Taxation in Digital Economy: Income Tax provisions in India vis-à-vis Permanent Establishment

Taxation in Digital Economy: Income Tax provisions in India vis-à-vis Permanent Establishment

Introduction:

With the evolution of the digital economy, business models throughout the world have had to be revamped in light of recent changes. This poses significant challenges for traditional tax frameworks throughout the world, as tax is levied when there is a territorial nexus with the taxing country. This was initially done using the concept of a “permanent establishment” which helps in determining a country’s right to tax business profits. The traditional definition of permanent establishment requires some presence in the country, either in the form of a physical establishment, the rendering of services or having an agent capable of making decision within the territorial jurisdiction of the country.  However, when looking at the current business models dominating the market, we see instances of companies having significant revenue in other countries while their businesses are conducted entirely online. In such instances, the principles of permanent establishment will be inapplicable. The enigma of taxing rules for companies with a wholly online business presence can be aptly summarized through the following quote.

“Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.”[1]

In light of these changes, it is essential for the laws governing taxation to develop accordingly to ensure that the tax base of a country is preserved.

Taxation in the digital economy in India:

Considering that the traditional rule of territorial nexus to tax the profits of Multi National Enterprises(MNEs) based on physical presence is slowly becoming redundant, there were multiple concerns regarding the rightful collection of dues. In order to address these concerns, the Organization for Economic Co-operation and Development (OECD) and G-20 countries came up with 15 distinct action plans. Action 1 of the Base Erosions and Profit Shifting (BEPS) Action Plan pertains to tax challenges arising out of digitalisation. It recognized the problems of companies not being liable to tax despite having a significant presence online, merely because there was no territorial nexus, or physical presence. While the implementation of the 2 Pilar Solution continues to remain uncertain, several solutions offered by the OECD have been incorporated into Indian laws. These primarily include.

• Widening the cope of “Business Connection” under Section 9 of the Income Tax Act to include Significant Economic Presence (SEP)
• Withholding taxes to simplify the collection of tax dues with the nexus to India.
• Equalisation levy (EL): Initially, EL was implemented with the aim of taxing online advertisements and related services, but since its amendment via Finance Act, 2020, it has become all encompassing, and any online sale of good, provision of services or any combination thereof will be subject to EL. EL provisions are not applicable if the operator in question has a fixed place of business in India.

Significant Economic Presence:

The provisions relating to SEP in India were introduced by way of Finance Act, 2018, inserting Explanation 2A to Section 9(1)(i).With respect to SEP, the OECD stipulated for both, revenue based and user-based factors to be combined and jointly used, so that they could indicate a sustained interaction with the economy of the country concerned.[2]

As per Section 9(1)(i), income arising directly or indirectly from any business connection in India shall be Income deemed to accrue or arise in India. By inserting Explanation 2A, the scope of “Business Connection” was widened, and brought within its ambit, transactions in respect of any goods or services carried out by any non-resident with a person in India. As per the proviso to Explanation 2A, the activities will constitute SEP, regardless of whether or not the non-resident has residency, or a fixed place of business in India, or renders services in the country. As per rule 11UD, as amended[3], SEP will be established in the following instances.

• Amount of aggregate payments carried out by non-resident during previous year exceeds two crore rupees.
• The number of users with whom systematic payments and continuous business activities are carried out exceed 3 lakhs.

If any of these conditions are satisfied, the non-resident will be said to have an SEP, leading to a business connection in India. It is pertinent to note that the Memorandum to the Finance Bill clarified that the introduction of SEP would not override existing Permanent Establishment (PE) rules in DTAAs.

Equalisation Levy

EL was a direct tax imposed on digital transactions involving non-residents. The intent of introducing EL can be found in the Memorandum Explaining Finance Bill, 2016, an excerpt from which is given below.

“The typical direct tax issues relating to e-commerce are the difficulties of characterizing the nature of payment and establishing a nexus or link between a taxable transaction, activity and a taxing jurisdiction, the difficulty of locating the transaction, activity and identifying the taxpayer for income tax purposes. The digital business fundamentally challenges physical presence-based permanent establishment rules. If permanent establishment (PE) principles are to remain effective in the new economy, the fundamental PE components developed for the old economy i.e. place of business, location, and permanency must be reconciled with the new digital reality.”[4]

Equalization levy was introduced with the aim of taxing transactions where difficulties arose in establishing territorial nexus and was aimed at addressing the shortfalls of permanent establishment. However, with the amendment in Finance Act, 2020, the scope of equalization levy was increased drastically, and any part of the transaction conducted online would make the entire transaction chargeable to EL. While the legislative aim was to tax wholly digital e-commerce giants where the entire business was conducted online, today, it has become all encompassing, and even if a tiny part of the transaction is conducted online, the entire consideration paid can be subject to Equalization Levy.

