Ritu Shaktawat and Krutika Chitre of Khaitan & Co discuss the consultation document addressing the tax challenges of digital economy released by Indian’s Central Board of Direct Taxes on July 13, 2018.
Soon after having introduced ‘Google Tax’ in 2016, India becomes one of the first tax jurisdictions to treat ‘significant economic presence’ of a foreign enterprise as its taxable presence in India (effective from April 1, 2018 (that is, from assessment year 2019-20)).
The definition of ‘significant economic presence’
‘Significant economic presence’ is defined under section 9 of the Income Tax (IT) Act, 1961, to mean a transaction (including provision of download of data or software) carried out by a foreign enterprise in India, if the aggregate of payments arising from such transaction(s) during the year exceeds a prescribed amount.
Further, the systematic and continuous soliciting of business activities or engaging in interaction with a prescribed number of users by a foreign enterprise in India through digital means also constitutes ‘significant economic presence’ in India of such foreign enterprise.
Pertinently, to determine ‘significant economic presence,’ it is immaterial whether the agreement for such transactions or activities is entered into in India, or whether the foreign enterprise has a residence or place of business in India or renders services in India. The relevant thresholds have not been provided so far and this explanation currently remains dormant.
OECD’s work on BEPS Action 1
India’s move to introduce a tax nexus based on ‘significant economic presence’ was motivated by Action Plan 1 of the OECD’s base erosion profit shifting (BEPS) project. BEPS Action 1 discusses tax challenges posed by the digital economy and suggests taxation based on ‘significant economic presence’ as one of the options to tackle erosion of a tax base due to the thriving digital economy having no physical boundaries. OECD recommends the ‘revenue factor’ to be supplemented with “factors that have a purposeful and sustained interaction with the economy.” In furtherance of this, India has introduced ‘significant economic presence’ as a measure to tax emerging business models operating without any physical nexus but having a significant economic allegiance to India.
India’s consultation on the concept of ‘significant economic presence’: questions remain
To fully implement taxation based on ‘significant economic presence,’ the Government, on July 13, 2018, requested for suggestions and comments from stakeholders on the revenue and user-based thresholds that should be prescribed in this regard.
While the amendment seeks to update the Indian IT Act to keep pace with the evolving business environment, the fine print of the amendment leaves few questions unanswered. Merely prescribing thresholds may not fix the missing pieces of this ‘significant economic presence’ puzzle.
To begin with, it is unclear from the IT Act or the explanation provided in the Explanatory Memorandum to the Finance Bill, 2018, as to which business models the ‘significant economic presence’ test would apply to. Would intermediaries merely providing online platforms to facilitate interaction between various in and out of country sellers and domestic buyers be taxable in India if they meet the envisaged thresholds?
Further, the phrase ‘systematic and continuous’ is both subjective and ambiguous and its very interpretation could be a magnet for tax litigation. The wide language of the provision seems to go beyond the stated objective and may bring within its purview even non-digital transactions. It is also unclear as to how the transactions where under the title and risks in the goods pass outside India would be evaluated from the perspective of the ‘significant economic presence’ test. Whether such a transaction would constitute a ‘transaction carried out in India’ is a critical question and yet it has been left unanswered, like many other questions.
Government must pay close attention to key factors
Thus, before the Government prescribes thresholds, it should pay close attention to key factors such as the business set-ups it wishes to cover, the strength of the relevant market, inter-related effects on connected businesses, aligning the administrative set-up to recognize transactions that could be taxable in India, among other things. This exercise would have to be based on a thorough industry research as well as a study of the legal systems of countries with similar legislation, such as Israel.
Pertinently, given that ‘significant economic presence’ is a domestic tax provision, unless India re-negotiates its bilateral tax treaties to introduce a similar test, the beneficial provisions under such tax treaties would continue to prevail, limiting the effectiveness of this bold tax move targeting e-commerce.
All in all, the thresholds should be set at an optimum level such that they are neither too high to allow significant income from escaping tax, nor so low that small businesses are over-burdened with tax.