Technological developments in electronic commerce over the past several years have strained the ability of the tax authorities to apply existing principles and concepts to tax persons on the resulting income. Perhaps the most obvious electronic commerce transaction involves the sale of goods over the internet. But there are many other types of transactions. These include, banking, access to information databases, travel reservations, stock trading and even gambling to name but a few. Each new form of electronic commerce raises issues as to the manner and extent of taxation of the resulting income. This paper will attempt to outline the most salient aspects of Canadian tax legislation which impact on the conduct of electronic commerce.
I. CANADIAN DISCUSSIONS
Canada has been an active participant in discussions regarding the internet and electronic commerce. On April 30, 1998, the Minister of National Revenue released the report ("Committee Report") of the Advisory Committee on Electronic Commerce (the "Committee") composed of representatives of the private and government sectors. The specific objectives of this Committee were stated to be to:
- Review domestic and international trends in electronic commerce;
- Identify the potential growth and uses of electronic commerce in the future;
- Identify the implications and associated risk of these trends and their growth on tax compliance;
- Examine approaches being taken in other countries; and
- Recommend measures that Revenue Canada should consider to ensure compliance in light of identified trends, risks and international approaches.
The term electronic commerce is not easily defined. However, the Committee Report defined it broadly as "the delivery of information, products, services or payment by telephone, computer, or other automated media". The definition recognized that electronic commerce can take place through many electronic means. These include telephone, fax, automatic banking machine, credit and debit cards, television shopping and the internet. Further, internet access can be by various methods including telephone, cable T.V., cellular mobile networks and satellites.
Electronic commerce can change the traditional sales model involving retailers, wholesalers and distributors so that consumers can more easily have direct access to manufacturers or other suppliers. Traditional jurisdiction rules used in Canada such as residency, place of business or source of income need to take into account the new methods of communication. Also, traditional Canadian tax collection routes such as withholding at source on payments to non-residents may become more prone to advertent or inadvertent non-compliance.
II. NEUTRALITY AS A GOAL
Under Canadian law, functionally equivalent transactions may be taxed differently depending on their form. For example, the sale of prepackaged software may be treated as the sale of a tangible good or licence of intangible which may be subject to different tax rules. The Committee recommended that electronic and non-electronic transactions that are functionally equivalent should be taxed the same regardless of their form. Further, it recommended that the government should avoid placing undue regulation and restrictions on, and should avoid undue taxation of, electronic commerce. The Committee also recommended that tax authorities continue to tax electronic commercial transactions in accordance with existing tax legislation. It noted that existing rules could be adapted and enforcement processes should be bolstered in order to ensure widespread compliance. It encouraged international cooperation.
III. OVERVIEW OF THE CANADIAN TAX SYSTEM
A. Allocation of Taxing Powers
The Constitution Act, 1867 allocates taxing power in Canada between the federal and provincial governments. The Parliament of Canada has legislative authority to raise money "by any mode or system of taxation". Therefore, it can raise money through direct or indirect taxation. On the other hand, provinces are limited to "direct taxation within the province in order to the raising of a revenue for provincial purposes".
A direct tax has been held to be one whose general tendency is to be assessed on the person who is intended to bear it: for example, an income tax or sales tax levied at the retail level. Accordingly, provinces cannot impose indirect types of taxes on vendors of electronic commerce services who would be expected to pass those charges onto others.
B. Taxes Imposed
For the purpose of this subject, the most important federal taxes are those imposed under the Income Tax Act (Canada), Part IX of the Excise Tax Act and the Customs Act. As might be expected, the ITA imposes taxes on various forms of income. The Excise Tax Act imposes a value-added type tax known as the Goods and Services Tax ("GST"). The Customs Act imposes duties in respect of the importation of various goods into Canada.
Each of the provinces impose income tax and, other than Alberta, each imposes a retail sales tax. Three of the provinces have entered into an agreement with the federal government to combine their sales taxes with the GST in the form of a harmonized sales tax ("HST").
