The use of the internet has led to the transformation of the physical world into a digital one. Various concerns arise in the digital economy ranging from the issue of big data to taxing of the economy. At present, the international, as well as the Indian tax regime in India, seems unequipped to deal with various taxing issues arising out of the digital economy. Tax plays a crucial role in the development of an economy especially when the case is of a developing one like India. In the recently concluded G20 Summit 2019, the issue of taxing the digital economy comprising of various tech giants like Google, Facebook, Amazon, etc. found a top place in its agenda.
The imposition of tax on these global tech companies has taken a prominent place at the international level, owing to the complexity involved in the process as digital business is conducted using intangibles like algorithms, internet domains, user data, etc. However, the revenue generated based on these algorithms is starkly high in various local jurisdictions like India, France, Italy, Hungary, etc. prompting these countries to take advance measures to tap the revenues generated under the local tax laws. In the Financial Year 2018, Facebook’s worldwide total revenue reached $55.838 billion. In India alone, Facebook collected total revenue of Rs 521 crores. As per the reports, Google’s total revenue in India crossed Rs 10,000 crores last year. However, Google and Facebook paid a total tax of only 200 crores to the Government of India.
In light of this disparity in the amount of revenue generated and collection of tax by the Government, the taxing regime needs to be reassessed to accommodate taxation of the digital economy in India. The article focusses on the difficulties that would arise in the adoption of digital tax along with # international perspective and the way forward.
What is Digital Tax
International tax regime primarily focusses on dealing with taxation of physical business activities. The digital enterprises like Google, Amazon, Facebook, etc. operate their business on virtual space making it difficult to bring them under the local tax radar, which is only limited to physical business activities. To cater to this problem, the concept of digital tax has emerged to maximise on revenue-based taxes vis-à-vis digital business in local jurisdictions.
It is sometimes referred to as Google tax or digital service tax (DST) imposed by the source country on the revenue generated by global tech companies in such countries. Digital tax has not been defined in any domestic law or an international treaty. It is an informal name given to a tax collected on income generated through digital services.
India’s Approach Towards Digital Tax
Reports have suggested that internet usage in India has surpassed half a billion users and is expected to reach 627 million by the end of 2019. Due to the expansive proliferation of internet in the urban and rural space, digital economy is poised to undergo explosive growth and is expected to touch the $266 billion mark in 2020, accounting for nearly 7% of our GDP. As digital businesses are distinct from traditional business, India has introduced the concept of equalisation levy (EL) through the Finance Act, 2016. The levy was charged at the rate of 6% on payments made to beneficial foreign owners for providing digital services in India. But the levy is only limited to advertisement services. Thereafter, the concept of significant economic presence (SEP) was introduced through the Finance Act, 2018 with the object to widen the scope of business connection in India, which is discussed further in the latter part of this article. At present, the SEP provision remains ineffective due to India being a signatory to various double taxation avoidance agreement (DTAA) with other countries.
Issues Related to Taxation of Digital Economy
(1) Characterisation of Income Generated through Digital Economy
Section 9 of the Income Tax Act, 1961, which is applicable to non-residents, has categorised income into three classes as business income, royalty and fee for technical services. The issue of income characterisation becomes relevant for the determination of tax as the tax consequences are different based on the head under which the income is classified. The Act provides for different rates for different categories of income, for example, income characterised as royalty or fee for the technical services and the income characterised as business income are charged at 10% and 40% respectively. But, to characterise the income as a business income, establishment of permanent establishment (PE) is a prerequisite, which is a difficult task in case of a digital economy.
The problem, which exists in the case of a digital economy is regarding the characterisation of income generated by its business model. One such concern that arises in such a model is whether to characterise the profits earned on the digital marketplace as business income or fees for technical services.
(2) The Problem of Permanent Establishment
For a non-resident entity’s business income to be taxed in India, it is required that the entity maintains a PE or a business connection in India. In case of digital economy, establishing a PE becomes problematic owing to the business model of such an economy, which places reliance on intangibles like patents, algorithms, etc. and can conduct business by residing in a foreign jurisdiction, as a place of their central functions. For this reason, it becomes immensely complicated to tax these entities as they conduct business in India and generate revenue without having any physical presence in the territory.