The move has also gained global backlash, with the United States Trade Representatives taking action against India on the grounds that EL was unreasonable and discriminatory[5]. The report also concluded that EL was inconsistent with various principles of international taxation.

One question which does arise, is what is the tax treatment for transactions which can be covered under both, Equalisation Levy, and Section 9(1)(i). To answer this, we turn to Section 164(i) of the Finance Act, 2016, which defines “Specified services” as

“online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Central Government in this behalf;”[6]

Section 10(50) of the Income Tax Act provides exemption for income arising out of specified services on or after the date on which the provisions of Chapter VIII of the Finance Act, 2016 come into force, and chapter VIII deals primarily with EL. Therefore, in instances where specified services are chargeable under EL provisions, SEP provisions under Section 9 will not be triggered as the income is exempt.

Another possibility is that a specific transaction falls under Section 9(1)(i) due to the foreign entity having an SEP and is chargeable as Fee for Technical Services (FTS) under Section 9(1)(vii). Under the FTS provisions of the income tax Act, tax jurisdiction is determined based on the site where the services are actually rendered. This requirement of territorial nexus was upheld in the Ishikawajima case, where the SC held that.

“despite deeming fiction in S.9, for any income to be taxable in India, there must be sufficient territorial nexus between such income and the territory of India. To establish such territorial nexus services have to be rendered and utilised in India”. [7]

Let us understand with an example. Let us assume there is a purchase of software used for providing training services. In instances where there is transfer of technology, and the make available clause, if the same is stipulated by the DTAA is satisfied, the services rendered by the non-resident will fall under the ambit of FTS[8]. At the same time, if  the monetary threshold stipulated by Rule 11UD is satisfied, it will lead to the creation of a business connection in India, due to which, the provisions of Explanation 2A to Section 9(1)(i) will apply. Finally, if part of the transaction concludes online, the entire transaction will be taxable under EL. In such a situation, the same income could be chargeable to tax as FTS, EL or Section 9(1)(i).

In case of overlap between FTS and Section 9(1)(i), the provisions of Section 9(1)(i) will be inapplicable due to the principle of ‘generalia specialibus non derogant’. While Section 9(1)(vii)  is a special provision dealing with the taxability of royalty/FTS, Section 9(1)((i)  is a general provision, and the special provision would always prevail over a general provision.[9]

In conclusion, in the absence of a permanent establishment in the country, if the transactions are taxable under the provisions of equalisation levy, they will be subject to tax, and the said income will be exempt while calculating the taxable income. If EL provisions are inapplicable, the FTS definition as per the respective DTAA needs to be seen if the conditions for constituting FTS are satisfied. Only when the services rendered do not constitute FTS, will the SEP come into picture, and the income will be chargeable under Section 9(1)(i) of the Act.

Permanent Establishment:

It is pertinent to note that income will be chargeable under the aforementioned provisions (SEP, EL and FTS) only in instances where there is no Permanent Establishment(PE) in India. However, if the enterprise operates through a PE, the profits attributable to it would be subject to taxation in the country where PE exists. Under traditional taxation principles, a PE refers to a fixed place of business through which, the activities of an enterprise are wholly or partly carried out. The criteria for PE are laid out in Article 5 of the OECD Model Tax Convention, which has had a significant influence on international tax treaties and domestic laws.

If there is an existence of a permanent establishment, the business profits of the enterprise can be taxed under Article 7 of the respective DTAA which deals with “Business Profits”. However, these are charged to the extent that profits are directly or indirectly attributable to the said permanent establishment. Generally, PE can be classified into 6 categories. These include.

1. Place of Effective Management

2. Fixed place PE

3. Construction PE

4. Installation PE

5. Service PE

6. Agency PE

However, for the purpose of this paper, we will focus solely on Fixed Place PE, Service PE and Agency PE. As per the OECD Commentary, POEM is defined as the place where, in substance, the key managerial decisions essential for carrying out the business of the entity are made. Installation and Construction PE as per Article 5 extends to instances whereby building sites, or construction or installation projects can lead to the establishment of a PE, if the minimum time period is complete. However, since the controversy surrounding taxation of digital entities revolves around the lack of physical presence in the country, these are immaterial in the current context.