IV. INCOME TAX
A. Residents of Canada
The ITA imposes an income tax on the taxable income for each taxation year of every person resident in Canada at any time in the year. Income includes income from all sources inside or outside of Canada. Therefore, a Canadian resident carrying on business outside of Canada will be subject to income tax in respect of that income.
The Canadian courts have traditionally applied the principle developed by the British courts that a corporation is resident where its central management and control is situate. Accordingly, Canadian courts have typically looked to the location of the meetings of the board of directors of corporations in order to determine where their central management and control is situate.
i. Corporate Residence
Modern corporation statutes no longer necessitate the meeting of a board of directors in any given location. Such statutes usually provide that directors may carry on their functions by way of signed resolutions which may be by way of facsimile or other written means. Directors may also carry on many of their functions through conference telephone calls, video conferencing or other communication means. As a result, physical presence is no longer required in any particular jurisdiction.
It has been held that a person (including a corporation) may be resident in more than one jurisdiction. This could lead to cases of double taxation where Canada and at least one other jurisdiction seek to impose taxation on the basis of residence. Canada has not issued any formal guidance as to the impact of modern telecommunications technology on the concept of residence. The Committee Report recognized that there is an increased risk that multinational enterprises ("MNEs") operating with telecommunication equipment may be considered to be resident in multiple jurisdictions by the tax authorities of each of those jurisdictions. Accordingly, it makes three important recommendations with respect to residence. These are that Revenue Canada should:
- consider ways to shorten the competent authority process in order to eliminate or minimize the impact of double taxation on taxpayers;
- consult with the Canadian Department of Finance as to methods for ameliorating the potential adverse effects of the competent authority process for Canadian small and medium-sized enterprises entering international trade; and
- issue an Interpretation Bulletin addressing the significance of modern telecommunication technology on the concept of residence.
ii. Relief for Foreign Taxes
The ITA provides several mechanisms for relieving foreign taxes. These include direct foreign tax credits, exemptions and deductions.
a. Foreign Tax Credits
Direct foreign tax credits apply on a country-by-country basis in respect of both business-income taxes and non-business-income taxes. Separate computations are required for business-income taxes and non-business-income tax in respect of each country. In order to obtain a credit, only taxes payable to the government of the country in which the source of the income was, is eligible for foreign tax credit relief.
1. Business-Income Taxes
In general terms, a taxpayer who is resident in Canada may credit against his Canadian tax liability an amount in respect of foreign taxes paid on income earned from sources in a particular foreign country. Unused foreign business-income tax credits may be carried back three years and forward seven years. The credit is generally limited to the lesser of the income or profits tax paid to the particular foreign country and the Canadian tax otherwise payable for the year on income from sources in that country.
aa. Double Taxation Potential
The credit mechanism can result in double taxation in several circumstances, some of which are as follows:
- Income or Profits Tax Definition
For credit purposes, a particular levy must qualify as an income or profits tax. In making this determination, the basic scheme of application is compared with that of the ITA. If the basis of taxation is substantially similar, Revenue Canada has indicated that it will accept the foreign tax as an income or profits tax. Basically, the foreign tax must be levied on net income or profits unless it is a tax similar to that imposed under Part XIII of the ITA (relating to Canadian source withholding, see discussion below). Taxes that do not qualify as "income or profits taxes" include sales, commodity, consumption and turnover taxes. They might also include a "bit" tax. Revenue Canada accepts some foreign taxes based on net income established under a prescribed formula if certain conditions are met. These are that:
- it can be considered that the formula produces a reasonable approximation of actual net income in typical situations; and
- an actual computation of net income would be significantly affected by arbitrary or estimated expense allocations.
A tax that is specifically identified as being subject to the provisions of a comprehensive treaty between Canada and a particular country automatically qualifies as an income or profits tax.
If the tax does not qualify as an income or profits tax, it may still be deductible in computing income from the foreign jurisdiction under the general provisions for computing income as an expense laid out for the purpose of gaining or producing income.
