Bernard du Plessis
CA(SA) MCom (Taxation) (Pret)
PricewaterhouseCoopers
Michelle Viljoen
CA(SA) MCom (International Taxation) (RAU)
Introduction | Jurisdiction | International tax concepts | Identification of taxpayer | Transaction information | Collection mechanisms | South African income tax concepts | South Africa: the future | Conclusion | Author biographies
1. Introduction
The advent and growing use of the Internet and electronic commerce (“e-commerce”) has signalled the beginning of a new era in taxation. Many fundamental tax concepts, currently used in tax jurisdictions globally, are challenged. Tax authorities will have to adapt their application of existing tax principles, practices and procedures for an e-commerce environment. Alternatively, new methods of levying and collecting taxes will have to be devised. Taxpayers, on the other hand, will have to adapt their tax planning strategies and consider the impact of a changing business environment on their global tax charge.
 
In essence the problems of physical location and distance (and time) as an obstacle to economic development have been overcome by e-commerce. A person’s need through centuries to be physically close to markets has fallen away. Services can be supplied and goods sold remotely, and that is the crux of the problem. However, most taxation and tax collection systems in force globally are based on the premise of physical presence of a taxpayer in a jurisdiction as a prerequisite to having a taxable presence there. This premise potentially renders the application of these systems ineffectual in an e-commerce environment.
 
For any tax system to be effective, four fundamental requirements must be met.1 These are:
  • Jurisdiction to tax, which is commonly defined as the power, authority and control in the territory over which taxation authority is exercised. Jurisdiction is a significant issue as this authority is generally confined to a particular geographical territory, while e-commerce by its nature is not.
  • Identification of the taxpayer who is responsible for remitting tax revenue is a fundamental element of any tax system as remedial action is required in the event of default.
  • Transaction information (including nature and value), which is essential for tax administrators in order to effectively assess and collect taxes.
  • Mechanisms to collect taxes effectively are also an integral part of any efficient tax system. If taxes duly payable cannot be collected, or if the cost of collection is unacceptably high in relation to the amount collected, then a tax system is ineffective.

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Due to the fragmentation of commercial functions and risks in e-commerce transactions and ventures, identifying the taxation rights of various jurisdictions has become extremely difficult. Similarly, it is virtually impossible in many instances to identify the taxpayer, or specific transaction information. It follows that collection of tax also becomes difficult if not impossible to enforce.
 
The challenges posed by e-commerce are not new; they have been prevalent in mail or telephone ordering businesses for many years. The reasons for their increased significance in an e-commerce environment are twofold. First, cross-border transactions are made faster and easier by new technology (quicker processing and data transmission) and increase the mobility of goods, services and resources. These factors have made it harder for tax authorities to identify, trace, locate and value transactions. Second, most of the logistical constraints of traditional mail-order businesses have now been overcome through new technology. These two technological advances will lead to the proliferation of these types of transactions.
 
It is probably fair to say that, from a taxation perspective, e-commerce will have the largest impact on the taxation of revenue from services and trading in digitised products. The main reason for this is that where physical goods are involved and have to be moved between locations and states, transactions will still have a physical element that is easier to subject to tax, e.g. customs duties on shipment and importation of goods. Services and digitised goods such as computer software and recorded entertainment (audio and visual) also form an important part of many world economies. The United States Department of Treasury (USDT) identified a number of industries that are most likely to be affected.2 These are computer software, photographic images, media, online information, services, health care, video conferencing, share trading, global dealing in securities and offshore banking and incorporation of entities.

E-commerce will affect most of the developed and developing economies of the world. It could also have a profound effect on the global distribution of tax revenues if global policies are not adapted to deal with the taxation of e-commerce, as illustrated in the example below. It is, therefore, crucial for tax authorities and taxpayers alike to assess the efficiency of current domestic tax legislation. This is of particular importance in South Africa where income tax is substantially levied on a source (geographical) basis.

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We now turn to investigate in more detail the specific impact that e-commerce will have on international and South African direct tax concepts.
2. Jurisdiction
A major problem posed by e-commerce is the identification of the country or countries that have the jurisdiction to tax specific transaction income. The essence of e-commerce is that transactions are carried out without any regard to national or geographical borders. E-commerce does not seem to occur in any physical location but instead takes place in cyberspace. Persons engaged in e-commerce could be located anywhere in the world, and their customers will be ignorant of, or indifferent to, their location. However, in order to be taxable in a specific jurisdiction certain connecting factors need to be present.
3. International tax concepts
3.1 Connecting factors and domestic tax systems
Traditional principles of international income tax are closely tied to the question of physical presence. A country’s income tax system must specify to whom (individuals, corporations and other entities) the tax applies and, for those it does apply to, what income is subject to tax. Internationally, residence and source are the two most widely used connecting factors. At present most states will not assist other states in enforcing their tax claims. Hence, a country will be most successful in the collection of revenue in the international context if it focuses its enforcement activities on persons or economic transactions connected with that country. As a matter of principle, the country of residence is regarded as the place with which a taxpayer has the closest personal links (his/her real home). The country of source is the country with which income has its closest economic connection. Most tax systems contain elements of both resident and economic taxation. Income tax is normally levied on the domestic and foreign (world-wide) income of its residents and on the domestic source income of non-residents.

