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Taxation of Internet Commerce by Zak Muscovitch

Special Issue Update

This paper is included in the First Monday Special Issue #3: Internet banking, e-money, and Internet gift economies, published in December 2005. Special Issue editor Mark A. Fox asked authors to submit additional comments regarding their articles.

When I originally wrote this paper in late 1996, the Internet was not the mainstream, robust medium that it is today. The Internet was thought of as a novelty of sorts and was frequently referred to as the “Information Superhighway”, a term that sounds somewhat campy today. Furthermore, the “Internet” had to be defined and described in the paper because many readers were not familiar with what the Internet actually was. As far as I am aware, this was the first published paper that addressed the topic of taxation of internet commerce.

It was truly a new frontier. The paper likened the Internet to the Silk Roads of China and coined the phrase, “The New Silk Road” to describe the Internet not as merely a new communications tool, but a new channel for the exchange of a new commodity - information.

With Internet Commerce at its infancy there were real questions looming as to whether it would take hold as a viable “trade route” and become a fixture in the marketplace, and if so, ‘who would regulate it’, if it was possible to regulate it at all. The paper envisioned the displacement of traditional means of payment in favour of “digital cash”, however this prediction proved to be inaccurate. Credit cards continue to be the most common means of paying for goods and services on the Internet, and traditional banks are now also participating through direct withdrawals from bank accounts.

At the time, it appeared that the Internet was “ungovernable”, and accordingly traditional taxation would be impossible to enforce. At the time, there was serious discussion of a “bit tax” or an “access tax”. As it turned out, this form of taxation never took hold, in part helped by the passing of an Internet Tax Moratorium by the U.S. Congress in 1998.

Traditional bricks and mortar business together with virtual businesses have tended to model themselves on the mail-order business, with taxes being levied on purchasers who reside in the same state or province as the seller, but additional forms of taxation targeted at Internet Commerce alone have not been enacted. Nevertheless, import duties have of course been avoided completely for intangible consumer products such as software and music files.

Some businesses however, primarily online casinos, have located themselves in tax haven jurisdictions and have accordingly avoided corporate taxes. For example, corporations located on-shore that are involved in the internet casino business have structured their affairs so that they reap revenues not from wagers, but from licensing fees and software development.

Residency of individuals for income tax purposes has not been significantly affected by the advent of Internet Commerce. Whereas the paper envisioned residency becoming “meaningless” on the Internet, traditional understandings of the residency of individuals for tax purposes has remained largely intact. Likewise, the location that a web site is hosted at is largely ignored when determining residency of an Internet-based business.

The advent of the Internet has affected the way many business structure their affairs and has caused certain “losses” of “traditional” taxation revenue, but the Internet apparently has not caused a wholesale revision to traditional principles of and approaches to traditional taxation. Reluctance to enact new “Internet taxes” combined with practical obstacles to collection of taxes on inter-jurisdictional internet commerce has allowed the Internet to flourish as a viable new trade route.

This paper analyzes how commerce and banking will be affected by the Internet, with particular attention to existing international frameworks for taxation. Domestic tax laws are shown to be unable to adequately control the emergence of a "new international trade route". Individual and Corporate Residency laws, Tax Avoidance and Evasion, Laundering, Crossborder-Shopping, and the Transfer of Technology will be discussed in relation to taxation laws, particularly the United States' and Canada's.


The Internet in the Context of International Commerce
Background to the Information Highway
The Internet as an International Trade Route
The Jurisdictional Framework of Internet Commerce
Examples of Practical Commercial Applications
Example of a Typical Transaction
Government Controls in General
The Effect of the Internet on Particular Aspects of Taxation Laws

The Internet in the Context of International Commerce

We live in a society in which existing legal frameworks are constantly challenged by technological advancements.This creates a need to constantly update and adapt the way in which we organize ourselves in order to maintain the state's overall control of its domestic affairs and national interest.The advent of technology that enables the transmittal of voice, data, image, and video information has been called an "information superhighway [ 1 ]." This new technology constitutes a brand-new route for the exchange of goods and services that has yet to be fully examined.Much has been written on how the Information Superhighway affects intellectual property yet substantial questions have yet to be answered in regards to how this new trade route will be treated by various laws of taxation.

In fact, the United States Treasury Department has identified the tax ramifications of such high-technology issues as transactions over the Internet as a "top-priority" international issue for 1996 [ 2 ].According to Carol Doran Klein, Deputy International Tax Counsel in the Department's Office of Tax Policy: "The possibilities of the Internet are just beginning to be explored, as are the tax implications of doing business over the Internet [ 3 ]." This paper is intended to evaluate the consequences that the Information Superhighway presents to traditional precepts of international taxation.

In such a study of new frontiers of taxation practices, the nature of Internet business itself must be examined in order to appreciate how taxation will be affected. In a study of shipping and taxes for example, it would not be necessary to explain much of what a "ship" is, nor how shipping lanes work.Given that the Internet is a new phenomenon which tax professionals are just beginning to grapple with, a greater degree of detail will be employed in outlining Internet commerce as a platform for taxation.

