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" #?? #!#!$"$x"% ?"%? #&?#&$'%'%(&)&*'+),B*\# Y2Ԋ   Y2#XN\  P[AXP#x  lFr #2P>P#Selected Tax Policy Implications  - of   Global Electronic Commerce x  Y[ 2#XN\  P[AXP#  ~D @P#\  PsP#  lF#2P>P#      1 KKKK Figure 1 y! &KKKK ddtreaseal.wpgreasealy$(#(#3CC!C$ y  !C y  !C y  !C y  !C y  !C y  !C y  CCN(#(#   [ 2m #i2PacP#Department of the Treasury Office of Tax Policy   [$2xNovember 1996#Xw P7[AXP#  Y%2  @-  -@  #XN\  P [AXP#xX%0*0*0*%3 C)"!ow& involve new paymenX  lF    r #2P >P#Selected Tax Policy Implications  - of   Global Electronic Commerce x  Y2#XN\  P [AXP#"'''"   This paper provides an introduction to certain federal income tax policy and administration issues presented by developments in communications technology and electronic commerce. This paper is a discussion document, designed to elicit views on the issues presented as well as suggestions as to solutions for new problems. This paper is neither intended, nor should be taken as an expression of the legal or policy views of the United States Government, including the Department of the Treasury and the Internal Revenue Service. In addition, no inference is intended as to current law. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code). This paper has also been posted on the Treasury Departments home page on the World Wide Web at http://www.ustreas.gov. Comments on any of the issues raised by this paper should be addressed to: Joseph H. Guttentag, International Tax Counsel, Department of the Treasury, 1500 Pennsylvania Avenue, NW., Washington, D.C. 20220. Comments may also be submitted to Treasury via Internet email to TAXPOLICY@treas.sprint.com, with the subject line technology issues. All comments will be available for public inspection and copying. "''&'&"  Y2     #XZ2P q/XP#TABLE OF CONTENTS  Y2#XN\  P [AXP#I Section I: Introduction à  Y2 #XN\  P[AXP#Executive Summaryp"(#z1     Yf2Xx1.Introduction(#p"(#z3 Section II: Technical Background x  Y 2Xx2.An Overview of the Global Information Infrastructure or Information Superhighway(#`"(#u.5 Y 23.The World Wide Web and Electronic Commercep"(#z7  Y 24.Security and Encryptionp`"(#p12  Y2Xx5.Payment Mechanisms(#p`"(#p14 G Section III: Tax Policy and Administration Issues x  Y$2Xx6.Tax Policy and Administration Issues: General ConsiderationsX  (#p`"(#p19 Y27.XSubstantive Tax Law Issues (#p`"(#p#XN\  P[AXP#21  Y28.XTax Administration and Compliance Issues(#p`"(#p36 Y29.XConclusion(#p`"(#p43 Glossaryp`"(#p44  S>2ԛ#XZ2Pq/XP#">0*(("  S2   EXECUTIVE SUMMARY ă  Y2#XN\  P[AXP##XN\  P[AXP#New information and communications technologies such as the Internet are creating exciting opportunities for workers, consumers, and businesses. Information, services, and  Y2money may now be instantaneously transferred anywhere in the world.#XN\  P[AXP# Firms are increasing their imports and exports of goods, services, and information as the costs associated with participating in global markets plummet, and they are forming closer relationships with suppliers and customers around the world. New markets and market mechanisms are emerging. Consumers can choose from a much broader range of goods and services, and intelligent agent software will soon give consumers an unprecedented ability to hunt for bargains.  Y 2#XN\  P[AXP#These new technologies, particularly communications technologies including the Internet, have effectively eliminated national borders on the information highway. As a result, crossborder transactions may run the risk that countries will claim inconsistent taxing jurisdictions, and that taxpayers will be subject to quixotic taxation. If these technologies are to achieve their maximum potential, rules that provide certainty and prevent double taxation are required. In order to ensure that these new technologies not be impeded, the development of substantive tax policy and administration in this area should be guided by the principle of neutrality. Neutrality rejects the imposition of new or additional taxes on electronic transactions and instead simply requires that the tax system treat similar income equally, regardless of whether it is earned through electronic means or through existing channels of commerce.  A major substantive issue raised by these new technologies is identifying the country or countries which have the jurisdiction to tax such income. It is necessary to clarify how  Y|2existing concepts apply to persons engaged in electronic commerce. #XN\  P[AXP#In addition, transactions in cyberspace will likely accelerate the current trend to deemphasize traditional concepts of  YN2sourcebased taxation, increasing the importance of residencebased taxation. #XN\  P[AXP# Another major category of issues involve the classification of income arising from transactions in digitized information, such as computer programs, books, music, or images. The distinction between royalty, sale of goods, and services income must be refined in light of the ease of transmitting and reproducing digitized information. In the area of tax administration and compliance, electronic commerce may create new variations on old issues as well as new categories of issues. The major compliance issue posed by electronic commerce is the extent to which electronic money is analogous to cash and thus creates the potential for anonymous and untraceable transactions. Another significant category of issues involves identifying parties to communications and transactions utilizing these new technologies and verifying records when transactions are conducted electronically. However, developments in the science of encryption and related technologies may lead to systems that verify the identity of persons online and ensure the veracity of electronic documents. "(0*0*0*&*"Ԍ Y2ԙ#XN\  P[AXP#Treasury invites comments on the issues raised by this paper as well as any other issues relating to electronic commerce.  