Analysing this transaction, one would find that the mode of completion of various legs of this transaction is electronic but that per se cannot make this transaction as E-commerce. It appears that there is a human intervention in rendering/execution/delivery of services by XYZ Inc. However, with a slight variation in the above model i.e. instead of XYZ Inc., if services are rendered by the internet portal of XYZ Inc. on an automated basis, then the entire transaction would become an e-commerce transac-tion and then, the determination of source or place of accrual of income would become complex.
Again, the taxability of income in India, in the hands of the service provider (SP), would depend upon the characterisation of such income i.e. whether it is in the nature of business income or royalty or fees for technical services (FTS).
Indian Revenue Authorities hold the view that as long as the service recipient is in India the source of income for the service provider is in India regardless of the place or mode of rendering service or location of the service provider. This view was incorporated by way of amendment to section 9(1) of the Income tax Act, 1961 (the “Act”) to provide that for determining the place of accrual or arising of the income by way of royalty or FTS, the existence or otherwise of the place of business, residence or business connection of a non-resident is of no consequence whatever. Further, it provided that for the purpose of taxability of royalty and FTS, it is not necessary for the non-resident to render services in India.
However, Business Income stands on a different footing. Even though the source of income is in India, Section 9(1) of the Act, plus and the provisions of tax treaties provide that income of a service provider is taxed in the “Source State” only if the source link is powerful enough to establish “Business Connection” (BC): under the Act or “Per-manent Establishment” (PE) under a Tax Treaty.
The above discussion is based on the premise that income in the hands of service provider is neither received nor deemed to have been received in India and therefore, section 5(2)(a) of the Act has no applicability.
Even section 5(2)(b) fastens the tax liability in the hands of the SP if the income accrues or arises in India or deemed to accrue or arise in India under section 9 of the Act (as discussed above).
The term “income accruing or arising in India” as provided u/s 5(2)(b) of the Act is not defined in the Act. However, the Supreme Court, in the case of Hyundai Heavy Industries Ltd. (2007-TII-02-SC-INTL) inter alia observed as follows:
“……as far as 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(es) or through some other form of its presence in India such as office, project site, factory, sales outlet etc. (hereinafter called as “PE of foreign enterprise”) ……..”
Interestingly, the term PE is restrictively defined in the Act and that is in the context of transfer pric-ing and section 44DA of the Act (special provisions for taxation of royalty and FTS which are effectively connected with PE), otherwise it has its origin in the tax treaties. Definition of a PE u/s 92F (iiia) of the Act is an inclusive one, according to which, PE includes a fixed place of business through which the business of the enterprise is wholly or partly carried on. Basically, it refers to “fixed place PE” and not to other variants of PE such as “Project PE”, “Dependent Agent PE”, “Service PE” etc. as defined in a treaty . However, the Supreme Court’s observation as mentioned above [which is regarded as “judge made law” and followed in the case of ITO vs. Right Florists Pvt. Ltd. 2013-TII-61-ITAT-KOL-INTL] explains PE on the lines of a treaty definition.
One thing is clear from the provisions of section 9 and interpretation of section 5(2)(b) of the Act by the Apex Court – that in either case of a PE or BC, only so much of income would be taxed in India as is attributable to such a PE or BC in India.
Thus, taxability in India of online services can be summarised as follow:
Therefore, characterisation of income in the hands of a service provider assumes great significance.
Characterisation of income in the hands of a service provider – Royalty/FTS vs. Business Income
There are various kinds of online transactions. However, for the sake of simplicity and understanding the principles involved, let us restrict our discussion to the most frequent transaction of “online advertisement” through popular search engines, say, “Yahoo” and “Google”. However, the concepts discussed herein would be applicable to other forms of online business transactions as well.
Payment for online advertisement – Is it Royalty in the hands of the Service Provider?
Royalty and FTS are Business Income essentially. The distinction is carved out only for the purposes of taxation in the hands of the non-residents. If the income is characterised as royalty or FTS, it is taxed on gross basis unless such income is effectively connected with a PE situated in India.
Where such income is not characterised as Royalty/ FTS, it is treated as business income and is taxed in the source state (say, India) only if the foreign enterprise has a PE/BC in India. Such taxability of the business income in the source state is always on net basis i.e. net profits computed as per domestic tax laws of the source state.