Background to the Information Highway

Although it is beyond the scope of this paper to present a comprehensive description of the Information Highway, it is nevertheless crucial to understand the basics in order to appreciate the complex ramifications that it presents to issues of international taxation [ 4 ].

The "Information Superhighway" refers to the concept of merging all sources of information into a single retrievable "database". For example, every home, office, news medium, library, data bank, business, government agency, and computer will be connected to every device, such as the telephone, television, or personal computer. This is being accomplished largely by a collection of independent computer networks that are linked electronically, known as the Internet.

The first computer network, known as ARPANET [ 5 ], was created by the United States Department of Defence in 1969. Its purpose was to provide computer-to-computer communications over long distances for use by the Department of Defence and various research centers, both industrial and academic. The Internet, which evolved out of ARPANET, has no central control, as it was designed to maintain a functioning means of communication despite nuclear attack. In other words, because the Internet is not a single computer network with a central administration (e.g., a university's administrative computer network), but a collection of independent computer networks, it is generally impossible to regulate or shut it down. In many countries around the world, there are more than ten thousand of these smaller networks linked together to comprise "the Net [ 6 ]".

Today, the Internet is used by the widest range of individuals and groups. One study indicated that, as of April 1, 1996, roughly 37,000,000 people (or .62% of the world's population) had access to the Internet; the figure seems to double every year [ 7 ]. By the year 2000, based upon this forecast, approximately 840 million people worldwide will use the Internet [ 8 ]. Today it is used for everything from academic research to interactive video gambling.

The Internet as an International Trade Route

The Internet is commonly thought of as a communication tool, however this is characterization is incomplete. Although the Internet is a tool that enables people to send and receive text, voice, images, and other data, it is also characterized not as a 'more modern communications device', but as a new trade route. The Internet can be likened to the Silk Roads of China (circa 2nd century B.C.) which constituted a brand-new route for the international trade of a "brand new" commodity [ 9 ]. The Silk Roads provided a new link between the East and West for the transport of a brand-new commodity (silk), whereas the Internet provides a link between every country for the transport of a more familiar commodity, information.

The growing sophistication of trade, including international trade, was one of the factors which led to the need for the creation of "money" to replace bartering [ 10 ]. Initially coins, made out of internationally valued commodities such as gold, were used. Money, was subsequently expanded from coins to paper as a response to the growing acceptance by merchants and traders of credit notes which were negotiable internationally. The ability to transport large sums of money across borders via a paper note, was a key development in international commerce [ 11 ]. The shift from a valuable substance (gold) to a representation of value (paper) can then be compared to the current development of electronic cash as a modern market response to the growing acceptance of Internet commerce. Electronic cash, then, is what will enable international trade to grow on the Information highway, the new Silk Road.

The Jurisdictional Framework of Internet Commerce

The establishment of the Silk Road presented legal challenges in much the same way as the Internet does. Both of these trade routes transcended national boundaries, and created the need to adapt laws to reflect the international transportation of goods. The need to adapt laws to reflect new trade routes is best evidenced by the international shipping routes which eventually replaced the Silk Roads in the seventh century as a safer and more efficient means of transporting goods [ 12 ]. Admiralty law is conceptually analogous to the transnational nature of cyberspace. Just as the territory that a ship traverses is not subject to any one state's jurisdiction, so too the user in cyberspace traverses a sovereign less region that is not subject to any one state's exclusive jurisdiction [ 13 ].

An important aspect of admiralty law that bears on Internet commerce is flag-shopping. It is a common practice for ships to choose a "flag-of-convenience" with which the vessel has little connection [ 14 ]. Reasons such as tax avoidance and preferable treatment under the state's substantive laws guide this choice. Companies operating on the Internet, can also choose a "flag" of a country that offers legal advantages, such as bank secrecy and low or no taxes. This is achieved by a company establishing their computer (which is an 'electronic establishment') in the beneficial country. The firm can then offer their intangible information-based goods and services to the entire world via the information highway.

Examples of Practical Commercial Applications

Commerce on the Internet, although in its infancy, can take many forms. "Home- shopping" (where consumers browse "cybermalls" and buy goods through credit cards and electronic cash) will comprise an estimated $7.2 billion U. S. marketplace by 2000 [ 15 ]. Electronic cash, will form the bedrock of Internet transactions, and will enable, for example, a consumer to download the latest word-processing program or video game right from his or her computer and pay for it with E-cash.