Y2#XN\  P[AXP#  Y2#XN\  P[AXP#Comments should be addressed to Joseph H. Guttentag, International Tax Counsel, Department of the Treasury, 1500 Pennsylvania Avenue, NW., Washington, D.C. 20220. Comments may also be submitted via Internet email to TAXPOLICY@treas.sprint.com, with the subject line technology issues. All comments will be available for public inspection and copying.  YH2#XN\  P[AXP#  S 2#XZ2Pq/XP#" 0*((` "  S2X` hp x (#%'0*,.8135@8:q/XP#7.XSUBSTANTIVE TAX LAW ISSUES #XN\  P?[AXP# (#  1. 1. 1. 1.(1)(a) i) a) 1. 1. 1. 1.(1)(a) i) a)  X2 7.1. Introduction  Y2` ` 7.1.1. General . This section discusses the impact of electronic commerce on  Y2substantive principles of taxation.&# Y2ԍThis chapter is focused on certain broad themes arising under United States international tax rules. However, certain specific provisions of the Code and Regulations may relate quite directly to technological developments and the growing role of intangibles in the modern economy. For example, U.S. persons are increasingly engaging in joint ventures in which intangibles play a major role and U.S. companies frequently provide intangibles to  Y2international joint ventures. #XN\  PA[AXP#If the transferred property is an intangible, section 367(d) may apply to treat the U.S. transferor as having licensed the intangible property to a related foreign corporation in exchange for an arms length royalty. In addition, sections 863(d) and (e) provide source rules for income arising from space and certain ocean activities and international telecommunications. Regulations have not been issued under either subsection. Treasury invites comments with respect to the relationship between the evolving issues described in this paper and these Code provisions and related interpretative guidance.  Current tax concepts, such as the U.S. trade or business, permanent establishment, and source of income concepts, were developed in a different technological era. However, the principle of neutrality between physical and electronic commerce requires that existing principles of taxation be adapted to electronic commerce, taking into account the borderless world of cyberspace. An advantage of an approach based on existing principles, in addition to neutrality, is that such an approach is suitable for adaptation as an international standard. Existing principles are, in broad outline, common to most countries tax laws.  Y 2` ` 7.1.2. Bases for taxation . The United States taxes income on the basis of both the source of the income and the residence of the person earning that income. U.S.  Y2source income is subject to taxX0ÍX0Í:' Y2ԍSections 871, 881 and 882.: when earned by foreign persons as is the worldwide income  Y{2of U.S. citizens, residents, and corporations.2( Y2ԍSections 1 and 11.2 Although U.S. persons are subject to net basis taxation on their worldwide income, the foreign tax credit provisions avoid double taxation of  YM2foreign source income.9) Y2ԍSection 901 et seq.9 Our international tax treaty network, while attempting to minimize taxation at source, also protects against double taxation.  Y2` ` 7.1.3. Source of income . Source of income concepts play a central role in international taxation since the country of source generally has a right to tax income and residence countries generally avoid double taxation through either a credit system or an exemption system. Source of income principles are generally similar worldwide. In general, the source of income is located where the economic activities creating the income occur. For example, income derived from the use of intellectual property has its source in the location  Y2where the intellectual property is utilized.X0ÍX0Í2*# Y2ԍSection 861(a)(4).2 Compensation for labor or personal services has  Yh2its source in the location where the labor or personal services are performed.X0ÍX0Í6+ Y2ԍSee section 861(a)(3).6 Furthermore, residencebased source rules have been adopted for certain types of income such as capital gains and swap income because the country of residence represents the location where the  Y#2economic activity that produces the income occurs.X0ÍX0Í[,# Y2ԍSee section 865, and Rev. Rul. 875, 19871 C.B. 180.[ Generally, the nature of an item of income is important for determining source because the source of income flows from its  Y2nature.X0ÍX0Í9- Y2ԍSections 861 through 865.9  Y 2#XN\  PB[AXP#` ` 7.1.4. Role of tax treaties . The United States currently has comprehensive  Y!2income tax treaties with 48 countries. The rules embodied in these tax treaties generally give the residence country an unlimited right to tax income while limiting or eliminating the source countrys right to tax. One of the most important concepts in tax treaties is that of a permanent establishment. Source countries tend to give up their sourcebased taxing rights over business profits if they are not attributable to a permanent establishment or fixed base in their jurisdiction. Treaties generally limit the rate of taxation at source that can be  Y('2applied to interest, dividends, and royalties paid to a resident of a treaty partner.