Significant Economic Presence In Explanation 2A of Section 9(1)(I) of The Income Tax Act, 1961
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.
However, it 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 economic presence. 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.
The digital 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 the assesse.
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.[1] There were three options discussed in the BEPS Report on Action 1:
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[2], royalty[3] and fee for technical services[4] 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.[5] In the case of DIT v. Morgan Stanley & Co.,[6] 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[7], 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.
The 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.[8] 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.
(1) The following incomes shall be deemed to accrue or arise in India:
(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).[10]
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.
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 future litigation.
It is a long-standing principle[15] 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.[16] 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[17],
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,[18] 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.[19]
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,[20] 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:[21]
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[22],
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.[23]
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 technical services.
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.[24] 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.[25]
In the case of Formula One World Championship v. Commissioner of Income Tax,[26] 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 country.[27]
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 such transactions.[28]
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.[29] 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:
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.[30]
Post 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.[31] 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.[32] 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.[33] The OECD eliminates the GFA as being contrary to the arm’s length price[34], which is based on global transfer pricing principles.
In the case of DIT v. Morgan Stanley & Co.,[35] 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.[36]
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.[37]
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.[38] This would be exempt because they would be considered to be of preparatory or auxiliary in nature. The underlying objective behind this provision are:
Notwithstanding the preceding provisions of this Article, the term permanent establishment shall be deemed not to include:
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 character.
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,[39] 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,[40] the Delhi Tax Tribunal was of the opinion that the term ‘auxiliary’ meant ‘subsidiary or ancillary’.
However, the test is designed of three elements:
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.
However, 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.[41] 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.[42]
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.,[43] 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,[44] 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 Delhi.
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.[47] 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.[48] 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.[49]
Equalization 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:
To ensure 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, 2016’.[51]
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,[52] 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,[53]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,[54] 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 Andolan (supra).
In furtherance, in the case of Reuters Transaction Services Ltd. v. DDIT,[55] 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,[56] 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.
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’.[57]
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.
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.[63] 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,[64] 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.[65]
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 establishment.
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.
Bibliography
Cases Referred
Statutes, Notifications & Circulars Referred
Books Referred
However, it 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 economic presence. 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.The digital 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 the assesse.
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.[1] There were three options discussed in the BEPS Report on Action 1:
- Articulation of a new nexus in the form of significant economic presence;
- 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[2], royalty[3] and fee for technical services[4] 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.[5] In the case of DIT v. Morgan Stanley & Co.,[6] 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[7], 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.
The 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.[8] 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[9]:(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, shall mean-
- 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
- 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 transaction or activities shall constitute significant economic presence in India, whether or not:
(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).[10]
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 legislation.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 future litigation.
What was The Need to amend The Rule of Permanent Establishment?
The permanent establishment rule as explicated in Article 5 of the Model Convention,[11] 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).[12] 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’.[13] The Commentary on Article 5 provides more transparency on its interpretation and on the criteria for creating a PE,[14] 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[15] 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.[16] 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[17],
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,[18] 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.[19]
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,[20] 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:[21]
- 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[22],
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.[23]
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 technical services.
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.[24] 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.[25]
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 location.In the case of Formula One World Championship v. Commissioner of Income Tax,[26] 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 country.[27]
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 such transactions.[28]
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.[29] 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 the provisions.
- 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 provisions.
- 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.[30]
Post 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.[31] 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.[32] 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.[33] The OECD eliminates the GFA as being contrary to the arm’s length price[34], which is based on global transfer pricing principles.
In the case of DIT v. Morgan Stanley & Co.,[35] 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.[36]
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.[37]
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.[38] 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.
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 enterprise;
- 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 character.
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,[39] 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,[40] 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.
However, 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.[41] 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.[42]
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.,[43] 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,[44] 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 Delhi.
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[45] 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’.[46]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.[47] 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.[48] 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.[49]
Equalization 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 India;
- 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 applications;
- Online software applications accessed or downloaded through Internet or telecommunication networks;
- Online software computing facility of any kind for any purpose; and
- Reimbursement of expenses of a nature that are included in any of the above.
To ensure 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, 2016’.[51]
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,[52] 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,[53]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,[54] 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 Andolan (supra).
In furtherance, in the case of Reuters Transaction Services Ltd. v. DDIT,[55] 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,[56] 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’.[57]
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.[58] 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.[59] 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.[60] 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.[61] 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.[62]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.[63] 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,[64] 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.[65]
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 establishment.
