1 CANADIAN TAXATION OF ECOMMERCE - AN OVERVIEW by Jack Bernstein Aird & Berlis LLP Toronto The Internet and e-commerce have raised a plethora of tax issues. Careful domestic and international tax planning during the earliest stages of an e-business development can yield the business and its owners significant tax savings. Although ecommerce has been in existence for many years, there are no reported Canadian tax cases and little current guidance from CRA. Ecommerce may include the provision of services, the licensing of intellectual property or the sale of goods over the Internet. Online consulting or the provision of technical support result in service income. Goods may include digital products, music, computer software, video images, or tickets which can be delivered electronically. It may also include the purchase of tangible property (e.g., clothing or furniture which will be physically delivered to the purchaser). Traditional customs duties and sales tax would apply on the delivery of these goods. For the sale of tangible property or the provision of services, a vendor in a Treaty jurisdiction may not be taxable in Canada unless the vendor has a permanent establishment (PE) in Canada. Canada subjects a resident of Canada to tax on worldwide income (with a deduction or credit for foreign tax paid) and a non-resident of Canada to tax on Canadian source business or property income. E-commerce has made it difficult, in some cases, to determine the residency of a vender of goods or services and to determine the source of the income. For example, in an Internet transaction, a vendor resident in country one may use a server located in country two. A consumer located in country three may use a server in country four. The consumer may access an anonymous cash payment system in order to purchase goods or services from the vendor. The vendor's location may be difficult to determine and the vendor may not have an office or assets in the location of the consumer. The territorial source of the income may be difficult to locate. It may be difficult to attribute a permanent establishment in the country where the consumer resides. The Internet business may require employees to update software, and with contracts and customer problems.
2 2 The vendor may be resident in a Treaty country or in a tax haven. The website may be in Canada or elsewhere. It may be launched through an internet service provider (ISP) located in Canada or elsewhere and may or may not be controlled by the Vendor. The intellectual property of the Vendor may be in a separate jurisdiction. Software services may be required to update the intellectual property of the Vendor and those services may be provided from Canada or elsewhere. There may or may not be Canadian customers. A payment processing company in another jurisdiction may be used to clear credit card payments. Cloud-based infrastructure may be used for delivery to the customers of a service. There is a concept of tax neutrality. Existing tax principles of residency, source of business, permanent establishment, and carrying on a business should be applied. Where a treaty applies, business income is taxed in the country of residence of the business and in another country only if there is a permanent establishment. Tax should be levied based on the type of income earned and the source of income, rather than the method of transmission. For example, the treatment should be the same whether goods are purchased by letter, telephone, fax, or overtime Internet. Tax certainty is important for businesses. In other words, existing principles of taxation should, to the extent possible, be applied to electronic commerce. This would ensure that the existing provisions of multi-national income tax agreements would apply. There is, however, difficulty in applying existing tax principles to electronic commerce. For example, it is difficult to determine the source of the income. Is the source determined by where the contract is concluded or by the place of residence of the vendor? Is the contract concluded in the country in which the consumer resides, where the consumer's server is located, where the vendors server is located, or is it based on the residency of the vendor? For example, if a consumer in Canada used the Internet to acquire a lottery ticket in Liechtenstein, has the consumer travelled to Liechtenstein in order to conclude the contract? Internet transactions may not be conducted in a physical location. The customer may not know the location of the vendor. The anonymous cash payment system makes it difficult to track electronic commerce transactions. It has been suggested that a government would have to attach a machine to each computer in order to be able to track some of the transactions. It is also difficult to audit and determine the location of the vendor. Collection of tax is difficult as the vendor may not have any assets to be seized in a jurisdiction where the tax arises.