#XN\  PC[AXP#"('0*((("Ԍ Y2ԙ` ` 7.1.5. The ascendancy of residencebased taxation . The United States, as do most countries, asserts jurisdiction to tax based on principles of both source and residence. If double taxation is to be avoided, however, one principle must yield to the other. Therefore, through tax treaties, countries tend to restrict their sourcebased taxing rights with respect to foreign taxpayers in order to exercise more fully their residencebased taxing rights. This occurs in a number of ways. The permanent establishment concept represents a preference for residencebased taxation by setting an appropriate threshold for sourcebased taxation of active business income. By setting a threshold, in most cases it is not necessary to identify the source of active business income and the income is only subject to tax in the country of residence. In the case of interest, dividends, and royalties, the income is still potentially subject to sourcebased taxation but in many cases is effectively subject to only  Y 2residencebased taxation because of a nil rate of withholding.#XN\  PD[AXP# The country of residence also agrees to take appropriate steps to ameliorate any possible double taxation resulting from the  Y 2limited sourcebased taxation. #XN\  PE[AXP# The growth of new communications technologies and electronic commerce will likely require that principles of residencebased taxation assume even greater importance. In the world of cyberspace, it is often difficult, if not impossible, to apply traditional source concepts to link an item of income with a specific geographical location. Therefore, source based taxation could lose its rationale and be rendered obsolete by electronic commerce. By contrast, almost all taxpayers are resident somewhere. An individual is almost always a citizen or resident of a given country and, at least under U.S. law, all corporations must be established under the laws of a given jurisdiction. However, a review of current residency definitions and taxation rules may be appropriate. In situations where traditional source concepts have already been rendered too difficult to apply effectively, the residence of the taxpayer has been the most likely means to identify the jurisdiction where the economic activities that created the income took place, and  Y}2thus the jurisdiction that should have the primary right to tax such income. For example, #XN\  PF[AXP#in the Tax Reform Act of 1986, Congress adopted residencebased sourcing rules for sales of noninventory property. This reflected Congress belief that source rules for sales of personal property should generally reflect the location of the economic activity generating the  Y!2income, taking into account the jurisdiction in which those activities are performed.X0ÍX0Í.# Y2ԍStaff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of  Y21986, 100th Cong. 1st Sess, (May 7, 1987) at 917. [hereinafter 1986 Bluebook.] In the case of certain sales of personal property, the residence of the seller was thought to best  Y2represent the location where the underlying economic activity occurred.*/# Y2ԍId. * Similar rules were  Y2adopted for certain space and ocean activities.v0# Y2ԍCode section 863(e); See also, 1986 Bluebook, supra note 46, at 932.v Therefore, United States tax policy has already recognized that as traditional source principles lose their significance, residencebased taxation can step in and take their place. This trend will be accelerated by developments in electronic commerce where principles of residencebased taxation will also  Y#2play a major role. #XN\  PG[AXP# "i$0*((%"Ԍ Y27.2. U.S. Trade or Business and Permanent Establishment  Y2` ` 7.2.1. Taxation of nonresident aliens and foreign corporations . Nonresident aliens and foreign corporations are generally only subject to tax on their U.S. source income, including income derived from the performance of personal services in the United States, and certain foreign source income that is attributable to a U.S. trade or business. Unless a treaty applies, nonresident aliens and foreign corporations are taxed at ordinary graduated rates on their net income effectively connected with a trade or business in the  YJ2United States,X0ÍX0Í:1 Y2ԍ` hp x (#%'0*,.8135@8: Y2ԍOECD Model Tax Convention, supra note 55, Commentary to Article 5, at paragraph   23.  ٘ A distinction is generally recognized between activities that contribute to the productivity of  Yw2the enterprise and activities that involve the actual realization of profits.X0ÍX0Í*?# Y2ԍId. * In the case of a foreign telecommunications service provider, the operation of a computer server in the United States or the sale of computing services and Internet access to U.S. and foreign customers is clearly integral to the realization of its profits, in contrast to the case of a foreign person who is primarily engaged in selling data which is stored on a U.S.based server.  Y 27.3. Digitized Information: Classification of Income  Y 2  Y 2` ` 7.3.1. Transactions in digitized information . Any type of information that can be digitized, such as computer programs, books, music, or images, can be transferred electronically. For example, a U.S. person could, via the Internet, communicate with a computer located in a foreign country and download a computer program or digitized image or video in exchange for a fee. The purchasers rights in the information transferred could vary depending on the contract between the parties. The purchaser of a digitized image could obtain the right to use a single copy of the image, the right to reproduce ten copies of the image for use in a corporate report, the right to reproduce the image for use in an academic work that is expected to have a limited press  Y2run, or the right to reproduce the image in a masscirculation magazine.k@# Y2ԍSee section 3.2.5.supra.