Section 6 - Broader Tax Challenges related to Nexus and Characterization of Income from Digital Transactions and common Disputes

6.1 Broader Tax Policy Challenges

55. The primary tax challenges that arise from digital economy largely relate to the issues of nexus and characterization.28 The BEPS Report on Action 1 (2015) details them in paragraphs 376 to 380 as under:

“10.3 Broader tax policy challenges raised by the digital economy
376. The digital economy also raises broader tax challenges for policy makers. These challenges relate in particular to nexus, data, and characterisation for direct tax purposes. These challenges trigger more systemic questions about the ability of the current international tax framework to deal with the changes brought about by the digital economy and the business models that it makes possible and hence to ensure that profits are taxed in the jurisdiction where economic activities occur and where value is generated. They therefore have a broad impact and relate primarily to the allocation of taxing rights among different jurisdictions. These challenges also raise questions regarding the paradigm used to determine where economic activities are carried out and value is generated for tax purposes, which is based on an analysis of the functions, assets and risks of the enterprise involved. At the same time, when these challenges create opportunities for achieving double non-taxation, for example due to the lack of nexus in the market country under current rules coupled with lack of taxation in the jurisdiction of the income recipient and of that of the ultimate parent company, they also generate BEPS issues in the form of stateless income. In addition, in the area of indirect taxes, the digital economy raises policy challenges regarding the collection of VAT.
377. The challenges related to nexus, data and characterisation overlap with each other to a certain extent. Although the challenges related to direct tax are distinct in nature, they often overlap with each other. For example, the collection of data from users located in a jurisdiction may trigger questions regarding whether that activity should give rise to nexus with that jurisdiction and regarding how data should be treated for tax purposes.
378. Evolving ways of carrying on business raise questions about whether current nexus rules continue to be appropriate. The continual increase in the potential of digital technologies and the reduced need in many cases for extensive physical presence in order to carry on business in a jurisdiction, combined with the increasing role of network effects generated by customer interactions, raise questions as to whether rules that rely on physical presence continue to be appropriate. The number of firms carrying out business transactions over the Internet has increased dramatically over the last decade. In 2014, B2C e-commerce sales were estimated to exceed USD 1.4 trillion, an increase of nearly 20% from 2013. According to estimates, the size of total worldwide e-commerce, when global B2B and consumer transactions are added together, equalled USD 16 trillion in 2013.
379. Increasing reliance on data collection and analysis, and the growing importance of multi-sided business models raise questions about valuation of data, nexus, and profit attribution, as well as characterisation. The appropriate allocation of taxable income among locations in which economic activities take place and value is created may not always be clear in the digital economy, particularly in cases where users and customers become an important component of the value chain, for example in relation to multi-sided business models and the sharing economy. The growth in sophistication of information technologies has permitted companies in the digital economy to gather and use information to an unprecedented degree. This raises the issues of how to attribute value created from the generation of data through digital products and services, whether remote collection of data should give rise to nexus for tax purposes, and of ownership and how to characterise for tax purposes a person or entity’s supply of data in a transaction, for example, as a free supply of a good, as a barter transaction, or some other way.
380. The development of new business models raises questions regarding characterisation of income. The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation under current rules of payments made in the context of new business models, particularly in relation to cloud computing. Further, to the extent that 3D printing becomes increasingly prevalent, it may raise characterisation questions as well, as direct manufacturing for delivery could effectively evolve into licensing of designs for remote printing directly by consumers.”