3 3 Most treaties for the elimination of double taxation are based on the Organization for Economic Cooperation and Development (OECD) model treaty. The OECD has made recommendations and most major countries including Canada, the U.S., Australia, Ireland, and the U.K. have studied the question of how electronic commerce may be fairly taxed. This involves a fundamental review of tax policies and laws. The objective should be to enable electronic commerce to be taxed on a consistent basis throughout the world. This is necessary in order to ensure effective tax treatment and the avoidance of double taxation. In Canada, a report was made to the Minister of National Revenue from the Minister's Advisory Committee on Electronic Commerce in April In September 1998, the Minister of National Revenue responded to the Advisory Committees report on electronic commerce. Canadian Tax Principles Residency Most countries of the world, including Canada, levy income tax on the basis of the residence of the taxpayer or the source of income. An individual or corporation resident in Canada will be subject to federal tax in Canada on their worldwide income. Tax credits will be available to the extent that tax is paid in other jurisdictions. Provincial tax is levied based on an allocation of wages and revenue to provinces in which there is a permanent establishment. A corporation is deemed to be resident in Canada if it is incorporated in Canada or if its central management and control is exercised from Canada. The doctrine of central management and control involves both a de jure (legal control) and a de facto (factual control) test. The legal control test would be satisfied if the majority of the directors resided in Canada. Factual control is based on who exercises control over day to day management of the business. A Canadian corporation forming an e-commerce business in a low tax jurisdiction should be careful to ensure that the activities of the offshore corporation are not exercised in Canada through the use of the Internet. This could be regarded as factual control from Canada if the day-to-day business is carried on in that manner. It is difficult to tax Internet transactions based on the source of the income. It is also difficult to argue that the Web site should be a permanent establishment. It is more likely that
4 4 Canada and other countries will attempt to tax the transactions based on the residence of the vendor or on a dependent server constituting a permanent establishment. In the United States, a non-resident will be subject to tax if that person carries on a trade or business in the United States and has effectively connected income. In Piedras Negras Broadcast Inc. Co. v. United States 43 BTA 297 (1941) aff'd 127 F. 2d 260 (5th Cir, 1942) a Mexican radio station that had no office or place of business in the United States, entered into contracts in Mexico with U.S. advertisers. The radio station maintained a post office box in the U.S. and an employee travelled to the U.S. to open the mail. Since the radio station was on the border, its programs were designed for an American audience. The court held that the radio station did not carry on a trade or business in the United States and did not have effectively connected income. The broadcast signal which was the core of the business was in Mexico. The advertising revenue was not subject to U.S. income tax. It has been suggested that this case could apply to electronic commerce with the result that most international Internet transactions would escape U.S. taxation. Carrying on Business in Canada A non-resident of Canada will be subject to tax in Canada if the non-resident is employed in Canada or carries on business "in Canada" during the year. The difficult issue is to determine when an Internet electronic commerce transaction is carried on "in Canada." It is difficult to determine where the goods or services are offered for sale and where the contract is concluded. Arguably, both of these events may occur outside of Canada where the transaction occurred via a Web site. In some cases, the individual may acquire hard goods which will be physically delivered to the consumer at a later date. For example, a consumer in Canada may order furniture or appliances from the United States which will be delivered to the resident in Canada. In that case, the place of delivery and the location of the goods are easy to track. In other cases, it may be difficult to determine where the non-resident is located as well as the place where the transaction originated and payment is made. The U.S. retailer who sells furniture to a Canadian consumer over the Internet should be subject to tax in the same manner as if the order were made over the phone or by fax. The retailer should be taxable in the U.S. only unless the retailer has a permanent establishment in Canada, for example.
