The advent of the Internet and proliferating digital transformation has had a notable impact on the 21st century. While innovative digital trends are a boon to global businesses, they have unsettled global taxation systems that were designed to tax cross-border transactions in the jurisdiction where physical presence of the business was established. Recognizing the evolution of business, which necessitates upgrading international tax rules while ensuring certainty and minimal complexity, the OECD has released a program of work to develop a consensus solution to the tax challenges arising from the digitalization of the economy.
Pillar One of the program focuses on the allocation of taxing rights between jurisdictions and reviews proposals for new profit allocations and nexus rules based on the concepts of significant economic presence and exploitation of user participation and marketing intangibles in a jurisdiction. Pillar Two is the global anti-base erosion proposal involving the development of a coordinated set of rules to address ongoing risks from structures that are deemed to allow multinational enterprises to shift profit to jurisdictions where they are subject to nil or very low taxation.
While the OECD is working towards a multilateral collaboration to make panoramic amendments to tax laws, a few jurisdictions have anxiously initiated unilateral measures to tax digital transactions. European countries such as France, Spain, Austria, the Czech Republic, Britain, Belgium, Latvia, and Italy have introduced a digital service tax (DST) of 2% to 7% on digital services such as online advertising of services, internet search engines, digital interface services, e-commerce transactions, sale or transmission of user data, and the like. Countries such as Indonesia, Israel, Turkey, Argentina, Canada, Malaysia, Mexico, Pakistan, Slovakia, Thailand, and Vietnam have also implemented withholding tax of approximately 5% on similar services. While digital taxation is in its nascent stages around the globe, India is designing an intricate system of taxing digital transactions with a mix of all recommendations under Pillar One, and has become the one of the first countries to implement an equalization levy as a separate code outside the traditional income tax regime for taxing digital transactions.
The equalization levy was introduced in 2016 as a 6% withholding tax on non-resident payments for online advertisements. A nexus rule based on significant economic presence was introduced in 2018 that would expand the definition of business connection beyond physical presence from April 1, 2021. Lately, India has introduced the equalization levy in its new avatar as a 2% levy on online supply of goods and provision of services by a non-resident exceeding the turnover threshold limit of 20 million Indian rupees ($265,000). This new levy came as a surprise to international trade partners and is set to impact non-resident players in all categories of digital businesses such as online marketplaces, online advertising, cloud computing, vehicle aggregation, online entertainment content, e-payments, digital wallets, travel and hospitality services, search engines, research platforms, and matrimony and dating platforms.
India’s equalization levy brings complex questions and ambiguities on amounts to which the levy should be applied, nature of transactions covered, possibility of double taxation, and extra-territorial reach to tax transactions on sale of data or advertisement services between non-residents if the taxpayer has links to Indian clientele. There are concerns about an obvious double taxation during the current fiscal year as the exemption under income tax for transactions subject to this equalization levy is effective only from April 1, 2021. Whether this is a drafting error, an oversight, or a premeditated inscription in the rule book may be addressed by the authorities later, but the interplay between the equalization levy and tax avoidance treaties necessitates a scrupulous analysis.
Article 2 of the tax treaties defines the taxes to which the provisions of the treaty would be applicable and usually covers only income tax levied in the contracting states. The UN Model also provides “identical or substantially similar taxes” to be included under Article 2, which extends the scope of the treaty to taxes that are principally in line with income tax and carry similar essential characteristics. India’s treaties with countries such as the U.S., U.K., Singapore, and the Netherlands include the term “identical or substantially similar taxes.” This term is commonly understood to mean taxes that are levied in addition to or in place of an existing tax, and the competent authorities are required to notify each other of any significant change made to their domestic tax laws. A new tax is considered as “substantially similar” to an existing tax if the new tax has a material likeness or resemblance to the existing tax taking into account essential elements of the tax such as the base on which it is levied and the mode of computation.
