How the e-Commerce Transactions are Taxed in India?

What is e-Commerce? How the e-Commerce Transactions are Taxed in India?

By K P C Rao., LLB., FCMA., FCS.,

CMA (USA)., FIPA (Australia)

Practicing Company Secretary

kpcrao.india@gmail.com

1.      Introduction

The development of electronic commerce can be said to be the greatest event in the economic history of mankind, next only to the Industrial Revolution of the early 20^th Century. Whereas Europe and United States were the main beneficiaries of the Industrial Revolution, there are clear indications that India  along with the United States and China, would be the major beneficiary of the electronic commerce revolution.  India’s e-commerce market was worth about $2.5 billion in 2009. About 75% of this is travel related (airline tickets, railway tickets, hotel bookings, online mobile recharge etc.). Online Retailing comprises about 12.5% ($300 Million as of 2009). India has close to 10 million online shoppers and is growing at an estimated 30% estimated compound annual growth rate (CAGR) vis-à-vis a global growth rate of 8-10%. Electronics and Apparel are the biggest categories in terms of sales.

The India retail market is estimated at $470 Bn in 2011 and is expected to grow to $675 Bn by 2016 and $850 Bn by 2020, CAGR  of 7%. According to Forrester, the e-commerce market in India is set to grow the fastest within the Asia-Pacific Region at a CAGR of over 57% between  2012-16. India e-tailing market in 2011 was about $600 Mn and expected to touch $9 Bn by 2016 and $70 Bn by 2020 – estimated CAGR of 61%. Mjunction.in is the largest B2B Ecommerce portal in India.

The huge pool of skilled technological manpower in India is at the basis of this indication. The Indian industry is attempting to harness technology to succeed in achieving its business objectives. In doing so, it has been focusing on balancing the benefits provided by new technology with the associated risks in having one's business depend on it.

2.      What is e-Commerce?

Electronic commerce commonly known as e-commerce, is the buying and selling of product or service over electronic systems such as the Internet and other computer networks. Electronic commerce draws on such technologies as electronic funds transfer, supply chain management, Internet marketing, online transaction processing, electronic data interchange (EDI), inventory management systems, and automated data collection systems. Modern electronic commerce typically uses the World Wide Web at least at one point in the transaction's life-cycle, although it may encompass a wider range of technologies such as e-mail, mobile devices and telephones as well. Therefore, e-commerce or electronic commerce, in its widest sense, means consumer and business transactions conducted over a network, using computers and telecommunications.

The OECD[1] defines e-commerce in a somewhat more restricted manner as commercial transactions between individuals and organisations, based on the processing or transmission of digitised data units, sound, and visual images, which are carried out over open networks (like internet) or over closed networks (like minitel) with a gateway to open networks. This more specific definition would therefore exclude electronic data interchange (EDI), carried out over closed networks, if such EDIs are being used by themselves, without access to an open network (e.g. credit cards used over a closed network, connecting specified merchants with a card organisation).  

The process of e-commerce Transacion

(1)  The consumer places an order.

The customer places an order at the Merchant Internet storefront, using his or her payment method of choice.

(2)  The transaction is processed in real-time.

The payment gateway, provides secure, real-time connectivity from your storefront to the payment gateway platform. Our gateway product, BluePay™, securely routes the transaction through the financial network to the appropriate banks, ensuring that customers are authorized to make their purchase.

BluePay™ Payment Gateway uses a client/server architecture for performing transaction processing. The client is installed on your merchant site and is integrated with your e-commerce application. The client may also be pre-integrated with shopping cart solutions and store management systems.

For transaction authorization, the BluePay™ client software establishes a secure link with the BluePay's processing server over the Internet using an SSL connection, and transmits the encrypted transaction request. The processing server, which is a multi-threaded processing environment, receives the request and transmits it to the appropriate financial processing network.

(3)  The transaction is approved or denied.

When the authorization response is received from the financial network, the response is returned via the same session to the client on your site. The client completes the transaction session by transparently sending a transaction receipt acknowledgment to the server before disconnecting the session.

(4)  The transaction is confirmed.

The BluePay™ Payment Gateway confirms that the transaction has been securely routed and processed. As proof of a securely processed transaction, both the customer and you, the merchant, receive a transaction confirmation number via web browser and/or e-mail.

