Table of Contents. Amar Mehta

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2 Table of Contents Executive Summary 1. Introduction 2. Indian tax authorities earlier attempts to tax income of digital businesses 3. The BEPS Final Report on Action 1 4. The Indian version of the equalization levy 5. Equalisation levy is a direct tax on a non-resident enterprise s income 6. Is it tax on income? 7. Is the equalization levy different from the corporate tax? 8. Some more dissimilarities between the OECD/ BEPS and the Indian versions of the equalisation levy 9. Rationale behind exclusion of income attributable to a PE 10. Does a tax cease to be tax on income merely because it is imposed on gross consideration? 11. No conflict in a non-treaty situation 12. No conflict if a treaty is bilaterally amended to accommodate equalization levy 13. Could a tax treaty apply despite the fact that the provisions for equalization levy are not incorporated in The Income Tax Act, 1961? 14. Compatibility with India s existing bilateral tax treaty obligations 15. Treaty Dodging is not permissible 16. Conclusion Disclaimer: This document has been carefully prepared. But, no representation is made or warranty given (either express or implied) as to the completeness or accuracy of the information it contains. The author and/ or any of the companies/ entities with which the author may be associated are not liable for any information or opinion contained in this document or for any decision or consequence based on the use of it. The author and any of the companies/ entities with which the author may be associated will not be liable for any direct, indirect, or consequential damages arising from the use of any information or opinion contained in this document. 1

3 Is The Indian Equalisation Levy Compatible With India s Existing Tax Treaty Network? 1 By Dr. Executive Summary: The Indian Finance Act, 2016 has introduced equalisation levy chargeable effective 1 June The equalisation levy is chargeable at the rate of six percent of the amount of consideration, for any specified service, receivable by a non-resident person from a resident of India carrying on business or profession in India, or from a non-resident having a PE in India. Specified service means online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Government of India in this behalf. As per a Committee constituted by the Central Board of Direct Taxes (CBDT), the main objective behind recommendation for introduction of the equalisation levy is to neutralize unfair advantage enjoyed by certain foreign enterprises on account of absence of tax liability in India. But, as discussed in detail in this whitepaper, that claim seems erroneous. The objective behind imposition of the equalisation levy may be to overcome the lack of right to tax certain foreign enterprises incomes, in accordance with Art. 7 (Business profits), under applicable tax treaties. 1 Dr. 2

4 For the reasons discussed in this whitepaper, the equalisation levy is in the nature of tax on income. Hence, it should not be regarded as beyond the purview of the applicable tax treaties. As the equalisation levy is imposed only in case of a foreign enterprise s income not attributable to a PE in India, in tax treaty situations, Art. 7 (Business profits) should negate applicability of equalisation levy. Renegotiation of the tax treaties seems the only legitimate way forward for imposition of equalisation levy in tax treaty situations. Else, it may amount to treaty dodging, which is held by the Indian courts as impermissible. 3

5 1 Introduction In 2016 Union Budget, India s Finance Minister introduced Equalisation Levy, which has come into force with effect from 1 June 2016 through The Finance Act, That levy is imposed by way of a deduction (withholding) from consideration for specified services payable to nonresident service providers not having a permanent establishment (PE) in India. At the outset, the above-mentioned proposal may appear benign and an effective mechanism for securing a fair tax share in the targeted non-resident enterprises incomes from Indian customers. Probably, it may also appear as a potential solution for overcoming the limitations of the concept of permanent establishment, evolution of which has not kept pace with technological developments. But, the above-mentioned equalisation levy is fraught with an engrained vexing question: is it compatible with India s existing bilateral tax treaty network? This whitepaper evaluates that aspect in detail. 2 Indian tax authorities earlier attempts to tax income of digital businesses The Indian tax authorities have been attempting to tax the incomes of online search engine advertisement service providers such as Google and Yahoo since at least over a decade. That may be observed from an April 2013 decision of the Income Tax Appellate Tribunal (ITAT) in ITO v. Right Florists Pvt. Ltd for tax assessment year In that case, Right Florists was an Indian company, which advertised on the U.S.-based search engines like Google, Yahoo, etc. It did not withhold tax on the payments to the search engine companies because, it believed, their said incomes were not attributable to a PE, if any, in India. The Indian tax authorities rejected that position and concluded that Right Florists was obliged to withhold tax on the said payments. Before the matter reached the ITAT, the Commissioner of Income Tax (Appeals) ( the CIT(A) ) had held in favor of Right Florists. 2 ITA No. 1336/ Kol./ 2011, dated 12 April

