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Rashmin Sanghvi & Associates

Chartered Accountants

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E-Commerce International Taxation Possible Solutions

PART III

Detailed Paper.


Part III.1 Permanent Establishment (PE) & E-Commerce.

1. E-Commerce or distance business is possible without physical presence, and without a local agent. The website & the servers may be in any country; or in several countries. And can be shifted at will. Or they can be mobile also. They need not exist in the country of consumption. Nor is it necessary for them to have any fixed place of business. Whereas PE is based on physical presence or on an agent.

2. Several non-residents of India do earn profits in or because of India. In what situation and based on what logic, the profits may or may not be taxed in India!

Assessees rely on the fact of absence of PE; and the legal position that business income cannot be taxed in the absence of PE; and claim exemption from Indian tax.

Tax department (whether Indian or U.S.) cannot accept this position and searches for ways to tax this income. When PE is not available, they want to categorise the payments as any of those categories where tax is deductible at source just based on the fact of payment from India. Large part of litigation is based on this crux of the problems. (Sorry for the repetition of paragraph. The same issue is logical at several places.)

3. What is a PE except a thresh hold for considering whether a NR is present within the COS or not. Have some other thresh hold. Some thing which is not as outdated a concept as PE.

One suggestion : The threshold may be the same whether for E-Commerce or for the rest of the Commerce. Let us say, Rs. 5,00,000 (or say, Euros 9,000 are fixed as the threshold). Anyone receiving more than Rs. 5,00,000 in a financial year from India, may be liable to file his tax returns in India. The payers will deduct tax where applicable. However, a single payer paying less than Rs. 20,000 a year need not deduct any income tax.

If a NR receives from India, within a previous year, any amount exceeding the thresh hold, he will be liable to file his tax return. He can claim that his receipt is not liable to tax in India – because, e.g., he has made no value addition within India. Under sections (5), (7) and (9) it is a settled issue that a foreign seller of goods to India, is not liable to tax in India. Almost all exporters to India will be entitled to make this claim, not file their returns in India, & not suffer any TDS of income-tax. The Indian importer will be liable to import duties. But that may not be the procedural concern for the non-resident. Others, who may be adding values within India, with a PE or without a PE, will be liable to file returns and pay appropriate tax.

Simultaneously, all exporters of services to India who have made no value additions within India, will be exempt from any income tax in India. The same principle and procedures may apply to all NR recipients –whether on account of sale within India of goods or services.

4. Server as PE.

A view has been canvassed that a server should be considered as the PE & tax should be allocated accordingly.

Server is simply a piece of machinery, a part in the internet system. The only value that may be allocated to a server would be the rent that any independent internet service provider would charge. Server can be installed in a tax haven & taxes can be avoided. It can be installed even on a mobile vehicle. It cannot be considered as PE. Tax jurisdiction cannot be shared based on a server.

5. Historical Background - Technology & Business Environment.

When the principles of permanent establishment were formed (the first model convention was drafted by OECD during 1956 to 1963. And for the moment we ignore the work done by League of Nations.) business world did not have computers. Nobody heard of internet. The communication and transport systems available to the common businessman were - as compared to the current systems - extremely slow, costly and inefficient. If one had to do business in another country, he had no choice except establishing a physical presence in the other country. He would open a branch, a factory or some such presence. When the first Committee on Fiscal Affairs drafted the model convention, naturally, it considered the business environment then present.

Hence we have these concepts -

“Fixed place of Business”; “Permanent” and “Tangible existence”. The word “tangible” is not present in the PE definition. And yet it is given importance in considering a PE. (OECD, TAG has opined that since a “web-site” is not tangible, it cannot be called an “equipment” and hence not a PE. Please see the report on “Categorisation of Payments” by OECD TAG.)

6. Change in technology.

E-Commerce is commerce transacted electronically. Communication messages are transmitted through electronic medium. The system is run by software. All softwares are nothing but electrons stored or arranged in specific manners.

Electrons are pure energy. Energy, by its very nature is constantly moving. Something, by nature, contrary to the concepts “Permanent”, “Fixed”, “Tangible”.

7. Attempts at applying these PE principles to today’s e-commerce are like – applying the rules and laws of physics, pertaining to a horse carriage; to an automobile car. It looks illogical that anyone might do so. However, it is a fact. When the initial automobiles were made in the nineteenth century by several companies, they were almost replicas of horse carriages.

(Pictures of these classic cars and short stories on the same are available on the following website: https://www.ausbcomp.com/~bbott/cars/carhist.htm)

Till then, people had not conceived the idea of an automobile car. So when they first made a car, they almost put an engine under a horse carriage. They could not think of a totally new design - though the motive force and hence total engineering had changed. In these cars, even bonnets & dickeys were not there. The car engine was placed below the body of horse carriage. Several individuals and companies WENT INSOLVENT before a successful model was made.

With experience they learned. And today we have a car totally different from horse carriage.

Applying PE principles to e-commerce is like those first automobile cars. However, we have the benefit of other experiences. Can we design new rules conceptually and totally; because the technology is new!

If we don’t, very soon we will learn by experience. “Change” is not acceptable to some people. There is no solution for this problem. Only disaster forces people to accept change –except when the issue is of fashion & people involved are collegians.

Since we want to act before disaster strikes, Let us consider a full range of solution.


PE completed.

Next : Categorisation of Income...


Part III.2 Categorisation of Income

1. Controversies and Litigation :

Is it a fair & correct legal position where if the income is categorised as business income; it is not taxable; but if it is categorised as royalty or FTS, it is taxable! The source based tax principle (nexus or connecting factor) is based on the presence or absence of source & not upon the category of income!

It is so clear that in the current legal position where tax depends upon category, all non-resident assessees will try to categorise their incomes as business; and tax department will try to categorise it as royalty or FTS.

Can we allow a basic legal position which causes & perpetuates litigation! We may attempt to develop a legal system where tax litigation is reduced rather than increased.

