Non-resident taxpayers may now have to watch out for a new nexus norm that will require enterprises with no physical presence in India to pay taxes in India on their business profits attributable to transactions or activities that constitute a ‘significant economic presence’ (“SEP”) of the non-resident in India.
Backdrop
The concept of SEP can be traced back to the report of the Organization for Economic Co-operation and Development’s (“OECD”) Task Force on the Digital Economy, which was constituted in 2013. It recognised that the digital economy posed many challenges for tax administrations worldwide, which extended beyond the realms of domestic tax policy. Technological advances and novel business models had since long made it possible for digitally-enabled businesses to operate in various markets globally, while being managed from limited jurisdictions only, i.e., without having a physical presence in each market jurisdiction, thereby rendering the traditional brick-and-mortar model of doing business redundant. Resultantly, physical nexus-based tax rules were no longer sufficient or appropriate to bring such businesses and their incomes from market jurisdictions where there was no physical presence, under the tax net. The OECD’s 2015 Action 1 Report assessed a digital-nexus rule based on an SEP, however, it did not specifically recommend it, prioritising an international consensus-based solution over unilateral measures such as SEP.
Meanwhile in India, based on the recommendations of a 2016 Central Board of Direct Taxes (“CBDT”) High-Powered Committee, the government conceived of its own concept of SEP, introduced vide Finance Act, 2018. An explanation was inserted under Section 9 of the Income-tax Act, 1961 (“IT Act”), to broaden the definition of ‘business connection’, which earlier only provided for a physical presence-based nexus for taxation of business income of non-residents in India.
Accordingly, as per the concept of SEP, a non-resident may be considered to constitute a business connection in India, irrespective of whether such a non-resident has a place of business in India, or rendered services in India, and whether the underlying agreement for the relevant transactions or activities is entered in India, if either of the following conditions is satisfied:
- aggregate of payments arising from transactions relating to goods, services, or property, including provision of download of data or software in India carried out by a non-resident in India exceeds a prescribed value during the financial year; or
- the non-resident undertakes systematic and continuous soliciting of business activities or engages in interaction with a prescribed number of users in India.
Recent announcement surrounding the provision for SEP
Although the concept of SEP was introduced in the IT Act in 2018, the revenue and user thresholds mentioned in limbs (a) and (b) above had not been notified. Through the Finance Act, 2020, it was decided to defer the applicability of SEP to FY 2021-22, in anticipation that the OECD consensus on the digital tax conundrum would be reached by then. To that end, on May 3, 2021, vide a CBDT notification[1], the thresholds have been notified as below, thereby operationalising the SEP provision, with effect from FY 2021-22:
- aggregate of payments during the financial year arising from transactions mentioned above exceeding INR 20 million; and
- soliciting or engagement in interaction as mentioned above with at least 3 million users.
The above thresholds are low enough to cover almost any non-resident engaged in the digital/ e-commerce sector. The timing of the decision to commission SEP signals the CBDT’s intent to capitalise on the ongoing paradigm shift in businesses and way of life – from physical to digital – with various new e-commerce services and ideas having mushroomed, especially during the pandemic.
However, the SEP rules are expected to impact only those non-residents residing in jurisdictions with which India does not have a tax treaty (“DTAA”) and non-residents who are not eligible to claim DTAA benefits. This is because currently, DTAAs do not provide for levy of tax on business income of non-residents in the absence of a permanent establishment of the non-resident in the source country. Hence, unless existing Indian DTAAs are renegotiated to incorporate SEP-based taxes that may be levied in India on non-residents without permanent establishments, the impact of the SEP provision may be limited to non-residents residing in non-DTAA countries. It is contentious whether DTAA partners would be willing to broaden tax rules under DTAAs to include SEP-based taxation, since that would leave many non-resident digital businesses vulnerable to high taxes in India. Thus, pro tem, non-residents eligible to claim DTAA benefits can continue to remain unaffected by the SEP rules.
Points to Ponder
There remain some uncertainties in the SEP scheme, which may sooner or later culminate in litigation. First, there is a lack of definition or clear guidance on how certain terms must be interpreted. ‘Engaged’, ‘interaction’, ‘systematic and continuous’ may be considered as equivocal and subject to a wide range of interpretations.
Second, it is presently not known how the user threshold would be computed, i.e., whether only resident users will be considered as meeting the requirement, or any users located in India at the time of undertaking the transaction/ using Indian IP addresses, albeit temporarily would also be taken into account. Considering that many individuals have been stranded during the pandemic in countries that do not form their customary place of residence owing to travel bans and restrictions, this is a key point in need of clarity. It also remains to be seen how digital businesses build infrastructure and capacity to track users and present clear and specific data to the tax department. On the other hand, it may also be beyond the ken of the tax department to amass the technological wherewithal required to monitor data and assess the accuracy of disclosures by taxpayers.
Moreover, the position is unclear as to whether taxpayers may be given a choice to opt for digital/ e-commerce payments to be taxed as fees for technical services (“FTS”), if possible. The IT Act provides for a much lower rate of taxation of FTS, i.e., 10% on gross basis, whereas business profits under the SEP rule would typically be subject to tax at 40% on net basis for a non-resident corporate entity. In a scenario where both tax rules could be applicable, while it is a well-accepted principle that the taxpayer must be allowed to benefit from the more advantageous rule, it is possible that the tax department may seek to enforce the SEP rule in all circumstances in which it is applicable.
Way Forward
The CBDT’s notification makes SEP applicable to non-residents from financial year 2021-22, corresponding to assessment year 2022-23. Hence, the operationalisation of the SEP thresholds is retrospective by approximately a month, which evidently does not allow non-residents sufficient time to prepare themselves for the potential additional taxes or to install the requisite tracking mechanisms required to compute the same. New rules being introduced in the tax book, especially in the midst of a global pandemic, may exacerbate the unpredictability and uncertainty surrounding the Indian tax system for foreign taxpayers.
As we delve deeper into the practical application of the SEP provisions, more ambiguities and grey areas are bound to arise. Hence, the impacted digital enterprises i.e., those residing in non-DTAA jurisdictions and those ineligible to claim DTAA benefits, must be watchful of the very wide arm that the Indian tax department has awarded itself and imminent interpretational challenges under the SEP rule. Fortunately, there is a silver lining – all unilateral tax rules such as the SEP and equalisation levy, employed to battle the tax problems of the digital economy, are expected to be temporary tools that will eventually be replaced by or aligned with the OECD global consensus.
[1] Notification No. 41 /2021/ F. No. 370142/11/2018-TPL dated May 3, 2021.