Taxing the digital economic system by vital financial presence: India

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Anshu Khanna

With the advent of digital taxation worldwide, the Indian tax system introduced the concept of Significant Economic Presence (SEP) as a measure of taxing digital transactions in India in 2018. The intent was to tax Indian income from non-residents who work in the online / digital space by attempting to establish an alleged business relationship / taxable presence in India.

In an attempt to make SEP regulations effective, India recently announced thresholds for revenue and number of users beyond which non-residents are expected to establish SEPs in India. These provisions apply from April 1, 2021 (tax year 2021–22).

According to this latest communication, which prescribes the thresholds, SEP is now defined as:

  • any transaction in relation to goods, services or property conducted by a non-resident with any person in India, including the downloading of data or software in India, subject to a payment threshold of 20 million Indian rupees (US $ 274,500); or
  • systematically and continuously solicit business or interact with 0.3 million or more users in India.

Creation of SEP

Digital business models are developing rapidly and the current global tax systems have not been able to keep up. The Government of India has been active and leading in ensuring taxation of such digital platforms in India, which the Government believes represents a legitimate share of the profits of such digital companies with Indian customers / users.

The genesis of SEP can be traced back to Action Plan 1 of the Organization for Economic Co-operation and Development (OECD) and G-20 Base Erosion and Profit Shifting (BEPS) on tax challenges posed by digitization, which paves the way for a consensus-based approach to taxation evolving digital economy.

Action Plan 1 recommended three options for taxing digital transactions:

  • Nexus based on SEP – creating a taxable establishment in a country when a non-resident company has a SEP based on factors that demonstrate a targeted and sustained interaction with that country's economy via technology / automated tools;
  • Digital Transaction Withholding Tax – on payments made by residents for goods and services purchased online from non-resident suppliers;
  • Countervailing levy – to address the broader direct tax challenges of the digital economy.

None of these options found a global consensus and it was left to individual countries to include any of these three options in their domestic laws or in their bilateral tax treaties.

Due to increasing political and economic pressure, many countries have opted for one of the three measures mentioned above, which are largely limited to the introduction of a digital service tax based on prescribed thresholds. India ended up using all three options:

  • 2016: Countervailing levy 1.0 (India was the first country to do so) limited to payments from Indian residents to non-residents for online advertising services; 2020: Compensation levy 2.0 (effective April 1, 2020) expansion of the scope of transactions to e-commerce operators who sell goods online or provide online services via a digital or electronic platform;
  • 2018: SEP criteria integrated into domestic tax laws for taxable connections or business relationships in India, which were postponed to the tax year 2021-22 due to the discussions about the uniform approach to Pillar 1 and 2, which was aimed for around December 2020;
  • 2020: New withholding tax regulations for e-commerce payments (with effect from October 2020).

SEP laws

Indian domestic tax law originally introduced the concept of SEP in 2018. Its purpose was to expand the scope of non-resident income that is incurred, incurred, or deemed to be accrued or incurred in India by establishing a "business relationship" with non-residents of India at prescribed thresholds. All income attributable to such a SEP was taxable in India.

The law prescribes two parameters to trigger SEP as described below (changed in 2020 so as not to limit the conditions to digital transactions):

  • Turnover Threshold – Transactions in relation to goods, services or property carried out by a non-resident in India, including the downloading of data or software in India, if the sum of the payments from such transactions in the previous year can be prescribed as an amount; or
  • User Threshold – systematically and continuously soliciting business activities or interacting with a potentially required number of users in India.

The Finance Act 2020 postponed the application of the SEP provisions to the tax year 2021-22 in the expectation that the OECD would reach a consensus on the taxation of the digital economy and also the withholding rules on income from the sale of goods collected in India Data would be expanded, goods or services using such data from India, or advertising revenue for Indian customers, etc.

In order to make the provisions of the SEP effective, India has now issued the rules (Communication No. 41/2021 dated May 3, 2021) that set the thresholds for the triggering of SEP by non-residents with effect from April 1, 2021:

  • Turnover threshold – 20 million Indian rupees
  • User threshold – 300,000

Effect of the notification

Although the SEP provisions have been in force for more than three years, they would have no effect without the thresholds. With the announcement of the turnover and user thresholds, the SEP provisions will come into force on April 1, 2021.

Scope and ambition

The scope and scope of SEP are quite broad and can have far-reaching implications. It can be triggered regardless of whether the transaction or business arrangement was entered into in India, whether the non-resident is resident or domiciled in India, whether the non-resident is providing services in India, etc. It can potentially include any transaction carried out by a non-resident in India regardless of whether it is digital or otherwise.

Thresholds and Applicability

The threshold to trigger this is very low at $ 274,000 (approx) or 300,000 users per year. This will create additional costs and administrative burdens for both taxpayers and the tax administration. In today's rapidly digitizing world, such modest thresholds are impractical and could cause huge problems for foreigners doing business in India, even with small amounts.

When SEP is triggered and applicable, business income from Indian customers is taxable in India. The non-resident must consequently follow the compliance process of attribution of profits, paying taxes and filing tax returns in India, while the Indian payer must comply with tax withholding and related compliance.

As the SEP rules apply from the 2021-22 tax year, both the payer and the non-resident must evaluate all of their transactions in order to assess the applicability of the SEP and be ready for compliance as soon as possible. There is a need to assess the applicability and consider the benefits / applicability of the agreement for the transactions covered much earlier.

