Being a large market for digital services, India has scores of non-resident companies without a Permanent Establishment (‘PE’). These companies escape tax liabilities by duplicating their tax benefits in both the residence and the source country, thereby leading to “double non-taxation”. To equalize the unfair advantage enjoyed by digitally operated services, India introduced an equalization levy of 6% for ‘digital advertising services’ and 2% for ‘e-commerce operators’ through the Finance Act of 2020.[1] This tax is only applicable to a non-resident earning consideration from India, but has no fixed place of business that qualifies as a permanent establishment. While the equalization levy has come under intense scrutiny for being a unilateral tax treaty override and a heavy burden to shoulder for startups and Small and Medium-sized Enterprises, it has also been argued that it violates anti-discriminatory obligations under the General Agreement of Trade in Service (‘GATS’).[2] The two main principles of the anti-discriminatory obligations in the GATS require that member countries shall not treat domestic market participants more favorably than foreign market participants (National Treatment – ‘NT’), and member countries shall also not discriminate between foreign market participants from different origin (Most-Favored Nation – ‘MFN’)
In this blog post, I try to chalk out the challenges that the equalization levy faces from a GATS perspective and argue why the levy does not, in principle, violate the anti-discrimination rules of the GATS. I also highlight the importance of the exemption provided for direct tax measures in the GATS and the qualifiers that bind such an exemption. In conclusion, I reflect on the need to have stronger rules to tax digital services, but the design and approach taken to introduce digital taxes will have a huge impact on its application and results.
Equalization Levy through the optic of GATS Framework
The equalization levy can be the subject of a WTO dispute under the GATS framework as Article I prescribes four modes of supply, and specialized digital services can be offered through the ‘commercial presence’ or ‘cross-border supply’ modes.[3] Article XVII of the GATS accords the ‘National Treatment’ protection by requiring that foreign services and service suppliers must be accorded equal treatment as their domestic counterparts.[4] This is subject to the specific commitments taken by the country in its schedule for a given sector. India has not made any specific commitments in ‘advertising services’ or ‘computer-related services’ sectors, under which the equalization levy is most likely to fall.[5] Consequently, India is not required to provide national treatment protection to foreign services and service suppliers in those sectors.
The challenge to the equalization levy as a Most-Favored Nation violation also cannot sustain, because Article II of the GATS only accords equal treatment to member countries supplying similar services.[6] An MFN inquiry involves establishing firstly, that the services and service suppliers of either countries are ‘like’; secondly, thatthe discrimination is based on the origin; and thirdly, that the measure accords less favorable treatment to goods or services from a set of foreign services and service suppliers alone.[7] In order to be ‘like’ services, they must be substitutable and competitive with each other.[8] In the context of ‘e-commerce operators’ that are subject to the levy, the Finance Act of 2020 defines it to include a wide array of services incorporating both – online sale of goods or services owned by the e-commerce operator or facilitation of such online sale of goods or services.[9] This definition is broad enough to encompass video streaming services, cloud services, and stores that sell their goods digitally. However, the GATS jurisprudence on MFN has emphasized that the assessment of likeness of services should not be in isolation from considerations relating to the service suppliers.[10] In the above-listed examples, it is clear that they provide services of varied characteristics,[11] do not target similar business sectors,[12] and do not demonstrate comparable end-uses.[13] Even if the likeness of services and service suppliers is established, since the equalization levy neither discriminates nor accords less favorable treatment to any particular member country, it does not violate the MFN obligation.
Flexibilities in the GATS for Direct Tax Measures and the Qualifiers
In my view, commentators have not given enough attention to the exception clause in the GATS that gives scope for sovereign nations to exercise their power to tax. The general exceptions in the GATS under Paragraph 2 to Article XIV excludes direct tax measures imposed for ensuring ‘equitable or effective’ collection of taxes.[14] However, this is not a per se exemption. The measure has to be applied in a manner that is not arbitrary or unjustifiably discriminatory between countries where like conditions prevail, or operate as a disguised restriction of trade in services. Therefore, even though direct tax measures are exempted, the WTO’s panel is allowed to rule on their compliance with the qualifiers that ground the exemption.
