Effect of Digital Economy on Taxation System in India

Vinayak Bhatia
Section A, Ll.B. 3yrs
A3256118043

1. Introduction

The Digital Economy refers to an economy focused on digital computer technology, although
we see it as a continuous business as an online marketplace and the World Wide Web. A
digital economy is sometimes called the Internet Economy, New Economy, or Web
Economy.1 In short, it refers to an economy based on digital technology.

Gone are the days of business in bricks and mortar because business types have been greatly
revitalized. Over the past decade, there has been a change in the way we do business. Today,
Uber's largest cab aggregator does not have any ports, Airbnb's largest provider of
accommodation does not have a flat, and many other restrictions such as MakeMyTrip,
Amazon, Flipkart, Paytm, etc. They do not work the way normal businesses do but thrive
with digital technology.

Current (international and domestic) tax laws were enacted decades ago based on the
performance of the brick-and-mortar economy. However, with the advent of the digital
economy, the current tax regime remains unpopular. The profitability of digital businesses
has been growing steadily, but there are no equal tax laws for that profit. As such, it is an
hour for all countries to establish and renew their tax laws, as the digital economy is ready to
be taxed.

2. Overview of Taxation in India

Direct Taxes in India are taxed under the Income Tax Act, 1961 (‘the Act’). Citizens are
taxed on the international income and non-residents are taxed only on the income earned in

1
Digital Economy. (2020, September 29). Retrieved October 19, 2020, from
https://en.wikipedia.org/wiki/Digital_economy.
India. Companies are treated as citizens to the satisfaction of any conditions: (a) placement in
India (b) Operational Management Area ('POEM') in India. Therefore, a company based
outside India and having its own POEM outside India is considered a non-resident person.

Property taxes are subject to section 5 read with section 9 of the Act and the provisions of the
Double Taxation Contract (‘DTAA’). Business revenue is governed by the provisions of
section 9 of the Act, where revenue is deemed to be a fundraiser or from India as a result of
business transactions in India. Under DTAA agreements, business benefits are made by
Permanent Establishment (‘PE’) as if it were a separate and distinct business in terms of
Article 5 read with Article 7 of DTAA. That business benefit can only be taxed if there is a
business connection or PE in India at a rate of 40 percent on a residual basis, unless the
income is eligible as cash or technical services ('FTS') taxable rate of 10 percent on a large
basis. In addition, in accordance with the provisions of section 90 (2) of the Act, a non-
resident person shall have the right to seek the beneficial provision between the Act and the
DTAA

In order to address the tax problems associated with the digital economy, three specific issues
need to be addressed: (a) Revenue definition (b) Availability of PE, and the provision of
benefits.

3. Characterization of Income

There is a significant difference in the management of income tax depending on its status.
The three main categories under which a non-resident's salary can be categorized are
‘Royalty’, ‘Fees for Technical Services’ (‘FTS’), and Business Income. Each income tax rate
varies according to the situation. Where a non-resident/taxpayer has made an improper
classification of income or a disclosure of income inconsistent with international standards,
that non-resident or taxpayer may face double the risk of tax evasion in different areas and
also keep up to testify against long-term offenses. Tax on living expenses is shown in the
table below:
 Nature of Income No PE/Business connection PE/Business connection exists
exists

Royalty Taxable on a gross basis at 10 Taxable on a net basis at 40

percent or DTAA rate, whichever percent (to the extent profits
FTS
is lower. attributable to PE.

Business Income Not Taxable.

There are a few examples where a transaction challenges the presentation of revenue as
follows:

a. Subscription Fees: The Authority for Advanced Rulings ('AAR') in the case of Dun
& Bradstreet Espana2, SA held that the proceeds of downloading business
information ('BIRs') containing general information about companies would not be
taxed as royalty, as they were only registered in the database located in the public
domain was compiled. In addition, where Indian AE was conducting its business and
was an independent company, not under the control and instructions of the applicant
in conducting its business, it issued its price depending on market conditions and the
purchase price paid by the applicant BIR, as amended by the applicant; it would not
be concluded that Indian AE itself was the agent of the applicant and therefore, not PE
to the applicant in India under Article 5. Therefore, payments made by Indian AE to
the applicant to purchase BIRs would be regarded as part of the applicant's business
profit as compiled internally of the provision of Article 7 but would not be taxed as
business benefits in India if there is no PE in India.
However, the Hon'ble Karnataka High Court in the case of Wipro Ltd.3 stipulates that
payments made to a non-resident to obtain a database operating license, such as
granting access to a database or transfer of copyright, will therefore be taxable as
royalty and not business income.
Therefore, judicial authorities have conflicting views on the same payment
transactions made to a non-resident to access the database, where few treat them
equally as royalty and others as corporate income or not as royalty.