E-cash is already being issued by online banks as a currency that can be traded for goods and services over the Internet [ 16 ]. E-Cash is the generic name given to the concept of currency which is digitally signed using the issuing institution's private encryption key. The institution withdraws (or otherwise charges the customer), and electronically transmits the note to the appropriate person. This note can then be electronically negotiated to others as payment for goods and services [ 17 ]. Banking is also seen as an area that will experience dramatic growth over the Internet [ 18 ]. Banks are already involved in electronic commerce by using Automatic Teller Machines, and wire transfers. Many banks are also establishing presences on the Internet which will soon enable customers to complete virtually every banking transaction over the Internet [ 19 ]. Security issues which are always a concern in financial transactions will be eventually overcome through the use of encryption or a digital signature [ 20 ].

Example of a Typical Transaction

The primary device used for Internet commerce is the World Wide Web Page. The World Wide Web can be simply defined as a multimedia interactive portion of the Internet, which visually resembles a catalogue or brochure and provides a presence for its operators on the Internet. The best comparison may be to an international telephone directory combining both white and yellow pages. The main difference however, is that once a user finds an entry that interests him, he may then retrieve more detailed information by following electronic links to other related pages.

A common transaction on the Internet is the downloading, or retrieval, of software from a computer located in another country. A user begins the process by using a "directory-assistance"-like search tool to find pages that fit his search parameters. Once a suitable entry is selected, the user clicks on it, and his computer goes to that page. The user will usually then find a text and graphical environment where for example, software products are described and offered. The final step is when the user requests a program, for example a video game or business application, and it is sent, usually in minutes, right to the user's computer. If the operators of a given Web site charge for a product or service, a credit card or other electronic payment system may be used.

Government Controls in General

As mentioned earlier, the Internet's design precludes a central control which may be regulated by governments. Nevertheless, some governments are interested in what passes over their phone lines and are pursuing various means of exercising some degree of control by sampling and intercepting some Internet communication. As a corollary, individuals and businesses conducting commercial transactions over the Internet are concerned with privacy and security. For example, a business will want to protect financial transactions and correspondence from being subject to eavesdropping. The answer to security concerns has been powerful encryption methods employed by individuals and companies. The problem for government, is that they may be unable to break these encrypted transactions, thereby being unable to control the flow of taxable or illegal information. Legislation has being considered in the United States that would empower and enable the government to hold the "key" for all such encrypted transactions [ 21 ].

In the context of tax avoidance and evasion, a government may hope to be able to intercept the transmissions of some residents and thereby assess their tax liability. This would be an effective regulatory mechanism only to the extent that it would either catch or deter some individuals attempting to avoid or evade taxes. It would not however, be able to shut down the transmissions emanating from tax haven companies. Understood as such, enforcement of domestic tax laws would be accomplished to a degree comparable to the number of speeders caught on a highway. Enforcement would have a mostly deterring effect, and would target individuals engaged in large-scale avoidance and evasion schemes, but would probably leave the average consumer untouched.

The Effect of the Internet on Particular Aspects of Taxation Laws

Clearly, the shift from a physically-oriented commercial environment to a knowledge-based electronic environment presents some very serious and substantial issues that must be addressed. Existing regulatory frameworks are likely incapable of adequately taxing electronic transactions, and must be adapted. Otherwise, governments may face a significant decrease in their tax revenues, as more and more commerce takes place over the Internet. The task for government then is to attempt to fit Internet transactions into existing rules of taxation. Where this is impossible, it may be necessary to adapt and amend the rules in order to catch Internet transactions.

Residency of Individuals

Residency of individuals is generally determined by looking to objective manifestations of whether an individual has established his or her allegiance to the country by joining its economic or social life [ 22 ]. Some countries rely on a "bright line" test that emphasizes the physical presence of a person, often for 183 days, and presumes that person a taxable resident for that year. The 183-day test must be enforced by strict recording of border-crossings, in order to identify that person as a resident of a country. Ostensibly, the reasoning behind using physical location as an identifier of residency is the assumption that a nexus exists between where a person spends their time and what jurisdiction can assert the best claim on that person's income. This test has met with substantial criticism because it is arbitrary and easily planned around by sophisticated individuals [ 23 ].

In the context of the Internet, the 183-day test becomes even more untenable. The geographic location of a person has historically been important in affecting where that person is a resident. However, physical location becomes almost meaningless when technology exists that enables individuals to carry out almost every facet of life in another jurisdiction while never actually physically leaving their geographic location even for a single day. A person could effectively make thousands of "trips" per year via the information highway to another jurisdiction without ever being subject to a border control mechanism.

The problem of defining residency for taxation purposes is made less difficult when we apply the "facts-and-circumstances test" which is generally thought to be more reliable than the "bright-line" test [ 24 ]. For example, let's examine the hypothetical case of an individual who has a family home in Michigan but works for a company that operates exclusively on the Internet via a World Wide Web site, controlled by a computer in Windsor, Ontario. Normally an individual whose employer is in Windsor would need to commute by car in order to use their company's offices and equipment. Also, they would usually need to meet with clients or customers who worked in Windsor. In this case however, all work including face-to-face meetings is done over the Internet.