Section 9(1)(vi) of the Act deals with royalty income whereas section 9(1)(vii) thereof deals with FTS. In fact, every payment must be examined from the point of view of royalty/FTS under an applicable tax treaty and also under the provisions of the domestic tax laws of the source state (India) such that the taxpayer can opt for the most beneficial provisions out of these.
Let us first examine whether payment for online advertisement can be termed as royalty income in the hands of the service provider?
The definition of royalty under section 9(1)(vi) of the Act is quite exhaustive and inter alia includes payment for computer software and the use or right to use any industrial, commercial or scientific equipment. Thus, the question arises for consideration is whether payment for online advertisement/ services can be construed as payment for the use or right to use industrial, commercial or scientific equipment or for computer software?
The payment for online advertisement/services is certainly not for buying or using computer software. Though computer software is used for delivering the services of hosting advertisement or for online selling of services/product, the payment is for ser-vices and not for the underlying computer software. Similarly, one must ask a question as to whether one is paying for the “use” of equipment or for the “services” which are provided by the “service provider” by using equipment in its possession. For example, payment for online advertisement may involve renting an earmarked space by the service provider on the website and server owned by it (i.e. equipment at its disposal and control), but one is paying for the display and advertisement and not for rent of server. The same may well be the case in respect of print media, e.g. when one advertises in a newspaper, one pays for the services of a published advertisement and not for the equipment used by the newspaper for its production.
As far as use of equipment is concerned, the issue was aptly dealt with by the Mumbai Tribunal in the recent decision of Pinstorm Technologies [54 SOT 78] / TS-536-ITAT-2012(Mum). In this case, an Indian company, which is engaged in the business of digital advertising and internet marketing, utilised the internet search engines such as Google, Yahoo etc. to buy banner advertising space on the inter-net on behalf of its clients. The Assessing Officer held that the payment was in the nature of FTS whereas the CIT(A) held that it was in the nature of royalty as Google or Yahoo etc. would allot the space to the appellant company and its clients in their server and that whenever any internet user search for certain web sites, the appellant’s or its client’s name would appear and its contents be displayed on the computer screen.
However, the ITAT observed that the search engine renders this service outside India through internet. Google does such online advertising business in Asia from its office in Ireland. The search engine service is on a worldwide basis and thus is not relatable to any specific country. The entire transaction takes place through the internet and even the invoice is raised and payment is made through internet. The ITAT relying on the decision in case of Yahoo India [140 TTJ 195] / TS-290-ITAT-2011(Mum), held that the amount paid by the assessee to Google Ireland Ltd. for the services rendered for uploading and display of banner advertisement on its portal was in the nature of business profit on which no tax was deductible at source, as the same was not chargeable to tax in India in the absence of any PE of Google Ireland Ltd. in India.
In the case of Yahoo India (supra) the assessee made payment to Yahoo Holdings (Hong Kong) Ltd. [Yahoo Hong Kong] for services rendered for uploading and display of the banner advertisement of the Department of Tourism of India on its portal. The banner advertisement hosting services did not involve use or right to use by the assessee (i.e. Yahoo India) of any industrial, commercial or scientific equipment and no such use was actually granted by Yahoo Hong Kong to the Yahoo India. Uploading and display of banner advertisement on its portal was entirely the responsibility of Yahoo Hong Kong and the Yahoo India was only required to provide the banner advertisement to Yahoo Hong Kong for uploading the same on its portal. Yahoo India thus had no right to access the portal of Yahoo Hong Kong Having regard to all these facts of the case and keeping in view the decision of the Authority of Advance Rulings in the case of ISRO Satellite Centre 307 ITR 59 and Dell International Services (India) P. Ltd. 305 ITR 37, it was held that the payment made by the assessee to Yahoo Hong Kong Ltd. for the services rendered for uploading and display of the banner advertisement of the Department of Tourism of India on its portal was not in the nature of royalty was business profit and in the absence of any PE of Yahoo Hong Kong in India, it was not chargeable to tax in India.
In the case of Dell International Services (India) P. Ltd., it was held by the AAR that the word “use” in relation to equipment occurring in clause (iva) of Explanation to section 9(1)(vi) of the Act is not to be understood in the broad sense of availing of the benefit of an equipment. The context and collocation of the two expressions “use” and “right to use” followed by the word “equipment” indicated that there must be some positive act of utilisation, application or employment of equipment for the desired purpose.