E-commerce may affect the efficiency of tax systems. Residence-based tax systems are, as discussed below, generally better suited to deal with e-commerce. Existing income allocation between states, and consequently the allocation of tax revenues, may become distorted as a result of new technology and e-commerce (see the example on page 236).

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Countries that import capital and skills, such as South Africa and most other African countries (normally source-based tax systems), are likely to experience an erosion of their tax bases if the application of existing tax legislation is not adapted to deal with e-commerce. For this reason it is likely that there will be a global trend away from source-based tax systems to residence-based tax systems.
3.2 Source
A source-based tax system (fundamentally based on geographic location) has shortcomings in an electronic business environment, as e-commerce is not bound by any statutory or geographic boundaries.
 
The reasons for the shortcomings are twofold. First, the true source of income has become somewhat obscured as the elements of a transaction can be performed in any number of jurisdictions. For example: an order for goods can be placed by a buyer in one country, the order processed through a server in another, payment effected in a third, and delivery processed from a fourth country. It becomes increasingly difficult to determine the source (and dominant source under South African case law3) of income. Second, it has become easier and more economically feasible to transfer significant value added elements of businesses, which account for a significant portion of the profits of the enterprise, out of the source jurisdiction. The transfer will typically be to a low tax jurisdiction.
 
In this regard it is then also interesting to note that both the USDT and the Australian Taxation Office (ATO) speculate on the demise of the source basis of taxation. The USDT takes the following, interesting view:4

“The growth of new communication technologies and electronic commerce will likely require that principles of residence-based taxation assume even greater importance. In the world of cyberspace, it is often difficult, if not impossible to apply traditional source concepts to link an item of income with a specific geographic location. Therefore, source-based taxation could lose its rationale and be rendered obsolete by electronic commerce. By contrast, almost all taxpayers are resident somewhere ...”

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In similar vein the ATO comes to the following conclusion:5

”The Internet provides an environment where automated functions, by their very nature, may be able to undertake a significant amount of business activity in a source jurisdiction with little or no physical activity or participation in the economic life in any jurisdiction anywhere. This highlights the inappropriateness in an Internet environment of allocating taxing rights on a concept based on geographical fixedness.”
 

Both countries agree that source as a basis for taxation will come under
pressure. As regards the application of Australian source rules the ATO further states that:6

“Australia’s source rules are challenged by electronic commerce. Universal access to a web site, automation and high mobility mean that most electronic commerce activities may generate considerable revenue without necessarily being located in close physical proximity to the market and without significant use of any infrastructure anywhere. For highly mobile activities (e.g. high value services), source rules based on location are more likely to facilitate tax planning. The need to apply source rules to different types of income on a case by case, factual approach will create considerable difficulties in an Internet environment with a large number and variety of interfaces, activities and modes of delivery.”
The Organization for Economic Co-operation and Development7 (OECD) also identified source rules as a generic problem area for all member states.
“The Internet is expected to pose challenges to the operation of the domestic source rules of all member countries. The ability of members to apply domestic source rules to Internet businesses could become crucial if most Internet businesses eventually migrate to low tax jurisdictions, which are generally expected to fall outside tax treaty networks. Potential jurisdictional and enforcement issues for source rules will be common to all OECD members and are likely to benefit from a co-ordinated approach.”

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Judging from these quotes, e-commerce will increase the urgency for South Africa to transform its substantially source-based tax system into a residence-based tax system, a process that has already started with the introduction of sections 9C and 9D of the Income Tax Act in 1997. The application of source-based provisions will also have to be adapted to be effective in an e-commerce environment. The example below illustrates how South Africa’s tax base could potentially be eroded if no action is taken to adapt the application of existing tax provisions, both in domestic law and in its tax treaties.

 


Example

ABC Limited, resident in country A, sells goods in South Africa and earns taxable income of R100. Country A has a residence-based tax system and South Africa has a source-based tax system.
 
In column A of the table ABC Limited sells the goods through traditional, fixed business premises (e.g. a shop or store) situated in South Africa, which will be treated as a branch for South African tax purposes. The source of the income is, therefore, in South Africa and the company will be subject to tax under South African domestic tax rules at the rate of 35% (branch tax rate). South Africa will generally, under the appropriate South African double tax treaty, have the right to tax the income as ABC Limited has a permanent establishment in South Africa.

Country A will also tax the R100 as ABC Limited is resident there. However, a foreign tax credit will be granted for foreign taxes suffered. The credit will be limited to country A tax arising from the inclusion of the South African profits (i.e. 30).

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In column B ABC Limited sells its goods through a web site with no physical presence in South Africa. As ABC Limited does not have any physical presence in South Africa the source of the income is not from South Africa and it arguably does not, for the purposes of the South African double tax treaty, have a permanent establishment in South Africa. As such, South Africa will not have the right to tax the income of ABC Limited.
 
As ABC Limited, however, is resident in country A, the income will be subject to tax in country A on its profits generated in South Africa.
 
 
A
B
 
Conventional business
Virtual business
 
in South Africa
in South Africa
Profit
100
100
South Africa:
branch tax @ 35%
  (35)
    0 
Country A: tax @ 30%
   30 
  (30)
Less credit
  (30)
    0 
Profit after tax
   65 
   70 
Tax collected by South Africa
   35 
    0 
Tax collected by country A
    0 
   30 
 
In the case of conventional business being carried on in South Africa, South Africa collects R35 of tax revenue. Where the business is carried on electronically, South Africa will lose R35 of tax revenues. Country A will then collect R30 which it would not have collected in the case of a conventional business being carried on in South Africa. It is therefore clear that the collection of tax revenues has shifted away from South Africa to country A. South Africa loses R35 of tax revenue. This simplified example also illustrates why the issue of international allocation and distribution of revenues (discussed above) is so important, especially for capital and skills importing countries such as South Africa. Double tax treaty concepts will also be affected.