Even if a good structure of - tax treaty & domestic tax law- are evolved, there will still be litigation. Because there will always be some tax payers who simply do not want to pay any tax at all; and there will be some tax officers who would want to tax even a non-resident’s foreign incomes. If we ignore these extremes, we can safely say that when like assessees are placed in like tax liability, the incentive to litigate is reduced.

2. Reasons for Categorisation of Income :

Under the DTA, it is necessary to determine the Country of Source of Income. Since different incomes will have different ways of determining the country of source; different categories are useful to determine the source. The house property income is sourced in the country where the property is situated. The dividend income is sourced (generally) where the company distributing dividend is resident. Salary income is taxable where services are performed. Thus for determining the location or the country of source, the categorisation is useful.

Under the domestic law, computation of income is important. Within a country, different category of income needs different computation provisions. For example, business income needs detailed provisions for computation. Whereas the salary income computation is simpler. The two kinds of provisions: DTA & Domestic tax law have different reasons for categorisation of income.

3. Having listed the different categories, no attempt has been made under DTA to prescribe rules for determining the COS, nor the rules for attribution of profits between COS & COR. (As we study Professor Roy Rohatgi’s book on International Taxation, we realise that there is a history. There are reasons why the present situation has developed in the manner it has. However, now the changes in the business have reached a threshold. It has become necessary to refine the rules of COI by defining rules of source.

The correct machinery provisions will be - detailed source rules covering every different kind of income. Once the source rules are there, everything falls in place.

4. Can a businessman have his source of income in a country where he is neither resident nor does he have a PE? This probability was never considered before the advent of internet. A presumption was made that the income is sourced only in the countries of residence or PE. Hence a rule is made that the business income will be taxed in the country of residence and PE. E-Commerce has challenged the notion that one cannot earn income in foreign country without having a PE in that country.

5. Where is the rental income from immovable property sourced! Very simply the country where the property is located. This is one instance where the category of income and the source of income both give the same results. And hence there are no controversies on this kind of income.

6. Where is the royalty income “Sourced”? This question has not been raised, so no one has answered it. It has been accepted in the model convention that the royalty income should be taxed only in the “Country of Residence”. Taxing royalty in the Country of Payment / use is an exception to the OECD convention. Now of course it is followed almost by all countries.

7. Is the “Country of Payment” - the “Country of Source”? Not necessarily. Both the terms may indicate the same country or different countries.

Illustrations :

7.1 If General Motors manufactures a car in U.S.A. and exports it to Mr. Gerald in Germany, which is the “Country of Source”? The German resident Mr. Gerald makes the payment. He uses the car in Germany. So is the “Country of Payment”, the “Country of Source”?

No. The car is made in U.S.A.; the entire “value addition” is made in U.S.A. and hence U.S.A. is the “Country of Source”.

The “Country of Residence” for General Motors is also the “Country of Source” for the business income. Hence there is no controversy.

7.2 Dr. Patel from Mumbai gives medical advice to Mr. Smith in U.S.A. The fees are paid by Mr. Smith’s son in Singapore. Country of payment is Singapore. It has nothing to do with Country of Source.

8. However, when it comes to `Royalty’; so many Governments have simply presumed that the “Country of Payment” is the “Country of source”. Sometimes, they even argue that the technology for which royalty is being paid; is used in the “Country of Payment” and hence the “Country of Payment” has a right to tax it.

The fact that Gerald is using the GM car in Germany does not raise any claims that Germany should tax GM’s income. Why should similar situation raise a demand for tax jurisdiction in case of royalty? Since “Country of Payment” is not the “Country of Source”, OECD has clearly recommended that the “Country of Payment” should not levy any tax on the royalty payment.

Almost all countries want to levy income-tax on the royalty payments being made from their country. So almost all countries have ignored the OECD recommendation and levied withholding tax on royalty payment. Neutrality between “tangible goods” & “services & intangibles” has been sacrificed.

9. If we accept that a non-resident’s income may be taxed in India only if it is sourced in India; and that just because payment is being made from India, it does not become Indian sourced income; then royalties paid to non-residents will not be liable to tax in India. Similarly Indian software companies will not be liable to income-tax in Japan. (Japan had sought to levy income-tax on Indian software companies even when they did not have PEs in Japan; on the ground that these payments amount to royalties.)

10. Under the domestic law, different incomes are computed as provided in different provisions of the law. However, having computed incomes from different sources and categories; all the incomes constitute one figure of “Total Income”. Normal income-tax rate has to be applied to this figure. It is not that different categories of income are taxed at different rates (except where a particular income is to given some incentives). Similarly, when a non-resident’s income is to be taxed, all categories of his income should be taxed at the same rate.

Professor Richard Doernberg, in his IFA Report on “E-Commerce and taxation” has raised the issue why categorisation at all? “Income is Income - Distinctions between different types of incomes are artificial”. (Page No. 335 in the first edition of the book.)

I categorically submit that “Categorisation of Payments” should have no role in sharing of tax rights. Only “Source of Income” and “Residential Status of the Assessee” are relevant.

The OECD TAG on Categorisation of Payments has not discussed the fundamental issue of ‘source’ of income. It has simply tried to determine in the 28 illustrations given; whether an income might be categorised as ‘Royalty’ or “Business Income”. Once it is royalty, the country of payment acquires jurisdiction to tax the income on ‘gross’ basis. If it is “Business Income”, there is no right to tax.

11. Because of this position following situation has arisen.

Governments want to categorise all payments to Non-Residents in such a manner that they attract T.D.S. Most convenient is Royalty and FIS. So the definition of these two categories have been made so wide that they can almost cover all payments to non-residents.

And non-resident assesses try to categorise all receipts as business receipts without PE. A fundamental cause for controversies and litigation has been built into the system. Removal of this cause can reduce litigation significantly.

Categorisation of Income or COI completed.


Next : Source of Income…..


