[By Neha Mehta and Mahek Shah]
The authors are both students at the NMIMS Kirit P. Mehta School of Law.
As a response to the outbreak of COVID-19, businesses across the globe have adopted digital models. ‘Digital India’, a government initiative, got a big boost with the demonetisation move four years ago. A 2019 report by the Ministry of Electronics and Information Technology (MeitY) in association with McKinsey & Co. predicted India’s digital economic value to surpass US$ 1 trillion by 2025. With the changing business models, value – creation is becoming less dependent on the physical presence of people or property. However, the current Indian taxation regime is based on conventional notions of physical existence and these concepts are now being challenged. The digitalisation of the economy is raising questions regarding the effectiveness of existing international taxation rules. The intergovernmental economic organisation, the OECD has expressed deep economic and societal impacts with rapid digitalisation and the absence of a global consensus on aspects of international taxation regulations which make a fertile ground for tax disputes. The business models are undergoing a complete technological revolution at full throttle while facing challenges with the effectiveness of outmoded global tax systems. Keeping these transformations in mind, the article canvasses the conflict between the existing Indian taxation regime and the Equalisation Levy – a direct tax that is withheld by the service recipient at the time of payment to a non-resident service provider.
Flashback: OECD’s Action Plan and India’s Equalisation Levy
In 2015, the OECD and G20 nations concertedly aimed to come up with a global solution to specifically deal with tax challenges of the digital economy by the end of 2020. It was in the backdrop of the Base Erosion and Profit Shifting project (hereinafter referred to as the “BEPS Project”) that OECD released the Action Plan 1. Despite failing to provide concrete solutions, it has guided countries to structure their tax laws as per the changing digital landscape. Limitations of the existing Permanent Establishment rules (hereinafter referred to as the “PE rules”) and the ability of MNC’s to avoid taxes through profit shifting strategies create concerns for countries like India that follow source-based taxation. India is an active member of the OECD and has staunchly expressed the need to eliminate tax uncertainty and stimulate global trade. Drawing an inference from the 2015 Action Plan 1, India was amongst the first countries to implement the ‘Equalisation Levy Rules’ in 2016 (hereinafter referred to as “EL 1.0”). Primarily, the imposition of this direct tax vide the Budget 2016 was limited to only non-resident companies engaged in providing digital advertising services and digital space. However, the Finance Act, 2020 broadened the scope of Equalisation Levy 1.0 to contain all e-commerce supply of services known as Equalisation Levy 2.0 (hereinafter referred to as “EL 2.0”)
Equalisation Levy 2.0: What does it seek?
Unlike EL 1.0 that sought to uprightly tax online digital advertisement services at a rate of 6%, EL 2.0 imposes a 2% tax on e-commerce operators for supplying or providing services over INR 2 Crores:
i. Indian Resident;
ii. Persons availing online services using an Indian IP address;
iii. Non – Residents in the following cases:
- Only those sales of advertisement services that target a resident of India or a user having IP address located in India.
- Sale of data that is collected from a resident of India or a user having IP address located in India.
Challenging the Status Quo
The introduction of EL 2.0 certainly is a step in the right direction. However, the expansion in its scope poses numerous challenges.
a. Lack of Clarity on Definitions
EL 2.0 fails to explain several terms such as “operate,” “digital,” “electronic facility,” “platform,” “online sale,” “goods” and “online provision of services” that are mentioned in the statute. This creates room for wide interpretation and could be disputable. For instance, situations where sales could be concluded online through emails or messages but the deliveries are undertaken in an offline mode. The failure to define terms like “online sale” creates confusion in determining whether the levy would have applicability to a combination of online and offline sales. Therefore, it is unclear if the levy is applicable on every transaction with a component of digital dealing.
b. Impediments with Extra-Territorial Application
As per Section 92F(iii)(a) read along with Section 92F(iii) of the Income Tax Act, 1961 and the Double Taxation Avoidance Agreements (hereinafter referred to as “DTAAs”), non-resident entities need to generate profits that can be attributable to a fixed place of business or demonstrate sufficient business connection in India for their income to be assessed in India. However, owing to the digital economy, it has become difficult to show a PE of business models that relies on intangibles such as cloud- computing, algorithms, etc. They have enabled the capability to conduct business through foreign jurisdictions. Therefore, concepts like Place of Effective Management (POEM) that are based on corporeal and tangible aspects have now proved to be redundant. In its Action Plan 1 Report, the OECD identified three plausible options amongst which was to establish nexus through Significant Economic Presence (hereinafter referred to as “SEP”). Despite deferring the applicability of SEP in India, it may prove ineffective due to the treaty override.
