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    Amendment in Business Connection

    Over past few decades India has witnessed rapid growth in international business transactions and thanks to Modi Government as the international trade flow has increased dramatically post 2014. Even in the recent DAVOS conference, many CEO’s of international MNC’s have promised to do business in India. Accordingly, the stupendous growth in international business has steered to increase in tax issues as well. Therefore, the topic of Permanent Establishment (‘PE’) has become even more important as many MNC’s establish their subsidiaries, offices, distribution networks, etc in jurisdictions such as BRIC nations. 

    International tax rules have used physical presence to allocate taxing rights. However, by virtue of digital technologies, businesses are able to have a significant economic presence without necessarily having a substantial physical presence. Accordingly, to bring such transactions into Tax bracket, Budget 2018 proposes to expand the scope of the ‘business connection’ test (the equivalent of permanent establishment) by including a ‘significant economic presence test’ (“SEP Test”). Under the SEP Test, download of data or software, or solicitation of business activities through digital means in India could lead to non-residents coming within the tax net. The basic intent behind this SEP test is to expand the Tax bracket without having a fixed place of business or a dependent agent thereto. Hence, the question of existing definition of PE being inconsistent with the underlying tax principles is avoided. Interestingly enough, OECD in the BEPS Action Plan is still evaluating various options to tax the digital economy transactions. 

    While India has lead the way to carve out tax provisions to tax digital transactions by first incorporating equalization levy in 2016, and now the SEP Test, other countries are not far behind. 

    The expectation is that once implemented, the measures restore taxation in a number of instances where income would otherwise go untaxed. Depending on the planning structure used, one or more of the measures developed will have an impact and ensure that income is taxed at least one time and not more than once. Rather than closing individual schemes, the measures go to their roots. 

    BEPS Action Plan 1 

    Action Plan 1 in the 15-point Action Plan to address BEPS, the work on the tax challenges of the digital economy, aimed to consider whether the international tax rules were sufficient to meet the demands arising from new business models and ways of creating value that are emerging with the rise of new technologies. 

    Globalisation means that domestic policies, including tax policy, cannot be designed in isolation. Tax policy is at the core of countries’ sovereignty, and each country has the right to design its tax system in the way it considers most appropriate. At the same time, the increasing interconnectedness of domestic economies has highlighted the gaps that can be created by interactions between domestic tax laws. Therefore, there is a need to complement rules to prevent double taxation with a fundamentally new set of standards designed to establish international coherence in corporate income taxation. 

    The BEPS report (OECD, 2013a) calls for the development of “instruments to put an end to or neutralise the effects of hybrid mismatch arrangements and arbitrage”. Hybrid mismatch arrangements can be used to achieve unintended double non-taxation or long-term tax deferral by, for instance, creating two deductions for one borrowing, generating deductions without corresponding income inclusions, or misusing foreign tax credit and participation exemption regimes. 

    While it may be difficult to determine which country has in fact lost tax revenue, because the laws of each country involved have been followed, there is a reduction of the overall tax paid by all parties involved as a whole, which harms competition, economic efficiency, transparency and fairness. 

    India’s Action in line with BEPS 

    Under the existing provisions of Explanation 2 to clause (i) of sub-section (1) of section 9, "business connection" includes business activities carried on by non-resident through dependent agents. The scope of "business connection" under the Act is similar to the provisions relating to Dependent Agent Permanent Establishment (DAPE) in India’s Double Taxation 

    Avoidance Agreements (DTAAs). In terms of the DAPE rules in tax treaties, if any person acting on behalf of the non-resident, is habitually authorised to conclude contracts for the non-resident, then such agent would constitute a PE in the source country. 

    However, in many cases, with a view to avoid establishing a permanent establishment (hereafter referred to as 'PE') under Article5(5) of the DTAA, the person acting on the behalf of the non-resident, negotiates the contract but does not conclude the contract. 

    Further, under paragraph 4 of Article 5 of the DTAAs, a PE is deemed not to exist when a place of business is engaged solely incertain activities such as maintenance of stocks of goods for storage, display, delivery or processing, purchasing of goods or merchandise, collection of information. This exclusion applies only when these activities are preparatory or auxiliary in relation to the business as a whole. 

