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Convergence of Indian tax system and globalisation
December, 01st 2007

From time to time the I-T Act has treated certain receipts, which no classical economist will accept as income, as income for tax purposes. This has been due to the thinking of the tax authorities that all receipts tend to become income at some stage or other and tax revenue must be maximised.

N. Rangachary

Traditionally, the year 1991 is quoted as the year of radical change in the entire world structure a year which led to phenomenal reforms in the spheres of politics and economy. This is the year when the Cold War between the super powers came to an abrupt end; a year where Gorbachev decided to realign Russian policies to suit a world order built on cooperation and support.

Phased-out reforms

It is also the year where fundamental modifications were ushered in by a government that had taken charge in India, where gradually a controlled economy was assiduously chiselled to make way to a market-driven one.

We should be careful to note that all the changes that we now see in operation did not roll out simultaneously, but were brought in gradually in various spheres.

The financial sector is one broad area where reforms took place initially the rigours of the Indian income-tax legislation were sought to be tempered and fundamental changes in the Income-Tax Act, like taxation of firms as an entity by themselves, were introduced. Changes in the regulatory atmosphere were also embarked on. Capital market reforms were brought in by strengthening the Securities and Exchange Board of India (SEBI).

Reforms in the insurance sector were initiated with the setting up of RN Malhotra Committee which was followed by the setting up of the insurance regulatory body in 1996.

Banking reforms had also been carried out alongside. All these are significant indicators of the nations attempt to position itself as an integral part of a global system dictated by a feeling that India cannot isolate itself in an otherwise converging world economic situation.

Will Rogers had once famously said in The New York Times, You cant say civilisations dont advance, however, for in every war, they kill you in a new way an apt sum-up of the progress that the Indian tax system has made during the last 50 years.

The progress is strikingly evident with tax levies forming a significant portion of the Governments exchequer, but with new tax levies and protracted litigation come undetected hurricanes which leaves a hole in the pockets of corporates and individuals, thereby stifling the tangible economic progress.

The Indian income-tax system is based on the tax principles promulgated by the British Raj. The Income-Tax Act, 1961 has adapted several theories from the 1922 Act. The taxability of dividends and items which can be regarded as deemed dividend is a classic example of this adaptation. Even interpretations under the Indian tax law draw significant inspiration from British court cases thereby making the Indian tax law intertwined with the British thinking.

India had however realised the need to promote industrial growth through tax sops at a very early stage.

The introduction of Chapter VI-A deductions with respect to newly established industrial undertakings during the early 1970s orchestrated the path of progression through tax sops.

To this day, the income-tax laws continue to offer sops on specific sectors or for specific activities, although the thinking of the Government is to phase them out in the future.

The foreign exchange reserves position and the rupee appreciation trend is a major contributory to such thinking.

Until 1991, the Indian tax system was a mixed bag. On the one hand the Government had offered tax sops with respect to industrial undertakings/export activities while, on the other, there were income-tax levies even on undistributed income of certain companies much like the CFC regulations prevalent in the US.

There was considerable ambiguity on interpretational issues and the provisions of the I-T Act got progressively amended in the light of judicial pronouncements of the apex court, which at most times were against the Revenue.

India also had certain stringent tax rules with respect to non-resident companies, subjecting them to gross basis of taxation and absence of a broad tax treaty network prior to 1990s meant that India faced resistance in the board meetings of the global corporates, who otherwise would have found India lucrative for commercial reasons. India was shy to adapt to international tax principles until the early 1990s, despite entering into tax treaties with countries (India had a DTAA with Greece as early as 1966!).

This was mainly because of its status as a net importer and it wanted to hold on to the concept of source-based taxation.

A mix of old and new

The Indian tax law is a curious mixture of the old and ancient, and the new and modern concepts. In one part of the Act, one can find principles based on the theory of real income whilst in some other part, you will notice great emphasis and relevance placed on a refined income basis. Refined, I say, in view of the fact that from time to time the Act has treated certain receipts, which no classical economist will accept as income, as income for tax purposes.

This has been due to the thinking of the tax authorities that all receipts tend to become income at some stage or other and tax revenue must be maximised.

You can also find a spectacle in the Act of presumptive income being treated as taxable income as against the actually earned income. Basic accounting principles tend to be swept away and new concepts on accrual of income have been built into the Act.

While the Act holds out the principle that corporations and businesses will be liable to tax on an accrual basis (mercantile system of accounting) the Act prescribes a series of measures which are distinctly against this principle and the cash method of accounting recognised in certain situations.

Economic nexus

I now move to consider some fundamental issues in the areas of taxation which have got highlighted due to pressures of aligning our concepts to a world programme.

In a challenging economy, making every rupee count is part of the corporate DNA. At most companies, strategic tax planning plays an important role in achieving that goal. One area that is drawing increasing attention is the issue of economic nexus.

The legal concept of nexus determines whether a business has enough of a presence in a country to become subject to its taxes. It refers to the extent of physical presence in a country that triggers a companys tax liability in that country. The concept of economic nexus means that tax nexus exists whenever a business has derived revenue or income from a customer in a country, even if the business has no property, employees or other significant physical presence in that territory. Globally, taxing corporates on the basis of the concept of economic nexus is gaining significance.

