Abstract
The outdated idea that Permanent Establishment (PE) is based on physical location is no longer important in today’s technology-driven economy. This research paper examines the ways in which the usual PE framework fails to meet legal requirements when used for digital commerce, where multinational companies can profit from another country without leaving a physical presence. This study examines PE changes incorporated in OECD and UN Model Conventions, points out the issues with traditional fixed place, agency and service PE and explores India’s actions to stay current such as the SEP test and taxing from the Equalisation Levy.
There is a focus on the unique problems that cross-border digital exchanges bring to jurisdiction, compliance and enforcement, as well as progress being made by the international community, especially the OECD/G20 and their BEPS project. The work compares these multilateral efforts with unilateral actions, pointing out how national sovereignty can come into conflict with the necessity for shared tax policies. Further it studies what the law allows and how policies would be affected by applying a Virtual PE doctrine within India’s DTAA network based on authorities from courts and treaties.
As a result, this study supports a new concept of tax nexus that includes digital participation as well as greater international cooperation, better sharing of information and global laws that apply to everyone. Making these changes helps make tax systems fair, stop many cases of base erosion and suits today’s information-based era.
Keywords: Permanent Establishment, Digital Economy Taxation, Equalisation Levy, Double Taxation Avoidance Agreements, OECD BEPS Framework
I: Evolution of Permanent Establishment
The idea of Permanent Establishment (PE) plays a crucial role in international tax law, helping figure out how taxing rights are divided among different countries.[1] Originally developed during the industrial era, the PE rules targeted businesses with a physical presence. However, as the digital economy has grown, these rules have come under scrutiny for their relevance. In this chapter, we will delve into the historical background of the PE concept, its legal basis through the “fixed place,” “agency,” and “service” tests, and how they apply in today’s digital age. We’ll also look at the responses from both global and national perspectives, highlighting India’s innovative approach to adjusting tax frameworks.
Historical Context of Permanent Establishment
The idea of PE came about in the early 20th century as a way to tackle double taxation amid the rise of cross-border trade. It was formalized in the 1928 League of Nations Draft Model Treaty[2], aiming to assign taxing rights based on an entity’s physical presence—reflecting the industrial economy’s dependency on tangible assets such as factories and offices. The framework ensured that only those businesses with a stable presence in a jurisdiction would be subject to taxation, trying to balance tax equity with the encouragement of international trade.
As globalization progressed, both the Organization for Economic Co-operation and Development (OECD) and the United Nations (UN) updated the PE rules, including scenarios such as construction sites and dependent agents. However, digital businesses that earn substantial revenue without needing a physical office have revealed weaknesses in this system, which has led to calls for changes.[3]
OECD and UN Model Conventions
The OECD Model Tax Convention and the UN Model Convention both outline frameworks for defining PE, but they reflect different priorities shaped by the economic circumstances of their respective audiences.
OECD Model Convention
First introduced in 1963, the OECD Model Tax Convention focuses on residence-based taxation, benefitting developed nations. According to Article 5, a PE is defined as a “fixed place of business” where an enterprise operates, necessitating both geographical and temporal stability. Examples of this include offices, factories, and mines. However, activities seen as preparatory, like mere storage, are not considered PE under Article 5(4). Additionally, while dependent agents who finalize contracts create a PE, independent agents do not.[4]
UN Model Convention
The UN Model, which debuted in 1980, leans towards source-based taxation to support developing nations. While it largely reflects the OECD’s definition, it expands taxable activities significantly. Article 5(3)(b) introduces the “Service PE,” allowing taxation for services rendered in a country for more than 183 days within a 12-month period, even if no fixed place exists. It also lowers thresholds for construction activities and recognizes supervisory roles, thereby enhancing taxing rights for source states.[5]
Comparative Analysis
The OECD Model’s stricter definition of PE tends to safeguard capital-exporting countries, while the UN Model’s broader approach aims to assist developing nations. Both models rely on some form of economic connection; however, their focus on physical presence poses challenges for digital businesses, emphasizing the need for reform.