c. Fiscal Shortfall
The committee on Taxation of E-Commerce headed by Chairman Akhilesh Ranjan, Joint Secretary (FT & TR-I), CBDT, Department of Revenue, Ministry of Finance released a report in 2016. The report highlighted fiscal constraints on governments due to violation of tax neutrality. Fiscal deficits are often reimbursed through local residents who pay increased taxes on income earned, goods and services, etc. This adversely impacts businesses and disrupts the existing market equilibrium.
d. Characterisation of Income
Firstly, there is a possibility that transactions may be assessed as Royalty/ Fees for Technical Services (FTS) / Fees for Included Services (FIS) by the Assessing Officer in a tax audit, much after the payment of the Levy. As the Levy falls outside the ambit of the Income Tax Act 1961, an application for Authority for Advance Ruling (hereinafter referred to as “AAR” ) cannot be moved. Even if an AAR is sought under Section 10(50) of the Income Tax Act 1961 to determine the taxability or exemption under Section 9, whether the non-resident e-commerce operator will be refunded for paying the Levy is still unsettled. Secondly, EL 2.0 and GST are self-contained levies in India. Thus, there is no availability of credit under one regime when taxes have already been paid in another.
e. Gross Income v. Income from Commission
EL 2.0 does not define the term ‘consideration’ to determine the basis of the levy. The levy covers sale of goods and provision of services through a digital platform enabled by an e-commerce operator. However, the taxable value of transactions is still uncertain. For transactions where discounts, cash-back, etc. are offered, whether the levy seeks to tax the full consideration or only on the net commission income of the operator is ambivalent. While it is well settled that taxing provisions require a strict interpretation, the courts may have to modify the intent to fulfill the objectives of the levy.
f. Foreign Tax Credit (FTC) and the Possibility of Double Taxation
A taxpayer earning income abroad may be subjected to double taxation, making foreign tax credit an important part of the tax-filing process. For example, if a US citizen earns an income in India, they will be subject to tax in both the US and India for the same transaction. There are no avenues to claim benefits or credit within EL 2.0. Even though India has DTAAs with over 85 countries, it does not include any credit-based system to combat potential double taxation.
g. Impractical Responsibilities on E-Commerce Operators
EL 2.0 shifts the onus of compliance from the service-recipient onto the e-commerce operator. They are expected to keep a track of the IP address of every customer, map the source of data, and identify all possible targets of their advertisements which is highly impractical as well as unfeasible. The companies would have to commit a significant technical workforce to re-engineer their systems. These obligations are unviable and financially draining. Firstly, the term ‘residing in India’ makes it difficult to distinguish between ordinary residence and residence for tax purposes. For instance, whether an Indian resident’s online purchase of goods or services in a foreign country attracts EL 2.0? Secondly, the e-commerce operators are expected to pay the levy every quarter and furnish a detailed annual statement of all taxable e-commerce supplies or services to avoid any punitive action. They will be subjected to Indian tax assessment and pushed to employ the Indian tax litigation framework to resolve any disputes. However, the provisions fail to provide an opportunity for these non-resident e-commerce operators to choose their fiscal year. This could have adverse effects on foreign investment and global market sentiments.
While unilateral decisions like India’s Equalisation Levy can be a concrete example of measures that can be taken in the absence of a global consensus, they have their share of risks and ramifications. Although the provisions are in tune with the OECD’s objectives, arguments backed by the Action Plans only have a persuasive value before the Indian tax authorities. Behemoths like Google and Facebook have cited cross-border data transfer issues and norms surrounding intellectual property to postpone the levy. Therefore, the perspectives of all stakeholders need to be taken into consideration. Judge Posener’s assertion,“Law lags science; it does not lead it” has often proved to be true. Failure to understand changing business models will drive huge economies like India to forego substantial tax revenue. India’s taxation framework needs relevant laws to harmonize with the latest technology and market trends.
The Way Forward
Taxation is dynamic and the provisions of the statutes require constant revision to avoid redundancy. Therefore, the adoption of a separate Digital Tax Code is imperative to ensure that the system is at par to scrutinize complex transactions. Moreover, there exist provisions to only file an appeal for a penalty order. A separate enforcement mechanism for contesting EL 2.0 and the interest is obligatory. It is important to thoroughly define key terms and principles to avoid misinterpretations. A series of bright-line tests can be adopted to establish basic standards to judge a situation. In other words, it can be a judicial rule to determine the applicability of EL 2.0 and resolve ambiguous issues. Even though a global consensus and a unified approach could be too ambitious, India should continue with bilateral negotiations. Fortune favors the prepared. Hence, India should proactively embrace a powerful digital taxation system.