For skills and capital importing countries, such as South Africa, a move away from a source-based tax system to a residence-based tax system should ensure a more efficient system of taxing e-commerce, especially for that of income for services and digitised goods. Although generally better equipped to deal with e-commerce, a residence-based tax system is, however, still vulnerable to e-commerce.

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3.3 Residence
Although it appears that residence-based (world-wide) tax systems would be more suited and effective in an e-commerce environment, they are not without problems. Communications technology potentially affects residence tests under domestic tax laws and under double tax treaties, to the extent that reliance is placed on the location of management functions to determine a taxpayer’s residence.
 
Not only is this relevant for determining the operation of the “place of effective management”, the so-called tie-breaker test contained in most double tax agreements, but also for domestic tax systems that use tests such as “seat of management”, “place of management”, or “central management and control”.
 
The term “managed and controlled”in most countries generally means the place where strategic decisions (as opposed to executive decisions) are reached, i.e. where the board of directors meets. This is also the case in South Africa. This principle is based on the assumption that the directors will physically meet in a boardroom, around a table. This is no longer necessary. Directors can hold a board meeting, through video conferencing, while located on five continents.
 
This immediately prompts the question, “Where is the company resident?”In this regard the ATO warns8 that:
“The instantaneous and global facilities provided by the Internet are expected to allow residents to more easily influence the operations of their offshore subsidiaries (which would include tax haven entities). There is no clear guidance as to where such a business would be regarded as being carried on. Moreover, there would be difficulties in applying the concept of central management and control. The possibility of undetectable, anonymous or unverifiable nature of these communications could make it even more difficult for the ATO to obtain evidence of these activities should a taxpayer wish to conceal or disguise them.”

Even if guidelines were laid down in domestic law to determine where a company is managed and controlled, due to technological advances it will in principle still be easier for taxpayers to migrate or move their places of residence than is the case at present. The highly mobile nature of e-commerce and the ability of residents to establish offshore non-resident companies could lead to a tax-driven migration of businesses to low tax jurisdictions, as is the case in source-based systems. It will also be possible for a person to be more involved in the management of the operations of a business in a specific country, without necessarily having tax residence in that country. This will place even greater importance on the role of controlled foreign corporation measures and their current effectiveness in addressing e-commerce transactions. Even if residence rules and controlled foreign corporation measures prove to be capable of adequately dealing with e-commerce, potential for complete anonymity for Internet users could facilitate widespread offshore or domestic economic activity that cannot be traced back to users.

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3.4 Double tax treaties
Double tax treaties are bilateral and generally cover income and capital gains taxes. The primary function of a double tax treaty is to avoid double taxation of residents of the two contracting states and to prevent fiscal evasion by resident taxpayers. Tax treaties also provide residents of a state certainty on how their income will be taxed in the other state and this encourages international trade.
 
A key concept in any double taxation treaty is that of a permanent establishment. The application of this concept in an e-commerce environment may also be affected.
3.5 Permanent establishment
A permanent establishment is the concept used in double tax treaties to determine whether a resident of one state has a taxable presence in the other contracting state. Most of South Africa’s double tax treaties are based on the OECD Model Tax Treaty and under Article 7 of this treaty a resident of one country (A) can only be taxed on business profits in the other (source) country (B) if the income is connected to a permanent establishment of such resident (A) in the source country (B).
 
Get the OECD Model Tax Treaty at
 
Get all the Double Taxation Agreements South Africa concluded at http://www.sars.gov.za
 
The OECD Model Tax Treaty defines, in Article 5, what constitutes a permanent establishment:

“a fixed place of business through which the business of an enterprise is wholly or partly carried on”.

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In paragraph 2 of Article 5, the term permanent establishment furthermore specifically includes: a place of management; a branch; an office; a factory; a workshop; and a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
 
Article 5 continues in paragraph 5 with a further inclusion, which states that a dependent agent can also create a permanent establishment. Paragraph 5 states:
“where a person... is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State... unless the activities of such person are limited to those mentioned in paragraph 4...”
The exclusions in paragraph 4 mentioned above are the following:
 
a) 
 the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise
   
b) 
 the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery
   
c) 
 the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise
   
d) 
 the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise
   
e) 
the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character
   
f) 
 the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.
   
Fundamentally, the concept of a “fixed place of business” is founded on a
philosophy that taxing rights should be linked to a certain level of physical
presence, where physical presence can mean assets, or personnel, or both.

The principle of physical presence comes under pressure where a business is able to exploit a market in a country without establishing a significant physical presence there.

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With e-commerce, the same pressure is experienced on the physical presence test. The key question here is whether a web site or a server, owned or used by a foreign company, can create a physical (taxable) presence in a country, taking into account that there would not necessarily be any employees of the company present in the host country.
 
In an e-commerce environment there may be arguments or debates whether a web site and web page could create a permanent establishment. The same question arises in respect of servers.
3.6 Web sites and web pages
Looking at web sites one has to ask whether a web site can be considered a fixed place of business through which the business of an enterprise is wholly or partly carried on. Does the permanent availability of the web site to customers in a state, and the carrying on of business through that facility, give it a fixed place of business in that country? In considering the taxability of a web site regard must be had to the nature of the information displayed and the transactions carried out.
 
