Taxing the Digital Economic system Via Important Financial Presence: India

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Anshu Khanna

With the emergence of digital taxation globally, the Indian tax regime introduced the concept of significant economic presence (SEP) in 2018 as a measure to tax digital transactions in India. The intention was to tax Indian sourced income of nonresidents operating in the online/digital space, by seeking to create a deemed business connection/taxable presence in India.

In an attempt to make the SEP provisions operative, India recently notified thresholds for revenue and number of users beyond which nonresidents would be deemed to establish SEP in India. These provisions are effective from April 1, 2021 (tax year 2021–22).

Pursuant to this recent notification prescribing the thresholds, SEP is now defined to mean:

  • any transaction in respect of any goods, services or property carried out by a nonresident with any person in India, including the provision of download of data or software in India, subject to a payment threshold of 20 million Indian rupees ($274,500); or
  • systematic and continuous soliciting of business activities or engaging in interaction with 0.3 million or more number of users in India.

Genesis of SEP

Digital business models are evolving rapidly and current global tax regimes have not been able to keep pace. The Indian government has been active and a front-runner in ensuring taxation of such digital platforms in India, which the government believes to be a legitimate share of profits earned by such digital businesses from Indian customers/users.

The genesis of SEP can be traced to the Organization for Economic Co-operation and Development (OECD) and G-20 Base Erosion and Profit Shifting (BEPS) Action Plan 1 on tax challenges arising from digitalization which paved the way for a consensus-based approach for taxing the evolving digital economy.

Action Plan 1 recommended three options to tax digital transactions:

  • nexus based on SEP—creation of a taxable presence in a country when a nonresident enterprise has an SEP on the basis of factors that evidence a purposeful and sustained interaction with the economy of that country via technology/automated tools;
  • withholding tax on digital transactions—on payments by residents for goods and services purchased online from nonresident providers;
  • equalization levy—to address the broader direct tax challenges of the digital economy.

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

Due to rising political and economic pressure, many countries chose to adopt one of the triad of the measures above, largely restricted to the introduction of digital services tax based on prescribed thresholds. India ended up using all three options:

  • 2016: Equalization Levy 1.0 (India was the first country to do this), confined to payments from Indian residents to nonresidents for online advertisement services; 2020: Equalization Levy 2.0 (with effect from April 1, 2020) expanding the scope of transactions to e-commerce operators performing online sale of goods or providing online services through a digital or electronic platform;
  • 2018: SEP criteria incorporated in domestic tax statutes for taxable nexus or business connection in India, which was deferred to tax year 2021–22 due to the discussions on the unified approach around Pillar 1 and 2, which was targeted around December 2020;
  • 2020: New withholding regulations on 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 enlarge the scope of income of nonresidents that accrues or arises or is deemed to accrue or arise in India by establishing a “business connection” of nonresidents in India, subject to prescribed thresholds. Any income attributable to such SEP was to be taxed in India.

The law prescribed two parameters to trigger SEP as described below (modified in 2020 to not restrict the conditions to digital transactions):

  • revenue threshold—transactions in respect of any goods, services or property carried out by a nonresident in India, including the provision of download of data or software in India, if the aggregate of payments arising from such transactions during the previous year exceeds such amount as may be prescribed; or
  • user threshold—systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India as may be prescribed.

Applicability of SEP provisions was deferred by the Finance Act 2020 to tax year 2021–22 in the expectation the OECD would reach a consensus on taxation of the digital economy and also that source rules would be expanded to include income from sale of data collected from India, goods or services using such data from India, or advertisements income targeting Indian customers, etc.

To make the provisions of SEP operative, India has now issued the rules (Notification No.41 /2021 dated May 3, 2021) defining the thresholds for triggering SEP of nonresidents effective from April 1, 2021:

  • Revenue Threshold—20 million Indian rupees
  • User Threshold—300,000

Impact of Notification

Although the SEP provisions have been in place for more than three years, they remained inoperative in absence of the thresholds. By notifying the revenue and user thresholds, the SEP provisions come into operation with effect from April 1, 2021.

Scope and Ambit

The scope and ambit of SEP is quite wide and can have far-reaching implications. It can be triggered irrespective of whether the agreement for transaction or activity has been entered in India, whether the nonresident has a residence or place of business in India, whether the nonresident renders services in India, etc. It can potentially cover any transaction carried out by a nonresident in India irrespective of whether it is through digital means or otherwise.

Thresholds and Applicability

The threshold to trigger this at $274,000 (approx.) or 300,000 users annually, is very low. This will cause additional cost and administrative burdens for both taxpayers and tax administrators. In today’s rapidly digitalizing world, such modest thresholds are not practical and could cause major problems to nonresidents doing business in India even at low volumes.

If SEP is triggered and applicable, business income earned from Indian customers will be taxable in India. The nonresident consequently has to follow the compliance process of profit attribution, payment of taxes and filing of tax returns in India, whereas the Indian payer has to comply with withholding of taxes and related compliance.

Further, as the SEP provisions are applicable from tax year 2021–22, both payer and nonresident need to evaluate all their transactions to assess SEP applicability and be ready for compliance as soon as possible. There is a need to assess applicability and examine treaty benefits/applicability much sooner for the covered transactions.