While the same could also apply to Fixed Place PE, a significant digital presence requires the existence of certain digital equipment within the country, and courts have held that this equipment could be used to establish a PE in the country. This will be addressed later in the paper.

The concept of “Business Connection” has been in place since the inception of the Income Tax Act, 1961. Permanent Establishment was introduced by the Finance Act, 2002. Since then, these two concepts have sometimes been used interchangeably by the tax authorities. The difference between the two concepts was discussed by the SC in the Ishikawajima case, the relevant excerpt from which has been provided below.

“It is, therefore, in our opinion, the concepts profits of business connection and permanent establishment should not be mixed up. Whereas business connection is relevant for the purpose of application of section 9; the concept of permanent establishment is relevant for assessing the income of a non-resident under the DTAA.”[10]

It is also pertinent to note that the provisions of PE in the Income Tax Act, are extremely wide when compared to definitions in the respective DTAA. Section 92F defines PE merely, as a fixed place of business through which the activities of an enterprise are wholly or partly carried out. This is very different from the DTAA definitions which have multiple stipulations and conditions. However, as per Section 90 of the Income Tax Act, a non-resident is eligible to be governed, either by the provisions of the Act, or the respective DTAA, whichever is more beneficial. Since the scope of PE in DTAAs is generally narrower, and more favourable to the non-resident entities, in most cases, they are more beneficial and therefore, applicable.

Fixed Place PE:

Professr Klaus Vogel in his commentary, has defined the expression “fixed place” as follows.

“The fixed place of business must be more than merely temporarily at the enterprise’s disposal. A fixed place of business owned by an enterprise but placed at the disposal of a third party for the latter’s own purpose (and hence not for the enterprises) would not be a permanent establishment of the enterprise…”[11]

The Hyderabad Bench of the ITAT has previously held that  despite the restrictive definition, the concept of a fixed place of business would not be very different from the general provisions provided under Article 5(1) of the Model Convention[12]. Various factors have to be taken into consideration. For an arrangement to constitute fixed place PE, the requirements are.

1. Situs test: Requirement for a fixed place of business

2. Business test: Requirement for business to be carried out from said place.

3. Locus test: Fixed place to be located within the territory of taxing state.

All these tests should be satisfied. There is also the additional requirement of the disposal test, i.e. the place should be at the  disposal of the foreign enterprise.

Agency Permanent Establishment: 

Even if the conditions for Article 5(1) are not satisfied, a dependent agent within the meaning of Article 5(5) may constitute a PE. An Agency PE arises when a foreign enterprise engages a person in another country to act on its behalf in a manner that habitually exercises the authority to conclude contracts.

The criteria for an agency PE typically include the existence of a dependent agent who is authorized to negotiate and finalize contracts on behalf of the entity. This agent must act within their authority on a regular basis. However, activities carried out by independent agents will not constitute agency PE. 2 tests which can be used to determine agency PE are.

1. Binding Test: Whether the actions of the agent legally bind the foreign enterprise.[13]

2. Dependency test: Whether the agent is dependent on the foreign enterprise, legally and economically.

Service Permanent Establishment

Under Article 5(2) or 5(3), Service PE is attracted if the employees of a non-resident company perform services, other than services of the nature of royalties or FTS for a specified period of time. As per the India-US DTAA, the stipulated time period is 90 days within the preceding 12 months.

A brief overview of the categories of PE would initially indicate that none of them are applicable to digital entities. However, the digital presence of an entity requires computer servers/equipment to host, and offices to provide support services. These may constitute a sufficient link is establishing a PE. To understand the same, we shall analyse a case.

In 2020, a significant ruling was made by the Authority for Advance Rulings (AAR)  against Mastercard Asia/Pacific Pte. Ltd[14], which has had far-reaching implications for global conglomerates operating in India, specifically those whose operations are conducted online. Various different types of PE were identified by the AAR when analysing the arrangement between the Indian entity and the Singapore head office.

Background of the Case:

Mastercard, a global payments technology company, processes international card payment transactions for cards issued in India and used abroad, and vice versa. Since 2005, Mastercard voluntarily declared PE in India. However, the entire group was restructured in 2015.

