Report- Taxation of E-Commerce: Equalization Levy or Google Tax

A Committee on Taxation of e-commerce was constituted by the Central Board of Direct Taxes to examine the business models for e-commerce, identify the direct tax issues in relation to e-commerce transactions and suggest an approach to deal with these issues. The Committee included officers of the Central Board of Direct Taxes, representatives from the industry, the Institute of Chartered Accountants of India and tax experts. The Report of the Committee was received by the Government and taken into consideration in the preparation of Finance Bill, 2016. This Report provides the view of the Committee on issues related to taxation of e-commerce and recent international developments in this area.

The Report is as follows :-

PROPOSAL FOR EQUALIZATION LEVY ON SPECIFIED TRANSACTIONS

(Report of the Committee on Taxation of E-Commerce)

February, 2016

Prepared by the Committee on Taxation of E-Commerce formed by the Central Board of Direct Taxes, Department of Revenue, Ministry of Finance, Government of India

CONTENTS

Section 1 Constitution and Mandate of the Committee

Section 2 Digital Economy: Current status and Growth Prospects

Section 3 Tax Challenges from Digital Economy & Action 1 in BEPS

Section 4 Issues related to Tax Neutrality between Domestic & Multi-National Enterprises and their Implications

Section 5 Principles for Allocating Taxing Rights, Factors that contribute to Profitability & Historical Review of Existing Rules

Section 6 Broader Tax Challenges related to Nexus and Characterization of Income from Digital Transactions
and common Disputes

Section 7 Issues related to Value of data & User Activity in Multidimensional Business Models

Section 8 Recent International Literature on Taxation of Digital Economy Enterprise

Section 9 Options to address broader tax challenges of Digital Economy in the Indian Context

Section 10 Characteristics of the Proposed ‘Equalization Levy’

Section 11 Conclusions & Recommendations of the Committee

Executive Summary

The Committee on taxation of E-Commerce examined the tax issues arising from the new business models employed in the digital economy, in particular issues relating to tax nexus rules under existing law and tax treaties, characterization of payments made for services and facilities provided primarily through digital means and issues related to valuation of data and user contribution in profits of digital enterprises. The Committee took cognizance of the Report on Action 1 of Base Erosion & Profit Shifting (BEPS) Project, wherein very significant work has been undertaken for identifying the tax challenges arising from digital economy, the possible options to address them and constraints likely to be faced. The Committee also notes that this report has been accepted by G-20 countries, including India and OECD, thereby providing a broad consensus view on these issues. The Committee took note of the work done in this field by other experts, as well as the lack of uniformly accepted standards in taxation of royalty and fee for technical services, and the resultant tax disputes. The Committee also took note of the divergent approaches to characterization of such income taken by the taxpayers, tax authorities and appellate authorities, and the litigation arising from such inconsistencies. The Committee acknowledges the need for addressing all these issues in a holistic manner.

The Committee notes that the BEPS Report on Action 1 clearly brings out that the physical presence nexus in existing international taxation rules, which were developed in the last century keeping in view the business models of that time, provided a reasonable nexus test for identifying significant participation of a traditional brick & mortar enterprise in the economic life of a jurisdiction. However, with the evolution of new business models in digital economy, where revolutionary technological developments have made the need for physical presence redundant, it is no more a justifiable indication of nexus. The BEPS Report also brings out very clearly the challenges that are faced in characterizing the payments for digital goods and services, which are likely to be faced more often by countries like India, which opt for taxation of royalty and fee for technical services in the source jurisdiction. Lastly, the BEPS Report also recognizes the new issues that have emerged in respect of multidimensional business models, like valuation of data belonging to residents of source jurisdiction and the user contributions to the profitability of enterprises, both for the purpose of determining nexus and attributing profits.

The Committee notes that the ability of multinational enterprises to avoid taxes completely in the source jurisdiction under the existing rules, poses significant challenges and concerns for countries like India. The unfair advantage enjoyed by them over their Indian competitors can make Indian enterprises, both digital as well as brick & mortar ones, relatively less competitive in the long run, resulting in detrimental impact on growth of Indian enterprises. Further, their ability to avoid payment of taxes in India can also adversely impact revenue collections, and lead to a rising tax burden on Indian enterprises and Indian citizens that could be even more detrimental to Indian economy as a whole. Thus, the Committee considers that there is a need for addressing these issues without any further delay.

The BEPS Report on Action 1 clearly highlights the need for modifying existing international taxation rules, and identifies three options, i.e. a new nexus based on significant economic presence, a withholding tax on digital transactions, and Equalization Levy. The Report elaborates in detail the characteristics of these options and their possible tax design. The Report does not recommend any of these options at this stage, in view of the work that may be required in the area of attribution of profits, but concludes by recognizing the right of any country that may wish to adopt any of these options, either under its domestic law or in its bilateral tax treaties.

After examining the three options identified in the report, the Committee notes that compared to the first two options, i.e. a new nexus based on significant economic presence and the withholding tax on digital transactions, which would require changes in a number of tax treaties, the third option of ‘Equalization Levy’ provides a simpler option that can be adopted under domestic laws without needing amendment of a large number of tax treaties. Accordingly, the Committee recommends the adoption of this option to address the tax challenges of digital economy and provide greater certainty and predictability in its taxation. The Equalization Levy imposed on the payment for digital transactions, would not be a tax on income, and hence would not be covered by tax treaties. As Equalization Levy is not proposed as tax on income, it would need to be imposed outside the Income-tax Act, 1961.

The Committee proposes that the Equalization Levy may be imposed on specified digital services and facilities including online marketing and advertisements, cloud computing, website designing hosting and maintenance, digital space, digital platforms for sale of goods and services and online use or download of software and applications. The Committee recommends that only payment exceeding Rs. one lakh made by a person resident in India or a permanent establishment of a non-resident person to a non-resident enterprise be covered by this levy, which may be charged at a rate between 6 to 8 % of the gross payment made for specified services. Such a threshold will keep almost all B2C transactions, as well as a very large number of B2B transactions outside the scope of the Equalization Levy, thereby limiting its impact.

The Committee notes that income arising from payments subjected to Equalization Levy should not be subjected to income-tax, and hence proposes that income from transactions that are chargeable to Equalization Levy, and on which such levy is paid, may be exempted from income-tax. The Committee considered different options for ensuring compliance, and came to a view that it can be done by way of deduction of Equalization Levy by the payer, but such obligation should be limited to only those payers who wish to claim that payment as a deductible expense for determining taxable profits in India. Committee also notes that deduction by payment gateways and by authorized foreign exchange dealers can significantly reduce the obligations on payers, and strongly recommends that work should be initiated for exploring this possibility. The Committee also recommends that reporting obligations for Equalization Levy may be kept simple with facility of filing return being made available online. The Committee also acknowledges the need for continuously monitoring further developments in digital economy as well as further developments in international taxation rules.

Section 1

Objective of the Committee’s Work

1.1 Introduction

1. With expansions of information and communication technology, the supply and procurement of digital goods and services has undergone exponential expansion everywhere, including India. It has also made it possible for the businesses to conduct themselves in ways that did not exist earlier, and given rise to new business models that rely more on digital and telecommunication networks, do not require physical presence, and derive substantial value from data collected and transmitted through such networks. These new business models have also created new tax challenges in terms of nexus, characterization and valuation of data and user contribution. These challenges have been recognized by the international community, leading to their inclusion in the Base Erosion and Profit Shifting (BEPS) Project endorsed by G-20 and OECD. The findings and conclusions of Action 1 of this Project aimed at addressing these challenges, resulted in the publication of a detailed Report in September 2015 that has since been accepted and endorsed by the G-20 and OECD and thus provides a broad international consensus on these issues.

2. The issue of characterization of payments related to digital goods and services, and the inherent ambiguities therein, have been universally recognized as a challenge. These issues are faced more commonly by countries like India, which have included provisions that allow taxing rights to the source jurisdiction to tax royalty and fee for technical services in their tax treaties, and thereby have a difference in position with the OECD in respect of these provisions. The combination of inadequacy of physical presence based nexus rules in the existing tax treaties and the possibility of taxing such payments as royalty or fee for technical services creates a fertile ground for tax disputes, particularly in countries like India, where the taxpayer rights are fully protected by the appellate authorities, and imposition of tax under ambiguous laws are often not sustained.

3. The ambiguities in taxation of income arising from the digital economy, and the resultant tax disputes are also a constraint for the taxpayers, who may end up getting subjected to inconsistent approaches on the part of assessing as well as appellate authorities, making the tax regime in respect of such income ambiguous and unpredictable, a situation which has been noted as an area of concern by the taxpayers as well as tax authorities.

1.2 Constitution of the Committee

4. Recognizing the significance of issues relating to e-commerce transactions and the need to have a simple way to resolve them and bring greater clarity and predictability in the applicable tax regime, the Central Board of Direct Taxes (CBDT), Department of Revenue, Ministry of Finance, directed that a Committee be constituted, whose terms of reference should include detailing the business models for e-commerce, the direct tax issues in regard to e-commerce transactions and a suggested approach to deal with these issues under different business models. It was further directed that the Committee may include experts from industry and officers from CBDT and the field and also a nominee from the Institute of Chartered Accountants of India.

5. Accordingly a committee was constituted consisting of the following members1:

(i) Shri Akhilesh Ranjan, Joint Secretary (FT&TR-I), CBDT, Department of Revenue, Ministry of Finance & Chairman of the Committee

(ii) Ms. Pragya Sahay Saksena, Joint Secretary (TPL-I), CBDT, Department of Revenue, Ministry of Finance

(iii) Shri Pradip Mehrotra, Commissioner of Income Tax (ITA), CBDT, Department of Revenue, Ministry of Finance

(iv) Ms. Chandana Ramachandran, Commissioner of Income Tax (International Taxation), Bengaluru

(v) Shri Nihar N Jambusaria, Chairman, Committee on International Taxation of the ICAI, representative of the Institute of Chartered Accountants of India (ICAI)

(vi) Shri Pramod Jain, Head of Taxation, Flipkart, Industry representative

(vii) Shri Rashmin Sanghvi, Chartered Accountant, Expert on International Taxation and Taxation of E-Commerce

(viii) Dr. Vinay Kumar Singh, Director (FT&TR-I), CBDT Department of Revenue, Ministry of Finance & Member Secretary of the Committee

1.3 Work of the Committee

6. The Committee held its meetings in New Delhi from time to time to examine the issues and find possible alternatives to address them. Part of the work was undertaken by members working in sub-groups, as decided by the Committee. The Committee heavily relied upon the BEPS Report on Action 1, wherein the new business models of digital economy as well as the tax challenges arising from it in respect of nexus, characterization, valuation of data and user contribution have been examined in detail. The BEPS Report also identifies options to address these challenges and also recognizes the right of countries to adopt any of those options in their domestic laws or bilateral tax treaties. The Committee took note of the fact that India was an active participant in the BEPS Project, including Action 1, and the BEPS Report on this action has been endorsed by the G-20 and OECD countries.

7. The Committee took note of all aspects of digital economy that have been recognized and taken note of in the BEPS Report on Action 1, keeping the Indian context in view, and explored possible options to find a solution in accordance with the conclusions of this report. The Committee aimed at identifying a solution that will provide simple, predictable and certain taxation of digital economy. This Report is a result of this endeavour.

