[By Trilok Choudhary & Arya Tiwari]

The authors are students of Gujarat National Law University.

 

INTRODUCTION

Digitization has transformed the business landscape, blurring the boundaries between physical and virtual realms. As businesses navigate this digital frontier, so must tax policies evolve to ensure a fair and equitable taxation framework that captures value in an increasingly intangible economy.

TAXATION UNDER OECD MODEL CONVENTION

The challenge of taxation initially arose from how to tax foreign corporations. While India could tax domestic entities, complexities emerged with foreign companies operating internationally. The core issue was the risk of double taxation. Each nation holds the right to tax its residents, but this posed questions about where foreign enterprises’ profits should be taxed. This led to a conflict between the company’s incorporation state (resident state) and the state where profits were generated (source state). The OECD Model Convention’s Article 7 introduced the “permanent establishment” concept, a fixed business location in the source country. Foreign companies were primarily taxed by their resident state, but if they had a permanent establishment in the source state, that state could also tax them. Article 7(2) clarified permissible taxation, treating permanent establishments as separate entities. For example, let’s take a hypothetical situation involving a company, say Rico, and its establishment in different states were seen as distinct entities for tax purposes. Transactions between them involved theoretical compensations, like managerial services or licensing fees, determined through a process called benchmarking. The source state could then tax Rico based on these hypothetical payments. Despite attempts, the issue of double taxation persisted, as both source and resident states had tax authority. Article 23 resolved this with the Exemption Method (taxing remaining income after source state tax) and the Credit Method (taxing entire income but crediting back the source state tax). Article 10 extended source state authority to tax passive incomes, imposing conditions on dividends. The foreign company must hold 25%+ shares in the permanent establishment for 365+ days and qualify as the “Beneficial owner” of dividends. This ensures funds are genuinely for its use, and merely as a conduit. Source states can tax dividends (up to 5%) and interest (up to 10%). The “Beneficial owner” concept prevents non-treaty states from exploiting reduced tax rates for entities in treaty states.

How exactly do you tax digital entities that have only a digital presence within the market and no permanent establishment (The Digital Challenge)? 

This is perhaps the biggest challenge in the arena of international taxation in recent time and in this regard on July 11, 2023, 138 members of the OECD/G20 Inclusive Framework on BEPS agreed upon an outcome statement to address taxation challenges stemming from the digital transformation of global economies. This need was heightened by Multinational Enterprises (MNEs) exploiting tax discrepancies to shift earnings to low or no-tax areas, weakening the tax base of many nations. This exploitation, coupled with the ability of businesses to operate in areas without a tangible presence, challenged traditional tax norms based on “permanent establishments.” Consequently, the framework aims to promote fairness, tackle intricate tax avoidance tactics, establish a standardized global tax landscape, avoid double taxation, and amplify transparency. The solution comprises two main pillars. Pillar 1 focuses on Profit Allocation and Nexus, moving beyond the older notion limited to Permanent Establishment. It introduces taxation rights for nations with significant user/consumer bases, even if a business doesn’t have a tangible presence there. For MNEs surpassing a turnover of USD 20 Billion and a profitability above 10%, taxes are based on revenues from that specific jurisdiction. However, this might lead to additional tax levies. To counter this, the GloBE regulations mandate that MNEs contribute at least 15% tax on earnings from every jurisdiction.  These rules complement current corporate tax norms; if taxes on revenue in a jurisdiction meet the minimum tax requirement, no extra tax is levied. Furthermore, Pillar 2‘s 15% minimum tax levy addresses under-taxation by tax havens. For instance, if State S taxes a company at only 9%, the home state can impose an additional top up tax of 6%, guaranteeing the minimum tax threshold, addressing concerns related to patent boxes, thin-capitalization, and transfer pricing.

INDIAN EQUILISATION LEVY

India initially chose not to directly adopt the OECD BEPS recommendations. Instead, in 2016, it implemented its unique tax measure, known as the Equalization Levy, set at a 6% rate. This levy applied to specific services, primarily targeting online advertising services received by Indian resident businesses or non-residents with a permanent establishment in India, from non-resident service providers. This was referred to as Equalization Levy 1.0. In 2020, India further expanded the Equalization Levy’s scope through an amendment, introducing a new 2% levy on e-commerce supplies or services. This updated version is often referred to as Equalization Levy 2.0, it encompasses all e-commerce operators, regardless of their Indian residency status. An e-commerce operator, in this context, refers to a non-resident entity that owns, manages, or operates a digital platform facilitating online sales of goods or service provision. Under this framework, such operators are subject to a 2% charge on the total consideration received or expected. However, this levy does not apply to entities possessing a permanent establishment within India, provided the e-commerce activity is directly associated with that establishment. The following scenarios such as digital entities already subject to the existing 6% equalization levy, transactions with an annual consideration value under INR 2 crores are likewise excluded from this levy. However, the Equalization Levy was not without its shortcomings. The broadly phrased provisions in the levy introduce both interpretational and practical challenges. For instance, the levy stipulates that individuals providing services utilizing an Indian IP address can be subject to taxation. However, this raises a quandary when dealing with non-Indian residents using Indian IPs for transactions with service providers outside India. This ambiguity sparks concerns about the levy’s extrajudicial reach. Moreover, it’s unclear if the levy targets the total sales of goods or just the commission charges by e-commerce platforms. This distinction is significant, particularly for entities like hotel booking aggregators that pre-book rooms and subsequently sell these reservations on their platforms, essentially engaging in the sale of goods. Another complication arises from the fact that many treaties entered into by India under the OECD cover taxation under the Income Tax Act and related surcharges. However, the Equalization Levy falls under the Finance Act, creating a scenario where multinational enterprises (MNEs) may not have the option to claim credits in their resident states for the tax already paid. This situation could lead to instances of double taxation. Furthermore, potential conflicts arise between this levy and the Pillar 2 component of BEPS, which establishes a minimum effective tax rate of 15%. This rate exceeds the 2% stipulated in Equalization Levy 2.0. Striking a balance between these divergent provisions poses a significant challenge.

CONCLUSION

Due to the notable shortcomings of the Equalization Levy and a commitment to global collaborative efforts towards a standardized approach for taxing digital entities, India embraced the implementation of the BEPS framework alongside 138 other signatory countries. This decision holds potential advantages for India, as the BEPS Pillar 2 introduces a global minimum tax of 15% on digital giants like Google and Amazon. The OECD estimates that this move could enhance developing countries’ corporate income tax revenues by around 1.5 to 2 percent. However, under the multilateral convention (MLC), all participating countries are required to withdraw digital taxes and similar measures affecting all companies and refrain from introducing such measures in the future. Consequently, India will have to relinquish the Equalization Levy which had been progressively contributing to government revenue, by April 1st, 2026, the anticipated commencement date for the implementation of MLC’s Pillar 1 component. The main drawback for India in this arrangement is that while it anticipates increased revenue through BEPS Pillar 2, the rules outlined in Pillar 1 apply solely to organizations with revenues exceeding $20 billion and profit margins exceeding ten percent. This scope encompasses only the top 100 companies. In contrast, the threshold for the Equalization Levy is much lower at INR 2 crore, leading to a loss of potential revenue for India.