Dr.

SHAKUNTALA MISRA NATIONAL REHABILITATION UNIVERSITY

Lucknow

Faculty of Law

RESEARCH PROJECT ON

Tax challenges arising from digitalisation

For

‘International Taxation: Emerging Jurisprudence ’

Submitted by

Abhishek Gaurav

B.Com. LL.B/15-16/61

Roll No. - 154140002

Academic Session: 2018-19

Under the Guidance of

Mz. Vijeta Dua

Asst. Prof. Faculty of Law

Dr. Shakuntala Misra National Rehabilitation University

 ACKNOWLEDGEMENT
I would like to express my gratitude to my teacher Mz.Vijeta Dua
who gave me the golden opportunity to do this wonderful topic ‘Tax
challenges arising from digitalization’ which also helped me in doing
a lot of research and I came to know about my new things I am really
thankful to them.
 Tax challenges arising from digitalisation

Abstract

As MNCs increasingly digitalise their operations, taxing their incomes is proving a

challenge. Primarily since economic activity is no longer pre-conditioned on physical
presence. As a result the existing international tax rules are proving insufficient. In
response to this challenge, policy experts around the world are deliberating the basis
for taxing profits arising from digitalised operations. The alternative measures being
considered include withholding tax, equalisation levy and the test for significant
economic presence. Each of these measures is being critically assessed and a more
uniform approach has not yet been adopted owing to concerns that there may be
reallocation of taxing rights. This project presents evidence of base erosion and profit
shifting by digitalised businesses. Using such evidence the paper discusses the
adequacy and utility of the suggested tax measures and conjectures on the tax
consequences for source countries. The paper finds that the test for significant
economic presence may be a useful measure however its wider acceptance hinges on
consensus.
 Introduction

Multinational corporations operate across borders as separate entities. The

taxation of the incomes of each entity is governed not just by domestic tax
laws of that jurisdiction but also by the international tax rules. These rules
based on economic principles, have a long history.They were designed by
the developed countries such that source countries received the right to tax
passive incomes on a gross basis, at a rate prescribed by the double tax
conventions. Whereas active business incomes are taxed where the
corporation undertakes economic activity i.e. place of residence. To establish
connection between incomes and economic activity, the concept of
permanent establishment was introduced. This ensured businesses with
fleeting presence in an economy would not be taxed therein. However,
practices by some MNCs to avoid tax have frustrated the efforts of the
revenue authorities to align tax payments with economic activity. Thus
resulting in base erosion and profit shifting. Digitalisation exacerbates the
problem in two significant ways. First, the value created by such businesses
is the result of complex processes that intensively utilise intellectual property
and inputs such as data are endogenous to service delivery.These features
make it difficult to ascertain the value created and the characterisation of
incomes. Second, the existing rules assume physical presence as the basis for
economic nexus. This no longer is a pre-condition for digitalised businesses
to operate in a jurisdiction. User participation and data instead contribute
significantly to operations. These are being considered as potentially
important basis for establishing economic presence but countries such as
India and the EU. However diverging views exist on the precise nature of
contribution of these two. The observed lack of consensus is expected since
the adoption of such a new nexus rule may result alter the existing
distribution of taxing rights . In this context, this project discusses the
observed misalignment between economic presence and value created. The
paper therefore revisits the discussion on what constitutes value creation.
Further, it evaluates the alternatives available for the appropriate taxation of
incomes from digitalised operations, particularly from the point of view of
source countries.
Base Erosion and Profit Shifting in the context of
digitalised business

Revenue and user base

A digitalised business operating in any segment be it digital advertising,

collaborative consumption or e-commerce are characterised by two
important features. First-user participation contributes to value creation and
second, the generation and use of user data. User participation is
indispensable for the development of a platform. The data generated by
users in turn is valuable since services such as targeted or search
advertising are provided using such data. Thus user participation evidently
forms the basis for value creation. It is expected that the turnover reported
from various digital services is distributed similarly as the user population.

Operating profit margins

Evidence from India suggests that operating margin reported by MNCs in

India is lower than that reported for global operations by the parent
company. In 2016 profit before tax reported by Facebook India Online
Services Pvt. Ltd., Google India Pvt. Ltd. (GIPL) and Uber India
Technology Pvt. Ltd. was INR 2012 million. Whereas the sales reported by
these three companies were INR 64,565 million. A simple comparison of
the numbers suggests that profit for these three companies is 8.7 per cent of
the reported sales. In fact for GIPL this is 2.4 per cent. Further, for the
same year the operating profit margin reported in India by GIPL was 5.54
per cent7 and that by Facebook India is 9.94 per cent. These are
significantly lower than 25 per cent8 by Google’s parent company
Alphabet and 52 percent by Facebook from its worldwide operations. For
comparable operations, such difference in operating margins indicate that
while significant economic activity is reported in India the taxable profits
are a small fraction. Piecing together the two results, it can be said that in
countries such as India incomes generated are not being attributed
adequately. Further, even for in-comes attributable to India corresponding
expenses are possibly being reported in excess to reduce the effective rates
of tax. To tax incomes of digitalised businesses on par with traditional
businesses, three measures were suggested by the Task Force on Digital
Economy. None of the methods have yet emerged as the preferred solution.
The observed lack of consensus is symptomatic of deeper or more
fundamental issues. A detailed discussion of these issues is presented in the
next section.

