Background

India is again at the forefront of discussions globally; this time for some of the tax related proposals made in the Union Budget. Amidst high expectations and in the backdrop of some big bang reforms, the Hon’ble Finance Minister presented the Union Budget 2018. Several interesting and far reaching proposals have been made.

This Article discusses the proposals made in relation to “Business Connection” which have an impact on non-residents entities doing business with India.  

India’s involvement in the Base Erosion and Profit Shifting (BEPS) project has been intensive. Ever since this project was initiated a few years ago, the buzz has always been that India will likely be one of the first countries to take concrete steps to tackle concerns over BEPS and perceived international tax avoidance techniques of high-profile multinationals.

India being significant contributor to the creation of BEPS Action Plans and the Multilateral Instrument (MLI) implemented some BEPS AP recommendation through amendments in the Indian domestic tax law [i.e. Income-tax Act, 1961 (IT Act)]. E.g. CbCR, secondary adjustments, thin capitalization, etc. 

Concept of Significant Economic Presence introduced

Taking a step forward, the Budget of 2018 has proposed introduction of the concept of ‘SEP’. The scope of section 9(1)(i) of the IT Act dealing with Business Connection is proposed to be widened to include ‘SEP’.

The proposal states that ‘SEP’ of a non-resident in India shall constitute a business connection in India. For this purpose, ‘SEP’ shall mean:

i. any transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the tax year exceeds such amount as may be prescribed; or

ii. systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means

It is also proposed that the above transaction or activities shall constitute SEP in India whether or not the non-resident has a residence or place of business in India or renders services in India.

The above proposal marks a significant departure from the existing nexus rule based on physical presence. The new nexus rule seeks to bring within the tax fold foreign entities having significant virtual presence in India or earning income by serving Indian customers through internet with a flick of a switch.

With continued focus on digitization coupled with a growing population, the number of internet users in India has increased exponentially over the last few years. Innovative business models are emerging which are primarily driven by digital platforms. There are scores of foreign entities who are doing business with India through digital means. The above proposed amendment is likely to impact such companies.  

The above proposal is an enabling provision and the Government has clarified that the thresholds etc. for determining the SEP will be prescribed after consultation with the stakeholders. This is in line with the inclusion approach of the Government.

Interestingly, the existing concept of PE is still evolving through various judicial pronouncements with some issues now being adjudicated at the Apex Court level, the above proposed amendment may throw up interpretation challenges owing to complex business structures/ transactions and consequently trigger litigation. Further, it would important to see that if there is any overlap with ‘equalisation levy’ which is imposed for online advertisements.

Scope of business connection aligned with modified rule of Permanent Establishment PE as per MLI

As per the existing provisions, the scope of Business Connection (relating to dependent agent) under the IT Act is broadly similar to the provisions relating to Dependent Agent PE under Tax Treaties. Similarly, the definition of ‘Business Connection under the IT Act excludes certain prescribed preparatory or auxiliary activities similar to the PE definition in Tax Treaties.

The BEPS AP 7 recommended lowering the dependent agent PE threshold by providing that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts. The BEPS AP 7 also recommended the introduction of an anti-fragmentation rule so as to prevent a tax payer from resorting to fragmentation of functions which are otherwise a whole activity in order to avail the benefit of exclusion clause given in the PE definition (i.e. preparatory and auxiliary activities). These recommendations are now a part of the MLI signed by various countries last year, and to which India is also a signatory.

In line with the recommendations, an amendment has been proposed to align the provisions of section 9(1)(i) with the modified rule of PE (post modifications by the MLI, which is signed by various countries last year, and to which India is also a signatory).

Thus, even in case where the Indian agent of the non-resident only does marketing activities in India and the final contracts are executed / signed by the non-resident, having participated and played a principal role in conclusion of contracts, the agent would be regarded as a dependent agent thereby constituting a PE of the non-resident in India. In practice, it is possible that commercially the agent may be involved in negotiations, though such negotiations are always subject to limits set by the non-resident principal and subject to final approvals from the non-resident principal. Such arrangements may entail tax consequences in India.

This proposal may impact foreign entities (from non-Tax Treaty jurisdictions) having agency business models in India. Foreign entities from Tax Treaty jurisdictions would be entitled to be governed by the provisions of the applicable Tax Treaty if more beneficial, subject of course to conditions.

Given the wider definition of business connection, a question arises if such foreign entities (which were hitherto not filing tax returns) would now be required file their return of income in India as their income might be taxable in India under the IT Act (though may not be taxable as per applicable the Tax Treaty). It is pertinent to note, the Budget has also proposed that prosecution proceedings against companies for failure to file tax return within the prescribed time. 

The above two proposals have been made with the stated intent to deepen and widen the tax base. Such measures to unilaterally push through the BEPS AP recommendations by amendments in the domestic tax law also demonstrate the commitment India has towards the implementation of the BEPS project. Possibly, till the time the MLI becomes effective and Tax Treaties worldwide undergo a change concurrently, the Government may consider renegotiating individual Tax Treaties to bring about similar changes as proposed in its domestic law.