The borderless nature of e-commerce makes it difficult to define where income is earned, when a product is purchased, or value is added. As a result, it is difficult to determine at what point profits are being made and what country is allowed to tax them. The operation of consumption taxes, such as sales tax in the US and Canada, and Value Added Tax ("VAT") in the European Union, depends heavily on the ability of the taxing authority to find traces or records of transactions. This is especially difficult when the transactions at stake involve the purchase of a digital product from a seller located in an offshore tax haven.
The Internet offers the opportunity to perform transactions at a distance. This poses several difficult issues, such as determining the location of a transaction. Indeed, from a tax standpoint, websites and servers through which these transactions are made don't constitute a taxable presence in another country, since a website alone is not a fixed place of business. The collection of sales tax/VAT from a transaction involving digital product and conducted with offshore e-businesses is one of the most difficult issues regarding e-commerce taxation.
What exactly is the problem?
Let"s consider for instance the case of an individual consumer who wants to buy a product on the Internet. If this product consists in goods ordered and paid for from a distant seller and requiring physical delivery within the taxing jurisdiction, the case is quite simple, because a cross-border transit is necessary. Internet sales of this type are no different from existing mail-order catalogue sales. But if this product consists in digital but taxable goods, and the seller is outside the tax jurisdiction, then the tax will be hard to collect. Indeed, the taxing authority won't know and can't know about the transaction unless the consumer chooses to tell them, which is not likely!
How do sales tax/VAT regimes work?
In sales tax jurisdictions, the key concept is "nexus," meaning a sufficient presence in the taxing jurisdiction to justify collection of tax. In the US each State levies its own sales and use tax, so that an out-of-state supplier normally won't be caught by the tax unless they have physical presence (nexus), or habitual and substantial operational activity in the taxing State. In the latter case, the tax is very often collected from business purchasers in the taxing State through a "reverse-charge" mechanism; but this doesn't work with individuals so that the taxing State must look to the out-of-state supplier for its tax, if it can. Regarding sales made from non-US countries, the rules are clear about sales of physical products delivered in the US: if the seller is in a country with which the US has a double tax treaty. In this case, there is no sales tax unless the company has a permanent establishment in the US. For countries with which the US does not have a double tax treaty, which include almost all offshore jurisdictions, products are taxed on arrival if the sale is "effectively connected with the conduct of a U.S. trade or business."
In VAT jurisdictions such as the EU, taxes are collected based on the value added during each stage of the production and distribution process. There is a clear distinction between goods and services: for goods, VAT is charged on an origin basis within Member States, while for a supply of service between Member States the supplier does not charge VAT and the buyer has to pay it by a reverse-charge mechanism (and can offset it against output tax). Individuals and non-registered traders buying goods across borders will pay the origin tax concerned. Imports of goods from outside the EU are charged with destination VAT at the time of importation. For services, there is also an origin basis for trading within Member States, but for intra-EU cross-border trading the rules become complex. Most services are taxed where delivered, and the supplier has to set up a local office or agent to account for the tax, i.e. to become a registered trader, once turnover is over a certain level. Services delivered from outside the EU to a registered trader will normally give rise to a reverse-charge tax liability, again deductible for the importer. Services delivered from outside the EU to a non-registered person (individual or company) are not taxed, but if the non-EU supplier has a fixed establishment in any member state, then it is liable for tax in that State.
How do these rules apply to e-commerce?
In sales tax jurisdictions, a server is regarded as constituting nexus. It is simple to relocate the server outside of the taxing jurisdiction, and then the taxing authority will have the difficulty of finding transactions to evidence sales or use in the State. Consequently, for e-businesses that locate their servers offshore, in an International Offshore Financial Center ("IOFC") with very low tax or no tax at all, the taxing authority will have a hard time to find any trace of taxable transactions.
In VAT jurisdictions, the issues related to e-commerce are basically the same: for items such as digital goods, it will be hard to collect tax if the seller is outside the tax jurisdiction. A consumer buying digital information from a vendor outside the EU is not likely to account for VAT on it, and the tax is lost. The problems for VAT collection authorities are first that suppliers of services via e-commerce can increasingly avoid a fixed establishment in the EU by placing their servers offshore, and second that digitizing goods turns them into services, which then escape taxation in many situations.
What are the latest developments?
Worldwide, this issue and other issues connected with taxation of the Internet are currently studied. For instance, the EU proposed that companies that transmit digital products to consumers located in the EU should be required to pay a EU value added tax on the product, which in practice will require non-EU companies to register with EU tax authorities and send VAT proceeds to the EU for purchases made by consumers resident within the EU. A new Directive has been adopted in the EU in this respect regarding VAT applicable to certain services supplied by electronic means, such as software, computer services, distance teaching, etc.
Sales tax as well as VAT regimes as applied to e-commerce offer many possibilities to e-businesses to reduce their taxes, usually by trading from without the taxing jurisdiction; and a logical extension of this for an e-business is to base itself in an IOFC.