6 The ITAT upheld the CIT(A) s conclusion. The ITAT distinguished between a computer server and a website such as Google or Yahoo. The ITAT observed that a website was not a tangible property and, therefore, it did not meet the requirements for existence of a fixed place PE in terms of Art. 5(1) of the tax treaty between India and the United States. Hence, by virtue of Art. 7 (Business profits) of the tax treaty, the incomes of the search engine companies derived from Indian customers such as Right Florists were beyond the Indian tax net. The ITAT had also taken note of the Government of India s reservation on the OECD s view that a website, per se, should not constitute a fixed place PE. The ITAT had also noted the Indian position that, in certain circumstances, a website could give rise to a foreign enterprise s PE in India. But, in the ITAT s view, that reservation was relevant only to the extent that the OECD Commentary could be treated neither as a fair index of intention of the Government of India nor as contempoanea expositio in respect of India s subsequent tax treaties. But, beyond that, the reservation did not play any role in judicial analysis. Further, the ITAT had also found that the above-mentioned incomes of the non-resident search engine companies did not amount to royalty in terms of Sec. 9(1)(vi) of the Income Tax Act, 1961 ( the Act ), and fees for technical services in terms of Sec. 9(1)(vii) of the Act. The ITAT concluded that the said incomes could not be regarded as actually or deemed to arise in India. Therefore, the said search engine companies incomes were not taxable in India. While a decision like Right Florists frustrates the tax authorities intent to tax the incomes of the likes of Google, Yahoo and several other non-resident online service providers, the amounts involved are difficult for the Indian tax authorities to let go. For instance, as per a recent news report, Google s revenue from Indian customers was about INR 41 billion (i.e. approximately US dollars 600 million) in financial year

7 3 The BEPS Final Report on Action 1 About two and half years subsequent to the pronouncement of the above-mentioned ITAT decision, the OECD issued its final report on Base Erosion and Profit Shifting (BEPS) Project Action 1. 3 In Chapter 7 (Broader direct tax challenges raised by the Digital economy and the options to address them), at paragraph 7.6, it is stated that: the application of a withholding tax on digital transactions could be considered as a tool to enforce compliance with net taxation based on this potential new nexus, while an equalisation levy could be considered as an alternative to overcome the difficulties raised by the attribution of income to the new nexus. [Emphasis supplied.] At paragraph 7.6.4, the BEPS Report on Action 1 acknowledges that: To avoid some of the difficulties arising from creating new profit attribution rules for purposes of a nexus based on significant economic presence, an equalisation levy could be considered as an alternative way to address the broader direct tax challenges of the Digital economy. [Emphasis supplied.] It seems that, perhaps, the above-mentioned recognition in the BEPS Report on Action 1 forms the foundation for the equalisation levy introduced through the Indian Finance Act, That belief is reinforced by the following remarks in the official Memorandum explaining the Finance Bill, 2016: The typical direct tax issues relating to e-commerce are the difficulties of characterizing the nature of payment and establishing a nexus or link between a taxable transaction, activity and the taxing jurisdiction, the difficulty of 3 The OECD/ G20 Base Erosion and Profit Shifting Project, Addressing the Tax Challenges of the Digital Economy, Action Final Report, October

8 locating the transaction, activity and identifying the taxpayer for income tax purposes. The digital business fundamentally challenges physical presencebased permanent establishment rules. If permanent establishment (PE) principles are to remain effective in the new economy, the fundamental PE components developed for the old economy i.e. place of business, location, and permanency must be reconciled with the new digital reality. In order to address the challenges, it is proposed to insert a new Chapter titled Equalisation Levy in the Finance Bill, to provide for an equalisation levy of 6% of the amount of consideration for specified services received or receivable by a non-resident not having permanent establishment ( PE ) in India, from a resident in India who carries out business or profession, or from a non-resident having permanent establishment in India. It is important to point out that the BEPS Report on Action 1 does not recommend any particular solution, including imposition of an equalisation levy. That report, merely acknowledges that countries could introduce any of the three options considered by The Task Force on the Digital Economy (TFDE), a subsidiary body of the Committee on Fiscal Affairs (CFA) in which non-oecd G20 countries participate as Associates on an equal footing with OECD member countries. The three options discussed in the BEPS Report on Action 1 were: 1. Articulation of a new nexus in the form of significant economic presence; 2. A withholding tax on certain types of digital transactions; and 3. Imposition of an equalisation levy. The BEPS Report on Action 1 clearly states that none of the above-mentioned three alternatives are recommended at this stage of the developments on the subject matter. But, the aforesaid 7