Issues and Measures to address BEPS by digitalised

businesses
Issues

There exist different kinds of digital business models such as e-commerce,

app stores, online advertising, cloud computing, participative network
platforms, high speed trading and online payment services. Each of these
models is unique in the kind of service rendered. For example, e-commerce
platforms are a distribution model wherein sellers list products and the
buyers can purchase a product. Social networks connect users that
exchange information. Multi-sided platforms such as Uber and Airbnb
connect buyers and sellers of a service based on location and then there are
companies such as Netflix that provide on-demand content. The incomes
generated by each of these business models is characteristically different.
To elaborate, an e-commerce platforms earns commission from the sales of
listed items, social networks generate incomes through targeted advertising
based on user generated data, multi-sided platforms such as Uber or Airbnb
earn commissions for services that entail matching buyer and seller based
on user rating and location and Netflix earns subscription. Even though the
value generated for each of these models is distinct in process and nature, a
common thread runs through these businesses. They all rely, on intangibles
such as software including algorithms, servers, user interface and user
generated data in varying intensities for service delivery. As a result, it is
essential to understand how each of these elements contribute to value
creation. Once the domestic law of a jurisdiction interprets the contribution
of each element, the income from a service is characterised as profits or
payment for use of intellectual property. Consequently such income is
attributed to the relevant jurisdiction and taxed accordingly therein.
Digitalised businesses present a special challenge for tax not only because
of the intricate contribution of intangibles but also since no consensus
exists yet on the contribution of inputs critical to revenue generation, such
as user participation and data generated. This compounds the prevalent
challenges of characterisation and attribution of the value generated
(figure1)

Figure 1: Issues with value created

Three different points of view have been expressed on the relevance and
importance of user participation and data to location of value creation and
the identity of value creator. One view is that user participation is integral
to value creation and therefore the latter must be attributed to the
jurisdiction where data is generated. Another view is that merely the
collection of data on users is not activity that can be taxed solely because
the data is valuable. Further, critical to the discussion is whether the service
rendered is viewed as arising from a particular function or is it considered
rendered conjointly by processes located in separate jurisdictions. Thereby
resulting in a particular kind of attribution. In this context, the transfer of
right to use must be distinguished from merely the use of patented
technology. The Indian revenue authorities and taxpayers are mired in
litigation since there is lack of consistency in the application of
aforementioned distinction. For example, the Income Tax Appellate
Tribunal (ITAT), in cases such as Pinstorm Technologies Pvt Ltd Vs ITO
and Yahoo India Pvt. Ltd. held that the income in the specific case was not
considered royalty since the banner advertisement hosting services did not
involve use or right to use by the assessee any industrial, commercial or
scientific equipment. In sharp contrast, in the case Google India Private Ltd
vs. ACIT (ITAT Bangalore) the tribunal held that the revenue generated
from advertising was royalty. Thus the understanding of contribution of a
process to value creation and the resulting characterisation would result in a
particular tax treatment in a jurisdiction. The taxation of the income of a
digitalised business presents an interpretive challenge. Figure 2 summarises
the plausible tax implications for the source country given the different
kinds of characterisation.

