Digital transactions and tax consequences

In current times, every organization – regardless of its size or industry – increasingly relies on data and technology to operate more efficiently and deliver value to their customers with the help of digital transformation. Digital transformation refers to the process and strategy of using digital technology to drastically change how businesses operate and serve customers.

Although computer technology has been around for decades, the concept of digital transformation is relatively new. It arrived in the 1990s with the introduction of mainstream internet.

Rapid and expansive digital transformation has had deep economic and societal impacts resulting in significant changes. Constant adoption of digital transformation in businesses in varied scale has resulted into digital economy. The transformative process brought by information and communication technology makes technologies cheaper, more powerful, and widely standardised, improving business processes and bolstering innovation across all sectors of the economy. Hyper-connectivity between people, organisations and machines is the backbone of digital economy.

This revolutionary digital transformation has made need of physical presence almost redundant. It has enabled the creation of new business models and revenue streams. This has led to global debates in legal and regulatory realms and taxation worldwide. The international taxation is developed in a ‘Brick and Mortar’ economic environment and thus it does not remain fit for the global digital economy. Three important phenomena facilitated by digitalisation viz. (i) scale without mass; (ii) reliance on intangible assets; and (iii) the centrality of data, pose serious challenges to elements of the foundations of the global tax system.

These phenomena posed further challenges in determination of income, equal distribution of taxing rights on such income and collection of taxes as a result of such dynamic business models and revenue streams, business challenges, for the following identified reasons:

Nexus without physical presence: Growth of digital economy has resulted in non-resident companies operating in a jurisdiction without local presence. The fact that the existing thresholds for taxation rely on physical presence is to ensure taxing rights with source jurisdictions.

Data & attribution of value: Sophistication of information technology provided the way to gather & use information across borders resulting in issues of attribution of value created from generation, use and sale of data. Difficulty lies in identifying, the source of data for the purposes of imposing tax.

Charaterisation of income: No clear guidelines for proper characterisation of payments made in the context of new digital products or means of delivering services.

These challenges co-exists and not mutually exclusive.

Digital Transformation in India:

India is developing nation with 2nd highest population in the World. Also, it is growing at a rapid pace digitally especially from 2015 onwards in terms of access to internet and smart phones even in the remotest areas of India. Thus, development of digital economy for India is imperative for the overall growth of Indian economy.

In the past, for litigations in relation to taxing the digital transactions, actions taken by tax authorities have drawn flak as they do not have any permanent establishment nor do these payments qualify as royalties or fees for technical services under tax treaties. The Indian Tax Tribunals in case of Yahoo India Pvt. Ltd.[1] and Right Florists[2] have held in favour of Yahoo and Google stating that advertising income received by such companies is not taxable in India in the absence of physical presence in India and further held such payments are not taxable as royalty or fees for technical services as per tax treaty. Further, the Mumbai Tribunal in the case of ebay International AG[3] has held that user fee received by it for operating India-specific website providing online auction is not taxable in the absence of permanent establishment in India.

Pursuant to above, various steps were undertaken to tackle the situation and bring about optimum tax structure. Central Government constituted Committee on Taxation of E-Commerce (“Committee”), which issued its report. In this regard, the Committee recommended the imposition of an equalization levy. It was observed and stated by the Committee that – “these new business models have also created new tax challenges in terms of nexus, characterization, valuation of data and user contribution.”

Based in the recommendation of the committee, vide Finance Act, 2016, India introduced the concept of Equalisation Levy. India is the first country to introduce an equalization levy under its domestic tax legislation based on the recommendations of the Committee formed by the apex tax body. The Committee in its report has mentioned that the purpose of the levy is to equalize the income tax disadvantage faced by Indian digital companies and facilitate an environment, where Indian digital companies can compete with foreign players without having to locate outside India.

Further, pursuant to Finance Act, 2018, concept of Significant Economic Presence (‘SEP’) was introduced for establishing business connection in India effective from AY 2022-23, i.e. transactions entered into from April, 1, 2021.

At the time of introduction of Equalisation levy, the scope was limited to specified services which included services in relation to online advertisement, any provision for digital advertising space or any other facility or service for the purposes of online advertisement. Further vide Finance Act, 2020, more developments made to expand the concept of equalisation levy onto E-Commerce Operators. There is no doubt that the concept of equalisation levy will continue to expand to cover under its ambit more technologically enabled businesses run by the non-residents.

Also, specific clarification has been provided to exclude services which are chargeable as royalty or fees for technical services to be outside the purview of concept of equalisation levy. This way, efforts has been made to provide clear demarcation between applicability of equalisation levy and income-tax on royalty or fees of technical services, and to keep both mutually exclusive to avoid double taxation.

So, lets understand the concept of Equalisation Levy:

Equalisation Levy:

Provisions of equalisation levy are divided between 2 categories of services, viz.