9 Memorandum explaining the provisions of the Finance Bill, 2016 erroneously states that the OECD, in BEPS Action Plan 1, has recommended, inter alia, imposition of an equalisation levy on consideration for certain digital transactions received by a non-resident from a resident or from a non-resident having a PE in the Source State. 4 The Indian Committee for Taxation of E-Commerce In the meanwhile, the Central Board of Direct Taxes (CBDT) constituted a Committee on Taxation of E-Commerce (hereafter referred to as the Indian Committee ). It comprised of eight members, five of them were senior officials of the CBDT or the Indian tax authorities. The Indian Committee recommended imposition of the equalization levy. The scheme of equalization levy, introduced through Chapter VIII of the Finance Act, 2016, adopts most of the recommendations of the Indian Committee, except the scope of the specified services. The Indian Committee had recommended inclusion of consideration for 13 types of specified services. At present, the Finance Act, 2016 includes only one of those 13 types of services in the definition of the specified services. It may be reasonable to anticipate that the scope of the expression specified services would be expanded in due course to include the remaining types of the services. 5 The Indian version of the equalization levy 5.1 Key Features of equalisation levy (a) Overview Chapter VIII in the Finance Act, 2016 contains the provisions for equalisation levy. The key features are as follows: 8

10 The equalisation levy is chargeable at the rate of six percent of the amount of consideration, for any specified service, receivable by a non-resident person from: (i) (ii) (b) A person resident in India and carrying on business or profession in India; or A non-resident having a permanent establishment (PE) in India. Scope of the term specified services Specified service means online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Government of India in this behalf. (c) Meaning of online Online means a facility or service or right or benefit, or access that is obtained through the Internet or any other form of digital telecommunication network. (d) Exclusion from the scope of equalisation levy The equalisation levy is not chargeable if (i) (ii) A non-resident provider of the specified services has a PE in India and the specified services are effectively connected with such a PE; The aggregate amount of consideration for specified services received or receivable in a financial year by a non-resident, from a person resident in India and carrying on business or profession, or from a non-resident having a PE in India, does not exceed INR 100,000. Also, the equalisation levy does not apply if the payment for the specified service is not for the purpose of carrying out business or profession. Thus, the equalisation levy applies only in case of business-to-business (B-to-B) transactions. 5.2 The underlying objective of equalization levy The Report of the Indian Committee states that the main objective behind recommendation for introduction of the equalisation levy is to neutralize unfair advantage enjoyed by certain foreign 9

11 enterprises 4 on account of absence of tax liability in India, because their incomes may not be attributable to PE in India. It is difficult to reconcile as to how absence of a foreign enterprise s tax liability in India, due to India s bilateral commitment to its tax treaty partners, could be viewed as an unfair advantage enjoyed by the foreign enterprise. In case of enterprises from many jurisdictions (for instance, the United States), their incomes may be taxable in the Residence State at rates comparable (or greater) to the Indian tax rates applicable in case of Indian enterprises. Even for that reason, it is difficult to reconcile as to how absence of tax liability in India in accordance with Art. 7 (Business profits) of an applicable tax treaty could be regarded as an unfair advantage. In view of the above, it seems that the motive behind introduction of the equalisation levy is to tax foreign enterprises incomes, notwithstanding the fact that such incomes are not taxable under the applicable tax treaties, because they are not attributable to a PE in India. In other words, it seems, the objective behind introduction of the equalisation levy is to dodge treaty obligations. The above-mentioned impression, that the motive behind introduction of the equalisation levy is to overcome treaty obligations, is reinforced by the Revenue Secretary s confirmation in a recent interview in Business Today Magazine (Issue dated 5 June 2016) that equalisation levy is a tax on income of a foreign enterprise. It is also relevant to note that, at paragraph 109 of its Report, the Indian Committee reproduced the discussion about the equalisation levy in the OECD BEPS report on Action 1. The CBDT Committee also reproduced the following remarks of the BEPS Report on Action 1: 44 I.e. the non-resident enterprises rendering specified services to Indian customers. 10