#XN\  PQ[AXP#k Depending on the facts and circumstances, some of these transactions may be viewed as the equivalent of the purchase of a physical copy or copies of the photograph, which would probably not subject the seller to U.S. taxation, while other of these transactions would result in royalty income because they involve payments for the use of or the privilege of using copyrights or similar  YQ2property in the United States, which could be taxable in the United States.A# Y2ԍSee, section 861(a)(4) and sections 871(a)(1) and 881(a)(1); Compare, U.S. Model Tax  Y2Convention, supra note 54, Article 12. Technological developments have necessitated a reexamination of existing income classification principles in light of the ease of perfectly reproducing and disseminating digitized information. Classifying transactions involving digitized information may require a more complex analysis that disregards the form of the transaction " without regard to whether tangible property is involved " in favor an analysis of the rights transferred. This is necessary to ensure neutrality between the taxation of transactions in digitized information and transactions in traditional forms of information, such as hard copy books and movies, so that decisions regarding the form in which information is distributed are not affected by tax considerations.  Y=&2` ` 7.3.2. Classification of income issues . Information that can be digitized is generally protected by copyright law. Payments made for the use of or for the privilege of"''0*((("  Y2using copyrights are considered royalties.X0ÍX0ÍKB Y2ԍSection 861(a)(4); Treas. Reg. 1.8615.K Similarly the U.S. Model Tax Convention defines royalties as payments of any kind received as consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph  Y2films....X0ÍX0ÍiC# Y2ԍU.S. Model Tax Convention,  supra note 54, Article 12, paragraph 2.i It is not always clear how this definition applies to the sale of digitized information. Yet, it is clear that some of these transactions, such as the electronic purchase of computer programs, are merely substitutes for conventional transactions involving physical objects. Digitized information also presents unique issues because it can be perfectly reproduced, often by the purchaser. Although someone desiring to purchase ten copies of a bound book will generally purchase ten copies from a publisher, someone wishing to purchase ten copies of an electronic book may simply purchase one copy and acquire the right to make nine additional copies. This transaction might literally be considered to create royalty income, at least in part, since the right to make reproductions is a right reserved to the copyright holder and by allowing a third party to make reproductions, the payment is, at least in part, in consideration for the use of the copyright. However, this transaction may also be viewed as merely a substitute for the purchase of ten copies from the publisher in which the purchaser has undertaken to make the copies, a process which would not be feasible were the information not digitized. Therefore, it is necessary to apply the definition of royalties in a manner that takes into account the unique characteristics of digitized information.  Y27.3.3. Proposed regulations on computer program transactions . The proposed regulations on the classification of income from transactions involving computer programs  Y2represent an initial attempt to resolve this issue.:D# Y2ԍ` hp x (#%'0*,.8135@8:These developments also raise issues under the criminal provisions of the Internal Revenue Code, sections 72017344, and under the Bank Secrecy Act, 12 U.S.C. 1829b, 19511959, and 31 U.S.C. 53115330. However, these issues are outside the scope of this study.  In many cases, the products and techniques that will be required cannot be developed or implemented by Treasury or the IRS on a unilateral basis. Private sector and international cooperation is likely to be necessary to develop and implement appropriate software and hardware technologies. Electronic commerce is still developing and no electronic money system has yet achieved widespread usage. Nevertheless, it is important to consider these issues now since some issues may require that the needs of tax administration be addressed while electronic commerce systems are still under development. Others issues may not require immediate action and decisions can be delayed while Treasury and the IRS obtain more experience with these systems.   Yc2`  8.2. Categories of issues. These technological developments create issues under many different sections of the Code. Instead of dealing with these issues with respect to particular Code sections, they will instead be approached on the basis of their technological features. This is both a more useful means of categorizing these issues and is also more likely to identify potential solutions since solutions must be tailored to the technology. These broad categories of issues, which are discussed in detail below, are: ` ` (i) electronic money; ` ` (ii) identity verification; XX` ` (iii) record keeping and transaction verification for electronic transactions; and (#` XX` ` (iv) disintermediation and information reporting. (#`  Y"2   Y 2 8.3. Electronic money. As discussed in chapter 5, developments in electronic payment systems have the potential to create electronic money. Electronic money is a broad term, and just as electronic money systems differ in their technical features, they also differ in the extent to which they create issues for tax administrators. Depending on the type of system used, electronic money can be either an advantage or a disadvantage for tax administrators. As discussed below, electronic money poses a tax evasion potential similar to that created by paper money. This raises the issue of whether the evasion potential is manageable and what must be done to manage it. As discussed below, it is possible that the techniques that have been developed over time to combat evasion using paper money can be adapted and"&'#0*((d(" expanded to combat evasion through electronic money. In