2
(2005) 142 Taxman 284 (AAR).
3
(2011) 203 Taxman 621 / (2013] 355 ITR 284 (Karnataka HC).
 b. Broadcasting of an Event: Mumbai High Court in the case of IMG Media Ltd.4 held
that the amount paid to the person who participated in the recording and live
broadcasting and live viewing of IPL cricket matches was not FTS, as BCCI had not
acquired the technology from the viewer that would enable them to produce live feeds
after the IPL ends. It was also held that because BCCI is the owner of the content of
the program and there is no transfer of any broadcasting rights to an eyewitness, the
payments will not reach royalty.
However, this stated decision applies in each case because if the payer/receiver of the
service receives the appropriate expertise from the service provider and is able to
apply the stated technical knowledge, knowledge, or ability alone ie. without the
assistance of a service provider, then the transaction will fall under the FTS model.
Therefore, judicial authorities should follow a consistent approach in line with
internationally accepted standards and thus create a fair environment for taxpayers.
Apart from the above, there are many other transactions such as web hosting services,
data storage, data retrieval, etc. tax. Therefore, it is important to strengthen the tax net
in relation to transactions involving technology and therefore do not escape any tax.

4. Permanent establishment and attribution of profits

Once the income has been determined in accordance with the type of transaction i.e. royalty
or FTS, taxation may be taxed at the rate stated in the preceding table. However, if the
income is recognized as business income, unless PE is established in India or there is a
business connection in India, the income cannot be taxed at the hands of a foreign/non-
resident company. Business Connection relies on the idea of a source-based tax, thus granting
the source country, the right to receive tax revenue from the activities performed in that
country.

For example, a foreign company in a taxpayer earns advertising money to publish the
contents of an Indian resident taxpayer on its search engine. The business model of foreign
companies using the search engine relies heavily on Intellectual Properties (‘IPs’),
algorithms, etc. And as such, it is free to access its essential services at any low tax base.
Similarly, such online advertising revenue earned by a foreign search engine company is not

4
(2015) 155 ITD 527 / 173 TTJ 591 (Mumbai – Trib.).
a fee for technical services and is tax-free in India due to the non-permanent establishment of
this foreign company in India. In addition, a foreign company that is a tax citizen in a tax
country will not be liable for any taxes in the country where you live, therefore, you will not
be taxed in any of the countries. Therefore, establishing PE in India or demonstrating
business connections in India is very complicated especially when business models thrive in
digital technology.

However, if the tax authorities indicate that there is PE in any business connection in India,
the following problem is given to the PE profit by the non-resident taxpayer. In addition,
unless the current worldwide adjective rules apply significantly, there may be no tax revenue
available in India. Generally, according to Article 7 of the Organization for Economic Co-
operation and Development ('OECD') Model Model Convention, if the books of account are
kept, PE should be made as a separate and distinct organization and profits need to be
distributed in accordance with the arm length procedure. If separate accounts are kept or
profits are not available, the tax authorities may take Rule 10 of the Taxation Laws, 1962,
and allocate profits in any way: The Inspector General ('AO') may deem it appropriate.

However, due to the lack of a uniform mechanism for tax authorities in implementing Act 10,
CBDT formed a committee that would provide clarity on the Indian approach, review
existing benefit-giving rules and recommend changes under the draft report. Accordingly, on
18 April 2019, a public consultation document/draft report was issued recommending minor
changes to the benefit-giving rules and inviting the views of stakeholders. In the draft report,
the committee recommended a framework for the distribution of benefits to PE in terms of
demand and provision of features. In the meantime, we await the release of the final report
and its inclusion in the tax regime.

Keeping the above issues in mind, we present the proposed amendments received by India
and foreign authorities as well as a few shortcomings and other possible recommendations for
final implementation. Before setting things up, it is important to note that negotiations are
only in India.