5 5 In Canada, in the absence of an income tax treaty, a determination would have to be made as to whether the non-resident is carrying on business in Canada. Business is defined to include a trade, manufacturing, or undertaking of any kind whatever, and would thus encompass any economic business activity. It would also include a venture or concern in the nature of trade which could be a one-time business venture. An interesting issue is whether the minimal activity required in connection with some Web sites would constitute carrying on a business. An independent server may accept a credit card and authorize delivery. In determining where a business is carried on, reference may be made to where the business is located (e.g., office, employees, inventory), where the sales are solicited, where the contract is concluded, where delivery is made, and where payment is made. Interpretation Bulletin IT-305R4, paragraph 26, sets out administrative guidelines for determining where various businesses are carried on. For example, a services business may be carried on where services are performed and a business of selling goods may be carried on where the contract is completed, inventory is maintained, at the place of payment, and where the purchase and sale decisions are made. Basis for taxation in Canada: Carrying on business in Canada There are no specific statutory provisions in the Income Tax Act governing e-commerce. General taxation principals and rules are applied to electronic commerce. In order to be taxable in Canada, the non-resident vendor must, inter alia, either carry on business in Canada (sections 2(3)(b) and 115(1) of the Tax Act) or derive income such as rent which is subject to Canadian withholding tax. If the vendor is resident in a Treaty country and carries on business in Canada, there will be no tax in Canada unless the vendor has a permanent establishment in Canada as defined in the relevant income tax agreement. The CRA has taken the view that the threshold to find that a non-resident carries on business in Canada is a low one. If the vendor is located in a non-treaty country, the applicable standard is the common law meaning of carrying on a business in Canada as extended by section 253 of the Tax Act. Section 253 of the Income Tax Act provides an extended definition of carrying on business. It includes anyone who solicits, orders, or offers anything for sale in Canada through an agent or a servant, whether the contract or transaction is to be completed inside or outside Canada or partly in or partly outside Canada. The definition in section 253 requires that the
6 6 solicitation or offering of goods for sale be "in Canada." The vendor need not be physically present in Canada and the solicitation may be by letter or direct mail, over the telephone, fax, in a magazine or newspaper published outside of Canada, or over the Internet. Simply selling goods to Canadian consumers may not constitute carrying on business "in Canada." Although the definition may encompass the server and the contract may be completed outside of Canada in an e-commerce transaction, the issue is whether the no-resident vendor has solicited orders or offered anything for sale "in Canada." The consumer may have surfed the net and located the goods or services sold by the vendor without the vendor having to take any other positive action. However, it is arguable that the advertisement by the vendor on the Internet is an advertisement to the world and constitutes a solicitation or offering of goods for sale in Canada. In Sudden Valley Inc. v. The Queen 70 62C 6448, the Court concluded that a U.S. corporation, engaged in the sale of land in Sudden Valley in the State of Washington, which advertised in Vancouver did not carry on business in Canada. The advertisement did not offer land for sale nor did it use words from which such an intention could be implied. It was merely an inducement to buy. All sales contracts were drawn up and executed in the U.S. and all payments remained in the U.S. The Trial Division concluded, under the predecessor to section 253, that the concept of soliciting orders could not be extended to include a mere invitation to treat. A Web page that merely advertises goods for sale may constitute an invitation to treat. The place of conclusion of contracts is where contracts are accepted (see Geigy (Canada) Ltd. v. Commissioner, Social Services Tax,  CTC 79 (BCSC) and Grainger & Son v. Gough (Surveyor of Taxes, 1896) 3 TC462 (H.L.). It may be argued that an e-commerce contract offered on a Web site outside of Canada is accepted and therefore concluded outside of Canada. Paragraph 253(b) of the Tax Act, extends the meaning of carrying on business in Canada to include agency (both dependent and independent agents) and employment relations, where the taxpayer solicits orders or offers anything for sale in Canada through an agent or a servant. An agent or servant would be a person and a website or server is not in itself a person. A distributor controlled by the non-resident may be an agent. Where no agent or servant is used, paragraph b does not apply. Thus, the non-resident in a non-treaty country who uses an ISP in Canada should not be deemed under this provision to carry on business in Canada since it is