particular, it may be necessary to consider the role that issuers of electronic money can play in this effort, since they represent the interface between the physical economy and the electronic economy. In general, however, the extent to which electronic cash will be a problem will likely depend on the extent to which it results in an extensive payment system outside of normal banking channels. Treasury intends to study, and requests comments on these issues, including the extent to which (i) current techniques can be adapted to combat tax evasion using electronic cash, (ii) new audit techniques will be necessary, and (iii) information reporting and similar  YH2requirements can and should be imposed on issuers of electronic money.YIt may also be necessary to consider how section 6103, which provides rules governing confidentiality and disclosure of returns and return information, should apply in this context.  #XN\  Pn[AXP#  Y 2` ` 8.3.1. Accounted systems . Chapter five distinguished electronic money systems in part based on whether they are accounted or unaccounted systems. In accounted systems, the electronic money issuer maintains a central record of the flow of its electronic money through the economy. In unaccounted systems no such central record exists. Accounted systems are unlikely to present substantial tax administration concerns because the central record of transactions, if it is available for examination on audit, will permit tax administrators to match payments and receipts to specific taxpayers. In fact, the growth of accounted systems will be an advantage for both taxpayers and tax administrators since the central records maintained by an accounted system could be used by taxpayers and auditors to verify payments. Some taxpayers may therefore choose to use accounted systems when a record of the transaction is necessary for tax or other purposes. Treasury intends to study, and requests comments on, how the records maintained by accounted systems can be integrated into the system of tax administration and the standards that should be applied to determine whether the records maintained by an accounted system are acceptable for tax purposes.  Y2` ` 8.3.2. Unaccounted systems . In contrast to accounted systems, problems may arise with unaccounted systems, which maintain no such central record and are therefore analogous to cash. The extent of this problem will be measured by the extent to which unaccounted systems are used instead of accounted systems. It may be that unaccounted systems will be used primarily for certain types of small transactions, just as cash is used primarily for certain types of transactions. In many cases consumers will prefer existing payment mechanisms, such as credit cards, for the payment terms and the consumer protection that they provide. In other situations, consumers will use electronic money but will use accounted systems in order to have a central record in case a dispute arises with the merchant. While unaccounted electronic systems are unlikely to completely displace other payment systems, the tax evasion potential they create could be substantial. Transactions using unaccounted electronic money create the opportunity for both not reporting or underreporting the resulting income because detection of these transactions is difficult. For example, a taxpayer might sell physical goods in exchange for unaccounted electronic money, which might be transferred via a cardbased system. This problem currently exists for paper currencybased businesses. However, it has been historically"%'$0*((d(" possible to examine a business flow of inventory and similar physical indicia of the magnitude of the taxpayers business. This may not be possible for a taxpayer who sells electronic goods or services; there is unlikely to be any physical indicia of the amount of the  Y2taxpayers receipts.MZFor example, if a taxpayer sells computer software imprinted on floppy disks, the taxpayers purchases of blank disks could be used to approximate his gross sales. If the taxpayer sells the same software electronically, a copy is simply transmitted to the purchaser at the moment of sale and no such guidepost exists. M  Y2` ` 8.3.3. Bank secrecy . Finally, electronic money creates increased opportunities to deposit unreported income in a bank or other financial institution. As a result of electronic moneys advantage in transmitting large amounts of money with relative ease, combined with the continued use of cash, the problem of an underground, unaccounted for economy is likely to be exacerbated. #XN\  Po[AXP#Electronic money and the Internet substantially increase the ease and safety with which bank accounts can be opened abroad, letterbox companies and trust accounts can be established abroad, and funds transferred anonymously. Unlike paper currency, electronic money can be securely and instantaneously transmitted anywhere in the world. It is now possible to open a bank account over the Internet#XN\  Pp[AXP# in a bank secrecy jurisdiction, without  Y2actually traveling to the banks location.[ Y2ԍA Web site exists which allows the user to open an account with a bank in Antigua. The bank offers multicurrency current and time deposit accounts, numbered accounts, international wire transfers, portfolio management, and tax protection. Bank secrecy is assured. Such accounts are, of course, subject to the reporting requirements for foreign  Y2financial accounts. See 31 C.F.R. 103.24.  