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International Taxation-Economic Presence as amended by CA. Harsh Mathur

International Taxation
-Economic Presence as amended

Article by: CA. Harsh Mathur
Email: harsh31492@gmail.com

In this digital world, taxation of business profits based on economic allegiance is the core logic of international taxation!

Section 9(1)(i) of the Indian Income Tax Act 1961, tax any income earned by a Non Resident from a business connection in India. The term business connection has not been expressly defined in the act per se. The term has been the subject matter of various interpretations of judicial pronouncements

The finance act has widened the scope of the term business connection in line with BEPS action plan 1 by inserting a new explanation 2A to section 9(1)(i)

The background of the loophole

The explanatory notes to finance bill 2018 released by CBDT dated 26.12.2018 states the problem before the amendment as below:

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

With the advancement in information and communication technology in the last few decades and a push gave by almost all the governments towards digitization, new business models operating remotely through digital medium have emerged.  Under these  new  business  models,  the  non-resident enterprises interact  with customers in another country without  having any physical presence in that country  resulting  in avoidance  of taxation in the source  country. The existing nexus based on physical presence do not hold good anymore for taxation of business profits in source country.  As a result, the rights of the source country to tax business profits that are derived from its economy are unfairly and unreasonably eroded.

Action Plan-1 Addressing the challenges of the digital economy in its recommendations has discussed that, a non-resident enterprise would create  a taxable  presence  in a country  if it has a significant  economic  presence  in that  country  on the  basis of factors that have a purposeful  and  sustained interaction with the economy  by the  aid of technology  and other   automated  tools.   It further recommended that   revenue   factor   may be used   in combination with the aforesaid factors to determine 'significant economic presence'.

India's action on BEPS recommendations:

In view of the above, a new Explanation 2A has been inserted in clause (i) of sub-section (1) of section 9 of the Income-tax Act to provide that 'Significant Economic Presence’ in India shall also constitute 'business connection' and that "Significant Economic Presence" for this purpose shall mean-

(i)  transaction in respect of any goods, services or property carried  out by a non-resident in  India  including  provision   of download   of data  or  software in  India,  if  the  aggregate  of payments arising from such transaction or transactions during the previous  year exceeds such amount  as may be prescribed; or

(ii)  systematic and  continuous soliciting  of business  activities  or engaging  in interaction with such number  of users as maybe prescribed, in India through  digital means.

6.7  It is further provided that only so much of income as is attributable to such transactions or activities as specified in (i) or (ii) above shall be deemed to accrue or arise in India. It is also provided that the transactions or activities shall constitute significant economic presence in India, whether or not-

  • the agreement for such transactions or activities is entered in India;
  • the non-resident has a residence or place of business  in India; or
  • the non-resident renders services in India
Equalization Levy and Significant Economic Presence

EQL was introduced as a separate chapter in Finance bill 2016, to impose tax on e commerce transactions. Once paid, it is not allowed as credit in the country of residence as to get relief as per DTAA tax has to be paid as income tax. This has been a major drawback in implementation of EQL which has not seen any increment in its scope since introduction.

Also, there is no separate article in any of the DTAA for EQL and as per section 90(2) of the Income Tax Act, 1961 DTAA or Provision of Income Tax whichever is more beneficial is applicable and therefore this was deliberately introduced as a separate chapter and not in Income Tax Act.

SEP has been brought in the Income Tax Act, 1961 and therefore any attributable profit will be taxed as per normal tax laws in the source country and the credit shall be allowed for the tax deducted in the country of residence.

However as clarified in the explanatory notes unless corresponding modifications to PE rules are made in the DTAAs, the cross border business profits will continue to be taxed as per the existing treaty rules.

The insertion of this clause has expanded the base of taxation for source countries and once amendment is done in definition of PE it will also be effective in DTAA's.