1.4 Organization of the Report

8. The following sections of this Report are organised in the order that the Committee approached the issues. The second section notes the current status of digital economy and its future growth projections. Section 3 details the tax challenges arising from digital economy and the work in Action 1 of the BEPS Project undertaken in this regard. Section 4 details the observations of the Committee related to the need for achieving tax neutrality between multi-national enterprises and domestic enterprises, as well as between digital and traditional (brick & mortar) enterprises. Section 5 provides an overview of the underlying principles for allocating taxing rights between the jurisdiction of residence and the jurisdiction of source, the factors that lead to profitability of businesses, and a historical review of existing rules. Section 6 identifies the tax challenges in digital economy that have now been recognized by the international community, including those related to nexus and characterization, as well as the tax disputes that can arise from them, particularly in the Indian context. Section 7 takes a look at the issues related to valuation of data owned by residents in the source jurisdiction and their contributions as ‘users’ in the profitability of the enterprises in multidimensional business models. Section 8 reviews the recent international literature on tax issues arising from digital economy that was also taken cognizance of during the BEPS project. Section 9 details the options identified by the BEPS Report on Action 1, and their conclusion that countries may adopt any of these options in their domestic laws or bilateral tax treaties. In Section 10, the Committee puts forward a proposal for the Equalization Levy that can be adopted under Indian laws. Section 11 provides a summary of the conclusions and recommendations of the Committee.

Chapter 2

Digital Economy: Current status and Growth Prospects

2.1 Introduction

9. Rapid and progressively evolving changes in information and communication technology have led to cataclysmic changes in the manner businesses are conducted around the world. Technological advancements and cheaper innovations have ensured widening spread of these techniques to hitherto unexposed populations. Entrepreneurs across the world have been quick to evolve their businesses to take advantage of these changes. The digital means of doing business have perpetrated so fast that the Task Force on Digital Economy (TFDE) of the Committee on Fiscal Affairs of the OECD has commented in its report that the digital economy is fast becoming the economy itself. The digital economy2 has not only forced radical departures in ways of doing business it has also created entirely new businesses and opened up new markets and growth and new job opportunities. The growing prevalence of E-Commerce3 and new services like Cloud Computing4 indicate the rising significance of digital economy in international commerce.

10. Part of the reasons for the rapid expansion of the ICT sector is progressive fall in prices of ICT devices and services because of the tendency for greater standardization, commoditization and interoperability in this sector. Technological innovations in hardware and greater integration of hardware and software produced commodities with greater value for money and led to expansion of use. Coupled with improving telecom network infrastructure, open source codes leading to development of software applications and self-propagating user generated content have led to increasing penetration.

2.2 Forms of Prevalent Businesses in various segments of Digital Economy

11. There has been a consistent expansion of E-Commerce businesses over the last couple of decades. The BEPS Report on Action 1 (2015) lists some of the more prevalent forms of these in paragraphs 118 to 121, as under:

“4.2.1.1 Business-to-business models

118. The vast majority of e-commerce consists of transactions in which a business sells products or services to another business (so-called business-to-business (B2B)) (OECD, 2011). This can include online versions of traditional transactions in which a wholesaler purchases consignments of goods online, which it then sells to consumers from retail outlets. It can also include the provision of goods or services to support other businesses, including, among others: (i) logistics services such as transportation, warehousing, and distribution; (ii) application service providers offering deployment, hosting, and management of packaged software from a central facility; (iii) outsourcing of support functions for e-commerce, such as web-hosting, security, and customer care solutions; (iv) auction solutions services for the operation and maintenance of real-time auctions via the Internet; (v) content management services, for the facilitation of website content management and delivery; and (vi) web-based commerce enablers that provide automated online purchasing capabilities.

4.2.1.2 Business-to-consumer models

119. Business-to-consumer (B2C) models were among the earliest forms of e-commerce. A business following a B2C business model sells goods or services to individuals acting outside the scope of their profession. B2C models fall into several categories, including, for example, so-called “pureplay” online vendors with no physical stores or offline presence, “click-and-mortar” businesses that supplemented existing consumer-facing business with online sales, and manufacturers that use online business to allow customers to order and customise directly.

120. The goods or services sold by a B2C business can be tangible (such as a CD of music) or intangible (i.e. received by consumers in an electronic format). Through digitisation of information, including text, sound, and visual images, an increasing number of goods and services can be delivered digitally to customers increasingly remote from the location of the seller. B2C e-commerce can in many cases dramatically shorten supply chains by eliminating the need for many of the wholesalers, distributors, retailers, and other intermediaries that were traditionally used in businesses involving tangible goods. Partly because of this disintermediation, B2C businesses typically involve high investment in advertising and customer care, as well as in logistics. B2C reduces transaction costs (particularly search costs) by increasing consumer access to information. It also reduces market entry barriers, as the cost of maintaining a website is generally cheaper than installing a traditional brick-and-mortar retail shop.

4.2.1.3 Consumer-to-consumer models

121. Consumer-to-consumer (C2C) transactions are becoming more and more common. Businesses involved in C2C e-commerce play the role of intermediaries, helping individual consumers to sell or rent their assets (such as residential property, cars, motorcycles, etc.) by publishing their information on the website and facilitating transactions. These businesses may or may not charge the consumer for these services, depending on their revenue model. This type of e-commerce comes in several forms, including, but not limited to: (i) auctions facilitated at a portal that allows online bidding on the items being sold; (ii) peer-to-peer systems allowing sharing of files between users; and (iii) classified ads portals providing an interactive, online marketplace allowing negotiation between buyers and sellers.”

2.3 Extent of Digital Economy in World & Prospects of its Growth

12. A report by the Boston Consulting Group in 2012 had estimated that there would be 3 billion internet users in the world by 2016.The digital economy which contributed USD 2.3 trillion in G-20 countries in 2010 would expand to USD 4.2 trillion. The digital economy is growing at 10% a year, significantly faster than the global economy as a whole. With increasing penetration, the emerging economies are now becoming the drivers of innovation.5 The number of Internet-connected devices (12.5 billion) surpassed the number of human beings (7 billion) on the planet in 2011, and by 2020, Internet-connected devices are expected to number between 26 billion and 50 billion globally.6

13. The growth of internet and this so called ‘digital economy’ has been all encompassing around the globe. The volume and scope of its expansion is aptly summarized in the BEPS Report on Action 1 (2015) as under:

“123. For example, e-commerce in the Netherlands has increased as a share of total company revenue from 3.4% in 1999 to 14.1% in 2009. Similarly, between 2004 and 2011 this share increased from 2.7% to 18.5% in Norway and from 2.8% to 11% in Poland. Based on comparable data, as illustrated in the chart below, e-commerce is nearing 20% of total turnover in Finland, Hungary, and Sweden, and 25% in the Czech Republic (OECD, 2012).

124. In 2014, B2C e-commerce sales were estimated to exceed USD 1.4 trillion, an increase of nearly 20% from 2013. B2C sales are estimated to reach USD 2.356 trillion by 2018, with the Asia-Pacific region expected to surpass North America as the top market for B2C e-commerce sales in 2015 (Emarketer, 2014). According to the research firm Frost and Sullivan the B2B online retail market is expected to reach double the size of the B2C market, generating total revenues of USD 6.7 trillion by 2020. Such B2B online sales will comprise almost 27% of total manufacturing trade, which is estimated to reach USD 25 trillion by 2020 (Frost and Sullivan, 2014).”

“139. Internet advertising is rapidly growing, both in terms of total revenues and in terms of share of the total advertising market. PwC estimates that Internet advertising reached USD 135.4 billion in 2014. The market for Internet advertising is projected to grow at a rate of 12.1% per year during the period from 2014 to 2019, reaching USD 239.8 billion in 2019. Internet advertising would by that point surpass television as the largest advertising medium. Within the online advertising market, search advertisement holds the greatest share. Paid search Internet advertising revenue is forecast to grow from USD $53.13 billion in 2014 to USD $85.41 billion in 2019, accounting for over 35% of total Internet advertising by then, although video and mobile advertising are experiencing rapid growth. While video Internet advertising only accounted for 4.7% of total Internet advertising revenue in 2014, it is expected to grow at over 19% a year, rising from USD $6.32 billion to USD $15.39 billion in 2019. Similarly, mobile Internet advertising grew from just 5% of total Internet advertising in 2010 to 16.7% of the global share in 2014 and is expected to increase as mobile devices continue to proliferate (PwC, 2015).”

14. More than two billion people globally are expected to use mobile devices to connect to the Internet in 2016, with countries like India, China and Indonesia leading the way. More than a billion people use the Internet to bank online, to stream music, and to find a job. More than two billion use email and read news online and more people than ever before are making purchases online, it added.7

15. The growth and development of digital economy is reported and analyzed in great detail in Chapters 3 and 4 of the BEPS Report on Action 1 (2015), in statistical terms as well as in terms of their reliance upon information and communication technology as the primary means of doing business, along with the various business models that have emerged in the process. Because of their extensive reliance upon telecommunication and exchange of data, arising primarily from the revolutionary breakthroughs in their costs, these businesses are characterized by features that make them stand apart from the traditional brick & mortar businesses in many ways. Paragraph 158 of this summarises them as under:

“158. In addition, technological advances increasingly make it possible for businesses to carry on economic activity with minimal need for personnel to be present. In many cases, businesses are able to increase substantially in size and reach with minimal increases in the number of personnel required to manage day-to-day operation of the businesses (so-called “scale without mass”). This has been particularly true in the case of Internet businesses, which have in many cases quickly amassed huge numbers of users while maintaining modest workforces. As a result, the average revenue per employee of top Internet firms, as shown in Figure 4.8, is substantially higher than in other types of businesses within the ICT sector.”

2.4 Digital Economy in India

16. The Indian story in this regard is similar. According to Internet and Mobile Association of India (IAMAI), India’s internet user base grew over 17% in the first six months of 2015 to 354 million. It took 10 years for India to get her first 10 million users and another 10 years to clock the first 100 million. As the rate picked up, the next 100 million users came in three years and the third 100 million took only 18 months. Internet users crossed 300 million in December 2013. India was expected to reach 402 million internet users by December 2015, registering a growth of 49 per cent over 2014 and surpassing the number of users in the United States. About 306 million of these are expected to access Internet from their mobile devices. At around that time the number of mobile users crossed one billion. With greater penetration, improving speeds and cheaper devices hitting the market, the target to reach 500 million internet users is likely to be achieved by 2016.3

17. The Department of Electronics and Information Technology (DeiTY), Government of India, is of the opinion that with the advent of the Internet of Things (IoT), which is defined as the interplay of software, telecom and electronic hardware industry, the number of connected sensors will soon reach trillions, working with billions of intelligent systems involving numerous applications which will drive new consumer and business behaviour. The demand for increasingly intelligent industry solutions based on IoT will drive trillions of dollars in opportunity for IT industry and even more for the companies that take advantage of the IoT. The draft IoT policy of DeiTY has set an objective of creating an IoT industry in India of USD 15 billion by 2020 assuming that India would have a share of 5-6% of global IoT industry.8 The launch of the Digital India Campaign also points to the high priority the Government of India accords to changes in the broadband infrastructure and favourable regulatory policy.

