Report to the Treasurer and Minister of revenue - by a committee of experts on tax compliance

Bill Birch Treasurer

Report to the Treasurer and Minister of revenue

By a committee of experts on tax compliance


14.1 Electronic commerce is a generic term used to describe a variety of new forms of commerce, such as smart cards, electronic cash, electronic banking and the internet.

14.2 Electronic commerce is not a new phenomenon. It has existed since the use of telegraphic transfers by financial institutions. However, the rapid growth in technological developments in the communication industry over the last two decades has been facilitated by the following factors:

The deregulation of telecommunications sectors by approximately one third of OECD member countries.

The improvements of telecommunication infrastructures such as high speed modems, satellite and terrestrial broadcast.

A fall in the price of accessing the internet.

14.3 The main concerns raised by the growth of electronic commerce are first, whether existing tax policy is sufficiently robust to address any new and existing issues, and secondly, whether such activities pose a threat to the revenue base through avoidance and evasion.

14.4 Many of the tax policy issues concerning electronic commerce can be split into two groups - issues for the taxation of income and issues that affect the taxation of consumption. Some alarmist comments have been made to the effect that electronic commerce will remove the ability of countries to levy tax. The committee considers that such comments are too extreme. Electronic commerce does not require immediate fundamental changes to tax policy. The conclusion drawn by the committee is that this issue needs to be followed and reacted to, but it does not raise new tax policy issues. However, it does make more acute many existing problems faced by those designing tax policy. For tax administrations the growth of electronic commerce creates both opportunities and problems.256

Implications for the taxation of income
14.5 The communications revolution undoubtedly makes it easier for non-residents to conduct substantial business activities and derive substantial income without having a fixed place of business in New Zealand. This ability has implications for many of the concepts embodied in international tax rules, which were developed at a time when operating a business commonly required a physical presence. For example, under many double taxation agreements, a resident of one state is required to have a permanent establishment in the other (source) state, before that source state is able to impose tax on the non-resident's business profits. A permanent establishment requires a physical presence if it is to exist. With telepresence technologies,257 a physical presence is no longer needed in many jurisdictions to conduct business. However, even if a physical presence were to be established in New Zealand, modern technology has made it relatively straightforward to ensure that the bulk of the value-adding activities is left outside New Zealand. In that case, New Zealand would not be able to sustain the attribution of any significant share of the overall profits to that physical presence.

14.6 The communications revolution poses two important questions in relation to the taxation of income. First, do governments need to redefine existing terms to accommodate the change to business practices caused by the communications revolution? Perhaps more fundamentally, however, the question arises on the extent to which source-based taxation is the appropriate policy strategy for governments in the future.

New Zealand's application of residence and source principles
14.7 New Zealand imposes tax on the worldwide income of its tax residents. This approach is referred to as the residence principle of taxation. However, New Zealand also imposes tax on all income sourced in New Zealand, whether it is derived by resident or non-resident taxpayers (the source principle). The application of these principles can be modified by New Zealand's double tax agreements.

14.8 Both the residence and source principles have difficulties in definition that may be exacerbated by the communications revolution. The discussion below focuses on the implications of the communications revolution for the source and permanent establishment definitions (affecting the source principle) and for the centre of management concept (affecting the residence principle).

14.9 The main challenge of the communications revolution is to the source rules, that is, the statutory provisions defining income that is sourced in New Zealand, especially business income. From a New Zealand perspective, the provisions are mainly relevant to the New Zealand taxation of non-residents, particularly residents of double tax agreement countries, as the requirement for a permanent establishment for source country taxation presents a higher threshold for business income than New Zealand's normal legislative source rules. Consider an analyst living in Switzerland who is contracted to design a database for a New Zealand bank, and conducts all of his or her development from a terminal in Switzerland. Under New Zealand's double tax agreements with Switzerland, the definition of permanent establishment would require the Swiss analyst to have an actual place of business in New Zealand before New Zealand could tax the income. New Zealand could not, therefore, tax the business income of the analyst. Similar protection would apply to most non-residents engaging in electronic commerce with New Zealand from a double tax agreement country.