Part III.3 Source of Income :

1. Definitions: The term “Source” is neither defined in the domestic Indian law, nor in the OECD & UN model conventions. It helps. If a simple word is not defined, every one understands it. It acquires new meanings as times change. It meets with the requirements of the changing business. The moment, you define a word, it acquires boundaries & exclusions. Every word of the definition can be countered. And the meaning will be frozen. Times will keep changing. And there will be a time when the definition will be irrelevant. People will not accept its irrelevance & there will be litigations!

2. What is the meaning of “Country of Source”!

As far as manufacturing & regular business incomes are concerned, we know the currently accepted meaning. For E-Commerce, we need new meanings. For example:

For a company broadcasting television programmes globally, which country is the source!

A medical doctor working from his hospital in Mumbai; advises a patient sitting in New York on a video conference facility. The fees are paid by the patient’s son working in Singapore. What is the source country! If service provider, service consumer & the payer for the services are all situated in three different countries, where is the source of income!

If Infosys maintains from India, software operating in USA, installed on US computers, the source of income lies in India or in USA!

For any fundamental problem, we try to look for Professor Klaus Vogel’s book and some precedents. Well, Prof. Vogel has also complained that there is no definition of source. And one can’t find much precedence on law applicable to technologies which have developed recently. In a long history of tax negotiations, several issues have been raised. A broad meaning has been accepted by OECD & followed by most countries in their DTA. Recently, this meaning is again challenged. Let us consider the issue.

3. OECD Approach :

One might say that the present interpretation accepted by OECD is as under. OECD TAG report on Attribution of Profits to PE –August 2004 may be considered.

The country of source is where the assessee has made value addition. For -every function conducted by the PE, assets allotted to the PE, and risks taken by the PE; - in different countries, consider the value addition, and compute the profits within the value addition. This may need application of attribution principles. Under this understanding, market or demand side is not considered as “Source of Income”.

So, if the TV broadcaster has produced programmes in India & in U.S.A., to the extent of production, it has source in both these countries. For the function of broadcasting the programmes, the value addition is in that country where people managing the broadcast are located.

4. Market Vs. Supply side theories. [Paragraphs (4) to (13)]

The challenge to the above concept is: Profits are earned because of the supply side efforts as well as the availability of the market. Who should tax the income! The country of residence from which goods have been supplied! Or the Country of Market where the goods have been sold! or both!

Illustrations :

4.1 Infosys providing software services without PE in the COS- USA.

4.2 Chinese toy manufacturer exporting toys without PE in COS - USA.

4.3 Microsoft selling software packages in India without PE in India.

5. Infosys sells software services to a U.S. client. Let us assume that it has no PE in U.S. Full service is provided from India. If the service were provided to an Indian customer, it would have earned Rs. 10 millions. However, when provided to a U.S. customer, Infosys is able to get revenue of Rs. 45 millions. Can the U.S. Government tax all or any part of Infosys’ income!

6. When a toy factory in China exports toys to U.S., it earns more than what it would earn by selling locally. A significant amount of profit is earned because the toys are sold in USA & not in China. Does USA acquire a right to tax this extra profit that the Chinese toy manufacturer has earned! No. The source of income is China & not USA.

7. Issue : “Should goods & services be treated differently!” Should the concept of neutrality mean that sale of goods & services –both should be treated equally! It should. But for some historical reasons, all tax authorities and even professionals are treating goods & services differently.

8. Proposal : Income-tax must be treated equally whether the business is traditional or E-Commerce. Methods of delivery of goods or services, and methods of communication can not impact tax allocation between different countries. And whether the sale is of goods or services, there should be no difference in Income tax.

9. The income tax can be levied based on the factors connected with the assessee and his income. The market does contribute to income. And yet, the claim for market based tax is indirect tax like sales tax, VAT, service tax, octroi & customs duties. Not income-tax.

10. Once, a payment is covered by indirect tax, there should be no direct tax on it. In any case, what is the difference between TDS of Income-tax (which is calculated on gross figures) and a Service tax or VAT! In both cases, who ultimately suffers the tax is a matter of facts. The difference between direct and indirect taxes is, to an extent only theoretical. (This issue is also discussed at length under ‘base erosion’. Hence not elaborated here.)

11. Instead of any interpretation and theoretical issues on the differences between the two, if it is decided that only one of the two (direct or indirect) tax will be charged; by the country of market; matters will be simpler and more efficient in administration.

12. In any case, attempts to charge service tax as well as income-tax would be unjustified.

13. COS Vs. COC :

To illustrate the country of consumption or COC as different from Country of Source or COS we may consider following :

13.1 General Motors produces a car. All functions are completed within U.S.A. An Indian resident imports the car and uses within India. India is COC. India is not COS. India has provided a market. But India is not considered source for the limited purpose of allocation of income-tax between India and U.S.A.

13.2 China produces toys. Some toy factories work exclusively for the U.S. market. But for the U.S. market, these factories would be wound up. Complete function of manufacture and marketing is done from China. The factories have no PE in U.S.A. The Country of Residence as well as Source is China. U.S.A. – the exclusive market is not COS. It has no right to levy any income-tax on the Chinese manufacturers.

13.3 Country of Market (COM) or Country of Consumption (COC) is different from the Country of Source (COS). This principle is accepted as far as goods are concerned. When the matter comes to import of services, there are disputes. India may be importing goods worth $ 150 billions every year. Article (7) is accepted & no one complains. Import of services & such disputable items may be less than $ 10 billions. And there is tremendous debate & litigation!!!

13.4 An assessee may manufacture components of its goods in three different countries. Then assemble in a fourth country. All these four countries are COS. The finished products may be sold in twenty five countries (let us say without PE). The twenty one countries in which goods are sold are not COS. The four countries where production & sale both are made, do not get any additional rights to tax based on sales.

13.5 Submission : For income-tax, both goods & services have to be treated equally. The concept of neutrality should cover this aspect also. For goods, article (7) is accepted. Then for services also, similar provision should be developed. Alternatively, change article (7) also. Imagine the chaos that it would create.

