India: Significant Economic Presence – Paradigm shift in new Nexus Rules

“It is not the strongest that survive, not the most intelligent, but the ones most res­pon­sive to change”, Charles Darwin had said.  

 

The world is rapidly changing, newer business models are emerging. Digitalization has emerged as the way of living and doing businesses. With a dramatic shift in tradi­tional, “brick and mortar” business models, countries are trying to align their laws, and in particular, tax laws to cope up with these changes. Global efforts are centered around tackling these “Challenges arising from Digitalization”. 

 

The OECD/G20 Inclusive Framework has agreed a two Pillar solution to address the tax challenges arising from the digitalization of the economy. Frantic efforts are therefore underway at a global level to cope up with these challenges.

 

In addition to these concentrated efforts, countries are individually implementing changes in their respective tax laws. Many countries have implemented the “Digital Services Tax”. Most others have ammunition ready, to put in place measures to tackle digital business models, should the efforts of the OECD at global level do not progress in desired timeframe.   

 

India spearheads these efforts to tackle loss of tax revenue due to innovative digital business models by lea­ding the implementation of some of the measures proposed in the Action Plan 1 of the BEPS. India was among the initial few countries to introduce an Equalization Levy (by the Finance Act, 2016) on certain non-resident businesses. The levy was applied at a rate of 6 percent on specified services such as online ad­ver­tise­ment and any provision for digital advertising space or any other facility or service for the purpose of online ad­ver­tise­ment. The scope of this levy was expanded in 2020 to cover non-resident business operations facilitated by advancements in e-commerce sector, within its ambit.  

 

In addition to the above measures, India has also adopted the concept of “Significant Economic Presence” (SEP) through the Finance Act, 2018, again a concept borrowed from the Action Plan 1. It expanded the scope of taxing incomes of non-residents doing business in India. The SEP expands the scope of “business con­nec­tion” provisions, which are akin to but much broader than the concept of Permanent Establishment (“PE”) in tax treaties. The two concepts of “business connection” or “PE” are relevant, since business profits of non-resi­dents having a business connection or PE in India are taxed in India. This implies that non-residents could be subjected to higher tax liabilities and compliances in certain situations with broadening of the scope of business connection on introduction of concept of SEP.  

 

This Article focuses on the concept of SEP and its consequences for non-residents. 

 

A SEP is defined to include:

 

It has further been clarified that transactions or activities would create SEP irrespective of whether or not the non-resident has a residence or a place of business in India or renders services in India.  However, only income attributable to operations in India or transactions in India would be taxable.

 

It is pertinent to note that even though SEP provisions were introduced in FY 2018, implementation of these provisions was deferred on the grounds that the thresholds for constituting SEP were not finalised and dis­cus­sions on this issue were ongoing at a global level as a part of the OECD BEPS project. These provisions were eventually made operational from financial year 2021-22 onwards. 

 

The first limb of SEP seeks to include within its purview, transaction in respect of any goods, services or property carried on by non-residents. The explanation is an expansive definition and seeks to cover all trans­actions which relate to goods, services or property. 

 

The second limb of SEP deals with systematic and continuous soliciting of business activities or engaging in interactions with users, in India. Two activities are sought to be covered, one is soliciting of business activities and the other is engaging in interaction with users. 

 

One of the primary objectives of OECD BEPS Action Plan 1 (which has led to the introduction of the SEP rule) can be said to be bringing into tax net, income arising from new business models (digital transactions/busi­nesses) which do not require non-residents’ physical presence in the respective countries. 

 

The first and foremost challenge is the low thresholds, owing to which a large number of non-residents could get covered under the SEP. 

 

Secondly, as also explained above, the definition is widely worded. This would imply that even if goods are sold or services are rendered from outside India, the same may result in SEP in India if the revenue or user thresholds are exceeded. This may likely bring within the ambit of SEP, transactions of goods sold, or services rendered from outside India, thereby creating SEP for such non-residents, even though there may not be any activities undertaken by the non-resident in India or there may not be much change in business model due to digital advancements. 

 

The provisions as they stand today, are much wider and go beyond taxing digital business and transactions and seek to cover all and any transactions that non-residents may have with persons in India.   

 

The other question is whether income streams like royalties, cost recharges, etc could also result in SEP.  

 

The concept of continuity and regularity which are attributes of a business connection are disregarded in the manner in which the provisions are currently drafted. Stand-alone, stray and isolated transaction could also be held to constitute SEP, if the monetary thresholds are breached. 

 

Where a SEP is constituted, non-residents would be subject to tax in India on the basis of income attributable to operations/transactions in India. In case of income attributable in India, non-residents would need to comply with requirements of maintenance of books of accounts, conduct of audit and other compliances in India. However, this would be subject to tax treaty interplay, as explained below.

 

The SEP provisions do not seem to impact tax liability of non-residents, with which India has in place tax treaties, providing for a favourable tax regime. The onus to establish treaty residency, however, lies on the non-resident entity itself. 

 

For non-resident entities, who are affirmatively able to claim tax treaty benefits based on their residential status, tax residency certificate, beneficial ownership of income, etc.; SEP provisions will be overridden by the tax treaty provisions which provide that income of non-residents would be taxed in India, when they constitute a Permanent Establishment, which has some defined criteria in respective treaties. Gross basis taxation of certain types of income such as dividends, royalties, fees for technical services, etc. would continue to apply as earlier, even if there is no PE.

 

The SEP provisions impact non-residents from jurisdictions with which India does not have a tax treaty in place. For such entities, applicability of the SEP provisions would need to be evaluated. 

 

SEP provisions may also impact certain entity structures, for whom defence of tax treaty provisions may not be available. For instance, certain tax transparent entities like German, Austrian partnerships or US LLCs, the eli­gi­bility of tax treaty on the basis that such entities qualify as residents of the respective countries is a deba­ta­ble position in India. A position was being adopted in the past, by placing reliance on the basis of arguments, that “once the income and profit of a tax transparent partnership is taxed in the hands of the partners, the treaty benefit should be extended to the partners”. For German entities, the payment of trade tax by partner­ships themselves was considered to be a relevant factor for granting treaty benefit by Courts. With the insertion of a new definition of “liable to tax” vide Finance Act 2021, the controversy is further fuelled, and treaty access of such entities will need to be further deliberated.   

 

Having said that, non-resident entities still need to analyse, if the SEP provisions are applicable to them. This is because, non-residents who are obliged to file Income Tax Returns have to now declare in the Return if they have a SEP in the Income Tax Return form from FY 21-22 onwards (=AY 22-23). Accordingly, this imposes an onerous task on non-residents of compiling the necessary information and analysing transactions which need to be reported in the Return of Income as per new requirement of disclosures regarding SEP.  

 

In addition, payments made to non-residents may be subject to withholding tax in respect of certain income (interest, dividend, royalty, fees for technical services etc). Remitters of such income demand the non-residents to confirm if they constitute a SEP in India, in addition to requiring them to furnish certain documentation like TRC, NO PE declarations etc. 

 

Introduction of SEP provisions is an indication of how India seeks to tax profits of non-residents doing busi­nesses with India. Given the complexities involved, proper impact analysis of the new SEP provisions is required in respect of cross-border businesses carried with Indian entities, whether through digital or conven­tional means.