Globally, tax authorities have been grappling with the challenges that the digital economy poses to traditional tax rules, which were developed during the brick and mortar era. Solving “the digital issue — specifically identifying appropriate tax rules to deal with digital business — has been designated the number-one action in the Organization of Economic Cooperation and Development’s (“OECD”) Base Erosion Profit Shifting (“BEPS”) Action Plan.
Likewise, India’s burgeoning interent economy with its cross-border bearings has also presented tax authorties with similar challenges of bringing digital transactions in the Indian tax net with the infrastructure of traditional permanent establishment (“PE”) rules, source & income classification rules. One such challenge for Indian tax authorities has been to tax non-resident enterprises on the income derived from online advertisement spend by Indian businesses.
Indian tax tribunals have found that the source rules under the Income-tax Act, 1961 (“IT Act”) and tax treaties do not assist the tax authorities’ claim to tax such income. In ITO v. Right Florists 1336/Kol/2011, the tribunal considered the question of taxability of payments made by an Indian resident to Google and Yahoo for advertisement services rendered through their respective search engines. It was held that such payments were not taxable in India because they could not be classified as royalties or fee for technical services. Additionally, since Google and Yahoo did not have servers in India, a mere website could not be classified as a PE so as to bring their business profits into the Indian tax net.To overcome the challenge of taxing online advertisement, spend, Finance Bill, 2016 has proposed the equalization levy outside the IT Act. This article gives an insight into the workings of the equalization levy.
In October 2015, OECD released its final report on the tax challenges of the digital economy under the aegis of the BEPS Action Plan (“Final Report”). The Final Report acknowledges that special rules designed exclusively for the digital economy would prove unworkable, broadly stating that the digital economy cannot be ring-fenced because it “is increasingly becoming the economy itself.” Instead, it states that challenges of digital economy will be effectively addressed by modifying the definition of permanent establishments in tax treaties, and the exceptions to such definition, and by updating transfer pricing regulations and controlled foreign company rules.
Several other options to address the broader tax challenges raised by the digital economy were considered such as (i) a new nexus test in the form of a significant economic presence requirement (ii) a withholding tax on certain types of digital transactions; and (iii) an equalization levy. But, none of such additional options were recommended at this stage. While these options were not recommended, the Final Report does state that countries could introduce any of them in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or include them in their bilateral tax treaties.
As acknowledged in the memorandum to the Finance Bill, 2016, Government’s decision to impose equalization levy appears to be inspired by such Final Report. However, the memorandum to Finance Bill, 2016 does not contain any policy discussion as regards the reasons wht the Government elected to impose an equalization levy as against other measures (discussed hereinabove) recommended by the Final Report. Additionally, while such report approves of intorduction of an equalization levy in domestuc tax legislations, it emphasises on the need to simultaneously repsect treaty obligations. As disussed, in the ensuing pragraphs in greater detail, it appears that the introduction of the equakization levy in India may not be consistent with India’s treaty obligations.
A levy of 6% imposed on consideration received by a non-resident for rendering specified services from an Indian resident carrying on business or profession, or an Indian PE of a non-resident (“Indian Business”). Such levy has to be deducted by the Indian Business from the consideration paid to the non-resident and is required to be deposited by the seventh of the calendar month succeeding the month in which such deduction is made.
Specified services have been defined to mean online advertisement, any provision for digital advertising space or any other facility or service or service for purposes of online advertisement including any other service that may be notified. Further, the term online has been defined to mean a facility or service or right or benefit or access that is obtained through the internet or any other form of digital or telecommunication network.
Interestingly, the Final Report notes the following features of business models that pose tax challenges, viz. e-commerce (including business to business, business to consumer, and consumer to consumer models), app stores, online advertising, cloud computing (including infrastructure as a service, platform as a service, software as a service, content as a service, and data as a service) , payment services, high frequency trading and participative networked platforms. However, at present, the equalization levy in India is restricted to online advertising. Note that the definition of specified service gives leeway to the Government to prescribe any other service within its scope. It is likely that after a test and run with online advertising, the Government may extend the scope of equalization levy to cover such other digital aspects of businesses.
The following three exclusions have been provided from the charge of equalization levy. First, any payment made to a non-resident for rendering specified services would not be subject to the equalization levy if such non-resident has a PE in India and such service is effectively connected to such PE. Second, no equalization levy would be payable where the aggregate consideration paid by an Indian business to a non-resident service provider does not exceed INR 1 lac. Third, any payment made by an Indian Business, which is not for purposes of carrying out business or profession would not be subject to the equalization levy.
At a micro level, there are some apparent issues that may arise in the implementation of such equalization levy. For instance, it is unclear whether the Indian Business will be under an obligation to deduct the equalization levy at the time of making actual payment to the non-resident or will such obligation arise at the time of crediting the account of the non-resident itself (as is the case under the TDS provisions). Although the use of the expression “received or receivable” indicates that such levy should be deducted at the time of crediting the account of the non-resident. Further, in the event that the Indian Business agrees to bear the equalization levy, will the levy be imposed on the tax grossed up amount like in the case of TDS provisions. Note that there is no provision akin to section 195A of the IT Act in the chapter on equalization levy.