14. Implementation : Difficulties in implementation is another problem cited in E commerce taxation.

Query 1 : In case sale of services from Business to Consumer (B to C), how to implement the tax system! How will the tax be collected! If Star TV is broad casting its programme to millions of viewers in India, how will Indian Government collect tax from those millions of consumers!

Query 2 : If instead of the consumers, tax is to be collected from STAR TV, how can the law be enforced on the non-resident! How can jurisdiction be applied to several such non-residents!

Response 1 : The TV company does collect its subscriptions from the viewers. It may be through the cable operators. They already pay entertainment tax. The suggested tax system (non-resident TV companies to pay consumption tax) is already in operation in Mumbai. Where there is a tax, there is a way to collect it.

Response 2 : All large non-residents will comply with the requirements of filing indirect tax returns. Small operators may evade the tax. This concealment of revenue or avoidance of tax is normal even in the traditional commerce. Leave aside non-residents. When the small resident operators do not pay the tax, Government tries to the extent practical. An attempt to collect all the tax in the jurisdiction will, for certain assessees, involve expenditure more than revenue.

U.S. Government has passed a law extending its jurisdiction over non-resident internet gaming companies by simply blocking all payments to them from U.S. Now it is of course possible for the U.S. people to have bank accounts outside U.S.A. They can always make payments from such foreign accounts. They do so at the risk of inviting the U.S. government enforcement machinery. It happens in all countries.

When an Indian High Court ordered- in the year 2006 - all TV channels including foreign /Non-resident channels to stop showing adult films to the Indian viewers, all big channels had no option but to comply with the order. Jurisdiction is always possible with big & relevant companies. And yet pornography in India goes on a large scale. Just because a Government cannot implement a prohibition completely, it does not mean that it cannot reasonably regulate or tax a system of commerce.

The tax system proposed in this paper is not offering any extra or new difficulties either in implementation or in computation. In fact, it offers simplicity.


Source Completed

Next : Solution…..


Part III.4 Solution : Direct & Indirect Taxes can be complimentary.

1. We generally consider one tax at a time. If we take a macro view, probably, we may get some better ideas.

2. As professor Richard Doernberg has said, Governments are concerned with revenue. Whether it comes in as a direct tax or an indirect tax, how is a Government concerned! Let us consider both taxes at a macro level.

3. It is now almost a general tradition that all governments exempt or give substantial reliefs from Indirect taxes for goods & services being exported out of the country. And they all tax imports. That is, they levy customs duty on imports. Indirect taxes are destination or consumption based. There is no international law or principle for this. It is just a normal phenomenon of encouraging exports.

4. On the other hand, income-tax is still levied on profits earned on exports. This is normal international trend. (India had granted substantial relief on export income. These are now reduced. These exemptions are exception rather than norm.) When goods are imported, the foreign exporter is not levied income-tax on the profits earned by him on his sale of goods. There is no doubt & no controversy about it. However, the moment we consider services, and intangibles like royalties, we want to tax even the income on the import of services. Is there any logic for this difference between goods and services, tangibles & intangibles!

5. For goods, it can be said that where customs duties are levied, no income-tax is levied. For services, one can propose that where service tax is levied on a non-resident, no income-tax may be levied on the non-resident. He pays one of the two taxes, not both. This way, the Government gets tax revenue without the complications of computing the net profits earned by a non-resident. Even the Research & Development tax should be abolished on all items where either service tax or income –tax is levied.

6. This proposal of a single tax on the transaction with a non-resident may be presented in a table :


  Exports Imports
Indirect tax on Goods : Excise Duty, Sales tax etc. No Tax. Countervailing Duty levied.
Indirect tax on Services : Service Tax No Tax. A tax is levied on import of services.
Direct Tax : Income-tax Income earned in India, full tax. Income earned outside India, no tax.

Notes :

6.1 Service Tax is a new tax. It is under evolution in India. Hence the principles stated in the table above may have several exceptions. The above table gives broad principles only.

6.2 Earlier, under Section 80 HHC & other similar provisions, export income was totally or largely exempt in India. Now except for SEZs, other export incomes are being taxed.

Observation :

When the direct & indirect taxes work in a complimentary manner for cross border transactions, they are largely following Governments’ current taxing trends. Complimentary taxes will reduce administration as well as litigation for all. In the broad process change, some people may suffer more tax than what they are paying now & some may suffer less or benefit. However, these consequences appear as loss or benefit to the assessee in the COS or COM only. Once the tax effect in the COR is concerned, on the whole, the assessee’s tax cost will not change.

7. In any case, the T.D.S. on payments to non-residents is generally calculated at a fixed percentage on the gross. That is how customs duties are also calculated. Then why not just levy the customs duty (or relevant indirect tax) & forget income-tax on import of services.

8. Proposal :

In case of goods, it is very clear principle that when goods are imported, import duty – customs duty is leviable. Foreign seller of goods is not liable to income-tax. (The Government may levy or may not levy customs duty on certain goods. It may for example, exempt life saving drugs. That is a different matter. These exceptions do not affect the principle.)

A similar principle needs to be evolved where import of services are liable to service tax (This law is already in operation); they should not be made liable to income-tax. This principle is yet to be incorporated into the law.

Whole proposal of solution for E-Commerce taxation may be presented as under :

1. Ignore the concept of PE.

2. Refine categorisation of income by developing rules of source of income.

3. A service provider’s country of source is where he has performed services, made value addition. Country of consumption and/or country of market are not countries of source of Income.

4. COM and COC may not levy any income-tax. They may levy service tax or VAT.

5. The COR and COS will levy income-tax and share the taxes as per their DTA.

6. The relief of - COM and COC not levying income-tax - may be granted on reciprocal basis. For this purpose, DTA may be used. A separate article may be added. Different governments may mutually agree to the principle.

7. Assessees from offshore countries not levying any income-tax may be kept out of DTA reliefs.


Presentation of Solution completed.

Next : OECD & E-Commerce ...