12 If the income is subject to corporate income tax in the country of residence of the enterprise, the levy would be unlikely to be creditable against that tax. To address these potential concerns, it would be necessary to structure the levy to apply only to situations in which the income would otherwise be untaxed or subject only to a very low rate of tax. [Emphasis supplied] The Indian version of the equalisation levy, however, does not address the above-mentioned concerns, and ignores the recommended solution. Therefore, it would be incorrect to state that the introduction of the equalisation levy in India is in accordance with the BEPS Report on Action 1. In any case, if a contracting state considers that a provision in a tax treaty confers undue advantage to the enterprises of the other contracting state, then the aggrieved contracting state may address that situation by renegotiating the tax treaty. India s recent renegotiation with Mauritius, which resulted in amendment to the Capital Gains article, is a leading example in that regard. 5.3 Likelihood of expansion of scope of specified services and the rate of equalization levy Presently, the equalisation levy is imposed only on consideration for specified services i.e. provision of digital advertising space or any other facility or service for the purpose of online advertisement. The Government of India, however, is empowered to expand the scope of the specified services by way of a notification. The Indian Committee has recommended imposition of the equalisation levy on the consideration for the following types of services: (i) (ii) (iii) Online advertising or any services, rights or use of software for online advertising, including advertising on radio and television; Digital advertising space; Designing, creating, hosting or maintenance of a website; 11

13 (iv) (v) (vi) (vii) (viii) (ix) (x) Digital space for website, advertising, s, online computing, blogs, online content, online data or any other online facility; Any provision, facility or service for uploading, storing or distribution of digital content; Online collection of processing of data related to online users in India; Any facility or service for online sale of goods or services or collecting online payments; Development or maintenance of participative online networks; Use or right to use or download online music, online movies, online games, online books or online software, without the right to make and distribute any copies thereof; Online News, online search, online maps or global positioning system applications; (xi) Online software applications accessed or downloaded through Internet or telecommunication networks; (xii) (xiii) Online software computing facility of any kind for any purpose; and Reimbursement of expenses of a nature that are included in any of the above. Accordingly, it may be reasonable to anticipate that consideration for many of the abovementioned services would be included in due course in the scope of the specified services for imposition of the equalisation levy. It is also important to note that the Indian committee ended that the equalisation levy should be imposed at the rate of 6 to 8 percent of the gross consideration. The Committee recommended that a lower rate (i.e. 6%) may be preferable to begin with. Hence, one may expect that the rate would be increased in due course. 5.4 Administration by the Income-tax authorities The equalization levy would be administered by the Income-tax authorities. First appeal (against penalty) may be preferred before the Commissioner of Income-tax (Appeals), and the next round of appeal before the Income Tax Appellate Tribunal (ITAT). 12

14 6 Equalisation levy is a direct tax on a non-resident enterprise s income The equalisation levy is a direct tax, because of its following features: - The equalisation levy would be imposed on consideration (for specified services) receivable by a non-resident enterprise; - Essentially, the equalisation levy is believed (by the Ministry of Finance in the Government of India) 5 to be a solution for overcoming the typical direct tax issues relating to e-commerce, such as the difficulties of characterizing the nature of payment and establishing a nexus between a taxable transaction, an activity, and the taxing jurisdiction; - The Ministry of Finance has recognized in the Memorandum explaining the provisions of the Finance Bill, 2016 that imposition of the equalisation levy as well as taxation under the regular provisions of the Act would result in double taxation. Therefore, the income subject to - equalisation levy would be exempt, from further taxation, by virtue of Sec. 10 of the Income Tax Act, 1961; and - Sec. 166(1) of the Finance Act, 2016 stipulates that: Every person, being a resident and carrying on business or profession or a non-resident having a permanent establishment in India shall deduct the equalisation levy from the amount paid or payable to a non-resident in respect of the specified service [Emphasis supplied.] Thus, the equalisation levy is a deduction from the consideration receivable by a non-resident service provider. Hence, it is a direct tax. 7 Is it tax on income? It is hardly debatable that a direct tax on the revenue (gross income) of a non-resident enterprise is very much a tax on income. For instance, a withholding tax on royalties or fees for technical services in accordance with Sec. 115A of the Income Tax Act, 1961 or Art. 12 of a tax treaty is a 5 As stated in the Memorandum explaining the Finance Bill,