Figure 2: Taxation of income from digitalised business

As has been discussed, the income arising in a particular circumstance will

be considered royalty if there is transfer of rights to use intellectual
property. If the treaties and domestic law in the jurisdiction that makes such
payment permit for withholding, as is the case in India, then that
jurisdiction will be able to tax the gross revenue at the rate specified. Note
that many of the treaties of OECD countries do not have a similar
provision. If the income is considered a payment for rendering managerial,
technical or professional services, it will be treated as Fee for Technical
Services (FTS). Source countries too may have limited right to tax such
incomes. To give an example,for income to be considered FTS, human
intervention has been interpreted by the India High Court as necessary and
for highly automated processes observed in such transactions, this may not
be applicable. On the other hand, if the income is interpreted as profit, as
been recommended in some cases by the Technical Advisory Group (TAG)
of the OECD , the source jurisdiction will only be able to tax profit if nexus
is established. Within the ambit of existing definition of PE, the server was
considered the closest concept to fixed place of business. However, for it to
be considered as PE the server has to be at the disposal of the company.
Thus if the MNE rents the server of another company then it can avoid the
PE status.It is widely discussed that the existing definition of permanent
establishment is no longer adequate. Therefore given that the present
definition of PE may not be adequate to tax in-comes of digitalised
businesses. It is imperative to examine what constitutes an appropriate
basis for establishing economic nexus. The nexus will accordingly result in
allocation of taxing rights to the relevant jurisdiction. It is possible to
conjecture the resulting allocation from a different kinds of attribution.
Firstly, data may be considered as the basis for value creation and therefore
can be considered a criterion for economic nexus. If data is considered
valuable when generated by the users the right to tax profits will rest with
the jurisdiction where users are located. Alternatively, if the data is
considered valuable when stored at the server or processed by algorithms
then the profits may be taxed in the jurisdiction where servers are located
or where the data is licensed and pro-cessed respectively. Thus the view on
where data is considered to have created value will determine the source
jurisdiction’s right to tax. In this context, it is important to emphasise the
interplay of various regulations. For example,data privacy laws in various
jurisdictions may result in localisation, in varying de-grees. Depending on
such localisation the jurisdiction where users are located is where the
incomes may get taxed. For business models such as multi-sided platforms
price is dynamically deter-mined through user participation wherein the
demand for the service is esti-mated and is differentially priced across time
and geography. In the online advertising space, more than 60 per cent of
the revenues are from search ad-vertising or advertising on social media.
The rates paid for such advertising are based on user generated data.
Similarly, Uber charges a higher or surge price when demand rises. This
demand is dynamically determined through real-time user information.
Thus user participation is a highly localised input that contributes to price
formation and value creation. Therefore if users are considered as
economic nexus, the source jurisdiction will receive the right to tax.
Further, differing rights to tax will be allocated to the source country
depending on whether income is characterised as royalty or FTS or profits.
It may be pertinent to mention here that the taxation of incomes as FTS and
profits has been a contentious issue for India. For example, using the
IBFD’s tax news service it is estimated that of the 3445 news items on
treaties between 1980-2017, 467 related to court decisions and rulings. Of
these 222 were for India and nearly half related to FTS and PE. In the
absence of withholding rights and nexus or characterisation of income as
neither profits or royalty/FTS, even with all the necessary existing
provisions the income will remain untaxed in the source jurisdiction. A
nexus rule such as test for SEP can help address the misalignment of the
economic presence and revenues. Since the basis for taxation is the users,
data or contracts concluded. it is important to note that the profits reported
may still not be attributed adequately. That is higher expenses may be
reported in source jurisdiction. At the moment, transfer pricing rules can
remedy overstating of expenses between related parties. Given that
digitalised markets are prone to concentration the application of these rules
may also become more problematic. The monopolist using internally
produced inputs such as data may make it difficult to find an uncontrolled
comparable.

Measures
As of now three measures are suggested to tackle the under-taxation of
digitalised businesses- equalization levy , withholding tax and test for
significant economic presence (SEP). The test for SEP can address the
inadequacy of the present PE rules thereby fixing the misalignment
demonstrated in section 1. India and Israel have implemented whereas
European Commission is proposing to introduce such test.

Test for SEP

European Commission’s proposal A digital platform will be deemed to

have taxable digital presence or virtual PE in the member state if it fulfils
any one of the following criteria-
i. It exceeds a threshold of Euro 7 million in annual revenues in a
Member State
ii. ii. It has more than 100,000 users in a Member State in a taxable
year
iii. iii. Over 3000 business contracts for digital services are created
between the company and business users in a taxable year.

India’s test of significant economic presence introduced in 2018 to the

Income Tax Act, 1961.

