BUYING IN THE WEB CAN BECOME TAXING
Case affects internet and international tax planning

By Richard S. Lehman, Esq., of Richard S. Lehman P.A.; Boca Raton, FL
Published: October 23, 2000
South Florida’s Sun-Sentinel

One unique aspect of the Internet is its potential for worldwide sales of products and services by even the smallest e-commerce entity. This can make tax compliance an unmanageable burden.

Compliance is partly hindered by the mobility of e-commerce enterprises. A seller may easily relocate its entire operation to another jurisdiction. Customers will not notice any difference. This mobility, while a nightmare for compliance, may offer tax-planning advantages for businesses.

The United States taxes income on the basis of both the source of the income and the residence of the person or company earning that income. A company organized in a foreign country is generally not a U.S. tax resident if it has no trade or business in the United States.

However, the source of that company’s income will be located where the economic activities creating the income occurred. That may very will be the United States. Generally, for tax purposes, the character or type of income earned is important (i.e., income from sales, royalties, personal services or gains).

A few examples will show the two-edged sword of both tax-planning benefits and tax traps that may lie in e-commerce profits.

For example, assume a Bahamas corporation with a Bahamas-based Web site that requires one employee in the Bahamas and no presence in the United States. Assume the Web site provides access to such services as online computer programs and research databases to persons located mainly in the United States.

If the Bahamas corporation is considered to have no tax residency in the United States and the source of the income is personal services performed in the Bahamas, the company’s profits would not be subject to U.S. taxation.

On the other hand, if the income was considered royalty income, there would be significant U.S. taxation on the company’s gross, not net, U.S. profits, since the source of royalty income is where the rights are used. The Bahamas company would not need to have a tax residency in the United States to be taxable on its royalty income.

In this same example lies a very dangerous tax trap. Under U.S. tax laws, buyers and sellers have certain obligations to withhold and pay to the United States taxes that may result from a foreign company’s profits earned in the United States. Making a determination about withholding requirements is likely to go beyond the capabilities of individuals and small business.

In some cases, if the buyer or seller who is responsible for withholding and paying those taxes does not do so, that party may be personally liable for the tax. Not only that, but the unknowing responsible party may be subject to penalties and interest on the tax.

Assume in our example that the profit earned by the Bahamas company was determined to be royalty income and not personal services income. In that case, the royalty income would be U.S. source income, and a U.S. buyer would be required to withhold the taxes due on this royalty income.

Another example of the changes to the tax laws brought by e-commerce will be their effect on the time-honored and court-approved Internal Revenue Service audit. One master copy of a software program can be used to create an unlimited number of copies. The typical audit tactic of determining gross income by determining how much raw material was consumed in the making of the product sold by the taxpayer is meaningless in such a situation.

While some believe this is an invitation to abuse, it should be kept in mind that the absence of complete records cuts both ways. Where the taxpayer has no records or inadequate records, the IRS may make its own reconstruction of the taxpayer’s income that is far in excess of the actual taxable income. It will be difficult to disprove the IRS reconstruction without records.

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Richard S. Lehman

* Georgetown University J.D.
* New York University L.L.M. Tax
* Law Clerk to the Honorable William M. Fay – U.S. Tax Court
* Senior Attorney, Interpretive Division, Chief Counsel’s office, Internal Revenue Service
* Author: “Federal Estate Taxation of Non-Resident Aliens,” Florida Bar Journal
* Contributing Author and Editor: International Business and Investment Opportunities” Florida Department of Commerce, Division of Economic Development, Bureau of International Development (translated in German, Spanish, and Japanese)