There is also ambiguity regarding the thresholds. For the revenue threshold, it is not clear if gross or net revenue is to be considered. For the user threshold, there is a doubt whether customers residing in India are to be considered or those customers who are accessing through IP address located in India. There is a need for guidance and clarification on these aspects.

Necessary clarification regarding definition of key terms such as goods, property, systematic and continuous soliciting, etc., is also awaited from the regulators.

Tax Treaties

Tax treaties have an important role here. SEP nexus (being an introduction into domestic tax law) is subject to tax treaty provisions. Such expanded scope of business connection under the domestic tax laws does not override a tax treaty. SEP provisions will not have impact on nonresidents from treaty jurisdictions unless a tax treaty is renegotiated and expanded through a bilateral or multilateral instrument to include provisions similar to SEP. However, SEP may impact businesses from countries where India does not yet have a tax treaty.

Even in cases where India has a treaty, eligibility to treaty benefits becomes all the more significant. Qualification as a beneficial owner and eligibility for tax treaty protection is more relevant and important in the changing dynamics of international tax law. These provisions make it challenging to take advantage of treaty networks for repatriation or financing absent significant substance, business operations, or qualifying persons as ultimate beneficial owners. Test of beneficial ownership could still be a relevant aspect to evaluate, especially in cases of multi-tier structures, where a nonresident seeks to invoke tax treaty protection to avoid the SEP test.

In addition to the above, many treaties entered into by India have been amended on account of the multilateral instrument, to include various limitation of benefits clauses. These tests also need to be satisfied for the application of the treaty and hence substance in the entity as well as the transaction assuming significant importance.

Interplay with the Equalization Levy

There may be overlap of SEP and the EL particular transaction may also be covered by the EL. However, given the recent amendments and mutual exclusion clauses introduced in the provisions as regards domestic tax law, in case of non-applicability of the provisions, SEP may be triggered.

To recap, in April 2020 India introduced its enlarged version of digital tax, also called the Equalization Levy (EL 2.0), bringing nonresident e-commerce operators engaged in online supply of goods or the provision of services into its ambit. It is charged at 2% if the gross consideration received by the nonresident e-commerce operator from residents (or nonresidents under specified circumstances) exceeds 20 million Indian rupees. The EL is not applicable to nonresidents having a permanent establishment (PE) in India.

The EL is levied through the Finance Act, 2016 and not the Income-tax Act, 1961, and as such it is intended to operate outside the framework of the current tax treaty framework.

Income from activities covered by the EL is exempt from income tax (and thus SEP provisions as well). Nonresidents will also need to evaluate the impact of the EL and its interplay with SEP, since both target all online sales of goods and services, and it may cover software payments that are not taxable as royalties.

It needs to be examined whether EL provisions prevail despite nonresidents having SEP in India. The way its provisions are worded, it appears that it will be applicable to nonresidents from non-treaty jurisdictions who exceed the revenue or user threshold and are not covered by EL. Therefore, even in the case of nonresident businesses that are from non-treaty jurisdictions and operating in the online/digital space, SEP provisions will not apply vis-à-vis incomes that are chargeable to the EL.

Profit Attribution

There is a need for final and clear guidance for profit attribution rules. Once a nonresident triggers SEP in India as per the prescribed parameters, only profit/income attributable to the activities prescribed will be taxable in India. Tax offices are given discretionary power to compute profit attribution in this regard. While a public consultation document on profit attribution for SEP was issued by the Central Board of Direct Taxes, no rules have been notified so far. There is an urgent need for clear and transparent guidance/rules in this regard.

Overlap with Domestic Tax Law

The SEP provisions, as enacted, have the possibility of overlap with other provisions of the domestic tax law. For instance, SEP provisions seek to tax transactions of services, download of computer software, etc., which are already covered under specific provisions of the domestic tax law. The provisions in the domestic tax law prescribe a gross basis taxation for such payments as against a net basis taxation under SEP.

Moreover, in case of taxability of the payments (say service payments which make available technical knowledge to the recipient in India) under a tax treaty (e.g., the India–U.S. tax treaty which prescribes a tax rate of 15%), a question may arise as to whether the provisions of SEP (net basis taxation at 40% for nonresidents, in case beneficial) would apply, or the specific provisions of the domestic tax law which prescribe a tax at 10% plus applicable surcharge and cess. The law at the moment thus leaves open many critical questions which require clarity from the government.

Conclusion

Considering the restrictive definition or conventional concept of PE in tax treaties, the inclusion of SEP under domestic tax laws will not have any practical impact unless corresponding modifications are made in the tax treaties. Determining eligibility for tax treaty benefits is crucial.

For non-treaty jurisdictions and nonresidents not eligible for treaty benefits, there is an immediate need to review their position on taxability and compliance considering the EL law. India will need to renegotiate for inclusion of SEP in its tax treaties to tax the tech giants under these provisions.

The relevance of SEP provisions is in the context of ongoing negotiations at the OECD–G-20 Inclusive Framework for arriving at a global consensus-based solution on taxing the digital economy, which is expected to reach a conclusion around mid-2021. It appears that the timing of the introduction of the SEP threshold is a preparatory step on the part of the Indian government.

Global consensus will ultimately be the viable and sustainable answer to taxing the digital economy and this is India’s step toward being fully equipped at the negotiation table.

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

Anshu Khanna is a Partner with Nangia Andersen LLP, a member firm of Andersen Global.

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