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.
Bibliography
Cases Referred
| SL.No | CASE | CITATION |
| 1 | CIT v. Ahmedabad Manufacturing and Calico Printing Co. | [1983] 139 ITR 806 (Guj) |
| 2 | Ebay International AG v. Deputy Director of Income Tax (IT). | Range-3(2), [2014] 61 SOT 62 (Mum) |
| 3 | In Re: Dun and Bradstreet Espana, S.A. | (2005) 193 CTR (AAR) 9 |
| 4 | CIT v. Wipro Limited. | [2013] 355 ITR 284 (KAR) |
| 5 | In Re Cargo Community. | (2007)208 CTR (AAR) 184 |
| 6 | DIT v. Morgan Stanley & Co. | [2007] 162 Taxman 165 (SC) |
| 7 | ABB FZ-LLC v. DCIT. | IT(TP) A.2102/Bang/2016 |
| 8 | Income Tax Officer v. Right Florists. | [2013] 25 ITR(T) 639 (Kol. – Trib.) |
| 9 | CIT v. Vishakhapatnam Port Trust. | [(1983), 144-ITR-146 (AP)] |
| 10 | ABB FZ-LLC v. Deputy Commissioner of Income Tax. | (IT(TP)A.1103/Bang/2013 & 304/Bang/2015 |
| 11 | McCulloch v. Maryland. | 17 U.S. 316 (1819) |
| 12 | Formula One World Championship v. Commissioner of Income Tax. | (2017) 394 ITR 80 (SC) |
| 13 | Rolls Royce Plc v DDIT. | (2008) 113 TTJ (Delhi) |
| 14 | UAE Exchange Centre Ltd. v. UOI. | [2009] 313 ITR 94 (Del) |
| 15 | BKI/HAM V.O.F. v. ACIT. | [2001] 79 TTJ 480 (Del) |
| 16 | DIT v. E-Funds IT Solution and Ors. | [2014] 364 ITR 256 (Delhi) |
| 17 | World Wrestling Entertainment, Inc. (WWE) v. M/s Reshma Collection & Ors. | 2014 ( 60 ) PTC 452 ( Del ) |
| 18 | Dhodha House v. S. K. Maingi. | 2006 (9) SCC 41 |
| 19 | Formula One World Championship Ltd. | (SC) (2017) |
| 20 | E-Funds IT Solution. | (Del HC) (2014) |
| 21 | Adobe Systems Incorporated. | (Del HC) (2016) |
| 22 | Airlines Rotables Ltd. | (Mum ITAT) (2011) |
| 23 | Motorola Inc. | (Del ITAT)(SB) (2005) |
| 24 | GE Energy Parts Inc. | (Del ITAT) (2017) |
| 25 | Union of India v. Azadi Bachao Andolan. | (2003) 184 CTR (SC) 450 |
| 26 | CIT v. Siemens Aktiongesellschaft. | 310 ITR 320 (Bom.) |
| 27 | Sumitomo Mitsui Banking Corporation v. Dy. Director of Income-tax. | ITA No. 5402/Mum/2006 |
| 28 | Reuters Transaction Services Ltd. v. DDIT. | ITA Nos. 6947 and 7211/Mum/2012 |
| 29 | Deputy Commissioner of Income Tax v. Mustaq Ahmad Vakil. | ITA No. 1531/Del/2011 |
| 30 | Krishna Das v. Town Area Committee, Chigaon. | AIR 1991 SC 2096 |
| 31 | Kerala Colour Lab. Association vs. Union of India (UOI). | 2003 264 ITR 633 Ker |
Statutes, Notifications & Circulars Referred
- The Constitution of India, 1949
- The Income Tax Act, 1961
- The Income Tax Rules, 1962
- The Companies Act, 2013
- The Finance Act, 2016
Books Referred
- Arvind P. Datar, Kanga and Palkhivala’s The Law and Practice of Income Tax, 10th edition, LexisNexis, New Delhi, 2014
- Durga Das Basu, Commentary on the Constitution of India, Lexis Nexis, 9th edition, 2014
- Justice G.P. Singh, Principles of Statutory Interpretation, Lexis Nexis, India, 12th edition,2010
- Sampath Iyengar, Law of Income Tax, Bharat Law House, New Delhi, 10th edition, 2010
- T.N.Manoharan& G.R. Hari, Direct Tax Laws, Snow White, 2015
- Manupatra Online Resources
- SCC Online
- Taxmann
- ITAT Online
- CDJ Law Journal
- Income Tax Department
- Tax Sutra
- Nishith Desai Associates
- Pricewater Coopers
- SAPR Associates
- Mondaq
- Indian Kanoon
- Lexis India
- Tax Guru
- IndiaCorpLaw
- The OECD/G20 Base Erosion and Profit Shifting Project, Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, October 2015,
- 9(1)(i), The Income Tax Act, 1961.
