Navigating the Pitfalls: Assessing the Sep Model for Digital Taxation

[By Isha Janwa]

The author is a student of O.P. Jindal Global University, Sonipat.



In today’s interconnected world, the ‘digital economy’ has emerged as a powerhouse, the rise of which can be attributed to advancements in information and communication technology (ICT). Multinational Enterprises (MNEs) now conduct cross-border business seamlessly, without the need for physical presence in foreign territories. This paradigm shift allows digital corporations to establish connections with consumers and operate virtually, transcending geographical boundaries via internet. 

However, this newfound flexibility in the digital landscape has sparked significant concerns in taxation. Traditional tax frameworks, designed for ‘brick-and-mortar’ economy, struggle to accommodate the borderless nature of the digital economy. The reliance on physical presence as a basis for taxation becomes increasingly inadequate in this dynamic environment. 

Recognizing these challenges, the Organisation for Economic Co-operation and Development (OECD) introduced Base Erosion and Profit Shifting (BEPS) Action Plan 1. This initiative characterizes the digital economy as data-driven, reliant on intangibles, and complex in determining value creation jurisdiction due to minimal physical presence requirements. 

OECD’s action plan identifies three key taxation challenges in the digital economy: the need for nexus, navigating data usage and value attribution, and characterizing payments for digital goods and services. To address these challenges, OECD proposes a two-pillar approach. Pillar one focuses on broader taxation issues, including profit allocation and nexus, while pillar two targets remaining BEPS concerns such as establishing a global minimum tax rate. 

The action plan presents three solutions for digital taxation: establishing a nexus based on Significant Economic Presence (SEP), implementing withholding tax on digital transactions, and introducing an equalization levy. However, it has not recommended any specific measure, therefore, countries can adopt either of these measures. 

One such measure, Significant Economic Presence, has been adopted by countries like India. This paper examines the importance of nexus in taxation and assesses the effectiveness of implementing Significant Economic Presence to address nexus challenges, with a focus on India’s tax framework. 


In the intricate landscape of taxation, the principle of nexus plays a pivotal role. Essentially, nexus refers to the connection between an entity’s income and the jurisdiction seeking to tax it. However, in the realm of ‘digital economy’, this connection becomes notably elusive. 

Digital companies, operating primarily in the virtual realm, often lack physical presence in the countries where their services are consumed. This absence of a tangible footprint makes it challenging for tax authorities to establish a direct link between the company’s income and the country, unless a permanent establishment exists. 

The absence of a permanent establishment often leads to the taxation of digital companies’ profits in the jurisdiction of their incorporation. This loophole enables digital entities to strategically establish themselves in low-tax jurisdictions while profiting from a global customer base online. 

Since the entity would be taxed in the place where it is incorporated, the countries try to have lower tax rates so that the profits are shifted but this competition puts the developing countries at a disadvantage because the corporate tax is one of the main sources of income for such countries. Therefore, one of the key objectives of BEPS project is to prevent ‘shifting of profits’ and ensure that companies pay taxes where their economic activities generate profits, irrespective of their physical presence. 

However, the absence of a clear nexus between digital companies and the countries where they operate presents a substantial hurdle. It can be avoided by establishing a taxable presence in the jurisdictions where the entities are performing economic activities even without being physically present. The concept of Significant Economic Presence was brought forth to address this issue. It means that non-resident entities can be taxed in a jurisdiction if they engage in significant economic activities there, even without a permanent establishment. This ensures taxation of substantial economic value derived from the jurisdiction, regardless of physical presence. It is based on three factors. Firstly, the generation of revenue. Secondly, digital factors like IP. Thirdly, user-based factors. 