The Canadian Tax Court case of R&L Food Distributors Limited v. M.N.R. [ 25 ] interpreted the residence requirement of the Canadian Income Tax Act, subsection 250(1), which reads:

250. (1) For the purposes of this Act, a person shall, subject to subsection (2), be deemed to have been resident in Canada throughout a taxation year if (a) he sojourned in Canada in the year for a period of, or periods the aggregate of which is, 183 days or more.

The court decided that even though an individual from Michigan may spend more than 183 days per year in Canada because that is where he is employed on a daily basis, he will not be deemed a resident if he maintains a home and social ties in Michigan and not in Canada. The conclusion here must then be (by way of analogy), that the Canadian government would not deem our hypothetical Internet-commuter as a resident.

If the hypothetical individual is not a deemed resident, can he be taxed as a non-resident? Section 2(3) of the Canadian Income Tax Act provides that, where a non-resident was employed in Canada, carried on business in Canada, or disposed of a taxable Canadian property at any time in a taxation year or a previous year, the non-resident shall pay an income tax on taxable income earned in Canada in accordance with Division D (sections 115 and 116) of Part I of the Act [ 26 ].

Corporate Residency

The court in Grainger & Son v. Gough (Surveyor of Taxes) [ 27 ] grappled with the problem of when business will be considered to be carried out in the United Kingdom for the purposes of income tax assessment. The Grainger case involved a French wine merchant who had sales agents in Britain. The role of the agents was to transmit orders for acceptance to the merchant in France. It was found that because the contracts were made not in England but in France, and because delivery to the purchaser was made in France, the wine merchant was not liable for taxation as a non-resident carrying on business in Britain.

The comparison of the circumstances in this case to Internet business is as follows: A World Wide Web site or home page (a primary device for the delivery of goods over the Internet) is operated from a host computer. Let's suppose that the Web Page offers downloadable software to consumers all over the world. The delivery of the software is immediate, and is actually stored on the host computer which issues copies to consumers. Lets further suppose that the host computer is located in France, while the consumer in question is in Canada, just like the Grainger case. If where the contract and delivery are made are determinative factors, is the software company taxable as carrying on a business in Canada?

The answer is probably "yes." If transactions over the Internet reach a point of reliability and acceptability equatable to the levels offered by postal services, then the "post-box" rule of contracts will likely apply, wherein a contract is deemed to have been accepted when it is first mailed [ 28 ]. The delivery requirement will however be more problematic. Even though the consumer will receive the software at his computer, it will have been sent from the host computer in France [ 29 ].

Since the Grainger case however, Canadian courts have considered factors other than the place where the contract was made in deciding whether a non-resident company exercised trade or carried on business in the jurisdiction [ 30 ]. These other factors may help us in deciding whether our hypothetical software company is liable to non-resident taxation. In G.L.S. Leasco Inc., McKinley Transport Ltd. V. M.N.R., [ 31 ] held that the "substance" of doing business must be present. This can include place-of-incorporation and place-of-management in addition to factors dealing with the location of contract and delivery [ 32 ].

Our hypothetical non-resident software company does not solicit business in Canada, has no agents in Canada, has no bank account in Canada, has no office in Canada, never sends any employees to Canada, does not purchase products in Canada, and does not necessarily intend to carry out business in Canada. So, despite being an adventure in the nature of trade, as per Section 248(1), the actual business cannot be said to have been carried out in Canada.

Permanent Establishments

Nevertheless, a very interesting argument exists that the company's business income should be treated as having its source in Canada because it was earned through a permanent establishment, namely its Web site. Article 7 of the OECD Model Treaty provides that "an enterprise of a Contracting State" generally is exempt from tax on its profits derived from business carried on in the Other Contracting State unless those profits are attributable to it a permanent establishment located in that other Contracting State [ 33 ]. Article 5 defines a permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partially carried on [ 34 ]. The Model Treaty also lists business premises which constitute a permanent establishment: a place of management, a branch, an office, a factory, a workshop, a mine, an oil/gas well, and a quarry or other place of extraction of natural resources [ 35 ]. If we were to characterize all of these examples, it is likely that we would conclude that a physical presence of some permanence is common to all.

Does a Web site or home page have a physical presence of some permanence? The best answer seems to be that a home page can have a physical presence. A Web page is made from binary, or digital code, and is housed on a magnetic surface, usually a disk of some kind. The binary code is viewable using a computer and a communications device. However, even though we can establish a physical presence, albeit a brand new form, the "establishment" exists on the host computer. Therefore, a Web page will likely constitute a permanent establishment only in the country where the host computer resides.

An alternative perspective exists however, if we look to the United Nation's Model Treaty instead of the OECD Treaty. The UN Model Treaty has a more expansive definition of a permanent establishment which includes dependent agents that maintain a stock of good from which they make deliveries on behalf of their principals [ 36 ]. A Web page can be considered an electronic agent, or even a robot of sorts, which holds software goods and automatically delivers them (upon an almost instantaneous conclusion of a contract) on behalf of its controller or "principal".