(3) The Double Taxation Avoidance Agreement (DTAA) Treaties
The taxation of digital economy would lead to instances of double taxation of various tech enterprises being taxed in multiple jurisdictions. By widening the aspect of “business connection” by introducing the concept of SEP, undue hardship of double taxation will be caused for the tech company as its PE will be situated in one country and SEP in multiple countries, rendering it liable for double taxation. This would defeat the objective of the double taxation avoidance agreement (DTAA) treaties signed between India and other countries in which the global tech companies are based.
Organisation for Economic Cooperation and Development (OECD) Propositions and the Initiatives
The proposals discussed under the public consultation document issued by the inclusive framework on base erosion and profit shifting (BEPS) working through its task force on the digital economy (TFDE) pursuant to its release of the Interim Report in 2018, form part of a long-term solution to the broader tax challenges arising from the digitalisation of the economy. The key proposals are the “user participation” proposal and the “significant economic presence” proposal.
(1) The “User Participation” Proposal
It is premised on the concept that soliciting the sustained engagement and active participation of users is a critical component of value creation for certain highly digitalised businesses. Various platforms like social media spaces, search engines and online marketplaces predominantly work on the user participation model to create value based on which huge revenues are generated. Under the current international tax framework, which focuses primarily on the physical activities of business itself (permanent establishment) in determining where profits should be allocated. Profits derived from value created by user participation or user data continues to be outside the scope of taxation as it fails to establish a physical business connection with the value generated through user-oriented data.
The proposal aims at taxing the value generated by user participation by modifying the traditional profit allocation rules and recommends that profits allocated to a user jurisdiction, in respect of the activities/participation of users, be calculated through a non-routine or residual profit split approach. To streamline its implementation, the proposal could rely on formulas that would approximate the value of user data, and the users of each country, to a business. This would also help in avoiding disputes between countries based on their subjective view of value generated by user participation.
(2) The “Significant Economic Presence” Proposal
This proposal 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 jurisdiction without a significant physical presence.
Under this proposal, a taxable presence in a jurisdiction would arise when a non-resident enterprise has a significant economic presence on the basis of the following factors, which evidence a purposeful and sustained interaction with the local jurisdiction via digital technology and other automated means: firstly, revenue-based factor, which would include the threshold level of revenue. Secondly, digital factors that would include domain name, local digital platform, etc. And, thirdly, user-based factors such as number of active users and volume of digital content collected through digital platform. Revenue generated on a sustained basis is the basic factor, but such revenue would not be sufficient in isolation to establish nexus. Only when combined with other factors would revenue potentially be used to establish nexus in the form of a significant economic presence in the country concerned.
(a) India’s “Significant Economic Presence” Approach
India has been a frontrunner in introducing the concept of SEP into its domestic law through the Finance Act, 2018, which has enlarged the scope of “business connection” to enable taxation of non-residents having a SEP in India. However, it remains ineffective till the time the treaty rules are amended in accordance with the international framework, which is to see the light of the day in 2020.
(3) Localisation of Data and Tax Ramifications
It is widely considered that when a website or data or software is hosted on a local server, it constitutes equipment having a physical location and the same can be treated to be a fixed place of business of the enterprise and can constitute PE given certain conditions stand satisfied. Therefore, if the non-resident entities localise their servers, they very well can be brought under the taxation regime. In India, various measures have been undertaken to ensure data localisation for e-commerce as well as entities holding large chunks of personal data.
The draft national policy on e-commerce and the Justice B.N. Srikrishna Committee proposed Personal Data Protection Bill, 2018 has mandated for data localisation by foreign entities conducting digital business in India. This will ensure the creation of a local host server, which will be treated as PE and thus, bringing the entities under the present taxation regime.
Unilateral Measures Adopted by Foreign Jurisdictions
Currently, there is no international consensus for taxation of digital economy. OECD is still working to form international consensus over this issue. But there are some countries which have gone ahead and introduced the laws to address the issue of digital tax. These are: France, Italy and Malaysia.