1.      How business is transacted through e-Commerce?

e-commerce is a method of conducting business transactions and not a business transaction by itself. Therefore, the contents of a business transaction done through e-commerce are no different from that of a business transaction carried out through traditional means.  The three distinct means of doing business in e-commerce are:

(1)  Electronic advertising: Advertising is done on the open networks, through websites. Potential customers access the websites and obtain the information they need which enables them thereafter to proceed with the transaction is suitable cases. If the e-commerce business is restricted to putting up a website alone, then the rest of the transaction is completed through traditional means; i.e. the placing of orders by telephone or mail, the making of payment by cheque and credit card and the delivery of goods through a carrier, the telephone etc. being referred to as intermediaries.

(2)  Electronic sales: This is done through ‘smart’ resources which enable the potential customer to place an order on the internet. The payment is effected through a closed network by means of credit cards.

(3)  Electronic delivery: This is of course possible only for goods and services that can be fully digitised, but this range is quite wide and ever expanding. Texts, visual materials, audio materials and computer software are digitised. Therefore products like journals, books, music, plans, designs, drawings and games to mention a few, would be goods available in digitised form. Besides goods, services like diagnostic services, could also be available in digitised form. Therefore a whole host of goods and services could be delivered electronically.

2.      Classification of e-Commerce Transactions

Based on parties involved in a transaction e-Commerce Transactions may be classified as follows:

(1)     Business to Customers (B2C): Businesses selling to the general public typically through catalogs utilizing shopping cart software. By dollar volume, B2B takes the prize, however B2C is really what the average Joe has in mind with regards to ecommerce as a whole.

(2)     Business to Business (B2B): Companies doing business with each other such as manufacturers selling to distributors and wholesalers selling to retailers. Pricing is based on quantity of order and is often negotiable.

(3)     Consumer-to-Business (C2B): A consumer posts his project with a set budget online and within hours companies review the consumer's requirements and bid on the project. The consumer reviews the bids and selects the company that will complete the project. Elance empowers consumers around the world by providing the meeting ground and platform for such transactions.

(4)     Customer to Customer (C2C): There are many sites offering free classifieds, auctions, and forums where individuals can buy and sell thanks to online payment systems like PayPal where people can send and receive money online with ease. eBay's          auction service is a great example of where person-to-person transactions take place every day since 1995.

Companies using internal networks to offer their employees products and services online--not necessarily online on the Web--are engaging in B2E (Business-to-Employee) ecommerce. G2G (Government-to-Government), G2E (Government-to-Employee), G2B (Government-to-Business), B2G (Business-to-Government), G2C (Government-to-Citizen), C2G (Citizen-to-Government) are other forms of ecommerce that involve transactions with the government - from procurement to filing taxes to business registrations to renewing licenses. There are other categories of ecommerce out there, but they tend to be superfluous.

3.      Regulatory Framework

The regulatory environment in India, which broadly governs e-commerce, comprises of the following laws:

(1)  Indian Contract Act, 1872;

(2)  Copyright Act, 1957;

(3)  Trademark Act, 1957;

(4)  Patent Act, 1970;

(5)  Information Technology Act, 2000(As amended) ; and

(6)  Indian Penal Code, 1860 etc.

4.      What way the method of e-commerce transactions is different from traditional practice of business?

The method of carrying on a business is widely different from the traditional practice of business on the following counts.

(a)  Firstly, traditional businesses have rested squarely on the physical presence and delivery of goods, but in e-commerce transactions, physical presence of goods is not required at all. Consequently, geographical boundaries between nations hold no significance.

(b)  Secondly, in such type of transactions, physical delivery of goods is not necessary. Where the goods and services are available in digital form, e.g. computer software, music, magazines, drawings etc. physical transactions are replaced by transfer of bytes.

(c)  Thirdly, e-commerce transactions can be completed almost instantaneously across the world and irrespective of the time of the day.

