By Ashish Goel
In its response to the United Nations’ base erosion and profit shifting (BEPS) questionnaire, the Indian Government stated that Action 1 of the BEPS project, on addressing the tax challenges of the digital economy, is “very crucial for India.” Why is this so? The Government explained thus: “In spite of the huge market for the digital economy in emerging economies like India, digital enterprises face zero or no taxation because of the principle of residence-based taxation as against source-based taxation. Since the dominant players in the digital world like Amazon or Google are not tax residents in India, profits sourced from India are not offered for taxation. Thus, significant base erosion is caused by the inadequacy of existing international tax rules to allocate profits to countries from where these profits are sourced, and in particular, the irrelevance of physical presence as a criteria for allocating taxing rights to source countries in case of digital enterprises.”
That was back in 2014. The Government subsequently introduced two key domestic tax measures directed at the digital economy: first, a six percent equalization levy to inter alia tax advertising payments made to foreign businesses; and secondly, expanding the definition of “business connection” in section 9(1)(i) of the Income Tax (IT) Act to incorporate a new digital nexus to tax business profits of foreign businesses based on “significant economic presence” in India (in the absence of a physical or representative presence). India has also reserved the right to include a provision in Article 5 of its tax treaties (permanent establishment Article) to the effect that a foreign businesses having “significant economic presence” in India would be deemed to have a permanent establishment in India. These domestic tax measures are admittedly inspired from the OECD’s work on BEPS project and were brought about at a time when BEPS became the ‘buzzword’ in the international tax community.
Though countries are unable to arrive at a uniform, consensus-based solution to taxing the digital economy, the direct (and indirect) tax challenges that arise from digitalization are not new and have been repeatedly talked and written about for some time now. As the Indian Government rightly stated in its response to the UN BEPS questionnaire, as well as in Budget documents, and more recently reiterated in the consultation document inviting members of the public to comment on the application of a new digital nexus to tax, the underlying problem of digitalization is to do with the fact that traditional international tax principles governing allocation of taxing rights, more particularly, a physical or representative presence-based permanent establishment principle, have failed to keep pace with the evolving and ever-sophisticated business models that rely mostly on digital means to earn profits.
The Indian Government, like some other countries including Israel for instance, has been quick in adopting a new digital nexus in domestic tax law to tax business profits of foreign businesses. Pertinently, India’s position on the 2017 update to the OECD Model Tax Convention was that the Government’s adoption of the “significant economic presence” concept in tax treaties would be based on the criteria identified in Chapter VII of the BEPS Action 1 Final Report. The domestic tax law definition of “significant economic presence,” therefore, ideally should have followed these standards for two reasons: first, it will be extremely difficult for the Indian Government to convince its tax treaty partners to adopt India’s own version of a digital nexus; and second, more often than not the permanent establishment article of the tax treaty would prevail over domestic tax law definition and, therefore, it is only logical that the latter mirrors the former.
The Indian IT Act definition of “significant economic presence” clearly does not adopt the approach set out in the BEPS Action 1 Report. “Significant economic presence” is defined to mean a transaction in respect of any goods, services etc. carried out by a foreign enterprise in India, if the aggregate of payments arising from such transaction during the year exceeds a yet-to-be prescribed amount. Furthermore, the “systematic and continuous soliciting” of business activities or “engaging in interaction” with a yet-to-be prescribed number of users by a foreign enterprise in India through digital means would constitute ‘significant economic presence’ of the foreign enterprise in India. Pertinently, to determine “significant economic presence,” it is immaterial if the agreement for such transactions or activities is entered into in India.
This is a poorly worded, sweeping definition and not only will it not be easy to implement on the ground, but it will also lead to unintended consequences: “any transaction” relating to “any goods or services,” cannot be interpreted to mean that it exclusively covers online supply of physical goods and services. When can a transaction be said to have been carried out in India? What is “systematic and continuous soliciting” of business and how is it different from “engaging in interaction” with users? Should the interaction with users also be systematic and continuous? Does user interaction necessarily imply value creation? Should the revenue threshold apply in exclusion or in combination of user interaction? Are we confusing digital “significant economic presence” with mere online “economic presence”? Above all, how will profits be attributed to the “significant economic presence” in India?
These are some of the questions that needed to be deliberated upon while arriving at a coherent and workable definition of “significant economic presence” to ensure that only those transactions that are intended to be covered are covered, while limiting compliance costs for taxpayers and providing certainty for cross-border business activities. However, this has not been done. The aforementioned definition of “significant economic presence” is now in effect (from April 2018 financial year) and perhaps clarifications on these issues would help allay concerns. For now, it can only be hoped that this consultation exercise results in something meaningful, and while it is anyone’s guess as to what the thresholds would look like, it is only fair to say that any change in rules must take into account the practical aspects of implementing them in terms of the Government’s ability to tax foreign digital businesses.