The ongoing deliberation around the taxation of the digital economy is the
unanimity of the tax regime, especially the amendments with respect to
Significant economic presence, needs to be re-evaluated and reshaped. The
Finance Act, 2018 enlarged the scope under the domestic law of the term
‘Business Connection’ to include a new nexus to tax benefit profits of
non-residents having Significant Economic Presence (commonly known as SEP) in
India. The said concept was raised by the Organisation for Economic Co-operation
and Development (OECD) discusses some key challenges that were proposed on their
final report on base erosion and profit shifting Action Plan 1.
failed to provide concrete solutions or recommendations for the governments to
act upon. Due to the recent advancements in the Information and Communication
Technology, the traditional international tax rules need to be reconceptualised.
The nuances in the Income Tax Act instigated the taxpayers to raise queries as
to how the Government is going to implement the new nexus.
To address the same,
the Task Force on the Digital Economy (TFDE) analysed and included alternatives
to the existing permanent establishment (PE) threshold based on a significant
. The current international tax regime was designed for a
brick and mortar economy and has failed to acclimate itself to the commercial
practices of the digital economy. The profits of digital businesses have been
augmenting perilously; however, there seem to be no commensurate tax laws to tax
such profits. It is high time for all countries to replenish their tax laws.
This research paper will critically explore the scope of §9(1)(i) explanation 2A
of Income Tax Act, 1961 and the legislative intent behind the same. In
furtherance, this paper will attempt to meticulously analyse the objectives,
scope, application, taxability, predicaments and lacunas involved along with the
situations that led to such a drastic change.
Taxation in Digital Economy: An Overview
Rules around the taxation of digital businesses have been nebulous as it is
universally accepted now that the historical rules on taxation fail to address
the eccentricity that characterise the digital economy. The growth and expansion
of the digital economy has brought unprecedented changes to the functional facet
of the traditional tax rules between source and resident countries. The
Information and Communication Technology has led to calamitous changes in the
manned businesses are conducted across the globe. Technological advancements and
cheaper innovations have widened the scope to unexposed populations.
means of performing business have perpetrated promptly that the Task Force on
Digital Economy (TFDE) of the Committee on Fiscal Affairs of the OECD has
commented in its report that the digital economy is becoming the economy itself.
The international taxation rules on the basis of which taxing rights are
earmarked under Double Taxation Avoidance Agreements for avoiding double
taxation. They are predominantly derived from the recommendations made by a
group of four economists appointed by the League of Nations in the 1920s, prior
to such new technological advancements were even conceptualized.
In the present digital aeon, the existing tax mechanism does not have the
relevant provisions to tax transactions by non-residents. Virtual professional
services to customers by foreign companies that is located in a market country
fail to pay income tax on the profits generated. Direct Tax is levied when the
incidence and impact fall on the same person i.e., tax is recouped directly from
Residents are taxed based on the income accrued worldwide while
non-residents are taxed only when the source of income is in India. These
concerns let to the adoption of Base Erosion & Profit Shifting (BEPS) Project by
G-20 and OECD to examine the loopholes in the existing international taxation
rules that empower the multinational enterprises to avoid taxes. Action 1 of the
BEPS Project of G-20 and OECD addressed the tax challenges of the digital
economy as the first of the fifteen actions that were outlined as part of the
project. There were three options discussed in the BEPS Report on Action
- Articulation of a new nexus in the form of significant economic
- A withholding tax on certain types of digital transactions; and
- Imposition of an equalization levy.
The current tax treaties impose tax on non-residents either on the basis of
profits that are attributable to permanent establishments as exemplified under
the treaty or by characterization of income as royalty / fees for technical
services. Per contra, taxation of online transactions where there is
non-requirement of physical presence is still in the nascent stage.
Characterization of income has been a contentious issue, when the applicability
of tax rates are different on different kind of incomes.
9 of the Act has been
widely classified into three categories i.e., business income, royalty and
fee for technical services that makes it applicable on non-residents and are
deemed to accrue or arise in India. Based on the heads of income, the tax rates
tend to differ. On one hand, if the income is royalty or fees for technical
services, then the rate of tax is 10% even if the non-resident does not have a
permanent establishment or a business connection in India. On the other, if it
is a business income, it is taxed at a rate of 40% only if the non-resident has
a permanent establishment in India. It is clear, there are substantial
differences in the tax treatment based on the characterization.
In a plethora of
cases, various judicial authorities had contradictory views with respect to the
nature of tax treatment in access data. In the case of DIT v. Morgan Stanley
, the Supreme Court, while dealing with the issues with respect to
permanent establishment, held that back office functions performed by the Indian
subsidiary were prefatory and ancillary in nature, and, therefore, did not
constitute a fixed place PE. The Court further held that if the foreign company
had appointed its employees to the Indian company to render stewardship
services, then no service PE would be constituted in India.
