India’s move from physical to economic presence criterion: “Significant Economic Presence” Comprehensive Insights
This article discusses the newly introduced concept of “Significant Economic Presence’ in the Indian Taxation Laws, with a specific focus on clause wise analysis of the introduced provision and implementation aspects of the same.
The Finance Minister of India, vide the Finance Bill 2018, has thrown a surprise to the Indian taxation fraternity by aligning the scope of “business connection” with the rules as per the Multilateral Instrument (“MLI”)1 and also introducing the concept of “Significant Economic Presence” into the already existing deeming provisions of Business Connection in the Income tax Act 1961 (“the Act”). The Finance Minister has given cognizance to world recognized principle of giving primacy to the economic allegiance rather than physical location and attempted, through this amendment, to make it clear that physical presence was only important to the extent it represented the economic location.
The Organization for Economic Co-operation and Development (“OECD”), through its “Base Erosion and Profit Shifting (“BEPS”) Action Plan 1” has attempted to address the tax challenges in a digital economy wherein it has discussed several options to tackle the direct tax challenges arising in digital businesses. One such option is a new nexus based on the concept of “significant economic presence”2, where the OECD has noted that this option (the concept of significant economic presence) would create a taxable presence in a country when a non-resident enterprise has a significant economic presence in a country on the basis of factors that evidence a purposeful and sustained interaction with the economy of that country via technology and other automated tools. This has made the genesis of introduction of the concept of significant economic presence into the Indian Taxation Laws.
However, it is pertinent to note that, the options which have been discussed vide the “BEPS Action Plan 1” i.e. (i) a new nexus in the form of a significant economic presence, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalization levy; have not been recommended by the OECD at the stage of issuing the Final Report on Action 1.
Further, with the concept of Equalization levy, India has proved that it is the front runner in bringing thoughts of OECD BEPS project into implementation by an amendment in the Indian Taxation Laws. India being one of the largest markets in the digital economy consisting of varied demography, surely requires to comprehensively understand the scope, magnanimity and application of this amendment. Here, in this article, we shall discuss the provision proposed to be introduced by the Finance Bill 2018 and various nuances of interpreting/implementing the same.
2. Existing law and the proposed amendments:
2.1. Section 9(1)(i) of the Act – Business Connection
Section 9 of the Act deals with income deemed to accrue or arise in India and Section 9(1)(i) of the Act deals with income accruing or arising from any business connection in India and the same shall be deemed to accrue or arise in India.
In the existing provisions of the Act, the Explanation 2 to Section 9(1)(i) of the Act explains with an inclusive definition of what is a “business connection”. The same has been proposed to be amended to provide that “business connection” shall also include any business activities carried through a person who, acting on behalf of the non-resident, habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by the non-resident. Thereby widening the scope of the existing provisions of business connection and now includes into the ambit of “business connection” not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts.
2.2. Introduction of Explanation – A clarificatory amendment
Upon widening the scope of business connection through amendment in Explanation 2 to Section 9(1)(i) of the Act, the concept of “Significant Economic Presence” is now proposed to be introduced through insertion of a new Explanation 2A to Section 9(1)(i) of the Act.
The proposed new explanation has been provided below:
“Explanation 2A.––For the removal of doubts, it is hereby clarified that the significant economic presence of a non-resident in India shall constitute “business connection” in India and “significant economic presence” for this purpose, shall mean––
(a) transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or
(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means:
Provided that the transactions or activities shall constitute significant economic presence in India, whether or not the non-resident has a residence or place of business in India or renders services in India:
Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.”
Given the background, the aforesaid explanation has been analyzed in the ensuing paragraphs.
3. Incisive analysis and corresponding thoughts:
3.1. Clarificatory amendment
Given that the language of the proposed new Explanation 2A is “For the removal of doubts, it is hereby clarified that………… it appears that the new insertion is intended to be clarificatory in nature. A clarificatory amendment could be known as an amendment which makes the intention of the legislature, clear. The intention of the legislature many a time could generally be a retrospective amendment as the intention of the legislature (which the legislature has intended, though not expressed, when the legislature has come in force) is now being clarified through the amendment. Hence, a clarificatory amendment, would generally, though not necessarily, be a retrospective amendment. However, while the insertion of Explanation 2A is seemingly been made through a clarificatory amendment, the same will take effect from April 01, 2019 and should apply prospectively in relation to Assessment Year 2019-20 and subsequent years.
3.2. ‘Mean’ing definition of “Significant Economic Presence”
While the proposed insertion of Explanation 2A has used the term “mean” for the definition of “Significant Economic Presence”, the legislature intends to give a restricted definition of the term “Significant Economic Presence” instead of using an all-encompassing “inclusive” definition with illustrative list of inclusions, leaving scope for many other inclusions making the section more wider in terms of its applicability.
