Changes in the provision relating to deemed accrual of income in India by Budget 2020

Business Connection:

SECTION 9 of the Income Tax Act deems certain incomes to accrue or arise in India even if these may not accrue under the ordinary interpretation of accrual in India. In the context of a non-resident carrying on business, it is declared that all income that directly or indirectly arises through a business connection in India is deemed to accrue in India and thus becomes chargeable to tax India under the domestic law.

Where a non-resident's business is carried out wholly in India, the whole of such non-resident's income arises in India. But in most of the cases, a non-resident's business is not likely to be carried out wholly in India alone. In such cases, the

This business connection nexus that exists in the Income Tax Act, is continuing from a long time since the British Raj and although the concept of business connection is considered to be much wider than the nexus as found in the treaty concept of permanent establishment, over the course of years, in judge made laws and even in view of circulars issued by the CBDT from time to time, its scope had narrowed considerably.

In the context of digitalisation of business, it is obvious that substantial business of a non-resident can be operated from abroad and moneys may flow out of India when operations are carried out in such a manner that the nexus or threshold of taxation in India is avoided. Following in the footsteps of the BEPS project Action 1 final report, when although no final conclusions were arrived out, the task force on digital economy considered three options to create the necessary nexus for taxation in the digitalised economy

The scope of the 'significant economic presence' was then to be defined. This was done through the insertion of Explanation 2A to section 9(1) as follows:

Explanation 2A.-. For the removal of doubts, it is hereby

(a)  transaction in respect of any goods, services or property carried out by a non-resident

(b)  systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India

Provided  that the transactions or activities shall constitute significant economic presence in India, whether or not,-

(i)  the agreement for such transactions or activities is entered in India; or

(ii)  the non-resident has a residence or place of business in India; or

(iii) the non-resident renders services in India:

Provided further  that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.

Although this Explanation expanded the scope of business connection concept, it still stipulated that the transaction should be carried out by the non-resident in India. At that time, I had written -"(…) there are some limitations even in the newly introduced explanation like the stipulation that the transaction in respect of goods, services or property  must be in India. This seems to be contrary to some of India's position elsewhere."

By the Finance Act, 2020, it seems that this has been corrected to the effect that the said explanation has now been replaced by a new explanation 2A, which contains almost the same language, with two minor but vital differences:

'Explanation 2A.-For the removal of doubts, it is hereby

(a) transaction in respect of any goods, services or property carried out by a non-resident

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India, as may be prescribed: (…)

Thus the requirement of the transaction to be carried out in India is dispensed with. Even if a non-resident carry on transaction with any person in India remotely, there may still be a significant economic presence of the non-resident in India. Secondly,

What is however more interesting is the fact that the Finance Bill, 2020 also proposes to introduce a new explanation in relation to attribution of income to a business connection in India as follows:

"Explanation 3A.-For the removal of doubts, it is hereby declared that the income attributable to

(i) such advertisement which targets a customer who resides in India or a customer who accesses the advertisement through internet protocol address located in India;

(ii) sale of data collected from a person who resides in India or from a person who uses internet protocol address located in India; and

(iii) sale of goods or services using data collected from a person who resides in India or from a person who uses internet protocol address located in India."

Having expanded the scope of business connection through Explanation 2A, the purpose of Explanation 3A seems to be to expand the scope of the income that is attributable to the operations carried out in India as required by Explanation1. This seems to be in the context of digital advertisement that is a hotly debated subject all across the world. The explanatory note however is rather vague relating to the reasons for adopting such a change. It states:

"Further, as per the discussion going on

This is a bit odd. The source rule in the Indian context will be the definition of business connection or what constitutes business connection. This has been expanded through Explanation 2A. The next issue is attribution as mandated in Explanation1. Explanation 3A expands the scope of attribution. That is perhaps the reason why after inserting the new Explanation 3A, a proviso has been added:

"Provided that the provisions contained in this Explanation shall also apply to the income attributable to the transactions or activities referred to in Explanation 2A."