The OECD Model tends to lean more toward residence-based taxation, which favors capital-exporting countries where most multinational companies are based.[6] This tendency is clear in its restrictive definition of PE, confining source-state taxation to cases of considerable physical presence or dependent agency relationships. The negative list in Article 5(4) further tightens the scope of taxable activities, safeguarding enterprises from tax burdens in places where their operations are merely incidental.[7]
On the other hand, the UN Model favors source-based taxation, which aligns with the interests of capital-importing nations wanting to tax income generated on their turf. The introduction of the Service PE and broader provisions for construction and supervisory activities acknowledge that economic activities in developing nations often consist of intangible or temporary contributions, like professional services or infrastructure development (Christians, 2017). By lowering the hurdle for PE status, the UN Model ensures that source states can benefit from a bigger share of the tax base, addressing long-standing disparities in global tax systems (Arnold, 2019)
Despite these differences, both models share a core belief that some sort of economic connection, whether physical or temporal is essential to justify taxation. This principle has shaped the development of bilateral tax treaties globally, with most agreements incorporating elements of both models to suit the interests of the involved countries[8]. The ongoing evolution of these frameworks, especially in light of digitalization and globalization, highlights the importance of continuous dialogue between developed and developing nations, aiming for a coherent and fair global tax system.
Core Elements of Permanent Establishment
PE is determined through three tests: Fixed Place PE, Agency PE, and Service PE, with each test presenting unique requirements and difficulties in today’s digital environment.
Fixed Place PE
According to Article 5(1) of the OECD Model, a Fixed Place PE requires a physical location, continuity, and the primary business activity. A “place of business” does not need to be solely owned; it can be rented or shared if used regularly. Typically, permanence needs to be more than six months, although shorter periods may apply to specific projects. Preparatory activities like storage are not counted. Courts emphasize the importance of control over the premises, as highlighted in cases like Fowler v. CIR (2004)[9]. Digital operations, such as servers, complicate this, a fact acknowledged in the OECD’s BEPS Action 1 report.
Agency PE
Article 5(5) points out that a PE occurs if a dependent agent frequently concludes contracts for a foreign business. The agent must have a significant economic or legal tie to the principal and possess binding authority. The case of Dell Products v. Norwegian Tax Administration (2011)[10] showed how a subsidiary’s contract negotiations created a PE. India’s judicial system, as seen in DIT v. Morgan Stanley (2006)[11], applies a substance-over-form perspective but faces challenges due to automation in digital transactions.
Service PE
The UN Model’s Service PE allows for taxing services delivered in a country for a certain duration, typically 183 days. While this caters to service-driven economies, it still assumes a physical presence, which limits its effectiveness for virtual services such as online consultations. In the case DIT v. Nokia Networks OY (2012)[12], Indian courts required a territorial link for these activities, indicating gaps in how digital service revenues are captured.
Challenges of Traditional PE in the Digital Economy
The growth of the digital economy, driven by data and algorithm allows businesses like Google and Amazon to pull in impressive revenue without a physical footprint, which puts traditional PE rules to the test.
Inadequacies of Fixed Place PE
The fixed place test mandates a physical location that is often irrelevant for digital firms that operate through cloud servers or platforms. In the case Formula One World Championship Ltd. v. CIT (2017)[13], the Apex Court identified a PE based on temporary physical setups, but digital platforms typically don’t have such evidence, raising fairness concerns.
Limitations of Agency PE
The Agency PE test is based on human agents closing deals, but today’s transactions often occur through automated platforms or AI. In Morgan Stanley (2006), the Supreme Court emphasized the need for human agency, which becomes problematic when contracts are executed by algorithms. The BEPS Action 7 suggests broadening the definition, but India’s partial uptake through the Multilateral Instrument limits its effectiveness.
Gaps in Service PE
The Service PE test presumes the physical presence of staff, which excludes remote digital services such as online tutoring or AI-based consultations. Courts, as seen in Nokia Networks (2012)[14], have difficulty establishing a connection for these activities, highlighting the need for reform.
Global and National Responses to Digital Taxation
The rapid expansion of the digital economy has triggered efforts at both global and national levels to overhaul PE rules.
OECD’s BEPS and Pillar One
The OECD’s BEPS Project, initiated in 2013, aims to combat tax avoidance in the digital sphere. Pillar One recommends a new nexus based on revenue and user engagement, allowing for taxation of tech giants in locations where they derive value, irrespective of physical presence. India supports this initiative, pushing for user data to be a taxable basis.
India has consistently advocated for Pillar One, emphasizing that user data and market contributions are essential elements of value creation in digital economies. In a consultation paper from 2019, India’s Central Board of Direct Taxes (CBDT) called for a broader interpretation of nexus, including factors like user base and data contributions[15]. This perspective reflects India’s unique standing as a massive digital market with over 700 million internet users, significantly contributing to the revenue of global tech giants[16]. Nonetheless, implementing Pillar One globally is complex, requiring consensus among over 140 countries, with ongoing discussions about revenue thresholds and profit allocation formulas.
