The changing face of technology has also changed the way businesses function across jurisdictions. Transactions originate off the shore of the receiving country, yet the utilization occurs in the latter, or even in a third country. Section 9 of the Income Tax Act, 1961 in India seeks to tax such offshore transactions. However, the allocation of the right to tax is guided through the principles of the Double Taxation Avoidance Agreements (DTAA’s).
The Organization for Economic Co-Operation and Development (the “OECD”), has produced a Model Tax Convention on Income and on Capital (the “OECD Model Treaty”) which serves as a guide to treaties across jurisdictions.
Article 5 of the OECD Model Treaty defines a permanent establishment (“PE”). A PE is a concept used to determine the right of one treaty country to tax the profits of a resident of an enterprise of the other treaty country. Such profits that are attributable to the PE are subjected to tax.
To assist persons in understanding and applying the OECD Model Treaty, the OECD also publishes commentary (the “OECD Commentary”) on the model treaty. One issue specifically addressed in the OECD Commentary on Article 5 is the extent to which engaging in electronic commerce may result in a PE (See Paragraphs 42.1 to 42.10 of the OECD Commentary on Article 5, available here).
Electronic commerce is the ability to perform transactions involving the exchange of goods or services between two or more parties, using electronic tools and techniques, which includes physical telecommunications networks, cable television, mobile, and cellular networks.
The OECD Commentary states that a web site does not itself involve any tangible property, and thus, cannot constitute a PE. However, if there exists a physical location and the requirement of the equipment being fixed is met, then the tangible property may constitute a PE.
This distinction between a web site and the server on which the web site is stored and used is important since the enterprise that operates the server may be different from the enterprise that carries on business through the web site. A server is generally owned and controlled by an unrelated Internet service provider (“ISP”). A contract for such hosting services does not typically result in the server and its location being at the disposal of the enterprise carrying on a business through the web site.
Consequently, the enterprise does not have any physical presence at the location where the server is located. This is because the web site is not tangible and the server is not at the disposal of the enterprise. The OECD Commentary notes that it would be very unusual for the ISP to be deemed to constitute a PE of the enterprise carrying on a business through a web site hosted on the ISP’s servers. Generally, the ISP will lack authority to conclude contracts in the name of the enterprise conducting the web site business (and will not regularly conclude such contracts) and will constitute an independent agent acting in the ordinary course of its business. The result may be different if the enterprise carrying on business through a web site has the server at its disposal because, for example, it owns (or leases) and operates the server. In such a case, the place where the server is located may constitute a PE. The argument that a server constitutes permanent establishment has been relied upon in certain negotiations for taxation in India.[i]
Policy Comments: The basis of the PE principle rested on the concept in the pre-digital age whereby accessing a market would require a business to establish in a host state in some form. This can now be achieved by sending bits of information via web into the host state, including exchange of payment.[ii] The erosion of PE as a tax treaty principle has been advocated by Arvid Skaar in his book ‘Permanent Establishment: The Erosion of a Tax Treaty Principle, 1st Indian reprint, Wolters Kluver India, New Delhi, 2008.
It is clear that in the present day scenario, the use of PE as a method of taxing operations in the host state is not feasible. This is due to the growth of e-commerce as a tool of business. The High Powered Committee on Indian Electronic Commerce and Taxation, has suggested a ‘base erosion’ approach to tax non-residents. The salient features of the concept are:
- The concept is applied to all commerce and not just e-commerce.
- The tax is implemented through a low withholding tax on all tax-deductible payments to the foreign enterprise.
- Preferably, the withholding tax is final without option of tax on net income being given to the taxpayer or the tax administration.
However, this would involve the concept of indirect taxation, including customs and thus, might not be a viable concept.
A more practical concept to adopt would be the “proxy access to market” concept. Under this concept, there is a radical shift from the country of 'value creation' to the country in which the market is accessible. While creation of value can now be achieved by automated software functions bearing no relationship to geographic boundaries, the same can be said for businesses' market access efforts. This subtle distinction between "location of value-creation" and a "market access" vantage also shifts consideration away from the existing arguments about e-commerce taxing jurisdiction and stimulates greater scrutiny of the activities used by e-traders/service providers to market their products. This would benefit developing nations to tax offshore operations of business, channeled through e-commerce.
Adding this market access proxy approach to the current debate featuring arguments for either revision or preservation of the traditional permanent establishment principles, in many cases, adds increased complexity and justification to proposals advocating reform.
Under the current PE rules, producers are increasingly able to use the nebulous nature of the web to avoid or minimize tax liabilities. We shall discuss in detail how Google has achieved an effective tax rate of 2.4% through its business structuring. At the same time it also translates into revenue loss for the exchequer.
Post Scriptum: It is important to note that the rules discussed above apply only in the treaty context, i.e., where the enterprise operating the website and the ISP are located in countries that have concluded an income tax treaty based on the OECD Model Treaty. Entirely different rules can apply if there is no treaty to rely upon.