5.      Issues involved in Taxing of e-Commerce Transactions

Due to absence of national boundaries, physical presence of goods and non-requirement of physical delivery, taxation of e-commerce transactions raises several issues. These issues have to be examined in the light of international taxation principles.  International taxation arises from cross border transactions for the reason that the author of the transactions arises in one country (called the Home State) and the sites of the transactions is in the other country (Host State).  Income arising out of such transaction is subject to tax in both countries by virtue of ‘personal attachment’ to the transfer (in the Home State) and again by virtue of ‘economic attachment’ to the income itself (in the Host State).  Thus, this gives rise to double taxation of the same income. This problem is generally solved by a Double Taxation Avoidance Agreement (DTAA) between the two countries concerned.   The key issues arising in respect of e-commerce transactions are as follows:

(a)  How to determine economic attachment?

In order to determine economic attachment, the situs of the transactions should be clearly determined. In a traditional commerce transaction, the situs of the transaction is clearly known, because of the physical presence and the physical delivery. Therefore, the ‘Source Rule’ as laid down in section 9 of the Income-tax Act, 1961 can be clearly applied to effect Host State taxation.

Section 9 of the Income-tax Act, 1961 provides that income is deemed to accrue or arise in Indian taxable territory if there is a business connection. In E-commerce situations, with transactions being completed in cyberspace, it is often not clear as to the place where the transaction is effected, giving rise thereby to difficulties in implementing Source Rule taxation.

(b)  How to determine existence of a permanent establishment?

Under most bilateral double tax treaties, a country will seek to tax corporate business profits if they can be applied to a ‘permanent establishment’ in that country. The basic requirement is, therefore, that there must be a place of business and it must have some permanence.

The major taxation problem of e-commerce is that no establishment is necessary across the border to carry on business. With regard to tangible property, the source can be traced, as the delivery has to cross the other territory through the customs or postal barrier. The destination also will be known from the shipping address. Where the seller is located in a tax-haven country, it becomes difficult to enforce tax laws on the non-resident business. In such cases, the natural option should be to tax the resident as the agent, especially where the non-resident cannot be reached. The difficulty is not so much in taxing those who are assessed and who maintain accounts but in taxing others who do business and there is no record of their transactions, like the persons liable to pay the ‘use tax’ in US. With the development of WAP (Wireless Application Protocol) which integrates mobile telephony with the Internet, e-commerce will be taken over by M-commerce (Mobile Commerce). This makes the place of origin of business invisible thus adding complication to the existing scenario and is a real challenge to domestic jurisprudence.

Further, how such income is to be attributed to the permanent establishment is also a significant matter. This is relevant to determine whether income from sales can be taxed on host country soil. For instance, if a particular income is classified as royalties or fees for technical services, or dividends or interests, then irrespective of the existence of a permanent establishment, the income will be liable to host country taxation under section 115A of the Income-tax Act, 1961. On the other hand, if the income is classified as income from sales, then unless there is a permanent establishment, there can be no taxation in the host country. And if there is a permanent establishment, how much income is to be taxable will be determined by how much of the income is to be attributed to the permanent establishment.

(c)  Legal  Impediments

Till now all cross-border commercial transactions have to cross the customs barrier or the postal barrier. All trade and commerce are operated in a physical world and in terms of tangible goods. Hence, there is a check on these transactions, though smuggling remains outside the scope of any control. Even in the present situation, the tax authorities are unable to fully grapple with the problem of myriad ways of tax evasion. In e-commerce transactions, the contracting parties are in two different states (Jurisdiction) and, therefore, the question would arise as to which state law would be applied.

(d)  Nature of contract

A contract need not necessarily be in writing unless; the statute requires it to be so. It can be oral. This will create problems relating to the law that will be applicable in case of dispute. In a contract, generally the parties are free to choose the law applicable to the contract and the same can be expressed or implied in the terms of the contract. In some cases, the principal place of business is relevant in deciding the law applicable. In some other case, the place where the buyer normally resides decides the law to be applied. Where there is a clause for retention of title until the buyer performs some act, then the matter of which lex situs will govern the validity clause is open to question. In answering this, the Rome Convention says that if the contract accords with the rules of anyone of the States, its validity cannot be questioned. This would be the most satisfactory solution and can be followed. All these problems arise mostly regarding transactions relating to movables and those relating to immovable properties are less difficult. There are many areas where the present domestic laws including international laws would be inadequate to deal with the emerging new field of e-commerce.