14.10 In the case of non-residents from non-double tax agreement countries engaging in electronic commerce with New Zealand, their business profits would not have tax treaty protection. It is arguable that if the analyst in the example above were from a non-double tax agreement country, he or she would be deriving New Zealand-sourced business income, by virtue of the fact that business is being partly carried on in New Zealand.

14.11 It may be appropriate to consider whether the concept of a permanent establishment enshrined in double tax agreements needs to be updated to reflect developments in the global trading environment. However, regardless of the definitions of source and permanent establishments, the committee notes that the government should not lose sight of the basic policy debate on the extent to which it is appropriate to tax non-residents under the source principle. This policy debate is discussed further below.

Central management as basis for corporate residence
14.12 The communications revolution does not present the same challenge for the residence rules. It is not as easy to change residence as it is to change the jurisdictional source of income, particularly in New Zealand, where individual residence is determined primarily by reference to a person's permanent place of abode, rather than by a test of length of presence alone. The communications revolution should not, therefore, make it any easier for individuals to circumvent this definition. What it means, in practice, is that if a New Zealand resident does not return income from electronic commerce, the issue is essentially one of evasion, rather than one of a deficiency in New Zealand tax rules.

14.13 Electronic commerce may, however, affect the determination of corporate residence. A company will be resident in New Zealand if it is incorporated or has its head office in New Zealand. A company will also be resident in New Zealand if it has its centre of management in New Zealand, or if control of the company by its directors is exercised in New Zealand. It is these latter tests to which the communications revolution presents a challenge.

14.14 The centre of management test is one of the primary international tests of corporate residence. The international norm appears to be that the centre of management is where the directors' meetings are held. If directors hold their meetings using telepresence technologies, the question arises whether there is no centre of management, or alternatively whether the company could be argued to have a centre of management in each of the countries in which the directors are present. The committee considers, therefore, that the concept of a centre of management and the tie-breaker rules for dual residence in double tax agreements should be reviewed as a result of the electronic revolution.

14.15 The committee considers that perhaps the trend should be towards tax systems that treat companies purely as agents for shareholders. To some extent, New Zealand has already put this policy into effect. For example, even if a company that is owned by New Zealand residents is non-resident, New Zealand's comprehensive controlled foreign company and foreign investment fund rules require the company's income to be attributed back to its New Zealand resident shareholders on a current basis.

Source-based taxation
14.16 Many of the specific tax issues the committee has discussed above, such as the concepts of source and permanent establishment, would be superseded by a shift to a residence-only basis for taxation. The committee considers that it is worth noting in this regard that double tax agreements commonly trade away source rights of non-residents for lower taxation of foreign-sourced income of residents. Put another way, source rights are often traded for more effective residence taxing rights.

14.17 The globalisation of world trade may lead to continuing pressure to minimise source-based taxation, because it presents some difficulties in enforcement. Unless a non-resident has a physical presence in the source country, it can be difficult to collect the prescribed tax liability. This feature is a primary reason for the existence of non-resident with-holding tax systems, which permit tax to be deducted at source, and recovery of the same to be sought from the resident payer of the income.

14.18 However, economic theory suggests that the minimisation of source-based taxation may not actually be bad for two reasons. First, it is not clear where the incidence of source taxation is actually borne, but there is some suggestion that it is often borne by the country imposing the tax, rather than the entity on which the tax is imposed. For example, before New Zealand introduced the approved issuer levy regime in 1991, it was common for non-residents to gross-up the amount of interest payable by the amount of non-resident withholding tax imposed. Thus, if the world rate of interest was 8.5 per cent, New Zealand companies would be charged 10 per cent (assuming a 15 per cent rate of non-resident withholding tax). The effect was that the full incidence of the tax was borne by the New Zealand borrower, rather than the non-resident on whom the tax was formally imposed. Many other countries have also eliminated non-resident withholding tax imposed on interest, in response to the increased mobility of capital and responsiveness to interest rates over the last decade.

