I. INTRODUCTION

A. What is Digital Economy?

Digital economy refers to an economy that is based on digital computing technologies, although we increasingly perceive this as conducting business through markets based on the internet and the World Wide Web. The digital economy is also sometimes called the Internet Economy, New Economy, or Web Economy.[1] In a nutshell, it refers to an economy based on digital technologies.

Gone are the days of the brick-and-mortar businesses because business models have been severely revamped. In the last decade, there has been a paradigm shift in the way of conducting business. Today, the biggest cab aggregator Uber does not own any cab, the largest accommodation provider Airbnb does not own any apartments and many other frontiers like makemytrip, Amazon, Flipkart, Paytm, etc. do not function the way conventional businesses functioned but they thrive on the digital technology.

The current tax rules (International as well as Domestic) were devised decades ago based on the functionality of the brick and mortar economy. However, with the advent of the digital economy the present tax regime stands redundant. The profits of the digital businesses have been increasing alarmingly, but there do not exist commensurate tax laws to tax such profits. Accordingly, it is need of the hour for all the countries to devise and revamp their tax laws, as the digital economy is ripe for taxation.

B. Overview of Taxation

Direct Tax in India is levied under the Income-tax Act, 1961 (‘the Act’). Residents are taxed on worldwide income and non-residents are taxed only on income sourced in India. Companies are treated as residents on satisfying either of the conditions: (a) incorporation in India (b) Place of Effective Management (‘POEM’) is in India. Accordingly, a company incorporated outside India and having its POEM outside India is considered as a non-resident.

Taxation of non-residents is governed by the section 5 read with section 9 of the Act and provisions of Double Taxation Avoidance Agreement (‘DTAA’). Business income is governed by the provisions of section 9 of the Act, where income is deemed to accrue or arise in India owing to an enterprises business connection in India. Under DTAA treaties, business profits are attributed to a Permanent Establishment (‘PE’) as if it is a distinct and separate entity as per the provisions of Article 5 read with Article 7 of a DTAA. Such business profits can be taxed only if there exists a business connection or a PE in India at the rate of 40 per cent on net basis, unless the income qualifies as royalty or fees for technical services (‘FTS’) which will be taxed at a rate of 10 per cent on gross basis. Further, as per the provisions of section 90(2) of the Act, a non-resident will be entitled to claim beneficial provisions between the Act and DTAA.

In order to address the tax concerns related to digital economy, three specific issues need to be resolved: (a) Characterization of Income (b) PE existence and attribution of profit

 C. Characterization of Income

There are considerable differences in the tax treatment of an income depending upon its characterization. The three primary categories under which a non-resident’s income can be classified are ‘Royalty’, ‘Fees for Technical Services’ (‘FTS’) and Business Income. The tax rate of each income differs depending upon its characterization. Where the non-resident / taxpayer has made an incorrect classification of an income or the characterization of income is not in tandem with the international principles, then such non-resident / taxpayer may face a potential risk of double taxation in different jurisdictions and also end up witnessing protracted litigation. Taxability of a non-resident income is depicted in the table below:

Nature of Income No PE / business connection exists PE / business connection exits
Royalty Taxable on gross basis at 10 per cent or DTAA rate, whichever is lower Taxable on net basis at 40 per cent (to the extent profits attributable to PE
FTS
Business Income Not taxable

Few illustrations where transactions pose a challenge in characterization of income are as under:

  • Subscription Fees: The Authority for Advanced Rulings (‘AAR’) in the case of Dun & Bradstreet Espana, S.A.[2] held that, fees received for downloading business information reports (‘BIRs’) containing general information about the companies was not taxable as royalty, as it was a mere subscription to a database where reports available in the public domain were compiled. Further, where the Indian AE was carrying on its own business and was an independent entity, not under the control and instructions of the applicant in carrying on its business, settled its own price depending upon the market conditions and paid purchase price to the applicant for BIRs, as fixed by applicant; it could not be concluded that the Indian AE itself was an agent of the applicant and therefore, not a PE to the applicant in India under Article 5. Therefore, payments made by the Indian AE to the applicant for purchase of BIRs would be treated as part of applicant’s business profits as covered within the provision of Article 7 but would not be taxable as business profits in India in absence of a PE in India. 

      However, the Hon’ble Karnataka High Court in the case of Wipro Ltd.[3] held that payments made to a non-resident in order to obtain a license to use the database, amounts to granting of a right to access the database or a transfer of right to use the copyright and thus, would be taxable as royalty and not business income.

