VIA NLSIR: Best Essays of the 7th Nani Palkhivala Foundation Taxation Law Essay Competition [# 2 by Hardeep Singh]

The 7th Nani Palkhivala Foundation Taxation Law Essay Competition, 2014 was organised by the National Law School of India Review (NLSIR), the flagship journal of the National Law School of India University, Bangalore.

The results of this prestigious legal essay competition were declared a few days back.

We requested NLSIR and the authors to share the prize winning entries with us so that the essays could be made available for a wider audience. They are sweet chaps and they agreed. A big shout out to all the authors and the people at NLSIR!

Here’s the essay by Hardeep Singh which won the 2nd prize.

BEPS- Issues and Challenges (Action Plan – 1) by Hardeep Singh

Globally, the amount of business being transacted on the internet is increasing by leaps and bounds and the traditional models of taxation are being made redundant. The concept of Permanent Establishment (“PE”) is fast changing in a world beyond geographical boundaries, where the end-customer is located.

There is a deep need felt to address the issues that emanate from such transactions. In several cases the taxpayers structure their transactions that neither the country of residence not the source country where ‘tangible’ business occurs, receive any taxes. To address these complex tax evasive structure, OECD initiated Action Plan 1 – Tax Challenges of the digital economy, of the Base Erosion and Profit Shifting (“BEPS”)

The BEPS Action Plan has noted the following in relation to the digital economy and challenges associated from an international tax perspective:

“The spread of the digital economy also poses challenges for international taxation. The digital economy is characterized by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), and the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs.

This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterization of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system.

It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.”

And hence a Task Force was constituted as subsidiary of Committee on Fiscal Affairs (“CFA”) in September’ 2013 and the Task Force reiterated that the principles established in the Ottawa Tax Framework were still relevant today. These principles are related to neutrality, efficiency, certainty and simplicity, effectiveness and fairness and flexibility.

In March’ 2014 OECD released a discussion draft which identifies the differences which have occurred over time during the shift from mortar business to e-commerce. The underlying fact is that business is transacted from a distance without physically meeting and as such when such business is transacted in different countries peculiar issues arise.

The concept of PE diminishes. The organizations can shift their operations to a tax haven an avoid residence tax. The income they earn can be characterized as “Business Income” and since there is no physical nexus, i.e, a PE, they exclude the source tax too.

A number of coordinated strategies associated with BEPS can be broken down broadly into the four following elements:

1. Minimization of tax by avoiding a taxable presence, or if there is a PE, either by shifting the gross profits to a tax haven or low tax jurisdictions via the trading structures or maximizing deductions. Google will have no PE, no hardware and almost no men in the countries from where it derives its revenue.

Under Articles 5 and 7 of the OECD Model Convention, a company being a non-resident is subject to tax on its business profits only if it has PE. The domestic tax laws of countries usually require this sort of physical presence before subjecting the country to taxation. Here, there is no physical interaction between the seller and the buyer. The transaction is happening on the internet. “Happening on the internet” where would the presence be? Add to this these Multi-National Enterprises (“MNE”) fragment their operation among multiple group entities to qualify for exemption of the PE status for auxiliary activities.

2. Low or nil tax paid at the level of the recipient with substantial profits going to a group company incorporated in a low tax jurisdictional area (intra-group arrangements). In reality such allocation of functions may not correspond to actual business functions performed and these are predominantly carried out because of tax considerations.

The intangibles are allocated via group members to low tax jurisdictions and likewise, in higher tax jurisdictions the operating company does not claim ownership of the intangible and do not hold capital that is generated from core profit. Thus the income is shifted to a low-tax jurisdiction in the most legitimate manner.

3. Low or nil withholding tax at source. Some assesses may be subject to withholding tax if they receive interest of royalties. Simultaneously, it is entitled to reduced/nil withholding of profits to lower tax jurisdiction. Such complex structures, for illustration the “double- dutch sandwich” involves treaty shopping by interposing shell companies located in countries with favorable treaty networks that contain insufficient protection and that primarily is our concern.

4. Low tax profits at the level of the ultimate ‘tangible’ parent by contractually, allocating risks and legal ownership of intangibles to the group entities in low tax jurisdiction environment, providing marginal remuneration for the ‘tangible’ business function while sifting away the profits to low tax jurisdiction.

Conceptual Foundation:

a. Modified definition of PE

The exemption included (generally) in para 4 of Article 5 of the DTAA’s range from storage, display, processing, delivery or purchasing of goods, i.e, activities which are preparatory in nature. The new realization that some of the activities listed might form core activity of a company in a jurisdiction needs to be emphasized upon. Therefore, these activities should be removed from the exemption or made subservient to real preparatory or auxiliary activity.

 b. Virtual PE

When the contracts are concluded by a virtual agency PE (contracts concluded through technological means) as oppose to an onsite business PE (where there is material economic presence in the source country). To include this a number structures and aspects would need consideration; it can teamed up with the prior proposition which can make it robust in the digital economic world.

 c. Withholding Tax on E-Commerce transactions

This proposal concerns without resorting to the PE conundrum, a final withholding tax on e-commerce transactions where it might be possible for the corporation to have economic activity without that activity coming under the ambit of taxable service/good. The administrative difficulty can be removed by using latest technology.

 d. Consumption Tax Conundrum

With technology which is considered the bane in the current scenario can become a boon and tax administration could simplify the compliance mechanism of VAT and make it feasible that a non-resident supplier in a cross-border transactions may collect and remit VAT. Enforcing this might be difficult but with political will coupled with information agreements between taxing jurisdictions can give teeth to the proposal.

 e. Alternative to PE

Let’s for a moment forget about the current tax regime and focus on any alternative to the PE concept. Let’s focus on the justification to tax a non-resident; since they are providing service in a source country the citizens of the sources country are using that service and therefore the source country is providing the market of the service and is contributing to the non-resident’s profit.

The demand side or the customer side. This approach is culled from deeming provision – explanation to Section 9(2) of the Income Tax Act, 1961. This idea can be furthered into threshold limits, that if certain threshold is breached that tax will be levied on the non-resident.

He still remains a non-resident in that they don’t need to pay TDS on payments made by them to another non-residents however, liable to file their Income Tax return and pay advance tax. All the considerations of Article 5 of the DTAA is replaced effectively by just one condition, if the nonresident earns more than a  certain threshold of income from its services in the source country.

The justification for having an alternative can be many. For illustration, Google is providing service to the users and to the advertisers or a source country. First, the source country is a market for the Company. Second, for tax authorities it is easier to administer. Third, for assessee it is easier to comply with these provision. The justification is based on clear understanding that the source country should be able to tax being the market. This involves; First, amending the Income Tax Act and Second, modifying Article 7 of the DTAA’s.

 The collective effect would be that a non-resident would be taxed in a source country if all of the following conditions are satisfied:

1. Services are provided to residents of the source country or to a person for conducting business in the source country.
2. Residents of the source country make the payments from the source country.
3. The non-resident provides services for more than 60 days in a financial year.
4. The non-resident earns beyond a certain threshold through the source country.

The present article remains a step towards better understanding the taxation of e-commerce transaction and provide solutions for a better regime in which the MNE’s don’t escape the tax net through complex structures. However best the tax system it seems now, after a few years it becomes redundant and it’s imperative that we keep revising and updating our taxation system to cope up with the changing circumstances of business.

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