SO, we now have a brand new entrant in the area of international taxation and the pioneer this time is India. The budget 2016 has proposed an ‘equalisation levy' to be effective from a date to be notified. This is India's answer to the base erosion and profit shifting by international digital companies that has been engaging the attention of the developed and emerging countries since the eruption of the financial crisis almost a decade ago.

The OECD that was tasked by the G-20 to come out with an appropriate response to the phenomenon of tax base erosion and profit shifting by multinationals came out with its final recommendations on 15 action points in November 2015. The OECD proclaimed that India and other non-OECD member countries have been enthusiastic participants in the BEPS project. Much of the initial enthusiasm of India and other fellow developing countries however stemmed from the grudging recognition by the OECD that the digitalisation of business has exacerbated the BEPS concerns of the countries and calls into question the basic infrastructure of the international tax system put in place by the developed countries almost a century ago. The system has worked so far to the advantage of the developed economies and many of these countries are even now wary of any change in the fundamentals of that architecture. That's the reason that the OECD BEPS action point 1 has not come up with any definitive plan on the ground that the world economy itself has become digital and it is not possible to further ring fence the digital economy.

However, the final report on action point 1has two components- one relating to BEPS concerns as understood by the OECD and the other relates to those aspects of the digital economy that raise some broader issues. In so far as BEPS are concerned, the task force on digital economy (TFDE) took the view that solutions suggested in other action points of the BEPS project and more particularly the proposal to modify the list of exceptions to the definition of PE to ensure that each of the exceptions is restricted to activities that are otherwise of a preparatory or auxiliary character will substantially take care of the BEPS concerns arising out of the digital environment. Moreover, the proposal to introduce a new anti-fragmentation rule would ensure that it is not possible to benefit from these exceptions through the fragmentation of business activities among closely related enterprises. By way of an example, it is mentioned that the maintenance of a very large local warehouse in which a significant number of employees work for purposes of storing and delivering goods sold online to customers by an online seller of physical products whose business model relies on the proximity to customers and the need for quick delivery to clients would constitute a permanent establishment for that seller under the new standard.

Under action point 7, the OECD has agreed to modify the definition of agency PE to address circumstances in which artificial arrangements relating to the sales of goods or services of one company in a multinational group effectively result in the conclusion of contracts. It has been proposed that in such cases, the sales should be treated as if they had been made by that company. This is stated to partly answer the problems created by the digital companies. Again by way of example, it is stated that where the sales force of a local subsidiary of an online seller of tangible products or an online provider of advertising services habitually plays the principal role in the conclusion of contracts with prospective large clients for those products or services, and these contracts are routinely concluded without material modification by the parent company, this activity would result in a permanent establishment for the parent company.

Besides, according to the OECD, the revised transfer pricing guidance makes it clear that legal ownership alone does not necessarily generate a right to all or any of the return that is generated by the exploitation of the intangible, but that the group companies performing the important functions, contributing the important assets and controlling economically significant risks, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return. Since digital companies rely heavily on intangibles, this proposed measure again is supposed to take care of some of the concerns.

It has also been asserted that the recommendations on the design of effective CFC include definitions of CFC income that would subject income that is typically earned in the digital economy to taxation in the jurisdiction of the ultimate parent company and thus residence country's tax base would be protected to some extent.

According to the OECD, the implementation of these measures together with the other measures such as minimum standard to address treaty shopping arrangements, best practices in the design of domestic rules on interest and other deductible financial payments, application to IP regimes of a substantial activity requirement with a nexus approach will substantially address the BEPS issues exacerbated by the digital economy both at the source country level and also at the residence country level.

As mentioned earlier, the OECD however recognizes that the digital economy raises broader tax policy issues in particular in relation to nexus, data, and characterisation. The report mentions that the TFDE discussed and analysed a number of potential options, namely (i) a new nexus in the form of a significant economic presence, (ii) a withholding tax on certain types of digital transactions, and (iii) an equalisation levy However, none was recommended at this stage in the hope that other measures developed in the BEPS Project will have a substantial impact on BEPS issues identified in the digital economy and some of these measures will mitigate some aspects of the broader tax challenges.