It would be pertinent to consider the judgment rendered on digital taxation by
the Bengaluru tribunal as it brought in a paradigm shift in the interpretation
of Service permanent establishment in India. In the case of, ABB FZ-LLC v.
DCIT, it was held that services of sharing or permitting to use special
knowledge provided by the assesse based in UAE, to ABB Limited in India would
constitute ‘royalty’ as per Article 12 of Double Taxation Avoidance Agreement (DTAA)
between India and UAE. Furthermore, the said income if not characterized as
royalty, it could be attributable to ‘Service PE’ as defined in Article 5(2) of
the India-UAE tax treaty.
It states that, a foreign company is deemed to have
its PE in India, if the foreign company renders services through its employees
or any other person for a period of 9 months or more in any 12 months period.
The ITAT held that the Service PE under the treaty is an independent clause and
the condition of having a fixed or permanent place of business in of Fixed Place
PE is not required to be met in case of Service PE. The ITAT further stated
that, the constitution of a Service PE under the treaty is not dependent on
whether the employees stayed in India for the threshold period, but upon the
fact that services or activities have been rendered/performed over a period of
more than 9 months within any 12 months period.
Taking into consideration the observations or the findings of the ITAT, it is of
paramount importance to note that for the constitution of a Service PE under
Article 5(2)(i) of the treaty, it is mandatory that services are furnished
through the employees or other personnel in the other contracting state
preposition ‘in’ connotes a physical location, for instance, in the house or in
the lake. In order to provide services in the host country, the presence of such
employees in that host country is essential. Such a presence could either be in
the form of the physical presence of the employees or if services have been
rendered by the employees offshore then through the non-resident’s fixed server
in India. The interpretation espoused by the ITAT seems dubious as it
broadens the scope of Service PE to incorporate every long-term cross-border
transaction whereby a non-resident renders services to a customer in the source
country beyond the stipulated threshold period as per the treaty.
Significant Economic Presence: A Brief
The principle of significant economic presence paves a way for the
jurisdictions, the right to tax businesses that have constant interaction with
their economies, even without any physical presence. §9 of the act deals
with Income deemed to accrue or arise in India
. The said provision was amended
for constituting ‘business connection’ in case of a non-resident in India. To be
clear, 9(1)(i) explanation 2A is read as follows:
(1) The following incomes shall be deemed to accrue or arise in India:
- all income accruing or arising, whether directly or indirectly, through
or from any business connection in India, or through or from any property in
India, or through or from any asset or source of income in India, or through
the transfer of a capital asset situate in India.
Explanation 2A - For 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,
- 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;
- Systematic and continuous soliciting of business activities or engaging in
interaction with such number of users as may be prescribed, in India through
Provided that the transaction 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:
At present, Article 5 of the Double Taxation Avoidance Agreements (tax
treaties) does not empower source countries to tax a foreign company’s profits
unless they are attributable to business activities. It states that the business
activities need to be carried on in the source country through a permanent
establishment (PE) i.e., through a fixed place of business (physical presence)
or through agents (representative presence).
Taxation of international digital transactions has been a convoluted issue. The
prime intention of the legislature to introduce this concept was to target
digital services and the digital goods but the intent seems to be missing in its
implementation. The reason is, internationally, significant economic presence
has been differentiated from significant digital presence. The latter relates
only with fully digitalized services whereas the former has a wide ambit to
include both digital as well as non-digital supplies of goods and services. The
provision has not been embodied in any tax treaty which India has entered to
date, and hence, it would have a limited impact.
Interpretation of §9(1)(I) Explanation 2A
There are few broadly worded terms in the provision such as systematic,
continuous, or soliciting
which are not defined in the Act. This might, in
turn, result in disparate interpretations and future litigation that would
create havoc. It is intelligible that some words need to be framed for proper
interpretation, however, the authorities must be circumspect that
interpretations of words shall be in accordance with the intention of the
Furthermore, the term ‘user’ has not been defined under the Act. A
user can comprise a click-based user, a subscriber, a viewer etc. It is
essential for the government to specify who will constitute as a user and what
level of engagement is needed in order to tax only a material user base that is
utilized for generating money for business. The concept of user must be taken
into consideration that it shall cater to all kinds of business models. Based on
the aforementioned analysis and interpretation, the provision of Significant
Economic Presence as introduced by the Income Tax Act, 1961 will need to be
amended to introduce greater transparency and objectivity in order to avoid
What was The Need to amend The Rule of Permanent Establishment?
The permanent establishment rule as explicated in Article 5 of the Model
Convention, has a robust normative infrastructure in international tax law.