A.         Specified services of online advertisement; and

B.          E-Commerce Operators.

A. Equalisation levy on Specified Services of online advertisement:

The mechanism for levy on online advertisement provides for deduction of 6% levy on the payment made to non-resident service provider. The recipient of service being a resident person or non-resident having a permanent establishment in India, are require to deduct the levy from the consideration payable, at the time of making payment. Further, equalisation levy is not to be deducted under following circumstances:

i.   Where non-resident providing specified services in India, has a permanent establishment in India and specified services is effectively connected with such permanent establishment in India;

ii.    Where aggregate of payment made to such non-resident does not exceed INR 1 lacs;

iii.  Where payment made by Indian Resident or permanent establishment of non-resident in India is not connected with business or profession in India;

Thus, features of Equalisation levy on specified services:

a.    Equalisation levy on specified services is applicable on B2B transactions. Also, it is applicable on the gross amount of consideration paid, irrespective of any profit earned on such services. Accordingly, it also applies on non-commercial transactions such as posting for job openings, business development services etc, incurred for business purposes.

b.   Also, since it is additional tax, outside the scope of income tax, no treaty benefit is available to non-resident on same and also no credit of taxes paid in India is available in the country of residence of such non-resident service provider. This could lead to double taxation in the hands of non-resident, if country of resident is charging tax on such income.

c.    In cases where equalisation levy needs to be grossed up, it becomes additional costs in the hands of Indian Businesses. It is also a mandatory compliance made by Indian businesses for deducting, paying and reporting of equalisation levy for online advertisement.

d.   Further, even if usage of the services offered by non-resident is outside India, say branch outside India, Indian businesses would still need to deduct equalisation levy as recipient of such services would be considered as Indian businesses. 

B. Equalisation levy on E-Commerce operator:

Equalisation levy on the E-Commerce operators at the rate of 2% is applicable from April 1, 2020 on the gross consideration earned by such non-resident e-commerce operators, who owns, operates, manages, e-commerce facility or platform for online sale of goods or services or both.

It shall be applicable on services provided to

i.        person resident in India; or

ii.       person who is non-resident in India and undertakes,

a.       Sale of advertisement which targets a customer who is a resident in India or a customer who accesses the advertisement through internet protocol address located in India; or

b.       Sale of data collected from a person who is a resident in India or a person who uses internet protocol address located in India;

iii.     person who buys such goods/services/ both using IP addresses in India

However, Equalisation levy is not applicable, where –

i.    E-commerce operator is having fixed place PE in India and such e-commerce operator is effectively connected with such fixed place PE in India;

ii.   Where equalisation levy is chargeable under specified services such as online advertisement or digital advertising space;

iii.   Total turnover of such e-commerce operator is less than INR 2 Crores.

E-Commerce supply or services has been defined to mean as under:

i.     online sale of goods owned by the e-commerce operator; or

ii.    online provision of services provided by the e-commerce operator; or

iii.  online sale of goods or provision of services or both, facilitated by the e-commerce operator; or

iv.   any combination of above-mentioned activities

Further vide Finance Act, 2021, a clarification has been provided to broaden the definition of ‘online sale of goods’ or ‘online provisions of services’, to include services such as (i) acceptance of offer for sale; (ii) placing of purchase order; (iii) acceptance of purchase order; (iv) payment of consideration; (v) supply of goods or provisions or services, partly or wholly. Also, it has been clarified that e-commerce operator who are merely aggregators would also be liable to a charge of equalisation levy.

Thus, it is apparent that efforts have been put to include FAANG companies covered under the ambit of equalisation levy. The compliance burden is shifted on such non-resident companies, it would be interesting to understand, how the non-compliance would be traced.

The scope of Equalisation levy on e-commerce operators is wide enough and may include most of the digital service providers such as online gaming and entertainment platforms, e-ticking portals, marketplaces, online payment gateways, etc. With the broadened scope of equalisation levy on e-commerce operator, it becomes imperative to examine case to case basis, for determining applicability of equalisation levy on non-resident service providers.

Significance Economic Presence (‘SEP’):

As discussed above, the concept of SEP was introduced to establish business connection for non-resident deriving its income from India. Provisions of SEP are applicable from AY 2022-23 i.e. from April 1, 2021, any non-resident having SEP in India, income of such non-resident would be subject to tax under section 9(1) of the ITA, subject to provisions of applicable DTAA

SEP shall mean,

(i)         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

(ii)        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.

Applicability of SEP is not dependent upon the situs of signing of the agreement or having place of residence or PE in India, neither it is dependent upon non-resident rendering service in India. The threshold as mentioned in the provisions are not yet prescribed. Thus, concept of SEP has been brought under the provisions of ITA to cover wider spectrum of business activities carried out by non-residents, even if situs of agreement signing or rendering of services is outside of India. Thus, emphasis has been put to bring in source-based taxation. Non-resident falling under the SEP concept can take DTAA advantage and also claim credit of taxes paid in India pursuant to establishing business connection in India.

In order to avoid overlap of provisions of SEP and equalisation levy, section 10(50) of the ITA provides for specific exemption from levy of SEP where equalisation levy would be applicable. Accordingly, where-ever, a non-resident is liable to equalisation levy for providing specified services and e-commerce services, concept of SEP would not be applicable to such non-resident. Thus, it may be possible that an e-commerce operator deriving income from India and having turnover of less than INR 2 crores would be liable to taxation in India by virtue of provisions of business connection in India due under SEP provisions. 

Thus, by expanding scope of taxation for non-residents either through equalisation levy or through business connection in India, efforts have been put to provide source based taxation. Also, considering pace of development in provisions of equalisation levy to cover under its ambit, broader category of non-resident service providers, the clear demarcation would need to be provided by way of guideline or bright line test to provide clear distinction between services covered under equalisation levy and services covered under royalty or fees for technical services and that of business connection in India.

Now, even if non-resident is incorporated in tax – heaven country, liability by way of equalisation levy would still be imposed on such non-resident providing specified services and e-commerce services. Also, preference has been given to the charge of equalisation levy over business connection. Thus, such non-resident would first have to examine the applicability of equalisation levy and if not applicable, would need to examine provisions of business connection, to apply beneficial DTAA provisions.

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[1] Yahoo India (P.) Ltd. v. Dy. CIT, [2011] 46 SOT 105

[2] ITA No. 1336/Kol/2011

[3] ITA No. 6784/M/2010 and ITA No. 7046/M/2010 dated September 21, 2012