The report states that countries could, however, introduce any of the three options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties. According to the report, the adoption of the options as domestic law measures could be considered if a country concludes that BEPS issues exacerbated by the digital economy are not fully addressed, or to account for the time lag between agreement on the measures to tackle BEPS at the international level and their actual implementation and application. According to the report, by adopting this approach, countries could address their concerns about BEPS in the short term and gain practical experience with the application of the options over time that can then be used to foster co-ordinated domestic law approaches in future.

From the above, it is therefore clear that right now, the OECD does not propose to do anything about the digital economy firms per se except for monitoring the developments in this sector till 2020 when presumably some consensus may emerge. In this connection, the OECD report mentions developments like the internet of things, peer to peer commerce etc. that are taking place at a fast pace.

The OECD BEPS digital report on the digital economy overall acknowledges that it is possible for non-residents to be heavily involved in the domestic economy of market jurisdiction without creating the nexus that is currently required for the market economy to tax any part of income that is generated by the different The report acknowledges that it poses significant policy challenges in terms of nexus, data and characterization. Besides as pointed out in several scholarly papers, there are also challenges in respect of valuation of user data and contribution that are relied upon by enterprises for earning profits from jurisdictions.

The digital companies also exist in the domestic jurisdictions. However, coherence in the matter of domestic taxation whereby the expenses of one is the income of another should normally take care of the concerns relating to base erosion. However, there is no such coherence in the matter of international taxation and often times the expense claimed in the source country is not followed by the taxation of the corresponding income. This state of affairs thus also discriminates against companies that are purely domestic players as against those that are multinationals.

It is therefore necessary for states to take remedial actions, particularly for levelling the field for the domestic players and the multinationals. In that context, some countries have already taken unilateral actions. As we have seen that the OECD has suggested three options that the countries might adopt. It is therefore necessary to briefly examine the relative merits of the three options suggested by the OECD.

The OECD report mentions that the nexus based on the concept of significant economic presence would create a taxable presence on the basis of factors that evidence a purposeful and sustained interaction with the economy in question via technology and other automated tools. The factors could be revenue based or even digital like a local domain name, a local digital platform, a local payment option etc. The significant economic presence could also be on the basis of user-based factors like monthly active users or the volume of digital content collected.

However, even if a significant economy presence criterion is used to create some kind of aPE, it will require modifications to be incorporated both in the domestic law as also in the treaties. Besides, unless there is a change in the rules relating to the attribution of profits, very little profit could be allocated to such economic presence and there won't be much gain for the revenue.

As for the option of the levy of withholding tax on certain payments made to non-resident providers of goods and services ordered on line, there will be problems of collection of the tax . Moreover, In the Indian context where the withholding tax is linked to the ultimate chargeability of the income in question, the option would be feasible only if the existing treaties are considerably modified.

That then leaves us with the third option of introducing an equalization levy that according to the OECD report avoids some of the difficulties from creating new profits attribution rules for purposes of a nexus based on significant economic presence. The Report states that this approach has been used by some countries in order to ensure equal treatment for foreign and domestic suppliers and that such a levy is intend to remove the disparity in tax treatment between domestic and foreign players.

The Report however flags the issue of potential conflicts of such a levy with some existing trade agreements particularly involving the EU. In the Indian context, it does not seem that such a levy will be in contradiction with any of our existing trade agreements. The Report also mentions that the relationship of the levy with corporate income tax may be a cause for worry where the foreign entities are charged with the levy in the source State and also pays corporate income tax at residence. One possible solution suggested is that levy could be credited against the corporate income tax.

It is in consideration of the above that budget 2016 has adopted the equalization levy as the best option. The proposal places the equalization levy in the domestic law as it becomes difficult to incorporate the same in all the tax treaties concluded by India. Such a levy is different from the tax on income and hence could not be placed as part of the Income Tax Act. Therefore the levy has been kept as part of the Finance Bill as was done in the case of Securities Transactions tax. The Finance Minister, in his speech, also mentions that application of the provision is restricted to B2B transactions. This is achieved by keeping the threshold of the transactions at INR 100,000 per year and by stipulating that any payment for personal purposes will be out of the purview of the levy. The income component of the levy has also been kept out of the income tax charge by giving an exemption under section 10(50). However, although the charge of the tax is on the non-resident, the tax is to be collected by the payer and all the obligations of collecting the tax and depositing the same to the exchequer in time and submitting the necessary particulars are placed on the payer. The payer is either an Indian resident or a PE. Naturally, there is also a provision for penalty for non-complaince by the payer.

