The international tax rules were conceived in the early 20th century, when profit-generating activities were still “bricks&mortar”. In the current environment, businesses can have significant economic engagements with consumers and users in a jurisdiction without having any physical presence there.

Three characteristics of highly digitalised business models—scale without mass, a heavy reliance on intangible assets, and the role of data and user participation—work together to enable value creation. For example, some highly digitalised business models may solicit substantial contributions to, and active utilisation of, a web-based platform by a jurisdiction’s residents, generating substantial value for a business but, under the current tax rules, that jurisdiction may not have a taxing right over any of that business’s income.

Some of these business models may facilitate large numbers of transactions between persons within the same country, generating value for the business without creating any taxing right for the user or market jurisdiction—notwithstanding the highly localised impact of the utilisation of the platform. Such remote participation in an economy, without a taxable physical presence, forms the crux of the digital tax debate.

The introduction of “significant economic presence” or SEP in the Indian tax law is motivated by the view that the digitalisation of the economy and other technological advances have enabled business enterprises to be heavily involved in the economic life of India without a significant physical presence. Under this rule, taxable presence would arise for a non-resident enterprise on the basis of evidence of a purposeful and sustained interaction with the jurisdiction.

This is defined based on revenue generated from Indian customers or the number of users in India. The monetary threshold for determining this nexus has recently been notified as annual revenues of Rs 20 million or more, and user-base threshold has been set at 300,000 or more. The rule came into application from April 1, 2021.

It is unlikely that the SEP rule would have an immediate impact on multi-national enterprises who may be eligible for protection under India’s tax-treaty network. As taxation rights in existing bilateral tax treaties are linked to having a physical presence in a jurisdiction, this would prevent India from applying the domestic SEP rule. Further, given the recent expansion in the scope of equalisation levy to cover a wide range of e-commerce transactions, it is likely that number of such transactions would be covered by the levy and therefore exempt from income-tax.

Revenue or user base may be a basic factor, but, in isolation, can these factors evidence a purposeful and sustained interaction with a jurisdiction? Further, the thresholds for the basic factors also appear to be fairly low considering the size of the potential user base in India and the ability for most digital businesses to achieve scale in a very short timespan.

This may place onerous burdens on relatively small and medium digital enterprises, impacting their growth, which, in turn, may have competition implications. Even in a situation where a taxpayer has an SEP in India, what may be taxed is only profits attributable to the SEP. Hence, any solution that seeks to address nexus must also address the closely related issue of profit allocation, or it is bound to fail—with likely increase in uncertainty and controversy without a meaningful increase in income allocation. The criterion of significant people functions relevant to the assumption of risk and to the economic ownership of assets in the context of digital activities may not be sufficient to ensure a profit attribution to the SEP. The government should therefore consider how the arm’s length principle can be applied to a SEP.

Over the last few years, the OECD/G20 Inclusive Framework has made progress on developing a global solution and proposed a two-pillar system. India is committed to the implementation of the global solution. With a global consensus expected to emerge on the new division of taxing rights, one would hope that some these unilateral domestic tax law measures are at best interim solutions and would be rolled back in due course or would be applied in more targeted circumstances.

Source : PTI