Income or profit which results from international activities, such as cross-border investment, may be taxed where the income is earned (the source country), or where the person who receives it is normally based (the country of residence). Residence taxation of income is based on the principle that people and firms should contribute towards the public services provided for them by the country where they live, on all their income wherever it comes from. Source taxation is justified by the view that the country which provides the opportunity to generate income or profits should have the right to tax it.

From the beginning of the 20th century, when taxation of income and profits became the main source of government revenue, firms involved in international businesses soon complained of the very high rates of taxes that resulted from taxation on both source and residence basis. Some countries decided unilaterally to limit their taxes on income derived from foreign sources. This was done by completely exempting it from residence taxes, Alternatively, some provided a credit for foreign taxes paid, but such a credit meant that the income always bore taxes at the higher rate.

To prevent double taxation, the League of Nations and its successors the United Nations (UN) and the Organisation for Economic Cooperation and Development (OECD) developed a series of model treaties that led to the current set of over 2,500 bilateral income-tax treaties, which provide the framework of international tax regime.

Source vs residence

Fundamentally, the treaties strike a compromise between source and residence taxation. Some rights to tax are given to the source, and the residence country is required to relieve double taxation either by giving credit for such sources taxes paid, or by exempting the relevant income from its taxes. Generally, source jurisdictions retain their right to tax active (business) income, except for short-term activities, but give up some of their right to tax passive (investment) income.

Therefore, the source country has the right to tax the business profits attributable to a branch of a foreign company (defined as a permanent establishment), as well as the profits of a foreign-owned company (subsidiary). In exchange, the source country agrees to apply nil, or only a low tax at source (described as withholding tax) on payments to residents of other country, such as interest on loans, dividends on shares, or royalties on intellectual property. Thus, the main effect of the tax treaties is to reduce source-based taxation in favour of residence-based taxation of passive income (sometimes referred to as income from capital). The degree to which this is done depends on each treaty; capital-exporting richer countries prefer the OECD model treaty, which is more favourable to residence, while capital-importing developing countries tend to favour the UN model treaty, which is more favourable to source. For example, the UN model allows source taxation of short-term business activities, such as short construction projects, and fees paid to foreign service providers, such as accountants or consultants, even if they only enter the country for a short period.

Theoretically, one can imagine a world in which all countries adopted either pure residence jurisdiction or pure source jurisdiction. Economists tend to favour residence jurisdiction, both because they consider the source of income to be hard to pin down (income often has more than one source), and because they think residence jurisdiction promotes economic efficiency, since the decision where to invest should be unaffected by the tax rate.

Unrealistic aspects

However, pure residence taxation is unrealistic, for three reasons. First, countries are unlikely to give up the right to collect tax from foreigners doing business within their economy and territory. Second, pure residence-based taxation would reduce revenues in poor developing countries, which rely heavily on source-based taxation, in favour of the rich developed countries where investors reside. Most importantly, residence taxation is much easier to evade or avoid, by channelling international investments through tax havens.

Strong protection of bank confidentiality and other secrecy provisions make it hard for the residence country to get information about its residents foreign source of income. Residents can channel their income from the source country, through a country with an appropriate tax treaty, and then park them in a convenient heaven. It is very hard for the residence country to try to tax this income, since it is very hard to find out about it.

Indeed, if the income is not paid directly to the beneficiary in the country of residence, but parked in a trust or company to be reinvested or spent abroad, this may not be tax evasion but only avoidance. Even countries with highly sophisticated tax administrations find it difficult to combat this, and for poorer countries it is virtually impossible.

Pure source taxation is also an option that has been favoured by some commentators, including academics from developing countries. The major problem with that option, however, is that it enables investors, especially transnational corporations (TNCs) to play countries off against each other to obtain the lowest source based tax rate - a system of tax arbitrage. This type of tax competition already exists for active business income. The semi-conductor chip manufacturer Intel, for example, legally avoids paying tax on any of its income outside the US by obtaining tax holidays from the various countries where it locates facilities. But the problem would get much worse if pure source based taxation were extended to passive income as well, since financial flows are extremely mobile. In that case it is doubtful whether any investment income would be subject to tax anywhere.

In addition, the problems of determining the source of income and of combating abusive transfer pricing (i.e. shifting profits artificially inside a TNC for a tax advantage) would become much more acute in a world of pure source taxation. The OECD countries introduced their controlled foreign corporations (CFC) regimes partly to combat these avoidance devices. Such regimes enable the residence country to combat the parking of foreign income in a subsidiary company or other entity formed in a low-tax heaven, by taxing its income directly as part of the income of its parent or owners in the ultimate country of residence. If they were forced to abandon them as inconsistent with pure source taxation, opportunities for avoidance would be much greater than they are now. Thus, a compromise which gives primacy to source-based taxation but keeps the option of residence-based taxation, still seems best option to preserve the revenue base of both developed and developing countries.