As mentioned above, one of the specific inclusions under permanent establishment in Article 5 of the OECD Model Tax Treaty provides in paragraph 5 that where a person is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting state an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that state.
 
The question then arises, could a web page be considered to be a form of physical presence in a country, based on the theory that it acts as a type of dependent agent that can conclude contracts on behalf of the company? Almost, but in fact not.9 The web page itself, while perhaps being an asset, cannot itself accept orders. The order acceptance would be done by an operator in some other location, albeit over the Internet. In any event, a web page might not be considered a fixed place of business. How many times would a web page need to be accessed in a particular country for its presence to be considered fixed or habitual, rather than temporary?

A further argument could be that web sites and web pages are not permanent establishments as the activities performed by web sites are limited and of a preparatory or auxiliary nature. In terms of paragraph 23 of the Commentaries to Article 5 of the Model Treaty, the supply of information is specifically regarded as being of a “preparatory or auxiliary” nature.

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The views expressed above were confirmed in a draft document released by the OECD for comment on 29 September 1999.10 This document suggests that web sites per se do not constitute permanent establishments. A distinction must also be drawn between computer equipment and the data and software used by that equipment. An Internet web site may be seen as a combination of software and electronic data that is stored on, and operated by, a server. The web site itself (i.e. the software and data) does not involve any tangible property and therefore cannot itself constitute a fixed place of business as intended by paragraph 1 of Article 5 of the OECD Model Treaty.
3.7 Servers
Paragraph 10 of the Commentaries to Article 5 makes it clear that a permanent establishment may exist “if the business of the enterprise is carried on mainly through automatic equipment”. In such a case, the location of the automatic equipment is the main determinant of presence. The computer server may be viewed as a fixed place of business for the company, in which case the country in which the server is located may want to claim some taxing rights over a portion of the profits. A counter argument may be that the provision of the information stored on the computer is merely auxiliary (Article 5, paragraph 4(e), or that the computer is merely a place for the storage of goods or services (e.g. the information) belonging to the enterprise (Article 5, paragraph 4(a)).11
 
In the OECD12 discussion document referred to above, a distinction is made between software used for a web site, and the server through which that web site is operated. This distinction is important, as entities conducting business through web sites often do not operate the server (e.g. they lease space on a third party server). Unless the server in another country is at the disposal of the enterprise that conducts business through the web site, the mere operation of the web site through a third party server located in a country will generally not constitute a PE of the web site owner. Having so stated, even if the web site owner controls the server, the server will only be regarded as a permanent establishment if it is “fixed”, i.e. it is located at a certain place for a sufficient period of time.

The proposal document also addresses whether Internet service providers (ISPs) can be viewed as permanent establishments of web site operators. Generally ISPs will not be deemed permanent establishments of the web site operators, as the ISPs will not be dependent agents of the web site owners.

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Where e-commerce is carried on through computer equipment (servers) and the operations are restricted to specified preparatory or auxiliary activities, a permanent establishment cannot be created. Whether or not activities qualify as being of an auxiliary or preparatory nature, depends on the facts of each case and will be determined by the relevant country.
 
Even if a web site or server can be classified as a permanent establishment, only so much of the income that is attributable to the permanent establishment can, under Article 7 of the OECD Model Tax Treaty, be taxed in the jurisdiction in which the permanent establishment is present. Given the fragmentation of various elements of a typical e-commerce transaction (i.e. various elements of a transaction are carried out in various jurisdictions) it is difficult, to say the least, to allocate values to the various elements of the transactions. No guidance is given by the OECD discussion document on this matter. This matter is, however, currently being considered by the OECD Steering Group on Transfer Pricing.
3.8 Characterisation of income
Another challenge posed by e-commerce is the characterisation of income. The nature of the income may have an impact on the way in which it is taxed. Take, for instance, withholding taxes on royalty payments.
 
Article 12(2) of the OECD Model Convention defines royalties as:
“payments of any kind received as consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films”.

As mentioned earlier, the Internet does not only make it possible to carry out the buying and selling of goods and services; it also allows digitisation, which opens up the potential for a number of types of goods to be delivered electronically. Any information that can be digitised, such as books, music, films, computer programs and images, can be transferred and sold electronically. A buyer’s right in the sale of digitised information may vary, depending on the contract between the parties. For example, the buyer could obtain the right to use a single copy of a book and to reproduce 10 copies for special purposes, or obtain the right to reproduce the book for mass circulation. Some of these transactions may be equivalent to the purchase of a physical copy of the book, which would result in business profits; others would rather result in royalty income, which may be subject to withholding tax in the source country.13

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It is not clear how the definition of royalties will apply to the sale of digitised information.14
3.9 Income from the sale of goods v royalties
Digitised information presents unique issues because it can be perfectly and easily reproduced. Someone desiring to purchase 10 copies of an electronic book may simply purchase one copy and acquire the further right to make nine additional copies. This transaction may be seen to create royalty income, at least in part, because the right to make reproductions is a right reserved to the copyright holder. By allowing a buyer to make reproductions, the payment is, at least in part, for the use of the copyright. On the one hand it may be argued that some of these transactions, such as the electronic purchase of a digital book, are merely substitutes for conventional transactions involving physical objects and that it would be inappropriate to treat them as creating royalty income. On the other hand, it is arguable that the transactions could involve substantial differences. For example, a consumer purchasing a physical copy of a book is usually unable to manipulate the data in the book, while a consumer downloading a digital copy of the book may be able to alter its format, manipulate the data, etc.15
3.10 Service income v income from the sale of goods/royalties