The general meaning of the article is to demonstrate the right of one
contracting state (the source state) to tax the profits of an enterprise of
another contracting state (the resident state). As per the definition in
Article 5, the term ‘permanent establishment’ means ‘a fixed place of business
through which the business of an enterprise is wholly or partly carried on’.
The Commentary on Article 5 provides more transparency on its interpretation and
on the criteria for creating a PE, namely that:
- It must be a fixed place of business;
- It must be fixed with a certain degree of permanence; and
- The business of the enterprise must be carried on through the fixed
place of business.
It is a long-standing principle used by many countries as a minimum
threshold for source countries to tax business profits of foreign companies,
based upon entrenched theories, including the sourcing and benefit
theories. The PE rule has hitherto played a vital role in the appropriation
of taxing rights between the residence and source countries as it cannot be
adequately reconceptualised to acclimate to changing times.
The PE concept in tax treaties runs corresponding to the concept of ‘business
connection’ expounded in Explanation 2 of §9(1)(i) of the Act. According to
Explanation 2, business connection includes,
Any business activity carried out through a person who, acting on behalf of the
non-resident, habitually exercises an authority to conclude contracts on behalf
of the non-resident in India, or habitually maintains in India a stock of goods
or merchandise, or habitually secures orders in India for the non-resident.
In the case of CIT v. Vishakapatnam Port Trust
, a landmark decision
on the subject of Permanent Establishment
, the Andhra Pradesh High Court held that
The words Permanent Establishment postulate the existence of a substantial
element of an enduring or permanent nature of a foreign enterprise in another,
which can be attributed to a fixed place of business in that country. It should
be of such a nature that it would amount to a virtual projection of the foreign
enterprise of one country onto the soil of another country.
The scope of the term business connection
was widened in the Budget 2018 by
inserting a new Explanation 2A of §9(1)(i) of the Act, according to which a
non-resident shall be said to have a ‘business connection’ in India if the
non-resident has a ‘significant economic presence’ in India.
Business connection as a concept is based in the source theory of taxation to
justify the source country’s right to tax income arising from activities carried
in that country, provided certain prescribed nexus thresholds are satisfied. In
the case of ABB FZ-LLC v. Deputy Commissioner of Income Tax, the Court held
that application of a virtual PE does not require the non-resident company to
have physical presence in India.
However, the concept of Significant Economic Presence (SEP) further expands the
definition of business connection such that a non-resident would be deemed to
have a SEP in India if it carries out any of the following:
- 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.
Article 7 of the tax treaties signed by India with foreign tax jurisdictions
articulates that, business profits of a foreign company cannot be taxed in the
source country unless the foreign company carries on business activities in the
source country through a PE. As per Article 7(1) of the OECD Model Tax
Conventions and UN Model Tax Conventions,
Profits of an enterprise of a Contracting State shall be taxable only in that
State unless the enterprise carries on business in the other Contracting State
through a permanent establishment situated therein. If the enterprise carries on
business as aforesaid, the profits that are attributable to the permanent
establishment may be taxed in the other State.
It is to be noted that paragraph 6 of Article 7 lays down a rule of
interpretation in order to analyse the scope of application of the provision in
relation to the other Articles dealing with a specific category of income. The
said provision will only be applicable to business profits which do not belong
to categories of income camouflaged by the special Articles on dividends,
interest, royalties and other income which under paragraph 4 of Articles 10, 11
and 12 and paragraph 2 of Article 21.
Hence, it is clear that the Indian tax authorities are authorized under the tax
treaty to tax the business profits of a foreign enterprise only if it has a
permanent establishment in India. Majority of the tax treaties endorses for a
low withholding tax (generally 10%) on fees for technical services in the
absence of a PE in India. Such a tax is not imposed on business profits and is
dependent on whether the services rendered fall under the purview of fees for
This has been justified under the Explanation of §9(2) as:
For the removal of doubts, it is hereby declared that for the purposes of this
section, income of a non-resident shall be deemed to accrue or arise in India
under clause (v) or clause (vi) or clause (vii) of sub-section (1) and shall be
included in the total income of the non-resident, whether or not the
non-resident has rendered services in India.
One of the case that brought about a change was Google Ireland’s PE dispute with
the French Tax authority. Google Ireland’s USD 1.3 billion controversy with
the French tax authority is a case in point. The French Administrative Court in
Paris ruled, on a strict interpretation of Article 2 of the France-Ireland tax
treaty, that Google Ireland did not any ‘fixed place of business’ in France, nor
did it have dependent agent in France who was habitually concluding contracts on
its behalf with its French customers. The Court ruled that the kind of marketing
services that Google France provided to Google Ireland fell under the sector of
preparatory or auxiliary activities, which is outside the ambit of Article 2.
Furthermore, the Court bluntly pointed out that in order to accomplish the tax
authority’s desired purpose of taxing Google Ireland, the French Government must
amend the PE definition to target such an arrangement.