Electronic money could be instantaneously and anonymously transferred to such an account, thereby eliminating the risks and reporting requirements involved in transferring cash. Alternatively, a smart card encoded with a large amount of unaccounted electronic money could be slipped into a pocket and taken anywhere in the world without the bulk and weight of cash. #XN\  Pq[AXP#However, in the case of a bank or financial institution located in the United States or a country with which the United States has a tax treaty or Tax Information Exchange Agreement, it may be possible in most cases to gain access to the taxpayers bank records or records of the funds transmittal.  S2#XZ2Prq/XP#  Y2#XN\  Ps[AXP#8.4. Identity verification. A New Yorker cartoon once featured two dogs sitting in front of a computer with a caption that read [O]n the Internet, nobody knows youre a dog. Tax administrators face a similar issue. On the Internet it is possible to use a false identity and it is not currently possible to independently verify a partys identity. This raises a number of issues because the identity of a counterparty is important for numerous tax provisions. For example, if securities are purchased electronically, the issuer is still subject to information reporting and record keeping requirements. If the purchasers are nonresident aliens or foreign corporations, payments of interest and dividends are subject to withholding and reporting. This withholding may be reduced or eliminated by a tax treaty if the beneficial owner is entitled to treaty benefits. Claiming an expense deduction requires proof of the payee and the transaction. Under Subpart F, the identity of the purchaser of goods is relevant in determining whether the sale creates foreign base company sales income. For example, a U.S. seller of electronic goods could route sales through a Web site maintained by a base company and claim that the purchases were for use within the base companys country of  Y#2incorporation.R\ Y2ԍSee section 954 and Treas. Reg. 1.9543.R Therefore, it will be necessary to develop techniques to verify that the purchases were indeed for use within that country. Finally, if tax returns and other documents are to be electronically filed, an acceptable form of digital signature will be required. "&'%0*((("ԌVerification of identity is also a problem for consumers, who want to be assured that  Y2the persons with whom they do business are who they claim to be.}] Y2ԍ`  4 <DL!See e.g., Digital Signatures Expected to be Necessary for Online Shopping,  Interactive Marketing News, Sept. 13, 1996.} As a result, companies engaged in electronic commerce are developing digital certificates or digital IDs that can  Y2be used to verify a persons identity over the Internet.^ Y2ԍSee e.g., http://www.verisign.com. The Postal Service is also testing an Electronic  Y2Postmarking Service. 61 Fed. Reg. 42,219 (1996); See also, http://www.usps.org. The Federal Government has adopted a Digital Signature Standard (DSS), 59 Fed. Reg. 26,208 (1994), and a Secure Hash Standard (SHS), 58 Fed. Reg. 27,712 (1993).  Digital certificates are issued by a trusted intermediary who verifies the identity of a person and performs appropriate  Y2background checks, depending on the level of assurance to be granted._ Y2ԍ`  4 <DL!For example, one digital signature provider offers three levels of certification. The simplest level verifies that a an email message was sent from an indicated address. The next level verifies the digital ID holder through online identity verification against a consumer database. The highest level requires that the holder personally appear before a notary public to have a digital ID application notarized. Once a persons identity has been verified, he is issued a digital ID, which is the online equivalent of a drivers license or passport which can be transmitted to a potential customer. The certificate is created using public key encryption techniques, which makes it independently verifiable by  Y12the recipient and immune from tampering.=` Y2ԍ`  4 <DL!The theory of digital signatures is discussed in Chapter 4, supra. = If they operate as designed, these digital IDs are likely to represent an important means by which taxpayers and tax administrators can prove the identity of electronic counter parties. For example, if it were necessary for tax purposes to prove the identity of an electronic counter party or comply with an information reporting requirement, a taxpayer could be required to obtain a digital ID from the counterparty and maintain a record of that ID which could be examined on audit. However, because some issuers of digital IDs may not perform sufficiently thorough identity checks prior to issuing a digital ID, the IRS may be required to develop standards for issuers of digital IDs and certify issuers. In order to do so, the IRS may be required to issue its own digital IDs to issuers of digital IDs so that they can electronically prove that they have received IRS certification. Treasury requests comments on the extent to which digital IDs can be utilized for tax purposes, including the extent to which they can serve as signatures on electronically filed documents, the extent to which their use should be required for certain purposes, and the role that the IRS should play in certifying issuers of digital IDs.  Y28.5. Record keeping and transaction verification. Taxpayers are required to keep accurate books and records, which are subject to examination by the IRS in order to verify  Y}2the income and expenses reported on the taxpayers return.a Y2ԍSection 6001; See also, Notice 9610, 96 7 I.R.B. 47 (electronic imaging of taxpayer records). Although many taxpayers rely on computerized record keeping systems to a large extent, many transactions still originate as paper records which can be used to verify the accuracy of the electronic records. However, for taxpayers engaged in the sale of electronic goods or services, no paper records are likely to be created because customer orders are placed and fulfilled electronically and therefore the only record that exists of these transactions could be an electronic one. As all users of computers know, this creates the possibility for tax evasion and fraud because computerized  Y2records can be altered without a trace.