TAX SERIES:CHAPTER 3: TAX CHALLENGES ARISING IN INDIAN DIGITAL ECONOMY

INTRODUCTION

The relationship between law and technology is dynamic and complex. The pace of growth is different and hence there is a gap between innovations and legal change.  India is facing many taxation challenges in its digital economy like other countries. Domestic laws do affect international regime of whosoever country is with transaction with India. The magnitude of cross border transactions is growing drastically. To know about challenges India faced due to its present laws, lets discuss how India levies taxes on multinational companies. The conception that taxation uphold plays an important role in any governmental set up and have been amended periodically to improve economic system.  There is a possibility of tax evasion in e-commerce.

GUIDELINE TO COMPUTE INCOME OF A COMPANY

Income of a company whether domestic or foreign (also known as resident or non-resident respectively) are liable for corporate Income tax (CIT) on income accrued in India. And the rate is specific decided by union budget every year. Income of a company is called corporate or company tax which is defined and collected under Income tax Act 1961. Income of a company is taxed according to the Act.  Under Income Tax Act 1961, a company is defined as an Indian company, a body corporate established by or under the laws and rule outside India, any institution or corporate which was registered under the previous Income Act or an Indian or foreign company which is declared CBDT to be a company. Each and every resident of India earning income within India has to pay their income tax according to the slabs and specific rates applied accordingly. A company is said to be a resident of India in any previous year to be liable to pay income tax is when:-

1. It is an Indian company
2. Place of effective management in that year is in India.

In other words, a company which is not even registered in India but its partial conduct of business is within the territory of India, the company will be liable to pay taxes to India on its income arising from the conduct of business in India. Every person is liable to pay income tax differently on the basis of the slab system.

However, arguments are about that on which level of association or connection with India will be determined enough to tax a foreign company in India.

According to OECD a place of effective management is a tie breaker. It is not defined such but it is a place where key management and decisions related to business are taken place in order to run any economic activities. The place of effective management will be where it superseded its ongoing procedures. It is a place where board of directors meet and make its decision.

In the light of E- business and its concerns were increasing due to impact of e-commerce on tax revenue. There was an urgent need for new IT security and tax solutions. Concerns have been expressed that e-commerce could definitely leads to tax evasion.

CHALLENGES ARISING IN INDIA

Challenges in e-commerce are numerous. Internet is transforming facets of Indian domestic as well as international tax policies because of traditional tax laws require changes to its existence.  It has changed significant business models and has created challenges for administration and tax laws enforcement.

TAX ISSUES IN DIGITALISED ECONOMY ARE: –

1. Permanent Establishment
2. Base erosion and profit shifting
3. Attribution on allocation of taxation rights in source based and resident- based economy (also called non-resident and resident)
4. Identity verification
5. Cybercrime
6. Tax avoidance
7. Jurisdiction
8. Characterisation of Income- Royalty or Business Profits
9. tax policy makers have observed more challenges related to services (i) the difficulty of collecting VAT/GST in the destination country where goods, services and intangibles are acquired by private consumers from suppliers based overseas which may not have any direct or indirect physical presence in the consumer’s jurisdiction. (ii) the ability of some businesses to earn income from sales from a country with a less significant physical presence in the past, thereby calling into question the relevance of existing rules that look at physical presence when determining tax liabilities. (iii) the ability of some businesses to utilise the contribution of users in their value chain for digital products and services, including through collection and monitoring of data, which raises the issue of how to attribute and value that contribution.