18. A report by Cisco estimates that all Internet of Everything (IoE) pillars – Internet of things, Internet of people, Internet of data, and Internet of Process for India have a value at stake (VAS) of INR 31.880 trillion (about half a trillion U.S. dollars) for the next ten years.9

19. Within the larger universe of the digital economy, India’s e-commerce market was estimated to be worth about $3.8 billion in 2009 which went up to $12.6 billion in 2013. In 2013, the e-retail segment was worth US$ 2.3 billion. A large part of India’s e-commerce market was travel related, but that may be changing now. According to Google India, there were 35 million online shoppers in India in 2014 Q1 and is expected to cross 100 million mark by end of year 2016. Electronics and Apparel are the biggest categories in terms of sales. Overall the e-commerce market is expected to reach ₹ 1,07,800 crores (US$24 billion) by the year 2015 with both online travel and e-tailing contributing equally.10

20. A research conducted by octane.in has revealed interesting insights regarding the state of online marketing in India. According to it, 85% of the Indian marketers are tracking revenues generated through e-marketing activities. 50% of respondents share that e-marketing activities are contributing to more than 10% share of their revenues. It also reports that social media updates was the top choice for achieving maximum customer engagement (46%) followed by email campaigns (28%). Social Media (66%) also topped the list of marketing activities planned for 2016. Email marketing was not far behind, with a 53% share of Indian marketers.11

21. These figures clearly indicate that digital means of communication and social interaction are giving rise to new businesses that did not exist very long ago. Many of these businesses that have generated only in last two decades, occupy considerable share of market segments, and form a significant part of the economy and tax base. Their growth in India has also reached proportions that make them significant actors in Indian economy.

2.5 Committee’s observations

22. In view of the aforesaid details and observations, as well as the details provided in the BEPS Report on Action 112, this Committee is of the view that this rapidly expanding segment of business that extensively relies upon the new advances in information and communication technology, the telecommunication networks and the internet, has now become a significant segment of economy around the world, including India. The Committee notes that these developments have made it essential that its impact in terms of the applicability of existing tax laws and the challenges posed by it, is properly appreciated, understood and taken into account in the tax systems. The Committee is also of the view that these challenges need to be addressed at the earliest, and also monitored on a regular basis.

Section 3

Tax Challenges from Digital Economy & Action 1 in BEPS

3.1 Evolution of new Business Models in Digital Economy

23. The advancements in the Information & Communication technology in the last few decades have literally revolutionized the human society in ways that may not have been envisaged a hundred years back. The extraordinary reduction in communication costs and the widespread connectivity at a small fraction of what it used to cost in the middle of the last century has changed most aspects of our life, including the way modern businesses are conducted.

24. Till a few decades back, it was essential for businesses aiming to supply goods and services to a large number of consumers to be in proximity to the market where they wish to have a significant presence, as otherwise the prohibitive costs of communication and transport, apart from other potential constraints, would make it impossible for them to access such markets. This need for proximity made it essential for such businesses to have a physical presence in proximity to the markets, even more so for the suppliers of services, in an era when services were provided primary in the form of human intervention. However, with advancements of ICT, it is now possible for the businesses to have significant participation in the economic life of a jurisdiction without any physical presence, as the digital or telecommunication networks become a substitute for physical proximity. This has enabled the evolution of new business models that enable them to have significant participation in a jurisdiction without necessitating physical presence. In particular, business models have emerged that can be conducted primarily by exchange or transmission of data. These digital enterprises have already acquired significant space in global economy, and as per current and anticipated trends, their proportion in the total economy will continue to rise. Due to their ability to cater to international markets at low transactions costs, many of these enterprises are already among the most valued enterprises globally.

3.2 Impact of Taxation

25. The international taxation rules on the basis of which taxing rights are allocated under Double Taxation Avoidance Agreements for avoiding double taxation are largely derived from the recommendations made by a group of four economists13 appointed by the League of Nations in the 1920s, long before such new technological advancements were even conceptualized. They recommended division of rights of taxation between the Country of Residence and the Country of Source while recognizing the rights of both to levy tax on such income. The existing rules that were developed as a consequence of their analysis, provide for a threshold for taxation of business income in the form of “permanent establishment” largely conceived as a physical presence of business entity, which differentiate businesses having significant economic presence in a tax jurisdiction from those having an economic participation of occasional nature. The permanent establishment based threshold thus derives its justification from the rationale that attempts at taxing a business that has a less than significant economic presence in a jurisdiction can lead to costs of compliance and administration that are unlikely to be commensurate with the revenues obtained by such taxation.

26. While the physical presence threshold has served an important purpose in optimizing compliance burdens for businesses that existed and were prevalent at the point of its conceptualization, its relevance stands undermined now with the emergence of digital enterprises, creating a need to modify the international tax rules so as to adopt them for the new business models of digital economy. This challenge related to the nexus thresholds in the existing rules is further complemented by challenges relating to characterization of certain incomes that arise from digital economy, challenges in developing rules for fairly attributing such income, as well as the challenges in valuation of contributions made by users and data belonging to them in the profitability of a digital enterprise in multidimensional business models. Thus, the emergence and evolution of new business models in the digital economy have given rise to substantial tax challenges that need to be addressed.

3.3 Action 1 of BEPS Project: Address Tax Challenges of Digital Economy

27. There have been growing concerns around the globe, raised by political leaders, media outlets and civil society, about the exploits of the multinational enterprises avoiding taxes in the economies from where their profits are derived. These concerns led to the adoption of Base Erosion & Profit Shifting (BEPS) Project by G-20 and OECD to analyze the loopholes in the existing international taxation rules that enable the multinational enterprises to avoid taxes. A BEPS Action Plan detailing the activities of the BEPS project was published in July 2013. The need for undertaking work for analyzing the tax challenges arising from digital economy were noted in the action plan of BEPS as under:

“the spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.”

28. The Action 1 of the Base Erosion and Profit Shifting (BEPS) Project of G-20 and OECD included addressing the tax challenges of the digital economy as the first of the fifteen actions that were planned as part of this project. The following action was planned to be undertaken under this action:

Action 1 – Address the tax challenges of the digital economy

Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation. Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.

29. The BEPS Action Plan, including Action 1, prepared by the OECD was adopted and endorsed by the G-20 countries, including India, in the G-20 declaration issued by its Leaders after their meeting in St. Petersburg on 5-6th September, 2013.

30. For implementing Action 1, the “Task Force on the Digital Economy” (TFDE) was established in September, 2013, with representatives of OECD, G-20 and other countries associated in the BEPS project. The mandate of the Task Force was to undertake work on Action 1 and submit a report on the same. As part of its work, the Task Force also held public consultations with the stakeholders including industry (both digital as well as brick & mortar industry), academicians and non governmental representatives. The report of the Task Force was finalized by September, 2014, wherein it analyzed in detail, the new business models which have come into existence as a result of advances in information and communication technology and the expansion of digital and telecommunication networks around the world. This report concluded that important issues related to nexus, characterization and data have arisen in the wake of development of digital economy that need to be examined further.

31. Further work on these issues was subsequently carried out by the task force and its focus groups, in consultations with renowned academicians and experts who have been working on this subject, while also seeking feedback from industry and other stakeholders from time to time. As a part of this work, the Task Force further detailed the broader tax challenges that have come into existence, including contributions made by the users and the value of data belonging to them, which contribute to profits of digital enterprises in multidimensional business models. In view of these challenges and the need to find solutions to address them, the Task Force identified and analyzed in great detail, the potential options that can be adopted to address these challenges.

32. The Final Report on Action 1 was finalized by the Task Force in September, 2015 and has since been endorsed by the G-20 as well as the OECD. The Report provides an internationally accepted recognition of the broader tax challenges arising from digital enterprises, their unprecedented business models including multi-dimensional businesses, mobility of these enterprises, their ability to relatively easily avoid taxes in jurisdictions that significantly contribute to their profitability, and the challenges and difficulties that arise in the application of currently practiced international taxation rules in their case.

33. The Executive Summary of the Report describes the contents of the report in the following manner:

“This final report first provides an overview of the fundamental principles of taxation, focusing on the difference between direct and indirect taxes and the concepts that underlie them as well as double tax treaties (Chapter 2). It then examines the evolution over time of information and communication technology (ICT), including emerging and possible future developments (Chapter 3) and discusses the spread and impact of ICT across the economy, providing examples of new business models and identifying the key features of the digital economy (Chapter 4). It then provides a detailed description of the core elements of BEPS strategies in the digital economy (Chapter 5) and discusses how they will be addressed by the measures developed through the work on the BEPS Action Plan and the OECD work on indirect taxation (Chapter 6). It identifies also the broader tax challenges raised by the digital economy and summarises the potential options to address them that have been discussed and analysed by the TFDE, both in the areas of corporate income tax (Chapter 7) and of indirect tax (Chapter 8). Finally, it provides an evaluation of the broader direct and indirect tax challenges raised by the digital economy and of the options to address them (Chapter 9), taking into consideration not only the impact on BEPS issues of the measures developed in the course of the BEPS Project, but also the economic incidence of the different options to tackle these broader tax challenges. The conclusions of the TFDE, together with determination of the next steps, are included at the end of the report (Chapter 10).”

34. This Report, the first of its kind, and a result of a two year effort undertaken by representatives from around the world, with contributions of experts and governmental representatives, has been finalized after several rounds of public consultation with stakeholders14 and taking their views and suggestions into account. This report, which has since been adopted and endorsed by the G-20 and OECD provides a detailed overview of the tax challenges arising from digital economy. It is a first of its kind recognition of the limitations of the existing international taxation rules, as embodied in the Model Tax Conventions recommended by OECD and UN Committee of Experts, in respect of the digital enterprises that conduct their businesses in a manner that was not conceivable at the time the existing taxation rules were being written in the last century. The Report also provides a broad international consensus on what can be done, by recognizing the possible measures that can be considered or undertaken for addressing the tax challenges arising from digital economy. The Conclusions of the Report do not recommend any measures for universal adoption at this stage, but recognize the right of countries that may prefer to address these challenges by adopting any of the options in their domestic laws, or in their bilateral tax treaties.

3.4 Committee’s Observations

35. In view of its acceptance by G-20 and the OECD, the Committee has placed extensive reliance on the BEPS Report on Action 1 (2015) in its work. However, the Committee also took into account the Indian perspective, the work done in this field by other experts as well as its independent analysis in preparing this report.

Section 4

Issues related to Tax Neutrality between Domestic & Multi-National Enterprises and their Implications

4.1 Principles of Tax Policy & Tax Neutrality

36. As part of its work, the Task Force on Digital Economy revisited and reviewed the fundamental principle on tax policy. It recalled that these principles were the basis of discussion in the 1998 Ottawa Ministerial Conference, and have been deemed appropriate for an evaluation of the taxation issues related to e-commerce. The Task Force listed these principles as neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility in its 2014 Report15, paragraphs 27 to 30 of which are reproduced below for ease of reference:

“1. Overarching Principles of Tax Policy

27. In a context where many governments have to cope with less revenue, increasing expenditures and resulting fiscal constraints, raising revenue remains the most important function of taxes, which serve as the primary means for financing public goods such as maintenance of law and order and public infrastructure. Assuming a certain level of revenue that needs to be raised, which depends on the broader economic and fiscal policies of the country concerned, there are a number of broad tax policy considerations that have traditionally guided the development of taxation systems. These include neutrality, efficiency, certainty and simplicity, effectiveness and fairness, as well as flexibility. In the context of work leading up to the Report on the Taxation of Electronic Commerce (see Annex 1 for further detail), these overarching principles were the basis for the 1998 Ottawa Ministerial Conference, and are since then referred to as the Ottawa Taxation Framework Conditions. At the time, these principles were deemed appropriate for an evaluation of the taxation issues related to e-commerce. Although most of the new business models identified in Section IV did not exist yet at the time, these principles, with modification, continue to be relevant in the digital economy, as discussed in Section VIII. In addition to these well-recognised principles, equity is an important consideration for the design of tax policy.