Avoidance and Evasion

Thus far we have examined the Internet's impact on existing taxation frameworks on the assumption that any transactions conducted over the Internet would be (to some degree) either self-reported or within the investigative and enforcement powers of revenue authorities. This however is not always the case. In fact, the special characteristics of the Internet, i.e. its lack of central control, combined with its international reach make it very difficult, if not impossible, to regulate the vast amounts of money that are expected to travel through it. The U. S. Treasury Department's International Tax Counsel Guttenag has expressed concern that the Internet may be used for tax avoidance and other criminal shifting of income. The Treasury Department has set up a group to study this problem [ 37 ].

Applicability of Existing Reporting Laws

The first and lesser problem relating to the regulation of Internet commerce for tax purposes is the uncertainty of whether current laws will even apply to financial transfers on the Internet. In the United States, the answer seems to be somewhat clear. The Electronic Funds Transfer Act (EFTA) applies to not only banks but to any other person who, directly or indirectly holds an account belonging to a consumer or who issues an access device and agrees with a consumer to provide electronic fund transfer [ 38 ]." The EFTA would therefore seem to catch "cyberbanking" despite its distinctly different character than traditional banking.

The EFTA also provides a means for government to keep track of electronic transactions although documentation requirements are framed as consumer protection issues. By requiring very specific documentation of every transaction the EFTA has attempted to extend the regulations that apply to paper-based banking into "cyberbanking". Nevertheless, it appears that this legislation was primarily targeted at technology such as automatic teller machines and wire transfers, but did not contemplate newer banking applications such as the Internet. For example, the requirements that consumers receive receipts and periodic statements reflecting electronic transfers of money do not make sense when applied to stored-value cards that operate independently of a bank account.


Stored value cards will likely replace cash to a significant degree as we move towards an increasingly paperless society. Stored-value cards could be used for not only transactions over the Internet, but could be internationally negotiable for goods and services in the "real world." This new currency is conceived as being downloadable from an Internet-connected bank right onto a card-shaped computer disk inserted into a device connected to a personal computer [ 39 ]. The card would be credited with the desired amount of "cash" drawn from an account with the cyberbank. At this point, assuming the bank is regulated, a record of the transaction would exist with the bank. From that point on however, transactions completed with the card could be as untraceable as cash. The concern for governments, is that unlike today's society wherein cross-border shopping is regulated by customs agents and the postal service, the Internet offers no such enforcement mechanisms. The Internet therefore, presents a serious informational and enforcement crisis to revenue authorities.

Cross-border Shopping on a Global Scale

Lets briefly examine how cross-border shopping by consumers will be affected by Internet commerce. A Canadian consumer is normally liable for customs duties imposed by the federal government on the importation of commodities and merchandise into Canada under the Customs Act [ 40 ] and the Customs Tariff Act [ 41 ]. These duties are imposed by the application of a percentage or specific (flat dollar) rates to the fair market value at the point of origin of the article imported [ 42 ]. Furthermore, under the Excise Tax Act [ 43 ] a Goods and Services tax is levied at a rate of 7% in addition to provincially levied sales taxes, if any [ 44 ]. If a Canadian consumer was to purchase a good, such as the latest software application, or a service such as a pay-per-view movie from a regulated Canadian company through normal channels, he would be subject to the GST and the PST. If he were to cross the border to Buffalo from Toronto to purchase software or a video cassette he would be subject to customs control at the border. In the case of Internet commerce however, a consumer may be able to purchase goods and services without ever incurring any tax whatsoever.

As the Internet evolves and becomes more accepted as a commercial trade route, companies on the Internet will have to abide by their own domestic sales tax laws. Therefore, a Canadian company operating a commercial Web site would have to add the 7% GST as well as any applicable PST to the purchase price of their product. The same may be true for customs duties in the form of a withholding tax. But suppose a company, CyberBahama Corp., is operating a commercial Web site that is hosted by a computer in a tax haven country. The ramifications to the concept of electronic-cross-border shopping could be very serious for government revenues. There would be no way for governments to collect sales taxes because of the lack of a treaty, and there would be no way to collect customs taxes because of the technical impossibility of customs checkpoints.

Use of tax havens for average consumers is virtually non-existent as most people do not have access to these countries for consumer purchases. This will likely change when entrepreneurs realize that they can compete with lower tax-free prices by setting up "shop" from a computer hard drive in the Caribbean rather than in Chicago, without any additional costs involved.

The U. S. Treasury Department has claimed that they will not be passive to this control problem and will set-up "toll-booths on the information-highway [ 45 ]". According to most Internet experts however, such a mechanism would be impossible to set-up because of the Internet's amorphous and decentralized nature [ 46 ].

