Author: Sankalp Pissay
In this era of globalisation, it is a trite observation that international trade and commerce has become essential to many economies. Even the global rise of protectionist and populist regimes, most of which seek to domesticate production, has failed to curb the international exchange of goods and services. Like all business transactions, the international exchange of goods and services generates income. Like all income-generating activities, it may be subject to taxation.
But what happens when a person or an entity, who is a resident of one nation, generates a large portion of their income abroad? Who gets to tax such income, and what are the applicable principles to determine this question? Has the rise of the digital era rendered these principles superfluous?
Along with exploring these questions, I will endeavour to argue that the superfluity of the existing principles for taxing a non-resident’s local income, is not reason enough to radically alter the foundational principles of international taxation. The legitimacy of any taxation regime rests on certainty, predictability and stability, and any hasty change in its basic principles is likely to result in needless confusion and significant economic loss.
The Statutory Background
Section 5 of the Income Tax Act, 1961 states that the worldwide income of a resident is taxable. To determine who is a resident, we look at Section 6, which has recently been amended to fight the growing menace of tax avoidance, and deserves a separate analysis of its own. That is not our concern here, as this section deals with taxation of residents.
The focus of this article is on taxation of income generated by a non-resident, which is done on the basis of the ‘source rule’, under which a nation where the income is generated gets the right or competence to impose taxes on it. Section 9 of the Act deals with the principles which are applicable to determine the taxability of non-residents, and Section 9(1)(i) covers within its ambit ‘all income accruing or arising, whether directly or indirectly, through or from any business connection in India.’
In a classic opinion authored by Justice J.C. Shah, in Commissioner of Income Tax v. R.D. Aggarwal AIR 1965 SC 1526, the Supreme Court held that business connection means “a real and intimate relation between trading activity carried on outside the taxable territories and trading activity within the territories, the relation between the two contributing to the earning of income by the non-resident in his trading capacity.” This is a broad interpretation placed on the words ‘business connection’ and does not categorically require the non-resident to have any physical presence in India.
However, Section 90 of the Act complicates things. Section 90(1) states that the Central Government may enter into agreements with other countries to avoid double-taxation (double-taxation happens when the same income is taxed twice, by both the resident and the source nation). Such agreements are called as Double Taxation Avoidance Agreements (DTAAs). Section 90(2) states that where the Central Government has entered a DTAA, the provisions of the Income Tax Act shall apply to the extent they are more beneficial to an assessee who is covered by that DTAA. This logically implies that when the provisions of the DTAA are more beneficial to an assessee, they will override the Income Tax Act, and India will lose its right to tax the assessee’s income.
Permanent Establishment
Article V of most DTAAs defines what a ‘Permanent Establishment’ is (one may look to the Indo-US DTAA as a reference point). Under most of the DTAAs, it is defined to be “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” A permanent establishment would constitute a business connection under Section 9 of the Income Tax Act, but it is immediately evident that it has a narrower definition than the latter. All permanent establishments are a business connection, but not all business connections may be a permanent establishment.
In Commissioner of Income Tax v. Vishakhapatnam Port Trust (1983) 144 ITR 146 (AP), Justice Jagannadha Rao (who was later on elevated to the Supreme Court) observed, “In our opinion, the words “permanent establishment” postulate the existence of a substantial element of an enduring or permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country. It should be of such a nature that it would amount to a virtual projection of the foreign enterprise of one country into the soil of another country.” (By ‘virtual’, the Court meant ‘near’ or ‘almost’, and not ‘digital’.)
This decision was cited and approved by the Supreme Court in Formula One World Championship v. CIT (2017) 15 SCC 602, and in Asst. DIT v. E-Funds IT Solution Inc. (2018) 13 SCC 294. In these cases, the Court held that a permanent establishment was a physical place of business at the disposal of the non-resident in question. The Court also observed that there were two distinct thresholds of a permanent establishment – (1) A Fixed Place of Business; or (2) A Person acting on behalf of the non-resident habitually. Interpreting ‘through’, as it appears in Art. V of most of the DTAAs, the Court held that it refers to a fixed place of business which is ‘at the disposal’ of the non-resident, with ‘disposal’ entailing the right to use or control the premises.
Immediately, one notices a problem here, as in the 21st century, a significant chunk of international trade happens digitallly, without any physical presence of major corporations in their market jurisdictions.