While the equalization levy does not discriminate between countries where like conditions prevail, it may operate as a ‘disguised restriction of trade in services’ as is already evinced by price increases in digital services offered by Apple.[15] The WTO has quite often dealt with both the restrictions together without differentiating between them adequately.[16] It has been argued by Chang-Fa Lo[17] that the protectiveness of the measure is a more reliable indicator to ascertain disguised restriction of trade in services. This position is also in conformity with the Dispute Settlement Body’s view that the objective and the content of the measure should hold primacy over application-based results.[18]
The levy, in its current form, can operate as a disguised protectionist measure hindering trade. This is due to the design of the levy and its expansive scope, particularly because it uses the phrase ‘Indian Resident’ as opposed to ‘users in India’. By seeking to tax transactions involving Indian Residents, the equalization levy imposes an onerous duty on companies to know each user’s country of residence. In contrast, the term ‘users in India’ is more accommodative of all transactions that have a territorial nexus in India as a source country. In the same vein, it also eases the task of companies as it is relatively simple to identify the location of any given user using their IP address.
Another key aspect that is worth exploring, is the nature of the levy itself. Though imposed as a direct tax measure, it is introduced outside the current income tax law. This poses questions on its inclusion in Double Taxation Avoidance Agreements (‘DTAA’), as they generally cover taxes, and any other surcharges or levies substantially in the form of taxes. Having been imposed as a unilateral levy that is outside the scope of inclusion in a DTAA, the equalization levy cannot be obtained as a foreign tax credit in other countries.
Altogether, the equalization levy introduced by India has a serious design flaw that will automatically restrict international trade in services. Though a national treatment or an MFN challenge is likely to not sustain, at the same time India must tailor the operation of its levy in a manner that will fulfill the qualifiers for a ‘direct tax measure’ exemption.
Revising taxation rules to reflect the digitized world
The equalization levy’s sole aim is to tax non-resident digital services that have long escaped its tax liabilities based on the traditional PE rules. This is in contrast to the digital services operated by Indians within the country that necessarily have to comply with the Income Tax Act 1961,[19] and their business incomes are automatically chargeable to tax under the statute. So, the equalization levy only remedies what traditional taxation frameworks could not achieve, which in turn resulted in countries losing large portions of their tax revenue.
The challenge to the equalization levy based on anti-discrimination rules overlooks the real intention of taxing digital services that are generally ‘hard to tax’ using the traditional framework. Digital services such as Facebook, with a huge user base in India reap enormous profits from the country but are not obliged to pay taxes, as they may not have set up a subsidiary or an office space that can qualify as a Permanent Establishment.[20] The Organisation for Economic Co-operation and Development (‘OECD’) in its report recommended charging an equalization levy “as an alternative to overcome the difficulties raised by the attribution of income.”[21] Likewise, it also recommended other forms of taxing the digital economy; for example, the OECD endorsed the concept of Significant Economic Presence (‘SEP’), which has already been incorporated into the Income Tax Act as Explanation 2A to section 9(1).[22] The distinction between the SEP and the equalization levy is that while the former lays down the criteria to determine when “income is deemed to accrue or arise in India” and is, therefore, liable to be taxed as any other non-resident that has a PE; the latter imposes a blunt levy on all transactions for specified services with a non-resident entity without a PE.
The OECD finds the SEP concept less disruptive and one that easily synchronizes with the existing laws on taxation.[23] The SEP in its current form seeks to tax the income of non-residents arising out of online transactions when the business has more than a threshold number of users or an aggregate of payments for a specific service in a given year. Any non-resident that meets the criteria for SEP has a PE in India, even though they might have no physical presence. In contrast to the equalization levy that disregards the existence of a PE, the SEP concept tries to identify the existence of PE through rules tailored to sufficiently define profit attributability in the digital economy. It also remedies the uncertainty surrounding equalization levy because upon notifying the threshold number of users and payment-aggregate, businesses know their liability to taxation in advance. Therefore, India could consider a digital taxation regime that solely identifies the existence of a SEP permanent establishment for non-residents, as it is a more holistic method of allocating revenue between states. Accordingly, these new forms of taxation are a way forward for all countries to extend their taxation regimes to digital services. Countries must keep in mind that the OECD discussions on digital taxes have long recommended these changes to the taxation codes, in furtherance of lessening the gap between economic reality and taxation rights. During the pandemic, when all activities have moved to the digital world, states need strong taxation rules to tax large companies that can have a strong commercial presence even without establishing any form of PE in India. However, the design of the taxes on digital services can cause greater uncertainty. To avoid possible negative effects on trade in services, India can calibrate the rate of the equalization levy after a year of its implementation. Additionally, stronger trade rules in the digital economy also demand concurrent clarity on issues of privacy, security, and data flows. India is only now formulating and discussing laws governing privacy, and its approach to issues in the intersection of the digital economy and privacy are yet to be seen.