Hence, only scenarios which specifically get covered in Clauses (a) and (b) of the Explanation should trigger a significant economic presence and consequently a business connection in India.
3.3. Clause (a) of Explanation 2A to Section 9(1)(i) of the Act
The Clause (a) of Explanation 2A to Section 9(1)(i) of the Act, which is one of the two mutually exclusive conditions to test whether a non resident has a significant economic purpose in India, mandates the type of transaction in respect of any goods, services or property carried out by non resident in India and also contemplates to provide for a threshold of aggregate of payments arising from such transaction/s during the year.
3.3.1. Transaction as a whole and performance in India
Basis the clause, it is apparent that the transaction has to be considered as a whole in lieu of multiple sub steps of one large transaction for any transaction to fall within the purview of significant economic presence. In the current digital operating scenario, the major obstacle which Countries’ face is to understand the entirety of the transaction and also comprehend where the transaction is being operational i zed. The proposed amendment indicates that the transaction as a whole is to be considered and the transaction is to be carried out by a non resident in India. In such a scenario, owing to the inherent lack of understanding of complex digital transactions, this may open up significant litigation on issues of what could be a transaction and whether that transaction has been performed in India. Also, the clause does not specify that the transaction should happen through digital means, meaning thereby, brick and mortar transactions are also covered by the Explanation, which shall have a far reaching impact on India’s position on business connection.
Moreover, the transaction has to be carried out in India, thereby opening another pandora’s box for litigation. Also, the first proviso to the Explanation explains that the transactions shall constitute significant economic presence in India, whether or not the non resident has a residence or place of business in India or renders services in India. Reading in tandem, the interpretation may be though the service is not rendered in India, the transaction pertaining to the same may be fall under the purview of significant economic presence in India vide the Clause (a).
3.3.2. Provision of download of data or software
The proposed amendment has included a criteria of provision of download of data or software in India, which appears to be a having a vast impact given the understanding of data in computer parlance could be “information processed or stored by a computer which may be in the form of text documents, images, audio clips, software programs or other types of data”3, thereby leading to a situation that opening an image from a social networking site, playing a song from an internet music site or mere opening a web page may constitute download of data in India. This has far reaching impact on interpreting the Clause, virtually encompassing all the activities performed using the Internet.
The Revenue should clarify the intention of the terms “download of data” along with its technical considerations to avoid needless litigation on the issue of what constitutes download of data and there should be a nexus between the type of data/content downloaded with economic status of the Country thereby bringing the same to the ambit of taxation.
3.3.3. Aggregate of payments –Indicates emphasis on “Source”?
The amendment has proposed to prescribe a threshold amount for aggregate of payments arising from the transaction/s during the year and any transaction where the payment exceeds the prescribed threshold4 shall fall under the purview of significant economic presence. With the language, one may understand that the legislature seems to be keen on taxing the income at “Source” and hence the language used was “aggregate of payments” and not “aggregate of receipts received by the non resident”.
In such case, there may be a catch 22 situation for a non resident where in, a non resident may fall within the purview of significant economic presence in relation to one transaction with say Entity A, and may not be falling within the purview of significant economic presence in relation to another transaction with say Entity B, merely on the basis of amount of the transaction, completely ignoring the actual nature of transaction/nature of the content/nature of service etc. While the non resident shall be taxed as a business connection in India5 on the transaction with Entity A, the non resident shall not be taxed as a business connection on the transaction with Entity B. This is owing to the Second Proviso of the Explanation 2A, which mandates that only so much of income as is attributable to the transaction or activities referred to in Clause (a) or Clause (b) shall be deemed to accrue or arise in India.
Also, in a business mechanism where there is service rendered to many small category individual consumers, wherein while the individual payment for obtaining such online service may be less than the threshold limit, but the total of all the payments may exceed the threshold limit. Such non residents may not fall under the purview of the significant economic presence as per Clause (a).
This may create artificial business connections or rather business connection only in relation to a particular transaction which satisfies the threshold amount, completely leaving the actual nature of transaction to darkness. The above understanding is on the interpretation that the word “aggregate of…..” is used to understand the words “during the previous year……” and not the aggregate of payments made by all the entities in India to a non resident.
Alternate view should be that the terms “aggregate of…..” is used to understand the aggregate of payments made by all the payees, which are received/receivable by the non resident. However, if the legislature had this intention, then the legislature would have used the word “receipts/receivables by the non resident”in lieu of the word “payments”. Hence, this could also probably open a different field for litigation.
