INTERNET PROFITS AND THE FEDERAL INCOME TAX - TAX COMPLIANCE TRAPS FOR THE UNWARY
Case affects internet and international tax planning

By Richard S. Lehman, Esq., of Richard S. Lehman P.A.; Boca Raton, FL
Published: December 13, 2000

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. Furthermore, the Internet is particularly suited to anonymous transactions in a tax system that requires the party's transactions to be known in order to properly tax them

These and other unique characteristics never envisioned by the pre-Internet tax law make it difficult for honest taxpayers to maintain accurate records and to determine and comply with filing requirements. This is especially true when the existing tax rules have not all caught up with the Internet world. The United States Treasury Department itself recognized this in its first important publication on these matters.

"These new technological developments dictate that the Internal Revenue Code and generally accepted principles of tax policy be examined."

Selected Tax Policy Implications of Global Electronic Commerce.

Compliance is further hindered by the mobility of e-commerce enterprises. A seller my 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 opportunities and allow businesses to locate in jurisdictions where they can defer or lower taxes by playing on the inconsistencies of the U.S. and other country's tax rules as they slowly adjust to the taxation of e-commerce.

The United States taxes income on the basis of both the source of the income and the residence of the person or company earning the income. A company organized in a foreign country is generally not a US tax resident if it has no trade or business in the U.S. However, the source of that Company's income will be located where the economic activities creating the income occurred and that may very well be in the US Generally for tax purposes the character or type of income earned is important (i.e., income from sales, royalties, personal services or gains). This is because the source may be different depending on the character of the income. E-commerce, unlike the old economy business, has the luxury of both the easy relocation of its business residency and several options on how to classify its source of income for tax purposes. Of course this leaves many uncertainties to be settled before there is precise guidance for taxpayers in this area.

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 semi automated website that requires one employee in the Bahamas and no presence in the United States. Assume the website provides access to such services as online computer programs and research data bases to persons located in the United States. Is the Bahamas corporation doing business in the United States? Furthermore, what income results from its activities? Is it sales income, personal services income or royalties?

In the event 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 US taxation at all. On the other hand if the income was considered royalty income there would be significant US taxation on the company's gross not net US 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 US to be taxable on its royalty income.

In this same example lies a very dangerous tax trap. Under US tax laws buyers and sellers have certain obligations to withhold and pay over to the US, the taxes that may result from a foreign company's profits earned in the United States that involve that buyer or seller. 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 to withhold and pay over 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 US source income and a US 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 its 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 materials was consumed in the making of the product sold by the taxpayer is meaningless in such a situation.

While some may 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 I.R.S. 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)