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This article is written by Aditi Lahiri, pursuing a Diploma in Business Laws for In House Counsels from lawsikho.com.

Introduction

In the last decade, business models have been severely revamped through the evolution of the digital economy. For example, the largest cab aggregator in the world, Uber does not own any cabs and the biggest global accommodation provider, Airbnb, does not own any housing facilities. 

The decades-old tax rules of India, as well as most other countries, were devised based on the business model of the brick and mortar economy. However, the paradigm shift in the way of conducting business has done away with the conventional structures and replaced them with businesses that operate globally without needing to establish offices or hire significant employees in different countries. These new businesses heavily rely on intellectual property assets, are typically located in a low-tax jurisdiction and are able to generate huge revenues from any country through highly engaged remote ‘user participation’ (engagement of customers with the business through digital platforms) from the domestic market, making it difficult to bring them under the domestic tax radar of the source country. 

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What is a digital tax

Digital service tax (DST) is an informal name given to a tax collected on revenue generated by providing digital services and has not been defined in any domestic law or international treaty. It is imposed by the source country on the revenue generated by global tech companies in such countries. 

Importance of digital tax

India, having over 560 million internet users, is the second-largest online user base in the world. Hence, digital businesses can be overlooked from the viewpoint of its tax revenue base. The rapid progression and development of technology have enabled businesses to carry on their business activities with a minimal physical presence. Further, the Covid-19 outbreak has helped even traditional businesses overcome their hesitation regarding operating remotely and compelled them to suddenly and rapidly convert from conventional to digital models of operations and generating revenue.  On account of such mass digitisation of business models, the complexities from taxation and regulatory standpoint have only amplified. 

A report from the Ministry of Electronics and Information Technology in partnership with McKinsey had come to the conclusion that “India can create up to $1 trillion of economic value from the digital economy in 2025”. Hence, the taxation framework has to be amended accordingly to ensure adequate taxation of technology giants to capitalise on this global expansion of the digital economy.

Current system of direct taxes in India

In India, under the Income Tax Act, 1961, Direct Tax is levied on income sourced in India on both Residents and Non-Residents of India. A company is taxed as a Resident if it has been incorporated in India or its Place of Effective Management (‘POEM’) is in India. Similarly, a company is treated as a Non-Resident for the purpose of taxation if it has been incorporated outside India and has its POEM outside India. 

Taxation of Non-Residents in India is governed by the provisions of the Double Taxation Avoidance Agreement (‘DTAA’). Under DTAA treaties, only if there exists Permanent Establishment (PE) or a business connection in India, business income can be taxed at the rate of 40 % on a net basis, unless the income qualifies as Fees for Technical Services (‘FTS’) or royalty, in which case it will be taxed at a rate of 10 % on a gross basis. 

In case of a business income (that has not been characterised as royalty or FTS) by a Multinational Enterprise (MNE), unless there exists a business connection in India or a PE is established in India, the income is not taxable. 

Grey areas

The current tax regime primarily focuses on dealing with the taxation of physical business activities. The provision of digital services or the digitalisation of economy has strained the applicability of the ‘permanent establishment’ (PE) rule, as companies are now increasingly doing business in various jurisdictions without having a physical presence within the respective jurisdiction(s).

Hence, companies with virtual business models thriving on digital technology (Intellectual Properties (‘IPs’), internet domains, user data, algorithms, etc.), primarily having their core functions in a tax haven country, are free to generate income from online activities (like online advertising fees) from Indian resident taxpayers without having a PE in India. 

Due to absence of the permanent establishment of such foreign companies in India and the business connection leading back to the tax haven country where it will not be liable to any tax in the country of residence, the business income altogether, will not be taxable in either of the countries. For instance, as per the reports, in FY18, in India, Google’s total revenue crossed Rs 10,000 crores while Facebook collected total revenue of Rs 521 crores. However, a total tax of only 200 crores was paid by Facebook and Google jointly to the Government of India.

A huge problem related to the taxation of the digital economy is that it might lead to double taxation of various digital businesses being taxed in multiple jurisdictions, leading to the violation of the double taxation avoidance agreement (DTAA) treaties signed between India and home countries of the global tech companies. However, the practical reality is that often in the absence of such digital taxation, the businesses are not getting taxed in the remote jurisdiction or in the country where they are based, hence leading to double non-taxation. 