15 tax on a foreign enterprise s income. Therefore, the view of the Indian Committee that equalization levy is not a tax on income is erroneous. The Brazilian tax authorities similar line of argument has been rejected by the higher courts in that jurisdiction (though the Brazilian tax authorities did not use the nomenclature equalization levy ). Though a decision of a foreign court does not enjoy binding effect (precedent value) in India, it could certainly be of significant persuasive value. Hence, it may be of interest to take a brief look at a couple of such decisions. The first case relevant in the context of the Indian equalization levy is in Veracel Cellulose. 6 In that case, a Brazilian company had obtained certain services from some Finnish companies. As per the Brazilian company, the Finnish companies incomes were exempt from tax in Brazil in accordance with Art. 7(1) of the 1996 tax treaty between Brazil and Finland and, therefore, it was not obliged to withhold tax on the payments to the Finnish companies. The Brazilian tax authorities, however, rejected that claim and directed the Brazilian company to withhold tax on payments to the Finnish companies. The Brazilian company was successful in an appeal before the Federal Regional Court. The Brazilian tax authorities contended before the Court that an administrative ruling (COSIT 1/2000) empowered them to apply Art. 21 (Other income) of the 1996 tax treaty between Brazil and Finland and, therefore, they were justified in directing the Brazilian company to withhold tax on the payments to the Finnish companies. The Court rejected that proposition. In the Court s view, inter alia, merely because the amounts receivable by the Finnish companies were in the nature of revenue for the purposes of the Brazilian tax law, that did not negate applicability of Art. 7 (Business profits) of the 1996 tax treaty between Brazil and Finland. We may also take into account the decisions of the Brazilian Federal Regional Court and the Superior 6 16 March Federal Regional Court of 2 nd Region, /ES. 14

16 Court of Justice in Copesul. 7 In those cases, a Brazilian company had obtained certain services from a Canadian company and a German company. As per the Brazilian company, since those services were not technical services, the incomes of the Canadian and the German companies had to be characterized as business profits for the purposes of the 1984 tax treaty between Brazil and Canada and the 1975 tax treaty between Brazil and Germany. Accordingly, and since the Canadian and the German companies did not have PE in Brazil, the Brazilian company claimed that it was not obliged to withhold tax on the payments to those companies. 7 4 June Federal Regional Court, /RS. 15

17 As per the Brazilian company, since those services were not technical services, the incomes of the Canadian and the German companies had to be characterized as business profits for the purposes of the 1984 tax treaty between Brazil and Canada and the 1975 tax treaty between Brazil and Germany. Accordingly, and since the Canadian and the German companies did not have PE in Brazil, the Brazilian company claimed that it was not obliged to withhold tax on the payments to those companies. The Brazilian tax authorities, however, rejected the Brazilian company s position. The Brazilian tax authorities refused to apply Art. 7 (Business profits) of the respective tax treaties since, under the Brazilian tax law, the above-mentioned payments were characterized as revenue rather than business profits. Therefore, in the Brazilian tax authorities view, the Other Income articles (rather than the business profits articles) of the respective tax treaties applied. 16

18 The Brazilian Federal Regional Court rejected the Brazilian tax authorities approach. In the Court s view, that approach rendered Art. 7 (Business profits) of the various tax treaties redundant. Accordingly, the Court concluded that Art. 7 of the respective tax treaties applied in the present case and since the incomes of the Canadian and German companies were not attributable to a PE in Brazil, the said incomes were not taxable in Brazil. As a result, the Court concluded, the Brazilian company was not obliged to withhold tax on the payments to the Canadian and German companies. 17

19 Thereafter, the Superior Court of Justice upheld the decision of the Federal Regional Court. The Superior Court of Justice clarified that the meaning of the expression business profits appearing in Art. 7(1) of the relevant tax treaties could not be restricted to net profit as understood under the Brazilian tax law. Rather, that term had to be understood in a broader manner. Therefore, the amounts receivable by the Canadian and the German companies were within the scope of Art. 7(1) of the relevant tax treaties. Otherwise, foreign enterprises receipts from business transactions with Brazilian tax residents might unintentionally escape the scope of Art. 7(1) of various tax treaties to which Brazil was a party. Thus, the Brazilian Superior Court of Justice concluded that the Brazilian company was not obliged to withhold tax on the payments to the Canadian and German companies. In the author s view, the above-mentioned decisions of the Brazilian courts conform to appreciable logic and it may be reasonable to anticipate that, eventually, the Indian Income Tax Appellate Tribunal (ITAT) and higher courts would follow a similar approach. Direct taxation (i.e. incidence of tax being borne by the recipient) of revenue does not cease to be taxation of income. Otherwise, tax treaty provisions such as Art. 12(2) permitting a Source State to tax royalties and fees for technical/ included services on gross basis would have been out of place. Thus, in the author s view, it may be reasonable to anticipate that the ITAT and the higher courts in India would eventually hold that equalization levy is indeed a tax on income. 8 Is the equalization levy different from the corporate tax? The Indian Committee states, at paragraph 110 of its Report, as follows: The Committee observes that the BEPS Report conceptualizes Equalization Levy as a tax that is different from the Corporate Income Tax, and thus may not necessarily be subjected to the limitations of the tax treaties. Such a tax on the gross amount of payment, would thus be very similar to the second option of withholding tax, except that it, not being a tax on income, would not be covered by the obligations of the tax treaties, and hence can be levied under domestic laws, even without changes in the tax treaties. 18

