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Digital tax: Plugging the loopholes

• The country’s digital economy is growing by leaps & bounds. Therefore, there is a need for countries to develop a framework to regulate and to get a ‘fair’ share of taxes from the revenues generated by such businesses.

• Recently, India has introduced an enabling provision that will make an overseas platform that advertises, streams or sells goods to an Indian IP address taxable.

• While formulation of digital tax legislation is definitely a step in the right direction, the current tax rules do not factor in extra-territorial applicability, DTAA and characterisation of income.

• Experts feel that India needs to look beyond the concept of PE and redefine the principle of profit attribution. Furthermore, multilateral action is required in order to mitigate this challenge and ensure fair taxation.

Be it a activities as mundane as buying groceries, booking cabs, transferring payments and watching movies or something as exciting as connecting with people across the world through social media/messaging applications – the internet has become an integral part of our lives. This is hardly surprising for a country that has the second highest number of internet users in the world, after China, as per the recent report of Internet and Mobile Association of India (IAMAI). It is hardly surprising that given the significant presence of internet across the nation, the country’s digital economy is growing by leaps & bounds. Therefore, India recognises a need to develop a framework to regulate and to get a ‘fair’ share of taxes from the revenues generated by such businesses.

Quick facts about India’s internet use:
  • India had 451 million monthly active internet users at end of financial year 2019.
  • Of the 451 million monthly active users, 385 million are over 12 years of age and 66 million are in the age bracket of 5 to 11 years.
  • In terms of absolute numbers, urban India with 192 million users had almost the same number of users as rural India.
  • In terms of percentages or penetration, however, given the inconsistency of population distribution in urban and rural India, urban India had a considerably higher penetration level.
  • Approximately 2/3rd of the Internet population in India involved daily users.
  • About 1/3rd of users accessed the internet for ‘more than one hour’ in urban India, where as in rural India, a similar proportion of users accessed Internet for 15-30 minutes.
Source: IAMAI

In 2016, India took some baby steps in this regard by applying Equalization Levy at a rate of 6% on payments made by Indian businesses to non-residents providing digital advertising services. Further, in 2018, India recognized virtual presence for the purpose of asserting taxing rights and introduced the concept of Significant Economic Presence (SEP) in its tax regulation. The Finance Act, 2018 defined the SEP to mean, among other things, 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.

Recently, India has introduced an enabling provision that will make an overseas platform that advertises, streams or sells goods to an Indian IP address taxable. “The idea is to have an enabling framework in place so that once the OECD framework is ready, we can go ahead,” a senior government official stated. The Finance Bill has proposed changes to the income tax Act to add new source rules that consider certain types of a foreign assessee’s income to be of Indian origin and hence taxable in the country. This is in line with the global push by the Organisation for Economic Co-operation and Development (OECD) to bring these digital giants under the ambit of local taxes.

SEP is one such proposal propounded by the OECD. Under this approach, the following factors are identified for a non-resident enterprise having a significant economic presence to have a taxable presence in a jurisdiction: (a) revenue-based factor, which would include the threshold level of revenue, (b) digital factors that would include domain name, local digital platform, and (c) user-based factors such as number of active users and volume of digital content collected through digital platform. Apart from this, there are two other proposed approaches to taxation. The “User Participation” Proposal aims at taxing the value created by user participation by modifying the traditional profit allocation rules and recommends that profits allocated to a user jurisdiction be calculated through a non-routine or residual profit split approach. Finally, there is localization of data and tax ramifications. Under this approach, if non-resident entities localise their servers, they can be brought under the taxation regime.

While formulation of digital tax legislation is definitely a step in the right direction, the current tax rules simply do not factor the following things:

  • Extra-territorial applicability:

In order to tax a non-resident entity’s business income in India, it is required that the entity maintains a permanent establishment (PE) or a business connection in India. However, in case of a digital economy, since the business model of such an economy places reliance on intangibles like patents, algorithms, etc. and can conduct business by residing in a foreign jurisdiction, as a place of their central functions, establishing a PE becomes difficult.

  • Characterisation of Income Generated through Digital Economy

The Indian income tax (I-T) law which was drafted about 60 years ago, is ill-suited to the current realities. Section 9 of the Income Tax Act, 1961, has categorised income of the non-residents into three classes: business income, royalty and fee for technical services. Different categories have different tax repercussions. One of the key questions that arises in this context pertains to whether to characterise the profits earned on the digital marketplace as business income or fees for technical services.

  • Double Taxation Avoidance Agreement (DTAA) Treaties

Last but not the least is the challenge of DTAA because a multinational enterprise’s PE may be situated in one country while it’s SEP may be in multiple countries. The friction created by this situation would defeat the objective of the DTAA.

 

Unilateral measures adopted by foreign jurisdictions
  • Australia: Proposal to levy digital services tax on income of large multinationals providing advertising space, trading platforms, and the transmission of data collected about users.
  • New Zealand: Proposal to levy Amazon tax on online book & merchandise purchases.
  • Uganda: Users of WhatsApp, Twitter, Facebook will pay a fee.
  • France: 3% digital tax on the revenues generated by the global tech companies like Google, Apple, Facebook and Amazon (GAFA tax) in its territory.
  • Malaysia: Taxation of digital services through the Service Tax (Amendment) Bill, 2019.
Source: MediaReports

Given the rise of novel technologies such as blockchain, virtual reality and artificial intelligence, India’s digital surge is well under way. According a recent report from Ministry of Electronics and Information Technology, in partnership with McKinsey, India can create over US$1 trillion of economic value from the digital economy in 2025. In riding on this wave of digital boom, India is keeping up with the global expansion of digital economy.

However, in order to reap full benefits of this situation, India needs to lift some of the cobwebs surrounding its digital taxation, in partnership with international forums like OECD. India needs to look beyond the concept of PE and redefine the principle of profit attribution. The Akhilesh Ranjan Committee on taxation of e-commerce argued for a relook into definition of “business connection” in the I- Act and “permanent establishment” in tax treaties. Further, at present, the concept of “significant economic presence” as a criterion to determine permanent establishment has not been included in any of the DTAAs signed by India with other countries. Therefore, a multilateral action is required in order to mitigate this challenge and ensure fair taxation.

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