- 9(1)(vi) Explanation 2, The Income Tax Act, 1961. Further, Royalty is the sum payable for right to use someone else’s property/asset for the purpose of gain as given in CIT v. Ahmedabad Manufacturing and Calico Printing Co., [1983] 139 ITR 806 (Guj).
- 9(1)(vii) Explanation 2, The Income Tax Act, 1961.
- Ebay International AG v. Deputy Director of Income Tax (IT), Range-3(2), [2014] 61 SOT 62 (Mum). In Re: Dun and Bradstreet Espana, S.A., (2005) 193 CTR (AAR) 9. CIT v. Wipro Limited, [2013] 355 ITR 284 (KAR). In Re Cargo Community, (2007)208 CTR (AAR) 184.
- DIT v. Morgan Stanley & Co., [2007] 162 Taxman 165 (SC).
- ABB FZ-LLC v. DCIT, IT(TP) A.2102/Bang/2016.
- Income Tax Officer v. Right Florists, [2013] 25 ITR(T) 639 (Kol. – Trib.)
- 9(1)(i) Explanation 2A, The Income Tax Act, 1961.
- See OECD Model Tax Conventions & UN Model Tax Conventions, Art. 5.
- Supra note 2.
- OECD Model Tax Convention on Income and on Capital: Commentary on Article 5 para. 1 (15 July 2014), Models IBFD.
- Art. 5, para. 1 OECD Model.
- Para. 2 OECD Model: Commentary on Article 5 (2014).
- The first time the PE concept was used in a bilateral treaty was back in
1899 in a treaty concluded between
Austrio-Hungary and Prussia. - See D. Pinto, E-Commerce and Source-Based Income Taxation (2003).
- 9(1)(i) Explanation 2, The Income Tax Act, 1961.
- CIT v. Vishakhapatnam Port Trust [(1983), 144-ITR-146 (AP)]
- Supra note 1.
- ABB FZ-LLC v. Deputy Commissioner of Income Tax (IT(TP)A.1103/Bang/2013 & 304/Bang/2015
- The Finance Bill, 2018 (1 Feb 2018), Bill No. 4 of 2018
- Article 7(1) of the OECD Model Tax Conventions & UN Model Tax Conventions.
- McCulloch v. Maryland, 17 U.S. 316 (1819) per Marshall, C.J.:
All subjects over which the sovereign power of a state extends, are, objects of taxation; but those over which it does not extend, are upon the soundest principles, exempt from taxation. This proposition may almost be pronounced self-evident. - Press Release, PARIS ADMINISTRATIVE TRIBUNAL, July 12, 2017, available at http://paris.tribunal- administratif.fr/Actualites-du-Tribunal/Communiques-de-presse/La-societe-irlandaise-Google-Ireland-Limited- GIL-n-est-pas-imposable-en-France-sur-la-periode-de-2005-a-2010.
- See Jonathan Schwarz, Permanent Establishment: La Lutte Continue, Kluwer International Tax Blog, available at http://kluwertaxblog.com/2017/07/24/permanent-establishment-la-lutte-continue/
- Formula One World Championship v. Commissioner of Income Tax, (2017) 394 ITR 80 (SC).
- Report of the Technical Advisory Group on Monitoring the Application of Existing Treaty Norms for Taxing Business Profits, Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce, available at http://www.oecd.org/tax/treaties/35869032.pdf
- 7Radhakishan Rawal, The Taxation of PEs: An International Perspective, (2ndedn, Spirasmus Press Ltd, 2006).
- Lina Spinosa & Vikram Chand, ‘A Long-Term Solution for Taxing Digital Business Models: Should the Permanent Establishment Definition be Modified to Resolve the Issue or Should the Focus be on a Shared Taxing Rights Mechanism?’ (2018) 46 Intertax, 6/7, 476-494.
- Klaus Vogel, vol. 1, p 501.