7 7 generally accepted that an ISP is neither an agent nor an employee. Similarly, a server or a website would not be an agent. Even if a server solicited orders and concluded contracts online, it would not carry on business in Canada under section 253. In this regard, the OECD Commentary on Art. 5 states: the ISPs will not constitute an agent of the enterprises to which the websites belong, because they will not have authority to conclude contracts in the name of these enterprises and will not regularly conclude such contracts or because they will constitute independent agents acting in the ordinary course of their business, as evidenced by the fact that they host the websites of many different enterprises In the absence of a specific deeming provision (such as paragraph 253(b)), the CRA will look to the particular facts and the traditional common law tests to determine whether business is being carried on in Canada. Common Law meaning For the purposes of the common law meaning of carrying on business, courts have considered the criteria listed below in making the determination. In this regard, the courts have found three factors from the list below to be particularly significant: (i) the place where the contracts are made, (ii) the place of payment, and (iii) the place where the profits in substance arise. In applying the factors below, the CRA has acknowledged that some of the factors that are relevant for businesses engaged in conventional business transactions may not be applicable to businesses engaged in electronic commerce. (CRA doc. P-051R2 Carrying on Business in Canada ). The Canadian tax nexus standard of carrying on business in Canada for sales tax is very similar, though not identical, to the income tax test. Although the Income Tax Act contains an extended definition of the phrase carrying on business in Canada (in section 253 of the Tax Act), the phrase is not exhaustively defined in either the Excise Tax Act or the Income Tax Act. Accordingly, common law pronouncements on the phrase are significant for both income and sales tax purposes. The CRA has published factors that have been considered in determining whether a no-resident person is carrying on business in Canada for both GST/HST purposes (P- 051R2) and income tax purposes (CRA Views doc I7). The factors generally overlap.
8 8 The CRA has previously made a statement in the sale tax context that a non-resident vendor supplying the right to use various software applications to customers in Canada was carrying on business in Canada [B-090 GST/HST and Electronic Commerce (July 2002)]. The specific facts of the example involved a non-resident who owned a website stored on an independent server in Canada. The non-resident advertised its software applications on its website directed to the Canadian market, and also advertised its software applications and website in Canadian newspapers. Canadian customers could order the software applications by completing and submitting order forms on-line and would thereby gain access via a computerissued password. The customers were invoiced electronically, automatically, according to the number of hours the applications are used, and may pay by credit card or cheque. An ISP located in Canada processed payment for the vendor. Finally, an independent contractor located in Canada provided after-sales customer support on behalf of the non-resident. In this example the CRA found that the facts supported the conclusion that the nonresident was carrying on business in Canada: of the list of factors to be considered, the following would indicate that the nonresident has significant business activity in Canada: advertising in Canadian newspapers; the use of independent contractors located in Canada for after-sales support; and the provision of payment processing by independent ISPs located in Canada. In addition, the activities carried out by means of the automated, interactive Website stored on a server in Canada also indicate a significant business presence in Canada. If a newspaper add merely urged consumers to call a call centre, the non-resident would not be soliciting orders. An invitation to treat does not constitute soliciting orders (Sudden Valley Inc. v. The Queen 76 DTC 6448 (FCA)). Factors considered by Courts with respect to carrying on business determination 1. Where the contract which is the basis of the transaction is made: For the purposes of the common law, the general rule is that in the case of instantaneous methods of communication the contract is made at the place where acceptance is received. If the website constitutes an offer for sale arguably, this would be outside of Canada. The Canadian customer would accept the offer and convey acceptance of the offer to the nonresident. The contract arguably would be made outside of Canada. However, this rule s
9 9 application to internet-based contracts has not been explicitly established. Further, several commentators have suggested that the weight of this indicia in the context of e- commerce will be less significant. 2. Where goods are delivered or payment is made: If tangible property is purchased on the Internet and delivered to the customer in Canada, the vendor may be carrying on business in Canada. If the vendor is in a Treaty country and does not have a permanent establishment in Canada, the vendor will not be taxable in Canada. Where an internet service (a software application) is downloaded by the customer in Canada, the place of delivery is not as clear. A Treaty may exempt the payment from withholding tax if it is in respect of software. The CRA has stated that in determining the place where payment is made in the context of electronic commerce, it may be more appropriate, depending upon the circumstances, to consider the place where approval for the electronic transfer of funds takes place, rather than the place of posting or receipt of cheques. (CRA doc. P-051R2 Carrying on Business in Canada ). If services are providing the place where services are performed may be determinative. 3. Where business assets are located: Assuming that the intellectual property (key software) is not held in Canada, this factor will not contribute to a tax nexus in Canada. 4. The place where assets used in the business are purchased: As there are few assets purchased on an on-going business for use in the business, the weight of this factor is likely limited. 5. Whether an agent or independent contractor is utilized: As noted above, a website or independent ISP is generally not considered to be an agent. 6. Whether activities in Canada are merely ancillary to the main business: To the extent that the vendor is soliciting Canadian customers, this activity would likely be more than merely ancillary to the main business and could contribute to a Canadian nexus. 7. The location of the bank account, listed telephone number or address: The vendor would not maintain any Canadian telephone numbers or bank accounts.
