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DIGITALIZATION & ITS EFFECTS ON INCOME TAX BASE WITH REFERENCE TO INDIA’S E-COMMERCE SECTOR

About the Author

The author of this article is Alakananda S Anil, 4th Year (8th semester) BA.LLB, Govt Law College Thiruvananthapuram.

‘Digitalization’ has been defined by many theorists in different ways. According to ‘Clerk J’, “Digitalization is the use of digital technologies and of data in order to create revenue, improve business, replace or transform business processes and create an environment for digital business, whereby digital information is at the core. ‘Ringenson’ suggested that “Digitalization” is about social life around digital communication and media infrastructure. ‘Morley’ 1 defined digitalization as a term used for “growing application of ICT across an economy ‘encompassing a range of digital technologies, concepts and trends such as artificial intelligence, the internet of things (IoT) and the fourth industrial revolution”.

Digitalization makes the data more structured, organized, easily accessible, storable, maintainable and shareable. It reduces paper usage, saves storage space and improves collaboration. This widespread digitalization has led to the evolution of the digital economy which is defined by the World Bank 2 as “a new way of economy based on knowledge and digital technologies within which new digital skills and opportunities are formed for the society, business and state”. There are three main components of the digital economy: e-commerce, e-business and e-infrastructure. 3

The term e-commerce can be used to describe any commercial transaction that is done or facilitated by the internet. Thus, e-commerce entails all the activities both direct and indirect that lead to market transactions with customers. It encompasses areas such as web design, web hosting, marketing, consulting, accounting services or credit card processing. Amazon, Flipkart, Netflix, Google pay, ICT sector etc. comes under the category of e-commerce.

Emerging markets such as BRICS countries play an increasing role in global e-commerce. Brazil, China, India and Russia are emerging markets. India has quickly become a leading ICT service exporter. Compared to the online retail industry of Latin America and Asia Pacific, the BRIC countries growth is still in a developing stage. In countries like China, Brazil & Russia, e-commerce is well developed and advanced. They have made great advancements in the area of internet accessibility, logical infrastructure and financial system. Even though India is 5 years behind China in technological advancements, since 2010, India’s e-commerce growth has been 150%. Indian companies like Small and Medium sized enterprises (SME) are using cross border e-commerce to expand into foreign markets.

According to UNCTAD, the combined volume of e-commerce amounted to 29 trillion dollars in 2017 of which the share of e-commerce in global retail sales had reached 12.2% in 2018. In 2019, e-commerce comprised 14.1% of the global merchandise trade. And in 2023, projections show that this share is forecasted to rise to 22%. When it comes to BRICs, in 2019 Brazil has shown 16% growth in e-commerce, whereas Russia held 18.7%, India with 31.9%, China shared 27.3% and South Africa experienced 25–20% growth in e-commerce in 2017 and 2018 respectively. (BRICS information portal)

The rise of digital economy has challenged the existing tax system, cross border transaction and international tax system which is built on the foundation of traditional commerce in which business operating in a country had physical presence in that country, but nowadays, foreign business can provide goods and services without having any physical presence in that country and it is a challenge for the government to collect income tax from these entities. Even though the government has amended the Income Tax Act 1961(introduced section 1940 in the 2020 Union Budget) to solve this problem, these guidelines are not enough to tackle the issue. Thus the paper further discusses the challenges faced by the income tax system by digitalization with respect to India’s e-commerce sector and to examine the implications of economic and legal policy framework to address these major challenges.

DIGITALIZATION AND INCOME TAXATION IN ASIAN COUNTRIES

Aftermath of the covid-19 pandemic, Digitalization has made a huge impact on Asian countries and it is extending beyond the information communications and technology sector (ICT) to many other fields like e-commerce, fintech, online financial services etc. Many firms are selling their goods and services through their websites and market places which connect consumers across the world with the firms. These platforms use highly advanced technologies like Artificial intelligence and machine learning which promotes better functioning of e-commerce markets. Asian countries like China, Japan, Indonesia are competing with the US multinational companies operating in Asia.

The digitalization of Asian countries depends on various factors like demography, geography, stages of economic development etc. China is dominant in e-commerce trade in Asia, with e-commerce being a significant share of GDP in the country, (In 2021, 40%, global average 18.8 percent). Though the US based Amazon is dominating the e-commerce sector, Chinese firms Alibaba, Taobao, JD.com etc. are also having high dominance in Asia. India is a rapidly developing market for e-commerce and online markets with evolving local firms. Since 2010, India’s e-commerce growth has been 150%. Indian companies are using cross border e-commerce to expand into foreign markets. Over 15,000 sellers export a variety of Indian handcrafted products to 112 million customers in 190 countries. Indian companies like Ajio, Bigbasket, Reliancedigital, flipkart etc… are also featured in the global revenue e-commerce net sales of 2022.