6.2 Issues related to Nexus

56. The issues in respect of nexus relate largely to the ability of digital enterprises to carry on their business in a particular jurisdiction and have a significant economic presence there, without crossing the threshold rules or criteria that are used for determining nexus between an enterprise and a tax jurisdiction for the purpose of imposing taxes. These issues have been analyzed and elaborated in detail in paragraphs 253 to 261 in the BEPS Report in Action 1 (2015), which are reproduced below for ease of reference:

““7.3 Nexus and the ability to have a significant presence without being liable to tax 253. Advances in digital technology have not changed the fundamental nature of the core activities that businesses carry out as part of a business model to generate profits. To generate income, businesses still need to source and acquire inputs, create or add value, and sell to customers. To support their sales activities, businesses have always needed to carry out activities such as market research, marketing and advertising, and customer support. Digital technology has, however, had significant impact on how these activities are carried out, for example by enhancing the ability to carry out activities remotely, increasing the speed at which information can be processed, analysed and utilised, and, because distance forms less of a barrier to trade, expanding the number of potential customers that can be targeted and reached. Digital infrastructure and the investments that support it can be leveraged today in many businesses to access far more customers than before. As a result, certain processes previously carried out by local personnel can now be performed cross-border by automated equipment, changing the nature and scope of activities to be performed by staff. Thus, the growth of a customer base in a country does not always need the level of local infrastructure and personnel that would have been needed in a “pre-digital” age.”
254. This increases the flexibility of businesses to choose where substantial business activities take place, or to move existing functions to a new location, even if those locations may be removed both from the ultimate market jurisdiction and from the jurisdictions in which other related business functions may take place. As a result, it is increasingly possible for a business’s personnel, IT infrastructure (e.g. servers), and customers each to be spread among multiple jurisdictions, away from the market jurisdiction. Advances in computing power have also meant that certain functions, including decision-making capabilities, can now be carried out by increasingly sophisticated software programmes and algorithms. For example, contracts can in some cases be automatically accepted by software programmes, so that no intervention of local staff is necessary. As discussed below, this is also true in relation to functions such as data collection, which can be done automatically, without direct intervention of the employees of the enterprise.
255. Despite this increased flexibility, in many cases large multinational enterprises (MNEs) will indeed have a taxable presence in the country where their customers are located. As noted in Chapter 4, there are often compelling reasons for businesses to ensure that core resources are placed as close as possible to key markets. This may be because the enterprise wants to ensure a high quality of service and have a direct relationship with key clients. It may also be because minimising latency is essential in certain types of business, or because in certain industries regulatory constraints limit choices about where to locate key infrastructure, capital, and personnel. It is therefore important not to overstate the issue of nexus. Nevertheless, the fact that it is possible to generate a large quantity of sales without a taxable presence should not be understated either and it raises questions about whether the current rules continue to be appropriate in the digital economy.
256. These questions relate in particular to the definition of permanent establishment (PE) for treaty purposes, and the related profit attribution rules. It had already been recognised in the past that the concept of PE referred not only to a substantial physical presence in the country concerned, but also to situations where the non-resident carried on business in the country concerned via a dependent agent (hence the rules contained in paragraphs 5 and 6 of Article 5 of the OECD Model). As nowadays it is possible to be heavily involved in the economic life of another country without having a fixed place of business or a dependent agent therein, concerns are raised regarding whether the existing definition of PE remains consistent with the underlying principles on which it was based. For example, the ability to conclude contracts remotely through technological means, with no involvement of individual employees or dependent agents, raises questions about whether the focus of the existing rules on conclusion of contracts by persons other than agents of an independent status remains appropriate in all cases.
257. These concerns are exacerbated in some instances by the fact that in certain business models, customers are more frequently entering into ongoing relationships with providers of services that extend beyond the point of sale. This ongoing interaction with customers generates network effects that can increase the value of a particular business to other potential customers. For example, in the case of a retail business operated via a website that provides a platform for customers to review and tag products, the interactions of those customers with the website can increase the value of the website to other customers, by enabling them to make more informed choices about products and to find products more relevant to their interests.
258. Similarly, users of a participative networked platform contribute user-created content, with the result that the value of the platform to existing users is enhanced as new users join and contribute. In most cases, the users are not directly remunerated for the content they contribute, although the business may monetise that content via advertising revenues (as described in relation to multi-sided business models below), subscription sales, or licensing of content to third parties. Alternatively, the value generated by user contributions may be reflected in the value of business itself, which is monetised via the sale price when the business is sold by its owners. Concerns that the changing nature of customer and user interaction allows greater participation in the economic life of countries without physical presence are further exacerbated in markets in which customer choices compounded by network effects have resulted in a monopoly or oligopoly.
259. These various developments must be understood in light of their relationship to more traditional ways of doing business. For example, while having a market in a country is clearly valuable to a seller, this condition by itself has not created a taxing right in the area of direct taxation to this point. It is also true that data about markets and about customers has always been a source of value for businesses as illustrated by phenomena such as frequent flyer programs, loyalty programs, the creation and sale of customer lists, and marketing surveys (in which customers participate for no remuneration), to name a few. The traditional economy also benefited from “network” effects in ways that are perhaps less obvious than the network effect present in social networks. Sellers of fax machines, for example, were dependent on a sufficiently broad supplier of purchasers in order to ensure that their product had value. The digital economy has, however, enabled access to markets with less reliance on physical presence than in the past. In addition, the digital economy has enabled collection and analysis of data at unprecedented levels, and has enhanced the impact of customer and user participation in the market, as well as the degree of network effects. It has been suggested that the lower marginal costs in digital businesses coupled with increased network effects generated by higher levels of user participation may justify a change in tax policy. See, e.g., Crémer (2015); Pistone and Hongler (2015). In considering policy changes to reflect customer interactions to the imposition of income tax, however, potential impact on traditional ways of doing business must be taken into account in order to maintain coherence in cross border tax policy. In addition, consideration should be given both to solutions based on income tax and to solutions focused on indirect taxes.
260. Another specific issue raised by the changing ways in which businesses are conducted is whether certain activities that were previously considered preparatory or auxiliary (and hence benefit from the exceptions to the definition of PE) may be increasingly significant components of businesses in the digital economy. For example, as indicated in Chapter 6, if proximity to customers and the need for quick delivery to clients are key components of the business model of an online seller of physical products, the maintenance of a local warehouse could constitute a core activity of that seller. Similarly, where the success of a high-frequency trading company depends so heavily on the ability to be faster than competitors that the server must be located close to the relevant exchange, questions may be raised regarding whether the automated processes carried out by that server can be considered mere preparatory or auxiliary activities.
261. Although it is true that tax treaties do not permit the taxation of business profits of a non-resident enterprise in the absence of a PE to which these profits are attributable, the issue of nexus goes beyond questions of PE under tax treaties. In fact, even in the absence of the limitations imposed by tax treaties, it appears that many jurisdictions would not in any case consider this nexus to exist under their domestic laws. For example, many jurisdictions would not tax income derived by a non-resident enterprise from remote sales to customers located in that jurisdiction unless the enterprise maintained some degree of physical presence in that jurisdiction. As a result, the issue of nexus also relates to the domestic rules for the taxation of non-resident enterprises.”