Part III.5 OECD & E-Commerce

1. MACRO View of the relevant OECD reports.

OECD groups have considered both the taxes Income tax & indirect tax on E-Commerce in separate TAGs. Can we combine reports on both the tax themes together! Can we consider both the taxes in one macro manner!

While this paper ignores some reports of OECD TAGs, it follows two major themes of taxation adopted by OECD in the same spirit as OECD suggests. And at MACRO level shows that OECD has already lead us to a fair solution.

First we see the two separate themes that OECD has already developed :

2. For Indirect taxes consider the following report :

OECD Consumption tax TAG, report on: Implementation issues for Taxation of E Commerce: 1st August, 2003.

This OECD report favours indirect tax on services rendered –whether by E-Commerce or by Traditional Commerce at the place of Consumption.

“32. It ultimately may be more productive to think in terms of the appropriate tax treatment for all supplies that can be traded cross-border or delivered to remote customers, rather than just e-commerce. The most straightforward option for achieving neutrality and consistency in all cross-border transactions is to tax all transactions at the place of local consumption.”

3. Now consider OECD theme for direct tax. It has been: “Allocate taxing rights between COS & COR. The COS gets the rights based on value addition within the COS, not based on its market. Hence COM gets no rights to levy income tax.”

When both these principles are applied to the same commercial transaction, we might see a fair resolution of the taxing problem. Income tax at the COR & the COS. Indirect tax in the COM or the COC.

While the above referred work is very useful, some of the reports are less useful. Consider a few illustrations.

4. OECD TAG has published its final report on “Are The Current Treaty Rules For Taxing Business Profits Appropriate For E-Commerce?” in Dec., 2005.

The report calls for compliance with the following rules :

A. Consistency with the conceptual base for sharing the tax base.

B. Neutrality.

C. Efficiency.

D. Certainty and simplicity.

E. Effectiveness and fairness.

F. Flexibility.

G. Compatibility with international trade rules.

H. The need to have universally agreed rules.

All the characteristics ‘A’ to ‘H’ listed above are necessary ideals. One can not object to them. There are two comments however.

i. Neutrality.

The OECD framework for neutrality considers only the neutrality between traditional commerce and E-commerce. While this is a must, in addition, there is need for neutrality for all kinds of incomes: whether earned by dealing in goods or services, tangibles or intangibles. See discussion on categorisation of income, paragraph III.2. The existing tax system needs to be modified to comply with the requirement of neutrality.

ii. The need to have universally agreed rules.

While this is an ideal, one law of nature may be considered. The law is: “If there are six billion human beings in the world, there are six billion ways of thinking. It is impossible for them to have a unanimous view. Universally agreed rules do not exist. (Un Ekant Vad.)

Religious leaders have tried their best to unify the world community into one universally agreeable view. However, each religion, instead of joining the people into one view, generates sub-divisions within itself. People will always think differently. Can you have the world follow one religion! Impossible. But can you see the uniform underlying theme of all religions: “Love, Truth, Non-violence, and Service to all life” etc.! Yes. The message is the same for all religions. But when it comes to practising the message in real life, every one has different ways. Similarly, the theme of all major tax systems may be the same. The implementation will be different in each country. As long as a broad consensus is achieved by the major partners in the world commerce, it is a good achievement.

Every violent person whether in a terrorist camp or in the Government – is an exception to his religion. Similarly, every tax payer avoiding his tax; and every tax officer exceeding his jurisdiction is an exception. There will always be the cases of non taxation or double taxation. You cannot have a system totally eradicating these exceptions. Individual cases of exceptions have to be dealt with by the enforcement or the appellate authorities.

Some OECD TAG reports have avoided making clear recommendation because they find that implementation of the recommendation may not be uniform in all countries. This is unnecessary.

5. OECD technical advisory groups do tremendous research & discussion work. However, all TAGs work within the prescribed guidelines/ mandates. If they are given a set of presumptions, they take those presumptions & proceed. With this work style, it is not possible for a TAG to work with an “Out of the Box” approach. And E-Commerce calls for an Out-of the Box approach.

1. The TAG report on “Are The Current Treaty Rules For Taxing Business Profits Appropriate For E-Commerce ?” in Dec., 2005 concluded as given below :

“350. As regards the various alternatives for fundamental changes that are discussed in section 4-B above, the TAG concluded that it would not be appropriate to embark on such changes at this time. Indeed, at this stage, e-commerce and other business models resulting from new communication technologies would not, by themselves, justify a dramatic departure from the current rules.”

As submitted in paragraph II.1 above- ‘Conceptual Statement of Problem’ -, neither the business nor the Government tax departments can wait any further. We will have to make a sincere attempt at finding out proper alternatives. The above TAG report cannot be accepted. At the same time, OECD has done tremendous work on the subject. This work may be gainfully used to the extent practical.

7. OECD TAG report on “Tax Treaty Characterisation Issues” Feb., 2001.

As discussed under paragraph III.2 above, this report is not acceptable. The concept of COI needs to be scrapped. We need to establish the rules of Source for all incomes. The taxing rights may be allocated to any country as a COS only if value addition is made by the assessee in that country.

8. Attribution of Profits to PE: General Report. August 2004.

In this report OECD assumes that the concept of PE is applicable to e-commerce and proceeds accordingly. In my submission, the concept of PE cannot be applied to e-commerce. Hence the OECD report on the subject may be less useful. Even when the concept is not applied to e-commerce, the fact remains that one has to find out the country of source of income. In cases where an assessee does in fact establish a PE (in the traditional sense) in a country other than the COR, the profits attributable to that PE will be taxable in the country of PE.

OECD has done excellent research on the subject of E-Commerce tax. A look at macro level to both – direct and indirect taxes gives the solution to the problems.


OECD issues completed.

Next : Consequences of Proposed solution ...


