Nuisance impact of Significant Economic presence (SEP) definition on transactions with Non-residents
OECD published a report on the issue of ‘Base Erosion & Profit Shifting’, in which they set out 15 BEPS action plans to tackle the issue of base erosion and profit shifting.
Since then OECD and G20 have continued to work on BEPS action through inclusive framework.
Action 1 addresses the tax challenges of the digitalization of the economy, and specifically aims to identify and address the main challenges that the digitalization of the economy poses for the existing international tax rules.
One of such option is a new nexus rule based on “significant economic presence”. As per the Action Plan 1 Report, a non-resident enterprise would create a taxable presence in a country if it has a significance economic presence in that country on the basis of factors that have a purposeful and sustained interaction with the economy by the aid of technology and other automated tools.
It further recommended that revenue factor may be used in combination with the aforesaid factors to determine ‘significance economic presence’.
India being a part of the G-20 countries is committed to incorporated BEPS provisions in the domestic law and in line with recommendation of BEPS, India has introduced many provisions in domestic Income tax Act in last few years.
One of such incorporation of BEPS action plan is introduction of concept of Significant Economic presence (SEP)
Objective explained as per memorandum of finance bill 2018 for SEP
“OECD under its BEPS Action Plan 1 addressed 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 rule based on “significant economic presence”. As per the Action Plan 1 Report, a non-resident enterprise would create a taxable presence in a country if it has a significance economic presence in that country on the basis of factors that have a purposeful and sustained interaction with the economy by the aid of technology and other automated tools. It further recommended that revenue factor may be used in combination with the aforesaid factors to determine ‘significance economic presence’.”
In Income Tax Act, scope of existing provisions of clause (i) of sub-section (1) of section 9 is restrictive as it provides for physical presence based nexus rule for taxation of business income of the non-resident in India. Explanation 2 to the said section which defines ‘business connection’ is also narrow in its scope since it limits the taxability of certain activities or transactions of non-resident to those carried out through a dependent agent.
Therefore, emerging business models such as digitized businesses, which do not require physical presence of itself or any agent in India, is not covered within the scope of clause (i) of sub-section (1) of section 9 of the Act.
Accordingly, with a view to incorporate the recommendation of BEPS Action Plan-1 to tackle the taxation of digital business on the basis of nexus rule, Government of India vide Finance Act 2018 has amended the existing provision of clause (i) of sub section (1) of section 9 of the Income Tax Act by incorporating the concept of significant economic presence.
As per amended clause (i) of sub-section (1) of section 9 of the Act ‘significant economic presence’ in India shall also constitute ‘business connection’. Further, “significant economic presence” for this purpose, shall mean
(i) any 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 the amount as may be prescribed; or
(ii) Systematic and continuous soliciting of its business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means.
It is further proposed to provide that only so much of income as is attributable to such transactions or activities shall be deemed to accrue or arise in India. It is further proposed to provide 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
As per finance Act 2018, this amendment will take effect from 1st April, 2019 and will, accordingly, apply in relation to assessment year 2019-20 and subsequent assessment years.
Rules for the applicability for the implementation of SEP provision was not notified by CBDT therefore SEP provisions will remain ineffective in the FY 2018-19 and FY 2019-20.
Thereafter, Vide Finance Act, 2020, a new Explanation 2A was inserted under section 9(1)(i) of the Act with effect from assessment year 2022-23 and earlier Explanation 2A inserted by Finance Act, 2018, with effect from 01.04.2019 was omitted.
As per SEP of a non-resident in India shall constitute “business connection” in India and reads as under:
“Explanation 2A.—For the removal of doubts, it is hereby declared 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 with any person 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 in India, as may be prescribed:
It is important to note that in the revised definition of ‘Significant economic presence’ given in Explanation 2A, some changes was done in comparison to the earlier definition provided by Finance Act 2018.
In the clause (a) of Explanation 2A, word “with any person’ has been added and in clause (b), last word ‘through digital means’ provided in the earlier Explanation 2A was deleted.
These minor changes in the definition of SEP has a larger implication as it provide wider scope of applicability for SEP provisions. As per the definition it covers any person in India dealing with non-residents and covers conventional transactions also even though not carried out through digital means also.
For the purpose of determining SEP of non-resident in India, threshold for the aggregate amount of payments arising from the specified transactions and for the number of users to be prescribed through rules. Therefore Finance Act 2020 has deferred the implementation of new provision of SEP from assessment year 2022-23.
Thereafter in between of running financial year 2021-22, CBDT vide notification number- 41/2021 dated 3rd May 2021 notified the new Rule 11UD.
As per the Rule-11UD, threshold limit for the purpose of SEP defined in clause (a) of Explanation 2A of section 9(1)(i) for the aggregate of payment arising from specified transactions shall be two crores rupees and threshold for the number of users as per clause (b) of Explanation 2A of Section 9(1)(i), shall be 3 lakhs.
