Permanent Establishment And Taxation Challenges In The Digital Economy

Introduction

The foundational principles of international taxation, meticulously built over the course of a century, are perched on one physical pivot-the Permanent Establishment (PE). A business’s profits are taxable in a source country if the enterprise has a PE there; meaning a fixed place of business through which the business is wholly or in part carried on. This notion which lies hidden within articles 5 and 7 in most of the Double Taxation Avoidance Agreements (DTAAs) is a concept that was conceived in a brick-and-mortar world and had an existence before an era of internet commerce rendered physical proximity irrelevant by nullifying spatial differences and boundaries. In the digital world, an MNE can do business “without a wall” around itself and get gigantic scale and huge profits from interacting with a market jurisdiction and its users without being physically present in the country. This discrepancy has both decimated tax bases and decimated a century-long consensus on nexus and the allocation of profits.

For India, a behemoth market for digital services and a key negotiator in the global tax arena, the situation is particularly problematic. The post-BEPS era has, by virtue of the OECD/G20 BEPS Project (especially its Action 1 concerning the digital economy), given India the intellectual and political heft required to revisit unilaterally its network of treaties. This article seeks to examine how this fundamentally new nexus challenge strains the concept of PE and analyses India’s aggressively pursued, treaty-based and legal responses: The Equalisation Levy and the Significant Economic Presence (SEP). Is this an evolution of international tax or a fragmentation?

The Crisis of the Classical PE Under a typical Indian DTAA, a PE can exist by virtue of being a fixed place of business, a construction or installation project, or an agent habitually having the authority to conclude contracts. Each of these limbs of the PE concept is undermined in the digital economy: Firstly, the “fixed place of business” notion clearly requires the use of physical premises at the disposal of the MNE. A foreign e-commerce website, online advertiser or cloud provider does not own or lease physical servers within India but uses services rendered by a local entity (or foreign service provider). There is no physical infrastructure at its disposal in the target market. It has been authoritatively stated that a server can indeed constitute a PE if it is owned or leased, and fixed; a standard business structure can simply avoid this by using third-party servers, as long as they are not leased or owned by the MNE.

Secondly, the “dependent agent” test focuses on whether a person is empowered to conclude contracts habitually. Contractual re-engineering often attempts to formalize arrangements with local agents to avoid this by having them conclude contracts as independent parties on their own behalf (a “principal-to-principal” arrangement). This concept is of course based on a person-to-person interaction. Post-BEPS, there is now an amended definition which states an agent is empowered to bind the enterprise if the contracts they habitually conclude are routinely concluded without material modification. But even this provision requires a person to play a role. The completely automated digital business can replace the agent with an algorithm. For example, the website automatically negotiates and concludes sales, where a person would previously have done so under an explicit agency or binding authority.

The BEPS Project and the Dawn of a New Nexus To repair these gaps, Action 7, part of the BEPS Project, modified the definition of PE by capturing, amongst other things, instances where “the person acting on behalf of the enterprise habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification.” While this has substance over form, it relies on a person and does not address wholly automated digital transactions. The true conceptually radical idea emanated from Action 1 of the BEPS Project which recommended the introduction of a new nexus rule – a “significant economic presence” (SEP). This notion would permit a tax jurisdiction to tax a non-resident enterprise on the basis that the MNE has a nexus with the market by having a sustained, purposeful interaction with that market’s economy through its use of digital technology based on various metrics including revenue and number of users, and the nature of digital contracts. This would be the first real move away from the physical connection benchmark.

India’s Unilateral Reassertion: From Equalisation Levy to SEP The lack of multilateral consensus led to India embracing radical unilateralism on the digital taxation front. Two legislative efforts stand out in this regard:

1. The Equalisation Levy, enacted in 2016, was India’s initial unilateral attempt at digital taxation, with a levy of 6% on the gross payments for targeted digital advertisements made by an Indian resident to a non-resident digital advertiser. Unlike the concept of PE or the idea of profit taxation, this levy was on the transaction, not the income, and thus artfully avoided any potential coverage by the DTAAs. The levy was constitutionally tested in 2021 in the Karnataka High Court and was upheld as a tax, distinct from income tax.
2. The Significant Economic Presence (SEP) legislation enacted in 2018, with effect from financial year 2021-22, is a direct Indian adaptation of the BEPS Action 1 notion. Section 9(1)(i) of the Income-tax Act, 1961, was amended, inter alia, to include in “business connection” a SEP.