Alterations in Traditional PE Rule
The current PE model is comparatively easy to explain, hard to govern and can be
seen as insurmountable to be suggested as the long-term solution. The
traditional PE concept had to undergo some radical change that involves a
physical or representative presence as the nexus for source countries to tax
profits of a foreign entity. The factors that determine whether or not a foreign
enterprise has a fixed place of business in the source country are the character
of income, the duration of the activities, and the right to use a particular
In the case of Formula One World Championship v. Commissioner of
, it was held that the principal test, in order to ascertain
as to whether an establishment has a fixed place of business or not, is that
such physically located premises have to be at the disposal
of the enterprise. For
this purpose, it is not necessary that the premises are owned or even rented by
the enterprise. It will be sufficient if the premises are put at the disposal of
the enterprise. However, merely giving access to such a place to the enterprise
for the purposes of the project would not suffice. The place would be treated
as ‘at the disposal’ of the enterprise when the enterprise has right to use the
said place and has control thereupon.
The objective of the current PE threshold is to delineate when a foreign
enterprise can be said to have adequate nexus with the source country to
rationalize source-based taxation. The determining factor is, whether a foreign
enterprise administers income-producing business activities through some degree
of physical presence, either in the form of labour or property, in the source
According to Article 7 of the OECD’s Model Tax
Convention, companies can only be taxed at the state of residency if business is
conducted through a permanent establishment. However, this concept has been
outdated and is no longer valid due to the emanation of the digital economy.
Article 7 hypothesizes PE as a separate entity ascertaining risks, attributing
assets, identifying functions and then comparing transactions of PE to
transactions by unrelated parties and thus arriving at arms-length price for
The major issue that arose with respect to attribution of
profit is, if a server is considered as a PE, there may not be any personnel on
ground to perform functions and hence it would be difficult to calculate
functions performed and risk assumed by such server. Thus, alternative
methods had to be considered to attribute profits to digital PE.
A Permanent establishment’s factual and functional aspects are a prerequisite
for the evaluation of profit attribution. The following are the mandatory
requirements for PEs in India:
- Maintenance of books of accounts and other documents in accordance with
- Auditing of accounts by an accountant and a duly signed and verified
audit report obtained in the prescribed format before the due date of filing
the return of income.
- Taxation of profits attributable to a PE in India at the rate of 40%
(plus applicable surcharge and cess) on a net basis, subject to domestic tax
- Mandatory Permanent Account Number (PAN), Tax Deduction and Collection
Account Number (TAN) and Indirect Tax registrations.
- Filing of return of income in India.
- Deduction of expenses incurred, such as salary cost of employees, from
income attributable to a PE, subject to its compliance with Withholding Tax
provisions under domestic tax provisions.
- Mandatory compliance with Withholding Tax requirements – Withholding Tax
on payments made, filing of Withholding Tax returns, issue of tax
withholding certificates, etc.
- Payment of Indirect Tax and compliance with its related rules.
- Mandatory personal taxation of employees of foreign companies in India.
Profit attribution is a key consideration in developing nexus based on
significant economic presence. In the context of income/corporation tax, the
taxable base is equivalent to the total ‘business profits’, which can emanate
only when an economic good is sold to the customer. Article 7 has profound
meaning for allocation of taxing rights insofar as, the company taxation as well
as taxation of any other entrepreneurial profits are within its sphere.
elimination of Article 14, the only provision that dealt with taxation of
business profits irrespective of the manner in which they are derived has become
Article 7. Under Indian tax laws, if a non-resident has a business
connection in India, attribution of profits is only permissible on the part of
its income that is ‘reasonably attributable’ to its operations in the country.
In order to determine the appropriate level of profits to be attributed to the
PE, a methodology for attribution of profit has been provided in the Income-tax
rules. As per Rule 10 of the Income Tax Rules, 1962, a profit rate can be
applied to India specific turnover of the foreign company for ascertaining
profits attributable to operations carried out in India.
The concept is
analogous to the Global Formulary Apportionment (GFA) approach, which recommends
allocation of global profits earned by the taxpayers to various countries, based
on financial parameters including the turnover and asset bases of taxpayers,
compared to transaction pricing-based allocation. The OECD eliminates the
GFA as being contrary to the arm’s length price, which is based on global
transfer pricing principles.
In the case of DIT v. Morgan Stanley & Co
., the court has clearly held that
attribution of profit will be based on the principles of transfer pricing.
However, there have been several decisions in India, where courts have
attributed profits to PE in an ad hoc manner.
