India has always been at the forefront of the campaign demanding new-age digital companies to pay their fair share of taxes to market jurisdictions.
After the OECD’s BEPS Action Plan 1, India was one of the first countries to introduce the equalisation levy, which now applies to almost all online cross-border sale of goods and services.
In addition, India has also introduced a new nexus rule ‘significant economic presence’ (SEP) in its domestic tax legislation. Statutory text relating to SEP was inserted in the Indian income tax law in 2018. The provisions are effective from April 1 2021.
The Indian government has expressly said that SEP draws its inspiration from the recommendations contained in BEPS Action Plan 1. Thanks to technology, non-residents can now interact with the customers in India remotely.
The existing nexus rules requiring physical presence in the source country has become outdated. While international consensus on this issue is still elusive, India has gone ahead with the new SEP-based nexus rule in its domestic tax law.
Concept of SEP: New nexus rule
Previously, under the Indian tax laws, any income accruing or arising from a business connection in India was taxable in India. Such business connection normally required carrying on of operations by the non-residents in India through physical presence of a fixed establishment, employees, agents, etc.
Going forwards, even a SEP in India of a non-resident is deemed to constitute a business connection in India and hence, income generated by a non-resident from such SEP will be taxable in India.
- A non-resident will be said to have a SEP in India in the following circumstances: The non-resident carries out transactions in any goods or services or property with any Indian resident, if the aggregate payments exceeds 20 million rupees (approximately $270,000) in a year; or
- The non-resident engages in systematic and continuous soliciting of business or in interaction with a minimum of 300,000 users in India.
SEP will be constituted irrespective of whether the agreements are entered, or services are rendered, in India or outside. The SEP-based nexus rule is not only limited to digital transactions but applies equally to cross-border transactions executed offline.
Impact of SEP on non-treaty countries
If a non-resident is located in a jurisdiction without a tax treaty with India, the SEP rule in the Indian domestic tax law will apply in full effect. For instance, in certain cases digital businesses are set-up in tax havens not having a tax treaty with India. Such businesses may be exposed to a significant tax burden in India, which may be recovered by way of tax withholding.
Possible impact on treaty countries
The SEP provisions in the Indian domestic tax law do not appear to have any impact on the non-residents operating from countries having tax treaties with India, as requirement of a permanent establishment in the source country like India continues to exist in treaties.
Having said this, SEP could still impact non-residents in treaty countries in the following way:
Additional compliance burden
Payments made to non-residents may be subject to withholding tax, unless documentation to support treaty benefit like the Tax Residency Certificate (TRC), no-PE declaration, etc. are provided. In addition, non-residents may even be required to obtain PAN and file tax returns in India, as exemption from such compliances have been currently provided to non-residents only having certain types of income like royalty and fees for technical services.
Denial of treaty benefit
It also exposes non-residents to possible denial of treaty benefits by the Indian tax authorities by application of the principle purpose test (PPT) or general anti-avoidance rules (GAAR) or other technicalities.
Profits attributable to SEP: Unsettling the law laid down by the Supreme Court?
Interestingly, while the OECD is still debating on the issue of profit attribution, the Indian tax law provides that the entire profit attributable to such SEP will be taxable in India.
In addition, the provisions also seek to tax certain indirect profits generated by virtue of SEP. For instance, any income from advertisements targeting the Indian users or income from the sale of data collected from Indian users may also be subject to tax in India.
Importantly, this expanded profit attribution rule is likely to have impact even on non-residents located in treaty countries and having a PE in India (either conventionally or on account of expanded definition in MLI).
Over and above the arm’s-length profits attributable to such PE, the Indian tax authorities may insist that even the indirect profits attributable to SEP in India is also taxable in India.
Thus, the provisions may have the impact of unsettling the existing judicially accepted position (see DIT (Int.) v Morgan Stanley & Co.  292 ITR 416 (SC) and Set Satellite (Singapore) Pte. Ltd v DDIT  307 ITR 205 (Bombay)) that if activities performed by PE are remunerated on arm’s-length basis (by making payments to associated enterprise), no further profits should be attributed to PE.
The SEP related amendment marks a significant leap in how India seeks to tax profits of non-residents doing business with India. Even taxpayers located in jurisdictions with which India has tax treaties may be exposed to a significant tax and compliance burden going forward due to these amendments.
Undoubtedly, proper impact analysis of the new SEP provisions is required on cross-border businesses carried on with India, whether through digital or conventional means.
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