(b Y2ԍPublic key encryption (as well as other encryption methods) also permits a taxpayer to encrypt his financial records to prevent their examination on audit. It would seem that this should be treated no differently from failing to keep or destroying paper records. ( Even taxpayers engaged in the sale of physical, as opposed to electronic, goods may soon receive orders and issue invoices electronically. Electronic documents must be verifiable in order to minimize the potential for tax evasion. This is also an issue for nontax businesses reasons. For example, a recipient of an electronic order needs to verify both that the order was sent by the proper person, and also needs to verify that the order was not altered in transit. Public key encryption techniques, which are used to create digital identity certificates, can also be used to verify that electronic documents and records have not been tampered with. For example, digital notarization"$'&0*(((" systems have been developed which are intended to make it possible to verify that electronic documents and records have not been altered. One such system purports to provide the digital equivalent of a notary stamp which can be used to certify and seal digital records in content and time so that it can later be proved that the electronic record was created when  Y2claimed and was not altered after the fact.#XN\  Pt[AXP#ec`  4 <DL!For example, one such system is based on a mathematical method called oneway hashing which creates a nearly unique hash value for each document, based on the arrangement of the characters and graphics elements within it. The hash value is generated using a hash algorithm which makes it easy to input the text of a document and generate a unique number, but it is virtually impossible to use the resulting hash value to recreate the  Y2original document. (In one system, there are 2228 possible hash values, while in contrast the  Yv2Universe is estimated to contain 2280 molecules.) Therefore, it is virtually impossible to create a second document that would yield the same hash value. The hash value is transmitted electronically to a local server, which digitally timestamps it and stores it. Any documents hash value can be recalculated and compared with the original one. Since even the smallest change creates a different hash value, it can be determined whether a documents contents or  Y 2timestamp have been changed. See, http://www.surety.com.e#XN\  Pu[AXP# Treasury requests comments on the extent to which such technologies can, in fact, be used to verify the authenticity of electronic transactions and on the role that Treasury should play in the development of these systems.   Y 28.6. Disintermediation and information reporting. Tax reporting and compliance relies in part on the use of centralized institutions and intermediaries that can be used to comply with information reporting and withholding requirements. For example, withholding on payments to foreign persons relies on the use of withholding agents who will generally be sophisticated persons who understand their obligations and can be identified, and the ability of the IRS to audit them. As discussed above, it is now possible for individual and relatively unsophisticated taxpayers to engage in crossborder investment and licensing transactions that previously would have taken place through traditional intermediaries, if at all. Disintermediation refers to the elimination of these traditional intermediaries. For example, a payment made for the right to download and reproduce a digitized image may be  Y52a royalty, depending on the transferees rights.Ed Y2ԍSee section 3.2.4, supra.E The parties to these transactions may be unfamiliar with their withholding obligations and current technology does not yet provide a means for computing and paying such taxes electronically. Such a system is, presumably, technically feasible but may not be accepted by electronic merchants and consumers. The small amounts involved will also complicate tax administration. In addition, the parties may be unfamiliar with their information reporting requirements. Information reporting plays an important role in tax administration and it may also be necessary to integrate these transactions into our system of information reporting. Treasury requests comments on how the tax system can be adapted to deal with such disintermediated microtransactions, and the role of information reporting in such transactions."8'0*((8"  X2 9.#X*0 xv7 iX#X# XZ2Pwq/XP#CONCLUSION #X*0 xx7 iX#(#  Y2# XN\  Py[AXP#As the communications revolution continues to sweep through the world economy, tax principles and systems of tax administration will have to adapt. This paper represents an attempt to further that process. It is not intended to resolve the tax policy and administration issues posed by the communications revolution but is intended to identify and assess some of these issues. Certain issues may initially appear to be so complex that they cannot be dealt with by existing principles. Further study is likely to result in the conclusion that one or more existing principles are more flexible than they may seem and they remain relevant notwithstanding technological developments. However, some of these technological developments, such as the potential growth of extensive anonymous transactions involving electronic cash, do raise certain existing administration and compliance issues to new levels of