The US administration will do better by engaging productively with the OECD- led BEPS initiative to accelerate consensus on taxation of digitised economy, which will ease pressure on nations.

By Mukesh Butani & Tarun Jain

Trade considerations have invariably been intertwined with tariffs; an increase in tax is inversely proportional to trade and vice versa. So much so that substantial foundational premise of the World Trade Organization is beset with prepositions which relate to the regulation of taxes on trade. Though, they are largely related to indirect taxes, such as customs & similar forms of tariff barriers, an inquiry into the role of direct taxes acting as trade barriers is unknown in the modern age. A case in point is the ongoing international debate on Digital Services Taxes (DST) that are evolving to address an area in relation to taxing of segments of the digital economy hitherto not taxed, due to constraints under the traditional rules of taxation that their origin to the League of Nations era, dating back to the early part of last century.

The Permanent Establishment test, in vogue for almost a century as the basis for taxing non-residents’ income in the source country, is found to be wanting, or, we must say, inadequate, in the modern digital model space, owing to the negligible presence of the Non-Resident Digital Service Providers (NRDSPs). The debate to move away from taxing such businesses has matured, and there are no takers, particularly in government, for leaving them untaxed. Its outcome is evident in the ongoing OECD lead Base Erosion & Profit Shifting (BEPS) debate culminating in an inclusive framework of nations, looking at achieving a consensus on the basis for taxation and sharing of such tax revenues amongst the nations.

While the endeavour of the OECD has been to arrive at a consensus, in the interim, it has invigorated adoption of unilateral measures by countries, challenging the continuation of a rule-based order in the space of international taxation. Indian lawmakers led by example in the year 2016 by enacting the Equalisation Levy (2016 levy) which has been substantially expanded in this year’s budget (2020 levy). It is the 2020 ‘expansive’ levy that has raised eyebrows in the international fraternity. Apart from grievance regarding the lack of lead time for implementing the new law and absence of stakeholder consultation, critics have claimed that the 2020 levy strains free-trade commitments and violates WTO rules. Seemingly acting on such lines, the United States Trade Representative (USTR) has recently initiated 301 investigations.

To appreciate the contours of the USTR action, it is expedient to appraise the nuances of India’s Equalisation Levy. The 2016 levy was technically a charge on the NRDSP, but practically borne by Indian Service Recipients (ISRs). Thus, the NRDSP were largely unaffected as, effectively, the cost of the 2016 levy and the compliance burden was upon the ISRs. Furthermore, the 2016 levy was restricted only to digital advertisements, which did not affect most NRDSPs. The 2020 levy is materially distinct and wider in its scope—it obliges the NRDSPs owning or operating an e-commerce platform to pay tax on consideration earned by them from the supply of their own goods or services, including consideration earned for facilitating supply made by third-parties on their platform.

The tax-incidence and the compliance burden, both, are upon the NRDSP under the 2020 levy, thus, obliging them to register in India, file periodic returns and undergo assessment by Indian Revenue. The charge under the 2020 levy extends not just to their transactions with ISRs, but to those with other non-residents in certain forms of specified transactions, such as the sale of data collected from Indian residents or advertisements targeted towards Indian residents.

The USTR inquiry is under the US Trade Act of 1974 and Section 301 of this law, hence referred as ‘301 investigations’, enables the USTR to initiate investigations to determine whether actions of other countries are actionable, on the premise that they interfere with the US’s trade interests. Though, it is essentially a domestic inquiry, the implications for countries being investigated can be ominous. An affirmative finding results in the US administration engaging with the country, resulting in tariff measures should a country fail to address USTR’s findings. A case in point is the infamous US-China face-off leading to sanctions and tariff barriers on Chinese exports; most of it is linked in large measure to 301 investigations.

In the context of DST, the USTR commenced 301 investigations against France in July last year, and has recently launched a fresh set against a host of nations including Austria, Brazil, Italy, Spain, the UK, the EU, etc, besides India. As a next step, the USTR will officially engage with these countries to determine if their DSTs interfere or act as a barrier for US companies to undertake trade. In practice, the USTR examines whether the measures being investigated are targeted specifically against US companies and, in this case, whether the DSTs are intended to penalise “particular tech companies for their commercial success”.

In the current economic environment, clearly, the 301 announcement is not good news for India. Firstly, it will strain the US-India trade-relations, despite the strong political capital the leaders of the two countries have developed. Secondly, these investigations are widely perceived by most EU nations as “arm-twisting’’ measures to push nations into changing their trade policies to advance the US’s interests. A popular example, though not specifically in the context of 301 investigations, is pushing India to undertake reduction of customs duty on Harley bikes to avoid trade sanctions.

Thirdly, in these unprecedented times, when economic fundamentals of most segments of the economy are under stress, the digital services have beaten the red lines. The 2020 levy presumably was enacted with an aim to mobilise additional revenues by tapping into the potential of the NRDSPs’ Indian supplies. Were 301 investigations to lead to a review of the 2020 levy, it would further dent the exchequer’s reserves.

The silver lining, however, is the fact that the current 301 investigations are not India-specific and extend to 10 countries, thus, offering scope for diplomatic engagements to ward-off a negative outcome. Another positive for India appears to be the fact that the threshold for the 2020 levy, which is Rs 20 million, is not exceedingly high, meaning that it doesn’t exclusively target US technology giants and may as well pass off as a tax measure equally applicable to almost all NRDSPs.

This is very different than the DST levy in other jurisdictions. It certainly provides a vital avenue to India to justify its levy as non-discriminatory towards US companies. Furthermore, a rate of 2% on revenues sketches it as a modest tax measure rather than an unreasonable restriction on NRDSPs from operating in India, thereby, stultifying 301 investigations.

In the overall framework, however, the 2020 levy and 301 investigations, viewed conjointly, reveal the onset of an era where national interests overwhelm international cooperation on tariffs and trade. Some of our Indian friends call it nationalism; we, though, label it a dilution of multilateralism, which is what the world needs most in today’s environment—more so to manage the economic consequences of an unprecedented health crises.

This is where the focus will be the most for years to come, when the pandemic is behind us. Political leadership will, hopefully, be alive to the reality that such standoffs are not good for any nation, let alone to the idea of promoting multilateralism on subjects such as tax, and there are very few situations where tariffs and sanctions are imposed as these are bound to evoke emotive reactions.

There could not be a more crucial time to engage in meaningful discussions, especially through diplomatic channels, instead of public inquiries, to seek consensus on policies and tax measures that affect other jurisdictions, so that unilateralism does not lead to isolation. In our view, the US administration will do better by engaging productively with the OECD- led BEPS initiative to accelerate consensus on taxation of digitised economy, which will ease pressure on nations, whether India or the EU, to ease up on unilateral levy such as DTS or equalisation levy. This will automatically make the 301 investigations academic.

Authors are Partners, BMR Legal Advocates. Views are personal