India adopted this measure of Significant Economic Presence (SEP) in 2018 but the applicability got deferred to 2021-22. India introduced the concept of Significant Economic Presence (SEP) in 2018, but its implementation was delayed until 2021-22. According to Section 9 of the Income Tax Act, 1961, any income earned by non-residents from a business connection in India is deemed to have accrued or arisen in India, making it taxable in the country. Explanation 2 to section 9(1)(i) defines “business connection” and now includes a new way to tax foreign companies’ profits known as “significant economic presence.” This means that if a non-resident has a significant economic presence in India, it will be considered as having a business connection in India, leading to the income being taxed in India, regardless of having a physical presence or providing services in India, or where the agreement for the transactions is made. This occurs if either of two specific conditions are met. One is revenue-based SEP, which considers taxation based on generated income, while the other is user-based SEP, which considers taxable presence on the basis of a substantial user base or customer activity within the jurisdiction. The former addresses revenue, while the latter addresses user activity.. Central Board of Direct Tax has issued notification defining thresholds for establishing SEP. The threshold for Revenue is 20 million Indian Rupees. The threshold for users is 300,000 users.  

In the traditional framework of taxation laws, the ‘source taxation’ was not established sufficiently for digital economy. However, the concept of Significant Economic Presence has enabled ‘source countries’ to tax the income which is generated from their jurisdictions.  


The provision of SEP seeks to bring non-residents within the ambit of domestic laws of taxation in India. Since this measure is adopted only in domestic law of India, it can’t override the tax treaty provisions of ‘Double Tax Avoidance Agreement’ (hereinafter ‘DTAA’)  which are primarily based on the concept of permanent establishment. Without revisions to these treaties to accommodate SEP, the treaties will take precedence. As a result, SEP may become ineffective despite its inclusion in domestic laws. 

Compounding this issue is the lack of consensus, the OECD model has provided three potential solutions allowing the countries to adopt any of these. As a result, there is a lack of consensus globally regarding a standardized approach to addressing the challenges of digital taxation.  

Moreover, measure like SEP the countries can define its own thresholds which might be a problem while renegotiating the tax-treaty because it is unlikely that countries would agree to widen the scope of tax framework within DTAA to expose their residents to taxation in another country with such low thresholds of SEP. 

Despite these challenges, SEP can still impact tax policies in cases where no tax treaties exist. However, for user-based SEP, the transaction takes place online, which is difficult to take into account apart from IP address, potentially resulting in double taxation for consumers. 

While the OECD continues to discuss profit attribution matters, Indian tax legislation dictates that all profits associated with such Significant Economic Presence (SEP) will be subject to taxation in India. Once the ‘business connection’ test based on Special Economic Presence (SEP) is satisfied, only so much income which is associated with SEP activities will be considered as if it accrues or arises in India. However, the lack of clear guidelines for calculating such profits may lead to misallocation of tax obligations.  

Furthermore, there is a possibility of overlap between Fees for Technical Services (‘FTS’) and SEP which occur when non-residents provide technical services that are already covered under specific provisions of domestic tax laws. This overlap raises questions about the tax treatment of such services, including whether they should be taxed under the SEP provisions or specific provisions of domestic tax laws that prescribe different tax rates and bases for taxation. 


Traditional tax frameworks have struggled to keep pace with the borderless nature of this digital economy, resulting in significant taxation challenges. The measures provided by OECD to address the issues of taxation of digital economy are more focused on mitigating BEPS rather than solving the long-term Issues of taxation. It is a belief held by some economists that, in the context of digitalisation, it is more appropriate to create tax regulations that do not disrupt investment choices and cater to the need of this new economy. While SEP aims to tax non-resident digital companies operating in India, its effectiveness is hindered by uncertainties and potential conflicts with tax treaties. Therefore, the taxation of such business entities which are virtually performing economic activities in many countries require modification of current tax law regime and harmonisation of different tax law regimes through consensus at international level.  

The SEP model lets the countries decide the threshold for taxation which would again lead to disparity among tax regimes of countries. Indeed, countries have adopted unilateral measures to deal with these issues. However, the widespread virtual presence of business across countries renders these domestically adopted unilateral measures unless some consensus is reached in international community which is reflected by the changes in the tax treaties. Otherwise, either the domestic measures would be practically ineffective or lead to double taxation.  

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