Part III.6 CONSEQUENCES OF THE PROPOSED SOLUTION

If the above proposals (income-tax by the COR & the COS for the assessee; and indirect tax by the COM) are accepted, the consequences may be as under :

1. Global companies broadcasting & marketing television programmes and websites offering services will be liable to service tax or consumption tax; not liable to income-tax in the countries of market or foot print. They will of course be liable to income tax in the COR and COS.

For the charge of income tax, the “foot print” is not the determining factor. It is a market concept. It does not give a nexus for levying income-tax. The Indian viewers & advertisers will pay the service tax. Foreign advertisers will not pay even service tax. And the TV broadcasting company also will not pay service tax or income tax in the COM on the revenues received from foreign advertisers.

2. Non-Resident FIIs will be liable to income tax in India for their business profits in India even if they have no PE in India. They purchase & sell securities in India. The profits made are earned within India. (They have made no value addition to the securities. Here the value addition for income tax purposes is the difference between cost & sale price.) Their value addition or gross profit is in India. Hence India is the COS. The cost of management, risk etc. may be deducted. Government may grant them some concessions as compared to normal 40% tax. But they cannot make tax free profits from India.

Considerable amount of tax planning, treaty shopping, round tripping of Indian residents’ black money will be redundant or less important. Share market frauds by avoiding income-tax may reduce.

3. Software developers & other experts from India maintain the software installed on computers installed in U.S.A. Service provider is in India & service consumer is in U.S.A. The service charges earned by the Indian software company may not be liable to income-tax in U.S.A., except when it has a PE in U.S.A. But these service charges may be liable to VAT or Service tax in U.S.A.

4. A server cannot be accepted as PE. The server’s value addition is equivalent to the rent that any other internet service provider may charge at arm’s length. Nothing more.

4.1 The concept of “taxing at the place of signing the contract” is redundant for e-commerce. To this extent, the source rules have to be modified. BPO companies booking airline tickets for non-resident airlines do not become a cause for taxing the non-resident air lines’ business profits in India. The BPO companies get their remuneration at arm’s length prices. They will be taxed on their profits in India & that will be the end of the Indian government’s taxing rights.

Different BPOs function differently. Some BPOs provide services to either the principal or to its customers. And in some cases, the BPOs’ functioning is such that the principal itself is working in the host country. The tax treatment of the PE & the principal will depend upon the facts of the case. Who is adding value in the host country is the issue to be considered. Tax rights allocation will go with the value addition. Same principle will apply in case of business connection also.

In my submission, CBDT never intended to tax the non-residents on their income. It was constrained with the existing law – especially Supreme Court decision on profits accruing at the place of signing of the contract & similar other precedents. Entire controversy surrounding CBDT circular no. 1 of year 2004 needs to be resolved by a clear stand on this matter. (Signing of contracts in E-commerce is irrelevant; and only that unit is taxable which does the value addition.)

The BPOs are providing services to the foreign principals. They may be liable to Service tax on the revenues earned by them.

4.2 I have submitted earlier that the Country of Market is not a Country of Source. The non-resident principals are not even the market. They are buyers of Indian services. Taxing a purchaser for his purchases from India is improper. It can be compared with the following illustration:

“China sells toys to U.S.A. The Chinese toys are cheaper than the toys made in U.S.A. Hence the U.S. trader gets more profits as compared to the profits that he would otherwise be earning. Hence his profits should be liable to income tax in China.” The proposal is so absurd that it has to be stated to be rejected.

If we accept neutrality between sale of goods & services, the BPO services cannot make the buyers of services liable to income tax in India.

5. MICROSOFT sells packaged software without any PE in India. This sale will not be categorised as royalty & will not be liable to income-tax in India. It may be liable to sales tax & import duties.

Some other non-resident sells custom made software to India. This will amount to provision of services in India. It will be liable to service tax. In other words, both the forms of software sales will be liable to some indirect tax.

Income-tax will be leviable only if the non-resident has done some value addition within India. Now if any value addition is made within India, then the value of import of the goods or service will be lower commensurately. Consider illustration:

A non-resident company sells software in two different manners to an Indian resident.


Software completed abroad. No work within India by the NR. Partially value added in India
Import price for the Indian resident $1,000. Import price $ 800. Value added in India $ 200.
No income-tax on the profit component in the $ 1,000. No income-tax on profit component in $ 800. Regular income-tax on the profit component within $ 200.
Sales tax on full $ 1,000. Sales tax on $800.

Thus, under this scheme, there will be no duplication of taxes. Only the import price will bear import duties.

Should it be import + sales tax or just any one of the two indirect taxes!

6. For the Government of COS: All Non Residents providing royalties and FTS to India without any value addition within India will be free from any income tax in India. They may be liable to VAT. Government revenues can be neutralised (no loss, no gain) by replacing the TDS of 10% by VAT or service tax. Just as customs duty is variable depending upon the type of commodities that the Government wants to subsidise etc., the VAT may be levied on some items, and not levied on many items of imports (like crude oil, life saving medicines etc.)

7. Less litigation will be the biggest benefit for the tax payer as well as the tax departments of all Governments concerned.

8. Base Erosion : This is a major issue.

8.1 Base Erosion Claim : Consider the case of an Indian resident assessee importing services on the net. He pays to the non-resident seller of services. The Indian resident will claim that expenditure as a deductible expense from his taxable profits. And yet, if the non-resident gets his price without paying any tax to the Indian government, then the Indian Government loses. There is base erosion for the Indian Government. Since India loses its tax base, it may not like to accept such a position.

8.2 This argument may be responded as under : The decisions on drafting the law & DTA may be taken based on the principles and not based on the results for a particular assessee or kind of assessees or for a Government. The results will keep changing as markets change and new technologies change the way the business is done.

Such a response to the criticism may not be found to be adequate. Let us examine several other issues concerning the concept of base erosion.

8.3 Consequences of Base Erosion : The income tax TDS is available for set off to the non-resident seller against his income-tax liability in his COR. Whereas VAT is available as set off to the Indian importer against the VAT payable in India. In case of VAT, the set off is borne by the Indian Government instead of the seller’s Government. If the importer is ultimate consumer, there will be no further set off. Indian consumer will suffer the tax instead of the non-resident seller of services suffering the tax.