20 But, the Indian Committee overlooked the crucial fact that the Indian version of the equalisation levy is fundamentally different than the equalisation levy envisaged in the BEPS Report on Action 1. As per the OECD/ BEPS version, the equalisation levy would be imposed on the gross value of the goods or services provided to in-country customers and users, paid by in-country customers and users, and collected by the foreign enterprise via a simplified registration regime, or collected by a local intermediary. 8 The BEPS Report on Action 1 also considered another form of levy (on data and other contributions gathered from in-country customers and users), but that is not relevant in the present context. 9 Thus, the OECD/ BEPS and the Indian versions of the equalisation levy are substantially dissimilar. Hence, the Indian Committee s argument that the equalisation levy (Indian version) is different from the corporate income tax because it is so stated in the OECD Report on BEPS Action 1 seems fundamentally flawed. As a consequence, the Indian Committee s claim that the equalisation levy is beyond the purview of the existing tax treaties seems incorrect. Also, the intrinsic nature of the Indian version of the equalisation levy is similar to the withholding tax on royalties and fees for technical services under Art. 12 (Royalties and fees for 8 Paragraph 304, Final Report on BEPS Action 1. 9 Paragraph 305, Final Report on BEPS Action 1. 19

21 included/ technical services) of the most Indian tax treaties. 10 Therefore, the Indian version of the equalisation levy is not different from the corporate income tax. As a result, an argument that the Indian equalisation levy is beyond the purview of the existing Indian tax treaties seems untenable. 9 Some more dissimilarities between the OECD/ BEPS and the Indian versions of the equalisation levy As mentioned earlier, the Indian version of the equalisation levy is substantially dissimilar to its counterpart envisaged in the OECD/ BEPS Report on Action 1. The OECD/ BEPS Report envisages the equalisation levy to be collected by the enterprise, and to be borne by the customer. But, the Indian version is diagonally opposite the equalisation levy is withheld by the customer and borne by the non-resident enterprise. Therefore, the Indian version of the equalisation levy is substantially similar to the withholding tax on royalties and fees for technical services. (The Indian Committee has acknowledged in its report that such a withholding tax requires treaty renegotiation, else it would violate the existing commitments under the tax treaties.) The Indian version of the equalisation levy also disregards the concern expressed in the OECD/ BEPS Report on Action 1 that if the equalisation levy is applied only in case of non-resident enterprises, then that would raise substantial issues with respect to trade agreements (similar issues would arise also with respect to tax treaties). To address that hurdle, it is suggested in the BEPS Report on Action 1 that the equalisation levy may be imposed in case of domestic as well as foreign enterprises. Thereafter, the domestic enterprises should be allowed to offset the equalisation levy against the domestic (corporate) tax liability. The 10 Art. 13 in case of the contemporary tax treaty between India and the United Kingdom. 20

22 Indian version of the equalisation levy, however, disregards that concern and recommendation. Even for that reason, the Indian version of the equalisation levy is not comparable with the equalisation levy envisaged in OECD/ BEPS Report on Action 1. Accordingly, the Indian Committee s statement at paragraph 125 in its Report, that Equalization Levy is intended to be a tax imposed in accordance with the conclusions of the BEPS Report on Action 1, seems factually incorrect. 10 Rationale behind exclusion of income attributable to a PE The Indian Committee, at paragraph 133 in its Report, states as follows: As the objective of the levy is to tax only those entities that enjoyed an unfair tax advantage, payments that are made to the permanent establishment in India of a foreign company or a non-resident person, would be exempt from the equalization Levy, if that payment forms a business receipt of that permanent establishment in India and hence subject to tax under the provisions of the Income-tax Act, But, as discussed earlier (see paragraph 5.2 above), foreign enterprises from many tax treaty jurisdictions may not enjoy an unfair tax advantage, because their incomes may be taxable in the Residence State at rates comparable to (or greater than) the effective tax rate in case of comparable Indian enterprises. In the author s view, since the Indian version of the equalisation levy appears to have been articulated with an apparent objective of circumventing the limitation under Art. 7 (Business profits) of the tax treaties (i.e. India is not entitled to tax the foreign enterprises incomes if they are not attributable to PE in India), and because of foreign enterprises incomes attributable to PE in India are taxable in India, such income may have been kept beyond the purview of the equalisation levy. If a foreign enterprise s income attributable to a PE in India was subjected to the equalisation levy, then in many cases, the Indian exchequer would have been at a loss by exempting such income under Sec. 10 of the Income Tax Act, That seems to be the case, because the average 21