If an advantage was taken from sophisticated equipment installed and provided by another, it could not be said that the recipient/customer “used” the equipment as such. The customer merely made use of the facility, though he did not himself use the equipment. What was contemplated by the word “use” in clause (iva) of Explanation 2 to section 9(1)(vi) of the Act was that the customer came face to face with the equipment, operated it or controlled its functions in some manner. But if it did nothing to or with the equipment and did not exercise any possessory rights in relation thereto, it only made use of the facility created by the service provider who was the owner of the entire network and related equipment. There was no scope to invoke clause (iva) in such a case because the element of service predominated. The predominant features and underlying object of the agreement unerringly emphasised the concept of service. That even where an earmarked circuit was provided for offering the facility, unless there was material to establish that the circuit/equipment could be accessed and put to use by the customer by means of positive acts, it did not fall within the category of “royalty” in clause (iva) of Explanation 2 to section 9(1)(vi) of the Act.
Characterisation under a Treaty Scenario
The definition of royalty is narrower in scope in a tax treaty than under the Act (e.g. Computer Software is not explicitly covered under a tax treaty), therefore the above discussion would hold good even under a treaty scenario and the payment in question would not be regarded as royalty in the hands of the Service Provider.
Payment for online advertisement – Is it FTS in the hands of the Service Provider?
Explanation 2 to section 9(1)(vii) of the Act defines FTS to mean “any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head “Salaries”.
There is no doubt that providing a sponsored search facility, as also placing a banner advertisement on another person’s website would amount rendering of services to the advertiser. There is also no doubt that these services are technical in nature. However, the question here is whether these online advertising services could be covered by the connotation of ‘technical services’ as defined in Explanation 2 to section 9(1)(vii) of the Act?
The Kolkata Tribunal in the case of Right Florists (supra) observed that “it is significant that the expression ‘technical’ appears along with expression ‘managerial’ and ‘consultancy’ and all the three words refer to various types of services, consid-eration for which is included in the scope of FTS. The lowest common factor in ‘managerial, technical and consultancy services’ seems to be the “human intervention”. A managerial or consultancy service can only be rendered with human interface, while technical service can be rendered with or without human interface. The Tribunal further observed that as long as there is no human intervention in a technical service, it cannot be treated as a technical service under section 9(1)(vii) of the Act. The Tribunal, in reaching this conclusion relied on the decision of the Delhi High Court, in the case of “CIT vs. Bharati Cellular Limited (319 ITR 139) [2008-TIOL-557-HC-DEL-IT) wherein it was held that “the word technical is preceded by the word managerial and succeeded by the word consultancy. Since the expression technical services is in doubt and is unclear, the rule of noscitur a sociis is clearly applicable”. [The Rule noscitur a sociis states that when two or more words which are susceptible of analogous meaning are coupled together they are to be understood in their cognate sense. They take their colour from each other, the meaning of the more general being restricted to a sense analogous to that of the less general].
Applying the above principle, the Kolkata Tribunal held that there is no human touch involved in the whole process of actual advertising service provided by Google and therefore receipts for online advertisements by the Google cannot be treated as FTS under the Act.
Characterisation under a Treaty Scenario
Google is a tax resident of Ireland. Definition of the FTS under Article 12(2)(b) of the India-Ireland tax treaty is materially similar to the definition under the Income tax Act and therefore the legal position discussed hereinabove would be equally applicable in the case of India Ireland tax treaty. In some treaties, the scope of FTS is further reduced by provision of the concept called ‘make available’ (e.g. India’s tax treaties with USA, UK, Singapore etc.). Payment to Yahoo USA would be governed by the India-US tax treaty which provides for “make available” concept in the Article on Fees for Included Services. The term “make available” was examined by, inter alia, by the Mumbai Tribunal in the case of Raymond Ltd. vs. DCIT (86 ITD 793) [2003-TII-05-ITAT-MUM-INTL] wherein it observed that “Thus, the normal, plain and grammatical meaning of the language employed, in our understanding, is that a mere rendering of services is not roped in unless the person utilising the services is able to make use of technical knowledge, etc. by himself in his business and or for his own benefit and without recourse to the performer of services.” The Tribunal also held that rendering of technical services cannot be equated with “making available” the technical services.
Thus, it can be concluded that receipt for online advertisement is neither royalty nor FTS in the hands of the service provider. Therefore, it would be considered as business income.