Neutrality- taxation should seek to be neutral and equitable between forms of business activities. A neutral tax will contribute to efficiency by ensuring that optimal allocation of the means of production is achieved. A distortion, and the corresponding deadweight loss, will occur when changes in price trigger different changes in supply and demand than would occur in the absence of tax. In this sense, neutrality also entails that the tax system raises revenue while minimizing discrimination in favour of, or against, any particular economic choice. This implies that the same principles of taxation should apply to all forms of business, while addressing specific features that may otherwise undermine an equal and neutral application of those principles.
Efficiency- compliance costs to business and administration costs for governments should be minimised as far as possible.
Certainty and simplicity- tax rules should be clear and simple to understand, so that taxpayers know where they stand. A simple tax system makes it easier for individuals and businesses to understand their obligations and entitlements. As a result, businesses are more likely to make optimal decisions and respond to intended policy choices. Complexity also favours aggressive tax planning, which may trigger deadweight losses for the economy.
Effectiveness and fairness- taxation should produce the right amount of tax at the right time, while avoiding both double taxation and unintentional non-taxation. In addition, the potential for evasion and avoidance should be minimised. Prior discussions in the Technical Advisory Groups considered that if there is a class of taxpayers that are technically subject to a tax, but are never required to pay the tax due to inability to enforce it, then the taxpaying public may view the tax as unfair and ineffective. As a result, the practical enforceability of tax rules is an important consideration for policy makers. In addition, because it influences the collectability and the administrability of taxes, enforceability is crucial to ensure efficiency of the tax system.
Flexibility- taxation systems should be flexible and dynamic enough to ensure they keep pace with technological and commercial developments. It is important that a tax system is dynamic and flexible enough to meet the current revenue needs of governments while adapting to changing needs on an ongoing basis. This means that the structural features of the system should be durable in a changing policy context, yet flexible and dynamic enough to allow governments to respond as required to keep pace with technological and commercial developments, taking into account that future developments will often be difficult to predict.
28. Equity is also an important consideration within a tax policy framework. Equity has two main elements; horizontal equity and vertical equity. Horizontal equity suggests that taxpayers in similar circumstances should bear a similar tax burden. Vertical equity is a normative concept, whose definition can differ from one user to another. According to some, it suggests that taxpayers in better circumstances should bear a larger part of the tax burden as a proportion of their income. In practice, the interpretation of vertical equity depends on the extent to which countries want to diminish income variation and whether it should be applied to income earned in a specific period or to lifetime income. Equity is traditionally delivered through the design of the personal tax and transfer systems.

29. Equity may also refer to inter-nation equity. As a theory, inter-nation equity is concerned with the allocation of national gain and loss in the international context and aims to ensure that each country receives an equitable share of tax revenues from cross border transactions (OECD, 2001: 228). The tax policy principle of inter-nation equity has been an important consideration in the debate on the division of taxing rights between source and residence countries. At the time of the Ottawa work on the taxation of electronic commerce, this important concern was recognised by stating that “any adaptation of the existing international taxation principles should be structured to maintain fiscal sovereignty of countries, [and] to achieve a fair sharing of the tax base from electronic commerce between countries…”.(OECD, 2001: 228)

30. Tax policy choices often reflect decisions by policy makers on the relative importance of each of these principles and will also reflect wider economic and social policy considerations outside the field of tax.”

4.2 Tax Neutrality: An Important Concern

37. Among these, the issue of tax neutrality, which was listed as the first of these principles in the report, was considered in detail during the work by the Task Force.16 The principle of tax neutrality provides that tax should seek to be neutral and equitable between various forms of business activities. When tax neutrality is violated, the unfair tax advantage enjoyed by some market enterprises can distort the market economy and the dead weight loss arising from it can adversely impact market efficiency. The Task Force noted that a neutral tax contributes to market efficiency by ensuring optimal allocation of resources in the market.

38. In the context of digital economy, tax neutrality has emerged as a major concern. While a purely domestic enterprise is taxed at the marginal tax rate under the domestic laws, a multi- national enterprise may not be taxable at all in the country of source due to the ability of digital enterprises to conduct their business through digital and telecommunication networks without requiring any physical presence in the country of source. As the existing international taxation rules in the treaties require the presence of permanent establishment based on physical presence, the multinational enterprises conducting digital businesses in the same way as their domestic competitors would not be taxed on the income derived by them from the source country. The multinational digital enterprises are characterized by high mobility, can easily locate in low tax jurisdictions and thereby minimize their global tax liability, resulting in significant tax advantages over their domestic competitors.

4.3 Committee’s Observations

39. Taking the aforesaid issues related to tax neutrality into account, the Committee is of the view that the asymmetry in tax burden faced by purely domestic and multi-national enterprises can have distortionary impact on the market competition and can adversely affect the development of purely domestic enterprises. The clear tax advantage faced by foreign enterprises over their Indian counterparts also creates strong incentives for Indian enterprises to either locate themselves in a low tax jurisdiction outside India or sell their businesses to such an enterprise. Thus, distortionary taxation arising from the limitations of existing international taxation rules and the lack of tax neutrality are likely to pose significant constraints in development of Indian digital industry, and thereby pose significant long term challenges for this extremely important sector of economy.

40. Another important manifestation of lack of tax neutrality and its implications is the difference between the tax burden faced by the traditional brick and mortar businesses and digital enterprises competing with them. The traditional brick and mortar businesses are likely to be taxable fully on their business income arising in source jurisdictions, such as India, either as a tax resident, or as the permanent establishment of a foreign company, and thus face a much higher tax burden on their profits than their multinational counterparts conducting their businesses by digital means. This lack of tax neutrality between digital enterprise and traditional enterprises can distort the market in favor of the former and thereby disrupt the existing market equilibriums.

41. These violations of tax neutrality can result in significant impacts on the economy. The tax advantage faced by multinational digital enterprises can adversely impact the growth of digital industry in India and profitability and expansion of traditional brick and mortar businesses in India. The long term impact of these distortions can be adverse to Indian businesses in general and Indian brick and mortar enterprises in particular, and in addition to the adverse impact on the economy, can also lead to fiscal constraints for Government of India. These fiscal shortfalls may need to be compensated by additional tax burden on local tax residents, which may further erode their competitiveness, thereby creating a vicious downward cycle.

Section 5

Principles for Allocating Taxing Rights, Factors that contribute to Profitability & Historical Review of Existing Rules

42. While endorsing the BEPS Action plan, the G-20 Declaration also emphasized the need to ensure that profits are taxed where economic activities deriving the profits are performed and their value is created. The profitability of a business is dependent upon the supply of goods or services to those wishing to pay for it. The primary economic activities that lead to profits of any business are production and sale.

5.1 Factors that contribute to profits of an Enterprise & Role of Public Resources and Taxation

43. The economic theory makes its obvious that the price of the goods and services that it can seek from the buyers, the volume of its sales, and costs that it incurs for production are the primary determinants of its profits. The market price as well the volume of sales, in turn, results from the interaction of demand and supply within a market, and are contributed by factors on both demand side and supply side. The supply side factors are related to production and marketing, whereas the primary demand side factor that influences the price of a good or service and the profitability of the enterprise supplying them, is the paying capacity of consumers.

44. The paying capacity of consumers is a function of the state of that economy, including availability of public goods, law and order, market facilitation, infrastructure as well as redistribution of resources (subsidies) to the consumers directly or indirectly, using public resources. The profits arise only when an economic good produced by supplier is paid for by a consumer during the sale transaction. The performance of sale, thus has two limbs – the buyer and the seller and their interaction leads to creation of value and profits. By stabilizing, promoting, preserving and augmenting the paying capacity of the consumers, the Government and the public resources belonging to that economy play a vital role in contributing to the profits generated by enterprises having a significant economic presence in that jurisdiction, and the resultant value of the enterprise.

This also serves as the primary justification for collection of taxes by that jurisdiction on profits and income earned by any enterprise having a significant economic presence therein.17

45. Similarly, factors that contribute on the supply side include the availability of economic stabilization, supply of public goods, law and order, market facilitation, infrastructure as well as subsidies provided to enterprises directly or indirectly. These factors contribute significantly to the ability of the enterprise to produce at competitive prices, and their provisioning from public resources provides a justification for the jurisdiction in which supply side activities are carried out by an enterprise to impose a tax on its profits or income.

46. In case of purely domestic enterprise, the demand side factors as well as the supply side factors are contributed by the same jurisdiction, which also levies taxes on it. However, in case of a multi-national enterprise, producing and selling in different jurisdictions, the contribution of demand and supply side factors to its profitability are made from the public resources of different tax jurisdictions, both of which can claim justification for taxing it. The possibility of resultant double taxation can be detrimental to the enterprise and its ability to carry its business across borders. Therein lies the origin of Double Taxation Avoidance Agreements, commonly referred to as “tax treaties” that evolved in the last century keeping in view the business models that were the focus on international trade and taxes at that point of time.

5.2 Historical Overview of International Taxation Rules

47. Action I Report finalized by the Task Force in 2015 provides a detailed historical overview of the conceptual basis for allocating tax and rights, wherein it recognizes two aspects to a state’s sovereignty: the power over a territory (“enforcement jurisdiction”) and the power over a particular set of subjects (“political allegiance”). It reports that relationship to a person (i.e. a “personal attachment”) or on the relationship to a territory (i.e. a “territorial attachment”) were usually adopted as the basis for taxation.18 It describes the significance of source in such taxation in paragraph 26 as under:

“26. With respect to the taxation of inbound investments of non-resident companies, both a worldwide tax system and a territorial tax system impose tax on income arising from domestic sources. Hence, the determination of source of the income is key. Sourcing rules vary from country to country. With respect to business income, the concept of source under domestic law often parallels the concept of permanent establishment (PE) as defined under tax treaties. Such income is typically taxed on a net basis. For practical reasons however, it may be difficult for a country to tax certain items of income derived by non-resident corporations. It may also be difficult to know what expenses a non-resident incurred in earning such income. As a result, taxation at source of certain types of income (e.g. interest, royalties, dividends) derived by non-resident companies commonly occurs by means of withholding taxes at a gross rate. To allow for the fact that no deductions are allowed, gross-based withholding taxes are imposed at rates that are usually lower than standard corporate tax rates”

48. The existing tax treaties have their origins in the Model of Bilateral Tax Treaty drafted in 1928 by the League of Nations, the details related to which are provided in paragraphs 28 to 32, which are reproduced below for ease of reference.

“2.3.2.1 A historical overview of the conceptual basis for allocating taxing rights

28. As global trade increased in the early 20th century, and concerns around instances of double taxation grew, the League of Nations appointed in the early 1920s four economists (Bruins et al., 1923) to study the issue of double taxation from a theoretical and scientific perspective. One of the tasks of the group was to determine whether it is possible to formulate general principles as the basis of an international tax framework capable of preventing double taxation, including in relation to business profits.2 In this context the group identified the concept of economic allegiance as a basis to design such international tax framework. Economic allegiance is based on factors aimed at measuring the existence and extent of the economic relationships between a particular state and the income or person to be taxed. The four economists identified four factors comprising economic allegiance, namely (i) origin of wealth or income, (ii) situs of wealth or income, (iii) enforcement of the rights to wealth or income, and (iv) place of residence or domicile of the person entitled to dispose of the wealth or income.

29. Among those factors, the economists concluded that in general, the greatest weight should be given to “the origin of the wealth [i.e. source] and the residence or domicile of the owner who consumes the wealth”. The origin of wealth was defined for these purposes as all stages involved in the creation of wealth: “the original physical appearance of the wealth, its subsequent physical adaptations, its transport, its direction and its sale”. In other words, the group advocated that tax jurisdiction should generally be allocated between the state of source and the state of residence depending on the nature of the income in question. Under this approach, in simple situations where all (or a majority of) factors of economic allegiance coincide, jurisdiction to tax would go exclusively with the state where the relevant elements of economic allegiance have been characterised. In more complex situations in which conflicts between the relevant factors of economic allegiance arise, jurisdiction to tax would be shared between the different states on the basis of the relative economic ties the taxpayer and his income have with each of them.

