It sets ambitious deadlines. The government is right to drive the agenda forward, but it is equally important for business to stake out some positions now. The most pressing deadline is 'to seek international agreement on the application of the permanent establishment (PE) principle to websites by March 2000'. The PE principle is that if a business has a PE in a country, then that country gets first go at taxing the profits. The key test for whether an office is a PE is whether it can conclude contracts, but the underlying idea is that there should be a fixed business operation. The PE principle makes sense in the context of old-fashioned businesses. If there is a substantial operation in a country, it will benefit from the country's roads, its schools (which supply labour) and so on. It is therefore reasonable to make the business pay taxes to the host country. Some argue that servers hosting websites should count as PEs. With an electronic business, a server may be the nearest thing there is to a fixed business establishment. But the rationale for using the PE test fails. A server does not make use of a country's infrastructure apart from its electricity supply and telephone systems, and the owner will be paying the utility companies for them anyway. So why tax profits that flow through the server? The answer is that it is convenient. The PE principle is entrenched in tax law, and most double taxation treaties use it. Dropping it for electronic businesses would mean taxing electronic and other businesses on different principles, simply because they use different tools. Dropping the PE principle would also leave no obvious way of deciding which country could tax an electronic business's profits. A gap left by dropping the PE principle would, however, soon be filled. There are some dubious alternatives. One is a worldwide share-out of taxable profits based on a measure such as turnover or number of employees. California had the same idea with its unitary tax proposals 15 years ago, although the target was not e-commerce. The result was an exchange of threats across the Atlantic and eventually a climbdown. Another approach would be for countries to take a cut of businesses' money whenever it flowed across borders. Thus if money flowed into a bank account in country A and was then passed up to head office in country B, 20% might be deducted. The tax could be given an air of respectability by calling it a withholding tax on a royalty for use of the website software, but that would not make it a good tax. It would bear no relation to profits, and would simply serve to make the countries concerned unattractive places to do business. However, if we are to stick with the PE principle we must face the difficulties it will bring. Any server can be accessed from anywhere in the world. If the location of a server will affect the taxation of websites on it, then all websites will transfer to servers located in the places with the best tax consequences. This does not mean all servers will be lying on beaches in island tax havens. If profits end up in a tax haven, it may be difficult to get them out and back to shareholders elsewhere without heavy taxes being levied. Countries seeking to attract e-commerce need not just good tax regimes, but good networks of tax treaties. The government is also concerned about transfer pricing. If we stick with the PE principle, we need to work out the profits of each PE. That means knowing what each unit in an enterprise is supplying to each other unit, and ensuring the 'prices' used for internal accounting purposes are fair. In the electronic world, functions will be increasingly distributed among business units and it will be harder to keep track of everything. Indeed it would be a great burden: businesses have better things to do than keep elaborate records that do little for overall profitability. Any day now, we should get a substantial paper from the Inland Revenue and Customs & Excise on the taxation of e-commerce. This will be our cue to say what needs to be done in the interests of business. - Richard Baron is deputy head of the policy unit at the Institute of Directors.
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