More broadly, the distinction between residence and source is very hard to apply to businesses that operate in an internationally- integrated seemless manner, as with most TNCs. Foreign direct investment by a TNC is very different from portfolio investment by an independent investor. The TNC can set up a network of intermediary subsidiary companies, formed in convenient jurisdictions, especially to manage its assets and financial flows. Many of these involve passive or fictional business functions, such as providing insurance, raising finance by floating bonds and lending the proceeds, and owning physical assets (e.g. ships) or intellectual property (e.g. patents and trade-marks). The active business profits of the TNCs operating subsidiaries, taxable in source countries, are reduced by fees and charges they pay for these inputs. Yet such income flows are not returned to the ultimate parent company unless and until they are needed to fund dividends to its shareholders. This enables TNCs legitimately to minimize taxation of their retained earnings, and to benefit from a reduced cost of capital compared to purely national firms.

It is extremely difficult to deal with such a scenario by the traditional approach of allocating rights to tax between the country of residence of the investor and the country of source of income, since both source and residence are fluid concepts which can be manipulated. The main international initiative against international tax avoidance, the OECDs drive against harmful tax practices, tries to do so by strengthening both source and residence taxation, but only by the rich OECD countries, and by attacking tax heavens, many of which are poor developing countries. The OECDs campaign could gain more political support if it aimed at strengthening the international tax system as a whole, rather than just trying to patch up the leakage of taxes from rich countries.

An important element in this, which is central to the OECD initiative, is improved exchange of information for tax purposes. An effective means to bring this about would be to impose withholding taxes at source on payments to non-cooperative countries. If this were done in a coordinated fashion, it would avoid the problem that the funds will just be driven to another country, and if done globally it would have dealt with the suspicion that only the rich OECD countries would benefit. Indeed, it would require the OECD countries themselves to be willing to supply such information, even to developing countries, which they are not always willing to do.

The OECD has also tried to combat preferential tax regimes, defined as those aiming to attract mobile capital with no genuine business activity. This has been done by treating companies with such business which are formed in low-tax jurisdictions as CFCs (controlled foreign corporations), and taxable by the country of residence of the ultimate parent. However, it has proved very hard to agree what constitutes a genuine business activity. This is partly because OECD countries themselves also compete to provide tax breaks to attract some TNC business functions, such as headquarters regimes, and financial services. Ideally, this problem, as well as the difficulties faced by dividing rights to tax between residence and source countries, would be dealt with by taxing global business such as TNCs on a unitary basis, allocating their tax base by apportionment according to a formula which could fairly take account of the contribution each activity makes to the global profit.

Meantime, all countries would benefit from re-defining the goal of the international tax regime as not just for preventing double taxation, but also as preventing double non-taxation, in other words combating fiscal evasion and avoidance. Taxpayers should be willing to pay tax somewhere and fairly on their cross-border transactions, and this would help ensure that investment is allocated more fairly and efficiently.

In India under the scheme of the Income Tax Act, Section 4 provides that it is the total income of every person which is taxable. Section 2(31), in turn, defines person as including a company, which in terms of the provisions of Section 2(23A), includes a foreign company as well. Section 6(4) of the Act lays down that a company, unless it is an Indian company or unless it is controlled or managed entirely from India, cannot be said to be resident in India. A foreign company, which is not wholly controlled or managed in India is, therefore, a non-resident so far as residential status under the Act is concerned.

Section 5(2) further lays down that as far as a non-resident assessee is concerned scope of total income of such an assessee is confined to (i) an income which accrues or arises in India or is deemed to accrue or arise in India, and (ii) an income which is received or is deemed to be received by or on behalf of such foreign company. This elementary analysis makes it clear that under the IT Act, so far as foreign companies are concerned, taxable unit is a foreign company and not its branch or PE in India, even though the taxability of such foreign companies is confined to (i) an income which accrues or arises in India or is deemed to accrue or arise in India, and (ii) an income which is received or is deemed to be received by or on behalf of such foreign company.

Further, a non-resident assessee may have several incomes accruing or arising to it inside India or outside India, but, so far as taxability under Section 5(2) (b) in India is concerned, it is restricted to incomes which accrue or arise, or is deemed to accrue or arise in India. The scope of this deeming fiction is set out under Section 9 of the Act. It will be highly interesting at this stage to note how the concepts of business connection and situs of property are going to be highly important in a situation where globalization takes deep roots in the world economy as a whole and where the flow of capital is dictated mainly by economic considerations and not by political considerations and geographical barriers. Today, it is an accepted fact that due to internationalization of business practices and globalization of businesses, there is a free flow among various nations of all the factors of production, except one viz., land. Due to mergers and acquisitions, ownerships of public companies change hands in a trice; often contracts are negotiated and executed, at places not connected with either the owners of the businesses or their locations. Shares and along with them control over the enterprises change hands at locations not belonging to home territories and often between non-resident parties. The Indian tax authorities who till very recently comforted themselves by dealing with gross profit additions, non-businesses expenses etc. are now called upon to sit in judgement over issues like transfer pricing and global capital gains. Even transfers of shares between non-residents have been attempted to be brought under capital gains provisions and tax levied. The case of Vodafone is not one that can be ignored. Similar instances are bound to multiply and possibly increase in a geometrical progression because of the interest of owners of foreign funds (FIIs) to invest in the Indian companies. Sec. 9 comes to the aid of the Indian tax authorities because of the emphasis placed there, by way of a 2004 amendment, to the situs of the shares leading to a conclusion of the transfer coming under the provisions of s. 45. In this connection, the decision of 16th November, 2007 by the Authority for Advance Rulings (Incometax) New Delhi in AAR No. 740 of 2006 will be very relevant. These developments conclusively establish the fact that the ever-growing appetite of tax authorities is significant.