57. The challenges arising from the digital enterprises to conduct their businesses, with business models that did not exist not so long ago, gives rise to situations where they derive significant profits from a tax jurisdiction, by making use of its resources and people, and yet, can claim not to have a taxable nexus with that jurisdiction, because of the limitations of the nexus rules existing in Model Tax Conventions and tax treaties that were made long back at a time, when such business models were not conceivable. The challenges related to nexus make a strong case for changing the nexus rules that are based on a physical presence threshold today, to adopt them to ways in which modern businesses can conduct themselves.

6.3 Issues related to Characterization

58. Characterization of income continues to remain an important and often contentious aspect in the taxation of income arising from digital enterprise. The importance of characterization issues arises primarily from the differences in the threshold for taxation of different types of income in the jurisdiction of source29, as well as the difference in the tax rates applicable on different kind of incomes30. Another reason that makes characterization very important is the lack of uniformity in the interpretation and application of characterization rules by different countries. These differences often relate to characterization of income as “Royalty” or “Fee for Technical Services”. In particular, payments made for using software or automated digital platforms consisting of software, or for services obtained by using a digital or mobile network can often be a bone of contention. While characterization issues can arise in case of any business, they become particularly important for digital enterprises, in view of their ability to carry on businesses without having a physical presence in the source country and consequently avoid paying taxes on their income derived from that jurisdiction.

