The Genesis: BEPS Action Plan 1

The Organisation for Economic Co-operation and Development (OECD) issued 15 Base Erosion and Profit Shifting (BEPS) Action Plans (APs) in November 2015. The first report, BEPS AP 1: Addressing Tax Challenges in the Digital Economy, dealt with tax-related challenges in the digital economy.

BEPS AP 1 recognised that the digital economy posed challenges that the traditional nexus-based approach to taxation could not resolve. It clearly stated that it is important to examine how enterprises in the digital economy add value and earn profits, since this determines the need to change the existing tax framework to address the specific features in the sector and prevent BEPS.

BEPS AP 1 analysed various potential options to address the challenges. These included the 'Equalisation Levy', which was implemented in India in 2016, and a new economic based nexus in the form of a 'Significant Economic Presence (SEP)', which was implemented in India in 2018.

In relation to SEP, BEPS AP 1 provides that a taxable presence can be created when a person who is not a tax resident of the country (non-resident) has a significant economic presence in it on the basis of a purposeful and sustained interaction with its economy via technology and other automated tools. It also stated that while formulating the conditions for SEP taxation, factors such as revenue earned from domestic customers, the person's digital presence in the country (domain name and digital platform) and domestic user base should be considered.

Global take on taxation of digital economy

The launch of BEPS AP 1 has accelerated the pace at which global economies are adopting ways of taxing digital businesses. The OECD's Interim Report 2018, A Brief on the Tax Challenges Arising from Digitalisation states that global practices can be broadly divided into four approaches?incorporation of a digital presence, turnover taxes, withholding taxes and specific regimes targeting prevention of tax avoidance. These approaches are discussed below:

Digital presence

Modification in domestic or tax treaty Permanent Establishment (PE) conditions is seen as a method of preventing BEPS in situations where a non-resident, established in a remote location, pro-actively interacts with customers of the person's country of residence, by using technological means.

Israel introduced the SEP concept in 2016 (applicable for non-treaty countries) to tax services relating to conclusion of online contracts, use of digital products, etc., provided by non-residents to Israeli customers, from remote locations.

The concept of Virtual Service PE has been slowly gaining traction. It arises when services are provided remotely without there being any material presence of the service providers in the markets they serve through the use of digitisation. Saudi Arabia has officially endorsed the Virtual Service PE concept.

Turnover taxes

Turnover taxes, are levy of taxes outside the framework of the Income-tax regime. Italy proposes to impose a 3% 'Levy on Digital Transactions (LDT)' on services provided by the use of electronic networks or the internet.

Hungary has introduced an Advertisement Tax that covers a broad range of transactions relating to advertising services, based on the destination of the advertisements and the location of the targeted audience. To some extent, this is similar to India's approach of levying Equalisation Levy on certain specified digital advertising transactions. France has also implemented a legislation on similar lines.

Withholding taxes

Countries are looking at expanding their definition of royalties and FTS in their domestic tax laws and tax treaties to capture digital transactions including cloud computing, Infrastructure as a Service (IaaS) and Software as a Service (SaaS). For instance, Malaysia has amended its definition of royalty under its domestic tax provisions to include payment for "visual images or sounds" transmitted through Information and Communication technology.

Specific tax regimes

Several countries have implemented specific anti-abuse regulations to address excessive BEPS by corporates, e.g., through the introduction of the Diverted Profits Tax by the UK and Australia.

India before SEP

India, like many other countries, did not have specific provisions for taxation of its digital economy prior to the introduction of the SEP and the Equalisation levy. Tax-related issues were decided by Indian courts, for instance, the Kolkata Tax Tribunal in the case of ITO vs Right Florist Pvt. Ltd [TS-6658-ITAT-2013(Kolkata)-O] held that an advertisement fee paid online to a non-resident web-based search company was not an FTS and was not taxable in India, since the enterprise did not have a PE in India. It observed that a website does not constitute a PE in India.

Similarly, in another matter, the Mumbai Tax Tribunal, in the case of Pinstorm Technologies (P.) Ltd. vs. ITO [TS-536-ITAT-2012(Mum)-O], held that payment made to a foreign company for uploading and display of banner advertisements on non-resident companies' portals was not taxable in India in the absence of it having a PE in India.