(e)  Taxable jurisdiction

The taxable jurisdiction of any country covers its national boundary. Besides this the territorial jurisdiction includes territorial sea and airspace above as per the territorial waters, continental shelf, exclusive economic zone and other Maritime Zones Act, 1976. Each one extends to specified nautical miles from the base line.  But electronic commerce takes place through satellite and the server can be in any part of the globe. It can in all probability be in a tax-haven country.  The following are the limits indicated therein:

(1)  Territorial Water -12 nautical miles from the nearest point of appropriate base line.

(2)  Contiguous Zone - 24 nautical miles beyond and adjacent to the territorial waters from the base line.

(3)  Continental Shelf - 200 nautical miles from the base line.

(4)  Exclusive Economic Zone is an area beyond and adjacent to the territorial waters extending to 200 nautical miles from the base line.

(f)   Residential Status

The incidence of tax on any assessee depends upon his residential status under the Act. All assesses are liable to tax in respect of the income received or deemed to be received by them in India during the previous year irrespective of (i) their residential status, and (ii) the place of its accrual. Income is to be included in the total income of the assessee immediately on its actual or deemed receipt. The receipt of income refers to only the first occasion when the recipient gets the money under his control. For all purposes of income-tax, taxpayers are classified into three broad categories on the basis of their residential status. viz (a) Resident and ordinarily resident (b) Resident but not ordinarily resident (c)  Non-resident.

Another condition for taxing the income arising or accruing beyond the taxable territories is the physical residence of the taxpayer for 182 days or more. This becomes meaningless with the Internet access. The information highway provides numerous visits to another jurisdiction outside the control of border mechanism.

6.      Taxation Framework

Some of the fundamental tax-related issues cropped up in the process of evolution of cross-border e-commerce transactions are:

(1)  Need to develop new norms and tenets of interpretation to determine the nature and character of income from cross-border e-commerce transactions.

(2)  Need to create new definition and meaning of permanent establishment (PE)

(3)  Need to change the basis of taxation (for example, residence-based taxation)

(4)  Need to adhere to the  principles of tax neutrality

The Committee of Fiscal Affairs of the OECD has been actively working on taxation issues relating to e-commerce. The committee has developed the taxation framework conditions setting forth the governing principles in relation to e-commerce. The key conclusion was that the taxation principles that guide Governments in relation to conventional commerce, should also guide them in relation to e-commerce. It was postulated that this would be possible only by adapting and adopting the existing principles to e-commerce situations.  Key areas in the context of international tax were identified for adapting and adopting the existing principles are:

(a)  Permanent Establishment in e-Commerce Situations

According to the principles of international taxation, business income cannot be taxed on Host State soil, unless there is a permanent establishment in the Host State. If there is such a permanent establishment, then the only income which the Host State is entitled to tax is the income attributable to the permanent establishment. Such attributable income is determined by imagining the permanent establishment to be an entity independent of the foreign enterprise, and dealing with the foreign enterprise at arm’s length price. The issue therefore translates to one of determining the transfer price between the foreign enterprise and permanent establishment, and rewriting the transaction between the two, at arm’s length.

(b)  Determination of the Nature of Income

The manner of taxation in income arising from e-commerce transactions and also in conventional commercial transactions, depends on the characterisation of the income. The characterisation of income is relevant because different types of income are taxed differently. Once this is identified, the existing rules may be adopted and adapted to the e-commerce transactions.

In conventional commerce, when all rights in a property are transferred it would amount to a sale giving rise therefore to business income. On the other hand, when only limited rights in a property are transferred, the transferor retaining substantial rights therein, the income there from would be classified either as a royalty in the case of intellectual properties, or a lease rent in the case of tangible properties. If the ultimate results of the transaction is the rendering of services, the income would have to be characterised as fees for professional services.

Similarly, in an e-commerce situation, if licensing of a know-how is done, the payment for this would clearly be characterised as a royalty income in terms of most double taxation avoidance agreements and this would be so irrespective of whether this is done by physical transfer of information or by transfer of digitised information. If on the other hand, practically all rights in a design are transferred, whether physically or through electronic transfer of digitised information, with no rights being retained by the transferor, under most double taxation avoidance agreements, the transaction would be considered to be one which is more in the nature of outright sale of the design rather than a licence thereof. The payment for this would then be characterised as a sale consideration rather than as a royalty.