59. With the rapid growth of digital economy, and in the wake of significant revenue and profits being earned by multinational digital enterprises without being liable to pay any tax in the source country, there have been attempts by tax authorities around the world, including India, to tax the income of such digital enterprises by arguing that their virtual presence through a website or through digital networks amount to permanent establishment, or by characterization of their income as royalty or fee for technical services. Compared to the former, the treatment of payments as royalty or fee for technical services have more often sustained the scrutiny of appellate authorities and hence, are resorted to more often by the tax authorities.

Differences between OECD and UN Model Tax Convention

60. The issues related to characterization of income as royalty have their origin in the strong differences between the preferences of developed countries that are technology exporting economies and developing economies, most of whom are technology importing ones. These get documented as differences between the OECD Model Tax Convention and the UN Model Tax Conventions. While the OECD Convention allocates all taxing rights in respect of royalty to the jurisdiction where the taxpayer is a resident, the UN Convention provides for dividing the taxing rights on royalty between the jurisdictions of source and residence. This difference is also reflected in the positions taken by countries regarding the scope of royalty and fee for technical services. Given the fact that OECD Model Tax Convention does not allocate any taxing rights to the jurisdiction from payments for royalty have generated31, it becomes questionable as to whether the OECD Commentary developed with the intention of preventing the taxation of royalty in the source jurisdiction, can be said to be applicable in a treaty where taxing rights are allocated to the source jurisdiction. This question of applicability of OECD Commentary on a tax treaty having Article on royalty that is not based on OECD Convention, becomes even more important, when the scope of royalty is narrowed down by a future amendment of OECD Commentary, particularly where one of the Contracting States in a treaty has clearly documented its position as being different from that of OECD.

Work of OECD Technical Advisory Group & High Level Committee in India

61. Given the positions of India on the OECD Commentary that document its differences with the OECD on whether a payment for software or its use can constitute royalty, and the fact that most Indian tax treaties precede the OECD interpretation of software payments that evolved in the 21st century, it becomes clear that OECD Commentary on Article 12 interpreting payments for software cannot be applied unquestionably for interpreting the definition of royalty in Indian tax treaties. These differences have also led to differences in the positions between OECD and India on characterization and taxation of e-commerce payments.

62. The need for examining taxability of payments made for using software was first emphasized by the OECD in the mid-eighties, when the report titled “Software: An Emerging Industry” was prepared for its Committee for Information, Computer and Communications Policy by an ad hoc group of experts from Member countries of OECD. Subsequently, the issues related to cross border taxation of royalty income from software were dealt in a report titled “The Tax Treatment of Software”, which was adopted by the OECD Council on 23 July, 1992. The texts suggested in Appendix 3 of the report were adopted as paragraph 12 to paragraph 17 of the OECD Commentary on Article 12 by a report titled “The Revision of Model Convention”, on the same day, i.e. 23 April, 1992. These changes, thus, were based on the views obtained from the member countries of OECD, without taking into account the views of countries outside OECD, including India. Thus, from the very outset, the views being developed by OECD regarding taxation of royalty from software are only governmental views of the member countries of OECD, and do not in any way represent the views of Government of India.

63. Subsequently, further amendments have been made in the OECD Commentary on 29 April, 2000 by the report titled “The 2000 Update to the Model Tax Convention” which was adopted by the OECD Committee on Fiscal Affairs on the same day. Later, a number of new paragraphs were added on this topic on 28 January, 2003 by the report titled “The 2002 Update to the Model Convention”, which was based on another report titled “Treaty Characterisation Issues arising from E-Commerce”, prepared by a Technical Advisory Group (TAG), commonly referred as the TAG Report, that was adopted by the OECD Council on 23 July, 2002. The TAG report recommended taking a very narrow application of the term royalty in respect of payments made for software and e commerce services and businesses, which can be considered largely in accordance with the preference of OECD of not allocating taxing rights on royalty payments in the source jurisdiction.