Digitised information also poses problems for the definition of service income, as distinguished from sales of goods income or royalties.16 Previously a reference work, such as an encyclopaedia, would have been sold as a set of bound volumes and such proceeds would have been regarded as income from the sale of goods. Now, instead of purchasing a bound volume, a potential buyer may be able to choose between a set of CD-ROMs and a computer online service through which the encyclopaedia’s content can be accessed. If the customer has a sufficiently fast modem connection, there may be little practical difference between accessing the online service and the CD-ROMs on the buyer’s personal computer. However, the proceeds of the sale of CD-ROMs will result in income from the sale of goods, while the character of the income arising from the online service is not clear.17 The online service may result in service income. In some instances, it could also be characterised as the distribution of copies of copyrighted works. A distinction between sales of goods and service income may still, however, be appropriate in this scenario. The online service will have to be frequently updated and the user of the online service must continue to make periodic payments. In contrast, the purchaser of the CD-ROM acquires the right to use the disk in perpetuity, for a single payment.18

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Given the characteristics of digitised information and the associated characterisation problems, it may be necessary to reconsider the definition of royalties in the OECD Model Tax Treaty.
 
An international tax principle that also considers the character of the income to determine whether it is taxable within a specific jurisdiction is the so-called controlled foreign corporation (CFC) legislation, which taxes specific types of income in the country of residence. CFC legislation is a form of anti-avoidance legislation used predominantly in residence-based tax systems. Transfer pricing legislation is another anti-avoidance measure used in the international arena.
3.11 Transfer pricing
The term transfer pricing is used for the process of moving profits out of high tax jurisdictions to low tax jurisdictions through pricing of goods or services. This is normally done by over- or under-invoicing of goods or services. The communications revolution and the growth of e-commerce will also make the application of transfer pricing measures more difficult. The nearly instantaneous transmission of information and the effective removal of physical boundaries will make it more difficult for tax administrations to identify, trace, categorise and quantify cross-border transactions. E-commerce may furthermore put pressure on the traditional transfer pricing approach taken to deal with non-arm’s length transfer pricing even though the basic nature of the problem has not changed.19  

The traditional transfer pricing approach, based on the OECD’s Transfer Pricing guidelines of 1995, requires:

  • a transactional approach
  • to establish comparability (taking into account functions performed, assets used and risks assumed) between the controlled and the uncontrolled transactions

Due to the speed, frequency, anonymity and integration of e-commerce transactions the effective application of a transaction based approach becomes more difficult. Furthermore, even if specific transactions can be identified and quantified, the obtaining of comparable transaction information may become impossible. The availability or absence of reliable comparable data also affects the selection of the most appropriate transfer pricing methodology.

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We have considered the impact of e-commerce on international tax concepts but, as discussed above, it will also have an effect on source-based tax systems as in South Africa. Adjusting its tax policies will, therefore, be essential if South Africa is to defend and secure its tax base in an electronic business environment.
 
As mentioned earlier in this chapter, jurisdiction is only one of the four requirements that must be met for a system of taxation to be effective. The next key requirement is the identification of the taxpayer.
4. Identification of taxpayer
Even though a country may have the jurisdiction to tax, it must still be able to identify the taxpayer before the tax authorities can collect taxes.
 
Currently, the links between activities on the Internet and the physical parties associated with the Internet are weak. The composition of an Internet address (or “domain name”) only indicates who is responsible for maintaining that name. It has no relationship to the computer or user corresponding to that address or even where the machine is located. Registration requirements are not difficult to satisfy and there is little to prevent transfer of the site to new controllers.20
 
The ATO made the following comments on the matter:21
“A key issue will be the extent to which the Internet will allow business activities to be undetectable or anonymous, so that the key taxing and auditing requirements of the existence and identity of persons or transactions cannot be determined. A high level of non-detection could lead to tax evasion in a highly competitive global business environment where businesses may be forced to adopt non-compliance facilities to compete with other businesses, thus exacerbating non-compliance. The migration of businesses to the Internet may be partially driven by the tax avoidance and evasion opportunities it presents.”

Currently, there is no facility to determine the owner of an existing web site. Monitoring the Internet sites is also not an option because usage may not leave a trail to the ultimate owners. The owners could use bogus names or complex networks to hide the existence or location of web sites. Many web sites will exist on offshore servers that will make monitoring even more difficult. Even where monitoring is possible, encryption may make it impossible to determine the nature and value of Internet activity and business transactions.