1. How is Asia’s Digitalization Different?

Asia is the Hub of many tech giants and has some of the largest e-commerce firms of the world. China’s Alibaba and JD.com have about 38 percent of global e-commerce market share by merchandise volume. The main difference between the American and Asia’s digitalization is that while US e-commerce makes most of its profits from outside the United States, while Japanese e-commerce Rakuten derives profit from Japanese markets, in India Ajio, Flipkart, Myntra etc. are the key players. But, like the US firms, the Asian tech giants also rely on intangible assets and these firms’ that use intangible assets, such as intellectual property, can be more difficult to tax since it is easier to shift these assets across borders to lower tax jurisdictions. Intangible assets are also difficult to value for the purposes of transfer pricing.

Some of Asia’s homegrown tech giants like Ali baba have income tax rates just like the US Multi National Enterprises (MNEs). The rapid growth of Asia’s e-commerce and the presence of US MNEs highlights the importance of new tax policies appropriate to digital technologies. Even small scale businesses and local markets sell their products through online platforms and with the rise of the e-commerce sector, revenue collection from local markets and tech giants has become increasingly difficult.

The ability of the highly digitalized firms and e-commerce to make cross border sales without physical presence poses a challenge to the traditional corporate income tax rules. These rules give the taxing rights to countries where the headquarters of the firms are situated or where the countries have permanent establishment. The country does not have taxation rights on firms that make cross border transactions without physical presence; “the assets of highly digitalized firms can be more concentrated in intangibles (for example, intellectual property) compared with other businesses. Intangible assets can be more easily transferred to related members of a corporate group in lower tax jurisdictions, allowing profit to be shifted away from a country with higher tax rates” (IMF Report 2021).

2. Challenges of taxing e-commerce business in Asia

There are many types of e-commerce business models, out of which 4 are major ones, Business to consumer (B2C), Business to Business (B2B), Consumer to Business (C2B) and Consumer to Consumer (C2C). There are many challenges associated with taxing the e-commerce sector,

The highly advanced technology has facilitated a large surge in both business to business (B2B) and business to consumer (B2C) remote cross-jurisdictional sales or exports, challenging the concept of a permanent establishment (PE) which requires a physical presence to generate taxing rights for income taxes in the country. Second,The e-commerce firms use the personal data of the users to identify their preferences and to provide them with personal advertising. Governments have claimed this practice contributes significantly to the profit of the company but users are not given compensation for using their data.

BEPS is a tax planning strategy that exploits gaps and mismatches between tax rules to artificially shift profit to low tax jurisdictions which result in little or no corporate tax being paid. The BEPS has major significance in developed countries due to their reliance on corporate income tax, particularly from multinational enterprises (MNEs).

The disadvantages of BEPS are: Loss to Government: Less revenue and a higher cost to ensure compliance, Integrity of the tax system is hampered, reduction in tax revenue lead to under development of public infrastructure.

The Organization for Economic Co-operation and Development (OECD) has proposed a solution for taxing the digitized economy in response to the concerns proposed by governments, political leaders, media and civil society and at the request of the G20. In 2013, the OECD developed an action plan on Base Erosion and Profit shifting (BEPS) (OECD,2013) . It identified 15 action plans to address BEPS. The OECD countries have also proposed many other plans for BEPS in the subsequent years. The 15 BEPS action plans are implemented by developed countries.

The European Union in January 2016 published a draft directive that recommends a minimum standard for EU member states in relation to various tax avoidance techniques. To some extent it overlaps with the OECD BEPS proposals, but there are some guidelines stated in that which an EU member state should implement in their own domestic tax rules on cross border transactions.

Even after implementing these 15 OECD BEPS plans there is tax erosion and still by using highly advanced technologies like artificial intelligence, the companies can hide their source countries or their origin. In 2018 and 2019 there were reports that the Chinese e-commerce companies used to deliver goods to India via couriers and postal gift shipments in order to evade tax rates. The Government of India then made subsequent laws to tackle the same.

