Significant Economic Presence Explained
Taxing the digital Economy
In the connected age where borders become ephemeral it becomes easier for digital businesses to work across multiple countries despite having an established base only in one. In this scenario governments all over the world are increasingly worried about tax losses stemming from digital businesses being based increasingly in low tax jurisdictions.
Shrinking Tax collections
A double Irish or an Dutch sandwich are not items on the menu of a European café. Instead, these are global structuring techniques that utilize Irish and Dutch subsidiaries to ensure that the company must pay little or no tax in the country of origin, in this case the US. India has not been oblivious to these developments and to the rapid changes in the way business is conducted.
In the recent past India has taken the lead from its global peers in implementing the BEPS recommendations and has implemented tax measures such as the equalization levy that ensure that global incomes otherwise not taxable in India are brought to taxes in India.
Enter Significant Economic Presence (SEP)
The latest salvo in this direction are the rules around significant economic presence, the concept of Significant Economic Presence was introduced in Finance Act 2018 and specifies that any Significant Economic Presence will constitute a business connection in India.
For this purpose, the act defines significant economic presence as:
- A transaction in respect of any goods, services or property, including provision of downloaded data or software, carried out by a non-resident in India if the aggregate of the payments arising from such transactions during the previous year exceeds the prescribed threshold
- Systematic and continuous soliciting of business activities or engagements involving interaction with the prescribed number of users in India using digital processes
To break it down, to constitute this virtual PE there must be, for the first condition:
- A transaction
- In respect of any goods or services or property this includes download of data or software)
- Carried out by non-resident in India
- Provided the total of payments from such transactions exceeds a specified limit
For the second condition on the other hand:
- A systematic and continuous soliciting of business activities, or
- Engagements involving interaction with the prescribed number of users using digital processes
This concept has potentially far reaching consequences. At the current moment taxation of foreign entities is driven by the presence or lack thereof of a business connection or permanent establishment in India. This is discussed in detail in our note on taxation of foreign entities in India. Without the active presence of such business connection or permanent establishment the incomes of the foreign business could not be brought to taxation in India.
What is the impact?
This changes with the advent of the concept of Significant Economic Presence. Now, businesses will be subject to tax in India if they happen to sell goods or services exceeding a certain threshold as defined by the government. This would impact almost all internet, software and trading companies that happen to be on the other side of these thresholds.
Consider this example, the Chinese internet giant Alibaba is currently not subject to any taxes in India even though it sells millions of dollars worth of goods in India since it does not have a business connection or a permanent establishment in India. With the advent of the SEP concept this will no longer matter, and the company will have to pay taxes in India on all sales made in India
For the second condition to be met there does not even need to be actual sales! The mere act of soliciting business from India can now subject the company to taxation in India. This must be read particularly in the context of news portals and news feed driven companies such as Facebook and Instagram. The exceeding of engagements beyond a certain limit will can result in their incomes originating from India to be subjected to tax in India.
This provision has the effect of subjecting the incomes of social networks and other engagement based platforms such as WhatsApp, WeChat and tiktok in India provided they exceed the defined thresholds.
A side effect of this clause is that may also subject liaison offices set up in India to tax, since they too are engaged in the systematic and continuous soliciting of business activities in India! If this is indeed the case, then more companies will be inclined to set up wholly owned subsidiaries in India if only for the lower rate of tax (25% as compares to 40% for the foreign companies)
The DTAA test
The ultimate test for deciding whether a foreign entities income will be taxed in India or the home country of the entity lies in the double taxation avoidance agreement (DTAA) between India and the home country.
Most DTAAs signed have clauses which clearly specify if and how the host country, in this case India, will have a right to tax incomes of companies located in other countries. More of then not, this involves the creation of a PE (read out note referred to earlier).
Since DTAAs overrule domestic tax law, in the absence of mentions of significant economic presence in DTAAs India would it difficult to impose taxes upon such foreign companies. The announcement of these measures is however a signal of intent and we can and should expect more action in this regard.
With inputs from Priya Jain
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