10 10 8. The presence of a representative or a resident expert in Canada: The vendor would not maintain any representatives or other support services in Canada. In some cases if the server is in Canada, the Vendor may wish to have technical support in Canada to assist with problems with the server. Ideally the technical support should be independent contractors rather than employees of the Vendor. The provision of technical support would be a service which if rendered in Canada by a non-resident may be subject to Canadian withholding under Regulation 105. In addition to the above, other indicium referred to by Courts includes: 9. Whether the reason for compliance with the jurisdiction s rules and regulations is business or legally motivated. 10. Whether the taxpayer intended to do business in Canada. 11. The degree of supervisory or other activity in Canada. 12. The substance or object of the transaction. 13. The nature of the activities, transactions. 14. Where the operations take place through which the profits in substance arise (as opposed to where profits are realized). 15. Whether individuals in Canada assist (or are available to assist) the taxpayer in his endeavours. 16. The reason for the taxpayer s existence. 17. How the reasonable man would answer this question. Treaty Protection Business Income: A non-resident who is a resident of a country having a tax treaty with Canada will be taxable under Article 7 of the relevant treaty on business profits derived in Canada only if the non-resident maintains a permanent establishment (PE) (a term defined in the Treaties) in Canada. Generally a PE exists if there is a place of business, an office or employees in Canada.
11 11 Generally for E-Commerce there is no need to have a PE in Canada. A server in Canada or outside of Canada which is not controlled by a non-resident, a website or an ISP would not constitute a PE. A server controlled by the non-resident may constitute a PE. Use of Canadian-resident billing service provider With respect to the use of a Canadian-resident billing services provider, the common law standard (or the extended meaning under the Tax Act) would need to be similarly satisfied in order to constitute carrying on a business in Canada. In this regard, assuming a similarly independent relationship between the billing provider and the website; no authority to conclude contracts held by the billing provider on behalf of the website; and payment by the customers to the website (and not the billing provider), a Canadian nexus should not be increased based on the use of a Canadian-resident billing provider alone. However, as stated above, the analysis ultimately involves a weighing of all the factors in the proposed operations. Cloud-based infrastructure Cloud-based infrastructure refers to a centralized intangible hard-drive without a specific geographic location. A review of relevant commentary did not return any discussion specifically addressing cloud-based infrastructure. There is no CRA guidance on cloud computing and it is accordingly difficult to assess what their view will be on this subject. It is arguable (though not assured) that cloud computing may be analogized to a website for the purposes of the residency determination. A website itself is not tangible, does not have a specific location and is generally understood not to constitute a permanent establishment in Canada for tax purposes. Alternatively, the CRA may view cloud computing to be more akin to a server - in the sense that it is infrastructure (albeit intangible). If that latter view was adopted, the residence analysis would follow that of a server. In short, it is not clear what the eventual position of the CRA will be on the residency and use of this form of infrastructure. Thus, the above carrying on business analysis would similarly be undertaken. In this regard, provided no other nexus to Canada, there will likely be no business carried on in Canada where the only presence in Canada is the use of an independent server by cloud infrastructure