3. DIGITAL SERVICE TAXES

Digital Service Taxes (DSTs) is aimed at ensuring that non resident, digital service providers their fare share of tax on revenues generated in the digital market. DSTs essentially attempts to overcome the permanent establishment problem, whereby “a lack of physical presence precludes governments from staking a claim to corporate profits on a source basis. Since bilateral tax treaties preclude countries from unilaterally adjusting taxing rights, countries have started to look for alternatives outside the purview of income taxation”. 4

At present, applying a DST is expected to yield relatively low revenues, as the initial Indian Equalization Levy introduced in 2016 and applied on payments for advertisement services, resulted in collections of about 0.02 percent of GDP from 2016 – 2020. However, given the current low base, revenue is likely to have high buoyancy in the future .The Covid-19 pandemic and the associated lock down had an accelerating impact on the use of digital economic activities, including transactions and sales of digital goods and services. This trend would likely have a bearing on future revenue potential.

The future role of DSTs in Asia is unclear. Globalization and international relations have a huge role to play in it and the experience of countries in the region following India’s lead in introducing withholding taxes resembling the initial equalization levy, suggest that DSTs may become more widespread and there are chances of other Asian countries implementing the DST for collecting revenue if it becomes successful in the implemented countries and if DST is able to generate a good percent of revenue, with the help of it, the Asia’s developing countries like India can improve their public infrastructure and can become economically developed.

4. ALTERNATIVE POLICY OPTIONS

Digitalization will continue to dominate the economy and there is a wide scope for alternative policy options by finding new alternative policy options to improve the income taxation by which the government can generate more revenue for public good.

4.1. FORMULARY APPORTIONMENT

It is a method by which multinational companies will allocate its profits across countries based on sales, payroll and capital base in each jurisdiction. This method will consolidate the corporate profits at the regional or global level and will allocate them among the jurisdictions, leaving the decision on the tax rate to individual jurisdictions. The allocation formula used in this method is a combination of real sources used (employment, payroll, fixed assets) and sales (usually destination based sales). This method has been successfully used by federal states like Canada, Germany, Japan and the United States to allocate corporate income tax revenue among subnational governments. The current EU initiative for adoption of the common consolidated corporate tax base (CCCTB) constitutes the first application of formulary apportionment at a supranational level. However, the formulary apportionment may increase tax competition and could lead to manipulation of the tax base. The transfer pricing issues cannot be completely solved by using this formula alone.

4.2. RESIDUAL PROFIT ALLOCATION

Residual profit allocation allocates the right to tax ‘routine profit’ to the country where the functions and activities take place, it also allocates the rights to tax residual profit to the market or destination countries where sales are made to third parties . There are 2 types of profits, Routine profit and residual profit. The routine profit is allocated to each entity based on its functions, assets, and risks, using benchmarking or cost-based methods. The residual profit is allocated to each entity based on its relative contribution to the value chain, using profit indicators or allocation keys. The distinction between routine and residual profit, which is at the heart of RPAs, is the basis for most profit splits under existing transfer pricing rules. RPAs can thus be viewed as a significant expansion and modification of an existing transfer pricing mechanism. An example of residual profit allocation: The Government of India has the right to tax a pepper manufacturing unit situated in its jurisdiction, it comes under routine taxation. When the pepper is exported to Thailand, both the governments of India and Thailand have a right for taxation. Thus, the Residual Profit Allocation (RPA) is used to tax multinationals by allocating their “routine” profits to source countries and sharing their remaining “residual” profit across countries on some formulaic basis. This paper explores the implications, conceptual and empirical, of moving to some form of RPA. Residual profits are estimated to be substantial and concentrated in relatively few multinational enterprises. The impact on tax revenue appears beneficial for developing countries. Aggregate production efficiency is unlikely to increase unless routine profits are lightly taxed.

The immobility of customers in the market country, combined with the relative transparency of transactions with third parties, should make it difficult to shift residual profit to other jurisdictions. The incentive to shift routine profit is also correspondingly lower than the incentive to shift total profit. Basing tax on residual profit in the destination country also significantly reduces the incentive for multinationals to locate their real activity in low tax jurisdictions, thereby reducing economic distortions.

Currently, if a multinational resident in country A sells directly to customers in country B, without any physical presence in B, then its profit will be taxed in A. However, under the Residual Profit Allocation (RPA) routine profit will be taxed in A and residual profit will be taxed in B. Taxation in the market country is not contingent on physical presence there under the RPA.

WHAT IS INCOME TAX BASE & HOW DIGITALIZATION AFFECTS IT?

