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All About Taxation of Digital Businesses

Digital economy is an economy which is digital technology based, although we progressively deemed this as conducting business via those markets which are based on the internet. The digital economy is also known as the Web Economy, Internet Economy or New Economy.

Direct Tax in India comes under the Income-tax Act, 1961. Residents are taxed on worldwide income and non-residents only on income whose source is in India. Companies are considered as residents on satisfying either of these conditions:

  1. Incorporation in India
  2. POEM (Place of Effective Management) is in India.

A company established outside India and having their POEM outside India is treated as a non-resident.

Taxation of non-residents is governed by the section 5 read with section 9 of the Act and provisions of DTAA (Double Taxation Avoidance Agreement). Business income is governed by the provisions of DTAA-section 9, where income is deemed to accrue or arise in India owing to an enterprises business connection in India. Under DTAA treaties, business profits are attributed to a PE (Permanent Establishment) as if it is a distinct and separate entity according to the provisions of Article 5 read with Article 7 of a DTAA. Such business profits can be taxed only if there exists a business connection or a PE in India at the rate of 40% on net basis, unless the income qualifies as royalty or FTS (Fees for Technical Services) which will be taxed at a rate of 10 per cent on gross basis. Further, according to the provisions of section 90(2) of the Act, a non-resident will be entitled to claim beneficial provisions between the Act and DTAA.

In order to address the tax concerns related to digital economy, these specific issues need to be resolved:

  1. Characterization of Income
  2. PE existence and attribution of profit.

There are major differences in the tax treatment of an income depending upon its characterization.

These primary categories under which income of non-resident can be classified are:-

  • Royalty
  • Fees for Technical Services (FTS)
  • Business Income

The tax rate of each income differs and totally depends upon its characterization. Where the non-resident / taxpayer has made an incorrect classification of an income or the characterization of income is not in tandem with the international principles, then such person may face risk of double taxation in different jurisdictions and also end up witnessing protracted litigation.

 Taxability of a non-resident income is represented below:

Nature of IncomeNo PE / Business Connection ExistsPE / Business Connection Exits
RoyaltyTaxable on gross basis at 10% or DTAA rate, whichever is lowerTaxable on net basis at 40% (to the extent profits attributable to PE
FTSTaxable on gross basis at 10% or DTAA rate, whichever is lowerTaxable on net basis at 40% (to the extent profits attributable to PE
Business IncomeNot taxableTaxable on net basis at 40%  (to the extent profits attributable to PE

Permanent Establishment & Attribution of Profits

Once the income is characterized based on the nature of transaction which is royalty or FTS, taxed can be levied as per the rates mentioned in the earlier table. However, if the income is defined as a business income, then unless a PE is established in India or there exists a business connection in India, the income cannot be taxed on foreign company / non-resident.

Equalization Levy

The finance world has been introduced the concept of ‘Equalization Levy’ vide Finance Act, 2016 in its domestic tax law. The levy was made effective from 1/07/2016. As per the provision, where any resident or a non-resident having a PE in India makes a payment for a specified service to a non-resident having no PE in India, and the aggregate consideration exceeds INR 10 lacs in a FY, and then taxes are to be levied at the rate of 6% on the amount of consideration.

Compliances & Regulation

Further, if the service recipient fails to credit the levy so collected to the treasury of the government, then he/she will have to pay simple interest @ 1% of such levy for every month. If the service recipient fails to deduct the equalization levy, then he/she will be liable to pay penalty equal to the amount of the equalization levy in addition to the levy to be paid.

Double Taxation

Equalization levy is defined in Finance Act as a separate chapter, it has been purposely kept outside the purview of the Act and therefore, the tax treaty benefit will not be available. As a result, foreign jurisdictions will not allow the non-resident Foreign Service providers credit of any taxes paid in the form of equalization levy in India that’s why no foreign tax credit will be available. This may eventually leads to double taxation, as the non-resident will have to pay income tax in its country of residence, although in different jurisdictions. This is one of the inherent limitations of the equalization levy.

The non-resident can have partial relief from such double taxation by claiming an expense deduction of equalization levy from their taxable income.