- Source of Income
Canada and another country could disagree as to the source of the income. A simple example is that of a Canadian corporation which sets up an internet site in Country A accessed by a consumer in Country B. Country B may assert that the source of the income is where the contract is accepted, such as in Country B. Canada may assert that the income is sourced either in Country A, where the server is located, or in Canada, where the vendor is located.
Revenue Canada generally relies on certain guidelines in determining the territorial source of income. In respect of merchandise trading, it has indicated that the place where the sales are habitually completed is the usual factor. However, other factors such as location of the stock, the place of payment or manufacture may be considered relevant in particular situations. In the case of services, the place where the services are performed is the usual guideline.
Revenue Canada has also suggested that in the case of a single business comprising more than one activity, each segment is considered separately in determining in which country or countries the business was carried on. An exception is made in the case where one activity is clearly incidental to a predominant one.
Royalty payments are considered to have a geographical source in the country in which the related right is used or exploited.
The inconsistent determination of source state determined for Canadian purposes and another state could mean the corporation will not be entitled to the credit.
- Calculation of Income or Tax Base
Differences between Canada and the other country as to the calculation of income or the tax base may result in foreign taxes being in excess of the Canadian tax otherwise payable on that income.
The Committee Report recognized that sourcing rules could result in the inability of a Canadian taxpayer to obtain a foreign tax credit and that Finance should monitor the income sourcing rules to ensure they continue to provide appropriate relief as electronic commerce grows.
2. Non-Business Income Taxes
A resident of Canada who pays foreign non-business income taxes or profits is also eligible for foreign tax credits. The consideration as in A are equally applicable.
Alternatively, a taxpayer may deduct foreign taxes which are not credited under section 126 under subsections 20(11) and (12) of the ITA. This deduction is generally less valuable than a credit because it merely reduces income rather than tax payable.
b. Income for Foreign Affiliates
The ITA contains a comprehensive scheme for the taxation of income derived by a Canadian resident from shares of "foreign affiliates". The scheme includes dividends from foreign affiliates in income but allows a deduction in computing taxable income for dividends from "exempt surplus" and "taxable surplus". In broad terms, these provisions seek to impose current income tax on the Canadian shareholder of a "controlled foreign affiliate" in respect of all income earned by the controlled foreign affiliate other than income from an "active business". For this purpose, income from an "investment business" is deemed to be income from property rather than income from an active business.
Income from an active business earned in a "designated treaty country" (i.e., generally one with which Canada has entered into a double taxation convention) by a "foreign affiliate" is given further preferential treatment. Such income will be exempt from tax when received by the Canadian corporate shareholder as a dividend. Income derived from an active business carried on in other than a designated treaty country will be taxed when received as a dividend, but eligible for a deduction which essentially gives a relief equivalent to that which would be given with a foreign tax credit.
- Interaffiliate Payments
These provisions also allow income to flow from one foreign affiliate to another and retain their character without being subjected to Canadian taxation in the hands of the Canadian shareholder. For example, a Canadian parent corporation may have two subsidiaries. Subsidiary A is located in a high-tax jurisdiction and conducts an active software development and sale business. It sells products throughout the world. Subsidiary B provides technology to Subsidiary A in return for royalty income which is deductible by Subsidiary A but is taxed at a low rate under the laws of Country B. If Subsidiary B is incorporated and resident in a "designated treaty country", then the interest income it receives from Subsidiary A will be deemed to be income from an active business. As such, the parent will not be required to include such income in its income on a current basis and will be able to exclude such income in computing its taxable income on receipt of dividends from Subsidiary B. These rules are largely dependent upon where income is sourced. Without clear guidance in respect of electronic commerce transactions, there is a potential that the rules may not be taken full advantage of by Canadian parent corporations.