Most of the computer programmes including software would clearly be considered to be covered by copyright. If software is licensed or its use is permitted in any manner, in accordance with Explanation 2 to section 9(1) (vi) of the Income-tax Act, the income would be royalty in nature. The income would therefore be deemed to arise in India in accordance with section 9(1) (vi) (b) when the payer of the same is an Indian resident, unless it could be established that the software is used in a business outside India. When therefore purchase consideration in respect of any software to be used in India is paid to a non-resident who has exported software, there are alternative views regarding the tax treatment. One view is that the payment will be construed as income deemed to arise or accrue within India, in terms of section 9(1)(vi); it would become income of the non -resident subject to Indian tax in terms of section 5(2); and consequently tax would require to be deducted by the buyer of the software in terms of section 195. In terms of most double taxations agreements entered into by India with other countries, again the amount would be considered royalty income accruing or arising within India, and therefore subject to Indian withholding tax. The other view is that such software payment cannot be treated as royalty. This has been a subject matter of extensive litigation. Recently, the Delhi High Court has, in CIT v. Dynamic Vertical Software India P. Ltd. (2011) 332 ITR 0222 (Delhi), held that since the assessee had purchased the software from a foreign company, Microsoft, and had subsequently sold the same in the market, it had acted as a dealer and therefore, the payment to the non-resident, Microsoft, cannot be treated as royalty.

(c)  Double Tax Relief

Double taxation refers to a situation where the same income becomes taxable in the hands of the same company or individual (tax-payer) in more than one country. Such a situation arises due to different rules for taxation of income in different countries.  The two main rules of income tax which may lead to double taxation are: (1) Source of income Rule (2) Residential status Rule. Under Source of income rule, the income of a person is subjected to taxation in the country where the source of such income exists i.e. where the business establishment is situated or where the assets/property is located irrespective of whether the income earner is a resident in that country or not; Under Residential status rule, which the income earner is taxed on the basis of his/her residential status in that country.  Hence, if a person is resident of a country, he/she may have to pay tax on any income earned outside that country as well. Thus, the same person may be taxed in respect of his/her income on the basis of source of income rule in one country and on the basis of residence in another country leading to double taxation. The relief against such double taxation in India has been provided under Section 90 and Section 91 of the Income Tax Act. They contain two ways of double taxation relief.

7.      Conclusion

Despite the divergence of method between traditional commercial transaction and e-commerce transactions, it is essential to conform to the tenets of neutrality of taxation.  On account of the characteristics of e-commerce namely that transactions are completed in cyberspace, thereby making national boundaries meaningless, and considering the level of dis-intermediation and untraceablity of the path of the transactions, traditional Source Rules of taxation become increasingly difficult to apply.

As techniques of e-commerce progress, the situations become more complex with increasing dis-intermediation. Instances of these could be where traditional transfer pricing rules cannot be applied to multiple servers which switch signals depending on their work loads. This could give rise to increasing emphasis on Residence Rule taxation whenever Source Rule taxation becomes difficult to apply. Such a situation could spell diminishing revenues for developing countries, particularly in situations of technology transfers, where Host States are generally developing countries. e-commerce has also given rise to a new breed of crimes called "cyber crimes," "cyber squatting," and "virus attacks," among others. There is a strong need for cyber policing to reduce the Internet's abuse for carrying out crimes that are, at times, more harmful than physical destruction. It is also imperative that  the  international institutions like  OECD,  International Fiscal Association, should  evolve more equitable tenets for cross-border e-commerce transactions so that there can be a more equitable distribution of tax revenues among nations. Countries that are feeling an erosion of their tax bases shouldn't be forced to adopt desperate measures that may be short term and, hence, likely to adversely affect the growth of their e-commerce economy. India, in particular, should adopt measures to ensure its position as the major beneficiary of the e-commerce revolution, along with the United States and China.

[Published in the Corporate Secretary -Monthly Journal of Hyderabad Chapter of ICSI during November, 2012]


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[1] The Organisation for Economic Co-operation and Development is an international economic organisation of 34 countries founded in 1961 to stimulate economic progress and world trade.