From the above analysis, it can be seen that foreign non-residential companies do not have
much access to the source country and so in order to strengthen the tax net, a proportional tax
is introduced.
 5. Evolution of Unilateral Measures

During the G-20 Summit, the G-20 countries discussed the need to create rules that would
charge for developing business models in digital technology, as the shift from brick and
mortar business to digital business is real and should be the next change in the tax sector.
Accordingly, it has instructed the OECD to address gaps in various tax systems around the
world. The OECD published the Action Plan on Base Erosion and Profit Shifting ('BEPS') in
July 2013 and the final report with 15 Action Plans was released in 2015. Essentially, BEPS
prohibits double tax evasion and tax evasion and refers to tax evasion strategies for space
users and non-compliance with tax laws to make excessive profit or non-tax authorities.

Of the 15 Action Plans, Action Plan 1 addresses the challenges posed by the digital economy.
Action Plan 1 has analyzed and suggested a number of alternatives:

i. Equalization Levy
ii. Withholding Tax on certain Digital Transactions
iii. Nexus based approach

None of the above options are recommended in this report. At the same time, the OECD has
agreed that until an international agreement is reached on this issue, countries can accept any
of the above in their domestic tax regime as long as they abide by the terms of the agreement
or participate in their two-way tax agreements. Given that the transformation of treaties will
take a long time, many countries in the last 3-4 years have used interim measures in their
local tax regime to address the tax challenges.

5.1. Equalization Levy

India as a pacesetter and more active, introduced the concept of ‘Equalization Levy’ vide
Finance Act, 2016 in its domestic tax law. This tax is effective from 1 June 2016. According
to the said provision5, when any resident or non-resident of PE in India makes a payment for
a particular service to a non-PE non-citizen in India, and the combined consideration exceeds
ten lakhs in the financial year, then the tax will be levied at a rate of 6 percent of the
5
Section 162 of the Finance Act, 2016
estimated value. Specified Service is defined to place an online ad, digital ad, or other site or
service for the purpose of an online ad and any other service as advertised by the
Government.

In addition, in some cases, where the service provider/non-resident without PE in India does
not agree with the new levy, the Indian service provider/salary may be required to make all
receipts, and therefore subject to another economic burden.

On the other hand, there are consistent amendments to the Act 6, which stipulate that where
any service provider's receipt has been subjected to valuation tax, then the same receipt will
be exempted from the Act and therefore will not form part of the taxable income.

5.2. Compliances & Regulation

In addition, if the recipient of the service fails to file the tax collected from the state treasury,
he or she will be required to pay a simple interest rate at the rate of one percent per month. 7 If
the recipient of the service fails to deduct the valuation tax, he or she will be liable to pay a
fine equal to the amount of the valuation tax in addition to the amount due. 8 An applicant
who is aggrieved by an AO-approved payment order may apply to the Income Tax
Commission (Appeal) within 30 days from the date of receipt of the order transferred by the
AO.9 The observer may continue to apply to the Appeal Tribunal within 60 days from the
date of receipt of the order approved by the Income Tax Commissioner (Complaints).10

5.3. Double Taxation

Since the equity tax was introduced as a separate chapter in the Finance Act, it was
deliberately kept illegally, and therefore, the benefit of the tax agreement would not be
available. As a result, foreign authorities will not allow foreign service providers who do not
reside in any taxable tax in India ie no foreign tax liability will be available. This could
eventually lead to double taxation, as a non-resident person will be required to pay income
6
Section 10(50) of the Income-tax Act, 1961
7
Section 170 of the Finance Act, 2016.
8
Section 171 of the Finance Act, 2016.
9
Section 174 of the Finance Act, 2016.
10
Section 175 of the Finance Act, 2016.
tax in his or her country of residence, although at a different rate. This is one of the
limitations of the equation. However, a non-resident may receive a slight exemption from that
double tax by seeking a reduction in the cost of the equity levy on his or her taxable income.

