Gaps in the current system that prevent digital economy to be adequately taxed
Features of businesses in the digital landscape are vastly different from those of typical brick and mortar businesses. These features include mobility, reliance on data, use of multi-sided business models, and volatility. However, tax policies still function on traditional concepts of territory and residence. They were designed to tax physical businesses and are not adept to handle ones that are conducted online. By playing on these gaps, practitioners in the digital economy are able to ‘legally’ avoid or at least substantially reduce their tax burden. For instance, social media websites earning huge revenue from advertisements pay no tax in the source country as they do not establish a physical presence in such countries. Therefore, devising a mechanism to appropriately tax the digital economy has become a popular agenda in international policy debates.
Against this backdrop, Vidhi’s report ‘Taxation of Digital Economy in India – The Way Forward’ first identifies the gaps in the taxation system that prevent the digital economy from being adequately taxed. The report subsequently discusses the work of international organisations such as the Organisation for Economic and Cultural Development, the United Nations and the European Union on the subject. Further, it also highlights various unilateral measures introduced by countries such as Italy, United Kingdom, Australia, Israel, Hungary, Spain and Colombia, while critically analysing in detail the unilateral measures taken by India.
Efforts by international organisations to tax digital economy
At the international level, it was the OECD which took the initiative for re-evaluating the interface of tax regime with the digital economy. Since 1995, it has consistently set the agenda through its reports, discussions as well as conferences.
Efforts of other international organisations such as UN and EU have essentially dovetailed the OECD’s efforts with minor differences. In 2015, OECD published a report titled ‘Addressing the tax challenges of the Digital Economy’ providing for three alternatives to address the issue of taxing the digital economy i.e. developing a new nexus based on the concept of significant economic presence, imposition of a withholding tax or an introduction of equalisation levy. However, it was concluded that all three alternatives need further study. For an interim time period, countries could introduce unilateral measures provided such measures are consistent with the existing treaty obligations.
Issues with the unilateral measures adopted by India
While it seems that the long-term solution to effectively tax income earned by the digital economy is amending the international tax treaties, in the interim, many countries including India adopted unilateral measures. Some of them have been:
1. The imposition of equalisation levy was the first measure that India introduced to tax certain specified digital services, where consideration is provided by a business to a non-resident either residing in India or having a permanent establishment here. While the aim of the imposition was sound, there are plausible arguments against its constitutional validity. Further, it has also been criticised on the grounds that it could result in double taxation.
2. Another measure that India adopted was the introduction of the concept of significant economic presence of non-residents under the Income Tax Act, 1961 (‘IT Act’) which says that economic presence is the main factor to determine taxation and not brick and mortar structures. While this concept is not effective at present, Vidhi’s report analyses this provision added to the IT Act. The report highlights the lack of a clear definition of widely worded terms used in the provision such as ‘significant’ and ‘user’. It the need of introduction of attribution rules for smooth implementation of such provision.
3. Lastly, the report analyses the impact of data localisation that mandates digital businesses to host servers in India. While the Reserve Bank of India has made data localisation mandatory for certain business, it is still at the stage of a proposal for a majority of digital business models. If enforced, this may mandate website to host servers in India which may result into tax liability.
• The most effective and efficient way of taxing digital economy is by way of amending treaties and introducing a new nexus rule that will bring digital business models under the taxation regime. However, negotiating with different countries to amend treaty provision seems to be a tedious process and take a long time to be accomplished. The report suggests that in the interim period, the treaties can be negotiated at a priority with countries whose residents are highly involved in digital transaction in India. Alternatively, a Multilateral Instrument may be introduced, however it is important to note that it is possible that every country may not agree to be a signatory of such instrument.
• Having presumed that treaties are negotiated, it is important that the unilateral measure taken by Indian government by way of imposition of equalisation levy be rethought and perhaps its existence to be re-evaluated. Further, along with the new nexus rule, rules for attributing profit to such new nexus shall also be introduced.
• Even if treaties are not negotiated, once data localisation laws are in place, many e-commerce companies may fall under the taxation regime. However, companies may still legally avoid taxation if their core function is not performed through the server located in India. Thus, a mandate is required under data localisation laws mandating every website to host servers only in India. While the tax impact of such data localisation law seems to be favourable, merit of such laws needs to be evaluated further.