Significant Economic Presence
The Organisation for Economic Co-operation and Development (OECD) has long been trying to combat the problems relating to Base Erosion and Profit Shifting (BEPS), wherein companies artificially shift their profits to low-tax jurisdictions to avoid heavier tax payments. By 2020, the OECD had decided to take a two-pronged approach in dealing with them. The first pillar of their plan relates specifically to the digital economy and its taxation, while the second pillar is more general and aims at preventing base erosion. Pillar 1 focuses on nexus and profit allocation rules and expands them to benefit the market jurisdictions. One of the key proposals under Pillar 1 is the Significant Economic Presence Model, which in fact, was introduced by the Parliament of India in 2018 (by amendment to the Income Tax Act 1961, s. 9 (1) (i), explanation 2-A). This was again amended in 2020, and the enforcement of this model has been deferred to April 2022 (Finance Act 2020, s. 5).
The current definition of ‘Significant Economic Presence’ is as follows:
“Explanation 2A.—For the removal of doubts, it is hereby declared that the significant economic presence of a non-resident in India shall constitute “business connection” in India and “significant economic presence” for this purpose, shall mean—
- transaction in respect of any goods, services or property carried out by a non-resident with any person 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 such amount as may be prescribed; or
- systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India, as may be prescribed:
Provided that the transactions or activities shall constitute significant economic presence in India, whether or not—
- the agreement for such transactions or activities is entered in India; or
- the non-resident has a residence or place of business in India; or
- the non-resident renders services in India:
Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.’”
This is a very broadly phrased definition, and it is not unreasonable to expect that the judiciary will interpret it to cover a broad range of activities. While it is tempting to think of this law only in respect of multinational giants like Facebook and Google, it is more than likely that it will affect small businesses more than the former. It will impose higher burdens (both financially and compliance-wise) on start-ups looking to expand into India. It may also burden domestic businesses which prefer foreign digital services for various reasons, such as better quality of services or affordable prices.
In 2016, the Government of India introduced the Equalisation Levy (and broadened it in its scope in 2020), which is a tax on non-residents who are e-commerce operators or who provide online advertisement services. The burden of complying with this levy was imposed on consumers, even though it was a tax on service providers (S. 166, Finance Act 2016). Moreover, since it bore resemblance to an indirect tax, the resulting tax burden also was shouldered by the consumers.
While the Income Tax Act does not deal with indirect taxes, it is not difficult to imagine a similar compliance burden being placed on the consumers of non-resident service providers who have a Significant Economic Presence in India, as the latter will not be physically present in India while rendering their services. Hence, to ensure that the taxes are ultimately paid, the government may have to either shift the responsibility on the consumers or restrict the presence and business of the non-resident as a penalty for non-compliance. Moreover, since there is no international consensus on this issue, it will prove to be difficult to get the home countries of these digital corporations to cooperate with the market jurisdictions to ensure compliance.
Comparison with South Dakota v. Wayfair (2018) 138 S. Ct. 2080
It is not just India which has been grappling with a physical presence requirement in its income tax laws. In the United States of America, in cases involving mail-order delivery, the U.S. Supreme Court had held that a state could not tax businesses which did not have a physical presence in its jurisdiction, as such a tax would constitute an unconstitutional burden on interstate commerce (See, Quill Corp. v. North Dakota (1992) 504 US 298; National Bellas Hess v. Department of Revenue of Illinois (1967) 386 US 753). In 2018, these decisions were overruled by a majority of 5:4 in South Dakota v. Wayfair. Although Wayfair deals with domestic taxation, the facts and opinions in this judgment are pertinent and relevant to the situation in India in the field of international taxation.
Because of the physical presence requirement, the States were estimated to lose between $8 and $33 billion every year in revenue, while South Dakota alone had been losing an estimated amount of $48 to $58 million in annual revenues. In 2016, to combat such significant revenue losses, the South Dakota legislature enacted an Act which requires out-of-state sellers, that, on an annual basis, deliver more than $100,000 of goods or services into the State or engage in 200 or more separate transactions for the delivery of goods or services into the State, to collect and remit sales tax as if the seller had a physical presence in the state. The Act foreclosed the retroactive application of this requirement and provided means for the Act to be appropriately stayed until the constitutionality of the law had been clearly established.
Soon, this Act was challenged, and the litigation reached the doors of the U.S. Supreme Court, where the State ‘was calling for one of those great occasions in legal history. [It] was asking the Supreme Court to change its mind.’ (quote paraphrased from Anthony Lewis, Gideon’s Trumpet (first published 1964, Vintage Books 1989), ch. 1).