- Investment Income Penalized
The Committee Report suggested that Canadian businesses may be subjected to additional Canadian tax on foreign income that is characterized as investment income as human-based activities are replaced through technology. The Committee Report questions whether activities require a human element and where a fully automated server conducts all transactions, whether an active business can exist? The Committee Report then goes on to suggest that the ITA should not penalize bona fide business entities that choose or find themselves forced to reduce human activities and increase reliance on technology in order to conduct the appropriate activities. Accordingly, it suggests that Revenue Canada should clarify the definition of active business and the extent to which income arising from activities that may be done by computers, (e.g., taking orders, executing sales and invoicing) is considered active business income regardless of the absence of human involvement in the process.
The Committee Report also observes that the movement by businesses away from the sale of tangible property to the delivery of intangibles results in royalties which are taxed as income from property rather than an income from an active business. Accordingly, such income is disadvantaged in comparison to income from an active business in that it is taxed currently under the foreign affiliate regime. Accordingly, the Committee suggests that, where appropriate, Finance should consider the possibility of excluding from the definition of passive investment, receipts from the exploitation of intellectual property.
iii. Interprovincial Allocations
As in the case of allocations of income between Canada and the foreign country, there also exists a concern with respect to the allocation of income between the various provinces of Canada.
Each of the provinces allocates a corporation's taxable income between different provinces in which it has a permanent establishment based on the average of:
- The proportion of a corporation's gross revenue that is attributable to a permanent establishment in that province; and
- The proportion of the corporation's salaries and wages that are paid to employees of a permanent establishment in that province.
B. Non-residents of Canada
A non-resident of Canada is subject to income tax under Part I of the ITA, inter alia, if he carried on business in Canada and is also subject to withholding tax under Part XIII of the ITA on specific types of payments by a resident of Canada.
i. Part I Income Tax
For the purpose of this paper, the important issues are whether (a) the non-resident carries on business; (b) whether that business is carried on in Canada; and (c) whether the non-resident enjoys permanent establishment protection under one of Canada's double taxation conventions.
a. Whether Carrying on Business
The term "business" is broadly defined to include, inter alia, an undertaking of any kind whatsoever. Income from a business is to be differentiated from income from property, but the distinction is not easily made. For example, royalty income earned by software developer and licensor may be categorized as income from business rather than income from property. The characterization of income is especially important in the analysis of electronic commerce transactions because of the change in delivery method. For example, the purchase of hard-copy books and tapes is replaced by a license of digitized information.
b. In Canada
The Canadian courts frequently refer to the UK test of "where do the operations take place from which the profits in substance arise?". A number of British cases have held that where a non- resident sells goods in the UK through an agent or otherwise, the most important factor in determining whether he is exercising a trade in the UK is whether contracts of sale are completed there. If a non-resident sells goods or services in Canada and the contracts are completed in Canada, the non-resident could be held to be carrying on business in Canada.
In The Queen v. Gurds Products Company Limited, the Court indicated that one of the principles applicable in cases where it is alleged that income derived from transactions in which non-residents are involved is taxable generally speaking is in the jurisdiction where the operations take place from which the profits arise. The connection with Canada need not be substantial. For example, in Gurds, the Court held that a business was being carried on in Canada because the taxpayer:
- intended to carry on business in Canada;
- established a bank account in Canada;
- purchased product in Canada and earned a profit therefrom;
- had an official agent in Canada; and
- its associates involved were not dealing at arm's length.
Certain activities have been held not to be carrying on business in Canada. For example, where the sale of goods by a non-resident to a Canadian where the non-resident does not solicit business or offer anything for sale in Canada through an agent or servant and the contract of sale is completed outside of Canada. This could be applicable in an electronic commerce situation. Under Canadian law it is important to distinguish between carrying on business in Canada and deriving income from property in Canada. For example, rentals and royalties would normally be considered to be income from property rather than income from carrying on a business. In Linde Canadian Refrigerator Co. v. Saskatchewan Creamery Co., a non-resident selling machinery to Canadians and having a servant or agent in Canada giving advice to customers and supervising installation of the machinery was held not to be carrying on business in Canada. This decision could be applicable to a non-resident vendor who sells goods through the internet with an agent who renders similar services in Canada.