Policy Considerations in Applying Current Taxation Practices

A very persuasive argument is possible however, that if taxation of Internet commerce is difficult to impossible to control, a "hands-off" approach would not only be best, but would be justified. One of the objectives of tax policy is to provide the government with revenue for a variety of programs and maintenance of the internal infrastructure. Individuals and businesses are said to benefit from these government expenditures, and therefore owe a duty to contribute a portion of their earnings and profits. A traditional department store avails itself of the protection that government offers through police, regulation, and the civil courts. A store also uses the infrastructure such as roads and electricity that a government usually makes possible. In the case of Internet commerce however, very little if any of these benefits are necessary.

An alternative to the traditional forms of taxation may be appropriate in light of this. Government will still be able to tax personal income taxes as well as Internet businesses that are resident in treaty countries. Revenues will indeed decrease as a result as more businesses move online, but only those goods and services that are "intangible" will escape. For the most part, if a consumer places an Internet order for a couch (for example), it will still have to cross the border and thereby be caught. Couch manufacturers will have availed themselves of much more of a nations's infrastructure, using wood, roads, and land compared to the minimal amount used by a producer of intangible property. This factor may provide a justification for the different tax treatment of Internet transactions.

Bank Secrecy Laws

Aside from consumer-oriented transactions, tax-evasion on a wide scale will be made easier and more difficult to catch when carried out over the Internet. In the following examination of tax-evasion issues, the United States will be used as an example. U. S. tax and law enforcement agencies have long had difficulty in attempting to apply extraterritorially U. S. discovery laws to tax haven states [ 47 ]. As of 1986, fifteen states had adopted blocking legislation expressly designed to counter U. S. discovery efforts [ 48 ]. Parties engaged in international tax evasion and money laundering schemes avail themselves of the bank secrecy laws that tax haven countries provide.

In response to this problem, the U. S. Congress has enacted legislation such as the Bank Secrecy Act in 1970 [ 49 ] which requires that all transactions involving the import and export of currency to and from the United States be reported. This measure has likely been ineffective in curbing tax evasion and laundering schemes as it relies largely on self-reporting, and enforcement is difficult because tax haven countries keep the identity of bank clients secret. The same obstacles will likely affect Internet transactions if the Bank Secrecy Act is used in relation to transfers of money over the Internet.

The U. S. government has also attempted to create incentives for Caribbean Basin nations to negotiate new tax treaties by instituting the Caribbean Basin Recovery Act [ 50 ] in 1984. This legislation is based on the realization that many Caribbean countries need to be encouraged economically in order to abandon the lucrative business of holding off-shore accounts in a secretive environment. Tax haven countries need very little in the way of infrastructure or sophisticated economies in order to become attractive as havens. The same can be said for the housing of host computers in tax haven countries. Ostensibly, a Caribbean country, for example, could allow companies to set-up Web sites that would be treated by their secrecy laws in the same way as traditional banks. This measure too however, has been largely ineffective in curbing tax haven status, as to date only the Barbados has signed a new exchange-of-information agreement [ 51 ].


The ramifications of tax haven countries getting into the Internet business are perhaps the most serious of all issues evolving from Internet commerce. Tax haven countries currently, are likely only used by sophisticated business people and criminals. In the future however, individual consumers will be able to set up bank accounts with cyberbanks in the tax havens, and effectively circumvent the international banking system. Whereas pre-Internet commerce, this would be an unrealistic option for most people because they would have to involve a domestic bank at some point in their transactions, cyberbanks could now issue untraceable currency that could be negotiated internationally. Furthermore, the transfer of such currency could be completed directly between the banks and account-holders through personal computers, thus never creating any traceable information trail that is accessible to revenue officials.

Money Laundering

The same holds true in the case of money laundering. Normally, launderers secretly withdraw currency from one country and deposit it in a tax haven bank. The currency can then be transferred back into the original country in a legitimate non-taxable manner, for example as a loan, and directed back to the depositor through a foreign trust or dummy corporation under the depositor's control [ 52 ]. Because the Internet enables the drawing of untraceable electronic cash from a cyberbank, the need to obfuscate its source by using a foreign trust or dummy corporation becomes obsolete. By way of example, lets use a hypothetical launder, called CyberCartel. CyberCartel earns fifty million dollars from illegal businesses carried on in Canada. The business income is in the form of untraceable electronic cash drawn from a cyberbank in a tax haven country, the currency of choice in modern transactions. CyberCartel deposits the illegal income into their cyberbank via a personal computer hooked-up to the Internet. The money is may then be drawn on for future investments at the leisure of CyberCartel. Futuristic? Yes, but not overly so in the context of the inevitability of paper less electronic transactions.

A more immediate example of how tax haven countries can increase their effect on revenue sources relates to the emergence of Internet casinos. There are currently several casinos operating on the Internet, many of which by no coincidence operating out of host computers in the Caribbean. The most high profile of which is Caribbean Internet Casino, actually owned by a Toronto businessman [ 53 ].