BEPS Action Plan 7 analysed the definition of PE with a view to curb avoidance
of payment of tax by circumventing the current definition of PE definition by
way of commissionaire arrangements or fragmentation of business activities. The
action plan recommended modifications to paragraph (5) of Article 5 to provide
that an agent would include not only a person who habitually concludes contracts
on behalf of the non-resident but also a person who habitually plays a principal
role leading to the conclusion of contracts.
It also recommends the introduction of anti-fragmentation rule in order to
prevent the taxpayer from resorting to fragmentation of functions which are
otherwise a whole activity. The main intention of this rule was to prevent the
use of Article 5(4) to split up the business activities carried on by the same
enterprise or closely related enterprises in the same country into smaller
pieces that would not meet the PE threshold as per the said provision. This
would be exempt because they would be considered to be of preparatory or
auxiliary in nature. The underlying objective behind this provision are:
- An enterprise should not fragment complementary functions that
constitute cohesive business operations; and
- An enterprise should not fragment complementary functions that
constitute cohesive business operations between related parties or in
multiple places of business in a country.
As aforementioned, India’s tax treaties ostracize certain activities from the
ambit of PE because they are preparatory or auxiliary in nature. Article 5(4)
explicates the activities that are excluded from permanent establishment.
provision is read as follows:-
Notwithstanding the preceding provisions of this Article, the term permanent
establishment shall be deemed not to include:
- The use of facilities solely for the purpose of storage, display or
delivery of goods or merchandise belonging to the enterprise;
- The maintenance of a stock of goods or merchandise belonging to the
enterprise solely for the purpose of storage, display or delivery;
- The maintenance of a stock of goods or merchandise belonging to the
enterprise solely for the purpose of processing by another enterprise;
- The maintenance of a fixed place of business solely for the purpose of
purchasing goods or merchandise or of collecting information, for the
- The maintenance of a fixed place of business solely for the purpose of
carrying on, for the enterprise, any other activity;
- The maintenance of a fixed place of business solely for any combination
of activities mentioned in subparagraphs a) to e),
provided that such activity or, in the case of subparagraph f), the overall
activity of the foxed place of business, is of a preparatory or auxiliary
The term ‘preparatory or auxiliary’ has not been defined in the OECD’s Model Tax
Convention or UN’s Model Tax Convention or its commentaries. The Indian
Judiciary in the case of UAE Exchange Centre Limited v. Union of India, the
Delhi High Court held that the term auxiliary
denotes air or support.
Furthermore, in the case of BKI/HAM V.O.F. v. ACIT, the Delhi Tax Tribunal
was of the opinion that the term ‘auxiliary’ meant ‘subsidiary or ancillary’.
Place of Business Test
A distinguishing feature of the PE for source-taxation based on the enterprise’s
trade or business is the requirement of a ‘fixed place of business’. Article
5(1) of the UN Model defines the term PE accentuating its essential nature
as ‘fixed place of business’ with a specific ‘situs’. There is no definition of
‘fixed place of business’ in the UN Model Convention.
However, the test is designed of three elements:
- The existence of a ‘place of business’, i.e., a facility such as
premises or, in certain instances, machinery or equipment;
- This place of business must be ‘fixed’, i.e., it must be established at
a distinct place with a certain degree of permanence; and
- The carrying on of the business of the enterprise through this fixed
place of business. This means usually that persons (personnel) not
‘independent’ of the enterprise conduct its business in the State in which
the fixed place is situated.
According to the UN’s ‘Commentaries on the Articles of the United Nations Model
Double Taxation Convention between Developed and Developing Countries’ (UN’s
Commentary) and the OECD’s ‘Commentaries on the Model Tax Convention, 2010’
(OECD’s Commentary), it is considered that a PE has been constituted in a
country, even without the formal presence of the foreign company in it.
the company should have some space at its disposal. The Indian Judiciary has
stated that for a place of business to be at the disposal of a foreign country
in India, it is essential for such a company to have a certain degree of control
over the premise or space in the country, so that it has unrestricted access to
it and can use it, based on its requirements, to undertake its business
activities in India. In the case of E-Funds IT Solution, the Delhi
High Court held that a subsidiary cannot be deemed to be a PE of a foreign
company if the Disposal Test is not satisfied.
One of the interesting developments that caught the attention of the experts is
the Judgment of the Delhi High Court in the case of the World Wrestling
Entertainment, Inc. (WWE) v. M/s Reshma Collection & Ors., wherein it was
held that the ‘availability of transactions through the website at a particular
place is virtually the same thing as a seller having shops in that place in the
physical world’. Relying on the principles laid down by the Supreme Court in Dhodha
House v. S.K. Maingi,
 the Court observed that the condition of carries on
business in Delhi’ was satisfied since appellant’s customers were located in
Delhi, accessed the website in Delhi, communicated their acceptance to the offer
of merchandise advertised on the website, at Delhi, and received the merchandise
in Delhi, even though the server for the appellant’s website was not located in
Reason behind adopting The Concept of Equalization Levy
Action Plan 1 undertaken by the Task Force of Digital Economy had analysed and
developed possible options that can be adopted for addressing the tax challenges
wherein Equalization levy was one of them. It acknowledged that new business
models created new tax challenges in terms of nexus, characterization and
valuation of data and user contribution
 and that ‘the application of a
withholding tax on digital transactions could be considered as a tool to enforce
compliance with net taxation based on this potential new nexus, while an
equalization levy could be considered as an alternative to overcome the
difficulties raised by the attribution of income to the new nexus’.