30. On the basis of this premise, the group considered the proper place of taxation for the different types of wealth or income. Business profits were not treated separately, but considered under specific classes of undertakings covering activities nowadays generally categorised as “bricks and mortar” businesses, namely “Mines and Oil Wells”, “Industrial Establishments” or “Factories”, and “Commercial Establishments”.3 In respect of all those classes of activities, the group came to the conclusion that the place where income was produced is “of preponderant weight” and “in an ideal division a preponderant share should be assigned to the place of origin”. In other words, in allocating jurisdiction to tax on business profits, greatest importance was attached to the nexus between business income and the various physical places contributing to the production of the income.

31. Many of the report’s conclusions proved to be controversial and were not entirely followed in double tax treaties. In particular, the economists’ preference for a general exemption in the source state for all “income going abroad” as a practical method of avoiding double taxation4 was explicitly rejected by the League of Nations, who chose as the basic structure for its 1928 Model the “classification and assignment of sources” method – i.e. attach full or limited source taxation to certain classes of income and assign the right to tax other income exclusively to the state of residence. Nevertheless, the theoretical background enunciated in the 1923 Report has survived remarkably intact and is generally considered as the “intellectual base” (Ault, 1992: 567) from which the various League of Nations models (and consequently virtually all modern bilateral tax treaties) developed (Avi-Yonah, 1996).

32. Before endorsing the economic allegiance principle, the group of four economists briefly discussed other theories of taxation, including the benefit principle (called at the time the “exchange theory”), and observed that the answers formulated by this doctrine had to a large extent been supplanted by the theory of ability to pay. Several authors consider that the decline of the benefit theory is undeniable as far as determination of the amount of tax liability is concerned, but not in the debate on taxing jurisdiction in an international context (Vogel, 1988). Under the benefit theory, a jurisdiction’s right to tax rests on the totality of benefits and state services provided to the taxpayer that interacts with a country (Pinto, 2006), and corporations, in their capacity as agents integrated into the economic life of a particular country, ought to contribute to that country’s public expenditures. In other words, the benefit theory provides that a state has the right to tax resident and non-resident corporations who derive a benefit from the services it provides. These benefits can be specific or general in nature. The provision of education, police, fire and defence protection are among the more obvious examples. But the state can also provide conducive and operational legal structures for the proper functioning of business, for example in the form of a stable legal and regulatory environment, the protection of intellectual property and the knowledge-based capital of the firm, the enforcement of consumer protection laws, or well-developed transportation, telecommunication, utilities and other infrastructure (Pinto, 2006).”

5.3 Permanent Establishment: Historical Overview

49. It can be observed that the initial conceptualization of Permanent Establishment based on physical presence was undertaken keeping in view certain industries of that time and the business models employed by them, such as mines, oil wells, factories and commercial establishments. These industries, part of the brick and mortar businesses, were based on physical presence, and based on their analysis, physical presence was conceived as a reliable threshold indicative of the intent and capacity of an enterprise of having a significant participation in the economic life of an economy. It is also not difficult to appreciate that the high costs of transportation and communication at that point of time ensured that most enterprises intending to cater to the needs of a significant market would usually prefer to locate itself in close proximity to the markets in which that enterprise intends to have a significant share, in which case, the demand side as well as supply side factors, contributed by public resources, arose in the jurisdiction where it was physically located, and aptly justified the allocation of taxing rights to that jurisdiction on the basis of physical presence. The concept of permanent establishment as a threshold for taxation of business profits in the source jurisdiction is elaborated in paragraph 35 of the Report as under:

“35. The PE concept effectively acts as a threshold which, by measuring the level of economic presence of a foreign enterprise in a given State through objective criteria, determines the circumstances in which the foreign enterprise can be considered sufficiently integrated into the economy of a state to justify taxation in that state (Holmes, 2007; Rohatgi, 2005). A link can thus reasonably be made between the requirement of a sufficient level of economic presence under the existing PE threshold and the economic allegiance factors developed by the group of economists more than 80 years ago. This legacy is regularly emphasised in literature (Skaar, 1991), as well as reflected in the existing OECD Commentaries when it is stated that the PE threshold “has a long history and reflects the international consensus that, as a general rule, until an enterprise of one State has a permanent establishment in another State, it should not properly be regarded as participating in the economic life of that other State to such an extent that the other State should have taxing rights on its profits”.5 By requiring a sufficient level of economic presence, this threshold is also intended to ensure that a source country imposing tax has enforcement jurisdiction, the administrative capability to enforce its substantive jurisdiction rights over the non-resident enterprise.”

5.4 Evolution of Permanent Establishment since its initial conception19

50. The concept of Permanent Establishment has also evolved since its original conceptualization in the last century. These include the interpretational expansion in the Commentary on OECD Model Tax Convention, of the phrase “fixed place of business” that literally means a business that is completely immobile, to include businesses having a commercial and geographical coherence within a particular jurisdiction.20 The scope of permanent establishment has also evolved beyond the physical presence to include “a person acting on behalf of an enterprise and habitually exercising an authority to conclude contracts on its behalf”21. Further, provision of services beyond a threshold duration22, construction activities beyond a threshold duration23, and collection of insurance premiums24 have now been recognized as alternative thresholds that constitute permanent establishment, without the need to satisfy the “fixed place of business”. Each of these developments can be seen to have resulted from the need of international taxation rules to adapt to the new business models that have evolved and become prevalent over time in international commerce. With time, the differences in preferences and willingness of different economies to agree with such expansions, arising expectedly from their own fiscal interests, have also become clearly documented in the form of parallel evolution of the OECD and the UN Model Tax Conventions, with significant differences in the definition of permanent establishment. These differences have become more contrasting in rules on attribution of profits to a permanent establishment.25 In the light of these developments, it becomes clear that the concept of permanent establishment based on physical presence would need to be updated in view of the new business models characterizing digital economy in the same way as it has been updated earlier to adapt to the need of service industries, construction industries and insurances. However, the persistence of differences between countries preferring source based taxation and those preferring residence based taxing rights26 also indicates that such expansion will be resisted by those who stand to lose, and may not be as easy to achieve as it might appear from an almost apparent need to do so.

5.5 Tax on gross payments in the absence of a PE

51. The Model Tax Conventions developed by the OECD and UN provide for certain categories of income to be taxed in the jurisdiction in which they arise without the need for satisfying the permanent establishment based threshold. These have been elaborated in paragraph 38 and 39 of the Report on Action 1 (2015) as under:

“38. By virtue of separate distributive rules which take priority over the PE rule, some specific items of income may be taxed in the source jurisdiction even though none of the alternative PE thresholds are met in that country. These include:

Income derived from immovable property (and capital gains derived from the sale thereof), which generally may be taxed by the country of source where the immovable property is located.
Business profits that include certain types of payments which, depending on the treaty, may include dividends, interest, royalties or technical fees, on which the treaty allows the country of source to levy a limited withholding tax.
39. In the case of outbound payments of dividends, interest, and royalties, countries commonly impose tax under their domestic law on a gross basis (i.e. not reduced by the deduction of expenses) by means of a withholding tax. Bilateral tax treaties commonly specify a maximum rate at which the source state may impose such a withholding tax, with the residual right to tax belonging to the state of residence.6 However, where the asset giving rise to such types of income is effectively connected to a PE of the non-resident enterprise in the same state, the rules for attribution of profits to a PE control (Article 10(4), 11(4) and 12(3) of the OECD Model Tax Convention).”

52. These exceptions to the permanent establishment threshold indicate the adaptation of permanent establishment based rule of taxing income to the needs of simplicity and predictability, which are recognized as important principles in designing a tax.27 If the existence of a permanent establishment is seen as an evidence of significant participation of an enterprise in the economic life of a jurisdiction, then the taxing of these payments at a concessional rate on a gross basis provides a simple alternative way of taxing income on the basis of a simple presumptive thumb rule, without getting caught in the difficulties that arise in determining the existence of a permanent establishment and the profits that may be attributable to it. The simple tax rule for taxing these payments also suggests an alternate to the complex methodology inherent in permanent establishment based taxation of income, and a way to avoid the potential disputes that can arise from its application.

5.6 Committee’s Observations

53. In view of the extensive analysis of these aspects provided in the BEPS Report on Action 1 and the observations made above, the Committee is of the view that the physical presence based threshold for taxing income in the economy from where the payments arise, was conceptualized in an era when it reasonably indicated the significant economic presence of an enterprise in the economy of a jurisdiction. The evolution of the definition of permanent establishment, both in terms of its interpretation, as well as in terms of alternate conditions that give rise to it, is an evidence of the adaptation of this rule to the evolving ways in which business conducts itself. It signifies the dynamic evolution of taxable nexus with business modes, and justifies its further evolution to the needs of new business models of digital economy.

54. At the same time, the lack of universal acceptance of a single definition of permanent establishment rule and the divergence in the preference for attribution rules indicates a wedge between preferences of different countries that may not be easy to fill up. In this light, the gross taxation of payments in the jurisdiction where they arise, at a concessional rate of tax, offers a potential option that has already been relied in tax treaties as an alternative to the permanent establishment based rule. In broad terms, both these alternatives allocate taxing rights to jurisdictions that contribute to the profitability of an enterprise by way of demand or supply side factors provisioned by public resources belonging to that jurisdiction.

Section 6

Broader Tax Challenges related to Nexus and Characterization of Income from Digital Transactions and common Disputes

6.1 Broader Tax Policy Challenges

55. The primary tax challenges that arise from digital economy largely relate to the issues of nexus and characterization.28 The BEPS Report on Action 1 (2015) details them in paragraphs 376 to 380 as under:

“10.3 Broader tax policy challenges raised by the digital economy

376. The digital economy also raises broader tax challenges for policy makers. These challenges relate in particular to nexus, data, and characterisation for direct tax purposes. These challenges trigger more systemic questions about the ability of the current international tax framework to deal with the changes brought about by the digital economy and the business models that it makes possible and hence to ensure that profits are taxed in the jurisdiction where economic activities occur and where value is generated. They therefore have a broad impact and relate primarily to the allocation of taxing rights among different jurisdictions. These challenges also raise questions regarding the paradigm used to determine where economic activities are carried out and value is generated for tax purposes, which is based on an analysis of the functions, assets and risks of the enterprise involved. At the same time, when these challenges create opportunities for achieving double non-taxation, for example due to the lack of nexus in the market country under current rules coupled with lack of taxation in the jurisdiction of the income recipient and of that of the ultimate parent company, they also generate BEPS issues in the form of stateless income. In addition, in the area of indirect taxes, the digital economy raises policy challenges regarding the collection of VAT.

377. The challenges related to nexus, data and characterisation overlap with each other to a certain extent. Although the challenges related to direct tax are distinct in nature, they often overlap with each other. For example, the collection of data from users located in a jurisdiction may trigger questions regarding whether that activity should give rise to nexus with that jurisdiction and regarding how data should be treated for tax purposes.

378. Evolving ways of carrying on business raise questions about whether current nexus rules continue to be appropriate. The continual increase in the potential of digital technologies and the reduced need in many cases for extensive physical presence in order to carry on business in a jurisdiction, combined with the increasing role of network effects generated by customer interactions, raise questions as to whether rules that rely on physical presence continue to be appropriate. The number of firms carrying out business transactions over the Internet has increased dramatically over the last decade. In 2014, B2C e-commerce sales were estimated to exceed USD 1.4 trillion, an increase of nearly 20% from 2013. According to estimates, the size of total worldwide e-commerce, when global B2B and consumer transactions are added together, equalled USD 16 trillion in 2013.

