India’s digital service tax landscape and its implications

As India becomes more digital, it is facing challenges related to taxation and unfair competition in the digital space. It has therefore introduced a series of measures for ensuring a level playing field. These measures, however, have stirred up a huge debate, which this blog explores.

• The issue of fair taxation in international trade of digital services was taken up for the first time by the Organisation for Economic Co-operation and Development in 2013.
• In 2016, India became the first country to introduce a 6% Equalisation Levy on digital advertising services provided by non-residents. Subsequently, in 2020, a 2% Equalisation Levy was introduced on services provided by non-resident e-commerce operators.
• This was done to neutralize the “unfair advantage” that MNEs enjoy over their Indian competitors, both digital as well as brick and mortar ones as the latter have to be fully tax compliant.
• The US has called the Digital Service Taxes imposed by India and other countries discriminatory and is planning retaliation. As India and other countries begin to take unilateral measures, it is extremely important that parallelly, they actively participate in OECD deliberations to reach a global consensus to harmonise taxation in digital space at the earliest.

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The interaction of digitalisation and globalisation in the 21^st century has given rise to multinational enterprises (MNEs) that have taken the world by storm. These enterprises have penetrated global markets by offering unique products and services via the internet. However, problems arise as although they have huge economic presence in numerous countries, they often lack a physical presence there, leading to ambiguities regarding taxation of such cross-border trade of goods and services.

This issue was first acknowledged in 2013 with the Organisation for Economic Co-operation and Development (OECD) publishing an action plan on base erosion and profit shifting (BEPS) to prevent cases of “double non-taxation as well as cases of no or low taxation” using a “consensus-based” approach. In 2015, it recommended minimum standards under each of the fifteen action items of the plan. This is a major development as around 130 countries will be now committing to implement these standards collectively by mid-2021.

Timeline of India’s Digital Service Tax

India indubitably stands out as one of the most promising digital markets in the world, with over 500 million active internet users, as of 2019. There are estimates that this number will shoot up to 750-800 million by 2023. It is, therefore, only natural that world’s top digital companies like Amazon, Facebook and Google count India among their top markets globally and continue to devise strategies to expand and diversify their presence further.

To examine tax issues in India’s rapidly growing digital market, a Committee on Taxation of E-Commerce was constituted by the Government of India in March 2016. With the OECD’s BEPS Action 1[1] Report as a source of inspiration, the committee recommended imposition of Equalisation Levy on payments to non-residents for specified services to ensure a level playing field between residents and non-residents.

The Equalisation Levy being a tax on payment (and not on income) would be outside the purview of Income Tax and tax treaties, the committee stated. Subsequently, a 6% Equalisation Levy (EL 1.0) was introduced in Finance Act, 2016 for taxing digital advertising and related services provided by non-residents who do not have a permanent establishment in India. The tax came into effect on June 1, 2016. The tax is charged on gross payable amount exceeding INR 100,000 in a financial year for transactions of business- to-business nature. With this, India became the first country to unilaterally impose a digital service tax (DST) on cross-border services.

Lately, e-commerce services have also been brought under the ambit of DST. Finance Act 2020, with effect from April 1, 2020, legalised the imposition of a 2% Equalisation Levy (EL 2.0) on considerations received by non-resident e-commerce operators who do not have a permanent establishment in India. The services included here are online sale of goods, services or a combination of both. Unlike EL 1.0, EL 2.0 covers both business-to-business and business-to-consumer transactions for considerations exceeding the value of INR 2 crores. Another point worth highlighting is that while in the case of EL 1.0, the payer is required to withhold the levy from payable amount, EL 2.0 is to be directly paid by the e-commerce operator.

Rationale behind the tax

The Committee on Taxation of E-Commerce highlights the importance of the digital tax in neutralizing the “unfair advantage” that MNEs enjoy over their Indian competitors, both digital as well as brick and mortar ones as the latter have to be fully tax compliant. It is believed that, if not corrected, these tax distortions may incentivize Indian firms to relocate overseas or sell their business to foreign firms, thereby hindering the burgeoning Indian digital industry’s growth.

It also notes that the non-payment of taxes by the enterprises translates into huge revenue losses for the country and also implies higher tax burden on Indian enterprises. India has imposed the tax unilaterally instead of arriving at a consensus with other countries under the OECD framework. This is because India believes that arriving at a consensus on international taxation issues is going to be a long process due to the fundamentally different positions the participating countries have over various provisions. The duty is further justified on the grounds that the OECD allows for imposition of equalisation levy by individual countries as long as the tax treaty obligations are adhered to.

Debate around India’s DST

India’s DST measures have stirred up a global debate. A number of issues pertaining to its design, manner of implementation and implications have been pointed out. Firstly, it is argued that the act was passed in a rushed manner in the middle of a pandemic, without consulting the stakeholders involved. Secondly, the clauses are believed to be lacking clarity on several important terms and coverage. For example, under EL 2.0, it is unclear if only digital goods and services are to be taxed or physical ones too that are ordered online. Similarly, it is unclear how middlemen facilitating e-commerce sales will be taxed. Thirdly, it is pointed out that since the levy doesn’t come under the purview of Income Tax, the MNEs can’t claim a tax credit in their home countries, thereby inflating the cost of doing business. Fourthly, it is feared that the levy may do more harm than good to Indian firms, particularly small businesses and start-ups as many of them use the platforms of MNEs to sell their products. The MNEs may also choose to transfer the costs of tax payments on the Indian businesses.

In a major setback, United States Trade Representative’s investigation report on India’s DST has deemed the tax to be “discriminatory, unreasonable and restrictive for US digital companies and thus actionable under Section 301”. The reason cited is that India has excluded the domestic businesses and non-digital providers of identical services from the imposition of DST. Ambiguity in the provisions regarding key aspects such as scope of services and companies covered is also flagged as a concern for US companies. The report asserts that out of 119 companies likely to be affected by the tax, 86 (72%) are US based, leading to an additional US$ 30 million tax burden per year, approximately.

Another Trade War?

In the recent years, several countries have enacted taxes on digital services. USTR’s investigations so far have concluded that DSTs adopted by France, Austria, Spain, United Kingdom, Italy and Turkey are also discriminatory against US companies. The US has, therefore, announced retaliatory tariffs to the tune of US$ 1 billion annually, to offset the DST revenue collected by the countries from the US companies. In the case of India, it is believed that a 25% tariff would be imposed by the US on around 40  products like rice, shrimps and gems and jewellery. India has responded by reiterating that the tax is imposed to ensure fair competition among resident and non-resident companies and applies equally to all non-residents. If the countries choose to retaliate, it would unleash another ugly trade war.

With the world reeling under the COVID-19 pandemic, developing countries like India are facing huge strain on their resources. On the other hand, in the past year, digitalisation has accelerated at an unprecedented pace, benefitting the digital companies greatly. It thus makes sense for India to ask MNEs to pay their fair share of taxes. However, the issues pointed out in India’s DST structure, particularly the ambiguity in the text should be addressed urgently for smooth implementation and better compliance. Besides, as India and other countries begin to take unilateral measures, it is extremely important that parallelly, they actively participate in OECD deliberations to reach a global consensus to harmonise taxation in digital space at the earliest.