There are also uncertainties regarding the threshold values. With regard to the revenue threshold, it is not clear whether gross or net revenue is to be taken into account. With regard to the user threshold, there are doubts as to whether to consider customers residing in India or customers who are accessing via an IP address based in India. There is a need for advice and clarification on these aspects.

Necessary clarifications regarding the definition of key terms such as goods, property, systematic and continuous recruiting, etc. are also expected from the regulatory authorities.

Tax treaty

Tax agreements play an important role in this. SEP nexus (as an introduction to domestic tax law) is subject to the provisions of double taxation agreements. Such an extended scope of the business relationship under the domestic tax laws does not override a double taxation agreement. SEP provisions do not affect non-residents of contracting states unless a tax treaty is renegotiated and expanded through a bilateral or multilateral instrument to include provisions similar to SEPs. However, SEP can affect companies from countries where India does not yet have a tax treaty.

Even in cases where India has a contract, the right to contract performance becomes all the more important. The qualification as beneficial owner and the entitlement to protection through tax treaties are more relevant and important in the changing dynamics of international tax law. These provisions make it difficult to use contractual networks for repatriation or funding in the absence of substantial substance, business or qualified persons as ultimate beneficial owners. The beneficial ownership test could still be a relevant aspect to be assessed, especially in cases of multi-tier structures where a non-resident is trying to invoke the protection of a tax treaty to avoid the SEP test.

In addition, as a result of the multilateral instrument, many treaties entered into by India have been amended to include various performance limitation clauses. These tests must also be fulfilled with considerable significance for the application of the contract and thus for the substance in the company as well as for the transaction.

Interaction with the equalization charge

The SEP can overlap and the EL transaction can also be covered by the EL. However, due to the recent changes and the mutual exclusion clauses introduced in the national tax law rules, an SEP may be triggered if the rules are not applicable.

In summary, it can be said that India introduced its extended version of the digital tax, also known as the equalization tax (EL 2.0), in April 2020, which brings non-resident e-commerce operators that offer online goods delivery or services into its scope. It is charged at 2% if the gross consideration the non-resident e-commerce operator receives from residents (or non-residents in certain circumstances) exceeds Rs 20 million. The EL does not apply to non-residents with a permanent establishment (PE) in India.

The EL is charged by the Finance Act of 2016 rather than the Income Tax Act of 1961 and is therefore intended to function outside the scope of the current tax treaty.

Income from activities that fall under the EL are exempt from income tax (and thus also from the SEP provisions). Non-residents will also need to assess the impact of the EL and how it interacts with SEP, as both target all online sales of goods and services and can cover software payments that are not taxed as royalties.

Verify that EL regulations apply even though non-residents in India have SEP. The wording of the provisions appears to apply to non-residents from non-contracting states who exceed the turnover or user threshold and do not fall under EL. Therefore, even in the case of non-resident companies that come from non-contracting states and operate in the online / digital sector, the SEP provisions do not apply to income attributable to EL.

Profit allocation

There needs to be definitive and clear guidance on the rules governing profit allocation. As soon as a non-resident in India triggers SEP according to the prescribed parameters, only profits / income attributable to the prescribed activities are taxable in India. The tax offices are given a margin of discretion when calculating the attribution of profits. While a public consultation document on profit allocation for SEP has been issued by the Central Board of Direct Taxes, no rules have yet been announced. In this regard, clear and transparent guidelines / rules are urgently needed.

Overlap with domestic tax law

The SEP provisions in the current version have the possibility of overlapping with other provisions of domestic tax law. For example, the SEP rules aim to tax transactions of services, downloading computer software, etc., which are already covered by specific provisions of domestic tax law. The provisions of the domestic tax law prescribe gross basic taxation for such payments as opposed to net basic taxation according to SEP.

In addition, in the case of taxation of the payments (e.g. service payments that provide technical knowledge to the recipient in India), under a double taxation treaty (e.g. the tax treaty between India and the US, which prescribes a tax rate of 15%) ) a question should be asked: whether the provisions of the SEP (net basic taxation of 40% for non-residents, if advantageous) or the specific provisions of domestic tax law, which prescribe a tax of 10% plus applicable surcharges and levies, apply. The law therefore currently leaves many critical questions unanswered that require clarification from the government.

Conclusion

Given the restrictive definition or traditional concept of permanent establishment in tax treaties, the inclusion of SEP in national tax law will have no practical effect unless appropriate changes are made in the tax treaties. Determining your eligibility for tax treaty benefits is critical.

For non-contracting states and non-residents who are not entitled to treaty benefits, their position on taxation and compliance with the EL Act must be reviewed immediately. India needs to renegotiate the inclusion of SEP in its tax treaties in order to tax the tech giants according to these provisions.

The importance of the SEP provisions is related to the ongoing negotiations within the OECD G-20 Inclusive Framework to achieve a global consensus-based solution for taxing the digital economy, which is expected to be completed in mid-2021. The timing of the introduction of the SEP threshold appears to be a preparatory step by the Indian government.

A global consensus will ultimately be the viable and sustainable answer to taxing the digital economy, and this is India's move to be fully armed at the negotiating table.

This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.

Anshu Khanna is a partner at Nangia Andersen LLP, a member firm of Andersen Global.

The author can be contacted at: anshu.khanna@nangia-andersen.com