In addition, there are other important issues such as defined services under the equity tax that
may also be subject to the Integrated Goods and Services Act, 2017 (‘IGST Act’). According
to IGST law, any provision of services imported from outside India to the interior of India
shall be deemed to be a service provision between international trade or commerce and shall
be subject to taxation under the IGST Act. The GST payment debt is to the recipient of the
service in India, if the supplier of such service is located outside India. So, one point to look
at is that one transaction is taxed twice. However, it should be noted that it is a well-
established legal basis that the double taxation, two or more taxes must be paid: (i) in the
same place or in a particular case, (ii) by the same Government or authority, (iii) at the same
tax time, and ( iv) for the same purpose. In fact, there is no double tax when the purpose of
taxation is different. The Equalization Levy is set because non-resident companies have a
negative return than Indian competitors doing the same business. On the other hand, IGST is
collected as there is a purchase of goods or services in or both, which includes the import of
services. Therefore, it is not the same as a double tax. Therefore, before legal action, there is
no tax deduction; however, it is desirable to avoid double taxation. In addition, the sector
remains unpaid for a long time, and negotiations with foreign authorities will take a long
time, therefore, there should not be too many questions due to double taxation.

6. Nexus Based Approach

After the introduction of The Equalization Tax in 2016, India went ahead and became one of
the first countries to introduce the concept of Significant Economic Presence (‘SEP’) in its
domestic tax regime. Accordingly, the definition of business connection contained in section
9 of the Act is expanded, thereby bringing in income from a non-SEP resident under the
Indian tax net. The Finance Act, 201811 defines the SEP as follows:

 transactions in respect of any goods in India in excess of a specified amount,

including digital goods; or

11
Explanation 2A to section 9 of the Finance Act, 2018.
  transactions in respect of any Indian services in excess of a specified amount,
including digital services; or
 transactions in respect of any property in India in excess of a specified amount,
including data download or software; or
 formal and continuous business request from India from a specified number of users
through digital means; or
 systematic and continuous engagement with a set number of users through digital
means.

It is noted that the value stated will be on the basis of consolidation and is based on the value
of a single function. The Act further stipulates that no matter where the residence or business
premises of a non-resident person remains, it will still be business communication if it falls
within the definition of SEP.

Eligibility limits for eligibility as SEP will be determined by CBDT. CBDT also invited
comments/suggestions from stakeholders and the general public to determine the revenue and
user numbers thresholds and thereby determine the SEP of a non-resident in India. 12
Moreover, even the OECD has sought public opinion on proposals that address the challenges
of the digital economy and thus formulated nexus rules just so that profit can be authorized
based on value-building.13

7. Unilateral Measures adopted by different jurisdictions

12
Framing of Income-tax rules relating to Significant Economic Presence as per Section 9(1)(i) of the Income-
tax Act, 1961, Comments and suggestions reg. (2018, July 13). Retrieved October 20, 2020, from
https://www.incometaxindia.gov.in/news/sep-rules-calling-stakeholder-comments-13-07-2018.pdf.
13
OECD invites public input on the possible solutions to the tax challenges of digitalisation. (2019, February
19). Retrieved October 20, 2020, from https://www.oecd.org/tax/oecd-invites-public-input-on-the-possible-
solutions-to-the-tax-challenges-of-digitalisation.htm.
S. No. Country Measures Description

1. Italy Web Tax  Levied exclusively on B2B digital

transactions where supply of service
is through electronic means.
 Rate: 3 percent
 The total no of transactions for a
specific taxpayer shall be above 3000.

Modification in PE Introduced the concept of significant and

definition continuous economic presence.

2. Hungary Advertisement Tax Tax Levied on advertisement published in

media service.

Rate: 7.5 percent

Range: Business with advertising revenue

exceeding HUF 100 million.

3. Spain Digital Service Tax  Tax be levied on specific digital

services.
 Rate: 3 percent
 Worldwide revenue exceeding Euro
750 million and in Spain exceeding
Euro 3 million.

4. Israel Amendment of the Definition of PE to include economic

definition of PE activities conducted through the internet.

5. France Digital Service Tax  Tax to be levied on companies that

sell digital products from third
parties, traffic in user data, or sell
digital advertising.
 Rate: 3 percent
  Worldwide revenue exceeding Euro
750 million and in France exceeding
Euro 25 million.

