India budget advances virtual/digital PE concept to tax non-resident business
India budget, presented by the government on February 1, focusing on BEPS-related measures that concern permanent establishment definitions and the digital economy..
Angela Ahrendts, Senior Vice President of Retail at Apple, Inc. once said, “I grew up in a physical world, and I speak English. The next generation is growing up in a digital world, and they speak social.”
This is equally applicable to the Indian budget, presented by the government on February 1. This is probably the first budget that mentions next generation words like ‘artificial intelligence,’ ‘block chain,’ ‘internet of things,’ ‘cryptocurrencies,’ ‘big data,’ ‘3D printing,’ and ‘digital economy.’
The budget, which was the Indian government’s last full budget before the upcoming general election next year, comes amidst lower than expected economic growth, fiscal challenge, and farm distress.
This budget also gains importance due to 12 state elections in the next ~12 months. Therefore, the challenge before the government was to strike a fine balance between populism and fiscal prudence.
On the direct tax front, the government continued its approach towards broadening the tax base and implementing OECD/G20 base erosion profit shifting (BEPS) plan outcomes and related measures.
This article focuses on two BEPS-related measures incorporated in the budget which concern permanent establishment (PE) and digital economy and are effective April 1, 2019.
Lower PE threshold
Under the budget, India’s domestic law would be amended to adopt the lower dependent agency permanent establishment (DAPE) threshold set out in the OECD BEPS report on artificial avoidance of PE.
This revised definition adds an agent playing ‘principal role leading to conclusion of contract’ to the concept of DAPE. India has opted for this lower DAPE threshold by signing the multilateral instrument (MLI) as well. Now the definition of DAPE in the domestic law is on par with the definition in the treaties to be revised by the MLI.
Some of India’s key treaty partners, including France, Japan, and the Netherlands, have also opted for the revised threshold. Therefore, after the ratification of the MLI by these countries, the revised PE definition will apply.
Other significant treaty partners have not opted for the revised threshold in the MIL, including the US, UK, Ireland, Italy, Singapore, and Australia. While India’s revised DAPE threshold should, in theory, not impact these treaties, that may not be what happens in practice.
The Indian tax authorities have always taken a very aggressive position on the DAPE threshold; it will not be surprising if India starts interpreting the DAPE provisions aggressively based on the amendment in the domestic law even in the absence of treaty partner agreement in the MLI.
Indian domestic law would also be amended to include the concept of ‘significant economic presence’ in the definition of PE. This is in line with India’s recent comments to the revised OECD model treaty and commentary.
As per the BEPS report on the digital economy, significant economic presence will be determined on the basis of factors that evidence a purposeful and sustained interaction with the economy of that country via technology and other automated tools. The budget has defined significant economic presence to include any:
- Transaction in respect of goods, services and property by non-resident in India including provision of download of data/software beyond a specific revenue threshold.
- Systematic and continuous soliciting of business activities or engaging in interaction with specified number of users through digital means. The number of users beyond which this will be triggered is yet to be prescribed.
The transactions or activities shall constitute significant economic presence in India whether or not the nonresident has a physical presence in India or renders services in India.
The above change is a significant departure from the existing rules on PE. Under the existing rules, significant economic presence in the context of PE is typically determined based on physical presence in a country.
While the explanatory memorandum talks about taxing emerging business models, such as digitized businesses, the way the law is drafted, the concept of significant economic presence could apply to brick-and-mortar businesses as well.
Therefore, companies should start reviewing their existing structures to see if they will trip the PE threshold based on the amendment in the law.
In line with the government’s inclusive approach, before introducing major changes it has been made clear that the threshold of revenue and users for determining significant economic presence will be decided in consultation with the stakeholders.
Existing tax treaties would not be impacted by this new concept of significant economic presence. However, the intention of the proposed amendment is to enable the government to negotiate treaties to include new nexus rules in the form of significant economic presence.
Thus, the concept of significant economic presence will apply only after due negotiation of the double tax avoidance treaties. This has been clarified in the explanatory memorandum as well.
The US is India’s largest trading partner and is home to most of the world’s largest digital companies. It will be interesting to see if the US agrees to negotiate its treaty with India considering the fact that the US has not signed the MLI.
Increasingly, more and more countries have been voicing concern that the current rules are not adequate to tax nexus due to significant digital presence in a country.
The EU’s discussion draft on the digital economy is a case in point. The EU discussion draft states that alternative indicators for significant economic presence are required to protect taxing rights in the new digitalized business models.
Similarly, the UK discussion draft on the digital economy highlights the need to consider the active participation of users (and the value it creates) in determining how the taxable profits of certain digital businesses are allocated between countries.
While the OECD is yet to come out with the revised discussion draft on the digital economy (due ~April 2018), India has already taken the lead in formalizing the concept of digital or virtual PE.
India’s proposed amendment, together with increasing concern on this issue raised by other countries, highlight that this is an area of interest, not just in India but globally, as well. Until the time there’s a multilaterally agreed and implemented solution on this, the number of countries taking unilateral measures will increase, leading to double taxation and more uncertainty.
A discussion on PE is incomplete without a discussion on corresponding profit attribution.
The existing OECD PE profit attribution guidance and discussion draft are of limited use in attributing profit in the digital context.
The PE discussion draft has been a subject of significant debate as the OECD is seeking to achieve consensus due to the lowering of DAPE threshold. Further changes to this threshold will make reaching global consensus on PE profit attribution even more challenging.
The change in nexus without corresponding changes in the OECD PE profit attribution guidance will result in countries adopting unilateral measures for attribution. In the absence of such guidance, it will be interesting to see the approach to be adopted by the Indian revenue to attribute profit to PEs arising out of the above changes.
Need for guidance
PE profit attribution is already a litigious issue. Changes to the definition of PE without commensurate clarity on profit attribution in the context of the digital economy will lead to further litigation.
Therefore, the government should issue appropriate clarification or a circular to address PE profit attribution before it starts alleging such PEs.
It should also be kept in mind by the Indian policymakers that many businesses in the digital space sustain losses for years before they achieve a sustainable market share. Therefore, depending on the facts, PEs alleged due to significant economic presence would have to be attributed loss as well. Thus, any guidance on profit attribution should explicitly talk about attribution of loss also.
James Surowiecki, an American journalist said, “Technology is supposed to make our lives easier, allowing us to do things more quickly and efficiently. But too often it seems to make things harder, leaving us with fifty-button remote controls, digital cameras with hundreds of mysterious features and book-length manuals, and cars with dashboard systems worthy of the space shuttle.”
While digital businesses have transformed the way we live and communicate, let’s hope that the rules on taxing significant economic presence for such businesses are made much simpler than the fifty-button remote controls or cars with dashboard systems worthy of the space shuttle.
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