The charging section in respect of the levy is section 162 of the Finance Act and states as follows:

162. (1) On and from the date of commencement of this Chapter, there shall be charged an equalisation levy at the rate of six per cent. of the amount of consideration for any specified service received or receivable by a person, being a non-resident from–– (i) a person resident in India and carrying on business or profession; or (ii) a non-resident having a permanent establishment in India.

Specified service has then been defined as follows: "specified service” means online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Central Government in this behalf.

For the moment, the levy is thus restricted principally to online advertisement and other significant form of digital payments from India, whether in respect of web hosting services, cloud computing services, access to databases etc. are not within its ambit. It seems that the committee that had recommended the levy and that included representatives from the private sector, wanted its scope to be much wider. However, the government may be testing the waters by restricting it to online advertisement alone for the moment at least.

But then what is online advertisement? Wikipedia defines online advertising as follows: "Online advertising , also called  online marketing  or  Internet advertising  or  web advertising , is a form of marketing and advertising which uses the Internet to deliver promotional marketing messages to consumers. It includes email marketing, search engine marketing (SEM), social media marketing, many types of display advertising (including web banner advertising), and mobile advertising." According to some reports, the online advertising market in India was projected to reach INR 3,575 crore by March 2015 with a year on year growth rate of 30 per cent. The market was pegged at INR 2,750 crore in March 2014. Search and display are the top two contributors to the total digital advertisement spends in India. Of the total digital advertisement market, search ads constitute 38 per cent of the overall ad spends followed by display ads, which contribute 29 per cent with the social media contributing 13 per cent of overall digital advertisement spends. (Source: http://www.bestmediainfo.com/2015/09/online-advertising-market-pegged-to-grow-at-30-yoy-in-india/ ). According to another report, online advertising market in India could jump threefold to INR 10,000 crore by 2018, increasing at a compound annual rate of 28 per cent. Of course, some of this will relate to domestic players as well but the foreign players dominate the space at the moment and the revenue involved could be substantial.

So, what have been the reactions to the proposal? As usual there are already murmurs of discontent. Fortunately, there is yet no allegation of tax terrorism. But, let's wait and see. So far, the issues raised against the levy relate mainly to credit of the levy. In that context, it may be noted that credit of taxes will have to be granted by the country of residence of the taxpayer. The residence country may, on its own allow the credit since the same is in line with the OECD proposal relating to BEPS. Besides, if other countries also choose to impose a similar levy, the government might consider entering into any appropriate reciprocal agreement.

A point was made that in respect of some of the services, there is a reverse charge mechanism and hence it may not be correct to say that no tax is paid on such services. However the counter point is that the purpose of the levy is to create a level playing field between the domestic players and the MNCs. The domestic players are also subject to the service tax levy and hence the field remains skewed in favour of the MNCs in the area of income tax and that is the area that is sought to be leveled.

The other point made was that the levy at 6% of gross payment might be quite high. In the absence of the figures relating to profitability of the disparate players in the sector, it may be difficult to comment on the profitability. In this connection, it may be noted that the diverted profit tax introduced by the UK has also been kept out of the corporation tax, is levied at a higher rate and no credit is available. The idea seems to be to nudge companies to create a PE in the market jurisdictions and then these can pay tax on net basis. The same logic applies in case of the equalisation levy.

A point is also made that the levy will be ultimately passed on to the payers. That is a risk relevant for all withholding taxes and will depend on the market forces. The option to advertise through the domestic companies may, however, keep such temptations at bay.

There may still be small issues in the actual implementation of the scheme but these can be sorted out in course of time. There are many action points even relating to the OECD BEPS action plan where action is necessary but no action has been taken as yet. Thus, there is no action in respect of neutralizing the hybrid mismatch arrangements, no action on CFC or for limitation of interest deduction, or for disclosure of abusive arrangements. Even the recommendations relating to transfer pricing will have to be ultimately translated into the domestic law. This first tentative step taken by India is therefore welcome and one only hopes that even this is not further diluted under pressure from any quarters.