Income tax base can be defined as the “total value of all the assets, income and economic activity that can be taxed by a taxing authority (government) and it is used to calculate tax liabilities.

TAX LIABILITY = TAX BASE * TAX RATE

For the business income, the tax rates are as follows 5:

  • Income up to 2.5 Lakh = Nil
  • Income up to 5 Lakh = 5%
  • 5 to 10 Lakh = 10%
  • Above 10 Lakh = 20%

WIDENING THE TAX BASE & ITS IMPORTANCE

To achieve many goals like boosting the economic growth, the government seeks to widen the tax base usually by expanding the type or level of income or assets that are subject to taxation rather than raising the tax rates, by widening the tax base, more people who are legitimately liable to pay taxes and are not paying are asked to pay. For example: Changing the taxable income from 2.5 Lakh to 1 Lakh, by which many will be liable to pay 5% tax. Here the tax base is changed, but the tax rate remains the same.

India is the world’s largest democracy with 140 crore population, and is the fastest growing major economy, but according to the official data of the Indian parliament, only 5.3% of the total population files Income Tax Returns (ITRs)and out of this, those who actually pay taxes is very less. Less than 5% of Indians are paying income tax and they are shouldering the burden of 140 crore Indians in economic development.

There are many challenges before the government to collect the revenue from income tax as people who have taxable incomes but evading the taxes by using strategies like misreporting in income tax returns, concealing income, smuggling, bribery, false documentation and storing funds outside the jurisdiction.

“Tax evasion is not just a financial crime, it is a crime against society”. According to a study on “Widening tax base and tackling black money” ( FICCI, 2015), widening of tax base helps to generate higher tax to GDP ratio, meet the targeted tax collection and reduce the shortfall in tax collection with budget estimates. Most importantly, it shifts the burden of tax revenue from honest tax payers. If all the citizens who are eligible to pay taxes start to pay their fair share, in future there will be a decrease in the income tax rates and it will also lead to economic development. Otherwise, honest taxpayers will be forced to resort to tax evasion.

ROLE OF DIGITALIZATION IN TAX BASE

Digitalization and the rise of e-commerce has made a tremendous change in the economy, it has helped many people to improve their businesses and to get better profits. Even small scale businesses are getting good recognition through e-commerce. Unlike the traditional stores, the cost of operating an e-commerce store is very low as the owners can save the money that they are spending on buildings, labors and electricity which they use in a physical or traditional store. It removes geographical barriers and thus not only the local customers, international customers can also purchase the goods. It also helps to build better relationships between the sellers and the buyers. Usually the sellers sell their products through e-commerce entities like Amazon, Flipkart, Myntra etc., but there are sellers who use social media apps like instagram and facebook to sell their products.

Thus, digitalization and e-commerce firms has played a positive role in increasing the profit margin of even the local citizens and since the trend of e-commerce business is growing day by day, it will eventually result in the widening of tax base since the income of citizens are increasing, then the tax base can be shifted to 1 Lakh from 2.5 Lakh as the minimum amount for tax liability as income of 1 Lakh will.But, if in future, if the e-commerce markets lose its significance or if the sellers are not getting enough profit from the firms, then it will result in the narrowing of tax base.

Digitalization has also helped the government gather more information and insights into the tax and financial conditions of the taxpayers. With the help of the data sources that are available in a digital platform, the government can identify the people who have taxable incomes. The Income Tax Administration in India is a pioneer in introducing automation in the tax function with electronic e-filing of income tax returns, paperless correspondence and faceless assessments amongst others, creating a structured income-tax portal.

ADVANTAGES OF DIGITALIZATION

  1. Improving the ability to gather more tax information.
  2. Gain more insights into the tax and financial position of taxpayers.
  3. Reduce time spent on compliance.
  4. Easier to track payments, identify finance fraud & increase compliance with the tax system.
  5. Makes taxes more transparent and reduces the chances of tax evasion.
  6. Functions more accurately and efficiently
  7. Reduce paperwork and complexity associated with filing taxes
  8. Manage customer relationships better, connect with partners and supplies and access data quickly.

EFFECTS OF E-COMMERCE SECTOR ON INCOME TAXATION

One of the major segments of the “Digital economy” is e-commerce. The rise of e-commerce, reduced the complexity in running a business. It has many advantages, like low start up cost, ability to process orders in bulk, being able to sell internationally, and improving profit margin. The e-commerce has led to the increase in profit margin of the businesses. In 2023 the revenue growth of e-commerce was 10% in India. During the covid-19 pandemic, many people switched to online shopping and as a result, in 2020, the e-commerce market has the highest growth of 53%.