Digital Services Taxes (DSTs)
In India, the Equalisation Levy, introduced in 2016 and expanded in 2020, imposes a 2% tax on revenues generated by non-resident digital companies from Indian users. While this generates substantial revenue, it has drawn criticism from the U.S. for being discriminatory.[17] A 2023 study by NIPFP pointed out potential increases in consumer prices, emphasizing the need for a careful approach.[18]
Virtual Permanent Establishment (VPE)
The proposed Virtual Permanent Establishment framework aims to tax digital interactions based on user engagement, revenue, or data usage. In Google India Pvt. Ltd. v. Assistant Commissioner of Income Tax (2021)[19], India’s ITAT backed the taxation of digital earnings; however, VPE remains largely theoretical, facing hurdles like setting thresholds and avoiding double taxation complications. A VPE would acknowledge a taxable presence based on considerable digital interaction with a jurisdiction, even lacking physical offices. To establish a VPE, several criteria have been suggested:[20]
- Volume of local users: A large user base in a country, such as millions of active users on an app, could create a tax nexus.
- Revenue generated from the jurisdiction: Significant earnings from local customers, whether through subscriptions or advertising, might warrant taxation.
- Data utilization and customization: Heavily relying on local user data for tailored services could merit a taxable presence.
Judicial and National Approaches
India has been proactive in adapting PE to align with the digital reality. Cases like Morgan Stanley (2006) and Google India (2021) have focused more on economic activity than merely physical presence. Measures like the Equalisation Levy and the SEP test[21] specifically target digital revenues and user participation, though challenges surrounding compliance and risks of double taxation still exist. It imposes a 2% tax on revenues earned by non-resident digital companies from online advertising, e-commerce, and other digital services aimed at Indian users[22].
The U.S. continues to rely on the OECD’s physical PE framework but allows states to establish their own economic nexus for sales tax following the Wayfair decision (2018)[23]. It has opposed DSTs, favoring Pillar One, which could postpone federal reforms.[24] The EU’s CCCTB seeks to tax digital operations but faces pushback from low-tax jurisdictions like Ireland. France and Spain have introduced DSTs similar to India’s, but these measures create compliance difficulties, emphasizing the need for global cooperation.[25]
The concept of PE, which is rooted in the idea of physical presence, struggles to effectively address the needs of digital business models. India’s proactive strategies, such as the Equalisation Levy and SEP, position it as a trailblazer in digital taxation, striving to balance fiscal equity with economic viability. Meanwhile, global initiatives like Pillar One and VPE proposals aim to modernize tax systems to reflect digital realities, although challenges like geopolitical tensions and implementation hurdles persist. Ongoing international discussions are vital for crafting a fair and cohesive global tax framework.
II: CHALLENGES OF TAXING DIGITAL COMMERCE ACROSS BORDERS
Reporting Rules from 2020 require income reporting, and in India, KYC norms along with the GST Network help monitor vendors[26]. However, cryptocurrencies and decentralized systems like DeFi make it tough to track transactions, especially in developing countries[27]. India’s use of AI-driven analytics and the Annual Information Statement improves data collection, but there’s still a lack of global standards for transactions that are decentralized.[28] Small and medium enterprises (SMEs) often face high compliance costs when dealing with a variety of tax rules, in contrast to multinational enterprises (MNEs) that have more resources. While the EU has introduced the VAT Mini One-Stop Shop (MOSS) to simplify reporting, there isn’t a global equivalent, and India’s GST adds a burden on SMEs, pointing to a pressing need for more unified frameworks.[29]
Tax avoidance, especially through strategies like Base Erosion and Profit Shifting (BEPS), is widespread in the digital economy. Companies often shift their profits to low-tax regions by registering intellectual property or through royalty payments[30]. In response, India has put measures like General Anti-Abuse Rules (GAAR), Place of Effective Management (POEM), and the Equalisation Levy into place[31]. The OECD/G20’s Pillar One aims to shift taxing rights to the locations where markets exist, while Pillar Two proposes a minimum tax rate of 15%. However, political disagreements and the complexities of profit calculations are holding up progress (OECD, 2021). India has criticized Pillar One for benefiting developed countries and is advocating for fairer rights for source countries .
