India has implemented the new SEP-based Nexus rule in its national tax law
India has always been at the forefront of the campaign calling on new age digital companies to pay their fair share of taxes to the market jurisdictions.
According to the OECD’s BEPS Action Plan 1, India was one of the first countries to introduce the countervailing charge, which now applies to almost all cross-border online sales of goods and services.
In addition, India has introduced a new Nexus rule “Significant Economic Presence” (SEP) in its national tax laws. Legal text on SEP was inserted into Indian income tax law in 2018. The provisions come into force on April 1, 2021.
The Indian government has explicitly stated that SEP is inspired by the recommendations of the BEPS Action Plan 1. Thanks to the technology, non-residents can now remotely interact with customers in India.
The existing Nexus rules, which require a physical presence in the country of origin, are out of date. While the international consensus on this issue is still hard to pin down, India has adopted the new SEP-based Nexus rule in its national tax law.
Concept of SEP: New Nexus Rule
Previously, under Indian tax laws, all income from a business relationship in India was taxable in India. Such a business relationship usually required the conduct of business by non-residents in India through the physical presence of a permanent office, employees, agents, etc.
In the future, even an SEP of a non-resident in India will be considered a business relationship in India and therefore income generated by a non-resident from such an SEP will be taxable in India.
- A non-resident has a SEP in India in the following circumstances: The non-resident conducts transactions in relation to goods, services or property with any resident of India when the total payments are 20 million rupees (approximately US $ 270,000) in. exceed a year; or
- The non-resident engages in systematic and ongoing business initiation or interaction with at least 300,000 users in India.
SEP is constituted regardless of whether the contracts are concluded or services are provided in India or outside. The SEP-based Nexus rule is not only limited to digital transactions, but also applies to cross-border transactions that are carried out offline.
Effects of the SEP on non-contracting states
If a non-resident is in a jurisdiction without a tax treaty with India, the SEP rule of Indian domestic tax law applies in full. For example, in certain cases, digital businesses are set up in tax havens that do not have a tax treaty with India. Such companies can face a significant tax burden in India which can be recovered through tax withholding.
Possible effects on contracting states
The SEP provisions in Indian domestic tax law appear to have no impact on non-residents operating from countries with tax treaties with India, as treaties still require a permanent establishment in the source country such as India.
Nevertheless, SEP could affect non-residents in contracting states as follows:
Additional compliance effort
Payments to non-residents may be subject to withholding tax unless documentation is presented to support treaty benefits such as the Tax Residency Certificate (TRC), Non-PE Declaration, etc. In addition, non-residents may even be required to obtain a PAN and file tax returns in India, as non-residents who only have certain types of income such as royalties and technical service fees are currently exempt from such regulations.
Denial of contractual benefits
It also exposes non-residents to the possible denial of treaty benefits by Indian tax authorities through application of the Main Purpose Test (PPT) or General Tax Avoidance Rules (GAAR) or other technical details.
SEP Attributable Profits: Confusion of Supreme Court Law?
Interestingly, while the OECD is still debating profit attribution, Indian tax law provides that all profits attributable to such an SEP are taxable in India.
In addition, the provisions also aim to tax certain indirect profits made as a result of SEP. For example, any income from advertising targeting Indian users or income from sales of data collected from Indian users may also be taxable in India.
Importantly, this extended profit allocation rule is also likely to have an impact on non-residents who are residents of contracting states and have a permanent establishment in India (either conventionally or based on the extended definition in MLI).
In addition to the arm’s length profits attributable to such a permanent establishment, the Indian tax authorities can insist that the indirect profits attributable to SEP in India are also taxable in India.
Thus, the provisions can lead to the existing judicially recognized position being shaken (see DIT (Int.) Against Morgan Stanley & Co. [2007] 292 ITR 416 (SC) and Set Satellite (Singapore) Pte. Ltd v DDIT [2008] 307 ITR 205 (Bombay)) that, if PE’s activities are remunerated at customary market conditions (through payments to affiliated companies), no further profits should be attributed to PE.
Go forward
The SEP-related change marks a significant leap in the way India seeks to tax profits from non-residents who do business with India. Even taxpayers located in jurisdictions with which India has tax treaties may face significant future tax and compliance burdens as a result of these changes.
There is no doubt that a proper impact assessment of the new SEP rules is needed for cross-border business with India, be it digitally or conventionally.
With Vasudevan
Managing Partner, Lakshmikumaran & Sridharan
Karanjot Singh Khurana
Main shareholders, Lakshmikumaran & Sridharan
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