The government’s 2018 Budget – presented by finance minister Arun Jaitley on February 1 – contains a proposal that upsets a long-standing international tax principle governing source-based taxation of business profits of foreign enterprises. Currently, a foreign enterprise pays Indian income tax only on income that is attributable to a “permanent establishment” in India, that is, income attributable to a physical or representative presence in India. In Budget 2018, the finance minister has proposed to supplement this “physical” tax nexus with a new tax nexus based on “significant economic presence,” thereby lowering the current threshold stipulated in section 9(1)(i) of the Income Tax (IT) Act.
The Explanatory Memorandum released alongside Budget 2018 states that the proposal to create this new tax nexus is aimed at tackling the direct tax challenges posed by digital economy and that the proposal would prevent online businesses from “unreasonably and unfairly eroding India’s tax base.” As noted below, there is nothing inherently wrong with the proposal or the intent behind introducing this new tax nexus, but the unseemly haste with which the finance minister has proceeded to implement it in the IT Act will open up floodgates of international tax disputes and further dent India’s image in the international business community.
It is true that digital economy poses real threats to the application of the traditional principle relating to source-based allocation of taxing rights vis-à-vis business profits, which places a wholesome reliance on physical or representative presence. Unlike brick and mortar companies, digital businesses can interact and trade with their customers in India through digital means, without the need to establish a physical presence in India. And because tax treaties do not recognise the concept of a virtual economic presence, businesses who employ digital models fall outside the Indian income tax net even as they make full use of India’s infrastructure (legal and otherwise) to carry on their business activities and generate revenue.
The question, therefore, is not whether a new tax nexus based on virtual economic presence must be drawn to bring digital businesses into the Indian income tax net. Instead, the core question is how and when. The direct and indirect tax challenges posed by digital economy are not unique to India and countries across the world are debating and deliberating on effective ways to address them. In fact, as part of its work on base erosion and profit shifting (BEPS), the Organisation for Economic Co-operation and Development (OECD) is actively working on finding solutions to some of the key international tax challenges resulting from recent advancements in information and communication technology (ICT).
It is anybody’s guess why the Explanatory Memorandum released by the finance ministry alongside the Budget notes that the OECD has recommended countries to implement a new nexus based on “significant economic presence” to tax digital businesses. The finance minister is, of course, well aware of the international tax developments taking place at the OECD-level. He must also be aware that, although the OECD in its final report on BEPS Action 1 discussed introducing a new tax nexus based on “significant economic presence” to tackle the tax challenges posed by digital economy, it categorically advised countries not to consider the new nexus as an internationally agreed standard. The reason for this is clearly stated in the Report:
“The new nexus in the form of a ‘significant economic presence’ would require substantial changes to key international tax standards and would require further work. In the changing international tax environment, a number of countries have expressed a concern about how international standards on which bilateral tax treaties are based allocate taxing rights between source and resident countries. At this state, it is however unclear whether these changes are warranted to deal with the changes brought about by advances in ICT.”
Even if we assume for a moment that the finance minister’s decision to introduce a new nexus was informed, wholly or partly, by discussions taking place at the OECD-level, the meaning and scope of “significant economic presence” that is proposed to be introduced in section 9(1)(i) of the IT Act goes far beyond what is outlined in the OECD’s final report on BEPS Action 1. According to the Finance Bill, 2018, “significant economic presence” would exist if the aggregate of payments arising from a transaction during the financial year exceeds the prescribed amount (“revenue-based factor”), or if the foreign company systematically and continuously solicits business activities or engages in interaction with a prescribed number of Indian users through digital means (“user-based factor”). The definition implies that the revenue-based factor and the user-based factor would apply in exclusion to each other. On the contrary, the BEPS Action 1 report notes that the revenue-based factor is to be applied in combination with other factors so that only cases of significant economic presence are covered, compliance costs are limited, and there is tax certainty for cross-border activities.
There are other areas of concern too. The proposed definition of “significant economic presence” is overly broad, vague, and susceptible to more than one interpretations. Would the revenue threshold apply only to digital transactions or all kinds of transactions? Would solicitation of, or engagement with, Indian users through “digital means” include telephonic or e-mail solicitation or engagement? Would “number of Indian users” (as against active users) include robots and fake users? The Explanatory Memorandum to the Budget notes that the finance ministry will open up a consultation process with stakeholders to figure out what the minimum revenue threshold or the minimum number of users should be. For an amendment as important (and complex) as this, a consultation process should ideally have preceded the Budget.
It is unfortunate that the Indian government’s stance on some international tax principles runs contrary to the intent of the BEPS project and undermines global efforts in establishing a disciplined and consistent international tax landscape. Pending the release of OECD’s final report on digital economy taxation in 2020, it would be an uphill task for the Indian government to bring its treaty partners to the table to negotiate the incorporation of the new tax nexus in its treaties. Whether or not countries will agree to India’s version of “significant economic presence” and how taxing rights would be allocated in future is something that time will tell. For now, the Modi government must be well-informed that changes to tax law and policy must be inspired by settled principles of efficiency, certainty and simplicity.
Ashish Goel is a lawyer. He tweets @ashish_nujs