1. PERMANENT ESTABLISHMENT

Another challenge is to determine the existence of a permanent establishment for any economic activities on internet physically or conceptually. Presently, Article 5 of double taxation Avoidance Agreement requires permanent establishment (PE) in order to tax a non-resident’s profits in the source country. In general terms, PE provides a procedure for the allocation of taxing rights amongst the countries tax administrators. These rights are divided between governments when an enterprise of one state makes business profits in another state. From the comprehension of a tax policy angle, digital economy has led to increase in number of non-resident companies engaging their business into a market jurisdiction in a different manner from the time as compared when international tax regime was formed. As there are different business models introduced like online retail, social media, subscriptions etc. These models have challenged the assumption that a non-resident can operate in a market jurisdiction through physical presence only. Physical presence is defined as Permanent establishment (PE) or a dependent agent. For instance, a foreign company operating in the digital economy by a warehouse and the preparatory and auxiliary activity exemptions and current laws on dependency agency PE A PE is a fixed place of business called physical presence or act through some agents called representative presence. According to article 7 of tax treaties India has signed with other foreign countries, a foreign company’s business profits cannot be taxed in the source country unless it has its business activities in the source country through PE. Therefore, Indian tax authority has powers under treaty law to tax the enterprises operating through PE. But most of the Indian tax treaties allow for a minimum rate of withholding tax (ten percent) on technical services in the absence of PE in India. In other words, business profits are not taxed whereas impose withholding tax if the services come under the definition of “fees for technical services”. However, there was no provision for profits earned on internet. Obtaining necessary records for the purpose of audit and control requirements are problematic in e-commerce transactions. Everything being digitally handled and business on webspace are complicated than before. In other words, the article in treaty does not allow source-based countries to levy taxation on the profits earned from the provision of virtual services, which is a resulting in loss of revenue to the market countries. Therefore, the Physical presence of a non-resident was important to give rights to the source countries to levy tax on income generated within its territory. Permanent establishment being a major issue in loss of revenue. Need for creating a new PE nexus based on a significant economic presence to administer rights of source and residence countries and to determine the jurisdiction for any legal dispute as well. This will be discussed in chapter 4 of this paper. There is test that the company has to go through for its determination of PE.

One of the Indian case ITO v. Right Florists P. Ltd”- Kolkata ITAT held that Google (Ireland) and Yahoo (USA) cannot be taxed in India in respect of sums received by them from an Indian florist for the purpose of online advertising. ITAT found that Google and Yahoo did not have web servers in India and thus there was no PE in India, since a website does not constitute a PE unless the servers on which websites are hosted are also located in the same jurisdiction.

In light of the foregoing discussion, whether the business operating in a market country has PE or agency PE or is it liable to traditional rules of tax. With an international dimension keeping in mind, the French Google case in this respect is a perfect precedent. This case dealt with structural question where Google Ireland Limited have no such place of business (fixed place) in France. Meanwhile Google France provided its services to Google Ireland for which in return charged service fee. A fact that, Google France did not accept any advertising orders from French customers to be display in France because Google Ireland approves such order. Several questions raised on international law perspective. Question underlying all the facts are when a non-resident company provides its advertising services to local people and to other group of its company in the market country and is only supervising those services without a formal contract with customers, whether the latter can constitute an agency PE? Paris administration answered this question in 2017. The answer administration gave was negative. French Court in particular determined that Google French does not even have authority to conclude contracts. Subsequently, this case led to the conclusion of agency PE in regard to virtual provisions and factual circumstances by courts of other countries.

This is an clear example of how the current business models of business in digital period could easily famished their existence as PE and thus, procure from being subjected to Income tax thereupon and how traditional tax treaties may not provide any answers to these challenges.

• BASED EROSION AND PROFIT SHARING

Current international tax regime standards were formulated by the League of Nations in 1920s. main feature of these norms are separate entity principle (which states that every affiliate is considered to be independent from another) and arm’s length principle (wherein taxable transactions between the entities would considered as if they are dealing with other companies in the market). They have become irrelevant when international trade is not between tangible goods but also digital services. There is no doubt that digitalisation of the economy has upraised questions on foundation of the rules laid for cross-border taxation for business profits. It is difficult for tax authorities to audit transfer pricing transactions between the entities of MNCs resulting them to allocate their valuable assets to affiliates in low tax rate jurisdiction. MNCs for the sake of tax planning started transferring their profits to other countries having less or no tax. In other words, It is a tax strategy in which multinational enterprises transfer their profits from the place of actual economic activity and creation of value to a place where they could pay low or no tax. It is a tax strategy in which multinational enterprises transfer their profits from the place of actual economic activity and creation of value to a place where they could pay low or no tax. This strategy is called Based Erosion Profit Shifting. Lack of transparency results in loss of corporate tax avoidance and thus tax leakages are bounder to happen in large amount in low-income economies.

In regard to this a new project has been initiated by OECD which is started by G-20 countries. OECD for the first time talked about the tax challenges of a digital economy addressed by G-20 and OECD Tax challenges, disruption and the digital economy Pascal Saint-Amans, Director, OECD Centre for Tax Policy and Administration countries, under the Base Erosion and Profit Shifting (BEPS) project.  In 2013, OECD adopted 15 point BEPS Plan[1] to minimise the gaps in international tax regime which allow large companies to artificially nut legally shift profits. This programme was started in 2013 to stop multinational companies from shifting their profits from one country to another. Digital profits are one which can be easily moved. How companies are using this method. Companies sell their digital products or services to someone residing in other country, may be employees, facilities or other physical assets. Existing global tax rules allow companies to transfer those profits, often to a low-tax jurisdiction.