concern. `  ` hp x Treasury looks forward to receiving comments from, and working with taxpayers and their advisors, including both tax law specialists and computer technology specialists, academics, and foreign tax policy makers and administrators, to better understand these technologies and develop rational and enforceable tax rules. This can play an important role in fostering the growth of these technologies and transactions. Clear and rational principles will ensure that the tax law will not be an impediment to the growth of these exciting technologies that have such a great potential to improve our lives. #XN\  Pz[AXP#Comments on any of the issues raised by this paper should be addressed to: Joseph H. Guttentag, International Tax Counsel, Department of the Treasury, 1500 Pennsylvania  Y2Avenue, NW., Washington, D.C. 20220. Comments may also be submitted to Treasury via Internet email to TAXPOLICY@treas.sprint.com, with the subject line technology issues.  Y2All comments will be available for public inspection and copying "(0*((`" ` hp x 4 <DL!GLOSSARY x  Y2Bandwidth: (Also known as capacity) In simple terms, how much information or traffic can be carried on the Internet in a given amount of time. The simple rule is that the greater the bandwidth, the greater the opportunities for commerce. As a specific example: with low bandwidth, transferring the contents of a music CD via the Internet is not feasible; with higher bandwidth, it is entirely feasible.  Y22 Browser : A program used to access the World Wide Web.  Y 2 Bit : A contraction of the term binary digit; a unit of information represented by a zero or one. The speed of information transmission is measured in bits per second.  Y 2 CD-ROM : Compact Disc with Read Only Memory; compatible with computers, compact discs are inexpensive, high-capacity storage devices for data, text and video.  Y}2 Commercial Web Site : A computer site, attached to the Internet, which sells Internet merchandise.  XQ2   Y:2Convergence : The coming together of formerly distinct technologies, industries or  Y$2activities; the most common usage refers to the convergence of computing, communications and broadcasting technologies.  Y2 Cyberspace : The three-dimensional expanse of computer networks in which all audio and video electronic signals travel and users can, with the proper addresses and codes, explore and download information.  Y2 Digital : Information expressed in binary patterns of ones and zeros.  YW2 Digital Signature : Data appended to a part of a message that enables a recipient to verify the integrity and origin of a message.  Y2 Digitization : The conversion of an analog or continuous signal into a series of ones and zeros, i.e., into a digital format.  Y 2 Electronic Commerce : Consumer and business transactions conducted over a network, using computers and telecommunications.  Y#2 Encryption : The coding of data for privacy protection or security considerations when transmitted over telecommunications links, so that only the person to whom it is sent can read it. "G&)0*((`'"Ԍ Y2 Fiber Optic : A modern transmission technology using lasers to produce a beam of light that can be modulated to carry large amounts of information through fine glass or acrylic fibers.  Y2 Global Information Infrastructure or GII : The convergence of previously separate communications and computing systems into a single global network of networks.  Yx2 Hypermedia : Use of data, text, graphics, video and voice as elements in a hypertext system. All the forms of information are linked together, so that a user can easily move from one form to another.  Y 2 Hypertext : Text that contains embedded links to other documents or information.  Y 2 Information Superhighway : See Global Information Infrastructure.  Y 2 Intellectual Property : A collective term used to refer to new ideas, inventions, designs, writings, films and others; protected by copyright, patents, trade-marks, etc.  Y2 Internet : A vast international network of networks that enables computers of all kinds to share services and communicate directly.  Y;2 Internet Merchandise : Goods, services or other property (typically property in which  Y%2intellectual property rights subsist, such as music, software etc.) sold via commercial web  Y2sites. A distinction can be drawn between those cases where delivery is effected via the Internet itself (e.g. downloaded software) and where delivery is effected via conventional means. 4 <DL!4 <DL!  Y2 Internet Service Providers (ISPs) : Organizations which provide individuals and businesses  Y2with access to the Internet (including commercial web sites). ISPs may be wholesalers or retailers or both. A wholesaler normally resells bandwidth and certain other services to smaller ISPs who act as retailers. The most significant component of the sale price is the  Y]2amount of bandwidth purchased.  Y12 Modem : A contraction of mo(dulator) and dem(odulator), an accessory that allows computers and terminal equipment to communicate through telephone lines or cable; it converts analog data into the digital language of computers.  Y 2 Protocol : A standard procedure for regulating data transmission between computers.  Y"2 Server : Computers which store information for access by users of a network, including the Internet.  Ye%2 Virtual Reality : An interactive, simultaneous electronic representation of a real or imaginary world where, through sight, sound and even touch, the user is given the impression of becoming part of what is represented."8'*0*((P("Ԍ Y2ԙ World Wide Web, Web, or WWW : The graphical, hypertext portion of the Internet. The World Wide Web is described in chapter 3. 4 <DL!4 <DL! "+0*((" (v!bW 10.(  X2 4 <DL!4 <DL!~FOOTNOTES  Y2x #XN\  P~[AXP# d