To facilitate transactions, Mastercard used a global network that included components like a Mastercard Interface Processor (MIP), and the Mastercard Network. The MIP was a laptop which permitted institutions to connect to the Mastercard Network.

The primary question that arose was whether Mastercard’s operations in India constitute a permanent establishment. Mastercard argued that it did not have a fixed place of business in India and that its operations do not meet the criteria of a PE as its business operations in India were merely auxiliary or preparatory. The questions of law with respect to permanent establishment were answered in the following manner.

• MIPs constitutes Fixed Place PE: The AAR concluded that Mastercard Interface Processors (MIP), despite being owned by Mastercard India, were effectively at the disposal of Mastercard Asia Pacific, given that all critical decisions regarding their operation were made externally. The contention that the functions performed by MIPs were auxiliary was rejected. The MIPs played a crucial role in processing transactions, such as PIN validation and fraud alerts, which went beyond mere preparatory or auxiliary functions.
• Mastercard Network constitutes Fixed Place PE: The Mastercard network consisted of MIPs, Mastercard’s application, transmission towers, optic cable and leased lines, inclusive of those owned by third parties. Significant activities related to clearance and settlement occurred within India. Therefore, the Mastercard Network would pass the test of “permanency” and “fixed place”.
• Bank of India constitutes a Fixed Place PE: Employees at the Bank of India, acting under instructions from Mastercard Asia Pacific were under their control. Therefore, the space occupied by these employees were at the disposal of the foreign entity and constituted fixed place PE.
• Service PE through Visiting Employees: Visiting employees who were involved in tasks like customer feedback and promotion were integral to the services provided by Asia Pacific to Indian customers, due to which, a Service PE was constituted.
• Dependent Agent PE: Mastercard India was found to have regularly secured orders on behalf of Mastercard Asia Pacific, making it a dependent agent PE. This was evident from the fact that post restructuring, all agreements entered into with Indian customers were routed through Mastercard India.

In 2022, the High Court of Delhi commenced hearing in the petition challenging the aforementioned AAR ruling. With Sr Adv Harish Salve acting as the counsel for the assessee. The submissions with respect to Permanent Establishment have been briefly summarized below.

• MIPs were small equipment costing $3000 which merely performed preparatory services and should not be considered as a PE.
• MIP’s role is restricted to data collection, and not verifying or clearing transactions.
• The Indian subsidiary merely represents a liaison office and does not negotiate on behalf of the principle due to which there is no agency PE.
• To determine whether or not MIP will constitute PE, it is essential to see where auxiliary functions end and core functions begin.
• Mere visit of employees to meet and greet cannot be considered rendering of services.
• No dependent agent PE, as Mastercard India merely passes on information, and has no role to play in securing of orders.

There were also arguments made with regard to whether the payments made to Mastercard Pacific constituted royalty, but the same have not been included in this paper. Although AAR rulings are highly fact dependent, and binding only on the parties involved, they do have persuasive value, and ruling had far-reaching implications. It required companies operating in a similar business model to re-evaluate the functions attributed to Indian entities, so that no taxable nexus is created.

While factors like the existence of dependency PE, agency PE, and whether or not the functions performed by the MIP were ancillary or not are highly factually dependant, emphasis needs to be placed on the MIP and the Mastercard Network being considered Fixed Place PE. Large online entities cannot exist entirely online. They need to be supported by servers, routers and devices which are integral to hosting material and facilitating the transfer of information. However, a distinction needs to be drawn between equipment that would constitute Fixed PE, and equipment that would not.

Article 5 of the Condensed version of the OECD Commentary provides for when e-commerce operators can be said to have a permanent establishment.[15] As per the same, the physical location of the server where the website is stored may constitute a fixed place of business. However, not all computer equipment may lead to the creation of a PE. If an enterprise pays an Internet Service Provider (ISP) for disk space, these arrangements will not result in the location being at the disposal of the entity. Therefore, mere hosting arrangements will not constitute PE. There is  the additional requirement of the equipment being fixed. This, however, is not literal, and stipulates that it will have to be located at a specified place for a sufficient period of time. Para 42.7 of Article 5 states that no PE can exist when the functions carried out by the server are preparatory or auxiliary. Examples of auxiliary functions include.

