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8 October 2020, Gateway House

A compelling case for Digital Service Tax

The current notions of physical ‘permanent establishment’ or tangible locational nexus are not well-suited for the taxation of modern digital economy, especially for taxation of business income, rents or revenue creating activities. In a Covid-19 wrecked global economy, where government revenues are under severe stress, there is a compelling case for a market country or the value-creating jurisdiction to tax the income or rents attributable to the concerned market or location.

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The digital economy has thrown up several new challenges, including issues related to jurisdiction of countries to tax either certain types of transactions, activities or income. A number of global digital companies provide services in the nature of software, streaming services, online advertisements, payment processing services, internet-based telecommunication, social networking platforms, etc., from remote locations. These high-tech companies, some of them valued at a trillion dollars and larger in economic size than some middle-income countries, pay significantly low global taxes leading to “aggregation of ‘stateless income”. The latest in the continuing controversies is the taxing power of countries to target the revenue or the rents collected by these high-tech companies which provide services beyond their ‘home’ jurisdictions.[1]

The digital companies can provide most of these services without leaving their home jurisdictions, where most of their technologies and intellectual property rights are created. Most digital companies work on the basis of a two-sided business model.[2] They often charge little or no money from users for online services, but collect critical data; in turn, the large audience of the digital platform is highly attractive to the online sellers for targeted advertisements and promotional services. Accordingly, most of the revenue or rents collected by the global tech-companies derive from countries where the ‘value creation’ has taken place or where the users contribute to the value of the digital network. There is an increasing recognition that the network effects of digital platforms create market power without significant marginal cost, as the only major cost is developing and maintaining the digital platform.[3]

The countries from which the digital enterprises source their revenue and create the value, can be referred to as ‘market countries’. These enterprises have a cross jurisdictional presence and a predominant reliance on intangible assets, especially intellectual property rights. The value creation arises from the access to data relating to a particular location, user participation (for example, posting on Facebook or other social media platforms) and the synergies with intellectual property rights.

The current framework of tax laws, especially direct tax laws, are not well-suited to address the challenges posed by the digital economy. Those 19th and 20th century laws were designed for classic ‘brick-and-mortar’ business models. For example, most income tax laws are based on the concept of a permanent establishment (PE). The source of the income is based on the existence of the PE and reflects the principle that ‘until an enterprise of one State has a permanent establishment in another State, it should not properly be regarded as participating in the economic life of that other State to such an extent that the other State should have taxing rights on its profits’.[4]

The concept of PE requires two distinct thresholds: (1) a fixed place of business, and if no such fixed place of business can be found, (2) a person who acts on behalf of the entity and habitually exercises its authority.[5]

However, in a digital economy, traditional tax concepts require tweaking and a revised understanding.

The view that multinational enterprises that derive their income from foreign jurisdictions need to pay their fair share of taxes are based on equitable grounds and also economic reasoning. The non-resident digital companies have market power which they can use to extract rent from the users of the digital platforms. The quest, therefore, is to find out an appropriate form of taxation that has efficiency gains and is the least distortive among the comparable alternatives.

In the past few years, several countries have taken different approaches to address this problem. Some European countries including Austria, France, Hungary, Italy, Poland, Spain, Tukey, and the United Kingdom have enacted ‘Digital Service Taxes’ (DST). Others like India, Brazil and Australia have introduced sui generis forms of taxation such as equalisation levy, revenue apportionment or diverted profit tax. Another alternative is destination-based cash flow tax.[6] The purpose is to broadly allocate taxing rights over profits or rent attributable to value created by users of digital platforms. Although these taxes can be broadly brought under the category of DST, their character and nature differ vastly.[7] While some forms of DST are akin to income taxes, others verge closer to consumption taxes.

Digital taxation can be either on business income/profits or on digital transactions. There is a two-decade long discussion on the imposition of customs duty on e-commerce transactions at the WTO. There is an existing moratorium on imposition of customs duty which is getting periodic extension. However, imposition of customs duty is a relatively a minor issue when compared to the taxation of gross revenue or transactions of e-commerce companies attributable to a market jurisdiction. Ideally, the OECD discussion should yield an outcome on the allocation of business income to market countries, based on the presumption of a virtual PE or some other tax principle. A digital tax anchored on a virtual PE can be based on the gross revenue, turnover, sales or some other indicator.

Another alternative is to impose certain transaction taxes in the nature of valued-added taxes on the services rendered. Indonesia has pioneered this model. However, the imposition of valued added taxes cannot be selective and has to be across the board and will have to be applied to domestic enterprises as well. Non-discrimination in taxation or other forms of treatment is a key principle of the General Agreement on Trade in Services (GATS). Any kind of discriminatory transaction-based taxation could potentially be inconsistent with international commitments unless justified by one of the general exceptions under the GATS.

In this context, equalisation levy on the digital transactions have certain merits. The equalisation levy is a new category of tax that is not based on net income. In India, an equalization levy of 6% withholding tax was introduced in the 2016 Finance Bill. The 6% levy was on the gross consideration in relation to online advertisements and related services paid by Indian service recipients to a non-resident that did not have a PE in India.[8]

The immediate motivation for this legislative measure was the ruling of the Income Tax Appellate Tribunal in India in the Rights Florists case[9] where it was held that the payments by Indian residents to Yahoo and Google for advertisement services cannot be taxed because the tax related to business profits and that the online providers did not have a PE in India.