The equalization levy in India was introduced as a separate code under the Finance Act and is outside the horizon of income tax laws. Customary income tax is levied on net income, whereas the equalization levy reflects a turnover or transaction-based levy that is irreconcilable to tenets of the income tax statute and may not be regarded as an identical or similar taxes. While the UN model postulates that notification of such substantially similar tax laws to the contracting state is obligatory, at least by the end of each year, it also proposes that contracting states are not required to notify significant changes in “non-tax” laws even if the changes impact their obligations under the convention.
A noteworthy question, therefore, is whether the equalization levy is a tax or non-tax matter for dialogue between treaty partners. Unless notified as identical or substantially similar taxes, credit for the equalization levy in the home country of the taxpayer would remain vacillating for taxpayers with tax treaty coverage. This gap theoretically travels to Article 26 on non-discrimination as well, which provides that nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith, which is more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances are or may be subjected.
A rhetorical question, therefore, is, whether the equalization levy is one such burdensome tax on the non-resident. The overlap in applicability of income tax and the equalization levy may result in a transaction involving provision of services, being regarded as fees for technical services (FTS) under income tax provisions and still draw the equalization levy. While the beneficial provisions of tax treaties such as the requirement to “make available” services could still keep a transaction outside the realm of FTS tax, the equalization levy may continue to apply on such transactions. A transaction that did not suffer taxation in India due to shield under tax treaties can now attract a mandatory 2% levy, which may not even be creditable in the home country.
Unilateral measures adopted by countries to tax digital businesses have invited strong criticism as they are against the spirit of multilateral collaboration and are often a deviation from the internationally recommended policies. The U.S., being a tech-giant seems to be bearing the greatest impact of newly emerging levies on digital transactions. The Trump administration has not hesitated in sending strong messages and taking measures against countries taking solitary tax mechanisms. As a retaliatory wand, the U.S. has ordered an investigation on numerous tax jurisdictions and has invited public comments against such digital taxation under Section 301 of the USA Trade Act, 1974. This section allows the U.S. president to invoke rights under international trade agreements against an action of a foreign country which may be unfair or discriminatory and may negatively impact US commerce.
Primarily, the investigation would deal with issues like unreasonable tax policies, diverging provisions from U.S. tax laws, extra-territorial rights, and whether the mechanism is being used to penalize technology giants for their atypical success graph. This investigation is a tool to initiate dispute resolution and where the dispute is not settled, it may lead to trade sanctions and other restrictions on the foreign state. France had to keep in abeyance a similar levy as the U.S. struck back by imposing higher tariffs on the import of French products, and the countries agreed to engage in multilateral discussions and negotiations at the OECD level. All eyes are now on the OECD meeting scheduled in the first week of July, which the U.S. has agreed to attend in an attempt to reach a consensus.
The monstrousness of the economic challenges at hand cannot be understated. The temptation to impose digital taxes is hard to resist at a time when individual governments are stretching their arms to augment revenue collections and revive their economies. On the flip-side, multi-national corporations are struggling with dark clouds of uncertainty and complex policies looming over the horizon. An exemplar shift in taxation models may become a market disrupter and a hurdle in global economic prosperity, having an adverse impact on consumer sentiments. Standing at the brink of the steepest economic slowdown since the Great Depression of the 1930s, it is of paramount importance that a consensus-based approach is adopted by all countries. As we grapple with the aftermath of Covid-19, expectations remain high with the OECD to devise multilateral guidelines that could resolve the ongoing taxing right disputes.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Suraj Nangia and Sandeep Jhunjhunwala are partners at Nangia Andersen LLP. Suraj Nangia is an International Tax expert with over 12 years extensive professional experience in handling corporate and international tax matters of domestic and multi-national enterprises. An author of a book titled Doing Business in India—Simplified, intended to act as a reference tool for businessmen, entrepreneurs, professionals and executives providing them with necessary information about relevant legislation for setting-up and expanding business in India.