379. Increasing reliance on data collection and analysis, and the growing importance of multi-sided business models raise questions about valuation of data, nexus, and profit attribution, as well as characterisation. The appropriate allocation of taxable income among locations in which economic activities take place and value is created may not always be clear in the digital economy, particularly in cases where users and customers become an important component of the value chain, for example in relation to multi-sided business models and the sharing economy. The growth in sophistication of information technologies has permitted companies in the digital economy to gather and use information to an unprecedented degree. This raises the issues of how to attribute value created from the generation of data through digital products and services, whether remote collection of data should give rise to nexus for tax purposes, and of ownership and how to characterise for tax purposes a person or entity’s supply of data in a transaction, for example, as a free supply of a good, as a barter transaction, or some other way.

380. The development of new business models raises questions regarding characterisation of income. The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation under current rules of payments made in the context of new business models, particularly in relation to cloud computing. Further, to the extent that 3D printing becomes increasingly prevalent, it may raise characterisation questions as well, as direct manufacturing for delivery could effectively evolve into licensing of designs for remote printing directly by consumers.”

6.2 Issues related to Nexus

56. The issues in respect of nexus relate largely to the ability of digital enterprises to carry on their business in a particular jurisdiction and have a significant economic presence there, without crossing the threshold rules or criteria that are used for determining nexus between an enterprise and a tax jurisdiction for the purpose of imposing taxes. These issues have been analyzed and elaborated in detail in paragraphs 253 to 261 in the BEPS Report in Action 1 (2015), which are reproduced below for ease of reference:

“7.3 Nexus and the ability to have a significant presence without being liable to tax

253. Advances in digital technology have not changed the fundamental nature of the core activities that businesses carry out as part of a business model to generate profits. To generate income, businesses still need to source and acquire inputs, create or add value, and sell to customers. To support their sales activities, businesses have always needed to carry out activities such as market research, marketing and advertising, and customer support. Digital technology has, however, had significant impact on how these activities are carried out, for example by enhancing the ability to carry out activities remotely, increasing the speed at which information can be processed, analysed and utilised, and, because distance forms less of a barrier to trade, expanding the number of potential customers that can be targeted and reached. Digital infrastructure and the investments that support it can be leveraged today in many businesses to access far more customers than before. As a result, certain processes previously carried out by local personnel can now be performed cross-border by automated equipment, changing the nature and scope of activities to be performed by staff. Thus, the growth of a customer base in a country does not always need the level of local infrastructure and personnel that would have been needed in a “pre-digital” age.

254. This increases the flexibility of businesses to choose where substantial business activities take place, or to move existing functions to a new location, even if those locations may be removed both from the ultimate market jurisdiction and from the jurisdictions in which other related business functions may take place. As a result, it is increasingly possible for a business’s personnel, IT infrastructure (e.g. servers), and customers each to be spread among multiple jurisdictions, away from the market jurisdiction. Advances in computing power have also meant that certain functions, including decision-making capabilities, can now be carried out by increasingly sophisticated software programmes and algorithms. For example, contracts can in some cases be automatically accepted by software programmes, so that no intervention of local staff is necessary. As discussed below, this is also true in relation to functions such as data collection, which can be done automatically, without direct intervention of the employees of the enterprise.

255. Despite this increased flexibility, in many cases large multinational enterprises (MNEs) will indeed have a taxable presence in the country where their customers are located. As noted in Chapter 4, there are often compelling reasons for businesses to ensure that core resources are placed as close as possible to key markets. This may be because the enterprise wants to ensure a high quality of service and have a direct relationship with key clients. It may also be because minimising latency is essential in certain types of business, or because in certain industries regulatory constraints limit choices about where to locate key infrastructure, capital, and personnel. It is therefore important not to overstate the issue of nexus. Nevertheless, the fact that it is possible to generate a large quantity of sales without a taxable presence should not be understated either and it raises questions about whether the current rules continue to be appropriate in the digital economy.

256. These questions relate in particular to the definition of permanent establishment (PE) for treaty purposes, and the related profit attribution rules. It had already been recognised in the past that the concept of PE referred not only to a substantial physical presence in the country concerned, but also to situations where the non-resident carried on business in the country concerned via a dependent agent (hence the rules contained in paragraphs 5 and 6 of Article 5 of the OECD Model). As nowadays it is possible to be heavily involved in the economic life of another country without having a fixed place of business or a dependent agent therein, concerns are raised regarding whether the existing definition of PE remains consistent with the underlying principles on which it was based. For example, the ability to conclude contracts remotely through technological means, with no involvement of individual employees or dependent agents, raises questions about whether the focus of the existing rules on conclusion of contracts by persons other than agents of an independent status remains appropriate in all cases.

257. These concerns are exacerbated in some instances by the fact that in certain business models, customers are more frequently entering into ongoing relationships with providers of services that extend beyond the point of sale. This ongoing interaction with customers generates network effects that can increase the value of a particular business to other potential customers. For example, in the case of a retail business operated via a website that provides a platform for customers to review and tag products, the interactions of those customers with the website can increase the value of the website to other customers, by enabling them to make more informed choices about products and to find products more relevant to their interests.

258. Similarly, users of a participative networked platform contribute user-created content, with the result that the value of the platform to existing users is enhanced as new users join and contribute. In most cases, the users are not directly remunerated for the content they contribute, although the business may monetise that content via advertising revenues (as described in relation to multi-sided business models below), subscription sales, or licensing of content to third parties. Alternatively, the value generated by user contributions may be reflected in the value of business itself, which is monetised via the sale price when the business is sold by its owners. Concerns that the changing nature of customer and user interaction allows greater participation in the economic life of countries without physical presence are further exacerbated in markets in which customer choices compounded by network effects have resulted in a monopoly or oligopoly.

259. These various developments must be understood in light of their relationship to more traditional ways of doing business. For example, while having a market in a country is clearly valuable to a seller, this condition by itself has not created a taxing right in the area of direct taxation to this point. It is also true that data about markets and about customers has always been a source of value for businesses as illustrated by phenomena such as frequent flyer programs, loyalty programs, the creation and sale of customer lists, and marketing surveys (in which customers participate for no remuneration), to name a few. The traditional economy also benefited from “network” effects in ways that are perhaps less obvious than the network effect present in social networks. Sellers of fax machines, for example, were dependent on a sufficiently broad supplier of purchasers in order to ensure that their product had value. The digital economy has, however, enabled access to markets with less reliance on physical presence than in the past. In addition, the digital economy has enabled collection and analysis of data at unprecedented levels, and has enhanced the impact of customer and user participation in the market, as well as the degree of network effects. It has been suggested that the lower marginal costs in digital businesses coupled with increased network effects generated by higher levels of user participation may justify a change in tax policy. See, e.g., Crémer (2015); Pistone and Hongler (2015). In considering policy changes to reflect customer interactions to the imposition of income tax, however, potential impact on traditional ways of doing business must be taken into account in order to maintain coherence in cross border tax policy. In addition, consideration should be given both to solutions based on income tax and to solutions focused on indirect taxes.

260. Another specific issue raised by the changing ways in which businesses are conducted is whether certain activities that were previously considered preparatory or auxiliary (and hence benefit from the exceptions to the definition of PE) may be increasingly significant components of businesses in the digital economy. For example, as indicated in Chapter 6, if proximity to customers and the need for quick delivery to clients are key components of the business model of an online seller of physical products, the maintenance of a local warehouse could constitute a core activity of that seller. Similarly, where the success of a high-frequency trading company depends so heavily on the ability to be faster than competitors that the server must be located close to the relevant exchange, questions may be raised regarding whether the automated processes carried out by that server can be considered mere preparatory or auxiliary activities.

261. Although it is true that tax treaties do not permit the taxation of business profits of a non-resident enterprise in the absence of a PE to which these profits are attributable, the issue of nexus goes beyond questions of PE under tax treaties. In fact, even in the absence of the limitations imposed by tax treaties, it appears that many jurisdictions would not in any case consider this nexus to exist under their domestic laws. For example, many jurisdictions would not tax income derived by a non-resident enterprise from remote sales to customers located in that jurisdiction unless the enterprise maintained some degree of physical presence in that jurisdiction. As a result, the issue of nexus also relates to the domestic rules for the taxation of non-resident enterprises.”

57. The challenges arising from the digital enterprises to conduct their businesses, with business models that did not exist not so long ago, gives rise to situations where they derive significant profits from a tax jurisdiction, by making use of its resources and people, and yet, can claim not to have a taxable nexus with that jurisdiction, because of the limitations of the nexus rules existing in Model Tax Conventions and tax treaties that were made long back at a time, when such business models were not conceivable. The challenges related to nexus make a strong case for changing the nexus rules that are based on a physical presence threshold today, to adopt them to ways in which modern businesses can conduct themselves.

6.3 Issues related to Characterization

58. Characterization of income continues to remain an important and often contentious aspect in the taxation of income arising from digital enterprise. The importance of characterization issues arises primarily from the differences in the threshold for taxation of different types of income in the jurisdiction of source29, as well as the difference in the tax rates applicable on different kind of incomes30. Another reason that makes characterization very important is the lack of uniformity in the interpretation and application of characterization rules by different countries. These differences often relate to characterization of income as “Royalty” or “Fee for Technical Services”. In particular, payments made for using software or automated digital platforms consisting of software, or for services obtained by using a digital or mobile network can often be a bone of contention. While characterization issues can arise in case of any business, they become particularly important for digital enterprises, in view of their ability to carry on businesses without having a physical presence in the source country and consequently avoid paying taxes on their income derived from that jurisdiction.

59. With the rapid growth of digital economy, and in the wake of significant revenue and profits being earned by multinational digital enterprises without being liable to pay any tax in the source country, there have been attempts by tax authorities around the world, including India, to tax the income of such digital enterprises by arguing that their virtual presence through a website or through digital networks amount to permanent establishment, or by characterization of their income as royalty or fee for technical services. Compared to the former, the treatment of payments as royalty or fee for technical services have more often sustained the scrutiny of appellate authorities and hence, are resorted to more often by the tax authorities.

Differences between OECD and UN Model Tax Convention

60. The issues related to characterization of income as royalty have their origin in the strong differences between the preferences of developed countries that are technology exporting economies and developing economies, most of whom are technology importing ones. These get documented as differences between the OECD Model Tax Convention and the UN Model Tax Conventions. While the OECD Convention allocates all taxing rights in respect of royalty to the jurisdiction where the taxpayer is a resident, the UN Convention provides for dividing the taxing rights on royalty between the jurisdictions of source and residence. This difference is also reflected in the positions taken by countries regarding the scope of royalty and fee for technical services. Given the fact that OECD Model Tax Convention does not allocate any taxing rights to the jurisdiction from payments for royalty have generated31, it becomes questionable as to whether the OECD Commentary developed with the intention of preventing the taxation of royalty in the source jurisdiction, can be said to be applicable in a treaty where taxing rights are allocated to the source jurisdiction. This question of applicability of OECD Commentary on a tax treaty having Article on royalty that is not based on OECD Convention, becomes even more important, when the scope of royalty is narrowed down by a future amendment of OECD Commentary, particularly where one of the Contracting States in a treaty has clearly documented its position as being different from that of OECD.

Work of OECD Technical Advisory Group & High Level Committee in India

61. Given the positions of India on the OECD Commentary that document its differences with the OECD on whether a payment for software or its use can constitute royalty, and the fact that most Indian tax treaties precede the OECD interpretation of software payments that evolved in the 21st century, it becomes clear that OECD Commentary on Article 12 interpreting payments for software cannot be applied unquestionably for interpreting the definition of royalty in Indian tax treaties. These differences have also led to differences in the positions between OECD and India on characterization and taxation of e-commerce payments.