E-commerce shopping is becoming the new normal. According to the India based strategy consultant Redseer, the e-commerce of India is expected to grow at an annual compound rate of 27% to reach $163 billion by 2026. It is almost three times the growth of the overall retail market. According to the “State of Indian E-commerce Report Q1 2023” by INC42, the Indian e-commerce market is expected to reach $400 Billion by 2030, growing at a CAGR of 19% from 2022, the Indian e-commerce sector has attracted more than $31 billion in investments since 2014 and boasts 24 Unicorns and 15 soonicorns. 6

From the above stated data, it is clear that e-commerce is the new reality. Many business firms have improved their profit margin through e-commerce and in future this trend will increase. Thus, e-commerce is a major sector from which the government can generate high revenue. The ecommerce sector plays an important role in the widening of the tax base. If all the e-commerce companies which are liable to pay the income tax pay it without any evasion, then it will lead to the widening of tax base and can lead to better nation building, this trend will also lead to the decrease in tax rates in future. If the opposite happens, then it will lead to tax erosion and narrowing of income tax base.

In the era of Artificial intelligence, there are technologies by which a firm can hide its sources and destination of transactions, the website used in e-commerce is an intangible hence, does not come under the definition of permanent establishment (PE), however, the web server used in e-commerce businesses is tangible. The features of digitalization can create opportunities for high-level tax avoidance and lead to tax losses and narrowing of income tax base.

The drawbacks of e-commerce and digitalization with respect to income tax base is mentioned in the upcoming segment.

DRAWBACKS OF DIGITALIZATION IN TAX BASE

While regulating the income taxation, there are many challenges before the government and these challenges are also applicable in digital taxation.

PERMANENT ESTABLISHMENT

It is the fixed place of business that generally gives rise to income or value added tax liability in a particular jurisdiction. Permanent Establishment (PE) also means “having a taxable presence outside the company’s state of residence. The issue of permanent establishment (PE) arises when a business that is not legally resident has an enduring presence in the source country so, the source country has the taxing right on the profit of that business. However, this definition usually requires a physical presence in that country which is not sufficient to cover many cross border transactions in the e-commerce sector.

Many multinational companies (MNCs) have exploited the ‘e-commerce sector’ and ‘digitalization’ to obtain a large amount of income from different countries with low taxes. Traditionally, MNCs used to set up physical intermediaries in the targeted foreign markets, but now with the availability of e-commerce, a company can do the business without a physical presence in the source country and they can also easily shift the profit to low tax jurisdictions or tax havens which will lead to tax erosion. When the e-commerce firms function from their headquarters situated in their residence country without a physical presence in the source country, the source countries will suffer a loss of taxable profits. A website used for e-commerce business is intangible and as such cannot alone make up a place of business “An internet server consists of tangible computer equipment networked to the internet. A server is usually dedicated to the storage and internet accessibility of web sites, email accounts and databases and software programmes resident on the server can automatically administer the electronic transmission of digitalised e-commerce products or services to end consumers. E-commerce ventures may use the web hosting services of ISPs who allocate and make available to them sufficient server space for their e-commerce requirements. Alternatively, such firms may own or lease a server so as to command a higher level of control over the server”.

THE INDIAN LAWS FRAMEWORK

The Rule 10 of Income Tax Rules 1962 7, “ In any case in which the [Assessing Officer] is of opinion that the actual amount of the income accruing or arising to any non-resident person whether directly or indirectly, through or from any business connection in India or through or from any property in India or through or from any asset or source of income in India or through or from any money lent at interest and brought into India in cash or in kind cannot be definitely ascertained, the amount of such income for the purposes of assessment to income-tax [* * *] may be calculated :

(i) at such percentage of the turnover so accruing or arising as the [Assessing Officer] may consider to be reasonable, or

(ii) on any amount which bears the same proportion to the total profits and gains of the business of such person (such profits and gains being computed in accordance with the provisions of the Act), as the receipts so accruing or arising bear to the total receipts of the business, or

(iii) in such other manner as the [Assessing Officer] may deem suitable.”

The Finance Act 2016 has introduced the concept of Equalization Levy which targets specific transactions between residents and non residents. When it was introduced, the Levy was charged at 6% of the consideration earned by non resident entities from India for provision of online advertisement and digital advertising space. This was done to prevent the tax erosion caused by the non-residents who make income from India but do not fall into the ambit of the tax net, due to the lack of Permanent Establishment.