International efforts, spearheaded by the OECD/G20 Inclusive Framework, aim to reform tax regulations. Pillar One specifically targets MNEs with revenues exceeding €20 billion for profit reallocation, and Pillar Two ensures a baseline tax of 15% (OECD, 2021). Critics have pointed out that the high revenue thresholds tend to exclude smaller companies and favor OECD[32]. Developing nations, including India, find themselves grappling with administrative challenges and are pushing for a more equitable share of revenue [33]. Unilateral actions such as India’s Equalisation Levy, along with Digital Services Taxes (DSTs) in France and the UK, could lead to trade disputes and the risk of double taxation[34]. The EU’s MOSS[35] and ASEAN’s VAT[36] initiatives help simplify compliance but mainly address indirect taxes, leaving the issue of profit taxation unresolved. Political and administrative barriers limit their global effectiveness.
The socio-economic effects of these issues are significant, particularly for developing countries that depend heavily on VAT and GST. The rise of untaxed digital transactions shrinks revenue, which can limit investments in essential services like health and education. The current system tends to favor developed countries, worsening inequality. Trust in public systems diminishes when large digital companies pay very little in taxes, further undermining compliance. SMEs struggle with competitive disadvantages, which can stifle innovation, and the deficit in revenue makes it difficult to meet sustainable development goals[37].
Looking ahead, redefining the concept of ‘nexus’ based on significant economic presence and metrics related to users and markets could be beneficial[38]. Expanding the OECD’s Common Reporting Standard to include digital transactions could improve enforcement[39]. A global One-Stop-Shop platform might alleviate some of the burdens faced by SMEs[40]. Utilizing AI and blockchain technologies could enhance compliance monitoring, which is crucial for developing nations[41]. The establishment of a UN-led tax body could ensure that the voices of developing countries are heard, aiding in the pursuit of fair reforms[42]. A coordinated, technology-focused approach will be vital in creating a balanced digital tax system that fosters inclusive growth.
III: India’s Significant Economic Presence (SEP) Rule
India has positioned itself as a leading voice among developing nations in addressing the outdated international tax standards, especially in the realm of the digital economy. The traditional system of taxation—where businesses are taxed based on having a physical presence, or Permanent Establishment (PE), in the country where they operate—has become less relevant due to the nature of digital businesses. These companies, particularly major tech firms, can generate substantial profits from foreign users without having any physical office or operation in those areas.
To tackle this gap, India rolled out the Significant Economic Presence (SEP) rule as part of its Finance Act, 2018. This changed the game by redefining what constitutes a “business connection” within India, shifting the focus from physical presence to a virtual one.
Key Features of SEP
The SEP provision creates a scenario where a non-resident company is considered to have a business connection in India—thus liable for Indian taxes—if either of these two criteria is met:
1. Transaction-based SEP: A non-resident engages in transactions regarding goods, services, or property—including the downloading of data or software—with individuals or entities in India.
2. User-based SEP: A non-resident actively solicits business or interacts with users in India through digital channels, whether or not payments are involved.
Quantitative Thresholds
While the Finance Act, 2018 laid the groundwork for SEP, the Finance Act, 2020 put it into action by setting quantitative thresholds as specified by the Central Board of Direct Taxes (CBDT). Currently, these thresholds include:
- Revenue of INR 2 crore from transactions with Indian residents or users.
- Engaging with 300,000 users in India within a financial year.
These thresholds help clarify what is considered a “significant” presence, although they may be re-evaluated due to ongoing technological and economic changes.
SEP and India’s Digital Taxation Philosophy
The SEP framework mirrors India’s view that value in the digital economy increasingly comes from user engagement, data generation, and market interaction. Digital companies—particularly those in e-commerce, social media, online advertising, and streaming—gain value from the participation of Indian users, which according to Indian tax officials, justifies taxation.
Through its SEP rule, India aims to align its taxing rights with this new digital landscape. This aligns with India’s broader proposal for profit attribution based on a three-factor formula—sales, users, and assets—as detailed in the CBDT’s 2019 Public Consultation Paper. [43]This approach challenges traditional methods and seeks to factor demand-side contributions into profit distribution.
Practical Limitations and Treaty Constraints
Despite its innovative nature, the SEP provision struggles with enforceability due to India’s commitments under bilateral tax treaties (Double Taxation Avoidance Agreements or DTAAs). Most of India’s treaties follow the OECD and UN Model Conventions, which stipulate that a PE (typically defined as a fixed business location or an agent who regularly concludes contracts) is necessary for taxing business profits in the source country.
According to Section 90(2) of the Income Tax Act[44], when a tax treaty is in place, its terms take precedence over domestic law if they are more favourable for the taxpayer. As a result, the SEP rule can have limited practical effects on taxing profits from non-residents operating digitally, unless India renegotiates its treaties to include the SEP concept or reaches a broader multilateral agreement.