As for the income accruing or arising in India, an income which accrues or arises to a foreign enterprise or company in India can essentially be only such a portion of income accruing or arising to such a foreign enterprise as is attributable to its business carried out in India. This business could be carried out through one or more branches or some other form of its presence in India. To determine income accruing or arising in India to a foreign enterprise (hereinafter referred to as general enterprise or as GE), therefore, one has to compute income attributable to such branch (es) in India, or other form(s) of presence in India such as office, project site, factory, sales outlet etc, (hereinafter collectively referred to as permanent establishment or PE) of foreign enterprise.

It takes us to the question as to what is the scope of income accruing or arising to a foreign company in India. Section 9 of the Act elaborately deals with the same, but, the expression income accruing or arising in India is not defined anywhere in the Act.

The Indian IT Act does not provide for any special mechanism for taxation of PE of a foreign enterprise, except taxation on presumptive basis for certain types of incomes such as under Sections 44BB, 44BBA, 44BBB, 44D, etc. It is ironical that while the Indian IT Act deals with the scope of income deemed to "accrue or arise" in India, at great length and visualizing possibly all sort of deeming fictions, there is not much elaboration about the scope of income which "accrues or arises" in India in the hands of a tax entity which has a fiscal domicile abroad. Since there are no specific legislative provisions to keep pace with this aspect of increased cross-border commerce, by providing for a mechanism to compute profits accruing or arising in India in the hands of the foreign entities, the profits attributable to Indian PE of foreign enterprise are required to be computed in terms of general provisions of the IT Act and the normal accounting principles.

Therefore, ascertainment of a foreign GEs taxable business profits in India involves an artificial division of the overall profits of the GEbetween profits earned in India and profits earned outside India. Indian IT Act can only be concerned with the profits earned in India, and, therefore, a method is to be found to ascertain profits accruing or arising in India. The only way, it can be so done is by treating the Indian PE as a fictionally separate profit centre vis-a-vis GE. The very concept of computation of PE profits is created as a fiction of tax law in order to demarcate tax jurisdiction over the operations of a company in a country of which it is not a tax resident. Unless the PE is treated as a separate profit centre, it is not possible to ascertain the profits of the PE which, in turn, constitute profits accruing or arising to the foreign GE in India.

The Honble Supreme Court in the Hyundai Heavy Industries Co Ltd case accepted the concept of taxing based on economic nexus. In this case the Court held that under section 5 read with section 9 of the Act, the income accruing or arising in India, an income which accrues or arises to a foreign enterprise in India can be only such portion of income accruing or arising to such a foreign enterprise as is attributable to its business carried out in India. This business could be carried out through its branch(s) or through some other form of its presence in India such as office, project site, factory, sales outlet etc. Therefore, under the Act, while the taxable subject is the foreign general enterprise it is taxable only in respect of the income including business profits, which accrues or arises to that foreign GE in India.

The Court further, referred to Para (1) of Article 7 which states the general rule that business profits of an enterprise of one Contracting State may not be taxed by the other Contracting State unless the enterprise carries on its business in the Other Contracting State through its PE. That only so much of the profits attributable to the PE is taxable. Para (1) of Article 7 further lays down that the attributable profit can be determined by the apportionment of the total profits of the assessee to its various parts or on the basis of an assumption that the PE is a distinct and separate enterprise having its own profits and distinct from GE.

Applying the aforesaid principles the Court held that profits earned by the Korean GE on supplies of fabricated platforms cannot be made attributable to its Indian PE as the installation PE came into existence only after the transaction stood materialized. The installation PE came into existence only on conclusion of the transaction giving rise to the supplies of the fabricated platforms. The Installation PE emerged only after the contract with ONGC stood concluded. It emerged only after the fabricated platform was delivered in Korea to the Agents of ONGC. Therefore, the profits on such supplies of fabricated platforms cannot be said to be attributable to the PE.

The court further held that in terms of para (1) of Article 7, the profits to be taxed in the source country were not the real profits but hypothetical profits which the PE would have earned if it was wholly independent of the GE. Therefore, even if we assume that the supplies were necessary for the purposes of installation (activity of the PE in India) and even if we assume that the supplies were an integral part, still no part of profits on such supplies can be attributed to the independent PE unless it is established by the Revenue that the supplies were not at arms length price. No such taxability can also arise in the present case as there was no allegation made by the Department that the price at which billing was done for the supplies included any element for services rendered by the PE. Therefore, the profits that accrued to the Korean GE for the Korean operations were not taxable in India.

