Tax issues related to electronic business (e-business) have become increasingly important with the current growth in cross-border transactions conducted electronically over the Internet. Accepted ways of doing business are quickly changing and one would expect that tax rules applicable to Internet transactions would be well established by now. Yet, nothing could be further from the truth.

E-business covers a large area of commercial activities such as:

• e-commerce [usually described as use of the Internet to conduct business transactions, either B2B (business to business) or B2C (business to customer)].
• e-procurement (usually described as use of the Internet to increase purchasing efficiencies and to decrease the cost of purchases)
• use of the Internet to support "bricks and mortar" businesses (e.g. web based advertising, web based customer services such as FAQ and targeted e-mails, etc.)
• provision of Internet specific services [web hosting, online business facilitation, product aggregation (e.g. virtual malls), fulfillment services, etc.]

Given the large number of potential variations of e-business, the taxation of e-business is a complex and evolving field. In general, transfer pricing related to e-business taxation is driven by the same principles as transfer pricing for "bricks and mortar" businesses. The major difference between the traditional transfer pricing and the transfer pricing suitable for e-business transactions is a higher complexity of e-business transactions, higher use of intangible assets, and dematerialization of products.

Given the nature of e-business transactions, the basic questions for e-business transfer pricing are:

1. Where should the income be taxed? Since many e-business transactions take place in "cyberspace", it is often extremely difficult to decide which country has the right to tax the resulting income.
2. What is the precise nature of a transaction? E-business tends to: (i) bundle different transactions into one, (ii) bundle goods and services very closely, and, (iii) provide synergies from such bundling. As a consequence, it is often difficult to find reliable arm's-length comparables using the "bricks and mortar" businesses.
3. How should we characterize the income from an e-business transaction? The complexity of e-business transactions, the higher use of intangible assets and the dematerialization of products often make the characterization of income quite difficult. Since different kinds of income may be taxed differently (such as business income, royalties and service income) the income characterization is crucial.

There are no exact rules to answer these questions as each transaction must be analyzed based on its own unique set of facts and circumstances. The following discussion papers released by the Organization for Economic Co-operation and Development (OECD) may provide at least a partial guidance:

Canadian tax treaties are based on the OECD Model Tax Convention. Under article VII of this Convention, a resident of country A is taxed in country B only on income attributable to permanent establishment (PE) in country B. Article V then provides a definition of PE, which essentially says that PE is a "fixed place of business through which the business of an enterprise is wholly or partly carried on".

The relevance of PE cannot be overemphasized as the absence of PE would (in many countries) render a business carried in a host country by a non-resident to be non-taxable. The PE of a corporation in a province and of a foreign enterprise in Canada is defined in Regulation 400 of the Income Tax Act (Act) and in Interpretation Bulletin 177-R2. However, the treaty definition overrides the Act definition, thus it is always necessary to review each specific treaty for the applicable definition of the PE.

Once it has been established that a PE exists, the income earned must be attributed to this PE. In order to attribute the income to the PE, the tools of transfer pricing, particularly the functional analysis, must be used.

As discussed above, the bundling of products and the complexity of e-business transactions often result in an extremely difficult or impossible search for comparable transactions. Therefore, it is important to understand the business model and the e-business jargon before preparing a detailed functional analysis. While preparing the functional analysis, one should be aware of any potential unbundling issues that, in some cases, may help to find reasonable comparable arm's length transactions.

The functional analysis for e-business must take into account whether the company delivers the content over the Internet, uses the Internet only for some of its activities (advertising, delivery of information, actual trading, storage of intangible goods, delivery of these goods, invoicing, etc.), or whether the company fully integrates the Internet into its business model. In addition, website development costs, cost contribution agreements, sharing of intangibles and all the risks relating to an Internet based entity must be analyzed in detail.

Assuming that only part of the business is conducted over the Internet, such part can sometimes be split off and considered separately. An important issue here is the proper classification of the Internet based entity, which is applicable mainly in cases where the Internet is used to provide some, but not all, of the marketing and sales services. The facts and circumstances should determine whether the entity should be considered to be comparable to a service provider (e.g. an advertising agency, etc.), or whether it should be comparable to a marketer/distributor. The proper characterization of the entity coupled with an in-depth functional analysis may help us to find a reasonable comparable transaction.

Since an e-business transaction often collapses the value chain of the company and tightly integrates the company's operations, profit split and TNMM often represent the only possible transfer pricing methods, as no comparable transactions exist. Yet, given the hierarchy of methods in Canada, all the higher ranking transfer pricing methods must be considered prior to using the lower methods, such as profit split and TNMM.

The most important e-business income characterization issue is the difficulty to distinguish between a business profit and royalties that deal with the use of copyright. Article 12 of the OECD Model Tax Convention defines the term "royalties" as follows:

Since the electronic download of computer programs or other digital products might give rise to the use of copyright by the customer, the question of the nature of payment for such products is inevitable.

In addition, whereas the royalties may be subject to withholding taxes (regulated by the relevant tax treaties), the business income of non-residents is usually taxed based on the amount of income attributable to the PE. As a consequence, the differences in income characterization may result in large differences in taxes payable. In general, the OECD came to the conclusion that most of the downloads of the digital products should be characterized as business profits. However, there are some exceptions, such as for downloads that give the customer right to exploit or to display the copyrighted product, downloads of technical information and similar items. In addition, not all the countries agree to the OECD report on income characterization and some of them may decide to characterize the income differently.

There are no easy solutions to e-business tax "problems". However, as the taxation of e-business is still at its formative stage, such "problems" may be seen as opportunities rather than real problems. E-business allows the company to re-engineer its activities, risks, and employment of tangible and intangible assets, thus providing for the development of a worldwide tax minimization strategy.

Furthermore, to date, e-business has presented neither fundamentally new, nor categorically different problems that would require a new transfer pricing approach. The main difficulty in the context of e-business is to properly analyze the three issues discussed above. A more in-depth functional analysis is necessary and the use of transfer pricing methods such as profit split and TNMM sometimes represent the only option. Furthermore, if the certainty of tax treatment is required, the company may also consider a request for a multilateral advance pricing arrangement.