International Engagement and Future Prospects
India has actively brought attention to these constraints in international forums like the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS). It has shown support for Pillar One of the OECD’s two-pillar strategy, which suggests reallocating taxing rights toward market jurisdictions, though with some scepticism about the fairness and adequacy of the proposed formulations.[45]
Through the SEP, India emphasizes the urgency for developing countries to protect their tax bases in light of increasing digitalization. Although for now, the SEP rule may serve more as a statement of sovereignty and a negotiation tool in international discussions, it lays the necessary legislative foundation for future changes—whether through treaty revisions, multilateral agreements, or unilateral actions like the Equalisation Levy and GAAR.
IV: Redefinition of Permanent Establishment under the OECD’s BEPS Project
The transformation of the global economy through digitalization has fundamentally altered how multinational enterprises (MNEs) conduct business, rendering traditional international tax frameworks inadequate. Originally designed for a physically interconnected economy, the current tax rules fail to accommodate the profit-generating capabilities of digital firms that operate extensively in jurisdictions without maintaining any physical presence. Consequently, digital enterprises can accrue substantial profits from a market jurisdiction while avoiding tax obligations under the outdated definitions of Permanent Establishment (PE). In response, the Organisation for Economic Co-operation and Development (OECD) and the G20 launched the Base Erosion and Profit Shifting (BEPS) Project in 2013 to curb aggressive tax planning by MNEs and ensure a more equitable allocation of taxing rights.
Background of the BEPS Project
The impetus for the BEPS Project stemmed from growing global concerns about the ability of digital MNEs to reduce their tax liabilities by shifting profits to low- or no-tax jurisdictions, despite generating significant revenues elsewhere. Such practices eroded public trust in the tax system and created imbalances between residence and source jurisdictions. The foundational principles of international taxation—residence-based and source-based taxation—were misaligned with the operations of modern digital businesses due to fragmented and outdated domestic tax laws.
As a G20 member and a major emerging economy, India played a prominent role in the BEPS negotiations. Indian policymakers, particularly the Central Board of Direct Taxes (CBDT) and the Ministry of Finance, consistently advocated for reforms that would expand the taxing rights of source countries, especially in instances where user engagement, market access, and local goodwill significantly contributed to value creation. The adoption of the 15-point BEPS Action Plan in 2015[46] marked a critical step in promoting international cooperation and closing legal loopholes. Notably, Action Plan 1 was exclusively dedicated to addressing the tax challenges posed by digitalization.
The BEPS framework acknowledged that the reliance on physical presence to determine tax liability had become obsolete. It thus encouraged coordinated global action to address base erosion and prevent unilateral or conflicting policy responses among jurisdictions.
BEPS Action Plan 1
BEPS Action Plan 1 tackles a crucial challenge posed by digital businesses i.e., their ability to operate internationally and make significant profits in places where they do not have a physical presence. The traditional ideas around Permanent Establishment (PE), which hinge on having tangible offices and employees, just cannot keep up with the borderless movement of digital companies. This creates a loophole that allows these businesses to sidestep taxes in countries where they earn considerable economic value without establishing a tax connection.
To remedy this, Action Plan 1 rolled out three significant policy proposals. The first was the Significant Economic Presence (SEP) approach, which reshapes the meaning of nexus by including both digital and economic presence along with physical presence. The second proposal involved a withholding tax on digital payments made to non-resident service providers, aimed at protecting source-based taxation. The third introduced an Equalisation Levy, designed to tax profits from digital transactions even when there is not a PE.
India took the lead in implementing these measures on its own. The SEP concept was integrated into Explanation 2A of Section 9 of the Income Tax Act, 1961[47], broadening the tax nexus to encompass substantial digital interactions. In addition, India launched the Equalisation Levy in 2016, imposing a 6% tax on digital advertising revenues. This was followed by Equalisation Levy 2.0 in 2020, which applied a 2% tax on the gross revenues of non-resident e-commerce operators. Although these actions were unilateral, India has shown its dedication to reaching a global agreement by aligning its domestic policies with Action Plan 1 and actively engaging in the ongoing Pillar One negotiations. These initiatives underscore India’s role in reshaping international tax standards to better address the realities of the digital economy.
Pillar One
Pillar One proposes a transformative change in global taxation, shifting from an origin-based to a destination-based approach. Its aim is to assign taxing rights to market jurisdictions where multinational enterprises (MNEs) create value through user participation and customer interaction, even in the absence of a physical presence. This strategy particularly targets large, highly digitalized, and consumer-oriented businesses that benefit from their worldwide reach and local market engagement.