62. The need for examining taxability of payments made for using software was first emphasized by the OECD in the mid-eighties, when the report titled “Software: An Emerging Industry” was prepared for its Committee for Information, Computer and Communications Policy by an ad hoc group of experts from Member countries of OECD. Subsequently, the issues related to cross border taxation of royalty income from software were dealt in a report titled “The Tax Treatment of Software”, which was adopted by the OECD Council on 23 July, 1992. The texts suggested in Appendix 3 of the report were adopted as paragraph 12 to paragraph 17 of the OECD Commentary on Article 12 by a report titled “The Revision of Model Convention”, on the same day, i.e. 23 April, 1992. These changes, thus, were based on the views obtained from the member countries of OECD, without taking into account the views of countries outside OECD, including India. Thus, from the very outset, the views being developed by OECD regarding taxation of royalty from software are only governmental views of the member countries of OECD, and do not in any way represent the views of Government of India.

63. Subsequently, further amendments have been made in the OECD Commentary on 29 April, 2000 by the report titled “The 2000 Update to the Model Tax Convention” which was adopted by the OECD Committee on Fiscal Affairs on the same day. Later, a number of new paragraphs were added on this topic on 28 January, 2003 by the report titled “The 2002 Update to the Model Convention”, which was based on another report titled “Treaty Characterisation Issues arising from E-Commerce”, prepared by a Technical Advisory Group (TAG), commonly referred as the TAG Report, that was adopted by the OECD Council on 23 July, 2002. The TAG report recommended taking a very narrow application of the term royalty in respect of payments made for software and e commerce services and businesses, which can be considered largely in accordance with the preference of OECD of not allocating taxing rights on royalty payments in the source jurisdiction.

64. None of these OECD reports (as drafted by government representatives of OECD member countries) ever took into account the views or the position of the Government of India in respect of the tax treaties already entered into it, or its views, suggestions or concerns regarding the phrases or terms already existing in the various tax treaties entered into by India. Thus, the views of the Government representatives of member countries of OECD regarding the scope of royalty from software, as reflected in the OECD Commentary do not necessarily represent the views of the Government of India in this regard, neither can they be said to reflect the intention of the Government of India while using any phrase or term in the tax treaties entered into by ita with the Government of another country or specified territory.

65. Immediately after the publication of tax report by the OECD, a High Powered Committee (HPC) was constituted by the Ministry of Finance in India to examine its recommendations. This Committee, which included tax experts from both within and outside the Government, comprehensively analysed the issues and aspects of e-commerce, and made recommendations that were completely at variance with the conclusions adopted by the TAG Report. While the TAG Report recommended a very narrow interpretation of Royalty and Fee for Technical Services and concluded that most payments arising from e-commerce would not be taxable as Royalty and Fee for Technical Services, the Indian High Powered Committee advocated a much broader interpretation and scope of these terms and concluded that most of the payments made and received for e-commerce would constitute royalty and fee for technical service and would be taxable under the Indian tax treaties.

66. The differences between the views of the TAG report of OECD and the Indian High Powered Committee indicate the presence of a significant wedge between the position of India and the OECD, which has persisted since, and continues to remain a major source of tax disputes.32 It would be even more important to note that as per Article 3 of the Model Tax Conventions on definitions of the terms used therein, which also finds place in most Indian treaties, any phrase not defined in the treaty itself is to be understood as meant in the domestic laws. As the definition of royalty33 refers to use of copyright, the meaning of the word ‘copyright’ and the implications of that term need to be obtained from the Indian Copyrights Act, 1957 and the way it is interpreted under Indian laws. Indian positions on paragraphs in the OECD Commentary related to application of Article 12 to payments made for software, as documented by OECD along with its Commentary also makes it clear that it does not completely accept the OECD guidance on this important characterization issue.

67. BEPS Report on Action 1 acknowledges that for several categories of payments in the context of digital economy, characterization remains ambiguous and uncertain. Paragraphs 268 to 272 of the BEPS Report on Action 1 describing these issues in detail are reproduced below for ease of reference.

“7.5 Characterisation of income derived from new business models

268. Products and services can be provided to customers in new ways through digital technology. The digital economy has enabled monetisation in new ways, as discussed in Chapters 3 and 4, and this raises questions regarding both the rationale behind existing categorisations of income and consistency of treatment of similar types of transactions.

269. Prior work by the Treaty Characterisation Technical Advisory Group (TAG), discussed further in Annex A examined many characterisation issues related to e-commerce. Although this work remains relevant, new business models raise new questions about how to characterise certain transactions and payments for domestic and tax treaty law purposes.1 For example, although the TAG considered the treatment of application hosting, cloud computing has developed significantly since that work, and the character of payments for cloud computing is not specifically addressed in the existing Commentary to the OECD Model Tax Convention. The question for tax treaty purposes is often whether such payments should be treated as royalties (particularly under treaties in which the definition of royalties includes payments for rentals of commercial, industrial, or scientific equipment), fees for technical services (under treaties that contain specific provisions in that respect), or business profits. More specifically, questions arise regarding whether infrastructure-as-a-service transactions should be treated as services (and hence payments characterised as business profits for treaty purposes), as rentals of space on the cloud service provider’s servers by others (and hence be characterised as royalties for purposes of treaties that include in the definition of royalties payments for rentals of commercial, industrial, or scientific equipment), or as the provision of technical services. The same questions arise regarding payments for software-as-a-service or platform-as-a-service transactions.

270. In the future, development and increasing use of 3D printing may also raise character questions. For example, if direct manufacturing for delivery evolves into a license of designs for remote printing directly by purchasers, questions may arise as to whether and under what circumstances payments by purchasers may be classified as royalties rather than as business profits, or may be treated as fees for technical services.

271. Under most tax treaties, business profits would be taxable in a country only if attributable to a PE located therein. In contrast, certain other types of income, such as royalties, may be subject to withholding tax in the country of the payer, depending on the terms of any applicable treaty. Whether a transaction is characterised as business profits or as another type of income, therefore, can result in a different treatment for tax treaty purposes. There is therefore a need to clarify the application of existing rules to some new business models.

272. At the same time, when considering questions regarding the characterisation of income derived from new business models it may be necessary to examine the rationale behind existing rules, in order to determine whether those rules produce appropriate results in the digital economy and whether differences in treatment of substantially similar transactions are justified in policy terms. In this respect, further clarity may be needed regarding the tax treaty characterisation of certain payments under new business models, especially cloud computing payments (including payments for infrastructure-as-a-service, software-as-a-service, and platform-as-a-service transactions). In addition, issues of characterisation have broader implications for the allocation of taxing rights for direct tax purposes. For example, if a new type of business is able to interact extensively with customers in a market jurisdiction and generate business profits without physical presence that would rise to the level of a PE, and it were determined that the market jurisdiction should be able to tax such income on a net basis, modifying the PE threshold and associated profit attribution rules could permit such taxation. Source taxation could also be ensured by creating a new category of income that is subject to withholding tax. As a result, the issue of characterisation has significant implications for the issue of nexus.”

68. Paragraph 380 of the 2015 Report aptly summarises the challenges related to characterisation of income that emanate from digital economy, as under:

“380. The development of new business models raises questions regarding characterisation of income. The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation under current rules of payments made in the context of new business models, particularly in relation to cloud computing. Further, to the extent that 3D printing becomes increasingly prevalent, it may raise characterisation questions as well, as direct manufacturing for delivery could effectively evolve into licensing of designs for remote printing directly by consumers.”

6.4 Common Tax disputes related to Digital Economy

69. Tax disputes related to taxation of income arising from businesses conducted primarily through digital and telephonic communication networks, have been reported from different countries. The commoner forms of these disputes are related to the existence or otherwise of a permanent establishment in case of digital or e-commerce enterprises. The other category of disputes relating to whether payments for digital goods or services constitute royalty or fee for technical services, are expectedly uncommon in developed world due to the absence of taxing rights allocation to source jurisdiction on royalty and fee for technical services payments, but are more likely to be faced by countries such as India, where the source jurisdiction is allocated such taxing rights in tax treaties.

70. The disputes or questions related to permanent establishment have been observed frequently, such as whether installation of software on a server in the source jurisdiction constitutes a permanent establishment34; whether business conducted through a software owned by an enterprise that is installed on a server not owned by it constituted a permanent establishment35; whether websites hosting advertisements, payments for which arose from that jurisdiction constituted a permanent establishment36; whether a foreign enterprise selling on internet directly to customers in a jurisdiction but having registered there as a business entity and having an agent there to handle sourcing, storage etc. has a permanent establishment37; whether a gaming company offering various kinds of games online constitutes a permanent establishment38; whether sale and leasing of pictures electronically through the internet constituted permanent establishment39; whether carrying on business activity through a website hosted on a server outside the source jurisdiction constituted a permanent establishment40 and whether business activities carried out through a website operated by local unrelated individuals constituted a permanent establishment41. The fact that most of these questions were decided against the existence of permanent establishment is a testimony to the fact that significant economic activities through digital or telecommunication networks can be carried today without giving rise to the existence of a permanent establishment, an apparent anomaly, that was the basis of the Action 1 of the BEPS Project.

71. While most disputes relating to whether new business models give rise to a permanent establishment within the existing rules or not, have gone in favor of the taxpayer, there have been some interesting decisions that indicate a different view. In case of Dell Products, Ireland42, the Spanish Central Economic-Administrative Court held that the selling of goods in Spain by the taxpayer through a website located on a server outside Spain created a ‘virtual permanent establishment’ that was sufficient tax nexus for its taxation in Spain.

72. Another interesting developments that has caught the attention of experts is a recent Judgment of Delhi High Court43 in a non-tax dispute, wherein it held that the “availability of transactions through the website at a particular place is virtually the same thing as a seller having shops in that place in the physical world”. Placing reliance on the principles laid down by the Supreme Court in Dhodha House v. S. K. Maingi 2006 (9) SCC 41, the Court observed that the condition of “carries on business in Delhi” was satisfied since appellant’s customers were located in Delhi, accessed the website in Delhi, communicated their acceptance to the offer of merchandise advertised on the website, at Delhi, and received the merchandise in Delhi, even though the server for the appellant’s website was not located in Delhi. This observation of the Court may have greater impact on the applicability of “business connection” under domestic laws to digital enterprises, than “permanent establishment” under the tax treaties, but more importantly, it indicates signs of acknowledgement by the judiciary of the fact that digital enterprises undertake business in ways that were not conceived when the existing laws were made, and applying those laws to these new realities of digital world necessitates a flexible interpretation.

73. An interesting observation related to interpretation of statutes with reference to digital economy has been made in a recently published article44, wherein the author has referred to the work of Francis Bennion45 who has argued in favor of applying the “doctrine of updating construction”, which suggests that in construing an “ongoing Act”, the interpreter is to presume that Parliament intended the Act to be applied at any future time in such a way as to give effect to the true original intention and thus, the interpreter is to make allowances for any relevant changes that have occurred since the Act’s passing, in law, in social conditions, technology, the meaning of words, and other matters. Applying this doctrine, an enactment made earlier, may be read today in light of dynamic processing received over the years, with such modification of the current meaning of its language as will now give effect to the original legislative intention. Indeed, the decision of the Spanish Central Economic-Administrative Court in the case of Dell Products Ireland (supra) and the Delhi High Court interpreting “carries on business in Delhi” implicitly apply this doctrine, which has reportedly been relied upon by the Supreme Court of India in some cases46.