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In addition to weak links between the e-commerce world and the physical world, many of the emerging electronic payment systems, such as electronic cash and smart cards, are being designed to operate like cash, in that their use cannot be associated with a particular operator. This functionality will also weaken the ability to identify a taxpayer.22
 
Another concern, from a different perspective, is the need to verify the identity of a counterparty for double tax treaty purposes. For example, a seller of electronic information may claim to be a resident of a treaty country and thereby entitled to a reduced or zero rate of withholding tax on royalties. At present, in some countries, a payer may be able to rely on the postal address of the payee. In e-commerce there is not necessarily any relationship between an Internet address and a physical location. A person could easily establish an Internet address in a treaty country without any other connection to that country. If withholding taxes are to be imposed on e-commerce, it will be necessary to establish standards and procedures for verifying the identity of electronic counterparties. For example, a taxpayer who downloads a digitised photograph from an electronic photograph agency could obtain the right to reproduce the image in a book or magazine. The payment for this right would presumably be a royalty.23 This raises the question as to how the taxpayer would verify the payee’s claim that it was entitled to a reduced rate of withholding tax, and furthermore, if withholding was necessary, how would it be administered?
 
Two of the fundamental requirements of a taxation system have now been
discussed: jurisdiction and identification. A third fundamental requirement is information.
5. Transaction information
Usually the information required is about some measure of financial value that is subject to taxation.

In the physical world, the information to support the existing tax base is found in the financial records of a taxpayer or other entities such as banks and deed offices and, at the lowest level, in source documents such as receipts and invoices. Source documents are considered useful because they indicate the date and value of the transaction. They are also considered reliable because they cannot easily be altered without leaving evidence of such alteration.

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Electronic records, such as those that may be produced in an e-commerce environment, are not so robust. Electronic records can be altered without trace and therefore the reliability of these records may be more questionable. Further, an encrypted electronic record may not reveal any information about the value of a transaction.
 
Finally, there must be a way to link the information about the transaction to a taxpayer. In the physical world this can be achieved by examining documents for names and addresses. In the e-commerce environment, the weaknesses in the identity arrangements and some of the technological characteristics of the Internet mean that the ability to link transactional information to a taxpayer is also challenged. Even if the link is established, an audit trail will be required to verify the completeness and accuracy of the taxpayer’s tax position. By law, taxpayers are required to keep accurate books and records, which are subject to examination by the revenue authorities to, if needs be, verify the income and expenses reported on the taxpayer’s return. Traditionally, these records were kept in hard copy format. However, taxpayers engaged in the sale of electronic goods or services may never create paper records because customer orders are placed and fulfilled electronically, and therefore the only record that exists of these transactions could be an electronic one, which can easily be altered.24
 
Indirect methods of calculating and collecting tax, such as the capital reconciliation used by South African Revenue Service (SARS), may also be rendered inefficient through e-commerce and the lack of information to do such a test calculation.
 
The fourth fundamental requirement of tax administration is to have efficient collection mechanisms.
6. Collection mechanisms
In general, tax collections are facilitated by identifying key “taxing points”. A common example of a key “taxing point” is the tax arrangements whereby employers remit PAYE tax deductions on behalf of employees. Another example is the reporting and withholding requirements that are imposed on financial institutions because they are easy to identify.25

Efficient collection mechanisms are being challenged because the traditional taxing points are under threat owing to an effect known as “disintermediation”. Basically, disintermediation is the connecting of producers and consumers directly, cutting out middlemen such as wholesalers, distributors, retailers, agents and financial institutions. Although from a purely economic perspective such “friction-free” capitalism may be an advantage of the new technologies, the potential loss of these intermediate functions poses a problem for tax administration.

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The disintermediation that results from e-commerce may cause problems in the collection and administration of cross-border withholding taxes, resulting in revenue losses.
7. South African income tax concepts
South Africa predominantly taxes income on a source basis. Source principles are based on geographic location of certain activities, actions and businesses.
7.1 Source
The term “source” is not defined in the South African Income Tax Act. To determine the actual source of income a case by case, factual approach is followed as the courts have indicated26 that it would be an impossible task to formulate a definition of source that would provide a universal test for all kinds of income. Let us now consider some of the main principles laid down by the courts to determine the source of income, and how effective they are in an e-commerce environment.

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Get updated Income Tax legislation at
http://www.sars.gov.za/ho/bills_acts/index_bills_acts.htm
 
In the case of CIR v Lever Bros and Unilever Ltd27 the court held that in order to determine the source of income two problems must be resolved. First, the originating cause of the income must be determined. Once that has been determined, the location of the originating cause must be determined. The source of the income will be where the originating cause is located. It was held in the case of CIR v Black28 that where the income had multiple originating causes, the dominant cause of the income arising must be determined. The source of the income will then be where the dominant source of the income is located.
 
In determining the originating source of income the courts have generally isolated two fundamental bases or causes: one, the employment of capital, and the other, activities. The employment of capital cause was first formulated in the case of COT v William Dunn & Co. Ltd.29 The test has been applied in a number of important cases.30 It has often been used in conjunction with a “place of business”, as the capital of a taxpayer is often employed where the person’s business is carried on. The place where business is carried on has also been expressed in other ways, e.g. the place where contracts are concluded (Lovell & Christmas Ltd v COT31) and the place where control is exercised (Overseas Trust Corporation Ltd v CIR32).
 
Will this base be effective to determine the source of sales income of a non-resident vendor that sells goods in South Africa through a web site? If the person sold the goods through a conventional shop in South Africa there would be a direct link between the capital employed by the foreign entity in South Africa (the shop, its stock, fixed assets and physical business activities carried on) and the resultant income. It would, therefore, be likely that the originating cause of the sales income would be the shop (capital employed) and business carried on in South Africa. As the capital would be employed in South Africa the source of the income would also be South Africa. As such the income would be subject to tax in South Africa.