Over time, as corporates have adopted digital means of doing business, Indian tax authorities have also implemented new ways of taxing transactions in the digital economy. For instance, while holding that bandwidth-related payments made to a foreign company constituted royalty income, in the case of Verizon Communications Singapore Pte Ltd vs ITO [TS-577-HC-2013(MAD)-O], the Madras High Court categorically stated that in a virtual world, the physical presence of an entity is insignificant.

The Government of India has set up the Committee on Taxation of e-Commerce to address such issues in the digital economy. The Committee presented its report in 2016, wherein, based on BEPS AP 1, it explored the introduction of three options?(a) SEP, (b) withholding tax on digital transactions and (c) the Equalisation levy. It recommended implementation of the Equalisation Levy because the beneficial provisions of India's tax treaties would override SEP and withholding tax-related provisions.

Introduction of SEP in Indian domestic tax laws

Amendment made in the definition of 'business connection'

The Finance Act, 2018 introduced the concept of SEP in Section 9 of the Income-tax Act, 1961 (the Act). It provided that the SEP of a non-resident in India will constitute its business connection in India. For this purpose, SEP has been defined as the following:

(a) A transaction in respect of any goods, services or property, including provision of downloaded data or software, carried out by a non-resident in India if the aggregate of the payments arising from such transactions during the previous year exceeds the prescribed threshhold

(b) Systematic and continuous soliciting of business activities or engagements involving interaction with the prescribed number of users in India using digital processes

While the rules prescribing the threshold are awaited, we elaborate below certain aspects relating to SEP:

First condition: Transactions in respect of goods, services or property

The first condition of SEP seems to be inclusive in nature and can be widely interpreted. On first reading, it covers all transactions in respect of goods, services or property, whether tangible or intangible, irrespective of the mode through which it is transacted. The provisions also include transactions pertaining to provision of downloading of data or software. However, no guidance has been provided on the definition of the terms 'data' and 'software'.

Second condition: Soliciting of business activities through digital means

The second condition seeks to cover transactions wherein soliciting of business activities is undertaken through digital means in a systematic and continuous manner. This condition is of wide import and appears ambiguous. For instance, a user's 'interaction' in itself may not give rise to taxable income, which is sought to be taxed. Similarly, the words 'systematic', 'continuous' or 'soliciting' have not been defined and may be subject to different interpretations.

The Government should bring clarity in relation to these aspects to ensure a smoother rollout.

Interplay with Equalisation Levy

Section 10(50) of the Act provides that any income that is subject to Equalisation Levy will be exempt under it. These provisions should also apply in the case of SEP, i.e., SEP should not be applicable for transactions on which the Equalisation Levy is levied. Therefore, this issue should be addressed and resolved to avoid litigation or double taxation.

Consequences of constituting an SEP in India: profit attribution

Once an SEP is established in India, its profits (attributable to India) need to be determined. This would be a complex exercise, for instance, whether the presence of users or consumer base in India would be sufficient if the principle functions and risks are undertaken outside the country. Moreover, what would be the attribution mechanism in the case of loss-making companies having an SEP in India and/or which part of the profit would be considered for this purpose, is unclear.

The way forward: simple rules and ease of implementation

India has entered into tax treaties with most of its trading partners, most recently with Hong Kong. The provisions of these tax treaties are to override SEP provisions under the Act. Therefore, to what extent SEP-related provisions are effective is a matter that is open to debate.

Moreover, under the OECD's Multilateral Agreement (MLI), BEPS AP 1 measures have not been included since this was left to be determined by individual countries. Therefore, even after the MLI becomes effective, the beneficial provisions of the tax treaties will continue to prevail. SEP provisions therefore only appear to add complexity to India's domestic tax laws.

The Government should clarify the various aspects of implementation of SEP (detailed above), which will ensure that these provisions do not become a source of perineal tax litigation. Furthermore, the Government has recently sought input from stakeholders regarding the threshold of SEP implementation. While this is a welcome move, the Government should also issue detailed guidelines and FAQs along with adequate illustrations on implementation of SEP. This will help in removing ambiguities and enable taxpayers to assess whether they have an SEP in India.

Moreover, as a measure to reduce the compliance-related burden on non-residents that get caught in the net of SEP's provisions, the Government should consider the introduction of a single consolidated reporting form that can take care of Transfer Pricing, tax audit and corporate tax return-filing obligations in one go.