14 hours ago
'Indian income tax sleuths have no way to tax digital value loop'
Indian tax authorities are staring at a growing revenue loss in
digital tax collection
as artificial intelligence (AI) firms such as
OpenAI
, Anthropic and Perplexity generate income at a fast clip from Indian developers, companies and startups, despite having no physical presence in the country, reigniting long-standing concerns over the concept of 'permanent establishment' in the digital economy.
The companies are earning millions of dollars from Indian developers, startups and enterprises who access their AI models-eg ChapGPT, Claude, Perplexity etc-through paid APIs and subscriptions but they operate without local offices, employees, or servers in India, allowing them to bypass the country's tax obligations entirely.
Then there is also an additional conundrum of how to tax AI models that continuously extract important insights and information from Indian-origin data-users, startups and companies-but the revenue is generated and taxed in a different geography.
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by Taboola
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Tax experts say Indian tax authorities currently have no way to tax the 'digital value loop'.
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Experts feel that the India tax framework, which was created around the concept of physical presence, such as offices, employees, or equipment, is struggling to keep up with the new emerging software business models. And the current predicament has renewed the discussion over interpreting 'nexus'-the legal basis for taxing foreign entities-as algorithms obfuscate borders and challenge old tax concepts. "The digitalisation of the economy has posed serious challenges to the existing international tax system, primarily due to the ability of digital businesses to scale in a jurisdiction without any physical presence, and their heavy reliance on intangibles and the value created by user-contributed data," said Akhilesh Ranjan, adviser, tax and regulatory services at Price Waterhouse & Co LLP.
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He added the current international tax architecture, which was based entirely on physical presence and where allocation of profits was governed by the separate entity concept and the arm's length standard, has been shown to have become incapable of providing complete answers to questions of 'nexus', characterisation and a fair and equitable allocation of income.
The tax headache is only going to grow bigger as AI-related business activity in India is quickly gaining traction, with startups across sectors integrating AI through API subscriptions, while larger companies invest heavily in AI-powered automation and analytics tools.
'The issue with AI models isn't very different from the unresolved software taxation problem. For example, if someone in the US licenses software for use in India, India currently can't tax that income. Based on Supreme Court rulings, such payments are not considered as royalty, and furthermore, the previous equalisation levy that was applicable has been withdrawn. Since there's no permanent establishment either, the income remains untaxed. So, we end up in a similar situation with AI—where there may be an income source from India, but under existing treaty obligations, the country cannot tax it,' said Rohinton Sidhwa, leader, global business tax, Deloitte India.
This is part of a larger problem Pillar One was meant to solve, but geopolitical pushback—especially from the US—has stalled, he added.
'As long as treaties don't define software or AI payments as royalties or establish a clear nexus, countries like India can't tax this income, even if it's sourced from their own markets,' he said.
Under the OECD-led international tax reform, Pillar One allocated a chunk of profits from large multinational companies, especially those offering digital services, to market countries, allowing them to tax these firms even without a physical presence.
Experts say India is already playing an active role in ongoing United Nations efforts to develop a new framework for taxing cross-border digital services.
'It must continue to pursue multilateral consensus on the 'physical presence' test being supplemented by 'the place of generation of user data'; arm's length transfer pricing giving way to a formulary approach based on revenue sourcing; and the debate on the relative primacy of 'source' versus 'residence' being shifted to a discussion on the extent to which income taxation should be based on the situs of value creation and of consumption,' said Ranjan.