It is also relevant to note the Supreme Court decision in Ishikawajma Harima Heavy Industries Ltd vs DIT, wherein it was held that the concept of territorial nexus was fundamental in determining taxability of any income in India, and that income from offshore supply of equipment and services by the foreign company outside India would not be taxable in India merely because the equipment was supplied in relation to a turnkey project in India. However, recently, the Finance Act, 2007 amended the provisions of Section 9 of the Act to state that such income shall be taxable regardless of territorial nexus irrespective of whether the non-resident has a residence or place of business or business connection in India.

These decisions reaffirm the ambiguities surrounding taxation of foreign companies rendering cross-border services in carrying out turnkey projects in India where a part of the work has been carried on outside India. By reiterating the importance of establishing "economic nexus" for the purpose of bringing income to tax in India, the cases assume great significance in times when states are unsure of the extent of their jurisdiction to tax cross-border services.

The development of electronic commerce (EC) has made the application of the principles discussed hereinabove far more complex as it modifies the way of doing business. For centuries, traditional business around the world has been based on the concept of physical presence and physical delivery of goods and services. However, with the advent of electronic commerce physical presence is no longer necessary to perform activities (i.e., commercial transactions are no longer defined by geographical boundaries) and physical transactions are replaced by bytes of data. Since EC can be conducted virtually instantaneously around the globe and around the clock, the question where the profits should be taxed becomes crucial. Taxing the Internet is a topic that makes global headlines, everyday. The lure of setting out national tariffs for every byte of data that follows and taxing every product traded hopes to herald a new economy for the taxman. Most governments are alarmed at the extreme growth of the internet, and they should be, as the Net is the largest free information system the world has ever seen.

The task of taxing commerce on the Net is daunting, since the data flowing through the vast annals of the Internet is intangible and the network on which it is built is spread over the space of the Earth. The peculiarity of Net stems from the kind of "traffic" that flows through it- World Wide Web (WWW) pages, e-mail, internet relay chat, video conferencing, internet telephony, streaming audio and video file transfer and so on--- and each of this data is just a meaningless string of zeros and ones.

The development of electronic commerce has revolutionized the way business operates. It has also challenged the adequacy and fundamental validity of principles of international taxation such as physical presence, place of establishment etc. that has formed the basis of assessing tax liability.

Business conducted through the internet caters to globally located customers. This raises cross border legal issues. Transactions that may be legal and valid in one jurisdiction may not be enforceable in others. Creation of wealth through cyber space would also entail the use of "offshore" financial institutions to store this wealth. This would constitute an elaborate and often untraceable form of tax avoidance. This is not only a threat to national sovereignty but also overrides traditional principles of taxation- a transgression of traditional notion of political and monetary autonomy. As wealth is generated through the means of cyber space, accounting mechanisms and monetary control would become difficult. Taxes on cyberspace would be one method of getting some amount of monetary control.

The allocation of taxing rights must be based on mutually agreed principles and a common man understanding of how these principles should be applied. In addition to the need for consensus between governments and business, a need for co-operation between them has also been identified.

Changes in the business practice due to the advent of the EC will affect taxation in the following ways: -

(i) Lack of any user control to the location of activity: As the physical location of an activity becomes less important, it becomes more difficult to determine where an activity is carried out and hence the source of income.

(ii) No means of identification of users: In general, proof of identity requirements for Internet use is very weak. The pieces of an internet address (or domain name) only indicate who is responsible for maintaining that name. It has no relationship with the computer or user corresponding to that address or even where the machine is located.

(iii) Reduced use of information reporting and withholding institutions: Traditionally taxing statutes have imposed reporting and withholding requirements on financial institutions that are easy to identity. In contrast, one of the greatest commercial advantages of EC is that it often eliminates the need for intermediary institutions. The potential loss of these intermediary functions poses a problem for the tax administration.

Some of the fundamental tax related issues raised by the evolution of EC transactions may be summarized as follows: -

Whether international trading by an enterprise through EC will result in the enterprise creating a taxable PE in other countries in which customers are located? Is there a need to create new definition and meaning of permanent establishment (Hereinafter referred to as PE)? Is there a need to change the basis of taxation (for example, residence based taxation)? While considering taxation of EC transactions, should principles of tax neutrality be adhered to? If it is determined that an enterprise does have a PE in another country, another important issue than arises: How to attribute profits to PE?

EC also gives rise to new issues concerning the characterization of payments under the double tax treaties. Moreover, though EC does not give rise to any fundamentally new issues relating to transfer pricing, there may be some difficulties in applying traditional transaction methods, establishing comparability, deciding the tax treatment of integrated businesses and complying with documentation and information reporting requirements. Unless these issues are addressed, an erosion of the tax base may result, especially for developing and emerging economies.

Fundamental Principles: A taxpayer is generally taxed on its worldwide income in the country of its residence (residence based taxation). In the case of a company, this is usually the place where the company is incorporated, registered, or has its place of central management and control.