6. UK Digital Service Tax  Tax to be levied on specific digital

business models.
 Rate: 2 percent
 Applicable to search engines, social
media platforms, and online
marketplaces

8. Shortcomings in the Implementation of the Unilateral Measures

 Appropriately, the purpose of expanding the scope of business connectivity was to

cover new business models working with the digital medium. However, in a clear
study of the term ‘transaction in relation to any goods, services or goods’, assets may
be tangible assets and assets may include intangible assets, which may not have been
the intention of the legislature.
 It is not clear whether the transactions conducted outside of India and partly in India
are covered by this situation or not; in other words, if a person does not live in India
but the customer is in India, the goods imported by the customer to India may not be
considered as ‘India’ transactions.
 It appears that the specified services included under the tax equity standard may also
be covered as SEP under definition 2A. Section 10 (50) of the Act now provides that
any income from such service is set and taxable. This exemption will also apply to
remuneration that is deemed to be in excess or arising under clause 2A and thus to the
extent that proceeds have been deducted there may be no additional tax under
Definition 2A.
 When SEP is defined, a few words such as 'order', 'continuation', and 'request' are not
clearly defined and therefore less than one definition.
  The term 'user' is confusing, as it did not explicitly, whether the user only includes
active users or users acting as users using clicks, viewer, subscriber, etc. For example,
there are many apps that allow free access or a trial base so users will be more users.
 Paragraphs (a) & (b) in the description are separated by 'On', therefore, these should
not be read in conjunction. However, this does not seem to be the intention of the
legislature. The profit-based limit and user-based limitations cannot be the same.
 Transactions consolidated within the equity unit may also be subject to SEP
provision. Therefore, there may be a discrepancy between SEP terms and
measurement levy provisions. Therefore, a clear definition should be issued, which
means that the provisions of the SEP will not apply to transactions below the equity
tax.

9. Conclusion

Currently, subject to the provisions of section 90 (2) of the Act, taxpayers will be subject to
the provisions of the Act or the DTAA, whichever is for the benefit of the taxpayer. In
addition, taking integrated measures such as 'Google tax rates' or changing and expanding the
definition of 'business connection' alone will not be good for investors and other stakeholders
or help increase tax revenue unless agreements are amended in the same lines, domestic
provision will remain reduced. Therefore, the creation of an international instrument ('MLI')
as required in Action Plan 15 of the BEPS Action Plan needs to be done immediately.
However, all countries may not allow themselves to be a metal signer, because they cannot
form a certain relationship between the two countries. Therefore, resolving/clarifying a few
provincial reservations at the MLI and re-negotiating tax agreements will be very helpful in
addressing this issue.

In addition, if the MLI exists and the tax agreements are amended, then the existence of the
estimated revenue i.e. google tax will need to be re-evaluated, as the same tax results are
doubled. In addition, having a clear definition of the terms used in the SEP provisions will
provide much-needed clarity and purpose and avoid future complaints.

In addition, this problem can be reverted to the exit once the data localization rules are in
place. The government has already introduced the Personal Data Protection Bill of 2018 and
is equally supported by RBI guidelines and national e-commerce policy planning. The bill
was written to strengthen the control of data collected by companies for its customers and to
improve human rights in relation to their personal information. All confidential data is
required to store at least one copy of personal information on a server or data center in India.
This may involve significant operating costs for fiduciaries and may also increase the burden
of compliance with companies. The RBI guideline stipulates that payment system operators
will be required to store all data in India only, meaning they will have to host a local server in
India, and will not be able to interact with Indian customers from foreign servers. Also, as
suggested in the draft national policy on e-commerce, commerce websites and media firms
will be required to store customer information only in India. Few MNCs have already been
overcome by the growing pressure of the RBI to act in accordance with data processing
practices.14 As established in various judgments15 that hosting local servers in India will make
it easier to assert the presence of a ‘planned business environment in India’, thus attracting
tax provision for the construction of PE.

It would be too early to comment on the exact tax angle; however, it is unlikely that this will
lead to a broader tax and a new source of government taxes.

14
WhatsApp gives in to RBI's diktat on data localisation; Will Amazon, Google follow suit? (2018, October 9).
Retrieved October 20, 2020, from https://www.businesstoday.in/current/corporate/whatsapp-store-data-in-india-
rbi-localisation-norms/story/284415.html.
15
ITO vs. Right Florists (P.) Ltd. (2013) 25 ITR(T) 639 (Kol. Tri), Mastercard Asia Pacific Pte. Ltd. In re,
(2018) 406 ITR 43 (Delhi AAR).