64. None of these OECD reports (as drafted by government representatives of OECD member countries) ever took into account the views or the position of the Government of India in respect of the tax treaties already entered into it, or its views, suggestions or concerns regarding the phrases or terms already existing in the various tax treaties entered into by India. Thus, the views of the Government representatives of member countries of OECD regarding the scope of royalty from software, as reflected in the OECD Commentary do not necessarily represent the views of the Government of India in this regard, neither can they be said to reflect the intention of the Government of India while using any phrase or term in the tax treaties entered into by ita with the Government of another country or specified territory.

65. Immediately after the publication of tax report by the OECD, a High Powered Committee (HPC) was constituted by the Ministry of Finance in India to examine its recommendations. This Committee, which included tax experts from both within and outside the Government, comprehensively analysed the issues and aspects of e-commerce, and made recommendations that were completely at variance with the conclusions adopted by the TAG Report. While the TAG Report recommended a very narrow interpretation of Royalty and Fee for Technical Services and concluded that most payments arising from e-commerce would not be taxable as Royalty and Fee for Technical Services, the Indian High Powered Committee advocated a much broader interpretation and scope of these terms and concluded that most of the payments made and received for e-commerce would constitute royalty and fee for technical service and would be taxable under the Indian tax treaties.

66. The differences between the views of the TAG report of OECD and the Indian High Powered Committee indicate the presence of a significant wedge between the position of India and the OECD, which has persisted since, and continues to remain a major source of tax disputes.32 It would be even more important to note that as per Article 3 of the Model Tax Conventions on definitions of the terms used therein, which also finds place in most Indian treaties, any phrase not defined in the treaty itself is to be understood as meant in the domestic laws. As the definition of royalty³³ refers to use of copyright, the meaning of the word ‘copyright’ and the implications of that term need to be obtained from the Indian Copyrights Act, 1957 and the way it is interpreted under Indian laws. Indian positions on paragraphs in the OECD Commentary related to application of Article 12 to payments made for software, as documented by OECD along with its Commentary also makes it clear that it does not completely accept the OECD guidance on this important characterization issue.

67. BEPS Report on Action 1 acknowledges that for several categories of payments in the context of digital economy, characterization remains ambiguous and uncertain. Paragraphs 268 to 272 of the BEPS Report on Action 1 describing these issues in detail are reproduced below for ease of reference.

