‘Business Connection’ redefined- Budget 2018!

Budget 2018 introduced major changes to the concept of ‘business connection’ under Explanation 2 to Section 9(1)(i) of the Income-tax Act, 1961 aligning the same with the Action Plans of Base Erosion and Profit Shifting (BEPS) project headed by the Organisation for Economic Co-operation and Development (OECD). This article discusses the existing provisions, the challenges faced by the regulator and the changes made in the Budget in order to resolve these challenges.

Modification of term ‘permanent establishment’

Existing provisions

• If any person acting on behalf of the non-resident, is habitually authorised to conclude contracts for the non-resident, then such agent would constitute a permanent establishment in the source country. (Article 5(5) of India’s Double Taxation Avoidance Agreements (DTAAs))
• A permanent establishment is deemed not to exist when a place of business is engaged solely in certain activities such as maintenance of stocks of goods for storage, display, delivery or processing, purchasing of goods or merchandise, collection of information. This exclusion applies only when these activities are preparatory or auxiliary in relation to the business as a whole. (Article 5(4) of DTAAs)

Challenges faced by the regulator

With an intention to avoid payment of taxes, the existing definition of permanent establishment was circumvented through following ways:

• Commissionaire arrangements- Person acting on behalf of the non-resident, negotiates the contract but does not conclude the contract
• Fragmentation of business activities- Fragmentation of functions which are otherwise a whole activity in order to avail the benefit of exemption

Recommendations under BEPS Action Plan 7*

The OECD under BEPS Action Plan 7 reviewed the definition of permanent establishment and recommended the following changes:

• An agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts
• Introduction of an anti-fragmentation rule to prevent the tax payer from resorting to fragmentation of functions which are otherwise a whole activity

*included in Article 12 of Multilateral Convention to Implement Tax Treaty Related Measures (MLI)

Impact of the above recommendations on Income-tax Act, 1961

• Dependent Agent Permanent Establishment (DAPE) provisions in accordance with BEPS Action Plan 7 will become wider in scope than the current provision.
• Anti-fragmentation rule narrowed the scope of the exception under Article 5(4), thereby expanding the scope of permanent establishment in DTAAs vis-a-vis domestic provisions.

In effect, the relevant provisions in the DTAAs are wider in scope than the domestic law. However, Section 90(2) provides that the provisions of the domestic law would prevail over corresponding provisions in the DTAAs, to the extent they are beneficial. Since, in the instant situations, the provisions of the domestic law being narrower in scope are more beneficial than the provisions in the DTAAs, as modified by MLI, such wider provisions in the DTAAs are ineffective.

Proposal in Finance Bill, 2018

The Budget 2018 proposed the following amendment in Section 9(1)(i) with an objective to align the requirements in the Section with the provisions in the DTAA as modified by MLI so as to make the provisions in the treaty effective:

• Business connection to also include any business activities carried through a person who, acting on behalf of the non-resident, habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by the non-resident.
• The contracts should be-
• (a)   in the name of the non-resident; or
• (b)  for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that the non-resident has the right to use; or
• (c)   for the provision of services by that non-resident

The above amendment is effective from 1 April 2019 and applicable in relation to assessment year 2019-20 and subsequent assessment years.

Inclusion of ‘significant economic presence’

Existing provisions

Business profit of an enterprise is taxable in the country in which the taxpayer is a resident. If an enterprise carries on its business in another country through a 'Permanent Establishment' situated therein, such other country may also tax the business profits attributable to the 'Permanent Establishment'. For this purpose, ‘Permanent Establishment’ means a ‘fixed place of business’ through which the business of an enterprise is wholly or partly carried out provided that the business activities are not of preparatory or auxiliary in nature and such business activities are not carried out by a dependent agent. (Article 7 of DTAAs)

Challenges faced by the regulator

For a long time, nexus based on physical presence was used as a proxy to regular economic allegiance of a non-resident. However, with the advancement in information and communication technology in the last few decades, new business models operating remotely through digital medium have emerged. Under these new business models, the non-resident enterprises interact with customers in another country without having any physical presence in that country resulting in avoidance of taxation in the source country. Therefore, the existing nexus rule based on physical presence do not hold good anymore for taxation of business profits in source country. As a result, the rights of the source country to tax business profits that are derived from its economy is unfairly and unreasonably eroded.

Recommendations under BEPS Action Plan 1

OECD under its BEPS Action Plan 1 recommended introduction of a new nexus rule based on “significant economic presence”. As per Action Plan 1, a non-resident enterprise would create a taxable presence in a country if it has a significance economic presence in that country on the basis of factors that have a purposeful and sustained interaction with the economy by the aid of technology and other automated tools. It further recommended that revenue factor may be used in combination with the aforesaid factors to determine ‘significance economic presence’.

Impact of the above recommendations on Income-tax Act, 1961

The scope of existing provisions of Section 9(1)(i) is restrictive as it essentially provides for physical presence based nexus rule for taxation of business income of the non-resident in India. Explanation 2 to the said section which defines ‘business connection’ is also narrow in its scope since it limits the taxability of certain activities or transactions of non-resident to those carried out through a dependent agent. Therefore, emerging business models such as digitized businesses, which do not require physical presence of itself or any agent in India, was not covered within the scope of Section 9(1)(i) of the Act.

Proposal in Finance Bill, 2018

In view of the above, the Budget 2018 proposed appropriate amendment to Section 9(1)(i) of the Act to provide that ‘significant economic presence’ in India shall also constitute ‘business connection’. The term ‘significant economic presence’ as been defined as follows:

• any transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India if the aggregate of payments arising from such transaction or transactions during the previous year exceeds the amount as may be prescribed; or
• systematic and continuous soliciting of its business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means.

The threshold of ‘revenue’ and the ‘users’ in India will be decided after consultation with the stakeholders.

It is further proposed to provide that:

• Only so much of income as is attributable to such transactions or activities shall be deemed to accrue or arise in India.
• The transactions or activities shall constitute significant economic presence in India, whether or not the non-resident has a residence or place of business in India or renders services in India.

Unless corresponding modifications to permanent establishment rules are made in the DTAAs, the cross border business profits will continue to be taxed as per the existing treaty rules. This amendment will take effect from 1 April 2019 and will, accordingly, apply in relation to assessment year 2019-20 and subsequent assessment years.

Concluding remarks

?By bringing the above changes to the definition of ‘ business connection’, the Government has made it more stringent with an aim to toughen the existing tax provisions and prevent tax leakages by bringing in necessary changes to plug the loopholes in the existing provisions. For example, by introducing the concept of ‘significant economic presence’, the Government seems to cover various e-commerce companies operating in India through digital technology platform in its tax radar.