Where the vendor sells goods via a web site, no physical presence will be required in South Africa. The vendor will generally not employ any significant capital in South Africa: it has “virtual” business premises. It may be argued that the vendor carries on a business in South Africa. Will the business be carried on where the vendor’s activities are made available, i.e. where the buyer places an order, or where the vendor carries on physical business activities (in the host country outside South Africa)? Based on existing case law the latter is more likely. It is therefore doubtful whether the employment of capital test as applied by the courts will render the e-commerce vendor’s income from sales in South Africa, to be from a South African source.

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The location of activities cause was formulated in the case of CIR v Lever Bros & Unilever Ltd.33 The court stated that the originating cause of income was the work that the taxpayer did to earn the income. The work could be the carrying on of a business, an enterprise undertaken, or any activity. Activity may take the form of personal exertion (mental or physical) or it may take the form of employment of capital. It was held that the originating cause (the work) was often a combination of the above. This test was also applied in the case of CIR v Epstein.34
 
As for the capital employment test above it is unlikely that any vendor or person who renders services through a web site or electronically will have to employ any capital in South Africa, as they will not have any physical presence in South Africa. As regards activities or services in an e-commerce environment, the existing application of tax precedent is similarly challenged. The place where a person applies his/her skills and the place where the recipient of the services benefits from these services is not necessarily the same. If the originating cause is where the person who renders the service applies his/her skills (as in the case of Millin v CIR35), the source of income from services rendered electronically by foreigners in South Africa will be outside South Africa. If the originating cause is where the recipient benefits from the service, the test can still be effectively used for electronic or Internet services. Based on existing case law it is doubtful whether the activities test would be sufficient in taxing services rendered electronically.
 
Looking at the potential impact of e-commerce on these two source tests, it is clear that the South African tax base could be significantly eroded if cognisance is not taken of the problems posed by e-commerce.
7.2 Deemed source and residence
Although source is the dominant basis for taxation in South Africa, the residence basis has also found its way into the Income Tax Act. The application of some of the deemed source provisions, such as those contained in sections 9C and 9D, in fact are based on the residence of a taxpayer or its controlling shareholders. Certain important exemptions, such as section 10(1)(hA), are also only available to non-residents, and withholding tax on royalties or similar payments are only levied on non-residents.

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Let us now consider how these sections are likely to be affected in an e-commerce environment.
 
The test applied in South Africa for locating the residence of a company depends on the particular section of the Income Tax Act. For the purposes of sections 10(1)(hA) and 35 a company managed and controlled in South Africa is the equivalent of a South African resident. This is also likely to be the case with section 31. In sections 9C and 9D, a corporate resident is a person other than a natural person that has its place of effective management in South Africa.
 
Neither of the two terms is defined in the Income Tax Act. In determining the place of management and control of a company regard must be had to the business activities of the company and the place where the directors usually exercise their functions and direct the affairs of the company. The place where the directors, as the governing body, meet and exercise their control over the business of the company is therefore important. This is in accordance with UK case law (with high persuasive value in a South African court)36 and the Income Tax Practice Manual of the South African Revenue Service. The place of effective management is generally regarded as the place where the day-to-day activities of the company take place and where the operational functions are performed.
 
The interpretation of the above terms assumes that the strategic functions and the operational functions will be physically performed in one location. For instance, a company is managed and controlled where its board of directors meets, assuming that to be in a boardroom in a particular location. This, as has been pointed out, is no longer necessary as directors could conduct a board meeting through video conferencing while located in a number of different jurisdictions. Where will the company now be resident and will these sections apply to the taxpayer?

It is clear that even residence-based tax principles are under threat from e-commerce, and serious consideration should be given to the effective application of these provisions in an e-commerce environment.

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8. South Africa: the future
Over the part two years, a number of tax authorities and leading fiscal organisations (notably the USDT, the ATO and the OECD) have studied the impact of
e-commerce on the levying, collection and administration of taxes.
 
The SARS now appears to have followed suit, judging from Media Release 1 of 1999, which refers to a survey to be done on the possible electronic submission of tax forms.

If taxpayers vote in favour of the electronic submission of tax forms, they can expect the following:

  • issuing of tax forms in electronic format
  • receiving various tax forms and supporting documents electronically
  • requesting and receiving correspondence electronically
  • receiving payments electronically together with electronic receipts
  • having standard SARS forms available on the web site http://www.sars.gov.za
These measures will apply not only to Income tax but also for Customs and Excise, Value-added-tax and Employees’ tax.
 
To provide Business South Africa with some certainty on various matters concerning the Internet, the government recently instructed 19 government departments and institutions to draft a discussion paper on the impact of e-commerce on their departments. In this regard Mr Andile Ngcaba, director-general of the communications department, commented as follows:37
“Many businesses and consumers are wary of conducting extensive business electronically because the Internet lacks a predictable legal environment governing transactions and are concerned that governments will impose regulations and taxes that will stifle the Internet commerce.” (our emphasis)

This document was released earlier this year. Working committees have been formed to formulate further detailed guidelines on specific aspects. From the above and the reference to e-commerce in the 1999 Budget it is evident that the government is taking e-commerce seriously. One of the key focus areas is bound to be the impact on taxation. It is good news for South Africa that the taxation issue in e-commerce is receiving attention, as South Africa needs to protect its tax base.

