The digital economy is growing rapidly as technological advances open the market to more businesses and consumers. By 2016, Boston Consulting Group estimated the online market to increase to 3 billion internet users; expanding the digital economy from $2.3 trillion in 2010 to $4.2 trillion in 2016. India is a frontrunner in this digital economy as its e-commerce market was expected to reach $24 billion by 2015. Further, India is showing significant growth just in its own population of internet users; expected to reach 402 million by 2014. The Indian government also hopes to capitalize on this growth through creating an Internet of Things Industry in India that is valued at $15 billion. Needless to say, the digital economy represents a wide tax base for countries to capture. However, the business models in the digital space create unique tax challenges as tax systems have not caught up to the wave of technological progress. This concerns Governments across the globe, who have begun adapting their tax rules to preserve the integrity of their fiscal systems in the digital economy.
The very first action point of the Organization of Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) initiative is dedicated to resolving the tax challenges arising from the digital economy. India’s introduction of the equalization levy is also one such measure, which looks to address the challenges of taxing the digital economy. This article gives a broad overview of the key tax challenges and measures to address such challenges, which are being deliberated globally in the context of the digital economy.
Key Tax Issues
As companies take advantage of the opportunity to conduct business remotely and diversify operations through subsidiaries, they are able to circumvent taxes. Current tax systems are inadequate in preventing tax avoidance because they do not address the issues created by the digital economy. Companies can exploit territorial nexus rules and the characterization of income rules to avoid payment of taxes. Tax planning structures lend themselves to exploiting these outdated tax systems. For example, companies may consider avoiding a taxable presence where tax rates are high. Even if this presence cannot be avoided, profits are artificially reduced through trading structures or maximizing deductions. Further, through the use of subsidiaries, companies can strategically choose where they report the most profit.
For countries like India, the preservation of their source based tax base is key in the context of the digital economy. Businesses in the digital space are able to skirt past rules establishing territorial nexus in India. For instance, significant advertising revenue is earned by online search engines from customers in India. However, Indian courts have held that the business income of offshore online search engines cannot be taxed in India in the absence of a business connection or a permanent establishment (PE) in India. There was no evidence to suggest or demonstrate that the advertising revenues generated by offshore online search engines were supported by, serviced by or connected with any entity based in India. Further, a website would normally not be considered a PE because a website is a made up of intangible material like software and electronic data.
Additionally, characterization of income under the source rules for purposes of withholding tax is also a common issue in India and a topic of litigation. Key decisions have created significant judicial precedent on the matter of whether certain activities are treated as a royalty or business profit. For example, the court decided in Thoughtbuzz Pvt. Ltd. that fees paid for the service of “gathering, collating and making available or imparting information concerning the industrial or commercial knowledge” are taxable as royalties. Online advertising and data warehousing, however, have not been characterized as royalties. For example, according to ITO v. Right Florists, fees paid to online search engines to display an ad do not constitute a royalty because the person or company paying for the advertisement does not have access to the portal on which the advertisement is displayed. A similar decision was made in Standard Chartered Bank v. DDIT, which considered data warehousing. Like ITO v. Right Florists, the court found it necessary for the payer of fees to have access to the portal or servers in order for the payment to be considered a royalty. In eBay International AG v. ADIT, user fee paid by merchants to the website operator on successful completion of sale/ fee paid for display of products was not treated as fee for technical services. Similarly, decisions have been made in many categories of income for varying digital transactions.
OECD’s BEPS Initiative
The OECD members, have attempted to update current tax systems exploited by the digital economy. For example, the final report on the BEPS Action plan 1 recommends the updating of the definition of permanent establishment (PE) and modification of the list of exceptions to that definition. First, the overall list of exceptions to the OECD Model Tax Convention’s definition of PE should be restricted to “preparatory or auxiliary” activities only.
Second, the final report recommends that the OECD Model Tax Convention should be modified to close the loophole in the PE definition for agency arrangements between subsidiaries of offshore companies. Currently, companies can avoid PE status by creating artificial principal-agent arrangements with their own subsidiaries to close contracts. The “agents” in these situations avoid creating a PE even though they are acting as principals and closing contracts with minor modification or approval by the parent company. These local subsidiaries should no longer just be seen as agents of the parent company and these arrangements should constitute a PE.
Finally, the action plan recommends the prevention of tax avoidance through fragmentation of business activities with an anti-fragmentation rule. This could discontinue the practice of companies dividing activities between closely related enterprises. For example, a company can no longer avoid PE status by dividing the maintenance of large warehouses that store and deliver goods to consumers and the online seller of the goods. Under the new anti-fragmentation rule, these activities may constitute a PE.
Along with the modification to the PE definition, the OECD also suggests updating the transfer pricing guidelines and the CFC rules. Both of these updates could prevent companies from creatively structuring their operations to avoid taxes. The digital economy has exacerbated the issue of intangibles as they are a means for companies to create value and produce income. By moving intangibles to tax advantaged locations and claiming that these transfers constitute large allocations of income, companies are able to shift income to countries with low tax rates even if there is little or no business activity there. CFC rules also create a loophole for the digital economy because income from digital goods and services escapes taxation under the current CFC rules. Two options can solve this problem: CFC income could be redefined to include revenue generated in the digital economy or excess profits in low tax jurisdictions that are attributed to IP assets can be characterized as CFC income.
India’s Equalization Levy
The OECD does not specifically suggest an equalization levy at this stage because it believes that this measure would be more successful as domestic legislation rather than an international standard. However, it suggests that member countries enact a measure such as this in order to correct specific BEPS issues that they feel are not adequately addressed in the report. New domestic laws can also act as a “stop gap” until the OECD BEPS actions are fully implemented among all member countries.
India has chosen to initiate an equalization levy through the Finance act of 2016. This brings payments to non-residents under the tax radar by imposing a 6% tax on consideration paid by (a) an Indian resident carrying on a business or profession or (b) an Indian PE of a non-resident, to a non-resident for providing specified services. Currently, the only service that is covered by this new law is online advertising. However, the committee tasked with considering the tax implications of e-commerce had suggested that this tax be expanded to 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. Therefore, there is a likely possibility that the Indian Government may in the future expand the scope of the equalization levy.
Technological advances brought about the end of the brick and mortar era and the immense growth of the digital economy. As companies continue to enter this digital economy and exploit the current, outdated tax systems, improvements must be made to the definitions of PE, transfer pricing guidelines, and the CFC rules. In light of the digital economy’s growth, India has chosen to convey a 6% equalization levy.
With the growth of the digital economy, India, a capital importing country, is most concerned with preserving its source based tax base. Companies exploiting outdated PE rules threaten this large tax base so India is concerned with updating these and withholding tax rules. While the main concern at the moment is focusing on source based tax base, as more Indian companies expand into the global digital economy, focus on the resident tax base will also come into play.
 Figures are given in USD and calculated from the G-20 countries
 ITO v. Right Florists (2012) 346 ITR 345
 Thoughtbuzz Pvt. Ltd. (2012) 346 ITR 345 (AAR)
 ITO v. Right Florists (2012) 346 ITR 345
 (2012) 25 taxmann.com 500 (Mum)
- Amit Singhania - Partner, Shardul Amarchand Mangaldas
- Gouri Puri - Senior Associate, Shardul Amarchand Mangaldas
- Alison Jacobs, J.D. Candidate, Indiana University - Maurer School of Law
The article represents the personal views of the authors, which should not be construed as views of the firm.