FROM THE OFFICE OF PUBLIC AFFAIRS
October 7, 1998RR-2751
Thank you for the opportunity to discuss with you the important issue of the
characterization of income derived from electronic commerce. I would also like to bring you
current as to what the OECD and the U.S. have done and are doing with respect to software
transfers. I present this work also as an example of how we can proceed on many other issues we
face. As I hope becomes apparent during the discussion, this issue of characterization must be
resolved not only within each taxing jurisdiction but also between each taxing jurisdiction, and
thus is an issue that the OECD should play a major role in resolving.
Background
A little background. Today's technology permits text, images and sounds to be
"digitized", that is, converted into digital or numeric form. Any information that is capable of
being digitized can be made available over the Internet or similar technologies. There already
exists a substantial market for access to digital products, such as electronic magazines, news
broadcasts, stock information, photographs, software, videos, and sound recordings. Today's
technology also permits a myriad of services to be delivered over the Internet, from investment
advice and stock trading to travel information and booking services.
As technology improves and as the telecommunications, cable and television
industries converge, it can be expected that the market for digitized information and on-line
services will increase dramatically, as will the tax issues that need to be addressed: Among those
issues, characterization issues will be primary.
Characterization Issues
The ability to digitize data and provide it over the Internet, for a fee, presents issues
under income characterization rules. For example, is the income from the provision of digitized
information a royalty? Is it income from the sale of a good? Or is it income from the provision
of services? Of course, characterization questions are raised as well in the context of more
traditional transactions. However, such questions are made more difficult in the context of
electronic commerce generally, and in the context of digitized information specifically, because
of the varying uses to which digital products can easily be put. For example, a photograph may
previously have been made available to a consumer through the purchase of a physical copy of
the photograph. The consumer may now purchase a digital copy of the photograph, downloaded
from the Internet: Once the consumer has the digital copy, he may simply view an electronic
image of the photograph on his computer screen, he may copy it onto a disk, incorporate it into
another digital product or he may print out a physical copy on his printer. Payments for the
rights
to use the digital product in those different ways may be characterized differently for tax
purposes. Again, such issues are raised in more traditional commerce: a purchaser of a physical
copy of a photograph may make photocopies or scan the purchased photo to produce a digital
copy. However, the high-quality of downloaded information and the ease with which it can be
put to varying uses increases the likelihood that consumers will put the information to varied
uses and, more importantly, that vendors will include the rights to such use along with the
provision of the digitized product.
General Principles
Our analysis of these electronic commerce characterization issues must be governed
by those same principles that apply to characterization issues generally. To do otherwise would
violate the principle of neutrality, which requires that economically similar transactions be taxed
similarly. That principle is one of the bedrock principles agreed to in Electronic Commerce:
Taxation Framework Conditions to be released at the Ministerial meeting later this week.
In general, the character for tax purposes of any payment depends on the nature of the
transaction that gives rise to the payment. A payment might be characterized as a payment for
the supply of goods, for the provision of services, or for the use of or the right to use an
intangible, depending on the rights or property transferred. That very general principle should
guide us in determining the characterization of payments in electronic commerce. Thus, for
example, we should resist the temptation to settle on answers that represent oversimplifications
and over-generalizations, such as, for example, the conclusion that the provision of digitized
information is in all cases the provision of services and not the provision of goods or the right to
use an intangible.
Solution Requirements
Any solution reached to these difficult issues should not impede the further
development of electronic commerce.
Any solution must take into account the fact that strict, unbending application of the
definition of "royalties" may lead to inappropriate results, whereby, for example, minor
differences in the method of delivery may produce significantly different tax results.
Any solution must be neutral between forms of electronic commerce and between
conventional commerce and electronic commerce.
And, perhaps most importantly, any solution reached must achieve international
consensus. If the international community cannot reach consensus on classification issues, there
is high likelihood of either double taxation or tax avoidance, which can both hamper growth of
this exciting new method of commerce and in appropriately shrink national revenue. The global
nature of electronic commerce necessitates that characterization issues be considered in a global,
international context and it will be imperative to seek an internationally accepted view on
characterization. Promoting consensus is the area in which the OECD has a comparative
advantage over other institutions. Why? Because of:
Software
As a "case study" or example of the characterization issues and possible resolutions,
let us consider the distribution of computer software. A software distributor, in addition to
offering for sale "shrink-wrapped" physical software packages deliverable by mail or at a retail
location, could electronically store software on servers accessible through its Web page. The
stored software could, for the payment of an appropriate fee, be:
Downloading
Downloading of digitized information to a consumer's computer generally involves
the copying of material to the hard drive of the computer or a diskette or CD. In the case of
downloaded computer software, the right to download will ordinarily be accompanied by a
license to operate the program, subject to various restrictions.