12 12 applications for the provision of services to US-based customers by a non-resident company. However, as indicated above, as the indicia of Canadian activity are increased the risk of establishing a Canadian nexus will also increase. Residency and Website It is the CRA s view that a website is intangible and cannot therefore constitute a place of business or a PE in Canada. Nor is a server in Canada which is not controlled by the nonresident considered to be a PE in Canada of the taxpayer. In this regard, the CRA s position is that a computer server on which a website is stored may be considered a PE through which business is carried on only if the taxpayer who presents a website to Canadian customers, owns or leases the server, the host server is at the disposal of the non-resident, and the server is fixed in place and time and business is carried on through the server ( E5). If the Vendor does not have a tax Treaty with Canada, there is no Treaty provision which may override the common law test. Accordingly, the PE standard is not applicable. Characterization of Income An Internet transaction may involve the purchase of goods or services or payments for the use of property protected by copyright or patent. Income involving a business or service may be protected under a treaty to the extent that the vendor does not have a permanent establishment and may not be taxable in the country where the goods or services are delivered. However, payment for the use of property may be regarded as a royalty subject to withholding tax on the gross amount paid at the rate provided for in domestic tax legislation, as modified by a treaty. It may be difficult for a Canadian payer to determine whether a payment is being made to a nonresident of Canada A royalty payment made to a non-resident of Canada will attract Canadian withholding tax under paragraph 212(l)(d) in the amount of 25% of gross royalties unless modified by a treaty. Paragraph 212(l)(d) provides for Canadian withholding tax on rents, royalties, or similar payments, whether for "know-how" or for the use of technical information, unless it is otherwise exempt. The rate of withholding tax is 25% of the gross royalty unless reduced by treaty
13 13 (Income Tax Application Rule 10(6)). The non-resident may be entitled to claim a foreign tax credit in his or her country of residence. Subparagraph 212(l)(d)(i) provides that payments (including a lump sum) for the right to use, in Canada, any property, invention, trademark, design or model, plan, secret formulae, trade name, patent, process, or other things will be subject to Canadian withholding tax. This provision excludes the payments for the outright purchase of a product. CRA has taken the position that payments for "shrink wrap" software may be subject to this provision. From an administrative standpoint, however, CRA subsequently decided to treat prepackaged software (but not custom software) as a sale of goods which would not be subject to withholding tax on the basis of a royalty. Subparagraph 212(l)(d)(ii) provides for Canadian withholding tax on payments for information concerning industrial, commercial, or scientific experience (commonly known as know-how). The payment must be dependent, in whole or in part, on the use to be made or the benefit to be derived. It excludes any payments not dependent on use as well as any lump sum payments. Payments for e-commerce may escape this provision if there is no exclusivity and the payment is not dependent on use. Subparagraph 212(l)(d)(ii) provides for Canadian withholding tax on the payment for services of an industrial, commercial, or scientific character performed by a non-resident if the amount payable is dependent on production or the use to be made therefrom. Canadian withholding tax will apply regardless of where the services are rendered. The payments must be based on the production or use by the payer or the third party. There is no withholding tax if the payment is not based on production or use. A payment for services could be structured so as not to be dependent on the use or production of property but rather could be based on an hourly rate or other basis. A treaty provision will override any conflicting provisions of the Income Tax Act. A payment for services will generally be protected under the business profits provision of Canada's treaties. For example, a payment for services will be treated as business profits and will not be subject to Canadian withholding tax under paragraph 212(l)(a). In The Queen v. Saint John Ship Building & Dry Dock Co Ltd. 88 DTC 6272 (FCA), payments made for the use, for an undefined period of time, of computer tapes containing technical data were regarded as part of a non-