The Indian tax authorities have been striving hard to tax the incomes of online
search engine advertisement service providers such as Google and Yahoo for time
immemorial. The word equalization
represents the intention of ensuring tax
neutrality between different businesses conducted through different business
models or residing within or outside the taxing jurisdiction. This levy explores
to bring the foreign enterprises that earn significant income from a
jurisdiction that corrodes its tax base. Chapter VIII of the Finance Act,
2016 introduced the concept of equalization levy on consideration for specified
services to be paid to non-residents.
The levy was brought to light after the CBCT Committee issued a report proposing the same. It is to be imposed with
the object of equalizing the tax burden, by imposing it on payments made to
beneficial foreign owners for providing digital services who enjoy an unfair
advantage over Indian competitors who provide similar service.
Levy is an example of unilateral measures undertaken by the Government of India
to tax multinational companies operating in the digital economy which do not
have any physical presence in India. Section 165 of the Finance Act, 2016 is the
charging section wherein equalization levy is charged at 6% on consideration
received or receivable for any specified services. These ‘specified
services’ has been defined to include ‘online advertisement, any provision for
digital advertising space or any other facility or service for the purpose of
online advertisement. The Government of India, however, is empowered to enlarge
the scope of the ‘specialized services’ by way of notification.
The Act provides
three scenarios where equalization levy shall not be charged, namely:
- Where the non-resident providing specialized service has a permanent
establishment in India and such service has nexus with such establishment;
- Where the aggregate amount of consideration received by the non-resident
does not exceed one lakh rupees; or
- Where the payment for the specified purpose is not for carrying out
business or profession.
The Indian Committee has recommended imposition of the equalization levy on the
consideration for the following types of services:
- Online advertising or any service, rights or use of software for online
advertising, including advertising on radio and television;
- Digital advertising space;
- Designing, creating, hosting or maintenance of a website;
- Digital space for website, advertising, e-mails, online computing, blogs,
online content, online data or any other online facility;
- Any provision, facility or service for uploading, storing or
distribution of digital content;
- Online collection of processing of data related to online users in
- Any facility or service for online sale of goods or services or
collecting online payments;
- Development or maintenance of participative online networks;
- Use or right to use or download online music, online movies, online
games, online books or online software, without the right to make and
distribute any copies thereof;
- Online News, online search, online maps or global positioning system
- Online software applications accessed or downloaded through Internet or
- Online software computing facility of any kind for any purpose; and
- Reimbursement of expenses of a nature that are included in any of the
The imposition of equalization levy poses an immense risk for businesses in the
digital realm, especially when the market for online advertising is growing
excessively in India. Equalization Levy has been deliberately kept outside
the scope of India’s Income tax regime and consequently, the government has
taken the position that tax treaty relief should not be available.
conformity from foreign enterprises to the requirement of 6% equalisation levy,
the Finance Bill proposed that such income will be exempt in the hands of the
non-resident under the newly introduced Section 10(50) of the Income tax Act,
1961 in order to avoid double taxation of income which has been subject to an
equalization levy. The outcome is that e-commerce entities, which initially
wanted to evade tax, now end up paying more than what they would pay had they
had a permanent establishment in India.
This created chaos wherein, according to
many media reports a plethora of foreign e-commence enterprises, such as Facebook are considering to open a place of permanent establishment in Indian
Territory. This on the other hand escalates the revenue of the Government, and
at the same time paves the way for several companies to establish a permanent
establishment in India, which emphatically impacts the Indian economy. In
fact, ‘the revenue accrued for the Government exchequer through levy amounts the
equalization levy amounts to INR 1.46 billion from June 1, 2016, to December 3,
The objective of the levy makes a dubious generalization that all foreign
enterprises that operate without permanent establishment in India experience an
unfair tax advantage. In this regard, it is opined that there are tax
jurisdictions which impose an equal rate of tax as India does, if not greater.
For instance, German companies are liable to pay tax at a rate of over 30% in
their resident state, while the United States levies a combined tax rate of 35%
on the business of companies.
