1. Introduction

The current international tax regime was designed for a brick and mortar economy i.e. where physical presence is required in the other country to constitute Permanent Establishment and it has failed to address the changing business environment mainly through the digital economy. The Covid-19 pandemic has helped the digital economy business to expand by leaps and bounds. Technological advances and novel business models made it possible for business to operate in other countries without physical presence in that country and the traditional form of brick-and-mortar business model had become redundant. Since the transactions or business through digital economy is increasing and due to absence of permanent establishment of overseas company, the income earned is becoming exempt in the source country. In the digitised transaction, major market is the developing economy and there has always been opposition by these countries that they were not getting due share of their taxes on the business done in their country through digital economy.

Organisation for Economic Co-operation and Development (OECD) in November 2015 had issued 15 Base Erosion and Profit Sharing (BEPS) Action Plan (AP). OECD had recognised the challenges posed by digital economy in AP1 and how the existing framework of international tax regime was unable to address the taxability of the business carried out through digital economy. AP1 on digital economy had analysed various solutions to address the taxability of digital economy namely (i) Equalisation Levy, (ii) withholding tax on certain class of digital transactions and (iii) nexus in the form of Significant Economic Presence.

India introduced Equalisation Levy in 2016 taxing certain categories of income @ 6%. The incomes which were taxed as equalisation levy are exempt under section 10(50) of the Income Tax Act, 1961.

Another concept which is recognised by AP1 is based on economic based nexus i.e. Significant Economic Presence (SEP). India introduced SEP in 2018 by inserting an explanation 2A to section 9(1)(i).

2. Indian Domestic Tax Laws

2.1 India introduced SEP in 2018 by insertion of Explanation 2A to section 9(1)(i) which enlarged the scope of the term “Business Connection” under the Income Tax Act, 1961 to tax income of non-resident having Significant Economic Presence in India on the basis of the nexus theory. As per Memorandum to Finance Bill, 2018, the objective behind the introduction of SEP is enumerated as follows:

“The oranges upon the trees in California are not acquired wealth until they are picked, not even at that stage until they are packed, and not even at that stage until they are transported to the place where demand exists and until they are put where the consumer can use them. These stages, up to the point where wealth reached fruition, may be shared in by different territorial authorities.” (excerpts from a report on double taxation submitted to League of Nations in early 1920s).

Accordingly, both the residence and source countries claim the right to taxation.

Taxation of business profits on the basis of economic allegiance has always been the underlying basis of existing international taxation rules. Economists gave primacy to the economic allegiance rather than physical location and made it clear that physical presence was important only to the extent it represented the economic location.

Ordinarily, as per the allocation of taxing rules under Article 7 of DTAAs, business profit of an enterprise is taxable in the country in which the taxpayer is a resident. If an enterprise carries on its business in another country through a ‘Permanent Establishment’ situated therein, such other country may also tax the business profits attributable to the ‘Permanent Establishment’. For this purpose, ‘Permanent Establishment’ means a ‘fixed place of business’ through which the business of an enterprise is wholly or partly carried out provided that the business activities are not of preparatory or auxiliary in nature and such business activities are not carried out by a dependent agent.

For a long time, nexus based on physical presence was used as a proxy to regular economic allegiance of a non-resident. However, with the advancement in information and communication technology in the last few decades, new business models operating remotely through digital medium have emerged. Under these new business models, the non-resident enterprises interact with customers in another country without having any physical presence in that country resulting in avoidance of taxation in the source country. Therefore, the existing nexus rule based on physical presence do not hold good anymore for taxation of business profits in source country. As a result, the rights of the source country to tax business profits that are derived from its economy is unfairly and unreasonably eroded.

OECD under its BEPS Action Plan 1 addressed the tax challenges in a digital economy wherein it has discussed several options to tackle the direct tax challenges arising in digital businesses. One such option is a new nexus rule based on “significant economic presence”. As per the Action Plan 1 Report, a non-resident enterprise would create a taxable presence in a country if it has a significant economic presence in that country on the basis of factors that have a purposeful and sustained interaction with the economy by the aid of technology and other automated tools. It further recommended that revenue factor may be used in combination with the aforesaid factors to determine ‘significance economic presence’.

The scope of existing provisions of clause (i) of sub-section (1) of section 9 is restrictive as it essentially provides for physical presence-based nexus rule for taxation of business income of the non-resident in India. Explanation 2 to the said section which defines ‘business connection’ is also narrow in its scope since it limits the taxability of certain activities or transactions of non-resident to those carried out through a dependent agent. Therefore, emerging business models such as digitized businesses, which do not require physical presence of itself or any agent in India, is not covered within the scope of clause (i) of sub-section (1) of section 9 of the Act.