74. The question of whether the “doctrine of updating construction” can be applied on existing provisions of tax treaties, does not seem to have been taken up as yet in a tax dispute in India or outside. However, in its essence, it would be the basis of, and necessary justification for changes that are made from time to time in Commentaries on OECD and UN Model Tax Conventions with the aim and objective of modifying the interpretation of provisions existing in treaties based on these Models. Holding this doctrine inapplicable would mean negating the legitimacy of these changes, and accepting it may open the possibility of dynamic interpretation of tax treaties that may allow the taxability of digital economy to be covered by existing provisions. Either way, such an application has the potential to open new areas of interpretational disputes, greater uncertainty and unpredictability.

6.5 Committee’s Observations

75. The Committee concludes that in view of the extensive work undertaken as part of the Action 1 of BEPS Project, and the observations made in the Report, it is now internationally recognized and accepted that significant tax challenges arise from the difficulties in applying the existing international taxation rules, as they exist in our tax treaties today, in respect of digital economy. The issues related to taxable nexus between the taxable enterprise and the taxing jurisdiction, which is traditionally based on physical presence, is not appropriate for determining taxable presence in respect of the business models of digital economy. Similarly, there remains considerable ambiguity regarding the characterization of income arising from transactions involving telecommunication networks, software and data exchange. These disputes on characterization of payments are more commonly observed in countries like India, having tax treaties that allocate taxing rights to the source jurisdiction in respect of royalty and fee for technical services.

76. The continuing ambiguity related to nexus and characterization of the payments have the potential of giving rise to tax disputes, particularly in countries like India, where the tax treaties allocate taxing rights to the source jurisdiction47. If the underlying difference in the position of OECD, which does not prefer allocating taxing rights to source jurisdiction on royalty and fee for technical services payment and developing countries like India, which have tax treaties providing such rights to source jurisdictions are taken as an indication, it may be difficult, if not impossible, for the international community to arrive at a consensus on these issues, anytime soon. The resultant ambiguity, uncertainty and unpredictability can develop as a significant constraint for the expansion of digital economy in India. This makes an important case for finding a solution to all these issues, in the form of a simple, clear and predictable tax rule that unambiguously defines the tax liability of digital enterprises, thereby facilitating their business planning, reducing their tax risk and contingent liabilities, while also reducing compliance costs, disputes and administrative burden.

Section 7

Issues related to Value of data & User Activity in Multidimensional Business Models

7.1 Contribution of data to profitability of business

77. The Report on Action 1 (2015) lists “Reliance on data, including in particular the use of so-called big data” as one of the significant characteristics of digital economy.48 What distinguishes the digital economy from the traditional businesses is its ability to gather large amount of data and to process and exploit this data for furthering the ends of business and generating more value, particularly by tailoring product offerings based on this data. There are various methods employed by digital platforms for collection of remote data. This may range from direct online surveys seeking specific responses from users to indirect methods like analysis of user location and online behavior. Increasingly, most of this data is generated by the users themselves, and used by enterprises in a manner that significantly contributes to the profits arising in their business models. These aspects have been examined in detail in the BEPS Report on Action 1.

78. As per the report, big data is created when the scale of data is beyond the ordinary methods of collection and is not amenable to analysis using typical database management tools. Value is created because companies are able to target their advertisements and offer goods and services according to consumer preference after analyzing the data. The use of data for improving business efficiency is not unique to digital economy, but what characterizes its use in digital economy is the massive scale at which this is undertaken. Multisided business models create value by using the data gathered from the use of a product or service by a user as an input either in improving existing products and services or in providing products and services to another group of customers. These aspects are analyzed in detail in paragraphs 137, 138 and 145 of the Report, as reproduced below:

“137. Online advertising involves a number of players, including web publishers, who agree to integrate advertisements into their online content in exchange for compensation, advertisers, who produce advertisements to be displayed in the web publisher’s content and advertising network intermediaries, who connect web publishers with advertisers seeking to reach an online audience. Advertising network intermediaries include a range of players, including search engines, media companies, and technology vendors. These networks are supported by data exchanges, marketplaces in which advertisers bid for access to data about customers that has been collected through tracking and tracing of users’ online activities. These data can be analysed, combined, and processed by specialist data analysers into a user profile.

138. In advertising-based business models, publishers of content are frequently willing to offer free or subsidised services to consumers in order to ensure a large enough audience to attract advertisers. The most successful advertising companies have been those that combine a large user base with sophisticated algorithms to collect, analyse, and process user data in order to allow targeted advertisements. While traditional advertising involved payment for display of ads for a specified period of time, with little way to monitor visibility or user response, online advertising has given rise to a number of new payment calculation methods, including cost-per-mille (CPM), in which advertisers pay per thousand displays of their message to users, cost-per-click (CPC), in which advertisers pay only when users click on their advertisements, and cost-per-action (CPA), in which advertisers only pay when a specific action (such as a purchase) is performed by a user.”

“145. In the consumer markets, many cloud services (e.g. email, photo storage, and social networks) have been provided free of charge, with revenue generated through advertising or the sale of data on user behaviour, or on a “freemium” basis in which basic services are provided for free and expanded services require payment. Other consumer cloud services, such as web hosting or hard drive backup, are sold on a monthly subscription basis. In B2B markets, cloud services are most typically sold by subscription, although “pay as you go” models are increasingly available.”

7.2 Growing Significance of Data

79. With better servers, greater computing power and the expanding internet of things, the volume of data and its significance is likely to keep on increasing. BEPS Report on Action 1 (2014) quotes the Data Driven Marketing Institute which found in its report that Data Driven Marketing Economy (DDME) added USD 156 billion to the US economy in 2012. This data can be classified three ways. Firstly, collected data, whereby data entered by a user is tracked; secondly, submitted data, i.e. data that is specifically entered by a user, e.g. on a search engine; thirdly, inferred data, data that is compiled via pooling together various strands of data from a variety of sources.49

80. Websites can collect an extensive personal profile of users within a short span of browsing time. Information such as location, specific address, name, email address and phone number is obtainable. Companies are also interested in knowing about specific shopping habits, and which keywords are used to find their site and whether or not you were interested in advertisements on their pages. Internet tools that make this possible are IP addresses, Web browser cookies, e-tags and image files called Web beacons or Web bugs. A particular type of third-party ad-serving cookie, monitors the web browsing of users to show them advertisements relating to their interests.

81. Social networking websites gather large amounts of personal information about users, including ages, friends and interests, from account signing up forms as well as from browsing habits on their sites. Some of it is collected without users being aware of it. Companies are thus able to gather data about the location of visitors, what sites users have visited, what they have shopped for, preferred modes of payment, etc. From this they can infer other personal details, such as their income, self-owned or rented house and so on. These issues find mention in paragraphs 165-166 of the 2015 Report, as under:

“165. Data can include both personalised data and data that is not personalised, and can be obtained in a number of ways. In the case of personal data, as mentioned in Chapter 3 (3.1.5 Use of data), it can be obtained directly from customers (for example, when registering for an online service), observed (for example, by recording Internet browsing preferences, location data, etc.), or inferred based on analysis in combination with other data. It is estimated that sources such as online or mobile financial transactions, social media traffic, and GPS co-ordinates generate in excess of 2.5 exabytes (billions of gigabytes) of data every day (World Economic Forum, 2012). The dividing line between personal and non-personal data is not always clear; however, as data obtained from multiple private and public sources will frequently be combined in order to create value. A recent study quantifies the value of the Data-Driven Marketing Economy (DDME) and looks at the revenues generated for the US economy. The study found that the DDME added USD 156 billion in revenue to the United States economy in 2012 and notes that the real value of data is in its application and exchange across the DDME (Data-Driven Marketing Institute, 2013).

166. Although the use of data to improve products and services is not unique to the digital economy, the massive use of data has been facilitated by an increase in computing power and storage capacity and a decrease in data storage cost, as shown in Figures 4.9 and 4.10, which has greatly increased the ability to collect, store, and analyse data at a greater distance and in greater quantities than was possible before. The capacity to collect and analyse data is rapidly increasing as the number of sensors embedded in devices that are networked to computing resources increases. For example, while traditional data collection for utility companies was limited to yearly measurement, coupled with random samplings throughout the year, smart metering could increase that measurement rate to 15 minute samples, a 35 000 time increase in the amount of data collected (OECD, 2013). This has manifested itself in particular in the concept of “big data”, meaning datasets large enough that they cannot be managed or analysed using typical database management tools. Data analytics, defined as the use of data storage and process techniques to support decisions, are becoming a driver for innovation in a number of scientific areas and are used increasingly in collaborative and crowd-based projects. In this regard, a text search performed on one of the largest repositories of scientific publications shows that articles related to data mining doubled during the last decade, as shown in Figure 4.11. The value of the ability to obtain and analyse data, and big data in particular, is increasingly well documented by market observers.”

82. Paragraph 168 of the Report (2015), that refers to the findings of the McKinsey Global Institute on ways in which data can create value, is also reproduced below for ease of reference:

“168. The McKinsey Global Institute Report notes five broad ways in which leveraging big data can create value for businesses:

i. Creating transparency by making data more easily accessible in a timely manner to stakeholders with the capacity to use the data.

ii. Managing performance by enabling experimentation to analyse variability in performance and understand its root causes.

iii. Segmenting populations to customise products and services.

iv. Improve decision making by replacing or supporting human decision making with automated algorithms.

v. Improve the development of new business models, products, and services.”

7.3 Significance of User Data in Nexus and Value Creation

83. Thus, the exploitation of user generated data for value creation and use of multisided business models has been identified as one of the broader challenges of the digital economy by the Report on Action 1, which not only give rise to BEPS concerns but also have wider implications for jurisdictional allocation of taxes.

84. As a result, users and customers become an important part of the value creation chain. The logical sequence to this inference is whether the value creation achieved in this manner should be brought to taxation in the locations from where the user data is generated. Coupled intricately with this question would be queries related to measurement of value of user generated data. Action 1 Report acknowledges that this raises fundamental questions such as:

“whether the current international tax framework continues to be appropriate to deal with the changes brought about by the digital economy and the business models that it makes possible, and also relate to the allocation of taxing rights between source and residence jurisdictions. These challenges also raise questions regarding the paradigm used to determine where economic activities are carried out and value is created for tax purposes, which is based on an analysis of the functions performed, assets used and risks assumed. At the same time, when these challenges create opportunities for achieving double non-taxation, for example due to the lack of nexus in the market country under current rules coupled with lack of taxation in the jurisdiction of the income recipient and of that of the ultimate parent company, they also generate BEPS issues.”.

It goes on to say this:

“The expanding role of data raises questions about whether current nexus rules continue to be appropriate or whether any profits attributable to the remote gathering of data by an enterprise should be taxable in the State from which the data is gathered, as well as questions about whether data is being appropriately characterised and valued for tax purposes…… If remote collection of data gives rise to nexus (or in the case of an existing taxable presence) what impact this would have on the application of transfer pricing and profit attribution principles, which in turn require an analysis of the functions performed, assets used and risks assumed.”

85. While companies in the business of collection and analysis of data have evolved means of valuing data (one such means being customer lifetime value, CLV), the valuation of data from a taxation and nexus point of view has additional challenges. What has been clearly acknowledged now is that user generated data and its valuation, should be taken into account for deciding allocation rights to tax jurisdictions.

7.4 Issues related to User activities and contribution

86. Another unique feature of many business models is their ability to get value created by users and their contributions. Paragraphs 266-67 of the BEPS Report on Action 1 (2015) introduces these issues as under:

“266. Additional challenges are presented by the increasing prominence in the digital economy of multi-sided business models. A key feature of two-sided business models is that the ability of a company to attract one group of customers often depends on the company’s ability to attract a second group of customers or users
source - taxguru.in