As specified above that the broad intention of BEPS Action Plan-1 and the Memorandum of Finance Bill 2018 & 2020 is too cover the transactions carried out by non- resident in India through digital commerce, marketing etc in taxation net on the basis of nexus of user base/transactions threshold.
Whereas the present definition of SEP is wider enough to covers into its ambit, all the transactions with non-resident beyond a prescribed threshold limits.
A brief summary of larger impact of SEP on transactions is summaries below:
1. Import transaction through conventional mode: As per definition conventional transactions of import of material including capital goods from non-resident will also cover in its ambit if its exceeds prescribed thresholds. Ex: If company X import goods worth 3 crores from ABC Company situated in USA then SEP of the ABC company will established in India irrespective of facts whether ABC company have any office/branch/factory/fixed place of business/place of manufacturing/agent situated in India.
2. Non-business entity: SEP provisions will apply to non-business entities also as it used the word ‘any person’ in India. Ex: Transactions of sale of property situated in India by individual with non-resident will also covers within the ambit of SEP.
3. Methodology for computation of Income: CBDT notified the threshold limit for SEP but it is silent on methodology to compute profit attribution of income of non-resident in India.
4. TDS compliance burden- Section 195 provides for deduction of TDS by a person paying to a nonresident any sum chargeable under the provisions of the Income Tax Act 1961. Hence on a plain reading, if any payment is pursuant to a business connection including SEP of the non-resident, every individual tax payer has to deduct tax in India.
This can result in huge compliance issues for Indian taxpayers as rate of TDS as per Income Tax Act in case of non-resident assessee on business income will be 40% plus applicable surcharge & cess.
Further in the absence of clarity on the issues of income attributable of non-resident in India or income determination of non-resident in India by assessing office, TDS implication will arise on the gross value of transaction.
The definition of Permanent Establishment are still same in the all the DTAA/MLI entered by India therefore for providing the benefit of definition of Permanent establishment provided in the DTAA as per section 90 of the Income Tax Act, Tax residency certificate alongwith NO PE in India declaration and Form-10F also required from each importer/service provider.
This is huge task for the business entities to collect aforesaid documents from non-residents’ vendors in case of conventional transactions of import of material/capital goods also.
Further, in the absence of aforesaid documents, TDS as per the Income tax Act, will apply and in any case, if any vendor does not provide the aforesaid documents then TDS cost will also create a burden on the importer.
Disallowance of expenditure as per section 40(a)(i) will also a concern for business entities.
5. TDS implications in case of transactions with NON resident situated in country with whom India do not have DTAA: The aforesaid provision of SEP does not have any impact on transactions with non-resident who will provide the required documents for availing the benefit of DTAA.
There are 195 countries in the world today and India have DTAA with around 88 countries only. However, still there are many countries with whom India does not have any DTAA but usual transactions of imports/exports of goods/services are happening with these countries. In this case, it will be not possible for non-resident to avail the benefit of PE definition provided in the DTAA and provision of SEP will automatically apply.
Ex: India does not have DTAA with Nigeria. ABC Ltd, import goods worth Rs. 5 crores from XYZ company situated in Nigeria. In this case, SEP of ABC Ltd. will establish in India as its exceeds threshold limit of Rs. 2 crores. Accordingly, as per section 195 of the Income Tax Act, ABC Ltd is liable for the deduction of TDS @ 40 plus applicable surcharge & cess. In this case there, in the absence of any DTAA with Nigeria there is no option from escaping the provision of SEP.
6. CBDT notified Rule 11UD in between of running Financial year 2021-22 therefore if any person who has already entered into an one-time transactions with non-resident in excess of threshold limit in between 1st April 2021 to 2nd May 2021 then compliance of TDS provision on said transaction as per section 195 is not possible.
Further, being a non-routine transaction collection of prescribed documents (TRC, Form-10F etc) for providing benefits of DTAA is also not feasible for said person therefore harsh implication of penal provision of TDS alongwith disallowance of expenditure under section 40(a)(iii) will apply on said importer.
7. Implication of section 163 of the Income Tax Act- As per section 163 of the Income tax act, in relation to non-resident any person in India may be regarded as agent of no resident in India from or through whom the non-resident is in receipt of any income directly or indirectly. Therefore, according to section 163 of the Income tax Act, Income tax department may treat an importer or service recipient in India as agent of non-resident.
8. Compliance of Return filing: Whether Nonresident whose SEP is established in India is also required to file its income tax return in India or not is also a question still open for clarification. Further, other compliance of tax audit etc will also applicable to said nonresident or not is also an open question.
In view of the aforesaid wider applicability of SEP provision on normal business transactions beyond the intent of government, business are facing difficulties in compilation of required documents, it also create huge compliance burdon on normal business operation and also add TDS cost on their part etc in dealing with Non DTAA countries. Therefore, a clarification from the CBDT is required on urgent basis, on its applicability as per intention of memorandum and BEPS action plan-1.