This has led to tax authorities around the world to grapple with the challenge of adapting revenue collection models to digital technologies rapidly reshaping the global economy. Especially in a developing country like India, proper taxation of income made from the country plays a crucial role in the development of the economy. Hence, the current goal is to develop a framework to regulate and to get a ‘fair’ share of taxes from the revenues generated by such businesses.

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International advancement on the issue 

During the G20 Summit, all the participating countries deliberated on the issue of taxing the digital economy comprising various tech giants and directed the Organisation for Economic Cooperation and Development (OECD) to fix the gaps in the different tax systems worldwide. Accordingly, the OECD published an Action Plan on Base Erosion and Profit Shifting (‘BEPS’) in 2013 followed by a final report with 15 Action Plans in 2015. The BEPS talks about curbing double non-taxation and tax evasion and elaborates on tax avoidance strategies employed by the digital companies exploiting loopholes and mismatches in tax rules in various domestic jurisdictions to artificially shift profits to low or no-tax jurisdictions. Primarily, BEPS helped identify the problems associated with digital taxation and analysed and suggested a few possible solutions such as equalization levy, withholding tax on certain digital transactions and nexus-based approach, although none of these solutions was recommended in the final report.

For a proper modification of the international taxation system to accommodate the digital economy, a global consensus will need to emerge on the issue and ultimately bilateral tax treaties will have to be modified after negotiation. Given that modification of such treaties will be a time-consuming process, many countries including India, in the recent past, have adopted interim measures in their domestic tax regimes to accommodate adequate taxation of the digital giants.

For instance, France imposed 3% digital tax, popularly known as Google, Apple, Facebook, Amazon (GAFA) tax by virtue of the Digital Service Tax Act, on the revenues generated by the global technology giants like Apple, Google Facebook and Amazon. Similarly, 3% DST was also imposed by Italy on technology companies generating revenues from the digital services on a minimum threshold of revenue generation of 5,500,000 euros from Italy only. Countries like Malaysia, Australia and Uganda are also following suit by imposing digital taxes on these technology giants.

Tax amendments in India

Here are some of the key amendments-

Equalisation Levy

India being very proactive and the pacesetter, introduced the concept of ‘Equalization Levy’, colloquially called as ‘Google tax’, through a separate chapter in the Finance Act, 2016 within its domestic tax jurisdiction. It was charged at the rate of 6% on gross revenues in excess of Rupees ten lakhs in a financial year made by beneficial foreign digital companies for providing digital advertising services to Indian residents and raked in over Rs. 550 crores in the fiscal year 2017-2018. Effective from April 1, 2020, a new amendment has essentially expanded the equalization levy from only online advertising to nearly all e-commerce activities in India through the applicability of 2% on the revenues of digital businesses that do not have a taxable presence in India.

To ensure that the tax treaty benefits are not available, the levy has been deliberately kept outside the purview of the local income tax. Resultantly, the non-resident foreign service providers will not be allowed any foreign tax credit in any foreign jurisdictions for paying the equalisation levy in India. As an inherent limitation of the levy, this may have an undesirable outcome of resulting in double taxation, as the foreign service provider will have to pay income tax in its country of residence, as well as the equalisation levy in India, although the non-resident may opt to claim an expense deduction of equalization levy from its taxable income.

There are also other issues like the specified services imported from outside India into India, being treated as supply of service in the course of interstate trade or commerce which are under the purview of Integrated Goods and Services Act, 2017 (‘IGST Act’). Hence, these services are chargeable under two taxes, IGST and equalisation levy, leading to double taxation. However, considering that IGST and equalisation levy are charged for completely different purposes, strictly speaking, it does not amount to double taxation. Considering the long duration for which the digital services sector has remained untaxed and the further time that will be required to negotiate treaties with foreign jurisdictions, there should not be many issues on grounds of double taxation.

Nexus based approach- Significant Economic Presence (SEP)

After the introduction of Equalization levy, India introduced the concept of “Significant Economic Presence” (SEP) through the Finance Act, 2018 for the purposes of corporate income tax. It expanded the definition of ‘business connection’ in section 9 of the Act, thus bringing the revenue earned by a foreign company by way of SEP under the tax jurisdiction of India. The Explanation 2A to section 9 of the Finance Act, 2018 has 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 a prescribed number of users through digital means; or
  • systematic and continuous engagement with a prescribed number of users through digital means.”