Presently, the controversy that arose was whether
or not the equalization levy is a ‘tax covered’ in a tax treaty. Various reports
must, therefore, be read holistically so as to reach at an infallible solution
to tax income accruing online. On excavating the judicial trends on the subject,
it could be perceived that, beginning from Azadi Bachao Andolan, the
judiciary has laid down the law ostensibly insofar as it divulges the treaty
obligations. A tax treaty shall triumph over a domestic law and govern the
taxpayer to such extent as it is beneficial. It has been proffered that any
attempt to evade treaty obligations is impermissible and reprehensible. Siemens
Aktionesellschaft,is an authority on the specific point that no Contracting
State can tax income which is not otherwise subjected to tax by effectuating a
unilateral modifications to the tax treaty.
In Sumitomo Mitsui Banking
Corporation v. Dy. Director of Income-tax
, the court noted, If there is an
express provision made in the convention giving benefit to the assessee which is
contrary to the domestic law, then the provisions of treaty can be relied upon
which shall override and prevail over the provisions of the domestic law to give
any benefit expressly given to the assessee under the treaty. This view has
been fully supported by the Hon’ble Supreme Court in the case of Azado Bacho
In furtherance, in the case of Reuters Transaction Services
Ltd. v. DDIT,
 the law has been laid down with precision that when a
particular income was not taxable in the source state, no unilateral amendment
could validate and subject the same to tax.
In Deputy Commissioner of Income Tax
v. Mustaq Ahmad Vakil
, the Tribunal had an opportunity to venture into the
aspect of ‘double taxation’. It held that a tax treaty aimed at preventing not
only double taxation present, but also potential and prospective double
taxation. With the point formulated by a plethora of judgments delivered by the
lower judiciary, one has to stay put in anticipation for the position the Apex
Court will declare. In the light of the aforementioned aspects, it would be
appropriate to conclude that alterations in tax treaties would be the legitimate
and a secure way forward.
Constitutional Validity of Equalization Levy
Equalization Levy was implemented by the Central Government in 2016 prior to the
enforcement of Goods and Services Tax (GST). The specified services enlisted in
the Finance Act brought under the ambit of equalization levy mainly comprises of
services with respect to an online advertisement. It is clear that any law
passed by the Parliament must be tested the constitutionality so passed by the
Houses, which would obligate one to evaluate what the term ‘specified
services’ would entail.
The Centre’s power to tax income is determined from
Entry 82 of List I read with Article 245 and 246 of the Indian Constitution. The
levy clearly does not fall under the purview of income tax. As Equalization Levy
is a separate chapter in the Finance Act, 2016, one can ascertain that the
Parliament has drawn its power to impose the levy under Entry 97 of List
I, which is a residuary entry. This understanding is pivotal as it formulates
how the government has tried to tax foreign income without resorting to
negotiations of tax agreements.
In furtherance, the Indian Committee observed that, ‘the Base Erosion Profit
Shifting Report conceptualizes Equalization Levy as a tax that is different from
the Corporate Income Tax, and thus the same may not necessarily by subjected to
the limitations of the tax treaties. Such a tax on the gross amount of payment,
would thus be very similar to the second option of withholding tax, except that
it, not being a tax on income, would not be covered by the obligations of tax
treaties, and hence can be levied under domestic laws, even without changes in
the tax treaties’.
At present, incomes of foreign enterprises – regardless of whether they are
ascribable to permanent establishment or not – are taxed. The tax introduced
through Chapter VIII of the Finance Act, 2016, in spite of giving the impact of
being Machiavellian, is in actuality not so and only manifests the bona
fide intent of the Government to circumvent the impediments in the form of
specific provisions of Double Taxation Avoidance Agreement (DTAA) treaties
placed in the path of the government to tax incomes of a sophisticated nature.
Emergence of Double Taxation As Per Domestic Laws
According to Section 7 of the Integrated Goods and Service Tax Act, 2017 (IGST
Act), ‘supply of services imported into territory of India is to be treated as
supply of service in the course of interstate trade or commerce and is
chargeable under IGST Act. Furthermore, as per IGST Act, for online
information and data retrieval services (OIDAR services), the place of supply
will be the location of the recipient of services. As per Section 2(17) of
the IGST Act, OIDAR services means services that are provided through the
internet with minimal human intervention and includes electronic services such
as advertising on the internet etc. The liability to pay GST is on the
recipient in India of he/she is a registered entity under GST in cases where the
supplier of such service is located outside India. It is a well-entrenched
that to constitute double taxation, taxes must be levied on the same property or
subject matter, by the same Government or authority, during the same taxing
period and for the same purpose.
Based on the above facts and circumstances
that are prevailing, IGST and Equalization Levy are both levied on online
advertisement services despite the fact that the purpose of the levy is
different for both the taxes. On one hand, Equalization Levy is imposed with the
object of equalizing the tax burden, by imposing the levy on payments made to
beneficial foreign owners for providing digital services who enjoy an unfair
advantage over Indian competitors who provide similar services. On the
other, the purpose to levy IGST is to collect tax on inter-state supply of goods
or services or both which includes import of services. This could be one of the
controversy wherein by stating the abovementioned contentions one can enunciate
that it does not amount to double taxation.