Therefore, the judicial authorities have contradictory views on similar transaction of payment made to a non-resident for accessing a database, where few treat the same as royalty and others characterizing as business income or not as royalty.

  • Broadcasting of an event: The Hon’ble Mumbai Tribunal in the case of IMG Media Ltd.[4] held that sum paid to an assessee for capturing and delivering live audio and visual coverage of IPL cricket matches was not FTS, as BCCI had not acquired technical expertise from the assessee which would enable them to produce the live coverage feeds on their own after the conclusion of IPL. It was also held that in view of BCCI being owner of the program content and in the absence of transfer of any broadcasting rights to the assessee, the payments would not amount to royalty.

However, the said ruling is applicable on a case-to-case basis because if the payer / service recipient avails the relevant technical expertise from the service provider and is able to apply the said technical knowledge, know-how or skill on its own i.e. without taking recourse of the service provider, then the transaction would squarely fall within the nature of FTS.

Therefore, the judicial authorities must follow a consistent approach in accordance with the internationally accepted principles and thereby create a conducive environment for the taxpayers.

Apart from the above, there are many other transactions like web hosting services, data warehousing, data retrieval, etc. which have not yet been tested in the court of law or there is very minimal guidance or no commensurate provisions to bring them within the ambit of tax. Therefore, it becomes imperative to tighten the tax net with respect to transactions involving technology and thereby does not escape any tax.

To know more about service tax payment due date.

Check out https://taxguru.in/service-tax/service-tax-return-payment-monthly-quarterly-half-yearly.html.

D. Permanent establishment and attribution of profits

Once the income is characterized based on the nature of transaction i.e. royalty or FTS, taxed can be levied as per the rates mentioned in the earlier table. However, if the income is characterized as a business income, then unless a PE is established in India or there exists a business connection in India, the income cannot be taxed in the hands of the foreign company / non-resident. Business Connection relies on the concept of source-based taxation, thus giving the source-based country, a right to tax income arising from activities carried in that country.

For example, a foreign company based in a tax haven country is in receipt of advertising fees for publishing content of an Indian resident taxpayer on its search engine. The business model of such foreign companies using a search engine relies predominantly on Intellectual Properties (‘IPs’), algorithms, etc. and thus, free to locate their core functions in any low tax jurisdiction. Accordingly, such online advertising fees received by a foreign search engine company is not fees for technical services and is not taxable in India due to absence of permanent establishment of such foreign company in India. Further, the foreign company being a tax resident of a tax haven country will not be liable to any tax in the country of residence, thus, will not be taxable in either of the countries. Therefore, establishing a PE in India or demonstrating a business connection in India is more complex particularly where business models thrive on digital technology.

However, if the tax authorities demonstrate that there exists a PE or any business connection in India, then the next dilemma is attribution of profits to PE of the non-resident taxpayer. Additionally, unless the present attribution rules applicable globally are substantially amended, there may not be significant income taxed in India. Generally, as per Article 7 of the Organization for Economic Co-operation and Development (‘OECD’) Model Tax Convention, if books of accounts are maintained, then PE is to be constituted as a separate and distinct entity and profits need to be apportioned in accordance with the arm’s length principle. If separate books of accounts are not maintained or profits cannot be determined, then the tax authorities may take recourse of Rule 10 of the Income-tax Rules, 1962 and apportion the profits in either of the manner: (i) percentage of turnover (ii) proportion of total gains / profits (iii) any manner as the Assessing Officer (‘AO’) may deem fit.

However, due to lack of uniform approach by the tax authorities in implementing the Rule 10, the CBDT constituted a committee to provide clarity in India’s approach, examine the existing profit attribution rules and recommend changes under a draft report. Accordingly, on  18th April 2019, a public consultation document / draft report was released recommending few modifications to the profit attribution rules and inviting the comments of the stakeholders. In the draft report, the committee recommended a formulary method of apportionment of profits to PE based on demand and supply based factors. Presently, we await the release of the final report and its incorporation in the tax regime.

Keeping the above issues into consideration, we present the unilateral amendments adopted by India and foreign jurisdictions and few shortcomings and other recommendations that may be relevant in the final implementation. Before setting the things into motion, it is pertinent to note that the discussions are only India-centric.

From the above-mentioned analysis, it can be observed that the non-resident foreign companies do not have much physical presence in the source country and therefore in order to tighten the tax net, equalization levy was introduced.

