No U.S., India’s digital services tax is not discriminatory

On January 6, 2021, the office of United States Trade Representative (USTR) published a report concluding that the 2% digital services tax (DST) introduced by the Indian government, vide the 2020 Finance Act, discriminates against U.S. businesses, contravenes settled principles of international tax law, and restricts U.S. commerce. The report was published following an investigation conducted by USTR under section 301 of the U.S. Trade Act, 1974, which authorizes USTR to appropriately respond to a foreign country’s action that is discriminatory and negatively affects U.S. commerce.

India’s 2% DST is levied on revenues generated from digital services offered in India, including digital platform services, digital content sales, and data-related services. Pertinently, India was one of the first countries in the world to introduce a 6% equalisation levy in 2016, but the levy was restricted to online advertisement services (commonly known as “digital advertising taxes” or DATs). The 2020 DST, however, is broader in scope and extends to all kinds of digital transactions.

Broadly, USTR report finds the DST to be discriminatory on two counts. Firstly, it states that the DST discriminates against U.S. digital businesses because it specifically excludes from its ambit domestic (i.e., Indian) digital businesses. And secondly, the DST is discriminatory because, according to the report, it does not extend to identical services provided by non-digital service providers. While both these findings may seem justified on first blush, they are wholly misplaced and disregard the background and context in which the DST was introduced.

The DST is aimed at ensuring that non-resident, digital service providers pay their fair share of tax on revenues generated in the Indian digital market. Currently, Indian double taxation avoidance agreements (“tax treaties”) with foreign jurisdictions do not permit source-based taxation of business profits of non-resident companies in India in the absence of what is called a “permanent establishment” (PE). By definition, a PE is a fixed place of business through which the business activities of a non-resident company are carried on in India. Importantly, while non-resident, non-digital service providers pay Indian corporate tax on income attributed to a PE in India, business models employed by non-resident digital service providers obviate the need for a physical presence in India and profits attributed to the Indian market could easily escape the Indian income tax net.

It is true that the government amended the Income Tax Act to provide for a “significant economic presence” (to supplement physical presence) as a nexus to tax business profits of a non-resident company. However, an amendment of this nature in the domestic tax law is ineffective for all practical purposes in the absence of a corresponding change to tax treaties. Tax treaties usually override provisions of the domestic tax law and negotiating the inclusion of such a change, especially in tax treaties with countries such as the United States, is next to impossible. No wonder then that the DST is a tax not on income, but on revenue, and has been carefully devised to fall outside the scope of tax treaties.

At best, the U.S. government can term the DST as inconvenient to American digital businesses because, in the present scheme of things, most large technology companies are U.S.-based. Companies such as Google are second to none in the internet industry with a limited number of operators. It is true that Indian digital service providers will not pay the DST because of the explicit exemption in the law (of course, they are subject to Indian income tax), but even if the law did not provide for an exemption, only a handful of them would pay the DST in view of the revenue threshold (₹20 million in annual India-based digital services revenue). As per USTR’s own analysis, only 119 companies in the world would likely be subject to the DST, of which 86 are U.S. companies. The next most common nationalities are China and the United Kingdom with seven companies each, France with six companies, and Japan with five. Of course, there may be a meaningful discussion to be had when an Indian company gets as big in size and sales as Google in the future and yet falls outside the scope of the DST.

Section 301 allows USTR to take all appropriate and feasible action to obtain the elimination of the DST, including the imposition of duties, fees, or other import restrictions on Indian goods or services. Let us, for the sake of argument, concede that the DST is ex facie discriminatory. Even then, retaliation by the U.S. government in the form of imposition of tariffs on Indian goods is not the solution. There are legal ways and mechanisms to settle this kind of a trade or a tax dispute and unilateral imposition of tariffs do good to none.

In fact, a retaliatory tariff could be counter-productive in many ways. How can we rule out the possibility of the Indian government (or other governments facing section 301 investigations) responding with a counter-retaliatory measure? If that happens, most U.S. businesses—and not just U.S. digital businesses—would be impacted. Research by U.S.-based The Tax Foundation indicates that the total impact of imposed and announced tariffs will reduce long-run GDP in the U.S. by 0.5%, which means lower wages and fewer jobs.

The U.S. government must remind itself that the DST has been adopted as an interim measure to cope with the challenges posed by the digital economy, while a multilateral solution at the level of the OECD is underway. A prudent solution, therefore, is not for the U.S. government to flex its muscles but to participate in these global talks and protect the interests of U.S. commerce by entering to dialogues with hundreds of countries who are trying hard to reach global consensus on the issue of digital economy taxation.

What the U.S. government should be worried about the most is that the threat of retaliatory tariffs seems to not have worked so far because over two dozen countries have either adopted or are considering adopting, a DST or a DAT. The tax challenges posed by the digital economy is not an India versus U.S. problem. It is a global problem. The sooner Washington realises this, the better.

Views are personal. The authors practice law in the Supreme Court.