Another challenge what digitalised economy are facing is Transfer pricing.

OECD project on BEPS addressed many issues on transfer pricing. OECD has talked about transfer pricing because multinational companies strongly practices transfer pricing technique within their corporate group in order to shift profits from high tax rate jurisdiction to low tax or no-tax jurisdiction.  Having said that, the main problem is caused by intangibles. Because of their high mobility nature, they are easy to transfer to subsidiaries operating in low tax rate jurisdictions. Moreover, intangibles are hard to valuate. In other words, transfer pricing is a practice adopted by companies wherein one division of the company charges for their goods and services from another division of the company. This is usually done between a subsidiary or an affiliated companies. It can also be applied on intellectual property such as research, patents and royalties.

For better understanding on how transfer pricing impacts a company’s tax bill. Let’s consider the following example. Assuming that an automobile manufacturer has two entities: Entity A, which manufacturers software while Entity B manufactures cars.

Entity A sells the software to other car makers as well as its parent company. Entity B pays Entity A for the software typically at the market price that supposedly entity A charges other carmakers.

Let’s assume that entity A decides to charge a lesser amount as compare to others to entity B instead of using the market price. As a result, entity A’s sales or revenues would be lower because of the lower pricing. On the other hand, entity B’s costs of goods sold (COGS) are lower, increasing the division’s profits. In short entity A’s revenues are lower by the same amount as entity B’s cost savings. Hence, there would be no financial impact on the overall corporation.

However, if entity A resides in a higher tax jurisdiction than entity B. Both the company can save on taxes by making Entity A less profitable and Entity B more profitable. By making Division A charge lower prices and pass those savings onto Entity B through a lower COGS and entity B will be taxed at a lower rate. In other words, entity A’s decision not to charge market pricing to entity B allows the company to evade taxes. In other words, charging above or below the market prices. Having said that companies can use this method to transfer profits and costs to other division. Hence, helping in avoiding taxes.

Although, transfer pricing has been imposed with strict guidelines by tax authorities. Investigating extensive documentation for auditing purpose.

SOME EXAMPLES

Below are the list of some cases as a matter of contention between tax regime and companies.

·       Coca-Cola

Coca-Cola Co. has different company for production, marketing and sale of Coca-Cola in different jurisdictions. The company continues to defend $3.3 billion through transfer pricing of royalty agreement. The company has transferred IP value to its subsidiaries in Africa Africa, Europe, and South America. The case is yet to be resolved between Internal Revenue Service (IRS) and Coca Cola.

·       Medtronic

Ireland-based medical device maker Medtronic and the IRS are yet to settle in court in 2020. A dispute worth $ 1.4 billion. Medtronic is accused of transferring intellectual property to low-tax havens globally. The transfer involves the value of intangible assets between Medtronic and its Puerto Rican manufacturing affiliate for the tax years 2005 and 2006. The court has ordered in Medtronic favour but IRS has filed an appeal.

• RESIDENT AND SOURCE TAX BASE

Some of the conceptual challenges that e-commerce comes with are how to breakdown income and the approach concerning jurisdiction. Here, talking about resident- based and source -based taxation approaches. The nature of e-commerce transactions muddles the whole issue of “jurisdiction” which is a main element of taxation. It also challenges traditional rules because a business can exist wholly in cyberspace by using technology being used to communicate with directors or shareholders. In simpler words, e-commerce challenges when where and how taxation can be levied at a stage where local markets are transformed into global markets.  The definition of “service provider” is not clear in terms of taxation. Blurred definitions like this cause companies like Facebook and Google to avoid paying to India authorities a relevant share of tax.

Two legal internationally accepted bases of taxation are

1. Resident based tax system
2. Source based tax system

In Resident based system, a resident is liable to pay taxes on its income earned worldwide whereas, a non-resident will be liable for tax only on income earned sourced in a country. In Indian Income Tax, according to section 6 (3) of the act, a company is considered to be a resident of India as mentioned above.  However, mostly goods and services transacted are intangible in nature therefore, it is difficult to apply source concept to income linked with those items. Also in resident based system e-commerce faces challenges because technology permits operators to locate their offices in area with low tax rate which ultimately results in minimisation of tax burden.