A key innovation under Pillar One is the introduction of a new nexus rule that focuses on sales and user engagement thresholds instead of physical presence. MNEs with global revenues exceeding EUR 20 billion and profitability above 10% fall under this new framework. Here, a portion of residual profits—defined as profits over a 10% return—will be allocated to market jurisdictions through “Amount A,” guaranteeing that countries where customers are located receive a fair portion of tax revenues. “Amount B” simplifies compliance by introducing a fixed return for routine marketing and distribution activities. Meanwhile, “Amount C” addresses any additional profits beyond the standardized returns and includes measures for dispute resolution to minimize the risk of double taxation.
India has firmly endorsed Pillar One, highlighting the importance of market access and user engagement as critical factors in value creation. The SEP framework and Equalisation Levy reflect India’s early recognition of the limitations of traditional nexus rules. By backing market-based taxation, India aims to secure its fair share of tax revenues from foreign digital MNEs operating within its borders and to counter the historical bias in international tax treaties that leaned in favor of developed countries.
Despite its forward-thinking vision, Pillar One has faced criticism from several angles. MNEs may push back against the segmentation of profits by business lines, complicating revenue allocation. The administrative burden and compliance challenges could disproportionately hit developing nations, many of which already struggle with resources. Additionally, the proposed mandatory binding dispute resolution could infringe upon national sovereignty and legal autonomy. Plus, the high threshold of EUR 20 billion in global revenues might leave out a lot of active and profitable digital firms in developing economies.
India’s unilateral rollout of the Equalisation Levy 2.0 aimed to capture revenue from digital services not included in existing tax treaties. However, under the 2021 OECD/G20 agreement on a Two-Pillar Solution, India has promised to eliminate such unilateral measures once Pillar One is effectively implemented. This withdrawal is contingent upon successful reforms, ensuring revenue certainty for developing countries, and providing clear legal guidance during the transition. India’s stance reflects both a strategic assertion of its fiscal rights and a readiness to align with a global framework that fairly distributes taxing rights in this digital era.
India’s willingness to transition from unilateralism to multilateralism underscores its strategic intent to influence global tax rules while securing its interests as a digital consumer economy. The durability of Pillar One depends on international consensus, administrative cooperation, and timely implementation. Any delays may incentivize countries to reintroduce unilateral measures, risking trade disputes and undermining the Inclusive Framework.
Pillar Two
While Pillar One focuses on shifting taxing rights to be more aligned with market jurisdictions, Pillar Two is all about making sure that multinational enterprises (MNEs) pay a basic level of tax globally, no matter where their profits end up. The main goal here is to tackle harmful tax competition between countries and safeguard the global tax base by putting in place a 15% global minimum effective tax rate (ETR).
Often called the Global Anti-Base Erosion (GloBE) Rules, Pillar Two targets MNEs with total global revenues over EUR 750 million. It consists of three key parts. The first is the Income Inclusion Rule (IIR), which mandates that the parent company of an MNE must pay a top-up tax if any of its subsidiaries face an effective tax rate below 15% in their respective areas. The second part is the Undertaxed Payment Rule (UTPR), which acts as a safety net for the IIR. If the parent country doesn’t enforce the IIR, other countries can deny deductions or impose extra taxes to recover the unpaid top-up tax. Lastly, the Subject to Tax Rule (STTR) is a treaty-based approach that enables source countries to impose a withholding tax of up to 9% on specific cross-border intra-group payments, like interest or royalties, when these payments are taxed below a certain minimum in the recipient country. Together, these rules aim to create a coordinated international framework for fair taxation and help lessen the appeal of shifting profits to low or no-tax areas.[48]
V: Analysis of Global Harmonization
The OECD/G20 BEPS Project[49] represents an unprecedented global initiative aimed at modernizing international tax rules to align with the realities of a digital and interconnected economy. Central to this effort are Pillar One and Pillar Two, which strive to ensure that profits are taxed where economic activities take place and value is generated. However, even though the conceptual frameworks are ambitious and sound, putting them into practice presents various practical, political, and administrative hurdles.
Persistence of Unilateral Measures
Despite global promises, many countries—including India, France, the UK, and Italy—have kept unilateral digital services taxes (DSTs) and similar measures like the Equalisation Levy. These measures were initially temporary solutions to tackle the “scale without mass” issue but have become entrenched due to the slow pace of Pillar One’s rollout and concerns about the fairness of the new allocation rules. For example, India has made it clear that it will only withdraw its Equalisation Levy once Pillar One is fully operational. This reflects a lack of trust in the global process and underscores the risk that, without timely and fair implementation, fragmented tax systems will persist, leading to double taxation, higher compliance costs, and trade disputes.