14 14 resident's industrial and commercial profits and were protected from tax in Canada by virtue of a treaty. Article XII paragraph 4 of the Canada-U.S. Tax Treaty excludes services from the definition of royalties. The treaty will override 212(l)(d)(iii) which includes services. The business profits provision of the Canada-U.S. Tax Treaty will therefore apply to services; there will not be any withholding tax under Part XIII of the Income Tax Act. Regulation 105 of the Income Tax Act requires that 15% income tax be withheld on payments to a non-resident of Canada for services rendered in Canada. The amount withheld is a prepayment of the Part I tax liability. It is possible to get an exemption from this withholding tax. With respect to Internet or e-commerce services, it is difficult to determine whether services are being rendered as compared to something else and whether the services are rendered in Canada. Generally, services are rendered where the provider is located. For example, a hotline service located in the U.S. would not be regarded as rendering services in Canada. Subparagraph 212(1)(d)(vi) excludes from Canadian withholding tax a royalty or similar payment with respect to a copyright related to the production or reproduction of any literary, dramatic, musical, or artistic work. Computer programs are regarded as literary works. At the 1988 Revenue Canada Round Table 80, CR 53:89, question 41, CRA provided that the end user of a computer program acquires a right to use a computer program under a license agreement, and not the right to produce the program. In CRA's view, when a taxpayer has the right to make copies for his own personal use, the taxpayer is not making use of the copyright, but is merely exercising his right to use under the license agreement. In such cases, since the payer does not have the right to produce or reproduce the computer program, the domestic exemption will not apply and relief, if any, will be available only under a tax treaty. If a non-resident owner of a computer program grants the right to a Canadian resident to produce or reproduce computer software in Canada for distribution to Canadian end users, none of the payments will be exempt from withholding tax in Canada. Generally, there is Canadian withholding tax on computer license payments. However, a treaty exemption may be available. For example, Article XII, paragraph 3(B) of the Canada-U.S. Tax Treaty specifically excludes payments for the use of, or the right to use, computer software. Subparagraph 212(l)(d)(iv) provides for Canadian withholding tax on payments made under an agreement between a Canadian resident and a non-resident under the terms of which the
15 15 non-resident person agrees not to use or not to permit any other person to use any property or know-how. There is an exclusion under the Income Tax Act for a bona fide cost-sharing arrangement under which the person making the payment shares on a reasonable basis with one or more nonresident persons, research and development expenses in exchange for an interest in all property or other things of value that may result therefrom. Revenue Canada has established the criteria that must be met for a bona fide cost-sharing arrangement (see paragraph 30 of Interpretation Bulletin IT-303). The rules are designed to preclude the shifting of the scientific research expenses to Canada in order to take advantage of favorable tax treatment while retaining all of the rights to the research outside of Canada. There must be a reasonable sharing of costs and revenues and any benefits or income resulting from the shared research and development must also be shared. The 1998 OECD revisions to Article XII of the model treaty distinguished between a payment for direct use, which is considered a sale, and payments for exploitation or development, which is considered a royalty. If payment is made over the Internet for the use of a computer program, the payment may be regarded as a royalty and, in theory, should be subject to withholding tax (subject to any treaty relief). If there are payments for upgrades of computer software, then it may be a payment for services regarded as business income that would attract Canadian tax unless there is treaty protection and no Canadian permanent establishment of the non-resident vendor. A mixed technology contract involves the sale of goods as well as the provision of taxable services. Revenue Canada takes the position that the full amount of the payment is subject to Canadian taxation unless the taxpayer demonstrates to Revenue Canada that a portion of the payment should be exempt from tax (Interpretation Bulletin IT-303, paragraph 26). This would be in accordance with Article XII of the OECD Model Convention which provides for a reasonable apportionment of payments between the items in a mixed contract. Payments made for the right to reproduce computer software and for another right that is non-exempt from withholding tax must be allocated on a reasonable basis.
