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    Digital tax: Why India's approach to taxing Google, Facebook needs to align with international approach

    Synopsis

    As more and more people participate in the digital economy, there is a need for countries to develop a framework to regulate and to get a 'fair' share of taxes from the revenues generated by such businesses.

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    With newer technologies such as blockchain, virtual reality and artificial intelligence on the rise, the pace of digitalization is only going to accelerate.
    By Rishi Kapadia, & Mohit Rakhecha

    Rapid digitization is one constant that has changed the world we live in. From buying groceries, booking cabs, and watching movies to connecting with people world over through social media/ messaging applications, almost everything is possible online. As more and more people participate in the digital economy, there is a need for countries to develop a framework to regulate and to get a 'fair' share of taxes from the revenues generated by such businesses.

    Development of such a framework is challenging as typically, taxation rules have been built around traditional brick and mortar businesses. A source country can tax a Multi-National Enterprise (MNE) once a 'nexus' is established through physical activities undertaken in the source country i.e. Permanent Establishment (PE). Thereafter, profits attributable to this presence are determined and taxed in the source country.

    Unlike traditional businesses, digital businesses have three distinct characteristics:
    (a) They are not physically established - for example, Facebook, can offer all of their services with limited or no physical presence.
    (b) They heavily rely on intellectual property assets (which can be quite mobile) and are typically located in, or worse shifted to, a low-tax jurisdiction.
    (c) They are able to generate value through highly engaged 'user participation' from the source country market.

    The current tax rules simply do not factor these features and there is a need to realign profits and taxes to 'value creation' from new business models.

    If a company has no office or employees in a country and yet manages to earn huge revenues from that country through remote digital participation, it is only fair that a portion of the company's profit be allocated based on the market activity undertaken in such country. Though most recognize the 'free rider problem', the policy makers are grappling with developing a consistent and effective framework for taxation of digital business.

    The OECD, with the aim to deliver a set of consensus-based solutions to the G20 by 2020, has issued a discussion draft last month. The draft identifies three proposals under consideration that would revise the profit allocation and nexus rules, so that value created by a business's activity or participation in a user or market jurisdiction is recognised in the framework for allocation of profits. Two of the three profit allocation proposals i.e. the concepts of 'user participation' and 'marketing intangibles' - use a mechanism that would reallocate a proportion of a MNEs non-routine profit to the user or market jurisdiction.

    India has already moved forward and has applied Equalization Levy since 2016 at a rate of six per cent on the payments made by Indian businesses to non-residents providing digital advertising services. In 2018, India recognized virtual presence as constituting nexus for the purpose of asserting taxing rights and introduced the concept of Significant Economic Presence (SEP) in its tax laws. The SEP is defined based on certain revenue and user thresholds, that remains to be prescribed.

    The SEP provisions may be interpreted to mean that the entire income attributable to a transaction giving rise to a SEP is taxable in India, even though operations of such transaction/business activities may be carried outside India. This leaves significant room for ambiguity and raises questions over extra-territorial applicability. The OECD acknowledges that without effective changes to profit allocation rules, the introduction of standalone nexus provisions is likely to be ineffective. The SEP provisions, in the present form, deviate from this precept which is likely to increase controversy in India without a meaningful increase in profit allocation and tax collection.

    With newer technologies such as blockchain, virtual reality and artificial intelligence on the rise, the pace of digitalization is only going to accelerate. Any new legislative enactment must be fully considered, and its broader impact fully evaluated, before being implemented. A unilateral move can only expose India to retaliatory measures from other countries. As the OECD works towards a solution towards digital taxation, India's interests will be better served if it works through developing a consensus-based, longer-term, multilateral solution to digital taxation.


    (Rishi Kapadia is Partner and Mohit Rakhecha is Senior Associate from Dhruva Advisors.)



    (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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