“7.5 Characterisation of income derived from new business models
268. Products and services can be provided to customers in new ways through digital technology. The digital economy has enabled monetisation in new ways, as discussed in Chapters 3 and 4, and this raises questions regarding both the rationale behind existing categorisations of income and consistency of treatment of similar types of transactions.
269. Prior work by the Treaty Characterisation Technical Advisory Group (TAG), discussed further in Annex A examined many characterisation issues related to ecommerce. Although this work remains relevant, new business models raise new questions about how to characterise certain transactions and payments for domestic and tax treaty law purposes.1 For example, although the TAG considered the treatment of application hosting, cloud computing has developed significantly since that work, and the character of payments for cloud computing is not specifically addressed in the existing Commentary to the OECD Model Tax Convention. The question for tax treaty purposes is often whether such payments should be treated as royalties (particularly under treaties in which the definition of royalties includes payments for rentals of commercial, industrial, or scientific equipment), fees for technical services (under treaties that contain specific provisions in that respect), or business profits. More specifically, questions arise regarding whether infrastructure-as-a-service transactions should be treated as services (and hence payments characterised as business profits for treaty purposes), as rentals of space on the cloud service provider’s servers by others (and hence be characterised as royalties for purposes of treaties that include in the definition of royalties payments for rentals of commercial, industrial, or scientific equipment), or as the provision of technical services. The same questions arise regarding payments for software-as-aservice or platform-as-a-service transactions.
270. In the future, development and increasing use of 3D printing may also raise character questions. For example, if direct manufacturing for delivery evolves into a license of designs for remote printing directly by purchasers, questions may arise as to whether and under what circumstances payments by purchasers may be classified as royalties rather than as business profits, or may be treated as fees for technical services.
271. Under most tax treaties, business profits would be taxable in a country only if attributable to a PE located therein. In contrast, certain other types of income, such as royalties, may be subject to withholding tax in the country of the payer, depending on the terms of any applicable treaty. Whether a transaction is characterised as business profits or as another type of income, therefore, can result in a different treatment for tax treaty purposes. There is therefore a need to clarify the application of existing rules to some new business models.
272. At the same time, when considering questions regarding the characterisation of income derived from new business models it may be necessary to examine the rationale behind existing rules, in order to determine whether those rules produce appropriate results in the digital economy and whether differences in treatment of substantially similar transactions are justified in policy terms. In this respect, further clarity may be needed regarding the tax treaty characterisation of certain payments under new business models, especially cloud computing payments (including payments for infrastructure-asa- service, software-as-a-service, and platform-as-a-service transactions). In addition, issues of characterisation have broader implications for the allocation of taxing rights for direct tax purposes. For example, if a new type of business is able to interact extensively with customers in a market jurisdiction and generate business profits without physical presence that would rise to the level of a PE, and it were determined that the market jurisdiction should be able to tax such income on a net basis, modifying the PE threshold and associated profit attribution rules could permit such taxation. Source taxation could also be ensured by creating a new category of income that is subject to withholding tax. As a result, the issue of characterisation has significant implications for the issue of nexus.”

68. Paragraph 380 of the 2015 Report aptly summarises the challenges related to characterisation of income that emanate from digital economy, as under:

“380. The development of new business models raises questions regarding characterisation of income. The development of new digital products or means of delivering services creates uncertainties in relation to the proper characterisation under current rules of payments made in the context of new business models, particularly in relation to cloud computing. Further, to the extent that 3D printing becomes increasingly prevalent, it may raise characterisation questions as well, as direct manufacturing for delivery could effectively evolve into licensing of designs for remote printing directly by consumers.”

6.4 Common Tax disputes related to Digital Economy

69. Tax disputes related to taxation of income arising from businesses conducted primarily through digital and telephonic communication networks, have been reported from different countries. The commoner forms of these disputes are related to the existence or otherwise of a permanent establishment in case of digital or e-commerce enterprises. The other category of disputes relating to whether payments for digital goods or services constitute royalty or fee for technical services, are expectedly uncommon in developed world due to the absence of taxing rights allocation to source jurisdiction on royalty and fee for technical services payments, but are more likely to be faced by countries such as India, where the source jurisdiction is allocated such taxing rights in tax treaties.

70. The disputes or questions related to permanent establishment have been observed frequently, such as whether installation of software on a server in the source jurisdiction constitutes a permanent establishment34; whether business conducted through a software owned by an enterprise that is installed on a server not owned by it constituted a permanent establishment35; whether websites hosting advertisements, payments for which arose from that jurisdiction constituted a permanent establishment36; whether a foreign enterprise selling on internet directly to customers in a jurisdiction but having registered there as a business entity and having an agent there to handle sourcing, storage etc. has a permanent establishment³⁷; whether a gaming company offering various kinds of games online constitutes a permanent establishment38; whether sale and leasing of pictures electronically through the internet constituted permanent establishment39; whether carrying on business activity through a website hosted on a server outside the source jurisdiction constituted a permanent establishment40 and whether business activities carried out through a website operated by local unrelated individuals constituted a permanent establishment41. The fact that most of these questions were decided against the existence of permanent establishment is a testimony to the fact that significant economic activities through digital or telecommunication networks can be carried today without giving rise to the existence of a permanent establishment, an apparent anomaly, that was the basis of the Action 1 of the BEPS Project.