8.4 Response : Amongst the buyer and the seller, who bears burden/benefits from the tax modification will, as usual, depend upon the bargaining powers of the two.

For the foreign seller : In India the cost of income tax is reduced. Consumption tax paid by the buyer in the COM will not enter the accounts of the seller. However, whether the seller has borne the burden or the buyer; cannot be determined by the entries in the books of accounts. It will be determined by the prices - which in turn will be determined by the bargaining powers of both the parties.

For the Indian importer : His total cost /benefit because of the change will depend upon his bargaining strength. For the accounts, the impact will be: under the present system he is not claiming deduction of T.D.S. as his expense or against his own tax liability. After modification, Indian buyer will pay service tax & claim it as a set off against the similar tax payable on his sale. If the importer is the ultimate consumer, he will bear the burden & will not pass it off to others.

8.5 In fact, for this issue, there is no difference between e-commerce and traditional commerce. Consider two illustrations :

i. When an Indian residents import goods from abroad, they claim the cost of goods as deduction from their taxable profits. If the foreign seller has no PE in India, he will not pay any tax to the government of India. Indian imports of goods from abroad are more than U.S. $ 140 billions every year. In this case, no one complains about base erosion. Why should import of services be considered different! The services etc. which may be considered as taxable under different views, cannot be more than $ 10 billions per year. At normal T.D.S. rate, we are considering the question of $ 1 billion in tax revenue for India. (This is just an indication of the size of the revenue involved. The amounts keep changing every year.)

ii. Even if the Indian resident had imported any services under the traditional commerce, the tax treatment would be similar.

Under categorisation of income, we have seen that it is the definition of royalty and technical services which is improper. Almost all services would come under the definition and be liable to TDS. The need for amending the definitions to reflect the correct source principle is a separate issue.

Now consider a service which would come under professional practice (article 15-Independent Personal Services) and not under Included Technical Services (article 12). For example, a U.S. CPA gives tax advice to an Indian resident. The CPA does not have a PE in India. The fees paid to him by the Indian resident would be deductible expenditure. And yet, the CPA will not pay any tax to the Indian government.

For this advice, the CPA may come to India, stay here for three days and go back. This would be traditional commerce. Alternatively, the CPA and his client may discuss the entire matter over telephone and through e-mails. This would be E-Commerce. (Under the old definition of E-Commerce as considered by OECD, this service may not be considered E-Commerce. However if we see the TAG report on Consumption taxes, this service would be considered as E-Commerce or distance commerce.) Is there any reason why there should be any difference between the treatments of the same fees!

8.6 Government’s desire to cross the scope of its tax jurisdiction :

In fact, there is another side of the argument. Just as some taxpayers go to great lengths to avoid tax liabilities; some Governments also go to great lengths to tax incomes which are outside their jurisdiction. Any attempt to tax a non-resident on his foreign incomes is plain & simple incorrect. Of course, when a non-resident deals with India, he will sell goods or services to Indians. He will earn incomes from India. Payments to him will be deductible expenditure for the Indian residents. That is no reason to tax the non-resident. A non-resident may be taxed in India only if he has made value addition in India. Otherwise he cannot be taxed in India.

The same principle will apply to all the Governments.

Under the illustration of TV broadcasting company, we have considered an issue: Can the Indian Government tax the advertisement revenue received by the non-resident TV company from non-resident advertisers for their advertisements directed at Indian audiences! This issue itself is trying to tax beyond one’s jurisdiction. The fact that the advertisement is targeted at the Indian market is not sufficient nexus for the Indian Government to tax it.

8.7 What is base erosion?

When a Country’s tax base is eroded, it is called base erosion. What is tax base? The tax base for income-tax is - net profits. It is the profit that is taxable and not sales value. When an Indian resident incurs expenditure on import of goods and services; these are his legitimate expenses. In any case, these are not the tax base for India.

In my submission, the objection of base erosion against the proposed treatment of e-commerce is not proper. Where there is no base for tax, a base is assumed and then the assumed erosion is protested.

9. DTA for Service Tax.

It will be necessary to develop DTA for consumption taxes and all indirect taxes. Very soon, these DTAs will be more important than the DTA on income-tax. But that is another long story.


Consequence of Proposed Solution completed

Next : Comments on the Solution ...


Part III.7 Comments on the Solution :

Essentially, the solution offered here proposes that the Country of Market or Consumption (COM) may levy an indirect tax; and may not levy income-tax. This proposal raises the following issues:

1. The real issue under DTA is not allocation between direct tax and indirect tax; but allocation of income-tax between COS and COR. Criticism further goes to say that this proposal actually diverts the whole issue from income-tax.

In fact, as we have refined the concept of Country of Source by dividing it between the COS & COM, the real issue is now tax rights allocation between the COR & COS on the one hand and COM or COC on the other hand.

2. The above issue may be responded as under :

We have seen earlier that whether the tax is direct or indirect does not determine who suffers the tax. It depends upon the bargaining powers of the parties involved in the business.

3. An important consideration is ‘Efficiency’ of the tax measure. T.D.S. is adopted since it is found to be efficient. If all Governments were to make tax assessments of all non-resident assesses by computing their taxable net profits – there would be a chaos. And litigations. If flat T.D.S. rates are to be adopted, there is hardly any difference between T.D.S. and service tax or VAT.

4. Every tax has its purpose. A variety of taxes like VAT, service tax, income-tax, wealth-tax etc. together supply total revenue. But individually their tax base is different. Hence within a country, a few different taxes are necessary.

But the multiple taxes have to be limited. They can be a big impediment against the growth of an economy. One has to strike the balance between – multiple taxes and a single, simple and efficient tax.

Taxing the non-resident’s income computed on his net profits – when he does not have a presence in India – is more difficult than taxing a resident’s income. The balance of convenience and efficiency would be in favour of single indirect tax for the cross border transaction.