The company may also be taxed in another country if it has a recognized source of income there (source based taxation). Generally tax treaties restrict the use of domestic source rules by requiring a minimum nexus to allow taxation in that jurisdiction. Thus, taxation of business income on the basis of the source rule requires the presence, in the country of source, of a PE of the enterprise sought to be taxed.

Where the income or capital is taxed in the country of source, the country of residence has the obligation to give relief from double taxation. Such relief is granted either by exempting such income from taxation in the country of residence or by giving credit for taxes paid in the country of source.

Permanent Establishment: Under the tax treaties based on OECD Tax Convention, an enterprise providing services abroad is taxable in the country where it conducts business only if it has PE there. For most tax treaty purposes, a PE is a fixed place of business through which an enterprise carries on business. A PE presupposes a fixed place of business (the basic rule of PE) which may include premises, facilities or installations. The characteristic fixed demands a specific fixed long-term connection between the place of business and a specific part of the earths surface.

Secondly, if the services provided are the part of a construction or installation project that lasts for more than a particular period of time, a PE may be constituted under article 5(3), i.e., construction PE.

The third element of PE is article 5(5) and (6) under which an Agency PE may be constituted. This is the case if a provider of services in a country has a dependant agent there who involves his principal in business by regularly concluding contracts on behalf of the principal. Typically, however, tax treaties exclude from the definition of a fixed place of business any offices and facilities that are used merely for promotional activities or for the storage, display or delivery of goods and facilities.

Electronic commerce is a broad concept that covers any commercial transaction that is effected via electronic means and would include such means as facsimile, telex, EDI, Internet and telephone.

In addition it has also been said that:

Electronic commerce could be said to comprise commercial transactions, whether between private individuals or commercial entities, which take place in or over electronic networks. The matters dealt with in the transactions could be intangibles, data products or tangible goods. The only important factor is that the communication transactions take place over an electronic medium

With the rapid growth of the Internet, the process by which EC is conducted has magnified. An understanding as to the mechanisms involved in the operation of the Internet is necessary. All machines connected to a Network are generally identified by their Internet Protocol (IP) numbers. Devices communicate with each other through this IP number system, acting much like two conventional telephones. Further, specific IP numbers denoting a computer is given a domain name. The communication takes place in the form of packets which can traverse through several networks before reaching their destinations. Data packets are of specific size and if their content exceeds this size, it is split up and transmitted. The data portion of the packet can be encrypted for better security.

International tax issues in the area of e-commerce are manifold and include nexus of the vendor and tax enforcement agencies. Taxing authorities may have great difficulty collecting revenue from vendors conducting commerce through foreign Internet addresses. The foremost problem associated with Internet based commerce is fixing the place of transaction. The place where a web-server is located, the place where the user initializes the transaction and the server where payment is collected may be different. Electronic transfer of funds heightens the risk of money being sent to tax havens. Further, many jurisdictions rely on the taxpayer to voluntarily identify himself, herself or itself as falling within its tax system. Tax authorities may not be able to effectively enforce their rights to collect tax in such an environment, especially if a business does not consider itself to be within a tax jurisdiction and simply choose not to disclose its activities to the relevant authority.

Underlying any discussions as to whether a website, server, telecommunication equipment, local access numbers, etc. constitute a permanent establishment or not is the source or residency based taxation.

Not surprisingly, certain technology exporting countries are in favour of a move away from a source-based tax. The United States made a clear statement to this effect in a treasury paper. Treasury maintains that it is difficult to apply traditional concepts of source to link an electronic transaction with a particular country. This view has been re-affirmed by the USA and supported by Japan at the G8 meetings.

Importing countries will not necessarily take the same view and here is a danger that in the absence of clear guidelines that are universally accepted we will find some jurisdictions straining the traditional concept of permanent establishment to catch electronic trade and preserve local taxing rights or (and potentially more alarming) seeking to apply royalty treatment especially where treaties allow for a withholding tax on gross receipts.

Where a foreign enterprise is considered to be carrying on business in a particular country, it will generally be subject to tax in that country on that source of business income. However, it may be exempted from tax on the business income in the particular country if certain provisions are in a bilateral tax treaty. Tax treaties will generally restrict the ability of a country to tax a non-resident on its business income sourced to that country unless the income is attributable to a permanent establishment in that country. Thus, a foreign corporation that is resident in a country with which its home country has a double tax treaty is liable for tax in the former only if it has a permanent establishment there.

OECD definition of a permanent establishment:

Business profits are taxable in the State of the residence of the enterprise even if the business is carried on in the State of source, unless they are attributable to a permanent establishment is generally defined as a fixed place of business through which the affairs of an enterprise are carried on.

This definition contains the following conditions:- The existence of a place of business, i.e., a facility such as premises or, in certain cases, machinery or equipment; The place must be fixed, i.e., it must be established at a distinct place with a certain degree of permanence; the carrying on of the business of the enterprise through this fixed place of business is prescribed.

The conduct of a business usually implies that certain persons run the enterprises affairs from a fixed place. However, the OECD comments concerning automatic equipment make it clear that it is not necessary for personnel or any other human being to be present performing particular activities to be a PE.