Nor is the purchase of goods in Canada by a non-resident who transports them outside Canada without any processing, refinement or manufacture considered to be carrying on business in Canada. A non-resident may be held to be carrying on business in Canada through an agent who manufactures or processes goods in Canada on behalf of the agent. Also, a subsidiary company operating as a mere sham on behalf of its parent may be held to be carrying on the business of the parent. However, generally a subsidiary will not be held to be the agent of its parent company merely because of its shareholder relationship.
In addition to the meaning ascribed to the term by common law, the ITA contains an extended definition which, of particular importance, bring within its ambit anyone who solicits orders or offers anything for sale in Canada through an agent or servant whether the contract or transaction is to be completed inside or outside Canada or partly in and partly outside Canada. This raises the issue of whether a non-resident who solicits orders from Canadians through a web page will be considered to carry on business in Canada through an agent or servant. Further, does it matter if the web page is located on a computer situated in Canada, inter alia: (i) produces, creates or fabricates anything in Canada.
The Committee Report has raised issues as to whether an activity in electronic commerce constitutes carrying on business in Canada. These are:
- Where electronic goods or services are provided to Canadian customers by a non- resident, are these goods and services produced, created or fabricated in Canada for the purposes of section 253?
- Will the location of a file server, another central computer or a satellite with storage facilities affect the determination of carrying on business and the concept of selling or soliciting orders in Canada?
- In what jurisdiction is an electronic transaction completed and which jurisdiction has the right to impose tax on the profits earned by the parties to that transaction?
- Is the transaction manager an agent for the non-resident?
The Committee Report also recognized that the location of a file server or other computer is not necessarily decisive as to the site of a transaction for income tax purposes.
One of the issues that must be faced when a non-resident is found to be carrying on business in Canada is the extent to which he will be subject to income tax in respect of those activities. This is a matter of factual determination.
c. Permanent Establishment
Even if the non-resident carries on business in Canada, Canada's ability to tax the non-resident may be restricted by virtue of one of Canada's double taxation conventions. Canada has entered into an extensive array of such conventions. Those conventions provide that essentially Canada will not impose tax on a non-resident carrying on business in Canada except to the extent that the non-resident carries on that business through a "permanent establishment" situated in Canada. The term "permanent establishment" varies from convention to convention, but generally follows the pattern of the OECD Model Convention.
A frequently encountered issue is whether a file server or other computer installation constitutes a permanent establishment or fixed place of business. Even if it is a fixed place of business, are the activities of the file server preparatory or auxiliary to the activities of the enterprise and, therefore, excluded from the definition of permanent establishment? The Committee Report does not attempt to deal with these issues, but rather merely raises them as such.
Even if a file server constitutes a permanent establishment, a secondary issue arises as to the amount of income attributable to that permanent establishment.
A non-resident who is not subject to tax in Canada as a result of not having a permanent establishment in Canada may be subject to a Canadian withholding tax in Canada if he renders services in Canada. Section 105 of the Regulations provides that a resident of Canada who makes a payment to a non-resident of Canada in respect of services rendered in Canada by the non-resident is to deduct and withhold therefrom the amount of 15% of any such payment. and to remit that amount to the Receiver General. The non-resident is to file a tax return with the Canadian government and may claim a refund of the 15% withholding tax if it is not applicable. Therefore, it is important to determine where services are rendered in electronic commerce transactions.
ii. Payments by a Resident of Canada
A non-resident of Canada will also be subject to income tax in respect of various payments that are made by a resident of Canada to the non-resident. Part XIII of the ITA lists a number of payments which are subject to such treatment. They include, of particular importance rentals, royalties or similar payments. Without restricting the generality of that description, they also include any payment:
for the use of or for the right to use in Canada any property, invention, trade-name, patent, trade-mark, design or model, plan, secret formula, process or other thing whatever;
for information concerning industrial, commercial or scientific experience where the total amount payable is consideration for that information as dependent in whole or in part on:
the use to be made of, or the benefit to be derived from, that information;
production or sales of goods or services; or
profits;
for services of an industrial, commercial or scientific character performed by a non- resident person where that total amount payable as consideration for those services is dependent in whole or in part on:
the use to be made of, or the benefit to be derived from, those services;
production or sales of goods or services; or
profits;
but not including a payment made for services performed in connection with the sale of property or the negotiation of a contract.