Business Income vis-a-vis BC and PE
As stated earlier, business income of the owners of the search engines like Yahoo or Google is taxable in India provided it has a BC or a PE in India. The concept of BC was very well explained in the CBDT Circular 23 dated 23rd July 1969. It clarified that the expression ‘Business Connection’ admits of no precise definition. ‘The question whether a non-resident has a business connection in India from or through which income, profits or gains can be said to accrue or arise to him within the meaning of Section 9 of the Income-tax Act, 1961 has to be determined on the facts of each case.’ Then the circular went on to illustrate what would constitute BC and what would not. However, the said circular was withdrawn in 2009.
The Supreme Court had an occasion to define BC in the case of CIT vs. R. D. Agarwal and Co. (1965) 56 ITR 20; wherein it held that “Business Connection” means something more than business. It presupposes an element of continuity between the business of the Non-Resident and his activity in the taxable territory, rather than a stray or an isolated transaction”.
The concept of PE was formulated in the twentieth Century prior to the advent of computers. Therefore, the rules for determination of source links through PE do not hold good in today’s virtual world of e-commerce. The need for physical presence in case of e-commerce transactions in the source State (the chief determining criterion for existence of a PE) is totally obviated. Search engines like Google or Yahoo operate through their respective websites which in turn are hosted on a server. So the question arises as to what constitutes a PE, a Website or a Server?
“Website” – Is it a PE?
The OECD commentary on its Model Convention states that “website per se, which is a combination of software and electronic data, does not in itself constitute a tangible property. It, therefore, does not have a location that can constitute “place of business” as there is no “facility such as premises or, in certain instances, machinery or equipment” as far as software and data constituting that website is concerned”.
Therefore website per se cannot constitute a PE. Thus, the traditional tests for determination of PE fail in a virtual world of E-commerce. In order to study the tax impact of e-commerce, CBDT had appointed a High Powered Committee (HPC) in the year 1999. The HPC also observed that applying the existing principles and rules to e-commerce does not ensure certainty of tax burden and maintenance of the equilibrium in the sharing of tax revenues between countries of residence and source. “The Committee, therefore, supports the view that the concept of PE should be abandoned and a serious attempt should be made within OECD or the UN to find an alternative to the concept of PE”.
Interestingly, India has expressed its reservations on the OECD Model Commentary and has taken a stand that website may constitute a PE in certain circumstances. India expressed a view that depend-ing on the facts, an enterprise can be considered to have acquired a place of business by virtue of hosting its website on a particular server at a particular location.
However, the Kolkata Tribunal in the case of Right Florists (supra) held that the reservations of the Indian Government do not specify the circumstances in which, according to tax administration, a website could constitute a PE. Therefore, in the opinion of the Tribunal, the reservations so expressed by India as of now, cannot have any practical impact on a website being treated as a PE.
The Kolkata Tribunal in the case of Right Florists (supra) concluded that “a website per se, which is the only form of Google’s presence in India – so far as test of primary meaning i.e. basic rule PE is concerned, cannot be a permanent establishment under the domestic law. We are in considered agreement with the views of the HPC on this issue.”
“Server” Is it a PE?
The server on which the website is hosted and through which it is accessed is a piece of equipment having a physical location and such location may constitute a “fixed place of business” of the enterprise that operates that server. However, if the enterprise uses the services of an Internet Service Provider (ISP) for hosting website, then the location of such server may not constitute PE for such enterprise, if the ISP is an independent contractor and acting in its ordinary course of business. In such an event even if the enterprise is able to dictate that its website may be hosted on a particular server at a particular location, it will not be in possession or control of that server and therefore, such server will not result into PE. However, if the enterprise carrying on business through a website has the server at its own disposal, e.g., it owns (or leases) and operates the server on which the website is stored and used, the place where that server is located could constitute a PE of the enterprise if the other requirements of the PE Article are met, e.g. location of server at a certain place for a sufficient period of time so as to fulfill the fixed place criterion as envisaged in paragraph 1 of Article 5 of a tax treaty.
Even when server is found to be “fixed”, and results in a PE, it may not result in any tax taxability for the enterprise, if the activities of that enterprise are not carried on through that server or activities so carried on are restricted to the preparatory or auxiliary nature such as (i) provid-ing a communication link, (ii) advertising of goods and services, (iii) relaying information through a mirror server for security and efficiency purposes,
(iv) gathering marketing data and/or (v) supplying information etc.