A PE will also be deemed to exist where a person other than an agent of an independent status is acting on behalf of the enterprise and has, and habitually exercises an authority to conclude contracts in the name of the enterprise.

Most treaties list a number of business activities which are not considered as PE. The common feature of these activities is that they are, in general, preparatory or auxiliary in nature.

What constitutes PE for the purposes of electronic commerce?

EC may pose problems for the definition of permanent establishments that existing tax treaties do not address. While as yet unforeseen questions are bound to arise, the current debate over what constitutes PE can be broadly summarized in the following questions:

Whether a mere accessibility of a website from within a particular jurisdiction subjects the site-owners to income tax in that jurisdiction? Whether the presence of a server would constitute a PE? Whether a consumers computer constitutes a PE? Whether the provision of services by an Internet Service Provider (ISP) would constitute a PE?

Treaty negotiators will have to examine these questions to see how treaty concepts can be applied to new ways of doing business.

A web Site:

The most obvious question concerns the ability to access a website from within a particular taxing jurisdiction. In OECD countries, a mere existence of technical equipment is insufficient for creating a PE. Article 7 of the OECD Model Treaty provides that an enterprise of a contracting state is generally exempt from tax on its profits derived from business carried on in the other contracting state unless these profits are attributable to a PE located in that other contracting State. Article 5 defines a PE. The Model Treaty also lists business premises which constitute PE and if we were to characterize these examples, it is likely that we would conclude that a physical presence of some permanence is common to all. Does a website or home page have a physical presence of some permanence?

A website has no actual physical presence, but rather is highly mobile, borrowing only the presence of the server where it happens to reside at the moment. No employees need be present in the country to maintain the site. To the extent that advertising and ordering functions are performed, the website is analogous to mail order catalogue or a television advertisement, infomercial or home shopping channel. Mere solicitation, without more, does not create a PE under existing principles, and it should not, when effectuated through EC. To the extent that a customer can view stack or data, the website is analogous to a location being maintained solely for the purposes of storage, display or delivery.

Moreover under existing principles, electronic content that resides on a server only temporarily should not be a PE. For example, the construction rules reflect a concept of duration and require the presence of project activities, including he presence of a workforce, in-country for twelve consecutive months.

So does the fact that consumers can place orders through a foreign firms website subject that firm to income taxes in the country where the customer lives? The answer to that question, in my opinion, is certainly no. To say that the ability to access a website, without some other more substantial contact, is sufficient to constitute a PE is to say that online businesses are liable for income taxes in every country where their customers happen to reside. A website cannot be considered as a PE and such a principle is also virtually unenforceable.

It would be more useful to tie the presence of a homepage to some physical equipment, namely its host computer. And that takes us to the second debate, namely whether a serer constitutes a PE.


A second, more complex, question arises regarding the location of computer file servers: should the mere presence of a server in a particular taxing jurisdiction be considered sufficient contact to constitute a PE? In most cases, the existence of a foreign owned server does not require employees to be present in the host country traditionally a prerequisite for PE. This issue can be analyzed under four sets of circumstances:

Where a server is used merely for advertising, where the server is used for advertising and taking orders, where the server is used for advertising taking orders and accepting payment; and where the server is used for advertising, taking orders and accepting payments and for digitized delivery of goods.

In the first case, a server can not be held to be a PE. Exception 5(4)(a) of the OECD code will be attracted in this case where the use of a facility solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise will not amount to the existence of a PE. It could also be exempt under Article 5(4)(c), which exempts the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any activity of a preparatory or auxiliary character from the ambit of PE. In the second and third cases, it may possibly be held that the server is a PE. In the last case, there is an even stronger cause to hold the server to be a PE. However, an attempt to tax the server as PE will not serve any purpose as it is very easy to shift the server to a tax haven or to a low tax country. Further, difficulty will arise where a number of mirror websites on different servers located in different countries are used so that a customer can be directed to any one of these sites. Yahoo, for example, uses a number of mirror sites so that the users can have better access to its very heavily visited site.

The Users Computer As PE:

A view could be taken that the location of a computer who initiates the contract from his computer would constitute a PE for the non-resident. However, that place is only a location from which one logs on and is unlikely to be fixed. For example, a customer may access a web site through a mobile computer. This may even be outside the country.

Thus, the question of whether by simply accessing a website, a computer transforms itself into a PE of the owner of the website, is unlikely to be answered in the affirmative. It would lead to a situation where everyone with a web page would have a PE in every country. Further, the question of enforcement would remain unanswered.

Can The Services Of An ISP Constitute a PE?

Agency issues may also be clarified as they relate to the conduct of e-commerce. For example, some national governments will like argue that a domestic ISP, by connecting consumers to a foreign businesss website, acts as an agent for the purposes of determining the existence of PE.

The ISP merely acts as an intermediary between a non-resident seller and the customers in the source country. Therefore, the ISP will not qualify as the agent of the non-resident seller. Since the ISP acts on behalf of several website owners, even if it is treated as an agent, it would be an independent agent. Therefore, it will not constitute a PE. Even if it acts for only one website owner, it does not have the authority to conclude contracts on behalf of the website owner, which is an essential pre-requisite before it can be considered to be the owners PE.