23 effective tax rate in respect of the income attributable to a PE is likely to exceed 6 percent (the rate of the equalisation levy). 11. Does a tax cease to be tax on income merely because it is imposed on gross consideration? Not really. In fact, the Indian Committee at paragraph 106 in its Report takes into account a withholding tax option on payments in respect of digital transactions. The committee noted that the said option was substantially similar to the withholding tax already applicable in respect of payments of interest, royalties, fees for technical services, etc. It is submitted that even the Indian equalisation levy is a withholding tax because: (i) (ii) (iii) (iv) It is imposed by way of a withholding on the payments to the non-resident enterprises for specified services; It is intended to be borne by the recipient enterprises; Thus, it is imposed in the same manner as the withholding tax on royalties, fees for technical services, etc.; and Mere use of a different nomenclature (i.e. equalisation levy instead of withholding tax ) does not change the true character of the tax. Thus, in the author s view, the equalisation levy is very much a tax on income. That opinion is further buttressed by the fact that the equalisation levy will be administered by the income-tax authorities, the taxpayer can prefer an appeal before the Commissioner of Income Tax (Appeals), and the next round of appeal would be before the Income Tax Appellate Tribunal (ITAT). 22

24 In fact, even the name equalisation levy in the present context may be rather misleading because, in many cases, the levy may not equalize anything. In case of enterprises from many jurisdictions, the tax rate in the Residence State may be greater than the tax rate applicable to comparable enterprises in India. For instance, incomes of German companies are subject to a combined tax rate greater than 30 percent. In the United States, incomes of companies may be subjected to tax rates up to 35%. Therefore, enterprises from such jurisdictions may not derive any advantage whatsoever (leave aside unfair advantage, as argued in the Indian Committee s Report), even if their incomes are not taxable in India in accordance with Art. 7 (Business profits) of an applicable tax treaty. In fact, since the equalisation levy is unlikely to be creditable against the tax liability in the Residence State, the equalisation levy may lead to increased hardship for the non-resident enterprises unless they are in a position to pass on the burden of that tax to the Indian customers. Therefore, the Indian Committee s view that the equalisation levy facilitates the objective of neutralisation seems erroneous. It is also important to note the following statement of the Revenue Secretary of the Government of India, in respect of equalisation levy, in a recent interview with a leading business magazine (Business Today, Issue dated 5 June 2016): 23

25 Although people are viewing it as indirect tax, this is a direct tax. Our intention is that the person, who is giving advertisements to a foreign portal, is supposed to deduct 6 per cent out of the income that the other person is earning, and give it to the government. So, it is really income tax, but it s a different matter that the Internet company may gross the charges up by 6 per cent and the burden may come upon the Indian company. Also, the Indian Committee s thought process behind the articulation of the tax rate (6-8%) leads to a belief that the scheme of equalisation levy is indeed a scheme of taxation of a foreign enterprise s income. In that context, it is important to take note of the following remarks of the Indian Committee: Thus, the Committee was of the view that the rate of Equalization Levy needs to be fixed in a way that will lead to a tax incidence that is as close as possible, to the tax incidence that it [i.e. a foreign enterprise] might have faced had its income win taxable under the existing tax treaty rules. In a way this would make the Equalisation Levy close to the deemed profit taxation 11 [Emphasis supplied.] Thus, it is clear that equalisation levy is articulated to function as a tax on incomes of the nonresident enterprises rendering specified services to Indian customers. Also, as discussed above (see paragraph 6.2), a tax would not lose its intrinsic characteristic of income-tax merely because it is charged on the gross amount of consideration. 11 Paragraph 142, The Report of The Committee on Taxation of E-Commerce, 3 February

