The Equalisation Levy (Chapter VIII of the Finance Act 2016) has many unique features. It is not part of the Income-tax Act, though it directly refers to it for definitions, procedure and for exempting income tax on the income arising from a service which has been subjected to the equalisation levy. It is charged on consideration received by a non-resident for rendering any specified service to a business in India. The levy (6% of the consideration) is to be discharged by the Indian business by way of a withholding from the payment it makes to the non-resident. The specified service is currently restricted to online advertising, but the legislation allows the executive to notify any other service.
In form, the equalisation levy is close to the service tax (of about 15%), though in substance and purpose it is meant to ‘equalise’ the income-tax obligations of non-resident service providers with that of residents. Service tax on online advertising service received from abroad is levied on the value of the service and deposited on a ‘reverse charge’ basis by the service recipient in India.
Going forward, there will be debate and litigation on this legislation regarding Constitutional competence, treaty obligations, delegated powers, etc. However, we need to look at the public policy aspects of such a tax.
The Explanatory Memorandum to the Finance Bill states that the levy has been introduced to meet the challenge of taxing the cross-border income of e-commerce business models, as the existing international tax treaty structure is unable to address it. Why is this so? Existing bilateral tax treaties give the right to the source country to tax the business income of a foreign entity only if that foreign entity has a permanent establishment (PE) principally based on physical location in the source country. With the evolution of technology in a globalised world, a foreign business can now have significant economic presence in a source country without having a physical presence. Specifically, in the e-commerce space, it is exceedingly difficult to establish a physical nexus between the transaction and a taxing jurisdiction. Bilateral treaties also allow taxation through final withholding for certain income streams (royalty, fees for technical services) even without a PE, but the delivery of e-commerce services is not covered in such income streams.
The G20/OECD Base Erosion and Profit Shifting (BEPS) project had taxation of the digital economy as its first Action Plan. It was agreed by participating countries that other measures taken through the BEPS project would address some concerns regarding the digital economy and further work would be done on this issue by 2020 after monitoring the effects of steps already taken. The BEPS report discussed some ways individual countries could address the issue, but cautioned that the solutions should not violate existing bilateral treaties and lead to double taxation. What were these ways? One was to expand the definition of a PE beyond physical location to also include virtual PE based on digital presence. Another was to impose a final withholding on payments for digital goods or services. The third was an equalisation levy on digital transactions. These measures impact not just domestic law, they also entail substantial changes to key global tax principles embodied in tax treaties.
Certain countries have attempted to address physical-location-based PE issues (which subsume digital business models) in their domestic legislation by using anti-avoidance principles. The UK has introduced a new ‘Diverted Profit Tax’ and Australia a ‘Multinational Anti-Avoidance Law’. These target a non-resident entity which derives income from the supply of goods or services with the support of a resident entity, but does not attribute any of its income to a PE in that jurisdiction. The legislations deem and attribute income to such a PE relying on the principle that business activity is being carried on in the jurisdiction on behalf of the non-resident.
The difference in the Indian approach is that equalisation levy is a tax on gross income which strikes directly at the root of the existing international bilateral tax treaty network. The levy presumes that by not being taxed in India, the foreign e-commerce entity gains an advantage over an entity operating in India and this advantage is to be ‘equalised’. The report of the Committee on the Proposal for Equalisation Levy on Specified Transactions released in March 2016 states that as it is not an income tax, the levy is not covered by bilateral tax treaties. As the e-commerce entity being subject to the equalisation levy cannot seek credit of the tax in its home jurisdiction, it would be liable to be doubly taxed. The legislation specifically mentions online advertisement and provision of digital advertising space as being subject to the levy, but then allows ‘any other service’ to be notified by the executive, which seems to be an overreach of delegated powers. There are a plethora of disputes under the current tax treaty regime regarding the characterisation of income streams as royalty or fees for technical services. Theoretically, any of these income streams could be notified as a service under equalisation levy, bypassing current international treaty obligations.
The committee report states that the levy serves to create incentives for digital multinational enterprises to establish PE in India and get taxed only on the net income attributable in India. The practical implication of the levy could, however, be higher taxation of Indian entities rather than of the non-resident service provider. An Indian business paying a non-resident entity for online advertising already deposits service tax to the government, but can set it off against service tax paid on its inputs. It, therefore, does not significantly impact its cost base. The same entity will now have to deduct a further 6% as equalisation levy from payments made to the foreign entity without the advantage of any set off. Digital networks are based on a two-sided market model and network effects, which typically lead to market power in the hands of the seller. Therefore, the non-resident digital service provider may be able to dictate that the Indian business should keep paying it as before and deposit the levy from its own funds. In such a case, though the levy is on the foreign entity, its economic incidence will fall on the Indian entity.
While the Finance Act has been legislated, the equalisation levy is to come into force only from the date notified by the central government. Perhaps policy-makers should consider these practical implications in the Indian context as also the potential additional tax to be garnered from such a levy at this stage. It may be worthwhile to use the legislation as a shield to negotiate a consensus on taxing digital transactions through enlarging the PE definition or through a final withholding on digital transactions under the current treaty structure.
The author is Of Counsel, BMR & Associates LLP, and formerly Joint Secretary, ministry of finance, government of India