Final withholding tax
Unlike the tax deducted at source (“TDS”) regime under the IT Act, the equalization levy has been cast as a final withholding tax liability. Under the TDS regime the primary obligation to pay income tax on income received vests with the non-resident and only a secondary liability is cast on the payer to withhold tax. In case the payer fails to withhold tax, the tax authorities may recover taxes from the non-resident (being the income recipient). Additionally, such non-resident, being subject to Indian taxes, is required to file an Indian income tax return and report such income on which taxes have been deducted (unless exempted from filing a tax return under certain provisions of the IT Act).
However, in case of equalization levy, no obligation (neither primary nor secondary) has been cast on the non-resident to pay such levy to the Government. In case there is non-deduction of equalization levy from the consideration paid to the non-resident, the tax authorities will proceed only against the Indian business and not the non-resident service provider. Accordingly, the non-resident is not to file any returns or meet any other compliances in relation to the equalization levy.
To sum up, the legislative scheme of equalization levy only casts an obligation on the Indian Business and such tax may only be collected by the tax authorities from the Indian Business.
Application of Indian tax treaties
Interestingly, the equalization levy is proposed to be introduced as a separate chapter in the Finance Bill, 2016 as against under the framework of the IT Act. Seemingly, this move may be intended to ensure that the income classification and source rules under the IT Act alongside tax treaties do not act as a hindrance to the imposition of the equalization levy, as has been the case thus far.
There are several reasons to argue why Indian tax treaties would be inapplicable to the equalization levy. Most important being that Indian tax treaties are not self-executing and take force only when they are incorporated under the domestic law by way of legislation. Section 90 of the IT Act, which provides that a tax treaty would apply in place of India’s domestic tax law if it is more beneficial to the taxpayer, gives legislative effect to Indian tax treaties under the IT Act. However, Section 90 of the IT Act does not apply to equalization levy, which is proposed to be imposed under the Finance Bill, 2016 nor is there any provision akin to it in Finance Bill, 2016 so as to give tax treaties an overriding effect over the provisions of the equalization levy. For such reason, Indian tax treaties may not apply to the equalization levy.
Secondly, Indian tax treaties typically apply to such “Indian taxes” as are defined in the definition clause of the tax treaty. The term taxes is typically defined to mean income tax. And any surcharge thereon In this respect, it would be important to evlauate whether qn equalization levy (which is not a part of the IT Act yet has some nexus with the non-residents earnings) could qualify as an income tax for the purposes of application of tax treaty. Notably, India-US tax treaty provide that the treaty would apply to income tax and also to any identical or substantially similar taxes which are imposed after the date of signature of the treaty in addition to, or in place of, the existing taxes. It would be important to consider whether under such treaty equalization levy would qualify as a tax identical or similar to income tax.
Thirdly, Indian tax treaties typically allow non-residents foreign tax credit for taxes imposed on such non-residents. The equalization levy is akin to the dividend distribution tax, where in the tax is collected & in a sense imposed on the payer. In such a circumstance, it will have to be evaluated whether the non-resident’s country of residence would give such non-resident a foreign tax credit for taxes paid by the Indian Business from the consideration paid to the non-resident.
Exemption from income tax on income subject to equalization levy
To ensure there is no economic double taxation in India of income received from specified service, it is proposed to amend the IT Act to provide that any income that is chargeable to equalization levy would be exempt from income tax.
Compliances & other machinery provisions
An Indian Business deducting equalization levy will be required to file an electronic annual statement in Form 1 in respect of all the specified services chargeable to equalization levy during the financial year on or before June 30 of the next following financial year.
In the event that equalization levy is not deducted, the Indian Business will nonetheless be under an obligation to pay such fee to the Government. It is also proposed to amend the IT Act to provide that the business expense incurred by way of payment for such specified services will be disallowed in the hands of the Indian Business. Further, simple interest at the rate of one per cent will be payable for every month of such delay. In case of non-deduction of equalization levy, a penalty being equal to the amount which was required to be deducted may be imposed. In case of non-payment of equalization levy (where such levy has been deducted), a penalty of one thousand rupees may be imposed for each day of failure (subject to a maximum of the equalization levy, failed to be paid). Failure to file the annual statement may give rise to a penalty of one hundred rupees for each day of failure. However, no penalties (discussed above) will be imposed in case reasonable cause is shown for such failure.
The equalization levy regime will be administered by the income tax authorities set out under the IT Act. Appeals from decisions of the assessing officer are to be made to commissioner income tax (appeals). Similarly, the income tax appellate tribunal, high court and supreme court will serve as the higher appellate authorities.
Further, any executive rules made under the chapter on equalization levy are required to be tabled before each house of parliament for thirty days after they are made.
At a policy level, adoption of equalization levy as a domestic law measure to deal with challenges of digital economy may require further calibration in order to provide additional clarity about the details, as well as some adaptation to ensure consistency with India’s existing international legal commitments. Even otherwise, there are some foreseeable issues with the implementation of the equalization levy, which need to be addressed prior to its enactment. Considering that Indian Businesses have to do all the heavy lifting of the equalization levy, the Government should forthwith provide clarity on such issues. Needless to say, Indian Businesses employing online advertising will have to factor in the equalization levy while negotiating prices with non-resident service providers, and prepare for a set of new compliances.
Amit Singhania - Partner, Shardul Amarchand Mangaldas & Co.
Gouri Puri - Senior Associate, Shardul Amarchand Mangaldas & Co.