It shall be a great move if the Revenue attempts to clarify the aforesaid probable different interpretations and views to provide clarity on the intention of the legislation, rather than wait for the Assessee to take untested positions and further wait for the Courts to settle the judicial frustration created. Further, it should be noted that the OECD in the BEPS Action 1 Final Report has categorically mentioned that “revenues will not be sufficient in isolation to establish nexus but they could be considered a basic factor that, when combined with other factors, could potentially be used to establish nexus in the form of a significant economic presence in the country concerned”6
3.4. Clause (b) of Explanation 2A to Section 9(1)(i) of the Act
The Clause (b) of Explanation 2A to Section 9(1)(i) of the Act, which is one of the two mutually exclusive conditions to test whether a non resident has a significant business purpose in India, mandates that any systematic and continuous soliciting of business activities or engaging in interaction with users, in India through digital means brings the non resident within the purview of significant economic presence.
3.4.1. Systematic and continuous soliciting of business activities
The clause suggests that a non resident shall fall within the purview of significant economic presence if there is a systematic and continuous soliciting of business activities of the non resident in India, through digital means. It is pertinent to note that, the language used by the legislature is systematic and continuous soliciting of business activities, thereby implying that a one off transaction of soliciting of business activity may not fall under the purview of significant economic presence. Also, soliciting activity could be considered as a form of marketing and the online marketing platforms such as Adwords etc may be covered in this clause.
The language used in the clause being systematic and continuous would bring to an interpretation that the activity of marketing should be both systematic and continuous and both the conditions are twin conditions which have to be satisfied by the non resident in order to fall under the purview of this clause. Further, the condition that the activity should be performed in India should attain absolute clarity for a non resident to decide what is the scope of activity which shall be considered as performed in India?
3.4.2. Interaction with number of users
This is probably the most impactful clause for judging if a non resident has a significant economic presence. The clause sets a threshold7 of number of users with whom the non resident is engaging in interaction with. Any non resident engaging in interaction with more number of users than prescribed shall be considered to have significant economic presence. Hence, the billion dollar question is what shall be considered as “engaging in interaction with” and how should these terms be interpreted?
The oxford dictionary defines the term interaction as “reciprocal action or influence”. Hence, could it be considered that only if the number of users as may be prescribed have performed a reciprocal interaction with the non resident is when the clause shall be triggered? This clause may get the online business models into thinking as what is the scope of engaging in interaction as the same is not clearly defined. This is coupled with the first proviso of the Explanation which mandates that an activity shall constitute significant economic presence in India irrespective of whether the services are rendered in India.
Relevance of the amendment
The above analysis has been performed keeping the Double Taxation Avoidance Agreements’ (“DTAA”) silent for a moment. However, the memorandum of the Finance Bill clearly mentions that this amendment has been introduced to support negotiation for amendment in the DTAAs and the memorandum also mentions that unless corresponding modifications to Permanent Establishment (“PE”) rules are made in the DTAAs, the cross border business profits will continue to be taxed as per the existing treaty rules. This again signifies that though the Act has been amended with the concept of significant economic presence, the same shall actually start impacting the business class only when the corresponding PE clauses in the DTAAs are amended. Till then, the good old Section 90(2) of the Act shall provide benefit the Assessee.
The concept of significant economic presence has been introduced due to the need felt on the part of the Indian tax authorities and government to widen the scope of business connection. However, the provisions as proposed seem to be arbitrary and may give rise to significant litigation and tax disputes. The provisions seem to be disregarding many of the OECD options and appropriate safeguards discussed in the BEPS Action 1. There appears to be a haste in terms of proposals to introduce the provisions without appropriate ammunition to implement the same successfully. While the legislature have bought the concept of “Significant Economic Presence”, owing to the meteoric rise of digital transactions, the need of the day may be the concept of “Significant Digital Presence” than the concept of SEP.
1 Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting
2 The OECD/G20 BEPS Project, Action 1: 2015 Final Report, Page 107, Sl. 7.6.1, Para 277
3 As per www.techterms.com
4 The threshold is yet to be prescribed by the CBDT
5 Assuming for the time being that the Double Taxation Avoidance Agreements have no role to play
6 The OECD/G20 BEPS Project, Action 1: 2015 Final Report, Page 111, Sl. 22.214.171.124, Para 278
7 The threshold is yet to be prescribed by the CBDT
The author is a Chartered Accountant, Cost Accountant and a Law Graduate specializing in the field of International Taxation and Transfer Pricing. He is a Partner of Prasad and Prasad, Chartered Accountants. The views expressed by the author in this article are his own. The author may be contacted at firstname.lastname@example.org.
Article written by Srinivas Maddury, Partner, Prasad and Prasad Chartered Accountants with inputs from Krishna Chaitanya Bala, Executive, Prasad and Prasad Chartered Accountants.
(The author can be reached at email@example.com)