The Act further specifies that the lack of residence or place of business of a non-resident in India, would not mean there is an absence of a business connection if it falls within the definition of SEP. It was made applicable on the following:

  • Advertisement targeting the customer base residing in India or those accessing advertisement through internet protocol (IP) address in India.
  • Sale of data collected about people residing in India or those using an IP address in India.
  • Sale of goods or services using data collected from a person residing in India or those using an IP address in India.

The threshold limits for qualifying as SEP and other rules for the imposition of tax are yet to be notified and the SEP provision remains ineffective as of now due to India’s various double taxation avoidance agreement (DTAA) with other countries.

Withholding tax on E-Commerce transactions

Under Section 195 of the Income Tax Act, the Indian payer is required to withhold taxes while making payments to non-residents, which could be subject to taxes in India. However, this is difficult to do for the consumers when the transaction is not a tangible one but on a digital platform like Uber or Amazon. Hence, it has been proposed that a separate and user-friendly tax collection mechanism be crafted for digital transactions. Applicable from October 1 2020, the e-commerce operator is required to withhold tax at 1% on the gross amount of sale of goods/ services facilitated by it through its digital platform at the time of credit or payment to the e-commerce participant, which would be increased to 5% in the case of non-availability of a PAN of the e-commerce participant. 

Implications of recent developments

The Equalization Levy coupled with the SEP test is one of the more coordinated efforts towards a reformed digital tax model. The strategy is in line with the 2015 OECD BEPS Action 1 report, to bring digital giants like within the jurisdiction of local taxes. 

The amendments have introduced a wave of promising implications for India. Companies having digital presence but without a physical presence in India, that earlier conveniently escaped from the taxation framework, have now been brought under the ambit of domestic tax jurisdiction. At least as an interim measure, companies earning revenues from Indian audiences without a physical presence in India will no longer be able to evade taxation by shifting their core functions to tax havens.

Pros and cons

Digital taxation provides a level-playing field to both international and domestic companies instead of international players receiving an unfair competitive advantage over MSMEs and start-ups based in India. Furthermore, considering that the e-commerce sector is predicted to grow to $200 billion by 2026, adequate taxation of such high income will significantly increase revenues for the Indian government.

However, higher taxes are likely to adversely impact start-ups during their preliminary growth and expansion periods and thus hinder advancement. Companies will most likely pass on this part of the tax to consumers and/or end-users, through increased prices of commodities. The new amendments are also likely to cause double taxation and cash flow issues and also increase the compliance burden/costs for companies.

Way forward

  1. Avoidance of Double Taxation: India will need to enter into negotiations with home countries of digital giants conducting business in India to amend the DTAA treaties and develop a multilateral instrument (‘MLI’) as necessitated in Action Plan 15 of the BEPS Action Plan.
  2. Redefining Profit Attribution and PE: The definition of PE along with the profit attribution rules occurring under Articles 5 and 7 of most tax treaties will need to be amended to ensure a proper taxation framework for the digital economy.
  3. Doing Away of the Equalisation Levy: Being a flawed interim measure with undesirable side effects like the multiplicity of taxes, the concept of equalisation levy will have to bid adieu followed by the introduction of the new digital tax regime.
  4. Clarity on Value in “User Participation”: In accordance with the “user participation” proposal from the OECD Interim Report in 2018,  considering the increased weightage of user contribution in digital businesses, the adoption of ‘user base’ as an additional factor for the attribution of profits is highly advisable while avoiding subjectivity and conflicts between jurisdictions as to the international determination of “value” created by user participation. 

Conclusion

In light of the recent state of the world, the timing of amendment of international taxation is of utmost importance. With the COVID-19 outbreak, it may seem rash to impose more taxes on businesses already struggling to stay afloat. However, the world economies are in desperate need of revenues while e-commerce is flourishing due to limitations regarding physically stepping out and corporate work patterns are drastically shifting from the conventional models to remote methods of work. Hence, it is only fair that the emerging digital platforms immensely profiting from the current circumstances be taxed adequately to boost the revenue collections of the governments. Hence, with a view to capitalise on the changing working and buying patterns of people, this appears to be a step in the right direction at the right time.  

References

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