- OECD Comm on article 7 para 77
- Rule 10 of the Income Tax rules
- Morse, Susan. (2010). Revisiting Global Formulary Apportionment. Susan Cleary Morse
- Section 92F of Income Tax Act, 1961, "arm's length price" means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions
- Supra note 7
- For instance, Chand Mills Ltd v CIT (1976) 103 ITR 548 (SC) - (15 % of profits), Rolls Royce Plc v DDIT (2008) 113 TTJ (Delhi) 446- (35% of Global Profits) , Motorola Inc v DCIT (2005) 95 ITD 269 (Delhi) (SB) - (20% of Global Profits), Galileo International Inc v DCIT (2009) 116 ITD 1(Delhi) - (15% of Revenue).
- Article 5, Paragraph 5 of the Model Convention
- OECD, Action 7 Final Report, supra n. 25, at sec. B-2 (New Anti-Fragmentation Rule), 4.1, p. 39.
- UAE Exchange Centre Ltd. v. UOI, [2009] 313 ITR 94 (Del)
- BKI/HAM V.O.F. v. ACIT, [2001] 79 TTJ 480 (Del).
- Formula One World Championship Ltd. (SC) (2017); E-Funds IT Solution (Del HC) (2014); Adobe Systems Incorporated (Del HC) (2016); Airlines Rotables Ltd (Mum ITAT) (2011); Motorola Inc. (Del ITAT)(SB) (2005); Rolls Royce Plc (Delhi ITAT) (2009); GE Energy Parts Inc.(Del ITAT) (2017).
- DIT v. E-Funds IT Solution and Ors, [2014] 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.
- Report of the Committee on Taxation of E-Commerce, Proposal for Equalisation Levy on Specified Transactions (Feb. 2016).
- OECD, BROADER DIRECT TAX CHALLENGES RAISED BY THE DIGITAL ECONOMY AND THE OPTIONS TO ADDRESS THEM, p.7.6 (2015).
- The base erosion can take place either directly in a straight forward manner, by claim of deduction in respect of payments y businesses in B2B transactions, and indirectly by reducing the resources available for the domestic suppliers of goods and services.
- Report of CBDT Committee on Taxation of E-Commerce, February, 2016 (eCommerce Committee Report).
- Proposal for Equalization Levy on Specified Transactions, Report of the Committee on the Taxation of E-Commerce (February, 2016) 41 [65] available at
- Online advertising constituted 12.7 of the total spending onadvertisements in 2016. Also, India’s digital advertisementmarket is expected to grow at a CAGR of 33.5%. See KPMG/ Confederation of Indian Industry (CII), Digital, the New Normal of Marketing (January 2017), p. 8. Available at: https://assets.kpmg.com/content/dam/kpmg/in/pdf/2017/01/Digital-the-new-normal-marketing.pdf
- Lorys Charalambous, Indian Equalisation Levy Implementation Successful, http://www.taxnew s.com/news/Indian_Equalisation_Levy_Implementation_Successful_73015.html.
- 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, dated 30 March 2012, 61.
- Reuters Transaction Services Ltd. v. DDIT, ITA Nos. 6947 and 7211/Mum/2012, dated 18 July 2014.
- Deputy Commissioner of Income Tax v. Mustaq Ahmad Vakil, ITA No. 1531/Del/2011, dated 26 August 2011.
- Dr. Amar Mehta, Is the Indian Equalisation Levy compatible with India’s existing tax treaty network?, https://dramarmehta.com/Equalisation-Levy-White-Paper-2-June% 202016.pdf.
- Integrated Goods and Service Tax, 2017, Section 7 (4).
- Integrated Goods and Services Tax, 2017, Section 13(12).
- Integrated Goods and Service Tax, 2017, Section 2(17).
- GST Council, ‘Online Information Data Base Access and Retrieval,’ available at .
- Krishna Das v. Town Area Committee, Chigaon, AIR 1991 SC 2096; Kerala Colour Lab. Association vs. Union of India (UOI) 2003 264 ITR 633 Ker(Kerala High Court).
- Report of the Committee on the Taxation of E-Commerce (n. 166) 84 [125].
- Kerala Colour Lab. Association vs. Union of India (UOI) 2003 264 ITR 633 Ker(Kerala High Court) (n.194).
- Ashok K Lahiri, Gautam Ray, D.P. Sengupta, ‘Equalization Levy,’ Brookings Institution available at
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