Sales Versus Royalty Income

One of the primary issues concerning the tax treatment of Internet commerce is whether the downloading of software will generate sales income or royalty income [ 54 ]. Computer software can be viewed as either goods, a service, or intellectual property thereby creating a characterization problem when interpreting both domestic withholding tax and treaty provisions [ 55 ].

The OECD published a report in 1992 which set out how the OECD's model tax conventions should be interpreted in relation to software payments [ 56 ]. Catherine A. Brown, in "The Canadian Income Tax Treatment of Computer Software Payments" [ 57 ] provided a concise summary of the report's guiding principles:

  1. Payments made in connection with software represents royalties only where there is a limited grant of rights (not amounting to a change in ownership) for the commercial development or exploitation of the software.
  2. Payments for software (whether "bundled" or not) that is acquired for the personal or business use of the acquirer do not represent royalties.
  3. Payments made for the alienation of all rights attached to software do not represent royalties.
  4. Payments made for the purchase of some, but not all, of the rights attaching to software may result in an alienation, depending on the precise terms of the relevant contract. In those circumstances, the consideration paid does not represent a royalty.
  5. If payments are made under mixed contracts (such as sales of hardware with built-in software), either the payments should be apportioned to the component parts, or where some of the parts are ancillary to the principle part, the treatment of the principal part should prevail.
  6. Where double taxation agreement provides for source taxation in respect of some, but not all, royalties, software payments that have the characteristics of royalties will normally be characterized as paid in respect of copyright.

The apparent conclusion of the report is that most payments for software will not be considered royalties, but should instead be treated as either capital gains, business income, or personal service income.

The Canadian position in contrast, asserts that payments made by a user, pursuant to a contract that requires that the source code or program be kept confidential, are payments for the use of a secret formula or process, in Canada and are thus royalties [ 58 ]. The Canadian position seems untenable upon examination in relation to the use of software via the Internet. Software may be used while online, instead of actually downloading the program. For example, an individual may type a report using a word processor held on a computer half-way around the globe. If the software never leaves the foreign computer, how can this be construed as the use of "a secret process or formula in Canada"?

Canada's position of treating most software payments as royalties is likely a remnant of the tax treatment of traditional media such as books and music. The advisable treatment of software payments should be something closer to the OECD treatment, in that it contemplates more modern forms of software use and sale.


While existing laws at least address how traditional routes for the transportation of goods and service are to be regulated, a legislative vacuum exists when it comes to the regulation of this new Silk Road of the 21st century. Internet commerce, while not currently a major force, will in all likelihood become a fixture of International commerce. Policy makers and practitioners alike, must deal with the potential ramifications of Internet commerce. Otherwise, government will lose a potentially substantial source of revenue and lose control of its borders. Tax practitioners must also take notice, as the potential for Internet tax planning is enormous. End of article


1. Alfred M. Mamlet, 1993. "National Information Infrastructure 1," In: Technological Infrastructure: Paving the Information Highways of the 1990's. Chicago: American Bar Association.

2. "International Taxes: Financial Services, Internet, Among Top Foreign Issues, Treasury Department Official Says", Daily Tax Report, (Taxation, Budget and Accounting, January 19, 1996), The Bureau of National Affairs, Inc.

3. Ibid.

4. For a more in-depth study of the Internet see Dov Wisebroad's, "Controlling the Uncontrollable: Regulating the Internet," 1996, Quicklaw Document, DB LNTC Document 13.

5. Advanced Research Projects Agency Network.

6. Ibid., at p. 4.

7. These statistics were provided by the Statistics Generator at Amorph, cgi. They are based upon surveys conducted by Matrix Information and Directory Service of Austin Texas.

8. Because the statistics are based upon forecasts of exponential growth, they may be inaccurate. Nevertheless, growth is certain and only the degree is in question.

9. Compton's Interactive Encyclopedia, version 3.00, Tribune Publishing, 1994.

10. Ibid.

11. Ibid.

12. Compton's, infra.

13. Matthew R. Burnstein, 1996. "Conflicts on the Net: Choice of Law in Transnational Cyberspace," Vanderbilt Journal of Transnational Law (January), p. 42.

14. Ibid.

15. According to Jupiter Communications' 1996 Home Shopping Report, as cited in Netguide, January 1996, p. 56.

16. See Digicash, a brand of electronic currency issued by First Virtual (

17. American Bar Association Section of Science and Technology, Bulletin of Law, Science and Technology, at p.1 (April 1994). As cited in, Grosso, infra. at p.29.

18. Melanie L. Fein, 1995. "The New Business of Banking: What Banks Can Do Now", Corporate Law and Practice Coursebook, Practicing Law Institute. Westlaw: 912 PLI/Corp 91, p. 1.

19. For examples of banks operating on the Internet, see the Bank of Montreal's Home Page.

20. Grosso, infra. at p. 4.

21. Grosso, infra. at p.9.

22. Arnold/McIntyre, 1995. International Tax Primer. The Hague: Kluwer, p. 21.

23. Ibid. at p. 23.

24. Ibid. at p. 22.

25. [1977] C.T.C. 2579, 77 D.T.C. 411 (T.R.B.)