In 1999, High Powered committee was made by Shri Kanwalijeet Singh to examine features of e-commerce. The committee suggested a low withholding tax at that time to safeguard against base erosion. The whole motive was to avoid double taxation for the tax payer. But for instance, a person had imported some goods in India from a foreign country and set to claim it as deductible expenditure. There will be a situation where if India allows this then it will result to an erosion of tax base. In other words, if a non- resident earns its income from any economic activity within India and is liable to pay tax under Income tax Act, the person has to deduct income tax thereon. There is an assumption that payee will be benefitted of this withholding tax from the resident country as set off and double taxation will be avoided. But the whole situation depends on Double Taxation Avoidance (DTA) Agreements that India has signed with other countries. There is also a clause in DTA regarding withholding tax whether they permit set off under them or in the foreign country.  According to DTAs India has signed with Australia, Belgium, Netherland, Germany, Malaysia, Singapore, United states (US) AND United Kingdom (UK) they cannot allow foreign tax credits withheld for the sake of base erosion. Thus, recommendation by the committee to levy withholding tax on e-commerce did not seem convenient. Tax treaties are important and thus includes concepts and laws that were laid as per old and traditional way of conducting business and other economic activities which was duly signed between countries for better and smooth functioning of trade and to resolve any conflicts which could be duly amended by following a whole procedure when there is a need of the hour. This committee suggested source-based principle for India but this contradicts with tax treaties. The idea of allowing source country the right to tax active income whereas permitting resident country has right to tax passive income cannot be applied simply on income generated in e-commerce.

• IDENTITY VERIFICATION

One of the issues that arises is “identity verification”. In cyberspace, identification about transacting parties is difficult to be determined and this created a chaos for tax enforcement authorities to identify resident or non-residents regard to business opportunities. It is also said that the techniques used for the display of digitised information creates a problem in identifying source, origin and destination of locations. A webpage can be formed using sources from various locations in the world. Physical and logical locations of a webpage are not similar always.  One website can be a group of servers from the world. Verification of the identify is a challenge and is considered to be important in order to acknowledge any treaty signed between the resident of another country and India. This obviously have impact on laws relating to jurisdiction. In which India has allowed reduced or zero rate of withholding tax on royalties.  International regime is not easy to enforce in e-commerce due to restricted physical presence or by virtual nature of the transactions taking place. Identity verification is important because it depicts whether the server or website is in India or other jurisdiction. A mere website cannot construe a PE but a web server will.

• CYBERCRIME

One of the other issues in internet economy is loss of evidence. Here, the author is talking about cybercrimes.  As data includes information about other people which can be a cause for any crime or fraud. Its quite easy to destroy any crucial data in seconds and without even a trace.  Similarly, data or information about a person from another location and in another country is difficult to trace the offender. In addition to this, if we talk about present laws, section 75 of the Information Technology Act supports extraterritorial operation however, it can be enforced with high level of interagency -authorities.  Big e-commerce companies have set an internal dispute resolution mechanism to solve disputes internally and independently so that consumers does not feel any need to approach to any legal courts. E-commerce platforms are bound to collect personal information of the customers for this purpose Section 43A of the IT Act provides protection of data. Data includes personal information, passwords, bank details including credit card or debit card.  The whole notion was to protect information and save people from hackers.

• LEVEL PLAYING FIELD

It is also observed that internet retailers managed to avoid many taxes, including but not limit to entry tax. Traders having different prices from one state to another. Delegation of Confederation of All India Traders (CAIT) declared that level playing field was absent between the two levels of retail segment which leads to inequitable and drawback for offline traders which violates competition Act 2002. Constant concerns about revenue loss has been conveyed by the state governments but still this issue is a challenge in relation to e-commerce with states and will be the same until the time tax structure becomes uniform and same throughout states.

