Legal Narrative
ABSTRACT
The discovery of borderless, user driven digital commerce has ended the international tax treaties of the 20th century which was based on the brick and mortar theory. The definition of Permanent Establishment (PE) under the OECD and UN Model Conventions has failed to capture foreign technological giants which lacked the physical presence. After that OECD has come up with BEPS Action 1 and in which India pioneered the unilateral mechanisms to safeguard its sovereign tax base. The Equalisation Levy introduced in 2016 and India has come with Significant Economic Presence (SEP ) doctrine and enacted it under the Income tax Act, 1961. This article has analysed the structural reforms and conflict among these regimes , and the shift in India’s fiscal strategy ,the abolition of the 2% e-commerce equalisation levy in 2024 and the operationalisation of the SEP threshold. Examining these developments and related conflictual issues like treaty override, extra territorial issue and administrative compliance etc. This article has followed a balanced approach between multilateralism and unilateralism.
Introduction : The end of Physical Enterprise rule
For a long time , the international tax regime was working on the concept of taxing rights over active business income only when a foreign enterprise crossed its physical boundary. As per article 5 of OECD and UN model double taxation conventions . The rule of permanent establishment was designed for an era of brick and mortar, enterprise warehouses etc. Under this rule sovereign taxing rights hold where the machinery physically established.
After the fourth industrial revolution came into global picture it made the brick and mortar taxation doctrine obsolete. Now omnipresent tech giants whether it is search engine , software as a service or cross border marketplaces these all are extracting huge commercial value from the sovereign consumer foreign territory while maintaining the zero physical presence in that country. Today whole value creation has shifted from capital in the form of physical presence to its services and user participation, data harvesting , behavioral analytics.
The OECD has noticed these loopholes and they initiated a project called Base erosion Profit Shifting ( BEPS) with the aim to prevent these big giant tech companies from moving their profits to tax havens but at that time different countries could agree on these rules that’s why the project got delayed. At the same time India being the vast growing internet users country was losing a lot of tax money. Therefore it came up with two pronged strategy that is Equalisation levy and Significant Economic Presence to tax these digital giants.
The Equalisation Levy:
India has pioneered the digital tax concept with the reforms in the Finance Act, 2016, in which it introduced 6% Equalisation Levy on the online advertising payments to non resident entities, so that it can bypass the international tax treaty protection. In 2020 it triggered international trade friction and the USTR investigation which declared the levy discriminatory against American tech companies when the government came with a 2% levy on the gross consideration for the online e-commerce supplies. Furthermore the levy operated on the gross turnover rather than net profit, which mostly and severely hurting the low margin high volume platform business. But to ease the trade tension that arose due to this India has abolished the 2% e-commerce levy in 2024 while deliberately retaining the original 6% advertising levy.
The Significant Economic Presence:
Along with the Equalisation levy the government started to do deeper structural reform within the direct tax legislation itself. Through the Finance Act, 2018, India added the explanation 2A to section 9(1)(a) of the Income tax Act, 1961 which formally inaugurated the Significant Economic Presence doctrine in which it established that digital interaction alone constitutes a taxable nexus. In this new addition 2A an SEP is established if a non resident crosses these two following quantitative thresholds:
1. The Transaction Threshold: Any transaction either in goods, services, or property done by a non resident with any person in India, where total transaction or payments exceed Rs. 2 crore during a financial year.
2. The User Threshold: Any foreign business engaging with 3 lakhs or more users in India is deemed to have a significant economic presence.
This new law marks a huge shift away from traditional tax rules based on physical presence by passing the tax liability on the size of user base data because users are not just the passive buyers rather it builds actual financial value for the companies.
Jurisprudential and Practical Clashes:
Domestic SEP vs. DTAA Treaties
Under established Indian jurisprudence the landmark judgements such as Union of India v. Azadi Bachao Andolan , 2004 and Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT, 2002 in these rulings the provisions of under DTAA override domestic tax laws as it is more beneficial. Issue with SEP reform:
As per this treaty even if a non resident tech company crosses RS. 2 cr. revenue line or have users more than 5 lakh even though that entity resides in a treaty partner jurisdiction such as USA , UK , Singapore, Ireland it can invoke article 7 and article 5 of the relevant DTAA to make it treaty shield. At the same time domestic SEP cannot unilaterally reform the bilateral negotiation of changing the definition of “ Permanent Establishment” .
Therefore , the scope of SEP primarily hits non resident tech companies operating from non treaty jurisdictions , tax heavens , but for those traditional jurisdiction enterprises , the SEP remains silent.
Attribution complexities and Administrative Realities:
Even if international tax treaty protection fails even though India’s domestic tax system faces massive administrative hurdles, especially profit attribution due to difficulty of attributing digital profits to local activities. Practically, 3 lakh user threshold under Rule 11UD imposes borderline compliance requirements impossible on medium sized foreign SaaS vendors.
Conclusion and Suggestions:
India’s reform journey over the past decade from the introduction of equalisation levy in 2016 to its expansion in 2020 followed by its roll back in 2024 and again introduction of SEP indicates the tension between source based revenue claimed by sovereign and the tax treaties of the 20th century. Here India is rightly demanding the taxing rights by these reforms but unilateral measures make it problematic.
Suggestions:
India must amend the definitions of permanent establishment with its key bilateral DTAA to include digital and user based economic presence.
The central board of direct tax must come up with a clear and safe attribution methodology to remove arbitrary scrutiny from assessing officers.
India should positively engage with the body like OECD because long term stability of the digital economy can not survive without global coordination because it is beneficial for international investment and helps in removing perpetual jurisdictional disputes. The success of the SEP regime depends on the same treatment provided to digital users as brick and mortar factories.
I declare that this article is my original work on the topic allotted to me ; that the similarity index is below 9% and that any use of generative AI is below 15% and has not substituted my own analysis; and that is all the authorities have been cited.
References and Footnotes
1. Equalisation Levy Rules, 2016 , Chapter viii Finance Act, 2016
2. Finance Act, 2020
3. Income Tax Act 1961, Section 19(1)(a) Explanation 2A
4. Income tax Rules, 1962 Rule 11UD, 2021
5. Union of India v. Azadi Bachao Andolan, 2024
6. Engineering Analysis Centre of Excellence Pvt. Ltd. v. Income tax, 2022
7. OECD , Action 1- 2015 Final Report and OECD BEPS Project, 2015
8. Central Board of Direct Taxes rules.