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9. Conclusion
This chapter is a brief overview of some of the important areas where e-commerce will challenge the traditional application of domestic tax legislation and double tax treaties. Although some may question the potential impact of e-commerce on South African legislation, given the relatively small number of Internet users in South Africa, it is critically important for South Africa to stay abreast of, and participate in global developments in e-commerce and its taxation implications. It is in South Africa’s own interest to form a view on how e-commerce will affect its tax base, legislation and tax treaties and to act accordingly, or in conjunction with other nations. Furthermore, there is little doubt that technology will be one of the key drivers in the next millennium and only the foolish will choose, at their peril, to ignore its impact on all aspects of life, not least business.
Author biographies  
Bernard du Plessis matriculated in 1983 from the Afrikaanse Hoër Seunskool in Pretoria, after which he studied at the University of Pretoria and qualified as a chartered accountant. He completed his professional articles with Wiehahn Meyernel in Pretoria. Bernard then spent two years’ national service with the Legal Application Division of the South African Revenue Service during which time he obtained MCom (Taxation) from the University of Pretoria. He joined Coopers & Lybrand in 1993 and spent two years as a manager in the Corporate and International Tax Division of Coopers & Lybrand in London. Bernard is a tax partner at PricewaterhouseCoopers and is currently the head of the International Tax division of the firm in Johannesburg, and also the national lead tax partner for the Technology, Information, Communication and Entertainment and Media skills group. He is also the firm’s national lead tax partner for e-commerce. He has extensive experience in a wide range of areas in international taxation, gained from advising on numerous high-profile assignments, in South Africa and internationally, for multinational groups. He has also published numerous international tax articles in South Africa and international publications.

Michelle Viljoen matriculated in 1989 from Hoërskool Brandwag in Benoni. She obtained her BCom (Accounting) and BCom (Hons) Accounting degrees from the Rand Afrikaans University. Michelle did her professional articles with Coopers & Lybrand and qualified as a chartered accountant in 1996. After joining the Tax Department in 1996 she obtained her MCom (International Taxation) at RAU in 1998. Michelle spent three months with the PricewaterhouseCoopers specialist e-commerce skills group in Rotterdam where she obtained specialist knowledge in the taxation of e-commerce transactions. Michelle is currently a manager in the International Tax Division.

 

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  1. Australia: Discussion Report of the Australian Taxation Office Electronic Commerce Project 1997: Tax and the Internet. Canberra: Australian Government Publication Service (Back)
  2. United States of America: Department of the Treasury, Office of Tax Policy Implications of Global Electronic Commerce. Washington, DC: United States Government Printing Office, para 3.2
  3. CIR v Black 1957 (3) SA 748 (A) , 21 SATC 226
  4. United States of America: Department of the Treasury, Office of Tax Policy Implications of Global Electronic Commerce. Washington, DC: United States Government Printing Office, para 3.2.1
  5. Australian Taxation Office: para 7.2.17 (Back)
  6. Australian Taxation Office: para 7.2.9, 7.2.10
  7. Organization for Economic Co-operation and Development: Electronic Commerce: The challenges to tax authorities and taxpayers. Turku, Finland: Organization for Economic Co-operation and Development, para 119
  8. Australian Tax Office, para 7.2.21
  9. Horner & Owens Tax and the Web: New Technology, Old Problems (1996) 518
  10. Ibid (Back)
  11. Ibid
  12. Organization for Economic Co-operation and Development (1997) 24
  13. Horner & Owens Tax and the Web: New Technology, Old Problems (1996) 517
  14. USA, Department of the Treasury Office of Tax Policy Selected Tax Policy Implications of Global Electronic Commerce (1996) 25
  15. Department of the Treasury Office of Tax Policy, 1996:8, Organization for Economic Co-operation and Development, 1997:26 (Back)
  16. Organization for Economic Co-operation and Development (1997) 27
  17. USA, Department of the Treasury Office of Tax Policy (1996) 29
  18. Department of the Treasury Office of Tax Policy (1996) 29
  19. Organization for Economic Co-operation and Development (1997) 29
  20. Organization for Economic Co-operation and Development (1997) 26
  21. Australian Taxation Office (1997) 49 (Back)
  22. Australian Taxation Office (1997) 49
  23. Organization for Economic Co-operation and Development (1997) 11
  24. Organization for Economic Co-operation and Development (1997) 12
  25. Australian Taxation Office (1997) 50 (Back)
  26. CIR v Lever Bros and Unilever Ltd (1946 AD), 14 SATC 1
  27. (1946 AD) 14 SATC 1
  28. (1957 AD) 21 SATC 226
  29. 1918 AD 609
  30. COT v William Dunn & Co. Ltd (1918 AD) 609; M Ltd v COT (1958 SR) 22 SATC 27; Overseas Trust Corporation v CIR (1926 AD) 2 SATC 71; Rhodesia Metals Ltd (in liquidation) v COT (1940 AD) 11 SATC 244; CIR v Black (1957 AD) 21 SATC 226 (Back)
  31. (1908) AC 46
  32. (1926 AD) 2 SATC 71
  33. (1946 AD) 14 SATC 1
  34. (1954 AD) 19 SATC 221
  35. (1928 AD) 3 SATC 170 (Back)
  36. De Beers Consolidated Mines Ltd v Howe (Surveyor of Taxes) [1906] AC 455 and Union Corporation Ltd & others v Commissioners of Inland Revenue [1953] AC 482, 34 TC 207
  37. Business Day, 21 January 1999 (Back)