14.19 Secondly, economic literature suggests that the optimal tax system for a small country is one applying a pure residence-based system,258 with income earned by non-residents being exempt from tax. The requirement under various double tax agreements and unilateral decisions made by many countries to provide a credit for foreign taxes means that this optimal solution cannot be achieved in the present global environment.

14.20 The difficulties in applying source-based taxation are not restricted to the communications revolution, and are a broader consequence of the increasing globalisation of world trade. Some of the taxation issues raised by electronic commerce are not really new. Rather, they represent an extension of existing problems. The committee believes that perhaps the key consideration here is that governments should not be rushed into taking piecemeal measures in response to the effects of the communications revolution on existing international tax concepts.

Implications for goods and services tax
14.21 The aim of a value added tax is to impose a tax on final consumption. The issue for tax policy makers around the world is whether to place the economic incidence upon the consumer or the supplier. An important consideration is the practicality of the options.

14.22 The aim of New Zealand's GST is to impose a uniform tax on final consumption in New Zealand. GST is based on the 'destination' principle, that is, tax is charged according to the destination of goods and services, as opposed to the 'origin' principle, that is, the supply of goods and services is taxed according to the source of that supply. GST is imposed on what New Zealand consumes, rather than what it produces.

14.23 The European Union has adopted a reverse charge mechanism, which requires domestic taxpayers to pay value-added tax on receipt of imported services in their jurisdiction. The reverse charge ensures that services, like goods, are taxed when they are consumed in the relevant jurisdiction. A reverse charge in New Zealand's GST would impose an obligation on a New Zealand recipient of an imported service to levy GST. In the development stages of the GST system, it was considered that the administration and compliance costs associated with a reverse charge were too high in comparison with the expected revenue that would result.

Place of supply rules
14.24 The Goods and Services Tax Act 1985 imposes tax on the supply of services in New Zealand. Relying on the notion of physical performance creates economic distortions for imported services. If the service is physically performed outside New Zealand, it is not subject to GST. Electronic commerce has aggravated these distortions by simplifying the means by which suppliers may locate themselves offshore. 14.25 If the rules did not rely on physical performance, it would be necessary to prescribe particular tax treatments for particular supplies. This method of determining the impost of GST is used in the European Union, where the basic place of supply for services is the place where the supplier is established. However, in the context of electronic commerce where the service suppliers are often non-resident, this method for determining the place of supply would accentuate the extent to which supply is treated as taking place outside New Zealand.

Imported goods and services
14.26 Another issue that concerns the committee is the treatment of the growing volume of goods that are purchased and supplied electronically from the internet.259 This problem is just a variant of the existing 'mail order' problem. That is, such imported goods are subject to GST, but administrative difficulties are associated with levying and collecting that tax. To reduce those costs, New Zealand Customs Service at present, does not collect duties and GST, unless they are amounts above $50.

14.27 It is important to note, however, that services traded over the internet are not physically cleared by New Zealand Customs Service as they are delivered straight to the consumer's personal computer. Because no adequate audit methodologies exist, even if a reverse charge did apply, the Inland Revenue Department could find it difficult to collect GST from individual consumers.

The post-implementation review of GST
14.28 As part of the post-implementation review of GST, an analysis is to be undertaken of the current treatment of internationally traded goods and services. That analysis will consider the existing policy framework against the changing market for these supplies. This review may also involve a reconsideration of the place of supply rules upon which the GST regime is based. The original policy decision not to implement a reverse charge on imported services will also be considered.

Implications for tax administration
14.29 The growth in usage of the internet creates challenges for tax administrations. The committee considers that, although many of these challenges are not new to tax authorities, the rate of technological progress to date suggests that these issues should be considered sooner rather than later. Some of the emerging issues resulting from the increase in electronic transactions are listed below.

Audit trails - The lack of any central control of the internet and the ease of cross-jurisdiction transactions will make tracing complex arrangements difficult.

Verification of identity and residence - Taxpayers can establish and operate from an internet address in any jurisdiction, even though they effectively reside elsewhere.