But, Explanation 3A will take effect from 1st April, 2021 and will apply in relation to the assessment year 2021-22 and subsequent assessment years. However, for attribution of income related to SEP transaction or activities

Explanation 3A envisages three situations. The first situation in clause (i) covers income of a non-resident from advertisement targeting Indian residents or other clients that access the advertisement through an IP address in India. From the language used, this clause seems to concern income from advertisement targeted to Indian residents. The advertisement by this definition need not even be in India. All that is needed is that the advertisement should target a customer resident in India. Different websites hosted from outside target Indian customers and some may not target Indian customers specifically but may nevertheless attract Indian residents. Will it be possible to say that these 'target' a resident customer? Even if a customer accesses the advertisement through an IP address located in India, then also income from advertisement will be attributed. Here the customer need not even be resident in India Again, the question would be how the income from such advertisement will be isolated.

The second situation in clause (ii) of Explanation 3A treats income from advertisement from sale of data from Indian residents or others using an IP address in India. It is true that lots of data are collected from the users by the digital platforms. In fact, everybody seems to be collecting data from any user. It is also true that such data are mostly monetised. The now ongoing and already 7 year old debate on digital taxation at the OECD makes it clear that two-sided platforms collect data from customers by offering them free service and then utilise that data generated from the users for targeted advertisements by companies. Thus valuable data are monetised in some way or other. Apparently, only if such data are sold, there will be a trigger for any profit attribution under clause (ii).

The third situation in Explanation 3A envisages a situation where when data collected from Indian residents or even others from an IP address in India are utilised to sell goods or provide services. From the plain language of the Explanation, the sale of goods or services need not be to any resident of India but will encompass any sale of goods or services utilising such data. How these provisions will actually be implemented remains to be seen.

In that connection, we may note that the newly introduced provisions are enabling in nature. Section 295 that empowers the CBDT to prescribe rules has also been amended. It now will include specific framing of rules relating to manner in which and the procedure by which the income will be arrived in the case of

In so far as digital advertisement is concerned, we have already introduced the equalisation levy, although the same is limited to online advertisement and does not include other services such as web hosting services, cloud computing services, access to databases etc. The levy is of course charged on Indian residents or non-residents having a PE when they remit to non-resident online service providers abroad. Nevertheless, it is not entirely clear if there won't be any connection between the two, particularly when we keep in mind that the income that may arise to the advertisers has been specifically exempted by section 10(50) from taxation in India, where the levy is applicable.

Royalty:

There is also another change in section 9 although in relation to royalty that is deemed to accrue in India. Section 9(1)(vi) specifies the situations in which royalty income will be deemed to accrue in India. Responding to mostly adverse court cases, the scope of this deeming provision has also been progressively expanded over the years through addition of various explanations. The current Explanation 2((v) states that royalty means, amongst other things: "the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting, but not including consideration for the sale, distribution or exhibition of cinematographic films;" As far as I remember the highlighted portion was included to facilitate the filming of Richard Attenborough's Gandhi in India. But, it has continued in the statute ever since.

On the contrary, many of India's tax treaties give the taxing right to the source country as follows:

"The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films or films or tapes used for television or radio broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial, or scientific equipment, or for information concerning industrial, commercial or scientific experience."

But, the specific exclusion in section 9 means that such taxing right cannot be exercised by India in practice. This has now been corrected by omitting the reference to consideration for the sale, distribution or exhibition of cinematographic films.

Indirect transfer:

Explanation 5 to section 9(1)(i) was added after the Vodafone controversy specifically providing for taxability of capital gains from indirect transfer of assets. Many clarifications were subsequently added to attenuate the rigours of the provision. In 2015, an exception was made for assets held by non-residents by way of investment in Category I or Category II Foreign Portfolio Investors while category III investors could not avail of the same. Following revised categorisation of SEBI, there are now only 2 categories. Broadly speaking, Category I are well-regulated entities formed in FATF compliant jurisdictions. The exception from indirect transfer provision has now been restricted to Category I FPIs. Category II funds registered after September, 2020 will not get the benefit. Affected parties (Funds formed in Mauritius, Cayman etc.,) have latched on to the amendment and predicted dire consequences. One has to wait and see if their lobbying would be successful or not.