71. While most disputes relating to whether new business models give rise to a permanent establishment within the existing rules or not, have gone in favor of the taxpayer, there have been some interesting decisions that indicate a different view. In case of Dell Products, Ireland42, the Spanish Central Economic-Administrative Court held that the selling of goods in Spain by the taxpayer through a website located on a server outside Spain created a ‘virtual permanent establishment’ that was sufficient tax nexus for its taxation in Spain.

72. Another interesting developments that has caught the attention of experts is a recent Judgment of Delhi High Court43 in a non-tax dispute, wherein it held that the “availability of transactions through the website at a particular place is virtually the same thing as a seller having shops in that place in the physical world”. Placing reliance on the principles laid down by the Supreme Court in Dhodha House v. S. K. Maingi 2006 (9) SCC 41, the Court observed that the condition of “carries on business in Delhi” was satisfied since appellant’s customers were located in Delhi, accessed the website in Delhi, communicated their acceptance to the offer of merchandise advertised on the website, at Delhi, and received the merchandise in Delhi, even though the server for the appellant’s website was not located in Delhi. This observation of the Court may have greater impact on the applicability of “business connection” under domestic laws to digital enterprises, than “permanent establishment” under the tax treaties, but more importantly, it indicates signs of acknowledgement by the judiciary of the fact that digital enterprises undertake business in ways that were not conceived when the existing laws were made, and applying those laws to these new realities of digital world necessitates a flexible interpretation.

73. An interesting observation related to interpretation of statutes with reference to digital economy has been made in a recently published article44, wherein the author has referred to the work of Francis Bennion45 who has argued in favor of applying the “doctrine of updating construction”, which suggests that in construing an “ongoing Act”, the interpreter is to presume that Parliament intended the Act to be applied at any future time in such a way as to give effect to the true original intention and thus, the interpreter is to make allowances for any relevant changes that have occurred since the Act’s passing, in law, in social conditions, technology, the meaning of words, and other matters. Applying this doctrine, an enactment made earlier, may be read today in light of dynamic processing received over the years, with such modification of the current meaning of its language as will now give effect to the original legislative intention. Indeed, the decision of the Spanish Central Economic-Administrative Court in the case of Dell Products Ireland (supra) and the Delhi High Court interpreting “carries on business in Delhi” implicitly apply this doctrine, which has reportedly been relied upon by the Supreme Court of India in some cases⁴⁶.

74. The question of whether the “doctrine of updating construction” can be applied on existing provisions of tax treaties, does not seem to have been taken up as yet in a tax dispute in India or outside. However, in its essence, it would be the basis of, and necessary justification for changes that are made from time to time in Commentaries on OECD and UN Model Tax Conventions with the aim and objective of modifying the interpretation of provisions existing in treaties based on these Models. Holding this doctrine inapplicable would mean negating the legitimacy of these changes, and accepting it may open the possibility of dynamic interpretation of tax treaties that may allow the taxability of digital economy to be covered by existing provisions. Either way, such an application has the potential to open new areas of interpretational disputes, greater uncertainty and unpredictability.

6.5 Committee’s Observations

75. The Committee concludes that in view of the extensive work undertaken as part of the Action 1 of BEPS Project, and the observations made in the Report, it is now internationally recognized and accepted that significant tax challenges arise from the difficulties in applying the existing international taxation rules, as they exist in our tax treaties today, in respect of digital economy. The issues related to taxable nexus between the taxable enterprise and the taxing jurisdiction, which is traditionally based on physical presence, is not appropriate for determining taxable presence in respect of the business models of digital economy. Similarly, there remains considerable ambiguity regarding the characterization of income arising from transactions involving telecommunication networks, software and data exchange. These disputes on characterization of payments are more commonly observed in countries like India, having tax treaties that allocate taxing rights to the source jurisdiction in respect of royalty and fee for technical services.