Geopolitical Divergences and North–South Tensions
A major obstacle to harmonization is the differing interests of developed and developing countries. While OECD nations generally back profit reallocation based on established global thresholds, developing countries like India push for simpler, broader-based profit attribution methods that better acknowledge their roles as significant market economies. India’s focus on user participation, market access, and data localization as key components of value creation stems from concerns that the Pillar One formula, particularly Amount A, may favor residence jurisdictions (typically developed countries) over source jurisdictions (usually developing nations). Additionally, India’s preference for the UN Model Convention—which supports source-based taxation—over the OECD Model illustrates a wider push from developing economies to rebalance global taxing rights.
Complexity and Compliance Burden
The proposed global tax frameworks are quite technical and demand advanced administrative capabilities. From segregating financial data and reallocating profits (Pillar One) to calculating effective tax rates and imposing top-up taxes (Pillar Two), the compliance demands are hefty.[50] For developing countries like India, this presents a combined challenge:
- Capacity Constraints: Tax authorities may find it tough to implement and oversee complex mechanisms due to limited digital infrastructure, technical know-how, and institutional resources.
- Tax Certainty vs. Sovereignty: While the dispute prevention mechanisms under Pillar One aim to enhance certainty, they might also reduce national discretion in tax matters, raising issues regarding fiscal sovereignty and fairness. India has rightly stressed the importance of capacity building, simplified administration, and adapting the Pillars contextually to create a more inclusive and workable framework for all nations.[51]
Strategic Evolution of India’s Tax Policy
India’s tax policy has evolved—from unilateral actions like the SEP and Equalisation Levy to active participation in global consensus-building under the Inclusive Framework. This reflects a mature, strategic, and forward-thinking approach. By aligning with multilateral initiatives while firmly protecting its national interests, India has positioned itself as a thought leader and a reformist voice among developing economies. India’s input has influenced critical discussions—particularly concerning market-based taxation, simplicity in allocation, and the importance of user participation—that continue to shape ongoing negotiations. Its ability to shift from unilateralism to cooperative multilateralism without sacrificing its development goals illustrates a balanced approach to global tax governance.
VI: The Road Ahead: Risks and Recommendations
The real challenge for the BEPS reforms will be their implementation. Several risks and uncertainties need to be tackled such as delays in rolling out new rules could lead countries to maintain or intensify unilateral digital taxation. Some jurisdictions might also choose to opt out of Pillar One or Two, undermining global consistency. The ongoing digital taxes or tax conflicts could trigger retaliation and disrupt international trade and investment flows.
To mitigate these risks, implementing the following recommendations is vital that OECD and G20 nations should prioritize implementation with clear, binding deadlines and involve developing countries more actively in decision-making and technical drafting processes. International organizations must offer technical assistance and support simpler compliance models for developing regions. Market jurisdictions should receive fair shares of global profits to reflect the modern realities of the digital economy.
VII: CONCLUSION
The digital economy has changed the landscape of global commerce, making traditional tax systems seem outdated and highlighting the need for new regulations to ensure fair taxation. The idea of Permanent Establishment (PE), which has always been linked to having a physical presence, struggles to keep pace with digital businesses that earn substantial revenue without having a brick-and-mortar location. Standard PE tests like Fixed Place, Agency, and Service fall short when it comes to capturing the economic activities of digital firms that depend on user interaction and data. Through the OECD/G20 BEPS Project, initiatives like Pillar One and Pillar Two are introducing fresh concepts such as Significant Economic Presence (SEP) and a global minimum tax to shift taxing rights to the market jurisdictions where value is generated.
India has taken the lead among developing countries by establishing measures like the Equalisation Levy and SEP rule to tax digital transactions, helping to protect its revenue base. Nonetheless, these unilateral steps face hurdles due to existing Double Taxation Avoidance Agreements (DTAAs) and geopolitical strains, which could lead to issues like double taxation and trade disputes. A Virtual Permanent Establishment (VPE) framework, focusing on user base, revenue, and data use, represents a forward-thinking path to align taxation with the realities of the digital age. To tackle these challenges, global cooperation, streamlined compliance processes, and capacity building for developing nations are crucial. By finding a balance between national interests and multilateral efforts, much like India has strategically done, countries can build a fair and sustainable global tax system that fosters economic growth in the digital era.
– Arpit Srivastava, B.A. LL.B. (Final Year), Amity University Madhya Pradesh
[1] Brian J. Arnold, International Tax Primer (3d ed. 2019).