The scope of Equalization Levy has been expanded in the 2020 Finance Act: The Levy charges at 2% of the consideration earned by an e-commerce firm from:

  • Online sales of goods or services
  • Facilitation of the sale of goods or service
  • Combination of both the activities

The recipient being:

  • The person being the resident of India or using an IP address located in India
  • A non resident under specified circumstances.

A Recent Indian case related to Permanent Establishment is Union of India v. U.A.E. Exchange Centre 8, the Supreme Court held that an Indian liaison office of a United Arab Emirates (‘UAE’) company engaged in fund remittance services did not constitute a permanent establishment (‘PE’) in India. The Supreme Court ruled that the activities performed by the Indian liaison offices of the UAE entity were preparatory and auxiliary’ in nature and hence outside the purview of PE and further relied on the scope of RBI permission for setting up the liaison offices for its conclusion. 9

VIRTUAL PERMANENT ESTABLISHMENT (VPE)

The concept of “virtual PE” was first discussed in 1998 during the Ottawa Ministerial Conference on Electronic Commerce, which had been conducted after the OECD committee on Fiscal Affairs (“CFA”) agreed on such a resolution on June 1, 1996. (Jha, 2019). The virtual permanent establishment proposed that the taxing nexus of e-commerce should be “the continuous commercially significant conduit of business activity”, rather than the fixed place of business”. In addition to this, the modern permanent establishment definition should be reinvented in order to apply to e-commerce the idea of taxation on the basis of economic commitment and establish a common threshold for differentiating the commercial mainstream.

The OECD has worked for more than 20 years analyzing the impact of electronic commerce to the current international tax legislation. As mentioned before, in 1998 the principles that should guide the development of rules in international tax matters for electronic commerce were established. In 2005, the OECD released the report titled “Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce?”, based on the work of the business profit Technical Advisory Group. In such a report, the OECD, studied the “Virtual Permanent Establishment” theory as an alternative nexus that would apply to electronic commerce operations.

Even though the topic of Virtual permanent establishment is widely discussed, it is not widely implemented, though there are domestic laws to tackle the Permanent Establishment Issues, the existing laws still need to be reformed as there are high chances of tax evasion by using the exceptions and drawbacks of these laws.

CROSS BORDER TAXATION

Cross border taxation is used to determine the tax liabilities of entities operating in different jurisdictions and to avoid double taxation or the evasion of the taxes. Double taxation means the same income is taxed in multiple jurisdictions and it causes a significant burden to the business.

Many countries tax their residents on their worldwide profits, and countries from which the profit is derived also have the right to tax the business. Situations often arise when 2 countries try to tax the multinational companies on their profit. Double Taxation Treaties (DTT) are international agreements signed between two or more countries for the avoidance of double taxation, these agreements also facilitate trade and investments between the countries. It can determine many rules like whether the income should be taxed in the source country or the country of residence etc. Even though the goals and objectives vary accordingly, most of these treaties usually have the following features:

  • define which taxes are covered and who is a resident and eligible for benefits,
  • reduce the amounts of tax withheld from interest, dividends, and royalties paid by a resident of one country to residents of the other country,
  • limit tax of one country on business income of a resident of the other country to that income from a permanent establishment in the first country,
  • define circumstances in which income of individuals resident in one country will be taxed in the other country, including salary, self-employment, pension, and other income,
  • provide for exemption of certain types of organizations or individuals, and
  • provide procedural frameworks for enforcement and dispute resolution

The Double Taxation treaty has helped to reduce the double taxation and has also increased the tax generation, but it does not address the income taxation of the digital economy adequately. The multinational companies which operate in the ecommerce sector usually follow tax planning strategies to evade income taxation during cross border transactions and with the help of evolving technologies, a business firm can easily hide its transactions and sources if they are conducting business through their own platforms.

TAX HAVENS AND PROFIT SHIFTING

Tax Havens are the nations or jurisdictions which impose the least amount of tax on foreign businesses for their bank deposits in an economical and politically stable environment. These places are also known as offshore financial centers. Panama, Luxembourg, Netherlands, The British Virgin Islands are some of the tax havens. The tax havens negatively affects the economy in economic as well as administrative sectors. Tax havens contribute to income inequality as it concentrates economic power in fewer hands. It also results in administrative burden as the usage of tax haven results in base erosion and profit shifting. Profit shifting is a major issue faced in the e-commerce sector as countries multinational companies use this as a strategy to avoid their tax burdens by shifting the profit to tax havens. As a result, the countries from where the multinational companies generate their profits will suffer from huge loss in income taxation or base erosion. This will lead to the narrowing of the income tax base.