II. Evolution of Unilateral Measures

During the G-20 Summit, the G-20 countries deliberated upon the need to devise laws for taxing business models thriving on the digital technology, as the shift from brick and mortal model of business activity to digital business is a reality and there has to be a consequential change in the sphere of taxation. Accordingly, it directed the OECD to fix the gaps in the different tax systems worldwide. The OECD published an Action Plan on Base Erosion and Profit Shifting (‘BEPS’) in July 2013 and a final report with 15 Action Plans was published in 2015. Primarily, BEPS curbs tax evasion and double non-taxation & refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or
no-tax jurisdictions.

Of the 15 Action Plans, Action Plan 1 deals with addressing challenges posed by taxation of digital economy. The Action Plan 1 analysed and suggested a few possible options as follows:

  • Equalization Levy
  • Withholding tax on certain digital transactions
  • Nexus based approach

None of the above options were recommended in the report. Simultaneously, the OECD acknowledged that until a global consensus emerges on the issue, the countries can adopt any of the aforesaid options in their domestic tax regime provided they respect the treaty obligations or include them in their bilateral tax treaties after due negotiation. Given that modification of treaties will take a considerable amount of time, many countries in the past 3-4 years have adopted interim measures in their domestic tax regime to tackle the tax challenges.

A. Equalization Levy

India being the pacesetter and very pro-active, introduced the concept of ‘Equalization Levy’ vide Finance Act, 2016 in its domestic tax law. The levy was made effective from 1st June 2016. As per the said provision[5], where any resident or a non-resident having a PE in India makes a payment for a specified service to a non-resident having no PE in India, and the aggregate consideration exceeds ten lakhs in a financial year, then taxes are to be levied at the rate of 6 per cent on the amount of consideration. Specified Service is defined to include online advertisement, digital advertisement or any other facility or service for the purpose of online advertisement and any other service as notified by the Government.

Further, in some cases, where the service provider / non-resident not having a PE in India does not agree with the imposition of the new levy, the service recipient / Indian payer may have to undertake grossing-up of the consideration, thus be subject to additional economic burden.

On the other hand, there are corresponding amendments in the Act[6], stipulating that where any receipt of the service provider has been subject to equalization levy, then the same receipt will be exempt for the purview of the Act and thus, will not form part of the taxable income.

B. Compliances & Regulation

Further, if the service recipient fails to credit the levy so collected to the treasury of the government, then he / she will have to pay simple interest at the rate of one per cent of such levy for every month[7]. If the service recipient fails to deduct the equalization levy, then he / she will be liable to pay penalty equal to the amount of the equalization levy in addition to the levy to be paid[8]. An assessee aggrieved by the order of imposition of penalty passed by the AO, may appeal to Commissioner of Income Tax (Appeals) within 30 days from date of receipt of order passed by the AO[9]. An assessee may further appeal to the Appellate Tribunal within 60 days from the date of receipt of order passed by the Commissioner of Income Tax (Appeals)[10].

C. Double Taxation

As equalization levy is introduced as a separate chapter in the Finance Act, it has been deliberately kept outside the purview of the Act and therefore, the tax treaty benefit will not be available. As a result, foreign jurisdictions will not allow the non-resident foreign service providers credit of any taxes paid in the form of equalization levy in India i.e. no foreign tax credit will be available. This may eventually result in double taxation, as the non-resident will have to pay income tax in its country of residence, although in different jurisdictions. This is one of the inherent limitations of the equalization levy. However, the non-resident can have partial relief from such double taxation by claiming an expense deduction of equalization levy from its taxable income.

Further, there are other important issues like the specified services which are subject to equalization levy may also fall under the purview of Integrated Goods and Services Act, 2017 (‘IGST Act’). As per the IGST Act, any supply of services imported from outside India into a territory within India, is to be treated as supply of service in the course of interstate trade or commerce and will be chargeable to tax under IGST Act. The liability to pay GST is on the recipient of service in India, if the supplier of such service is located outside India. Therefore, one of the views is that a single transaction is subjected to tax twice. However, it is pertinent to note that it is reasonably settled position of law that to constitute double taxation, two or more taxes must have been levied: (i) on the same property or subject-matter, (ii) by the same Government or authority, (iii) during the same taxing period, and (iv) for the same purpose. Strictly speaking, there is no double taxation where the purpose of levying taxes is distinct. Equalization Levy is imposed because the non-resident companies have an unfair advantage over Indian competitors engaged in similar business. On the other hand, IGST is collected as there is interstate supply of goods or services or both, which includes import of services. Thus, it does not amount to double taxation. Therefore, on legal front, there is nothing which debars double taxation; however, it is desirable to avoid double taxation. Additionally, this sector has remained untaxed for a considerable span and negotiating treaties with foreign jurisdictions will take long time, therefore, there should not be much questions on grounds of double taxation.