Recognising that the physical presence requirement “created an inefficient “online sales tax loophole” that gives out-of-state businesses an advantage”, Justice Kennedy, joined by Justices Thomas, Ginsburg, Alito and Gorsuch, wholly discarded the rule. He recognized that it harmed small businesses which had a diverse physical presence but advantaged large remote sellers who had all their employees in one central location and a website accessible in every State. He also noted the market distortions which occur when “remote sellers can avoid the regulatory burdens of tax collection and can offer de facto lower prices caused by the widespread failure of consumers to pay the tax on their own.” As the companies have an incentive to avoid physical presence, they may set up their headquarters in low-tax jurisdictions, and thus, only pay taxes in that state, while they may be dealing in sales across the continent. He also noted the arbitrary consequences of the physical presence rule, which may now be argued to cover situations where “a website may leave cookies saved to the customers’ hard drives, or customers may download the company’s app onto their phones.” He noted that e-commerce operations now constituted a significant chunk of modern-day trade activities, and a physical presence rule in today’s world was unfair and unjust to the States, to the consumers, and to in-person businesses.
In his concurrence, Justice Thomas expressed regret over his joining the majority in the Quill Corp decision in 1992, which he had done to show appropriate deference to precedents. He stated that a quarter century of experience had convinced him that the physical presence rule can no longer be rationally justified. He also called for the overruling of the Court’s entire commerce clause jurisprudence, which allows the courts to strike down State Laws which constitute a burden on interstate commerce. While agreeing with him, Justice Gorsuch noted that the physical presence requirement was “a judicially created tax break for out-of-state Internet and mail-order firms at the expense of in-state brick-and-mortar rivals.”
Chief Justice Roberts dissented, joined by Justices Breyer, Sotomayor and Kagan, and his public policy concerns were succinctly expressed in the following paragraphs which are reproduced below:
“The Court argues in favor of overturning that decision because the “Internet’s prevalence and power have changed the dynamics of the national economy.” But that is the very reason I oppose discarding the physical-presence rule. Ecommerce has grown into a significant and vibrant part of our national economy against the backdrop of established rules, including the physical-presence rule. Any alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress. The Court should not act on this important question of current economic policy, solely to expiate a mistake it made over 50 years ago.” (Citations omitted.)
“The burden will fall disproportionately on small businesses. One vitalizing effect of the Internet has been connecting small, even “micro” businesses to potential buyers across the Nation. People starting a business selling their embroidered pillowcases or carved decoys can offer their wares throughout the country—but probably not if they have to figure out the tax due on every sale. See Sales Taxes Report 22 (indicating that “costs will likely increase the most for businesses that do not have established legal teams, software systems, or outside counsel to assist with compliance related questions”). And the software said to facilitate compliance is still in its infancy, and its capabilities and expense are subject to debate.”
He argued that correctly calculating and remitting sales taxes on all e-commerce sales will prove baffling for many retailers and result in substantial compliance costs. He also noted that various states differentiated between similar products, and distinction based on a physical presence requirement would be no different. “Illinois categorizes Twix and Snickers bars—chocolate-and-caramel confections usually displayed side-by-side in the candy aisle—as food and candy, respectively (Twix have flour; Snickers don’t), and taxes them differently.”
Thus, it is clear that the aim of digital taxation should not simply be the bringing of large corporations with a purely online presence within the tax base but should also be to ensure such laws and measures do not restrict innovation and unduly burden smaller businesses.
Conclusion
All the reasons discussed by both the majority and the minority views in Wayfair apply to the Indian context as well. In a developing economy like India’s, it would be unwise to create disruptions in the taxation regime which may create hurdles for emerging or foreign businesses and discourage them from innovating in the field of digital transactions.
The new definition of Significant Economic Presence has been enacted following the recommendations of the OECD to counter internet giants like Google. But it may be a wiser approach to not get swept up by feelings of resentment against MNCs like Facebook and Google and to refrain from enacting laws which will invariably harm smaller businesses who rely on digital transactions to expand and grow their income bases, at least till all the relevant stakeholders involved are heard (This may be the reason why the implementation of the new law has been deferred till April 2022).
It is also a pertinent observation that the threshold amount has not been prescribed yet (which in many jurisdictions is fixed in the principal act itself), tinging the whole matter with further uncertainty. There is no guarantee that a threshold amount, once prescribed, may stay the same for a reasonable duration without being tinkered with frequently. Additionally, it did not enthuse investors and businessmen when the Government introduced and pushed through the Parliament a significant last-minute amendment to the Finance Act 2020 without any warning or debate, which greatly broadened the scope of the Equalisation Levy.
Such laws, which target online businesses, are unprecedented in their scope, and must not be broadly drafted and hastily enacted. While plugging loopholes in the existing taxation framework is a desirable goal, it must not be done in an abrupt fashion, and the laws must be as clear as possible, with legislatively fixed standards. This will ensure that the executive does not have a lot of discretion to abuse and will also create certainty and predictability as all businesses will be aware of most of their obligations.
About The Law 