• Communications link
• Advertising
• Relaying information
• Supplying information
• Gathering market data

The scope of “core functions” will depend on the nature of the business. However, if the typical activities pertaining to sale, like processing of payment, conclusion of contract, execution of delivery, etc. are performed, they will not be auxiliary.

Given below is an excerpt from the Formula One case.

“It is universally accepted that for ascertaining whether there is a fixed place or not, PE must have three characteristics: stability, productivity and dependence. Further, fixed place of business connotes existence of a physical location which is at the disposal of the enterprise through which the business is carried on.”[16]

The same can be extended to computer equipment. During the AAR ruling and the subsequent HC appeal, it was evident that the computer would lead to the creation of a PE if it performed core functions. This is in line with the Formula One case, as it is stable, in the sense that it has a fixed place, the foreign entity depends on it, and the functions it performs are essential for the activities of the foreign entity. One point which is amply clear, is that if a foreign entity uses an ISP to support its website, no permanent establishment can be said to exist, despite the fact that it might be subject to tax under other provisions (EL, SEP). However, if they have dedicated servers within the country through which the digital presence is hosted, the same is sufficient to create a fixed place PE. If the computer equipment or the liaison office merely provides aid, there will be no PE. In the case of U. A. E. Exchange Centre Ltd. v. Union of India[17], the Delhi HC held that downloading of data and storing the same in India was in support of the main activity and did not lead to the creation of a fixed PE. The SC has held that providing information enabled technology services such as data processing and support, and back-office operations were merely preparatory, and would not lead to the creation of a fixed PE.

Therefore, for the creation of a digital permanent establishment, it is essential for there to be a fixed placed of business, in the form of computer equipment. It is not possible to establish PE purely based on digital presence. Fortunately, PE is not the only taxing mechanism, and they can be taxed under the previously mentioned provisions. Interesting to note that in the case of ITO v. Right Florists Pvt Ltd [18], the counsel for the revenue attempted to formulate a new “Website Permanent Establishment” concept which was wholly rejected by the tribunal. The tribunal held that no PE would be created unless the servers where the websites were hosted were within the country.

In conclusion, entities with a digital presence in India must be aware of the provisions of the Act under which their income can be taxable. Companies having a PE will be subjected to a higher corporate tax rate, whereas the withholding rates for income under the previously discussed provisions will be comparatively lower. While the existence of agency PE and service PE is entirely dependent on the business models of the digital entities, fixed place PE may be established if the entity has equipment, or a location in the country which is at its disposal and assists in performing core functions. The conclusive meaning of the terms “core” and “auxiliary” will be determined when the final order is passed by the Delhi HC. However, if the activities are intrinsically linked to the final sale or essential aspects of the business, and are not merely incidental, there is a high likelihood of there being a permanent establishment.

[1] Goodwin T, ‘The Battle Is for the Customer Interface’ (TechCrunch, 4 March 2015) <https://techcrunch.com/2015/03/03/in-the-age-of-disintermediation-the-battle-is-all-for-the-customer-interface/> accessed 12 May 2024

[2]Para 282, OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, https://doi.org/10.1787/9789264241046-en.

[3] NOTIFICATION G. S. R. 314(E) [NO. 41 /2021/ F. NO. 370142/11/2018-TPL], DATED 3-5-2021A

[4] Memorandum Explaining Finance Bill 2016, Clause 230

[5] Report On India’s Digital Services Tax Prepared In The Investigation Under Section 301 Of The Trade Act Of 1974, January 6 2021

[6] Section 164(i) Finance Act, 2016

[7] [2007] 288 ITR 408 (SC)

[8] [2023] 157 taxmann.com 640 (Delhi – Trib.)

[9] Meteor Satellite Ltd. v. ITO [1979] 2 Taxman 424

[10] supra

[11] Double Taxation Conventions published by Wolters Kluwer.

[12] GFA Anlagenbau GmbH v. ACIT (2014) TS-383 (Hyd)

[13] DIT v. Morgan Stanley & Co. Inc(2007) 292 ITR 416 (SC)

[14] MasterCard Asia Pacific Pte. Ltd (AAR No. 1573 of 2014)

[15] Commentary on Article 5, Model Tax Convention (Condensed Version)

[16] [2017] 80 taxmann.com 347 (SC)

[17] [2009] 313 ITR 94 (Delhi)

[18] (2013) 143 ITD 445 (Kol ITAT)