In view of the above, it is proposed to amend clause (i) of sub-section (1) of section 9 of the Act to provide that ‘significant economic presence’ in India shall also constitute ‘business connection’.”

2.2 From the extracts of the memorandum above, it is evident that the existing norms for taxing the business income is not sufficient to tax the business through digital economy. The source country has always been asking for their share of taxes on the income earned through their country which they were deprived in absence of Permanent Establishment as business was entirely carried out through digital mode. The source country was always of the view that since the market was in their country and without sale there will be no income, the taxes on the income earned on the business transaction should also be shared with them.

2.3 Finance Bill, 2018 inserted the following explanation to section 9(1)(i) relating to Business Connection:

Explanation 2A.—For the removal of doubts, it is hereby clarified 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—

(a) 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 such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means:

Provided that the transactions or activities shall constitute significant economic presence in India, whether or not, —

(i) the agreement for such transactions or activities is entered in India; or

(ii) the non-resident has a residence or place of business in India; or

(iii) 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.

2.4 Through the above amendment, India implemented one of the measures enumerated by BEPS, Action Plan 1 and tax the income earned through the digital transaction. Although the intention of the above amendment was to tax digital transaction, the wording of the explanation seems to suggest that all the physical transaction will be covered under explanation 2A.

2.5 Explanation 2A states that “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……”. The wordings used are transaction in respect of any goods, services or property and it does not restricts itself to digitised transactions. Further the words “including provision of download of data or software in India…..” indicates that even physical transaction will be covered. A clarification by way of circular/ FAQ from CBDT would resolve much of the doubts about the scope of clause (a) of explanation 2A.

2.6 Clause (a) deals with transaction ‘in respect of any goods, services or property’. The words “in respect of” has a wider connotation and as held by the Apex Court in the recent judgement of Engineering Analysis Centre of Excellence Private Limited v. CIT (2021) 125 taxmann.com 42, in respect of means “attributable to”. The term seeks to cover transactions relating to goods, services or property.

2.7 Clause (b) of explanation 2A states that SEP means “systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed …….”.

2.8 Here the amendment seeks to treat the transaction as business connection not on the threshold limit but on the number of users with respect to the systematic and continuous soliciting of business activities or engaging in interaction. It means that if there is one off transaction or not systematic (i.e. planned) and continuous (i.e. recurring) than it will not be treated as business connection. Here there are two activities which are enumerated to be taxed as SEP. One is “soliciting of business activities” and the other is “engaging in interaction”. Here the term “systematic and continuous” will qualify for both to “soliciting of business activities” and to “engaging interaction”. Thus clause (b) can be read as “systematic and continuous soliciting of business activities” or “systematic and continuous engaging in interaction”.

2.9 The term systematic means planned or organised which pre-supposes that there will be continuity and the term continuous means it will be recurring or on regular basis.

2.10 The first limb under clause (a) to Explanation 2A is separated by “or” from clause (b) which means that if the non-resident falls either under clause (a) or clause (b), then the non-resident will be deemed to be having SEP and will come under the purview of Business Connection. Explanatory memorandum also clarifies that both clause (a) and clause (b) are mutually exclusive. Relevant portion of the explanatory memorandum is reproduced hereunder:

“The proposed amendment in the domestic law will enable India to negotiate for inclusion of the new nexus rule in the form of ‘significant economic presence’ in the Double Taxation Avoidance Agreements. It may be clarified that the aforesaid conditions stated above are mutually exclusive.”

2.11 Further explanation 2A says that “it is hereby declared that the significant economic presence of a non-resident in India….” Explanation itself enumerates that SEP will be of a non-resident and not of resident. In a corollary to this, the other party will be resident of India.

2.12 Proviso 1 to explanation 2A provides that the transactions or activities shall constitute SEP in India whether or not:

(i) the agreement for such transactions or activities is entered in India; or

(ii) the non-resident has a residence or place of business in India; or

(iii) the non-resident renders services in India:

The proviso clarifies that it is not important where the agreement has been entered. Even if the agreement is entered outside India and other conditions of SEP are satisfied than also it will be deemed that there will be business connection in India. Under this more importance is placed on the transaction rather than the agreement. The transaction should be with India irrespective of where the transaction is entered.

Further, the proviso also clarifies that it is not relevant whether the non-resident has a residence or place of business in India. Even if the non-resident does not have a residence or place of business in India and if other conditions of SEP are satisfied than it will be deemed that non-resident has a business connection in India. It enumerates the source rule of taxation where the income is taxed where it arises.

Furthermore, the proviso clarifies that it is irrelevant whether non-resident renders services in India. Even if the services are rendered outside India and other conditions of SEP are satisfied, it will be deemed that non-resident has a business connection in India.