Recently, France approved 3% DST (or digital tax) on the revenues generated by the global tech companies like Google, Apple, Facebook and Amazon (GAFA tax) in its territory. The tax would apply to digital companies generating worldwide revenues on their digital services of at least 750 million euros ($845 million), with 25 million euros ($28 million) from France only. The Act called the Digital Service Tax Act will be applied retrospectively from 1-1-2019.
Italy is one of the first countries in Europe which has taken measures to tackle the issue of digital tax. Italian Government has introduced 3% DST through the 2019 Italian budget. The DST would apply to the taxable entity if it comes under two conditions, firstly, the tech companies generating revenues from the digital services that underpin user participation, which includes online advertising space or digital intermediary activity or sale of data generated from user-provided information and secondly the taxable entities generates total worldwide revenues on their digital service not less than 750,000,000 euros, with not less than 5,500,000 euros from Italy only.
Malaysian Government approved the Service Tax (Amendment) Bill, 2019, which provides for the taxation of digital services. Through this Bill the Malaysian Government inserted Part IX-A in the Service Tax Act, 2018, the part mainly deals with the imposition of tax on giant tech companies registered overseas and providing digital services to the Malaysian consumer. This law will be effective from 1-1-2020 after that Malaysian Government will be imposing service tax (referred as “digital tax”) at the rate of 6% on digital services that are provided by the foreign services provider (FSP) by consumers in Malaysia under a business to consumer (B2C) regime.
India has been a frontrunner in laying down a framework for establishing a digital taxation regime by introducing changes in the existing nexus rule in order to enlarge the scope of “business connection” by making it not just being limited to the concept of PE for the purpose of taxing non-residents in India. As mentioned above, out of the various measures recommended by the OECD in its public consultation document, India has already endeavoured to tax foreign digital entities by adopting the significant economic presence methodology, although inoperative. Apart from this, it has also embraced the concept of localisation of digital data to bring the corresponding revenues under the taxation regime by sticking to the PE principle.
However, the road to taxing of digital content through implementation of these plans does not run straight and has rather challenging turns and various hurdles, which can be overcome through the following approach:
(1) Avoidance of Double Taxation: Entering into negotiations with various countries whose entities are highly involved in digital data creation and transactions in India to amend the treaty provisions to enable the efficient implementation of the digital tax framework in India.
(2) Redefining the Scope of PE and Profit Attribution: It becomes imperative to amend the definition of PE along with the rules of attribution occurring under Articles 5 and 7 of most tax treaties to ensure a proper legal framework for taxing the digital economy.
(3) Doing Away of the Equalisation Levy: With the introduction of the digital tax regime, the concept of equalisation levy has to be bid adieu to avoid multiplicity of taxes.
(4) Clarity on Value in “User Participation” Proposal: It is of essence that in case the said model is adopted, avoiding subjectivity and conflicts between jurisdictions as to the determination of “value” created by user participation becomes important. This can be achieved through streamlining the implementation by adoption of standard formulas, which would approximately assess the value created by users, and associate the users of each country, to a business.
Given the revenue figures generated by various digital companies like Facebook, Amazon, Google, etc. in different user jurisdictions without being subject to local tax has stirred waves of change in the international tax regime regarding the digital economy. Various key developments have taken place around the globe regarding taxing the said economy. In light of the same, the OECD concluded in its latest interim report titled, “Interim Report on Tax Challenges Arising from Digitalisation” that the 110 participating diverse economies were of the common opinion that unilateral approaches towards taxing the digital economy will have an adverse impact on growth and result in double taxation. Therefore, an international framework becomes the need of the hour to resolve the issue of taxing the digital economy.
As regards India’s endeavours on taxing the digital economy by introducing various concepts like SEP and data localisation — such efforts will bore the fruit of successive implementation once an international consensus on the said issue becomes a reality. The final report of the OECD is due for 2020 — holding the answers to many perplexing questions.
† 5th Year, BA-LLB (Hons.), The National University of Advanced Legal Studies, Kochi.
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