Ecommerce taxation—a work in progress?

The two key issues that highlight the income tax concerns in the e-commerce space are: Difficulty in characterisation of income (especially for cloud computing services, database access etc) and difficulty in determining physical presence (criteria for permanent establishment, that is PE, or business connection) for tax purposes

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Ecommerce and digital transactions are under rapid expansion as a technological revolution is under way. It continues to transform the way businesses function internally as well as externally, allowing them to operate with little or no physical presence in a location.  Markets and customers can now be accessed at the push of a button.

International taxation rules, which predominantly require physical presence for businesses to invoke taxation, have not been changed to envelope this growing trend in technology.  At the behest of G20, OECD published an action plan on Base Erosion and Profit Shifting (BEPS) to address concerns raised by countries about erosion of tax base through profit-shifting, particularly with relevance to ecommerce businesses.

India’s ecommerce space is abuzz—experiencing a material growth with investors making large investments in these businesses.  A wide geographical distribution of people adds to the excitement for these businesses since physical expansion of stores is a challenge. According to a recent report of Internet and Mobile Association of India (IAMAI), India’s digital commerce market registered an average growth of about 35 percent since 2010 and is expected to grow further at 33 percent, crossing $20 billion by 2015.

This column attempts to outline two key income tax issues that the ecommerce industry faces.  The BEPS Action Plan characterises the digital economy by an unparalleled reliance on intangible assets, massive use of data, widespread adoption of multi-sided business models, and difficulty of determining jurisdiction in which value creation occurs.  The two key issues that, therefore, highlight the income tax concerns are: Difficulty in characterisation of income (especially for cloud computing services, database access etc) and difficulty in determining physical presence (criteria for permanent establishment, that is PE, or business connection) for tax purposes.

Characterisation of income is important to determine the taxability of ecommerce transactions.  For example, income could be classified as business profits if the purpose of payment is merely to enable customers to electronically download digital products, such as software, images etc, without acquiring their copyright.

However, if consideration is for grant of the right to use the copyright, income could be characterised as royalty. Owing to the manner in which transactions are commercially done in this space, limited user licences with a right to download a copy of the content are granted and these, sans specific rules to this effect, tend to create some doubts on characterisation—whether the income is in the nature of royalty or not.

Royalty income is taxable in India even if a foreign player does not have a taxable presence in India, under the applicable tax treaty.  However, based on existing tests laid down for determination of PE, it is difficult to determine the existence of PE in ecommerce businesses due to the intangible nature of transactions.  This is the second key issue for cross-border businesses in this space.

Jurisprudence on this subject in India is still evolving.  In a case of an Indian taxpayer, who advertised on search engines supplied by Google and Yahoo to generate business, it was held that a search engine which only has its presence through a website cannot be a PE, unless its web servers are also located in the same jurisdiction.  However, the Indian government has some reservations on a website not qualifying the physical presence test for a PE, contrary to the internationally accepted principles.  In another case, it was concluded that revenue earned by the taxpayer from operating India-specific websites was not taxable in India in the absence of a PE in India under Article 7 of India-Switzerland tax treaty.

Globally, taking cognisance of concerns raised by stakeholders, the BEPS Action Plan 1 helps to identify and address challenges of the digital economy.  The objective of the initiative is to identify the difficulties involved in applying international tax rules to the digital economy and to subsequently develop detailed options that address the difficulties.  The report was released in the interim; however, it was acknowledged that more technical work is required in connection with options available to deal with tax issues arising from the ecommerce.  The manner in which the recommendations will get implemented at the international tax convention level and how different countries are going to gear up their domestic tax laws imbibing these learnings is yet to be seen.  Some countries like UK and Australia have taken the lead in updating their domestic laws to address some of these concerns.

On the legislative front in India, no specific amendments have been made to the law that addresses the taxation of ecommerce transactions. Some concerns on the VAT side have emerged owing to the marketplace storage and delivery models; the players and state governments are actively trying to resolve the dispute.

The government should take a long term view on taxation of such businesses and not see them differently for short term revenue collections as these businesses have the strong ability to allow for and promote equitable growth in India down to the rural areas.  Judicial intervention would be key to appropriately interpret the principles of taxation with respect to ecommerce businesses.  Players in the digital space should tread carefully considering the inadequate legislative and judicial material available on a variety of topics in this business.

(With inputs from Anuj Agarwal)

- By Sumeet Hemkar, partner and Anuj Agarwal is assistant manager, BMR & Associates LLP 

The thoughts and opinions shared here are of the author.