5. This is an issue which needs debate. My proposal is: levy an indirect tax on the imports of goods and services. Then close the matter as far as the non-resident is concerned. The proposal does not have an inherent merit as for example, the comparison of milk & a cola. The decision in favour of milk has an inherent merit. This proposal for tax is more a balance of convenience & efficiency than an opinion on justification of taxing rights.


Comments on the Solution completed

Next : Building Blocks ...


Part III.8 The Building Blocks for the Proposals in this Panel Discussion :

1. There is no International Law.

By law, we mean an authoritative instruction about a behaviour. If that authority is violated, some one has the measures to impose & enforce the law. No such authority exists today in the international arena. We have seen enough instances of Governments abiding by or not abiding by the rules of WTO depending upon the particular Government’s vested interests.

Appropriate Statement is that “The world is trying to develop a common consensus code that can bring around the Governments of the world into some acceptable behaviour. No human entity has any authority over the Governments of any country. And God does not exercise his authority. So we are left to our own ways.”

The efforts to develop a consensus are on for many decades, on many fronts. On tax front, it started with the League of Nations. The effort is continued by U.N. & OECD. Let us give it a support.

2. There is nothing Fundamental about International Taxation.

The principles accepted today by a large majority are principles accepted by a group of people in some committees. Who has gone into the minutes of the committee discussions! How many people had dissented from the majority decision & for what reasons! Looking at the history of article (7) in the present OECD model convention will be an interesting exercise. It will prove that there is nothing fundamental about taxation.

Only things fundamental are that

i. most Governments need revenue for running the Governments. General way of getting the revenue is taxing the people with different kinds of taxes. If the tax administration for both the tax payer & tax collector is more efficient, less litigious, it is better for the global society. and

ii. The tax policy should be fair to all : the tax payers, and all Governments staking their claim for taxation.

3. E-Commerce- Definition :

When we define a concept, we restrict the concept.

With continuing technological developments & convergence of several technologies, with human mind constantly finding new ideas & ways of doing better business, any attempt at restricting a concept like Commerce to just electronic commerce is likely to cause more difficulties.

When a company markets its products over television, is it E-Commerce! No use of computers is involved. Even e-mail & internet are not involved.

When people will do more of commerce by mobile phones, shall we give it a new name or just call it E-Commerce!

Instead of any restrictive definitions, let the concept develop as time passes. May we call E-Commerce as: “A method of doing business where the goods or services provider and the consumer (or buyer) need not come together physically”! In simple words, “Distance Commerce”. The concept acquires real significance when the seller & the buyer are located across the national boundaries.

Governments generally collect their revenue in terms of taxes.. which have to be collected by force of law. And law always depends upon the precedents & past. In E-Commerce, past is not complete guide. A lot needs to be refined/ developed/ modernised. Hence it is essential that the law either does not define, or defines the concept in simple, short words.

4. Country Of Residence : With the Globalisation of commerce, and ease in forming companies in offshore centers on the internet, even the concept of Residential status is fast losing its importance. Very soon, that concept also will have to be complimented by the “value addition” or “source”. But that will be another long story.

5. The message of the Book “Who Moved my Cheese!” written by Stephen Johnson – as summarised :

“Change Happens. They Keep Moving The Cheese.
Anticipate Change. Get Ready For The Cheese To Move.
Monitor Change. Smell The Cheese Often So You Know When It Is Getting Old.
Adapt To Change Quickly. The Quicker You Let Go Of Old Cheese, The Sooner You Can Enjoy New Cheese.
Change. Move With The Cheese.
Enjoy Change! Savor The Adventure And Enjoy The Taste Of New Cheese!
Be Ready To Change Quickly And Enjoy It Again & Again.
They Keep Moving The Cheese.”

Author’s comments :

Those who cannot accept change will lose their Cheese.
Change happens in all walks of life. Many of us read all such books & praise the books. How many of us can apply these principles to tax law or to our regular life! This Panel Discussion is a part attempt at applying these philosophies to International Taxation.

If OECD does not take steps to modify the model convention appropriate to the needs of E-commerce, countries will go ahead and draft their own models making OECD less relevant.


Building Blocks completed

Next : Conclusion ...


Part III.9 Conclusion

The conclusion of this paper is that ‘tax rights allocation based on source’ (in other words, rights other than COR rights) should be allocated based on the value added by the tax payer in a particular country (source). Allocating the rights based on Categorisation of Income is incorrect. Concept of Permanent Establishment is not applicable in E-Commerce. And yet, the solution so far worked out can be implemented without disturbing presently accepted application of both these concepts (PE & COI). As the discussions progress, these suggestions may become more acceptable.

Income may be taxed in the Country of Residence and the Country of Source. Country of Market or Consumption may levy only indirect tax. The two taxes: Income-tax & indirect tax should be mutually exclusive.

The problems in rewriting all the tax laws is our reluctance to accept change; and in arriving at a consensus. Commerce – whether E-commerce or other commerce, has already changed beyond the assumptions that went into drafting the model conventions. Changing the existing rules is a necessity.

In this paper, we have distinguished between Country of Source (COS) on the one hand; and Country of Market (COM) & the Country of Consumption (COC) on the other hand. This refinement makes it possible to take a combined look at the OECD policies on direct & indirect taxes. And that helps resolve the long standing issues. For PE & COI, we have simply gone a few steps towards simplification.

This paper raises many controversial issues and then tries to solve those issues by proposing a theme. This theme itself may be found controversial. With full humility, I am submitting all the issues for debate and hope to learn a lot more from the responses from the readers.

The solution offered here is not a final solution. It is one step in the series of steps already taken & yet to be taken. All together will evolve a more efficient system of ‘allocation of taxing rights amongst nations in international commerce’. Whatever decisions the authorities may take, will have to be reviewed regularly. In fact, the system of DTAs may be so evolved that a regular improvement in keeping with developments in business becomes practical.

Thank You.

Rashmin Chandulal Sanghvi

 

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