III. Nexus based approach

Post introduction of Equalization levy in the year 2016, India went a step ahead and became one of the first countries to introduce the concept of Significant Economic Presence (‘SEP’) in its domestic tax regime. Accordingly, the definition of business connection contained in section 9 of the Act is expanded, thus bringing the income earned by a non-resident by way of SEP under the tax net in India. The Finance Act, 2018[11] explained SEP as under:

  • transaction in respect of any goods in India above a specified value, including digital goods; or
  • transaction in respect of any services in India above a specified value, including digital services; or
  • transaction in respect of any property in India above a specified value, including download of data or software; or
  • systematic and continuous solicitation of business from India from prescribed number of users through digital means; or
  • systematic and continuous engagement with prescribed number of users through digital means.

It is worth noting that the specified value would be on an aggregate basis and based on the value of a single transaction. The Act further postulates that even in case of non-existence of residence or place of business of a non-resident, it would still constitute a business connection if it falls within the definition of SEP.

The threshold limits for qualifying as SEP are yet to be notified by the CBDT. CBDT also invited comments / suggestions from the stakeholders and general public to prescribe thresholds on the quantum of the revenue and the number of users and thereby determine the SEP of a non-resident in India[12]. Further, even the OECD has sought public inputs on proposals addressing tax challenges of digital economy and thereby devise nexus rules so that just profits are allocated to a jurisdiction depending on the situs of the value creation[13].

IV. Unilateral Measures adopted by different jurisdictions

Sr No Country Measures Description
1. Italy Web Tax
  • Levied exclusively on B2B digital transactions where supply of service is through electronic means.
  • Rate: 3 per cent
  • Total no of transactions for a specific taxpayer shall be above 3000.
Modification in PE definition
  • Introduced the concept of significant and continous economic presence
2. Hungary Advertisement Tax
  • Tax Levied on advertisement published in media service.
  • Rate: 7.5 per cent
  • Range: Business with advertising revenue exceeding HUF 100 million.
3. Spain Digital Service Tax
  • Tax be levied on specific digital services.
  • Rate: 3 per cent
  • Worldwide revenue exceeding Euro 750 million and in Spain exceeding Euro 3 million.
4. Israel Amendment of definition of PE
  • Definition of PE to include economic activities conducted through internet.
5. France Digital Service Tax
  • Tax to be levied on companies that sells digital products from third parties, traffic in user data or sell digital advertising.
  • Rate: 3 per cent
  • Worldwide revenue exceeding Euro 750 million and in France exceeding Euro 25 million.
6. UK Digital Service Tax
  • Tax to be levied on specific digital business models
  • Rate: 2 per cent
  • Applicable to search engines, social media platforms and online marketplaces

 V. Shortcomings in implementation of the unilateral measures

  • Ideally, the intent behind expanding the scope of business connection was to cover new business models operating through digital medium. However, on plain reading of the phrase ‘transaction in respect of any goods, services or property’, the goods could be physical goods and property could include intangible property, which probably was not the intent of the legislature.
  • It is unclear whether a transaction which is partly carried outside India and partly in India is covered by the condition or not; in other words, if the non-resident is not in India but the customer is in India, the goods imported by customer in India may not be regarded as transaction ‘in India’.
  • It appears that the specified services covered under the ambit of equalization levy could also be covered as SEP under Explanation 2A. Now section 10(50) of the Act provides that any income arising from such specified service and chargeable to equalization levy is exempt from tax. This exemption would also be applicable to income deemed to accrue or arise under Explanation 2Aand hence to the extent there is equalization levy there cannot be any further tax under Explanation 2A.
  • While defining SEP, few words like ‘systematic’, ‘continous’ and ‘soliciting’ have not been defined expressly and thus are subject to more than one interpretation.
  • The term ‘user’ is ambiguous, as it has not made out explicitly, whether user includes only active users or passive users too like click-based user, viewer, subscriber, etc. For example, there are numerous apps which allow access for free or a trial basis and thus, the users would be more of passive users.
  • The clauses (a) & (b) to the explanation are separated by ‘Or’, thus, these are not to be read in conjunction with each other. However, this does not seem to be the intent of the legislature. The revenue-based threshold and the user-based threshold cannot be mutually exclusive.
  • A transaction covered within the ambit of equalization levy may also be subject to SEP provisions. Thus, there could be an overlap between the SEP provisions and the equalisation levy provisions. Therefore, an explicit clarification should be issued, stating that the provisions of SEP would not apply to a transaction which is subject to equalisation levy.