Under the Act, a business connection will be deemed to arise if the non-resident carries on:

• (i) Transaction in respect of any goods, services or property carried out by a non-resident with any person in India, including the provision of any download of data or software, exceeding a monetary threshold as prescribed, and
• (ii) Systematic and continuous soliciting of business activities or any other form of interaction with the prescribed number of users in India. The SEP legislation is a paradigm shift in seeking to bring profits from digital presence within the scope of the Income-tax Act. A clear paradox arises: a nation’s internal law cannot unilaterally override the benefits granted to the non-resident from a treaty partner nation, and since existing DTAAs do not refer to SEP, the internal law would essentially be meaningless in the context of treaty partners, acting as a bargaining tool to bring them around to signing treaties with this new norm, or face treaty termination by India.

Re-evaluation of Indian DTAAs: The MLI and the Future India is a participant in the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) and has opted for minimum standards and certain options. India is a party to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”), where it selected the minimum standards along with a number of optional measures.

Significantly, it has added new Article 13 to the MLI, containing an optional source-based taxation of gains on the alienation of shares of a company when such company is an immovable property-rich company. However, the one relevant to this discussion deals with action 7: India has applied the principal purpose test for specific activities where exemption for a PE engaged in certain activities was denied on grounds that these preparatory or auxiliary activities formed part of a cohesive business structure.

Significantly, it has opted for the broadened agency PE rule under Article 12 of the MLI where there would be an agency PE where the dependent agent “plays the principal role leading to the conclusion of contracts.” By doing so, it has modified a vast number of its treaties with its most major trading partners like U.K., France and the Netherlands, to plug the agency PE holes. Thus, a marketing subsidiary that is a player, negotiating and closing deals for a foreign digital player is likely to have an agency PE in India regardless of the physical fact that the final signatures are taken outside the country.

Even then the MLI is only a stopgap solution. It cannot account for the wholly digital, automation driven economy where there is no local human agency. This is where the DTAA renegotiation process comes into play. The recent Indian DTAA with Mauritius, protocol with Cyprus, and on-going discussions with others indicates that while countries are yet to fully include an SEP clause in their treaties, “principal purpose test” along with other stronger anti-avoidance clauses that render treaty benefits unusable to structures lacking commercial substance are slowly finding their way into the treaties. This gives Indian tax authorities a broad power to disregard the artificial structures formed for escaping PE.

The Court’s perspective: Interpretational evolutions Courts, have been instrumental in defining this evolving landscape. The judgment by the Apex Court in the “Formula One” case (2017), even though on physical event, set a modern business sensible test for Fixed Place PE holding that even temporary control over the place for the purpose of the event was sufficient to make it a place of business, where it need not be of an enduring nature. This teleological interpretation signals the court’s ability and willingness to look beyond the form into the substance.

The case of Right Florist (2023) heard by the Income Tax Appellate Tribunal dealt with SEP rule, holding that, since no SEP provision existed in India’s DTAA with the concerned country (USA in this case), domestic law concept of ‘business connection’ could not be read into the treaty and PE rule definition would take supremacy since it is narrower. The decision reiterates the principle that treaties override domestic law but implicitly highlights India’s need to renegotiate its DTAAs if it seeks to tax the digital SEP.

Conclusion: Fragmentation or consensus?

India’s post-BEPS policy is a calculated gambit. It has not sat passively, but instead has emerged as a dynamic and somewhat aggressive player that is not afraid to redefine the borders of fiscal sovereignty. While its digital services tax legislation and its stance with respect to SEP provisions may not have met with unqualified success, it has successfully managed to rework a number of its DTAAs through the MLI, particularly in relation to agency PEs, the true legal battlefield. Ultimately, its efforts will be judged on whether the global community will ultimately align around the OECD two-pillar solution which, in theory, replaces a patchwork of unilateral measures with two pillars for redistribution of profits (Pillar 1) and setting a global minimum tax (Pillar 2). For India, the challenge will be to reconcile its unilateral, innovation driven approach with the future consensus to be achieved, lest its tax treaties become a historical record rather than living, breathing instruments suited to the new digital age. In this regard, the re-evaluation of its tax treaties is a continuous, unending process.