Even though the OECD has developed various plans to tackle the same, these are not completely effective.

There are many other challenges for income taxation in digital economy,

THE OTHER CHALLENGES THAT ARISES OUT ARE:

  1. Inadequacy of international rules for effective digital transactions because rules are based on physical presence.
  2. Lack of adequate rules for cross border transaction
  3. Lack of sufficient domestic tax laws to tax MNCs including digital businesses that have significant operations in a country. (Lack of domestic laws to deal with PE issues, transfer pricing rules and with holding taxes on payments to non residents)
  4. MNCs locate their intangibles like license, trade mark, brands, goodwill etc. in low tax jurisdictions
  5. Uncertainty in taxing peer to peer economy on digital platforms eg: Uber, Ola etc. since they are treated under a range of taxes.

CHALLENGES IN APPLYING INTERNATIONAL TAX RULES TO THE DIGITAL ECONOMY

The Organization of Economic Co-operation and Development (OECD) has observed these:

  1. Significant economic activities within a country or stages of production across multiple countries with less significance to physical presence.
  2. Reliance on intangible assets including intellectual property
  3. Role of data and user participation including network effects to generate value.

The current international tax system which is based on the traditional method is highly uncertain for the application in digitalization and it has been exploited by many multinational e-commerce firms to evade taxes. Multinational e-commerce companies use tax planning strategies to exploit the weakness of the tax system. These strategies include abusive transfer pricing, mispricing of related party transactions, exploiting mismatches, taking advantage of different treatment of the same transaction in different countries. Objective of these strategies are usually to shift income to low tax jurisdictions and away from high tax jurisdictions or to shift tax deductions so that they can be claimed in high tax jurisdictions rather than in low tax jurisdictions. One of the reasons for the weakness in the framework are because of different tax outcomes in the source and residence countries. It can be because of specific policy choices made by the countries (tax rates) or to an unintended or unforeseen outcome which is often in case of digitalization.

Secondly, Big firms with the help of evolving technologies like artificial intelligence can make false documentation on their income, multinational companies transfer their profit from high tax countries to low tax jurisdictions or tax havens, they also uses advanced technologies to hide their sources, corruption is also a major challenge in taxation as the companies may bribe the authorities to make misrepresentations in their profits.

Since the current international tax framework is based on the traditional tax system, its uncertainty of application to the new technologies can lead to many problems in taxation . Thus there is an urgent need to implement the virtual permanent establishment and to reconstruct the existing tax laws for the better functioning of Income taxation.

SECTION 194 O OF THE INCOME TAX ACT 1961

The Section 194-O of the Income Tax Act 1961, deals with the payment of certain sums by e-commerce operators to e-commerce participants. This section was introduced in the 2020 Union Budget and it came into effect on 1st October 2020. According to this Section, an e-commerce operator is responsible for deducting 1% TDS of the gross amount credited to the seller’s account or at the time of making payment. This section applies to any transaction in the e-commerce platform that facilitates goods and services, here services include both professional and technical services.

The definitions of the e-commerce, e-commerce operator and e-commerce participant according to the Section 194-O are:

  1. “electronic commerce means the supply of goods or services or both, including digital products, over digital or electronic network;
  2. e-commerce operator means a person who owns, operates or manages digital or electronic facility or platform for electronic commerce;
  3. e-commerce participant means a person resident in India selling goods or providing services or both, including digital products, through digital or electronic facility or platform for electronic commerce” (Income tax department of India)

The TDS is to be deducted at 1% on the gross amount of sales, services or both according to 194-0. But, in the absence of Aadhaar or Pan card, The TDS is to be deducted at 5% (Section 206AA has amended accordingly)

The TDS rate under Section 194 -O has been reduced from 1% to 0.1% for transactions from 1st April 2024 onwards as per the Finance Act 2024.

According to this section, if an international company sells its product to an Indian through any e-commerce platform, for example: Amazon, The Amazon or any e-commerce platform that is used, will deduct 1% TDS from the amount received from the buyer before transferring it to the company.

