The recent decade has seen technology seep into virtually every section of the economy. The gap between 'digital economy' and traditional economy is thinning at an unprecedented rate. In this backdrop of significant growth in the digital economy, the taxation of income involving multiple, digitally connected countries, is fraught with difficulty and requires an unconventional approach.
Digital economy is borderless with no clear demarcation of its origin and consumption. Classic example of taxing digital economy can be seen in case of Airbnb where the revenue is generated in country X, user who books the room is in country Y, and the place where the actual service is consumed is in country Z. In such a complex multi-jurisdictional transaction, the actual source of income under taxation is uncertain and prone to unending dispute.
Four main tax challenges in the digital economy are as under:
- Nexus vis-Ã -vis income earned and physical presence of business - Reduced need for physical presence
- Characterisation - New digital products or means of delivery - business income, software license fee, service fee, rental fee for server, royalty, etc.
- Data - Possibility to gather and use information from various sources. Such information is a primary input into the process of value creation in a digital economy. How can you attribute value to such data?
- Collection of VAT - Exemption for imports of low value goods in countries and cross border B2C transactions
International initiatives to taxing income involving the Digital Economy:
Under the Double Tax Avoidance Agreements ('DTAAs'), typical business profits are taxed in a country only if business is carried out by an entity in a said country through a "permanent establishment". The term 'permanent establishment' generally refers to a "physical" presence in absence of which there is no taxation whatsoever in the country of source.
However, in current times, core business activities are carried out "virtually" (E.g. cloud-based software companies, internet companies like Google and Facebook, software platforms on customer premises, etc.) and sans a physical business presence, income goes untaxed in the source country. Internationally, there is a general lack of consensus amongst countries on what constitutes income sourced in a particular country in the digital scenario, and how such digital services should be brought under tax coverage.
Given the above incoherence amongst countries, the Organisation for Economic Cooperation and Development ('OECD') included a specific action plan under the Base Erosion and Profit Shifting ('BEPS') program on the Taxation of the Digital Economy (BEPS Action Plan 1).
Action Plan 1 introduced the concept of "significant economic presence ('SEP')" in any country to establish "nexus" in a virtual environment in absence of a physical presence in such source country for the purposes of taxing digital profits. The Action Plan gave each country freedom to draw up the criteria for determining an SEP. It also provided guidance to this effect in terms of the criteria, viz, revenue based factor, user based factor and digital presence-based factor (like local domain, local payment options, etc).
In relation to this, on 09 October 2019, the OECD published a proposal for public comments on the allocation of taxing rights and profits in the digitalised economy. The allocation of taxing rights and profits in the digitalised economy is proposed to be divided into two segments. Pillar One deals with the allocation of taxing rights to market and user jurisdictions, and Pillar Two focuses on global minimum taxation.
- Focus on allocation of taxing rights with reallocation of profits towards source market jurisdictions - essentially treating the entire world as one "unified" entity and allocating profits amongst various entities in different countries
- Definition of three new 'Amounts' of profit and how it is to be taxed
- Amount A:
- "Consumer facing", "large" business focus
- Residual profit attribution approach - Attribution of part of the residual group profit to source market jurisdictions, based on attribution criteria like sales, etc
- Amount B:
- All businesses
- Fixed return for assumed base of sales/marketing functions in source market
- Only where there is an established physical presence
- Amount C:
- 'Top-up' under existing transfer pricing principles if actual functionality is beyond assumed Amount B activities
- Subject to rigorous dispute prevention and resolution procedures
- Strengthening the ability of jurisdictions to tax profits where the other jurisdiction with taxing rights applies a low effective rate of tax
- Sets effective global minimum tax rate
The OECD's new proposal for a 'unified approach', under Pillar One, would broadly cover consumer-facing businesses, even if they are not highly digitalised. It would create new nexus rules that are based on sales and which do not require physical presence in a jurisdiction.
The OECD needs to engage with representatives of various countries in arriving at a consensus approach and ironing out the several practical challenges envisaged under the proposals. Nonetheless, the effort undertaken thus far in identifying the core issues and taking proactive steps is laudable.
The Indian scenario thus far:
Taxation of Digital economy is very crucial for developing countries like India because of the huge market for the digital economy in such countries. As discussed, a significant portion of income on account of these 'virtual' business activities goes untaxed in India in spite of the source clearly emanating from India.
This leads to significant base erosion due to inadequacy of existing international tax rules to allocate profits to countries from where these profits are sourced, and in particular, due to the relevance of physical presence as a criteria for allocating taxing rights to source countries in case of digital enterprises.
To address this issue of taxing digital economy, the Government of India introduced two key domestic tax measures. Firstly, in Finance Act, 2016 a 6% Equalization Levy was proposed to tax advertising payments made to foreign businesses. This was in fact one of the options suggested under BEPS Action Plan 1.
Secondly, in Finance Act 2018, the Government of India expanded the definition of "business connection" [in section 9(1)(i) of the Income-tax Act,1961]. The expanded definition introduces the concept of "SEP" in India as a measure of determining nexus vis-Ã -vis business profits of foreign entity in India (in the absence of a physical presence).
The term SEP has been defined to 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], such that aggregate of payments arising from such transaction(s) exceeds the prescribed amount (INR 200 million as per draft notification recently issued)
- Systematic and continuous soliciting of business activities or engaging in interaction with prescribed number of users in India through digital means: (500,000 users above as per draft notification recently issued)
India has also reserved the right to include a provision in Article 5 of its DTAAs (Article dealing with permanent establishments) to the effect that a foreign entity having "SEP" in India would be deemed to have a permanent establishment in India.
Union Budget 2020 proposal on SEP:
While the world, including India, is still in the process of assimilating the concept of SEP, the Finance Bill 2020 has proposed to further expand the scope of business connection and the source rule for SEP under the Indian tax law to include:
- Income derived from advertisements that target customers residing in India or customers who access the advertisement through internet protocol address located in India;
- Income derived from sale of data collected from a person residing in India or from a person who uses internet protocol address located in India;
- Income derived from sale of goods or services using data collected from a person residing in India or from a person who uses an internet protocol address located in India
Given that the BEPS report on this issue is likely to be released by the end of December 2020, the Finance Bill proposes to defer the applicability of the SEP tax rules, such that the Government would be able to specify the limits once the BEPS report on the issue is released. These amendments shall be made effective from fiscal year 2021-22.
Further, the CBDT has been empowered to make the necessary rules to determine the income arising out of operations carried out in India and transactions or activities of a non-resident. This amendment shall be made effective from fiscal year 2020-21.
With the proposed changes in the Union Budget 2020, the Government has sought to further widen its reach in taxing digital transactions.
The world economy is becoming digital every day. Even traditional businesses like transport (Ola/Uber), retail (Amazon/Flipkart), pharmacy (Medicine delivery apps), etc. are now labelling themselves as "technology" companies. Physical presence is now becoming a thing of the past and the core business value creation is now being portrayed through digital means. Tax jurisdictions around the world need to debate and arrive at a consensus view on a just and fair mechanism for taxing profits arising from digital transactions expeditiously so as to ensure appropriate allocation of tax to various countries. A pragmatic and implementable guideline is imperative to avoid confusion and protracted litigation/tax controversy in the future.