India introduced certain changes to the equalisation levy in the 2020 Finance Act. From 1 April 2020, the scope of equalisation levy has been expanded to include a 2% levy on all online sale of goods or services into India by non-resident e-commerce operators. For the purpose of this levy, an ‘e-commerce operator’ is defined as a non-resident who owns, operates or manages digital or electronic facility or platform for online sale of goods or online provision of services or both.[10] ‘E-commerce supply or services’ means: (i) online sales of goods owned by the e-commerce operator; or (ii) online provision of services provided by the e-commerce operator, or (iii) online sale of goods or provision of services or both facilitated by the e-commerce operator or, (iv) any combination of the above.[11] The equalisation levy will not apply where the sales, turnover, or gross receipts are less than Rs. 20 million during the financial year. Nor will it apply where the non-resident e-commerce operators have permanent establishments in India and provide e-commerce supply or services that are effectively connected to those establishments.

There are several global initiatives to formulate a conceptual framework for digital tax, including from the OECD and the G20. The OECD in its 2013- 2016 Base-Erosion and Profit Shifting (BEPS) project and in its public consultation document, sought coordinated global action towards adopting a principle that MNEs report profits where value creation has taken place. Action Plan 1 of OCED’s Base Erosion and Profit Shifting (BEPS) project was to address digital taxation. In the G-20 meeting at St. Petersburg in 2013, the leaders affirmed that profits should be taxed where the e-commerce companies derive their value from.  In 2018, the OECD issued an interim report with a suggestion to have a consensus based final report by 2020.[12] Three options viz. (i) significant economic presence;[13] (ii) withholding tax on digital transactions; and (iii) equalisation levy, were identified which a country may choose to adopt in its domestic tax laws, subject to bilateral tax treaties, to address the tax disparity between foreign and domestic business.[14]

The interim report provides details about the design and implementation of a variety of country measures that are potentially relevant to digitalisation, notably those relating to the broader direct tax challenges identified in the 2015 BEPS Action 1 Report. The various adhoc, un-coordinated and unilateral actions have been grouped into four categories as under:

1) alternative applications of the PE threshold;

2) withholding taxes;

3) turnover taxes; and

4) specific regimes targeting large MNEs.

The report identifies that certain design features are common to some of these unilateral and un-coordinated actions. Most of these actions aim at protecting and/or expanding the tax base in the country where the customers or users are located.

Importantly, the report states that there is discontent among some countries with the taxation outcomes produced by the current international income tax system. It indicates that a consensus-based outcome will be far more difficult to achieve than initially envisaged.

While many global initiatives are afoot, certain countries including the U.S. have sought recourse to unilateral measures under Section 301 of the infamous 1974 Trade Act. Section 301 empowers the U.S. to impose unilateral duties or suspend trade concessions. The U.S. initiated Section 301 investigations on France’ digital service tax which was introduced in 2018.[15] The U.S. allegation was that the French digital service tax was unreasonable and discriminatory against U.S.-based tech companies and inconsistent with various international agreements. The U.S. proposed countermeasures in the nature of additional duties of up to 100% on select French products.[16] According to latest reports, France has agreed to suspend the collection of the DST until December 2020 in exchange for the U.S. agreeing to postpone retaliatory tariffs on French goods.

In sum, the current notions of physical PE are not well-suited for the modern economy, especially in relation to taxation of business income of digital companies. Taxing digital companies based on destination-based indirect taxes also has its own limitations. In a Covid-19 wrecked global economy, government revenues are under severe stress and income inequalities have risen sharply. There is a compelling case for a market country or the value-creating jurisdiction to tax the income or rents attributable to the market or location. In the meantime, hybrid forms of taxation such as the DST or the equalization levies can be adopted as ad hoc tax measures, provided such measures are adopted in good faith and as interim mechanisms.

James J. Nedumpara is Head and Professor, Centre for Trade and Investment Law, Indian Institute of Foreign Trade, New Delhi.

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[1] Wolfgang Schon, One Answer to Why and How to Tax the Digital Economy, Max Planck Institute Working Paper 2019- 10(2019).

[2] Wei Cui, The Digital Service Tax: A Conceptual Framework (2019), available at

[3] OECD,  Public Consultation Document: Addressing the Tax Challenges of the Digitization of the Economy (2019), available at:

[4] OCED/G-20 Base Erosion and Profit Shifting Project, ‘Addressing the Tax Challenges of the Digital Economy, Action 1: 2014, at 39.

[5] Ibid, at 39.

[6] Treasury Discussion Paper, Digital Economy and Australia’s Corporate Tax System (2019), available at:

[7] Organization for Economic Co-operation and Development, Tax Challenges Arising from Digitalisation – Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD PUBLISHING, (2018) [hereinafter OECD 2018 Report]

[8] The Gazette of India, Extraordinary, Part II, dated May 14, 2016.;jsessionid=86D93EE8B8EE9D549BFE78A773DF79D9

[9] ITO v. Right Florists Pvt. Ltd, [2013] 143 ITD 445(Kol)

[10] Section 164 (ca) of the Finance Act, 2020.

[11] Section 164 (cb) of the Finance Act, 2020.

[12] OECD (2018), Tax Challenges Arising from Digitalisation – Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris,

[13] In 2018, India amended the definition of “Business Connections” under Section 9 of the Income-Tax Act, 1961 to include the principle of ‘Significant Economic Presence’.

[14] OECD/G20 Base Erosion and Shifting Project, Addressing the Tax Challenges of the Digital Economy, Action 1- 201, Final Report, OECD (2015) at 13,

[15] See USTR, Section 301 investigations, available at <>.

[16] “France’s Digital Service Tax” Federal Register Vol. 84, No. 235 dated 6 December 2019 at p.66956, [Docket No. USTR–2019–0009].