But, no TDS will be deducted when the e-commerce participant is an Individual or HUF and the gross amount of sales and services during the previous year does not exceed five lakhs and the e-commerce participant has furnished PAN card number or Aadhaar card number to the e-commerce operator.

E-commerce operator is defined under this section as a resident in India selling goods and services through digital through e-commerce platform. Thus, no TDS will be deducted from a non resident participant. For a non-resident, the Equalisation Levy is applicable. However, the equalization levy is criticized by the US Trade representatives as they believe that this policy discriminates against US businesses as it does not include domestic businesses and majority of the Indian e-commerce is dominated by the United States.

One of the major drawbacks of the Equalization Levy or the Digital Service Tax is the absence of an international policy. The lack of international taxation policy in this sector will be unmanageable for countries both in formulation and implementation of the policy in an effective manner.

SOLUTIONS FOR TACKLING THESE CHALLENGES

The international organizations like OECD and IMF have made many attempts to solve these income tax issues and have derived many strategies for the same. However, these strategies were not found highly effective as they were not sufficient enough to prevent the highly advanced technologies like Artificial Intelligence. The virtual permanent establishment is a good way to prevent tax base erosion however it is not implemented in the international rules. The Equalization Levy or the Indian digital service tax which may lead to the widening of income tax base in future is criticized by the US government. In India, there is no codified Act for e-commerce and different segments of e-commerce are found under different Acts.

After analyzing the problems faced by the income tax base in the e-commerce sector, the researcher came to the conclusion that the below mentioned strategies may help to widen the income tax base with the help of digitalization.

The measures are:

  1. Adoption of the Virtual Permanent Establishment (VPE) to the international tax rules.
  2. There should be a uniformity in the tax rules of different countries, thus an international taxation act with respect to digitalization should be formulated.
  3. Though the websites used in ecommerce platforms are intangibles, the web servers are tangibles so a provision should be made to insert it into the definition of Permanent establishment.
  4. The existing laws which are based on the traditional tax system should be reconstructed in such a way that it will include the advanced technologies like digitalization, artificial intelligence and Internet of Things.
  5. The Indian Government should make an “Ecommerce Act” in which all the segments of e-commerce and its provisions will be mentioned. The introduction of such an Act will help the judiciary as well as the administration to deal with the issues related to e-commerce sector.
  6. The Governments or the taxation authorities must use better softwares to identify the companies or individuals who have taxable incomes. With the help of improved technologies the authorities can find the source countries and the profit margins of the e-commerce companies.
  7. Strict penalties must be given for tax fraud and tax evasion
  8. The taxation authorities should recheck the tax rate and tax base by analyzing the taxable incomes and if a large number of e-commerce firms gets a profit above 1 lakh, the tax base should be shifted from 2.5 Lakhs to 1 Lakh.
  9. Strict surveillance should be made on the e-commerce platforms.

CONCLUSION

Digitalization is the new normal, it has many advantages as well as disadvantages. Digitalization plays a role in widening as well as narrowing of income tax base, If adequate measures are taken to prevent tax evasion in the digital economy, digitalization can be used as a tool for widening the income tax base and it will lead to the generation of high revenue and will have a positive effect on the nation building. So, actions must be taken from the grass root level to prevent the negative impacts of digitalization on the income tax base.

ENDNOTE

  1. Morley, J., Widdicks, K., Hazas, M.: Digitalisation, energy and data demand: the impact of internet traffic on overall and peak electricity consumption. Energy Res. Soc. Sci. 38(1), 128–137 (2018) ↩︎
  2. E A Dolbnya et al 2021 IOP Conf. Ser.: Earth Environ. Sci. 666 062133 ↩︎
  3. https://www.indianeconomy.net/splclassroom/what-is-digital-economy/ ↩︎
  4. How to tax in Asia’s digital age, Era Dabla-Norris, Andrew Hodge, Dinar Prihardini, IMF Article 2021 ↩︎
  5. https://www.adityabirlacapital.com/abc-of-money/check-out-how-is-income-tax-calculated-on-your-business ↩︎
  6. A unicorn is a startup company that has a valuation of $1 billion and more. A soonicorn is a fast growing startup with the potential to become a unicorn. It has the potential for high growth, introduces inhibition and has a scalable business model. ↩︎
  7. Income Tax Department, Incometaxindia.gov.in, Copyright: Taxmann Publications Pvt.Ltd ↩︎
  8. [2020] 116 taxmann.com 379 (SC) ↩︎
  9. Source: Taxguru.in ↩︎

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