Introduction

The rapid digitalization of global commerce has fundamentally transformed how businesses operate, shifting value creation from brick-and-mortar establishments to digital platforms. Multinational corporations (MNCs) now generate substantial revenue from cross-border digital services without requiring a physical presence in the markets they serve.

To keep pace with the evolving digital economy, and to tax such digital transactions, India introduced the Significant Economic Presence (SEP) rule in 2018 under Section 9(1)(i) of the Income-tax Act, 1961, refining the concept of business connection to include digital transactions even in the absence of a physical presence. This measure was designed to bring qualifying MNCs within the Indian tax net based on specified revenue and user-based thresholds.

While SEP represents a notable step toward adapting tax regulations to digital business models, its practical enforcement remains limited, largely due to the prevalence of tax treaties, interpretational challenges, and ongoing global tax developments. As India’s tax authorities continue to refine their approach to digital taxation, MNCs with significant digital footprints in India would benefit from reviewing their exposure under the current framework and ensuring compliance with evolving tax obligations.

Legal and Regulatory Background

Evolution of PE Rules in India

India’s taxation of foreign businesses has traditionally been governed by the concept of Permanent Establishment (PE) under:

• The Income-tax Act, 1961, which defines business connection for non-residents.
• Double Taxation Avoidance Agreements (DTAAs), which follow the OECD Model Tax Convention’s PE definition.

Historically, non-resident companies were taxed only if they had a PE in India, meaning:

• A fixed place of business in India (office, branch, factory, etc.).
• A dependent agent PE (a local entity concluding contracts on behalf of the foreign enterprise).
• A service PE (employees working in India for an extended period).

With the rise of digital businesses (e-commerce, streaming, SaaS, fintech, and digital advertising), these rules became inadequate, leading to the introduction of Significant Economic Presence (SEP).

Introduction of SEP and Its Scope

India introduced SEP under Finance Act 2018, expanding the “business connection” definition to capture digital transactions. SEP applies when:

• Revenue-based threshold: A foreign company earns more than ₹2 crore (INR 20 million) from Indian transactions in a financial year.
• User-based threshold: The foreign company undertakes systematic and continuous solicitation of business activities or is engages with 300,000 or more Indian users through digital platforms.

Unlike traditional PE, SEP applies even if the foreign company has no physical presence in India. The rule aligns with the OECD’s BEPS Action Plan 1, which proposes taxing digital businesses based on economic engagement rather than physical location.

Recent Developments in Digital Taxation

Equalization Levy: A Parallel Digital Tax Mechanism

• Introduced in 2016, India’s Equalization Levy (6%) initially targeted digital advertising payments to non-residents like Google and Facebook.
• In 2020, India expanded the levy, imposing a 2% tax on e-commerce operators earning revenue from Indian customers.

The Act was amended by Finance Act, 2024 to withdraw the 2% Equalization Levy on e-commerce supply or services effective August 1, 2024. This move follows the agreement with the United States and aligns with the transition toward OECD Pillar One implementation.

Furthermore, Finance Act 2025 has also proposed abolishing of 6% Equalization Levy on online advertising services effective April 1, 2025. This significant policy shift is aimed at resolving trade tensions with the United States and reflects India’s commitment to international tax harmonization under the OECD framework. Once implemented, this will mark the complete phase-out of the Equalization Levy regime.

Global Tax Reforms: OECD Pillar One & Two

The OECD’s Pillar One and Pillar Two frameworks propose a global shift in digital taxation:

• Pillar One: Allocates a share of global profits to market jurisdictions like India.
• Pillar Two: Introduces a 15% global minimum corporate tax, reducing tax avoidance.

India’s commitment to phasing out the Equalization Levy reflects a transition toward OECD-aligned digital tax policies.

Challenges Posed by DTAAs to SEP Implementation

While SEP was introduced as a progressive step to tax foreign digital businesses, its practical enforceability remains restricted, primarily due to India’s Double Taxation Avoidance Agreements (DTAAs). These treaties, which India has signed with over 90 countries, provides specific definitions of Permanent Establishment (PE) which have not been amended to include expanded scope of business connect / SEP as per the Act.

Also, the Act specifically provides that non-resident taxpayers can rely on the Act or the DTAA whichever is beneficial. Hence taking advantage of the beneficial provisions of the DTAA, business income can be taxed in India only if can be established that non-resident taxpayers have a PE in India.

Key Legal Barriers Posed by DTAAs

Treaty Supremacy Over Domestic Law

• India’s DTAAs with major economies (e.g., U.S., U.K., Singapore, Germany, and France) follow OECD’s Model Tax Convention, which adheres to traditional PE principles.
• Article 5 of the OECD Model Tax Convention establishes that PE requires a fixed place of business, dependent agents, or service presence—excluding digital-only operations.
• Article 9 of the OECD Model and Section 90(2) of the Act explicitly states that DTAAs take precedence over domestic tax laws, ensuring that non-resident businesses from treaty jurisdictions are not subject to unilateral measures like SEP unless the treaty is renegotiated.

Physical Presence Requirement in Tax Treaties

• SEP establishes a taxable nexus based on economic thresholds (revenue & user engagement).
• DTAAs, however, still rely on the traditional PE framework—meaning that unless an MNC has a physical establishment or a service PE or dependent agent in India, it is not taxable under corporate tax rules.
• As a result, even if a digital business meets SEP thresholds, it remains untaxed unless the DTAA is modified to reflect digital tax provisions.

India’s Limited Success in Renegotiating DTAAs for Digital Taxation

• While India has been advocating for digital taxation through the OECD and G20, renegotiating multiple bilateral tax treaties to incorporate digital PE or SEP provisions has been a slow and complex process.
• Most DTAAs continue to follow pre-digital economy principles, making it difficult to enforce SEP without international consensus on tax treaty amendments.

Case Study: SEP vs. DTAA Protection

A U.S.-based SaaS company generates ₹50 crore annually from Indian customers through digital subscriptions. This revenue far exceeds the ₹2 crore SEP threshold. However, the India-U.S. DTAA follows traditional PE principles, which require a physical presence (such as an office, agent, or employees) for taxation. Since the company does not maintain a fixed place of business in India, it remains outside the corporate tax net, despite its substantial economic presence in the country.

Conclusion

India’s approach to digital taxation, particularly through the Significant Economic Presence (SEP) rule, reflects a broader effort to modernize tax regulations in response to evolving business models. However, its practical enforcement remains constrained by the primacy of Double Taxation Avoidance Agreements (DTAAs), which continue to define taxability based on traditional Permanent Establishment (PE) principles. Also, the withdrawal of Equalization Levy marks a significant shift in India’s digital tax framework and does away with unilateral digital tax measures implemented by India to tax digital transactions.

Until these treaties are renegotiated to incorporate digital taxation provisions, SEP’s application will remain restricted, compelling tax authorities to rely on existing PE frameworks to assess MNC tax liabilities. Meanwhile, the global tax landscape is shifting, with initiatives like OECD’s BEPD Action Plan 1 aiming to establish a more uniform system for taxing digital businesses. The definition of PE in the DTAAs have not yet been amended to include provisions like SEP.

As tax scrutiny intensifies, MNCs operating in India’s digital economy must proactively assess their compliance obligations and evaluate potential exposure under both traditional PE rules and evolving digital tax measures. Companies should closely monitor regulatory developments, strengthen transfer pricing documentation, and consider structural adjustments to mitigate potential risks. While global consensus on digital taxation is still evolving, businesses that adopt a proactive compliance strategy will be better positioned to navigate India’s complex tax environment and minimize potential disputes.