Documentation - The growth in internet commerce will make obtaining information necessary for enforcement difficult, particularly when transactions involve jurisdictions with which no tax treaty exists and, therefore, no exchange of information between the tax authorities is possible.

Removal of convenient taxing points - With fewer intermediaries in the distribution of goods and services, and producers selling directly to consumers, some consumption taxes may become less viable sources of revenue.

Accessibility of offshore banking - The increasing ease of shifting funds offshore to tax havens, together with secrecy laws in tax havens providing anonymity, and low transaction costs, will make countering international tax evasion difficult.

14.30 Electronic commerce does, however, offer tax administrations an opportunity to make tax collection more efficient through lower administration and compliance costs. Electronic technology can provide more accurate tax data, and faster processing of returns at a lower cost to the tax authority and the public. Ways of achieving this include:

electronic filing - allowing taxpayers to file encrypted returns themselves or through a tax professional;

direct deposit programs - providing opportunities for prompt and time-saving means to pay and refund;

automated deductions of taxes - allowing employers required to withhold PAYE deductions to file them

directly with any other required deductions;

automatic matching of data; and

improved technology - facilitating and accelerating the exchange of information between tax authorities.

OECD initiatives
14.31 The growth in internet transactions has not so much created new problems for taxation, as caused a significant increase in the size of existing problems. The growth in the volume of sales of goods and services over the internet has prompted the OECD to re-examine how effectively current tax policy is at taking into account such commerce.

14.32 Many tax jurisdictions are looking for solutions that can be im-plemented unilaterally. History is full of examples where the ill-considered implementation of a tax by one jurisdiction has resulted in the departure of an industry from that jurisdiction. Indeed, it is this fear of capital flight that appears to have prevented some countries from implementing new technology based taxes.260

14.33 The OECD has become a key forum for countries to discuss and consider the tax implications of commerce through the internet. Four OECD committees are addressing the problems posed by the internet. Briefly:

Working Party 1 is looking at whether a vendor trading through the internet falls within the existing international framework concerning source and income allocation. The Working Party is also considering whether the principle of 'permanent establishent' should be revised.

Working Party 6 is looking at the impact that electronic commerce will have on the transfer pricing rules.

Working Party 8 is looking at developing audit-orientated solutions to electronic transactions and making recommendations on issues such as compliance, audit, encryption, and tax evasion and avoidance.

The Special Sessions on Consumption Taxes Committee is discussing a variety of VAT/GST issues, including the appropriateness of the existing place of supply rules and the appropriate treatment of commodities acquired directly from the internet, such as software and digitised music, literature and video.

The Inland Revenue Department is often represented on Working Party 1 and meetings held by the Special Sessions on Consumption Taxes.

14.34 The Commissioner of Inland Revenue recently attended, as part of a New Zealand delegation led by the Hon John Luxton, an OECD conference in Ottawa 'A Borderless World - Realising the Potential of Global Electronic Commerce'. Specifically, the Commissioner participated in a roundtable discussion on taxation and electronic commerce. The principle conclusions from the discussion were:

that the existing principles of neutrality, efficiency, certainty, simplicity, fairness and flexibility should apply to the taxation of electronic commerce;

that the framework for the taxation of electronic commerce should be guided by the existing principles that guide governments in relation to conventional commerce;

that electronic commerce offers tax administrations the potential to simplify tax systems and enhance service.

14.35 The committee recommends that the government should monitor and continue to participate in the efforts of the OECD in developing tax policy on electronic commerce, and should seriously consider any recommendations that are proposed. This recommendation recognises that any changes to tax policy as a result of the growth in electronic commerce will require international co-ordination.


  1. This approach has been endorsed at a recent OECD ministerial conference: A Borderless World - Realising the Potential of Global Electronic Commerce, Ottawa, October 1998.
  2. Use of computer based synthesis of remote sensor input to give the user the appropriate sound/sight cues, as if they were present.
  3. With a deduction, rather than a credit, for foreign taxes.
  4. For example, software, music, books, information services.
  5. Commonly referred to as 'bit' taxes.