This article has been authored by Indumugi C., Fourth-year student, Tamil Nadu National Law University (TNNLU).
[1] The Finance Act, 2020, §§ 165A, 166A.
[2] Ganesh Rajagopalan, Equalisation Levy – Applicability of Non-Discrimination Rules in International Agreements July 8, 2016, available at http://dx.doi.org/10.2139/ssrn.2815109 (Last visited on November 29, 2020); Ayushi Singh, India’s Equalisation Levy, Digital Services Trade, and the Evolutionary Approach – Part I, August 10, 2020, available at https://indiacorplaw.in/2020/08/indias-equalisation-levy-digital-services-trade-and-the-evolutionary-approach-part-i.html (Lat visited on November 29, 2020).
[3] General Agreement of Trade in Services, April 15, 1994, Marrakesh Agreement Establishing the World Trade Organization, Annex 1B, 1869 U.N.T.S. 183 (‘GATS’), Art. I.
[4] GATS, supra note 3, Article XVII.
[5] GATS, Schedule of Specific Commitment (India), April 15, 1994, GATS/SC/42.
[6] GATS, supra note 3, Article II.
[7] Id.
[8] Appellate Body Report, Argentina – Financial Services, ¶ 6.25-6.26, WT/DS453/AB/R, (April 14, 2016 adopted on 9 May 2016) (‘Appellate Body Report, Argentina – Financial Services’).
[9] The Finance Act, 2020, § 153.
[10] Appellate Body Report, Argentina – Financial Services, ¶ 6.29.
[11] Panel Report, EC – Bananas III, ¶ 7.322, WT/DS27/R, (May 22, 1997 adopted on 25 September 1997).
[12] Panel Report, China – Electronic Payment Services, ¶ 7.706, WT/DS413/R, (July 16, 2012 adopted on 31 August 2012).
[13] Appellate Body Report, Argentina – Financial Services, ¶ 6.31-6.32.
[14] GATS, supra note 3, Paragraph 2 to Article XIV.
[15] See Shomik Sen Bhattacherjee, Apple Will Increase App Store Prices in India To Reflect 2% Equalization Levy October, 2020, available at https://in.mashable.com/tech/17918/apple-will-increase-app-store-prices-in-india-to-reflect-2-equalization-levy (Last visited on November 29, 2020).
[16] Appellate Body Report, US- Standards for Reformulated and Conventional Gasoline, ¶ 25, WT/DS2/AB/R, (April 29, 1996 adopted on 20 May 1996).
[17] Chang-Fa Lo, The Proper Interpretation of ‘Disguised Restriction on International Trade’ under the WTO: The Need to Look at the Protective Effect 4 Journal of International Dispute Settlement 111 (2013).
[18] Panel Report, EC – Asbestos, ¶ 8.236, WT/DS135/R, (September 18, 2000 adopted on April 5, 2001); Appellate Body Report, Brazil – Retreaded Tires, ¶ 238-239 WT/DS332/AB/R, (December 3, 2007 adopted on December 17, 2007).
[19] Income Tax Act, 1961 (‘IT Act’).
[20] Business Today, Tech giants Facebook, Google under I-T dept scrutiny for underreporting revenues in India: Report, July 10, 2019, available at https://www.businesstoday.in/technology/news/facebook-google-income-tax-dept-it-underreporting-revenues-india-tech-giants/story/363193.html (Last visited on December 19, 2020).
[21] The Organisation for Economic Co-operation and Development (‘OECD’), OECD’s 2015 Final Report: Addressing the Tax Challenges of the Digital Economy under OECD/ G20 BEPS Project,(October 25, 2015) available at https://www.oecd.org/ctp/addressing-the-tax-challenges-of-the-digital-economy-action-1-2015-final-report-9789264241046-en.htm (Last visited on November 29, 2020).
[22] IT Act, supra note 19, Explanation 2A to Section 9.
[23] The Organisation for Economic Co-operation and Development (‘OECD’), Tax Challenges of Digitisation, Comments received on the request for input – Part II (October 25, 2017) available at https://www.oecd.org/tax/beps/tax-challenges-digitalisation-part-2-comments-on-request-for-input-2017.pdf (Last visited on December 19, 2020).
Image Source: Wired
Comments