26 12 No conflict in a non-treaty situation In a non-treaty situations, there cannot be any objection to imposition of the equalisation levy. A potential conflict would arise only in a situation where a tax treaty applies. 13 No conflict if a treaty is bilaterally amended to accommodate equalization levy Similarly, imposition of equalisation levy should not create any difficulties if an applicable tax treaty is bilaterally amended to accommodate the levy. 14 Could a tax treaty apply despite the fact that the provisions for equalization levy are not incorporated in The Income Tax Act, 1961? In the author s view, since the nature of the equalisation levy is similar to the withholding tax on gross income, by virtue of Art. 2 (Taxes covered) of the tax treaties, an applicable tax treaty should apply regardless of the fact that the provisions concerning equalisation levy are not incorporated in the Income Tax Act, It should be possible to argue that, in a tax treaty situation, Art. 2 (Taxes covered) of an applicable tax treaty would apply to the equalisation levy because: (i) (ii) The equalisation levy is a direct tax on the income of a non-resident enterprise (tax resident of the Resident Contracting State); and The equalisation levy India is, in effect, a tax on the income that is not taxable in accordance with Art. 7 (Business profits) of an applicable tax treaty. Thus, it appears that imposition of the proposed equalisation levy in a bilateral tax treaty situation could be a case of treaty override or treaty dodging. 25

27 15 Compatibility with India s existing bilateral tax treaty obligations The BEPS Report on Action 1 recognizes that imposition of equalisation levy may not be compatible with the Source State s obligations under existing bilateral tax treaties. Accordingly, the Report points out that countries may introduce, inter alia, equalisation levy in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in the bilateral tax treaties. Adoption as domestic law measures would require further calibration of the options in order to provide additional clarity about the details, as well as some adaptation to ensure consistency with existing international legal commitments. Thus as acknowledged in the BEPS Report on Action 1, imposition of equalisation levy as unilateral measure under the Source State s tax law may lead to protracted litigation in tax treaty situations. As the Indian equalisation levy seems to be in the nature of a tax on income, and since that tax is levied only in case of incomes not attributable to a PE in India, Art. 7(1) of an applicable tax treaty is likely to preclude imposition of the equalisation levy. Indeed, it appears that the objective behind introduction of the equalisation levy is to overcome this hurdle. But, in the author s view, with due respect, bilateral amendments through renegotiation of the existing treaties is the only legitimate way forward. Else, again with due respect, imposition of equalisation levy in tax treaty situations may amount to treaty dodging. 26

28 16 Treaty Dodging is not permissible It is a well-established principle that treaty override or treaty dodging is not permissible. This aspect is duly recognized by Indian courts. For instance, in Azadi Bachao Andolan, 12 the Supreme Court of India has held that in case of a conflict between the domestic tax law and an applicable tax treaty, the latter shall prevail to the extent it is beneficial for a taxpayer. In Siemens Aktionesellschaft, 13 the Bombay High Court has held that a Contracting State could not, by way of a unilateral amendment, tax income that was otherwise not taxable under an applicable tax treaty. The ITAT has acknowledged, for instance in Deputy Commissioner of Income Tax vs. Mustaq Ahmad Vakil, 14 that a tax treaty not only prevents current but also potential double taxation. Therefore, once the right to tax particular type of income vests exclusively with the Residence State, unless the tax treaty is amended, it continues to remain so. In Sumitomo Mitsui Banking Corporation vs. Dy. Director of Income-tax, 15 the ITAT s Special Bench has explained that if there is an express provision made in the convention 16 giving benefit to the assessee which is contrary to the domestic law, then the provisions of treaty can be relied upon which shall override and prevail over the provisions of the domestic law to give any benefit 12 (2003) 184 CTR (SC) ITR 320 (Bom.). 14 ITA No. 1531/ Del/ 2011, dated 26 August ITA No. 5402/ Mum/ 2006, dated 30 March 2012, Paragraph I.e. an applicable tax treaty. 27

29 expressly given to the assessee under the treaty. The decision of Hon nle Supreme Court in the case of Azadi Bachao Andolan (supra) fully supports this view. Similarly, in Reuters Transaction Services Ltd. v. DDIT, 17 the ITAT has acknowledged that if a particular item of income was not taxable under a tax treaty, then a unilateral amendment in the Source State s statute could not render such income taxable in the Source State. 17 Conclusion As discussed in this whitepaper, the equalization levy aims to tax business profits of non-resident enterprises rendering specified services to Indian customers without involvement of a PE in India. Therefore, in a treaty situation, Art. 7 (Business profits) would preclude imposition of the equalization levy. 17 ITA Nos and 7211/Mum/2012 dated 18 July