• JURISDICTION

Traditionally disputes are settled within the territories where one or both of the disputants reside or jurisdiction is determined by any physical presence or permanent establishment that have a right to tax. Internationally, this means different principles have to be applied in different jurisdictions. A substantial definition had to be given to jurisdiction in regard to internet disputes, which is a backbone for any suit to begin.  Initially, courts from different countries started to refer Zippo case in U.S to identify internet jurisdiction. In this case three tests[2] were analysed to determine specific personal jurisdiction over a non-resident defendant is appropriate or not for the courts in cases of internet disputes. However, this case was used by other courts but needed to be more appropriate and relevant due to extensive nature of internet. Courts realised there is more than internet. This means there is not only display of information but interactive websites. Proper law needed to be subjected. In the year 2001 when case of Yahoo! happened, U.S court appreciated the judgement of French Court as harm caused was in France and thus invoked foreign courts about actions. However, this judgment was found deterrent in determining jurisdiction. Based on discussions, the courts have decided to determine jurisdiction based on interaction level and commercial nature of the website and have differentiated them into three areas which thereby includes fully interactive sites of business, passive sites wherein you could see information about others and sites with limited interaction. It was decided that passive websites are not subjected to jurisdiction if they operate from outside the territory. Companies that do not want to be in jurisdiction in other foreign state or countries should limit their site to passive activity.

• ROYALTY OR BUSINESS PROFITS

This issue of characterisation is very important because both have different categories of transactions attached to it. This is because threshold amount is different. When the transfer consists of partial rights in the products then it can be termed as royalty. Such a payment can be taxed where it has risen. For instance, in Amazon and Flipkart payment can be done digitally but delivery is physical whereas in itunes Store, delivery happens digitally.  Whereas, business profit is classified when a website owner has a permanent establishment as well in the source state. The difference is the source of country can tax royalty and also any other service however, it cannot tax business profits. In Indian tax laws, royalty definition is in broader sense and includes transfer of software, transfer of any intellectual property right.

• VALUE ADDED TAX (VAT)/ GOODS AND SERVICES (GST)REGIME

There shall be a coordination between international VAT system and India. In absence of which will result in double taxation or unintended non- taxation. It is understood that international trade is not only about tangible goods but also for services. International VAT regime could lead to a negative result on international trade in services. This distortion may have led to hindrances in economic activities and competition.  Recognising an international VAT regime is a sine qua non for international trade, the OECD launched a project to develop International VAT/ GST Guidelines. These guidelines focus on two things. First, neutrality of tax and determination of the place of taxation for cross-border supply of services. Tax consultants have observed the guideline with Indian tax regime in order to provide the difference with Vat regimes. Following are the contrary guidelines with respect to Indian indirect tax legislations. Guideline says the burden of tax should be on customers and not on business whereas, there are many indirect taxes in India (service tax, centre tax, sales tax) levied by central government along with sales tax by state government. However, some taxes have creditability and some do not.  Guideline 2 says business in similar situation engaging similar transactions should be pay same. However, it is a long process to determine this as similar transactions could be a categorisation of tangible or intangibles. Whereas, in India credit refunds are dependent on the type of activity involved service, manufacture or sale of goods. Mostly guidelines are according to the OECD guidelines.

CONCLUSION

It is clear from the above stated problems India is facing in transformation to a digital economy. Proper outlaw must given in order to function smooth with other countries, keeping in mind that international tax treaties that are created ages ago, perhaps it is  the time to reframe them according to the needs of the economy. Although mostly discussed in this chapter are the overall tax concerns about India with respect to digital era which is leading to loss of revenue.  It is to be understood that as an emerging economy. India has a strong customer base in the world for which it has to stand strong. Since the growth of digital economy in past years, companies have taken undue advantage by aggressive tax planning to avoid taxes to government is the main reason of international tax regime and domestic legislation to formulate new rules and concepts. Indian traditional laws are unsuitable to tax economic activities of internet. It is an urgency to revise both domestic Indian Laws along with international laws, so that they could provide answers for challenges arising in e-commerce business to ensure economic efficiency and on another hand maintain equity between nations. Tax reforms were going global and countries are constantly taking steps to tax digital profits. Perhaps it could be said that tax competition caused significant decline in corporate tax rate. Most of the taxpayers thought international tax regime to be broken and unfair in regard to tax multinational companies (MNCs).  Taxpayers believe that tax havens countries are somewhere responsible for financial crisis and has an adverse impact on fiscal policies of a country. 

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[1]OECD (2015) BEPS Final Reports <BEPS 2015 Final Reports – OECD>

[2]ZIPPO MANUFACTURING CO. v. ZIPPO DOT COM, INC. | Case Brief for Law School | LexisNexis

Penned by: Ujjwala Gupta, Senior Legal Counsel, SUO