16 16 Withholding Tax A non-resident not carrying on business in Canada may still be subject to Canadian taxation if the payments made to the non-resident are considered to be a royalty rather than the sale of goods. Part XIII (paragraph 212(1)(d)) of the Act imposes a withholding tax of 25% (unless modified by Treaty) on royalty payments (payments based on production or use or payment for the right to use industrial, commercial or scientific experience) made to a nonresident. If the consumer, for example, has the right to commercially exploit the product, the payment may be a royalty. The copying of the digital signal on to a hard disk for the use and enjoyment of the consumer will not cause the payment to be a royalty. Downloading for personal enjoyment will not be a royalty. A licence for software to be used in Canada, subject to a Treaty exemption, may be subject to Canadian withholding tax. In some Treaties (e.g., Canada-US Treaty) copyright royalties, payments for the use of computer software and payments for the use of a patent or any information concerning industrial, commercial or scientific experience are exempt from withholding tax under Article XII(3) of the Treaty. In most Treaties, the withholding tax rate on royalties is reduced to 10%. The payment to a non-resident for space on a server to host a website should not be subject to Canadian withholding tax. Data warehousing is regarded as a service rather than as a rental subject to withholding tax. If the non-resident is considered to render a service in Canada then regulation 105 may require a Canadian withholding tax of 15% of the gross payment. Services may include technical assistance. Services may include the use of existing knowledge (knowhow) to create a product for the buyer to use. A transaction may include a sales, service and license component. CRA s position is that a mixed use contract including services rendered in Canada will subject all payments under the contract to the 15% Canadian withholding tax under Regulation 105. Tax Treaties If an income tax convention applies, business profits will be taxable in the country of residence of the taxpayer unless there is a permanent establishment in another country.
17 17 Permanent establishment is generally defined in the treaties as a fixed place of business through which the business of an enterprise is carried on. The treaty definition of a permanent establishment may be deemed to include a place of management, an office, or an installation project that lasts more than six months or a year. An interesting question is whether a software installation lasting more than six months is a permanent establishment. The definition may include fixed automated equipment and thus computer equipment. The furnishing of services is specifically treated in some treaties as a permanent establishment. A person having and habitually exercising the authority to execute contracts in the name of the taxpayer may constitute a permanent establishment. Permanent establishment may be defined to exclude the use of facilities for the purpose of storage or display and advertising and other activities of a preparatory or auxiliary character. The OECD has tentatively concluded that a Web site will not constitute a place of business because it does not involve any tangible property and there is no office or other facility through which business is carried on. A Web site would not be viewed as a person. Although the definition of permanent establishment may exclude the use of facilities used for storage, display, or delivery of goods or merchandise, this may not apply to a server. It is also arguable that a server performs activities of a preparatory or auxiliary character which are excluded from the definition of 'permanent establishment. The OECD model treaty extends a permanent establishment to a self-contained automated business process and this may include a server. However, it may not be possible to conclude that an independent service provider is a fixed place of business of a vendor that does not control it. Countries may attempt to view the server or a local provider or the use of the local telephone lines by customers and servers as constituting a permanent establishment. (For example, see Friedrich E.F. Hey, "German Court Rules Remote-Controlled Pipeline Constitutes a P.E.;" Tax Notes Intl Feb. 24,1997, p. 651.) However, most of these relationships are ones of independent contractors or agency. The use of an independent server would not constitute a permanent establishment as it is not controlled by the provider of the services or goods. In situations which local support services are required for the products being sold, it may be easier to conclude that there is a permanent establishment.
18 18 E-commerce, unlike other businesses, does not necessarily involve either employees or an office in each jurisdiction in which business is carried on. It is possible to structure an e- commerce business so that it does not have an office or employees in the country in which goods are sold or services provided. It may have a Web site and have customers in each jurisdiction. The Web site may advertise the products for sale or be capable of handling commercial transactions. The issue is how aggressive marketing can become through the virtual office without being subject to income tax in the jurisdiction where the consumer is located. If there is no treaty relief and if each country applies different taxation principles, double taxation is likely