76. The continuing ambiguity related to nexus and characterization of the payments have the potential of giving rise to tax disputes, particularly in countries like India, where the tax treaties allocate taxing rights to the source jurisdiction47. If the underlying difference in the position of OECD, which does not prefer allocating taxing rights to source jurisdiction on royalty and fee for technical services payment and developing countries like India, which have tax treaties providing such rights to source jurisdictions are taken as an indication, it may be difficult, if not impossible, for the international community to arrive at a consensus on these issues, anytime soon. The resultant ambiguity, uncertainty and unpredictability can develop as a significant constraint for the expansion of digital economy in India. This makes an important case for finding a solution to all these issues, in the form of a simple, clear and predictable tax rule that unambiguously defines the tax liability of digital enterprises, thereby facilitating their business planning, reducing their tax risk and contingent liabilities, while also reducing compliance costs, disputes and administrative burden.

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28. The third major issues recognized by the BEPS Report on Action 1 (2015) is dealt with in Section 7 of this Report.
29. Under the UN Model Tax Convention and most tax treaties entered into by India, business income of an enterprise can be taxed in the jurisdiction from where the payments arise only if the enterprise has a permanent establishment. However, income characterized as royalty or fee for technical services would generally be taxable under the tax treaties entered into by India.

30. Business income of a foreign enterprise is taxed in India at 40% of the net income, whereas the tax rate on royalty or fee for technical services is 10% of the gross amount.

31. It may be interesting to note that not having Article 12 in the OECD Model Tax Convention would make no difference as then the royalty income would be taxable as business income under Article 7, which would be the case even in the presence of Article 12.

32. OECD Commentary is prepared by a group of governmental representatives from the OECD countries, not including India, and position taken by it cannot have a binding effect on India or its tax authorities, particularly, when clear disagreements have been expressed by India on a view therein.

33. Paragraph 3 of Article 12 of the UN Model Tax Convention defines “royalty” in following words…..
“The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience.”

34. Western Union Financial Services Inc. v. ADIT [2007] 104 ITD 34 (ITAT Delhi)

35. Target Number 4890-13 dated 6.122013 (Supreme Court of Sweden)

36. ITO v. Right Florists Pvt. Ltd. [2013] 32 taxmann.com 99 (ITAT Kolkata)

37. Case Number 6479-12 dated 16.9.2014 (Court of Appeal, Gothenburg)

38. SKM2011.828 SR (Tax Board, Denmark)

39. Case Number 68/2001 dated 15.8.2001 (Central Board of Taxation, Finland)

40. Ruling Number IP-PB3-423-891/08-4/PS dated 5.5.2008 (Ministry of Finance, Poland)

41. Tax Resolution Number 65/06 dated 13.3.2007 (Taxation Authority, Israel)

42. Resolution Number 00/2107/2007 dated 15.3.2012 (Central Economic Administrative Court, Spain)

43. World Wrestling Entertainment, Inc. (WWE) v. M/s Reshma Collection & Ors.FAO (OS) 506/2013 and CM Nos. 17627/2013 and 18606/2013 decided on 15.10.2013

44. Ashish Karundia , Permanent Establishment: The Continuing Conundrum, 31.12.2015; ITAT Online , available at https://www.itatonline.org/articles_new/permanent-establishment-the-continuing-conundrum

45. Francis Bennion, Statutory Interpretation, Fifth edition, section 288 at pp. 889-890

46. State (Through CBI/New Delhi) v. S. J. Chaudhary (1996) 2 SCC 428 (Supreme Court, India) & CIT v. Podar Cement (P.) Ltd. [1997] 226 ITR 625 (Supreme Court, India)

47. Existing disputes till now relate more often to payments made in respect of online advertising, online advertising rights, software download for commercial exploitation etc. However, with expanding scope of digital economy, this list can potentially expand, and the tax disputes may also become more frequent.

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