buck to help them navigate the intricacies of the international e-commerce taxation framework. They should do so as early as in the formulation of their e-commerce strategies and on an ongoing basis.
William Buck has developed a complimentary taxation checklist available for download (HERE) listing the relevant questions e-commerce businesses should ask themselves while formulating their strategies.