26. Arnold/Edgar/Li, Canadian Income Tax, Carswell, 1993, p. 161.

27. [1896] A.C. 325 (H.L.)

28. Takach, Synopsis of presentation: "The Internet and Online Services: Exploring the Legal Implications of Doing Business Electronically," Quicklaw, Law/Net News, DB LNTC, p. 1.

29. The Canadian Income Tax Act, however seems to be able to catch such Web transactions in relation to non-resident persons. Section 253, states that a non-resident person will be deemed to have been carrying on business in Canada even if the transaction was completed outside Canada. Section 253 requires nevertheless, that the orders be either solicited or the goods offered for sale in Canada either through an agent or servant.

30. Arnold/Edgar/Li, infra., at p. 165.

31. [1986] 2 C.T.C. 2034, 86 D.T.C. 1484 (T.C.C.)

32. Arnold/McIntyre, infra., at p. 23.

33. Ibid. at p. 104.

34. Ibid. at p. 104.

35. Ibid. at p. 105.

36. Ibid. at p. 106.

37. International Taxes: Internet use for Tax avoidance under Investigation," Daily Tax Report, (Taxation, Budget and Accounting), February 16, 1996.

38. Fein, infra. at p. 4.

39. Fein, infra. at p. 4.

40. R.S.C. 1985, c.1 (2nd Supp.).

41. R.S.C. 1985, c. C-54.

42. Arnold/Edgar/Li, infra. at p. 39.

43. R.S.C. 1985, c. E-14.

44. Only Manitoba and Quebec currently collect PST at the border. Other provincial residents are left to self-assess.

45. "International Taxes: Internet use for Tax avoidance under Investigation," Daily Tax Report, (Taxation, Budget and Accounting), February 16, 1996.

46. See for example Wisebroad's paper, infra.

47. William C. Caccamise, 1988. "U. S. Countermeasures Against Tax Haven Countries," Columbia Journal Of Transnational Law Association, p. 1.

48. Ibid.

49. S. Rep.. No. 1139, 91st Cong., 2d Sess. 1-4 (1970).

50. Pub. L. No.98-67, title 2, 1983.

51. Caccamise, infra. at p. 9.

52. Ibid. at p. 3.

53. See

54. "International Taxes." infra. p. 1.

55. Catherine A. Brown, 1994. "The Canadian Income Tax Treatment of Computer Software Payments," Canadian Tax Journal, Volume 42, Issue 3, p. 594.

56. "Model Tax Conventions: Four related Studies," Issues in International Taxation, number 4, 1992 (as cited in Brown, infra. p. 595).

57. Canadian Tax Journal, 1994, Volume 42, Issue 3, p. 595.

58. Brown, infra., p. 609.

The Author

Zak Muscovitch obtained his Bachelor of Arts from the University of Western Ontario and his Bachelor of Laws from Osgoode Hall Law School.

Zak practices law in Toronto, with an emphasis on Internet Law. Zak was lead defense counsel in v. Sinclair (c.o.b. Friendship Enterprises (2000), wherein he successfully defended against the first attempt in Federal Court to obtain an interlocutory injunction against a domain name registrant. Zak was lead defense counsel in Easthaven, Ltd. v. Inc. (2001), the first decision in Canada to establish the convenient forum for international domain name disputes involving a Canadian domain name registrar. Zak was instructing counsel for the registrant of the defendant domain name in Heathmount A.E. Corp. v. (2002), which was the first in rem decision under the US Anti-Cybersquatting Protection Act and was successfully challenged on the basis of jurisdiction. Zak was the successful Applicant’s counsel in Black v. Molson (CANADIAN.BIZ), the first ICANN appeal in Canada.

Zak has represented numerous clients from countries such as Sri Lanka, China, England, Australia, United States, Belgium, South Africa, Korea, and Canada, in over 40 ICANN domain name disputes. Zak represented the registrant of SHOES.BIZ in the first “.biz” case involving an instance of Reverse Domain Name Hijacking (2002). Zak represented the registrant in the first successful challenge of a CIRA Complaint over the domain name, CHEAPTICEKTS.CA (2003).

Zak is the author of several articles on domain name law, such as “A Guide to ICANN Procedure and Policy”, Internet and E-Commerce Law in Canada (2000). Zak is frequently consulted by the media and has appeared as a guest on CBC Radio’s This Morning With Shelagh Rogers together with Member of Parliament, Dennis Mills wherein he discussed Internet Gambling laws, and also appeared with the President of the Canadian Recording Industry to discuss Napster.

Zak provides advise to numerous Internet companies, including online gaming companies and e-tailers.


E-mail: zac [at] muscovitch [dot] com

Copyright © 1997, First Monday

Taxation of Internet Commerce by Zak Muscovitch
First Monday, Volume 2, Number 10 - 6 October 1997