    The OECD under BEPS Action Plan 7 reviewed the definition of 'PE' with a view to preventing avoidance of payment of tax by circumventing the existing PE definition by way of commissionaire arrangements or fragmentation of business activities. In order to tackle such tax avoidance scheme, the BEPS Action plan 7 recommended modifications to paragraph (5) of Article 5 to provide that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts. Similarly Action Plan 7 also recommends the introduction of an anti fragmentation rule as per paragraph 4.1 of Article 5 of OECD Model tax conventions, 2017 so as to prevent the tax payer from resorting to fragmentation of functions which are otherwise a whole activity in order to avail the benefit of exemption under paragraph 4 of Article 5 of DTAAs. 

    In section 9 of the Income-tax Act, in sub-section (1), in clause (i), with effect from the 1st day of April, 2019,–– 

    (I) in Explanation 2, for clause (a), the following clause shall be substituted, namely:––

    “(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident or habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by that non-resident and the contracts are–– 

    • in the name of the non-resident; or
    • for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that non-resident has the right to use; or 
    • for the provision of services by the non-resident; or”;
      • after Explanation 2, the following Explanation shall be inserted, namely:–– ‘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––
    • 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 
    • 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 the non-resident has a residence or place of business in India or renders services in India: 

    While India has lead the way to carve out tax provisions to tax digital transactions by first incorporating equalization levy in 2016.Now it has took the next step of Significant Economic Presence Test (SEP Test). 

    The memorandum to the Finance Bill further throws light on the intention of the Legislature for introducing SEP. The relevant para is as follows:

    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. 

    Impact on Indian Economy 

    It is pertinent to note that that India is not waiting for a broader consensus on taxation of digital economy and has already started taking measures to deal with it unilaterally. However, the proposed introduction, may not be fruitful because the taxpayer can always avail the treaty benefit. Accordingly, unless there is a change in the PE definition in the bilateral treaties, the amendment may not have any impact. 

    Further, the countries who do not have treaties with India would be highly reluctant to undertake transactions with Indian entities, given the expanded scope of the provisions. 

    The existing provisions would mean that even if services are rendered from outside India the same may result in SEP in India if the revenue threshold is exceeded. This would bring within its ambit all services rendered from outside India assuming the revenue threshold is exceeded and thereby creating SEP for such non-residents. 

    Key Concerns 

    The taxation of digital economy is being discussed at various international forums (OECD, Council of European Union, G20), as unilateral action of a single country cannot resolve tax challenges of the digital economy. Before proceeding to obtain consensus among the members, views on following aspects be framed at an international level: 

    1. Compliances for a virtual permanent establishment; 

    Given the wide ambit of the amended ‘business connection’, it is possible that a large number of non-residents may satisfy the requirements of constituting a business connection in India, though they may not constitute a PE under existing tax treaty rules. It is not clear if such non-residents should file a tax return in India and undertake related compliances even though no income may be taxable in India on account of the tax treaty benefits. 

    1. Profit attribution for digital economy; 

    A key issue in this approach is the attribution of income to the SEP. The current guidelines for attribution of profits enshrined in the authorized OECD approach may not be adequate in a situation where the significant economic presence is established without any assets or people function, which is the very situation SEP seeks to target. It may require changing the current rules to get to a meaningful conclusions. 

    1. Characterisation of income derived from digital business models; 

    The present nature of the Digital PE rule raises questions on how it will be enforced. For instance, for the threshold based on interaction of number of users, calculating the number of users actually interacting with the non-resident could be cumbersome. Among other things, this would require a robust Audit trail to arrive at the number of users – especially in cases of business models where the user interaction is on a free-for-all basis. 

    1. Under Explanation 1(a), the attribution is restricted to the operations carried out in India. Whereas, in case of Explanation 2A, the attribution is to the transactions or activities referred to in clause (a) or class (b). Since the word ‘referred’ is used in 2nd proviso, it would appear that attribution under Explanation 2A would be wider/larger than that under Explanation 1(a). 

    Conclusion 

    To conclude, though India has taken the lead in making tax provisions to tax digital transactions, the Government should be able to resolve the ambiguity on income attribution. The provisions seem to be disregarding many of the OECD options and appropriate safeguards discussed in the BEPS Action plans. Businesses may not have immediate worries about Digital PE being created, but the government needs to clarify on various issues that may lead to time-consuming litigation without much revenue benefit to the Government.

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