An important issue to be determined is whether payments for access to on-line data bases outside of Canada by a Canadian resident are subject to withholding tax.
There are a number of payments which are specifically excluded from withholding. These include, in particular a royalty or similar payment on or in respect of a copyright in respect of the production or reproduction of any literary, dramatic, musical or artistic work.
The Copyright Act has been amended to provide that computer software constitutes a literary work. Therefore, payments in respect of the production or reproduction of computer programs are not subject to Canadian withholding tax. In addition, Revenue Canada has taken the administrative position that payments for shrink-wrapped computer software are not subject to withholding tax since they are more akin to the purchase of a product. The arbitrary line developed by Revenue Canada in determining whether software is shrink-wrapped or custom provides somewhat of a bright line test although it may be argued that Revenue Canada's position does not go far enough to exempt computer software.
In Canada's treaties with the United States and the Netherlands, payments for the use of computer software have been entirely removed from the ambit of Canadian withholding tax.
As seen from this discussion, both the source and nature of income determines Canadian tax liability. Therefore, it is necessary to consider electronic commerce transactions from both viewpoints in order to determine whether income tax or withholding tax is applicable.
C. Transfer Pricing
Under XVI.1 of the ITA, Canada has enacted a regime for redetermining prices between parties who do not deal at arm's length. In particular, amounts that would be determined for purposes of the ITA may be adjusted or the nature of the amounts may be adjusted or recharacterized. Adjustments may occur:
- when the terms and conditions between the participants in the transaction or series of transactions differ from those that would have been made between persons dealing at arm's length; or
- when the transaction or series of transactions would not have been entered into between persons dealing at arm's length and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.
In the first scenario, the terms and conditions would be readjusted. In the second scenario, the quantum and nature of amounts that would have been determined had the parties been dealing at arm's length would be reconstructed. The ITA provides for penalties and documentation requirements in order to avoid the penalties. In addition, Revenue Canada has issued an Information Circular 87-2 which sets out Revenue Canada's views on acceptable transfer pricing methods. This Circular is being redrafted to accord with the new provisions as described herein.
The basic problem which the Committee Report alludes to with electronic commerce in the area of transfer pricing is the ease with which goods and services may be transferred between jurisdictions. In particular, this may make it more difficult to determine appropriate transfer price values. The questions which the Committee Report posed but did not answer, were:
- How will the comparable uncontrolled price be determined?
- How will sources of activity be distinguished to establish an appropriate economic return for each source?
- What impact will the consolidation of business activities have on the tax base? and
- How will activities, profits, expenses or transactions be allocated to different tax jurisdictions?
The Committee Report expressed concern with the ability of corporations to shift revenues and expenses among and between jurisdictions; such as in the case of software development, engineering and other services.
CONCLUSION
There are a host of other issues which are relevant to taxation of electronic commerce transactions in Canada. These include: audit verification; enforcement and collection of tax; books, and record keeping; tax avoidance, especially through tax havens; and criminal law aspects of tax evasion, especially through the ability to transmit cash electronically. All of these areas need to be studied and their implications considered by Canada and the provinces.
Electronic commerce transactions are clearly going to become a prevalent method of doing business. Governments such as Canada need to, and indeed will, adapt or modify the existing laws to account for those transactions. Hopefully, participants in such transactions will have sufficient guidance from the government to understand the application of the rules to their transactions.