In many respects, downloading digital products is simply another method of delivering
goods. What the consumer is seeking to acquire is the content of the book or the photograph or
the sound recording or the software. A consumer who creates a physical product from the
electronic product that has been downloaded--a consumer who prints out a downloaded image,
for example--is in much the same position as a consumer who purchased a physical copy of the
image and took delivery by more traditional means. In the case of software, what the consumer
generally seeks is not a physical product such as a diskette but the electronically coded set of
instructions that can operate his computer as desired that is, the computer program. The
purchaser likely will be indifferent as to the method of delivery of the purchased product.
Some take the view, therefore, that the characterization of the payments in the two
cases physical delivery and downloading should not be affected simply because the method of
delivery was different. That is the conclusion that both the OECD and the United States have
reached with respect to computer programs.
Others, however, take the view that the difference in the method of delivery is relevant
because in the case of the purchased downloaded digitized information there generally is also
included the right to reproduce the digitized information, at least one time. In most jurisdictions,
the copyright laws will protect digitized information in the same way as physical text, images or
sound recordings, and thus the right to modify or reproduce the digitized information will vest
exclusively in the copyright holder. It is therefore arguable that where the copyright holder
permits others for a fee to exploit those exclusive rights, the payments should, at least in part, be
regarded as payments for the right to use the copyright and thus as royalties for tax
purposes.
A major challenge facing tax policy makers in relation to the transfer of digitized
products will be to decide whether to take an "economic equivalence" approach that is, to
characterize payments for downloaded information in the same manner as payments for
information delivered by more traditional methods or whether to take account of the copyright
use that might be inherent in downloading and characterize at least some portion of the payment
as a royalty.
OECD Approach to the Characterization of Payments for Computer Software
The OECD has already begun the process of forming an international consensus on
the issue of the characterization of payments for computer software. The revised Commentary to
Article 12 of the Model Treaty released today provides that "[t]he character of payments received
in transaction involving the transfer of computer software depends on the nature of the rights that
the transferee acquires under the particular arrangement regarding the use and exploitation of the
program." The Commentary further provides that "[t]he method of transferring the computer
program to the transferee is not relevant. For example, it does not matter whether the transferee
acquires a computer disk containing a copy of the program or directly receives a copy of the hard
disk of her via a modem connection."
U.S. Approach to the Characterization of Payments for Computer Software
The United States as well has addressed the issue of the characterization of cross-border
payments for computer software, including digitized computer software.
The regulations, which were issued last week, generally require that a transaction
involving a computer program be treated as being within one of four possible categories:
(i) transfer of copyright rights;
(ii) transfer of a copyrighted article;
(iii) provision of services;
(iv) provision of "know-how".
The rules of the regulations are based on the principle that functionally equivalent
transactions should be treated similarly. In addition, the regulations provide that copyright law
classifications should be a factor in classifying transactions for tax purposes but should not be
determinative. For example, even if a shrink-wrap license were a valid license for copyright law
purposes, we would treat the transaction as the sale of a good. Likewise, the determination of
whether a transaction involving a newly developed or modified computer program is treated as
the provision of services is to be based all the facts and circumstances of the transaction,
including, but not limited to, the copyright law aspects of the transactions.
Future Work
As I've previously stated, it is imperative that we work on the classification issues
I've been discussing not only within our respective countries but among our respective countries,
within the OECD and in consultation with other international organizations and with business.
The international aspects of this task can best be accomplished, I think, by addressing these
classification issues within the context of the OECD Model Tax Convention. As you will note,
this is an item on the post-Ottawa agenda. The OECD recognizes, as does the United States, that
the principles underlying the treatment of software discussed above may be relevant is
considering the treatment of electronic commerce transactions involving digitized content
generally. Just as with respect to other taxation issues raised by electronic commerce, it is my
firm belief that our current systems and principles are adequate to deal effectively with the
characterization issues electronic commerce raises. It is important, however, that we agree on the
application of those principles and systems and I thank you again for the opportunity to talk to
you and, I hope, to further that process of agreement.