Indian income tax authorities are finding it increasingly difficult to effectively tax the digital value loop, particularly as artificial intelligence (AI) firms generate revenue from Indian developers without establishing a physical presence in the country. This situation allows these firms to bypass traditional tax obligations, leading to potential revenue losses for the Indian government.

The core of the problem lies in the existing tax framework, which struggles to keep pace with emerging software business models. Traditional tax laws often rely on the concept of a "permanent establishment" (PE) to determine tax liabilities. This concept, rooted in the 1920s, requires a physical presence, such as an office or employees, in a country before a company can be taxed there. However, in today's digital economy, businesses can operate and generate significant revenue in a country without having any physical presence. This is especially true for AI companies that can leverage cloud computing and remote workforces.

The rise of the digital economy, characterized by heavy reliance on intangible assets, data, and automation, further complicates the issue. Current Indian tax laws lack specific rules regarding intangibles, particularly in the context of non-residents conducting business in India through digital means. This gap allows multinational corporations to exploit loopholes and shift profits to lower-tax jurisdictions.

India has attempted to address these challenges through measures like the Equalisation Levy, which taxes online advertising and e-commerce services provided by foreign companies. The levy was initially set at 6% on payments made for online ads and later expanded to include a 2% tax on e-commerce companies earning revenue from Indian users, regardless of where the transaction occurs. Another significant step was the introduction of the concept of Significant Economic Presence (SEP), which allows India to tax income based on economic activity and user base, even without a physical presence. Furthermore, Section 194-O requires e-commerce platforms to deduct 1% TDS on payments made to sellers, improving tax compliance in the digital space.

However, these measures have limitations. The Equalisation Levy, while generating revenue, only covers a portion of the digital economy. The SEP concept, though a radical divergence from traditional tax principles, faces challenges in its implementation and alignment with international standards. Moreover, these policies can increase operational complexity and compliance burdens for businesses, potentially impacting the profitability of companies operating in India.

One of the significant challenges is offshore trading. Estimates indicate that a substantial amount of Virtual Digital Assets (VDAs) are traded by Indians on non-compliant platforms, leading to significant losses in uncollected tax revenue. The government has levied a flat tax rate of 30% (plus applicable surcharge and cess) on income from VDA transfer and also levies 1% TDS on every crypto transaction. The tax department is actively probing tax evasion and money laundering linked to cryptocurrency investments, specifically targeting individuals and entities who have not disclosed Virtual Digital Asset (VDA) income in their tax returns.

To combat tax evasion, the income tax department is using data analytics to identify individuals and entities engaged in VDA transactions who have not complied with the Income-tax Act, 1961. The department is verifying ITRs filed by taxpayers with TDS returns filed by Virtual Asset Service Providers (VASPs) and has also launched a "NUDGE" campaign to encourage taxpayers to review and update their income tax returns.

Looking ahead, India is actively participating in international efforts to develop a new framework for taxing digital services. However, there are concerns that proposed multilateral conventions may not adequately protect India's interests and could restrict its sovereign power to legislate on tax law. The adoption, on a global basis, of an acceptable method of allocating taxing rights among various jurisdictions involved in a digital transaction remains an important task.