Based on the above analysis, it can be concluded that search engines, which have their presence through their respective websites cannot constitute PE in India, unless their servers are located in India.
Based on the above discussions, the Kolkata Tribunal in the case of Right Florists (supra) held that “the receipts in respect of online advertising on Google and Yahoo cannot be brought to tax in India under the provisions of the Income tax Act as also under the provisions of India-US and India-Ireland tax treaty”.
Withholding tax obligation
A question often arises as to whether the payer needs to deduct tax at source if the income arising from such payment is not taxable in the hands of the recipient. The question became more serious with the decision of the Karnataka High Court in the case of CIT vs. Samsung Electronics Co. Ltd. [2010] 320 ITR 209 wherein it was held that the resident payer is obliged to deduct tax at source in respect of any type of payment to a non resident, be it on account of buying/purchasing/acquiring a pack-aged software product and as such, a commercial transaction or even in the nature of a royalty payment. Also the decision of the Supreme Court in case of Transmission Corporation of A. P. Ltd. vs. CIT (infra) was interpreted in a manner that payer has to deduct tax at source whether the income is chargeable to tax in India or not.
However, the Kolkata Tribunal in the case of Right Florists (supra) relying on the Supreme Court’s decision in the case of GE India Technology Centre P. Ltd. held that “when recipient of an income does not have the primary tax liability in respect of an income, the payer cannot have vicarious tax withholding liability either.”
All controversies arising out of interpretation of section 195 regarding non-deduction of tax at source, where the income is not taxable in the hands of the recipient, were laid to rest with the decision of the Supreme Court in case of GE India Technology Centre P. Ltd. vs. CIT [2010] 327 ITR 456 wherein the Apex Court following Vijay Ship Breaking Corporation vs. CIT [2009] 314 ITR 309 (SC) held that “The payer is bound to deduct tax at source only if the tax is assessable in India. If tax is not so assessable, there is no question of tax at source being deducted.”
The decision of GE India Technology Centre P. Ltd. (supra) assumes special significance as it explained the decision of the Supreme Court in case of Transmission Corporation of A. P. Ltd. vs. CIT [1999] 239 ITR 587 (SC) in the proper perspective. The said decision is often invoked by the Income-tax Department to fasten TDS obligation on the payer on a gross basis even when the income is not chargeable to tax in the hands of the recipient thereof. The Apex Court stated that in case of decision of the Transmission Corporation (supra), the issue was of deciding on what amount of tax is to be deducted at source, as the payment was in respect of a composite contract. The said composite contract not only comprised supply of plant, machinery and equipment in India, but also comprised the installation and commissioning of the same in India.
With the above mentioned correct interpretation of the decision in case of Transmission Corporation (supra), the Supreme Court set aside the decision of the Karnataka High Court in case of CIT vs. Samsung Electronics Co. Ltd. (supra).
Thus, the payer is not obliged to deduct tax at source if the recipient is not chargeable to tax on such income. Secondly, no disallowance can be made u/s. 40(a)(i) on account of non-deduction of tax at source by the payer where the income per se is not taxable in India.
Summation:
Determination of tax liability in an e- commerce scenario is a difficult task as the age old methods of determination of PE/BC do not hold good in the modern ways of doing business. Though existence of a BC or PE has to be case specific, broadly we can conclude that website per se does not constitute either a PE or a BC and the location of server is a determinative criterion for PE. This conclusion is only in relation to fixed place PE, whereas PE/BC may exist in the form of Dependent Agent or otherwise.
As far the withholding tax liability of the payer is concerned, one needs to look at the entire transaction from the recipient’s perspective. As long as the income from such online payment is not taxable in the hands of the non-resident service provider, the payer is not obliged to deduct tax at source. For determining the taxability in the hands of the SP, the characterisation of income is of utmost importance as income in the nature of royalty and FTS can be taxed without any PE or BC in India whereas, business income per se, is not taxable in India unless the SP has a BC/ PE in India.
Even though the taxability and characterisation of income is explained in this article by taking an example of online advertisement through search engines like Google and Yahoo, the underlying principles could help in determination of the taxability of other online transactions such as subscription of online data bases, purchase of videos, books etc.
We do hope that on the lines of recommendations of the HPC, OECD and UN may come out with alternative methods for taxing e-commerce transactions. However, we are fortunate that in absence of clarity, we have Supreme Court decisions – judge made laws, to guide us.
