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In India, there are two dimensions of tax, namely, direct tax and indirect tax. Direct tax is levied on the income and is governed by the Income Tax Act, 1961. According to the Act, income is taxed on the basis of residence rule and source rule. Basically, the general rule followed in India is residence rule but while dealing in the taxation of international transactions or income of foreign companies, the source rule is followed. The conflict between these two rules leads to double taxation of the same income.
In the last few years, with the advancement in technology, the digital economy has emerged in the market. This means that instead of going to shops in the market, people are relying more on digital markets based on the internet. Now everything is just a click away for people. This convenience has evolved business through e-commerce websites. The issue in the emergence of the digital economy is that taxation of this income as the rules governing tax was enacted before the trend of online business. Hence, now there is a need to revisit and upgrade the current tax laws in line with the digital economy to tax the profits.
Business and transactions through e-commerce have seen a significant growth not only limiting in domestic transactions but international transactions too. The problem arises while taxing international transactions as it gets difficult to determine the place of business in e-commerce. The main conflict in the digital economy is between the source rule and the residence rule.
Taxation of Non-Resident Companies:
Under the Income Tax Act, 1961, the whole income of residents is taxed in India while non-residents are taxed when the source of income is based in India. Section 6 of the Act provides for determining the residential status of a person. This section also provides for the factors on which the residential status of a company depends, namely, such a company is incorporated in India or the place of effective management (POEM) is in India. Non-resident companies are not taxable under the Income Tax Act but the income of non-residents generated by transactions involved in the digital economy raises the question on two aspects i.e. characterization of income and classification as a Permanent Establishment.
Addressing the Issues in Digital Economy:
In e-commerce, the taxation of income and profits become quite tricky as the transactions take place through an online server from across the world. As there has been a significant shift from physical markets to electronic markets, so a need to devise new tax reforms was felt and as a result Organisation for Economic Co-operation and Development (OECD) took a step to bring change in the tax systems across the world.
In 2015, the OECD introduced 15 Action Plans on Base Erosion and Profit Shifting (BEPS) to address the issues of tax evasion, double taxation and other loopholes in the taxation system.
Taxation of International Transactions:
In International Tax regime, to avoid double taxation of income earned, countries enter into an agreement known as the Double Taxation Avoidance Agreement (DTAA). The purpose of DTAA is to promote international trade and avoid double taxation. As per standard rule, the same income cannot be taxed twice. Since there is usually a conflict between countries whether to apply residence rule or source rule hence, DTAA is entered into to avoid such conflict.
The Action Plans introduced by the OECD deals with various challenges. All countries including India are trying to implement the action plans.
Action Plan 1 deals with the taxation of the digital economy. This Action Plan discusses the following concepts to implement while taxing digital transactions:
- Equalization Levy- This concept was introduced in 2016 to impose a tax on the income of non-residents earned out of online advertising and such other activities.[i] It was introduced by the Finance Act, 2016 to be levied at 6% on the stated services. The equalization levy of 6% has to be charged from a non-resident if he is having a Permanent Establishment (PE) in India.[ii] Permanent Establishment can be defined as a fixed place of business of an enterprise present in another country. To fall under the definition of PE, the enterprise must fulfil the following tests: place of business test, location test, permanence test, right of use test and business activity test. To charge the equalization levy at 6%, it is important to establish that the e-commerce operator has received consideration from either a person who is a resident of India or from a non-resident who has a PE in India. If through this place of business, the business of the enterprise is wholly or partly carried on then it can be termed as a PE. With effect from April 01, 2020, by the virtue of Finance Act, 2020 the Finance Act, 2016 has been amended to introduce equalization levy 2.0 which is to be levied at 2%. This is charged on income generated by providing e-commerce supply of goods or services, if a single payment made to the service provider exceeds Rs. 1,00,000 in a financial year or if the total payment in a financial year exceeds Rs. 10,00,000.
- Significant Economic Presence (SEP)- Action Plan 1 introduced the concept of SEP which defines the criteria for determining the income deemed to accrue or arise in India.[iii] Originally this concept was introduced in 2018 but recently in 2020 Section 9 of the Income Tax Act, 1961 was amended to ensure that economic presence is not determined merely by having a physical presence or permanent establishment in India. This applicability of provisions related to SEP has been put off till the financial year 2021-2022.
- Withholding Tax on Digital Transactions- Withholding tax is supposed to be levied on the sale of goods or service through electronic means at the rate of 1%. The e-commerce operator (who owns, operates and manages digital platform) has to withhold tax at 1% of the gross amount of sale of goods or services through digital means. In case the e-commerce participant (resident of India involved in the sale of goods or services through digital means) does not has the Permanent Account Number, then in such case, the rate of withholding tax is 5%. This concept is to be applicable from October 2020.
Equalization Levy equivalent to GAFA Tax:
GAFA Tax is a digital tax to be imposed on large technology and internet companies. The name is influenced by the large tech companies namely, Google, Apple, Facebook, Amazon. In January, with the support of OECD, 137 countries agreed to negotiate a deal to tax multinational tech companies by the end of 2020. The motivation behind this tax was that these companies have been exploiting tax rules and have been taking advantage of tax havens. The need to bring such new policy was the shift from brick and mortar stores to the digital platform.
India does not impose GAFA tax. Rather, it has introduced the concept of equalization levy, significant economic presence and withholding of tax on digital transactions to impose a tax on digital transactions. Equalization levy imposed on online transactions is equivalent to GAFA Tax. Interestingly, equalization levy is called as ‘Google Tax’.
With the improvement and advancement in technology and outburst of COVID-19, people have made e-commerce the new norm of the day. Everything being available on a click has made the e-commerce business fast-growing. With this rapid growth of the digital economy, there is a need of OECD and International Fiscal Association to bring reform in tax models of countries to have an equitable tax system for cross border digital transactions. There is a need for an equitable tax system to avoid the conflict of different countries as they have divergence in opinion as to the approach of imposing a tax on digital transactions. Also, countries should avoid making the desperate choice in changing the tax reform as it might affect the economy adversely. The BEPS Action Plan is also in the grooming stage.
Corporations providing online services such as Google, Netflix, Amazon, etc. works on a virtual space hence it gets difficult to bring their services under the ambit of the local tax system. To overcome this issue, India has introduced new reforms to bring such digital transactions under the radar of the country’s tax laws. So, companies not having a physical presence in India cannot evade taxes if it is earning income from audiences in India. In all this, now the source rule seems outdated.
Digitalization made everything easy and approachable but it has given rise to various new issues for the taxation systems globally. To address the issue, the OECD should make a uniform tax system to tax digital transactions. Under BEPS, there is sometimes an issue of either low taxation or no taxation, to avoid this fundamental changes should be proposed so that shifting of profits can be prevented. Current rules should be amended and the countries should adopt new policies with consensus. Government should also take steps to prevent and tackle tax practices and aggressive tax planning which might result to be harmful for the economy. The changes can be successfully applied only when there is transparency in the mechanism implemented.
[i] Jiger Saiya & Jagat Mehta, Taxing the Digital Economy: Indian Equalisation Levy 2.0, BDO GLOBAL (Sept. 19, 2020, 06:25 PM), https://www.bdo.global/en-gb/microsites/tax-newsletters/world-wide-tax-news/issue-55-june-2020/india-taxing-the-digital-economy-indian-equalisation-levy-2-0.
[ii] Finance Act 2016 § 165.
[iii] Income Tax Act § 9.