VI. Way Forward

Presently, as per the provisions of section 90(2) of the Act, taxpayers will be subject to either the provisions of the Act or DTAA, whichever is beneficial to the taxpayer. Further, undertaking unilateral measures like equalization levy colloquially called as ‘Google tax’ or modifying and enlarging the definition of ‘business connection’ alone will neither be good for the investors community and other stakeholders nor help in increasing any tax revenues, as unless the treaties are amended on parallel lines, domestic provisions will remain reductant. Therefore, developing a multilateral instrument (‘MLI’) as necessitated in Action Plan 15 of the BEPS Action Plan warrants immediate action. However, every country might not agree to be a signatory to the instrument, as it cannot factor any specific relations between two countries. Thus, resolving / clarifying a few reservations of the states in the MLI and renegotiating the tax treaties will be of paramount assistance in tackling this issue.

Additionally, if the MLI is in place and the tax treaties are amended, then the very existence of equalisation levy i.e. google tax will require a re-evaluation, as the same results in double taxation. To add further, having precise definitions and meaning of the words used in SEP provisions will give much needed clarity and objectivity and also avoid future litigation.

In addition, this issue may also be brought to rest once data localisation laws are in place. The Government has already come up with Personal Data Protection Bill 2018 and equally supported with RBI guidelines and draft national policy on e-commerce. The bill has been drafted with the aim to tighten controls on the data that companies collect from its customers and to enhance individual rights with respect to their personal data. Every data fiduciary is required to store at least one copy of personal data on a server or data centre that is located in India. This may entail huge operational costs for the fiduciaries and may even upsurge compliance burden on companies. The RBI direction entails that payment system operators will have to store all the data only in India, which implies that they will have to host a local server in India, and they cannot transact with Indian customers from servers located in any other country. Also, as proposed in the draft national policy on e-commerce, e-commerce websites as well as social media firms will have to store customer data exclusively in India. Few MNCs have already succumbed to RBI’s mounting pressure on complying with data localisation norms[14]. As established in various judgments[15] that hosting of local servers in India would make it possible to assert the existence of a ‘fixed place of business in India’, thereby attracting the taxation provisions by virtue of constituing a PE.

It may be too early to comment upon the exact taxation angle; however, the possibility cannot be ruled out that this may lead to a wider tax base and a new source of tax avenue for the government.

[1] https://en.wikipedia.org/wiki/Digital_economy

[2] (2005) 142 Taxman 284 (AAR)

[3] (2011) 203 Taxman 621 / (2013] 355 ITR 284 (Karnataka HC)

[4] (2015) 155 ITD 527 / 173 TTJ 591 (Mumbai – Trib.)

[5] Section 162 of the Finance Act, 2016

[6] Section 10(50) of the Income-tax Act, 1961

[7] Section 170 of the Finance Act, 2016

[8] Section 171 of the Finance Act, 2016

[9] Section 174 of the Finance Act, 2016

[10] Section 175 of the Finance Act, 2016

[11] Explanation 2A to section 9 of the Finance Act, 2018

[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,—

 (i)  the agreement for such transactions or activities is entered in India; or

(ii)  the non-resident has a residence or place of business in India; or

(iii) the non-resident 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.]

[12] https://www.incometaxindia.gov.in/news/sep-rules-calling-stakeholder-comments-13-07-2018.pdf

[13] https://www.oecd.org/tax/oecd-invites-public-input-on-the-possible-solutions-to-the-tax-challenges-of-digitalisation.htm

[14] https://www.businesstoday.in/current/corporate/whatsapp-store-data-in-india-rbi-localisation norms/story/284415.html

[15] ITO vs. Right Florists (P.) Ltd. (2013) 25 ITR(T) 639 (Kol. Tri), Mastercard Asia Pacific Pte. Ltd. In re, (2018) 406 ITR 43 (Delhi AAR)

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