Taxation of international digital transactions has been a perplexing issue. As per the international tax rules, where an enterprise is a resident in one state with income originating in another state (source country), international tax rules provide that the source country will have the taxing rights over such income only if it is established that the enterprise has a permanent establishment (PE) in the source country. Thus, for the source country to be able to tax profits arising from the digital economy, some physical presence of the non-resident enterprise is required in the source state.
However, today a non-resident can carry out a large amount of internet transactions in the source state without having any significant physical presence there. A website can be launched from anywhere and made available to users anywhere in the world. There is no central point, or physical location, for such a transaction and thus, it may not fall within any country’s jurisdiction for taxation purposes.
This opens up two possibilities: double taxation or non-taxation. The concerned people could be even further creative, and actually set up an online business at a place where none of the founders / promoters are present, thereby making it even more difficult to tax them.
Recommendations under Action Plan 1 of BEPS
The Organisation for Economic Co-operation and Development (OECD) has recently acknowledged that the digital economy is the new economy itself and it would be very difficult to treat it separately from rest of the economy. Accordingly, the Committee set up by the OECD under Action Plan 1 of Base Erosion and Profit Shifting (BEPS) has recommended a new nexus based on ‘significant economic presence’. The Committee has also recommended that an enterprise should be considered to have a significant economic presence if the revenue generated from sales to residents of a given state cross the required threshold, or the number of registered users per month/ year or the volume of digital contracts concluded, and/ or the volume of digital content collected by the taxpayer, exceed a certain threshold, and such other digital factors.
Expansion of the scope of ‘business connection’
In alignment with the above action of the OECD, the Finance Bill, 2018 seeks to expand the scope and ambit of the term ‘Business Connection’ defined in an inclusive manner in section 9 of the Income-tax Act, 1961 (IT Act) and provides that a significant economic presence of a non-resident in India shall constitute a business connection in India. Accordingly, any income attributable to such significant economic presence will be considered as taxable in India.
Significant economic presence as per the Finance Bill has been defined as a transaction in respect of any goods, services or property carried out by a non-resident in India (including provision of data or software to be downloaded in India), if they exceed the threshold set for them. It also includes any systematic and continuous soliciting of business activities or engaging with the prescribed threshold of users in India through digital means.
The Bill further provides that even where a non-resident does not have a residence or place of business in India or does not provide services in India, the business connection could still be constituted. Further, transactions or activities shall constitute significant economic presence in India whether or not the agreement for such transactions or activities is entered into in India.
The Government has consequently announced that it is planning to begin a consultation process with different stakeholders to determine what should be the threshold limits for qualifying as a “significant economic presence”.
Jurisdictions impacted by the amendment
Although, these provisions will come into force from 1 April 2018, there may not be any immediate impact in cases of non-residents wherein India has executed a tax treaty. This is because, in most cases, the restrictive PE definition in the various tax treaties would override the definition of ‘business connection’. The Government has also clarified that it will use the rule of “significant economic presence” to negotiate its tax treaties. Thus, unless corresponding modifications are made to the tax treaties, the existing tax law would continue to apply. It will also be interesting to see the impact of MLI (The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS) in such situations.
The Governments of Israel, UAE and Saudi Arabia have passed internal guidelines that suggest that a non-resident would have a Service PE if it furnishes services, including consultancy services, through employees or other personnel who are offshore without being physically present in the Source State. Thus, tax authorities of such jurisdictions may contend that the rule of ‘significant economic presence’ be considered while interpreting the tax treaties between India and Israel, UAE and Saudi Arabia, given that the concept of ‘Virtual/ Digital’ PE has been recognised by the domestic laws of these countries.
It is also important to note that the proposed expanded definition of ‘business connection’ would apply with respect to all those countries with which India does not have a tax treaty, such as Bahamas, Hong Kong, Cayman Islands, etc. Hence, the rule of significant economic presence would apply to the tax residents of such jurisdictions with effect from 1 April 2018.
Issues relating to applicability and enforceability
Although the immediate implications of this amendment may be minimal and may apply to only a few jurisdictions, once the rule becomes effective, it is bound to raise a number of questions about its applicability and enforceability. For instance, it could be an extremely tedious job to calculate whether the number of users actually interacting with the non-resident has breached the threshold. Also, if a non-resident suddenly gets a dramatic response from users around the end of the financial year, how will it apply such provisions with retrospective effect? This may also increase administrative burden on the non-resident taxpayers and enhance their documentation and audit compliances.
It is also pertinent to note that this provision recommends that to fall within the purview of significant economic presence, the transaction has to be considered as a whole rather than as multiple sub-steps of one large transaction. Determining for this purpose whether a transaction has been performed in India could then become a litigious issue.
Computation of the income attributable to the PE would be a complex and highly subjective exercise. For example, a ‘business connection’ may be triggered based on the threshold of number of users the taxpayer interacts with, but the income attributable to the ‘business connection’ could be negligible or NIL, if the interaction does not result in any significant revenue.
Interplay with Equalisation Levy
Lastly, the interplay of the Equalization Levy with the ‘significant economic presence’ rule will also have to be seen. Based on changes made to the IT Act through the Finance Act, 2016, the Equalization Levy has already been introduced to collect taxes from certain specified digital services like online advertisements. It is also important to note that the Equalization Levy was not regarded as income tax and, hence, the non-resident online advertisement service provider is not able to claim foreign tax credit in respect of the Equalization Levy deposited by the Indian payer.
It is worth noting that for all those nations where the expanded scope of business connection would apply, the Equalization Levy would not be levied. The same would lead to another complication since it would be difficult for certain non-resident service providers to determine if it would constitute a business connection or a PE in view of the ‘number of users’ threshold limit prescribed under the ‘significant economic presence test’, while its customers may go ahead and deduct an Equalization Levy upon the payments exceeding 0.1 million unless the non-resident confirms that it constitutes a business connection or PE in India.
These factors need to be considered by the tax authorities before prescribing the threshold limit for ‘aggregate payments’ and ‘number of payments’. The Government may decide to apply these provisions on a prospective basis – i.e. on the basis that the number of customers who visited you previously should determine whether you have a significant economic presence in the current financial year.
Thus, it is imperative that the government consults various stakeholders and formulates a robust mechanism for the smooth implementation of this rule, failing which its implementation will open up a Pandora’s box.
* The author was assisted by Jyoti Anumolu, Associate