This amends the definition of business connection contained in section 9 of

the ITA, that now includes-
(i) any transaction in respect of any goods, services or property
carried out by a non-resident in India including provision of
download of data or software in India if the aggregate of payments
arising from such transaction or transactions during the previous
year exceeds the amount as may be prescribed; or
(ii) (ii) Systematic and continuous soliciting of its business activities
or engaging in interaction with such number of users as may be
prescribed, in India through digital means.
Though considered a long term solution by the European Commission , the
test has not gained wider traction. Particularly since all developed countries
are not convinced that user participation forms the basis for attributing
value creation. In the light of such impasse, countries are anxious that they
may cede tax on such activities. Therefore, many have taken the initiative
to unilaterally implement the withholding or equalisation levy, that is
applicable on gross revenues. For example, India introduced the
equalisation levy in 2016. Similarly, Italy, France, Hungary and Argentina
have introduced or are proposing to introduce some version of the
withholding that applies to gross revenues of non-resident digital
companies. From a relatively narrow base that applies only to digital
advertising in India and Hungary, the tax imposed by France applies to a
broader base of digital content. The European Commission too has
proposed to implement an interim tax on revenues from sale of online
advertising space, digital intermediary activities which allow users to
interact with other users and which can facilitate the sale of goods and
services between them, and the sale of data generated from user-provided
information. The appeal of these taxes is not just that they offer a quick fix
to base erosion, but that these are easier to collect. Moreover in most
countries the onus of collecting the tax is on the customer. Notwithstanding
the ease in compliance and limited applicability to incomes that potentially
escape taxation, the equalisation levy and withholding taxes have been
criticised widely on grounds that they violate the principle of neutrality. In
fact, these taxes are commonly referred to as unilateral measures, only to be
used in the interim. Businesses oppose these also since the levy, such as
that in India, are introduced outside the scope of the Income Tax Act and
no credit is available under the existing double tax avoidance agreements.
Other than the case where the income is not taxed at all owing to the
characterisation and the lack of basis to withhold or tax profits, the levy
could result in overtaxation. Especially since the levy applies to gross
revenues. Alternatively where the market structure is such that it can be
passed on will adversely affect the consumer. However, in cases where it
cannot be passed on to the consumer, a company with a low profit before
tax (PBT)by sales ratio may end up paying tax at a rate in excess of
statutory corporate tax rate. Say, a levy of 6 per cent, for any company with
a PBT by sales ratio below 20 per cent, would in fact amount to a tax on
profits higher than the statutory rate of 30 per cent. Thus the levy may be
reasonable only under limited circumstances. The new nexus rule such as
the test for SEP can ensure that the digitalised businesses are taxed on par
with the brick and mortar businesses while ensuring that they are not
overtaxed. However, for its general applicability, the rule will have to be
adopted in treaties along with domestic laws. Given that consensus is not
yet imminent on the very basis of nexus, interim taxes are being used
widely. It is possible that the overtaxation resulting from increased reliance
on unilateral measures may drive countries to form consensus swiftly.

Anticipating the future

The BEPS action plan did not explicitly intend to reset the allocation of
taxation rights between the state of residence and source. As it appears, the
discussions on taxation of digitalised economy have brought the issue to
the fore. The challenges that confront tax policy are measurement value
creation,its characterisation and suitable attribution. Given the intractable
nature of the problem, countries have resorted to the use of levies or
withholding taxes. The adoption of measures unilaterally, i.e. without the
provision of corresponding credits, can lead to overtaxation of certain
activities. Thus on one hand, if business continues as usual, there may be
undertaxation, whereas on the other hand unilateral measures such as levies
and withholding could result in over taxation. The new nexus rule is a
relatively balanced solution to the problem .A rule such as that adopted by
the EU, places relative significance on the contribution of users and
contracts concluded. If such definition is widely adopted it is expected that
developing economies that represent a large user base, will receive greater
right to tax incomes from digitalised businesses. In 2018 approximately
third of the users of Facebook were from six developing countries. Among
these is India, which has surpassed the United States with highest users at
270 million. It is expected that a new nexus rule based on users would
result in higher source based taxation. As a result, the rule may not gain
wider acceptance. Although countries such as India, have taken the lead in
recently introducing the test for SEP. This definition goes beyond the EU’s
definition to include data downloads. In spite of its introduction in the
domestic law, India or any other country adopting the test will not benefit
unless the tax treaties incorporate a similar article. In the international
context, the PE related articles in the MLI have not been adopted by a
number of jurisdictions. The said PE provision , however, is not sufficient
to tax digital activities. Therefore, even if the articles in the MLI are
adopted widely over time, they will not suffice. A revised article will have
to be inserted in the MLI, which in turn will have to be notified by all
signatories for its wider adoption. Given the rate of adoption of PE article
in MLI and the current lack of consensus, It expected that new nexus rule
may receive similar if not a more muted response. The European Union is
considering the common consolidated tax base as a solution to taxing cross-
border incomes. However, this too requires a formulary apportionment of
profits. For this consensus on the contribution of inputs such as data and
users to value creation is necessary. So that the weights may be assigned to
the relevant factors of production. Considering that digitalised businesses
have compounded the issue of attribution, the CCCTB may not be a tenable
solution. The test for SEP therefore emerges as a long term solution.
However it must be designed such that the thresholds are applied uniformly
and are not too high so as to result in under-taxation. Such a test will allow
jurisdictions where economic activity is undertaken to tax incomes
characterised as profits. However, for its wider acceptance consensus must
emerge on the role of user and data in value creation. Until this is achieved,
value created by digitalised businesses will remain unevenly taxed by a
patchwork of unilateral measures.

Bibliography
OECD (2018), Tax Challenges Arising from Digitalisation – Interim
Report 2018:

European Commission (2017), A Fair and Efficient Tax System in the

Euro-pean Union for the Digital Single Market

Digital Taxation: Commission proposes new measures to ensure that all

companies pay fair tax in the EU

WWW.Incometax.com

WWW.Goggle.com

WWW.Wikipedia.com