Apportioning E-Commerce Income For Tax Is Tricky

by Mike Godfrey, Tax-News.com, New York

25 September 2002

In a series of articles on www.ecommercetax.com, Professor David Hardesty is discussing the question of how to allocate profits in e-commerce transactions and businesses.

Problems can arise both in respect of transactions which span two or more US states, and also in respect of transactions between countries. The normal rules often don't apply, or are capable of various interpretations.

For instance, most US states apportion income according to a formula based on sales volume, property holdings and payroll. But for a company with an HQ in one state and servers both in that state and another one, the formula doesn't work well, or at all in many cases.

Likewise, countries often apportion profits according to a double tax treaty between them. This method relies on the existence of a 'permanent establishment', constituting a taxable entity, in one or both countries. Although there is some agreement that a server can constitute a permanent establishment, especially if it is associated with staff and major parts of a transaction are carried out on it, there are many border-line cases, and many uncertainties and ambiguities remain.

Professor Hardesty gives an example of a moderately complex but by no means unusual situation which exemplifies many of the difficulties that can arise:

• OnlineServices is a Bermuda-based seller of online entertainment services. It is a wholly-owned subsidiary of a worldwide entertainment company. OnlineServices provides its entertainment services for a fee from Web servers based in Washington, California, and Massachusetts. The servers are owned and operated by a separate unrelated company, WebsiteHosting, Inc. The company’s websites are programmed and operated by employees in Bermuda. In addition, all content is either developed in Bermuda or licensed from related and unrelated parties. OnlineServices has no employees or agents in the United States. Despite its lack of physical presence in the United States, OnlineServices assumes that it is engaged in the conduct of a U.S. trade or business, and elects to file US tax returns and pay tax based on US-source income.

In this example, OnlineServices pays tax only on its US-source income. Generally, when income results from the performance of services, the income is sourced where those services are performed. In this case most of the important services are performed outside the United States. However, Web server operations take place in the United States. The question posed by Professor Hardesty is, to what extent do the Web server operations taking place in the United States cause the services income to be sourced in that country?

The situation becomes even more complicated if transactions are performed by servers in more than one place, for instance, the order could be taken in California from a customer in Canada, and payment effected by an outsourced service in the Bahamas. Endless variations are possible, of course, each of which raises its own questiosn on taxability.

Professor Hardesty's articles are attempting to give answers to some of these questions. His first article, this week, focuses on the division of income between states, examining particularly the operation of the 'throw-back' and 'drop-shipment' rules where servers are involved.

His conclusions?

• State income tax is meant to be apportioned to states based on the relative degree of business activities taking place in the various states. Standard apportionment rules are supposed to result in a fair approximation of business activity.
• In calculating the sales factor it is best to define selling broadly, and assign online sales to the state where the majority of those activities take place. This methodology will tend to apportion income fairly.
• Remember that failure to apportion income in a manner that fairly represents the degree of business activity in a state can trigger the use by the state of equitable apportionment. Even if the taxpayer follows the form of the statutory apportionment provisions, the state can require use of other rules, if income is not fairly apportioned.

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