2.13 Proviso 2 to explanation 2A of section 9(1)(i) provides 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.

2.14 In explanation (i)(a) of section 9(1) income of the business will be deemed to be only such part as is reasonable attributable to operations carried out in India. Here in this explanation there is a presumption that there will be physical presence in India and the income will be attributable to operations carried out in India, whereas in the digitalised transaction since there will be no physical presence it is provided “that only so much of the income as is attributable to the transaction or activities…..”.

2.15 After introduction of explanation 2A in 2018, threshold limits were not prescribed and the applicability of explanation 2A was deferred to Assessment Year 2022-23 i.e. FY 2021-22.

2.16 Now, since the threshold limit has been prescribed, explanation 2A has been made applicable from Assessment Year 2022-23 i.e. FY 2021-22.

3. Threshold Limit

3.1 CBDT vide Notification No. 41/2021/ F. No. 370142/11/2018-TPL dated May 3, 2021 have inserted new Rule 11UD specifying the threshold for clause (a) and clause (b) of explanation 2A.

3.2 Threshold limit for clause (a) i.e. 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 will be more than ₹ 2 crores for the aggregate of payments arising from such transaction or transactions during the previous year.

3.3 Threshold limit for clause (b) i.e. systematic and continuous soliciting of business activities or engaging in interaction with 3 lakhs users in India.

3.4 The limit prescribed will be effective from AY 2022-23 that is effective from current financial year 2021-22.

3.5 It is not clear how the threshold limit will be computed. Whether only resident users will be considered, or non-resident users will also be considered. Presuming that non-resident users are excluded, where the delivery is in India although user may be non-resident, whether the transaction will be taken for computation of threshold limit. Whether only user using Indian IP will be considered for threshold limit and how it will be tracked. There are various grey areas on the computation of threshold limit which need to be clarified at the earliest.

4. SEP vs DTAA

4.1 India has entered into DTAA with almost 90 countries so the obvious question that arises whether SEP will affect the DTAA already signed by India.

4.2 The memorandum explaining the provisions of Finance Bill 2018 has categorically emphasised that unless corresponding modifications to PE rules are made in the DTAAs, cross border business profits will continue to be taxed as per the existing treaty rules. Relevant para of the explanatory memorandum is reproduced hereunder:

“The proposed amendment in the domestic law will enable India to negotiate for inclusion of the new nexus rule in the form of ‘significant economic presence’ in the Double Taxation Avoidance Agreements. It may be clarified that the aforesaid conditions stated above are mutually exclusive. The threshold of “revenue” and the “users” in India will be decided after consultation with the stakeholders. Further, it is also clarified that unless corresponding modifications to PE rules are made in the DTAAs, the cross-border business profits will continue to be taxed as per the existing treaty rules”.

4.3 Explanatory memorandum itself clarifies that if India has entered into DTAA with any country, then unless the PE rules are changed in DTAA with that country, tax will not be levied in spite of the fact that the non-resident may be having Significant Economic Presence in India according to explanation 2A of section 9(1)(i).

5. SEP vs Equalisation Levy

5.1 There may be activities which are covered both under equalisation levy and SEP. The issue that arises whether the activities will be charged to tax under equalisation levy provision or under SEP provision.

5.2 Section 10(50) of the Income Tax Act, 1961 provides that Income chargeable under Chapter VIII of the Finance Act, 2016 will be exempt if equalisation levy has been paid as per the said Chapter. Since the income which is chargeable under Chapter VIII of Finance Act, 2016 is exempt u/s 10(50), according to my view, application of SEP provision under explanation 2A of section 9(1)(i) does not arise.

6. SEP vs Royalty/ Fees for Technical Service

6.1 Further issue that arises is where the services are rendered outside India are covered both under Section 9(1)(vii) and also under explanation 2A to section 9(1)(i). Similarly, whether download of software would be covered under Section 9(1)(vi) and also under explanation 2A to section 9(1)(i).

6.2 Under section 9(1)(vi) and 9(1)(vii), tax is levied at concessional rate on gross amount whereas tax under section 9(1)(i) will be levied on net basis @ 40%.

6.3 There is no clarity on this and tax can be levied under both the sections. It is better if CBDT clarifies the matter and resolve the issue through circular.

7. Concluding thoughts

SEP provisions will be applicable only to transactions emulating from non-treaty countries or where non-resident is not eligible for taking benefit of treaty, thereby excluding almost 90 to 95 per cent of the transactions. SEP and equalisation levy are temporary measures which will be replaced by tax rules by all the countries according to the consensus approach of the OECD. Until then there are many grey areas which need to be clarified and earlier the issues are better to avoid further round of litigation.