The phenomenal growth of the Internet will force us redefine our concepts of the tax world and recreate the rules and regulations that apply to it. Because conducting business through EC is fast becoming the norm of the day, the speed at which the international institutions and the group(s) of nations are evolving strategies to catch up with the challenges posed by EC is too slow.

The existing canons of income tax based on source rules seem to be getting outdated. There is an immediate need for international institutions, such as OECD and International Fiscal Association, to evolve more equitable tenets for cross-border EC transactions so that there can be more equitable distribution of tax revenues among nations. Countries that are feeling an erosion of the taxes shouldnt be forced to adopt desperate measures that may be short term and hence, likely to affect adversely the growth EC economy.

EC has rendered geological precincts redundant and converted the world into a global community. Procedural and administrative hurdles must not interrupt the development of EC. Of particular importance is the avoidance of dissonance among nations on sharing the proceeds of taxation of EC transactions. Nations must make a coordinated effort to evolve principles of taxation of these activities through a body comprising of representatives of all nations. This is the challenge for the future.

83.Having recounted so far, the problems that face a business and consequently the tax authorities to tax appropriate revenues to be in consonance with accepted international principles, let me list out possible approaches to a smooth resolution of the issues :

One must realize the fact that the behaviour pattern in the world today is dictated by economic and business considerations rather than by political beliefs and geographical limitations. The power of commerce is made superior to the power of politics. This will, therefore, result in commercial considerations far out-weighing other pressures leading to a situation where the dictates and requirements of business will get attention. I, therefore, envisage a situation where all the universal commercial interests get together to organize a regime which will coalesce its interests to usher in a friendly regime. All considerations of narrow country specific requirements will submerge into a universal rule. We may then have a uniform approach untrammeled by considerations other than commerce.

Somewhat on the abovelines, we have European union which is a union of more than 15 European States. EU follows a uniform pattern of financial policies like customs and incometax rates. This association has functioned for sometime now. I may not be correct to say that this type of union has erased all sentiments of nationality, patriotism etc. feelings of nationalism have surfaced. Pride of a nation in regard to issue of currency etc. has often been found expressed in some quarters. It may possibly be mentioned that if after many years of such a union, fears are being expressed about relevance of such an association, whether we can think of a union on the taxation front among the developed and emerging economies where the issues of national development, unemployment strategies, taxation policies, industrial development, etc. will call for attention, will there be a convergence between the interests of the developed and the emerging markets on their approach to resolving problems faced in the revenue gathering sphere ? Will countries think that a compromise in this area will mean a sell-out to foreign powers and interests ? ;

Incidentally, it will be worthwhile to note that the financial sector is one area where convergence has been established almost on a universal level. Because of the inter-dependence of institutions and a necessity to adopt global standards to ensure a smooth functioning of financial institutions which have a world presence , the move to globalize standards, procedures and concepts has been accepted and put into effect. The financial sector can broadly be divided into three areas interdependent they are viz., banking, insurance and capital market. I have already indicated that capital knows no boundaries or geographical limitations and as capital freely flows in and out of markets whether developed or emerging the ground rules are also set. The institutions that belong to the financial sector are supervised, regulated and maintained by independent regulators in most cases and in some cases like U.K. and Japan by a single regulator. In India we have RBI, SEBI and IRDA discharging these roles. The regulatory bodies are part of a universal set-up which has persuasive powers on the national bodies. These regulatory bodies have set up almost common regulations regarding the establishment, management, functioning, accounting policies to be followed and salvancy measures of the integral bodies with the result that there exists today, at least in the financial sector, a regime of close association and congruence. This has been the biggest gain of globalization.

Following in these foot-steps, should we not also expect an understanding amongst the various countries on a common approach to taxation of incomes. ?

A similar common approach also emphasizes the need for the adoption of a common accounting standard to be adopted by all those countries that want to come together. Every one of us knows for a fact that this is still a dream to fructify ; Even amongst the developed countries, there exists basic differences on fundamentals of the accounting standards to be followed. UK has a system of accounting standards ; so is the USA. We have a set of standards that keeps evolving and tries to synthesise what is good for the local conditions. Enterprises that have raised capital in different markets are now called upon to file statements and disclosures in each country based on the individual requirements of law and regulations followed in that country. Recently, some efforts in integrating the different standards have been afoot and have resulted in a better understanding of this problem and some softening of the rigours of the requirements in USA are noticed.

Thus, all said and done, we have a long journey ahead of us. Globalisation per se has resulted in developments both welcome and unwelcome. Development in certain areas has been stupendous. But this has not resulted, at least in the major emerging economies of the world, the lessening of social tensions. We now are talking of inclusive development a concept that deals with an all round development and the improvement of the living conditions of all poor included. Let us, however, not get disheartened on the length of the journey or the time that it will take us to accomplish our goals. We must feel somewhat chastened in our approach and belief that development comes at a cost and over-all development is our desired objective and globalization has been a process to add congruence and relevance to that approach

(Edited excerpts of the K. R. Ramamani Memorial Lecture delivered on November 28 in Chennai.)
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