Another controversy that may be raised is that the levy of both IGST and
Equalization Levy amounts to double taxation as both the subject matter is same.
To be specific, both IGST and Equalization levy are charged on supply of online
advertisement services provided by non-resident. It is pertinent to note that
there is zero or no provision in the Indian Constitution that expressly or
impliedly bars double taxation. In the case of Kerala Colour Lab. Association v.
Union of India
, the Kerala High Court upheld that unless the Constitution
expressly or impliedly forbids double taxations, and as long as the statute is
within the competence of legislature, double taxation cannot be a ground for
invalidating a fiscal statute. Thus, equalization levy and IGST has to be
examined based on the factors such as economic effects, compliance costs,
administrative convenience and effects on economic efficiency.
Conclusion- Is It A Revolution or Reverberation
The concept of Significant Economic Presence and the changes that were brought
to light in the Income Tax Act is a pious effort of the Indian Government which
seem to be influenced by the recommendations of Action Plan 1 and 5 of the
OECD-G20 BEPS Project. However, the author believes that it has been introduced
in haste, whereas only a meticulous and comprehensive approach would help
further the objective of Significant Economic Presence and Permanent
A more competent and efficient way to deal with such enterprises
would be to amend the domestic tax law and correspondingly amend the treaties
through consequent protocols or putting in place a multilateral instrument to
ensure proper implementation of the same. It is pertinent to mention that the
Indian Government should first try and put its own house in order before
marching towards the non-residents.
Statutes, Notifications & Circulars Referred
||CIT v. Ahmedabad Manufacturing and Calico
|| 139 ITR 806 (Guj)
||Ebay International AG v. Deputy Director of
Income Tax (IT).
||Range-3(2),  61 SOT 62 (Mum)
||In Re: Dun and Bradstreet Espana, S.A.
||(2005) 193 CTR (AAR) 9
||CIT v. Wipro Limited.
|| 355 ITR 284 (KAR)
||In Re Cargo Community.
||(2007)208 CTR (AAR) 184
||DIT v. Morgan Stanley & Co.
|| 162 Taxman 165 (SC)
||ABB FZ-LLC v. DCIT.
||Income Tax Officer v. Right Florists.
|| 25 ITR(T) 639 (Kol. – Trib.)
||CIT v. Vishakhapatnam Port Trust.
||[(1983), 144-ITR-146 (AP)]
||ABB FZ-LLC v. Deputy Commissioner of Income Tax.
||(IT(TP)A.1103/Bang/2013 & 304/Bang/2015
||McCulloch v. Maryland.
||17 U.S. 316 (1819)
||Formula One World Championship v.
Commissioner of Income Tax.
||(2017) 394 ITR 80 (SC)
||Rolls Royce Plc v DDIT.
||(2008) 113 TTJ (Delhi)
||UAE Exchange Centre Ltd. v. UOI.
|| 313 ITR 94 (Del)
||BKI/HAM V.O.F. v. ACIT.
|| 79 TTJ 480 (Del)
||DIT v. E-Funds IT Solution and Ors.
|| 364 ITR 256 (Delhi)
||World Wrestling Entertainment, Inc. (WWE) v.
M/s Reshma Collection & Ors.
||2014 ( 60 ) PTC 452 ( Del )
||Dhodha House v. S. K. Maingi.
||2006 (9) SCC 41
||Formula One World Championship Ltd.
||E-Funds IT Solution.
||(Del HC) (2014)
||Adobe Systems Incorporated.
||(Del HC) (2016)
||Airlines Rotables Ltd.
||(Mum ITAT) (2011)
||(Del ITAT)(SB) (2005)
||GE Energy Parts Inc.
||(Del ITAT) (2017)
||Union of India v. Azadi Bachao Andolan.
||(2003) 184 CTR (SC) 450
||CIT v. Siemens Aktiongesellschaft.
||310 ITR 320 (Bom.)
||Sumitomo Mitsui Banking Corporation v. Dy.
Director of Income-tax.
||ITA No. 5402/Mum/2006
||Reuters Transaction Services Ltd. v. DDIT.
||ITA Nos. 6947 and 7211/Mum/2012
||Deputy Commissioner of Income Tax v. Mustaq
||ITA No. 1531/Del/2011
||Krishna Das v. Town Area Committee, Chigaon.
||AIR 1991 SC 2096
||Kerala Colour Lab. Association vs. Union of
||2003 264 ITR 633 Ker
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- The Income Tax Rules, 1962
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