[2] League of Nations, Draft Model Treaty on Double Taxation (1928).
[3] Rohit Rohatgi, Basic International Taxation (2d ed. 2020).
[4] Organisation for Economic Co-operation and Development, Model Tax Convention on Income and on Capital 2017 (Full Version) (2019), available at https://doi.org/10.1787/g2g972ee-en.
[5] United Nations, Model Double Taxation Convention between Developed and Developing Countries (2017, 2021).
[6] Reuven S. Avi-Yonah, Taxation and the Digital Economy, 19 Mich. L. Rev. 1 (2016).
[7] OECD (2017), Model Tax Convention on Income and on Capital, OECD Publishing.
[8] Supra note 2.
[9] Fowler v. Commissioners for Inland Revenue, [2004] UKHL 54 (UK).
[10] Dell Products v. Norwegian Tax Administration, HR-2011-02245-A (Nor.).
[11] Director of Income Tax v. Morgan Stanley & Co., (2006) 7 SCC 1 (India).
[12] Director of Income Tax v. Nokia Networks OY, (2012) 25 taxmann.com 225 (Delhi HC).
[13] Formula One World Championship Ltd. v. Commissioner of Income Tax, (2017) 394 ITR 80 (SC).
[14] Supra Note 13.
[15] Central Board of Direct Taxes, Consultation Paper on Digital Taxation (2019).
[16] Ministry of Electronics and Information Technology (MeitY) (2023), India Digital Economy Report, Government of India.
[17] Shivani Gupta, Digital Services Taxes and Global Trade, 31 J. Int’l Tax’n 45 (2022).
[18] National Institute of Public Finance and Policy, Impact of Equalisation Levy on E-Commerce Ecosystems, NIPFP Policy Brief (2023), https://www.nipfp.org.in/publications/policy-briefs/impact-equalisation-levy-ecommerce-ecosystems.
[19] Google India Pvt. Ltd. v. Assistant Commissioner of Income Tax, ITA No. 1511/Bang/2018 (ITAT Bangalore 2021) (India).
[20] Pranav Singh, Data as a Taxable Resource, 48 Indian Tax Rev. 89 (2020).
[21] Finance Act, 2018, No. 13, Acts of Parliament, 2018.
[22] Finance Act, 2020, No. 12, Acts of Parliament, 2020.
[23] South Dakota v. Wayfair, Inc., 585 U.S: (2018) (U.S.).
[24] Office of the United States Trade Representative, Report on India’s Digital Services Tax (2021), available at https://ustr.gov.
[25] Zimmer SAS v. France, ECJ Case C-73/09 (2010).
[26] GST Network, GST Network Vendor Tracking (2023).
[27] International Monetary Fund, Taxation in a Decentralized Economy (2022).
[28] Income Tax Department, Annual Information Statement Implementation (2023).
[29] European Commission, VAT MOSS and OSS Frameworks (2020).
[30] OECD, Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (2015).
[31] The Finance Act, 2016, No. 28, Acts of Parliament.
[32] Tax Justice Network, Digital Taxation and Global Inequality (2020 & 2021).
[33] Central Board of Direct Taxes, India’s Position on Pillar One (2024).
[34] Office of the United States Trade Representative, Report on India’s Digital Services Tax (2021), available at https://ustr.gov.
[35] Supra note 30.
[36] ASEAN Secretariat, Digital Tax Harmonization Discussions (2023).
[37] U.N. Committee of Experts on International Cooperation in Tax Matters, Source Country Taxation Models (2023).
[38] Supra note 21.
[39] OECD, Model Reporting Rules for Digital Platforms: Report by the OECD/G20 Inclusive Framework on BEPS (2020).
[40] Ibid.
[41] Supra note 28.
[42] Supra note 38.
[43] Central Board of Direct Taxes (CBDT), “Public Consultation on Profit Attribution to Permanent Establishments in India,” April 2019.
[44] Income-tax Act, No. 43 of 1961, § 90(2).
[45] OECD, Pillar One Blueprint, 2021.
[46] OECD, Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing 2015), https://doi.org/10.1787/9789264241046-en.
[47] Supra note 19, § 9, Explanation 2A.
[48] Supra note 6.
[49] OECD/G20 Inclusive Framework, Statement on the Two-Pillar Solution, July & October 2021
[50] CBDT, White Paper on Taxation of the Digital Economy, 2020
[51] NITI Aayog & ICRIER, India’s Digital Economy: Towards a Framework for Taxation, 2021.