The general principle governing taxing of business profits between two states revolves around the existence of Permanent Establishment (PE) i.e. unless there is a PE in the other state, the other state loses its taxing rights. What constitutes a PE has been a subject matter of massive litigation and deliberation not only in India but across the world.

Against this backdrop, Mr. Kanishka Dutta (Chartered Accountant) elaborates on the ‘Force of Attraction’ (FOA) rule, while also delving into what more needs to be done once it is established that a PE exists and what force it possesses. The author inter alia observes that the Courts while limiting the applicability of the FOA have laid down certain principles/guidelines which need to be tested before concluding that no profits will be attributed to Indian PE circuitously, and even those guidelines are diverse for different DTAAs. Considering this, the author concludes by remarking that “Understanding and navigating through DTAAs has always been difficult but with additional uncertainties and challenges imposed by rules such as FOA, it has become even more important to carefully consider these issues.”

“PE & the Force It Attracts…”

1. Introduction

The general principle governing taxing of business profits between two states revolves around the existence of Permanent Establishment (“PE”) i.e. unless there is a PE in other state, the other state loses its taxing rights. What constitutes a PE has been a subject matter of massive litigation and deliberation not only in India but across the world. The term (PE) has been used in tax treaties since 1920’s and with time new variants of PE have evolved - Service PE, Agency PE, Installation PE, E-Commerce PE to name a few. Later in this article we shall delve into what more needs to be done once it is established that a PE exists and what force does it possesses.

2. Tax Withholding on foreign payments

Any person (resident or non-resident), while making a payment to non-resident is required to withhold tax as per the prevalent rates in force, in case the payment represents income of the non-resident chargeable to tax in India. Additionally, wherever a tax treaty exists and provisions in the treaty are more beneficial, the income as well as the tax rate would be determined accordingly. The non-resident is not entitled to treaty benefits unless a Tax Residency Certificate (“TRC”) is obtained and Form no.10F is filed electronically by such non-resident.

From the perspective of the payer who is an Indian tax resident, another essential document that is additionally asked for, once the TRC and Electronic Form 10F are in place, is ‘Tax/No PE declaration’. It is common to see declarations that explicitly say that we have a PE in India, but this PE is not related to the services rendered /goods supplied to Indian Customer. Often such declarations are accepted without any objection and no tax withheld. But whether such a declaration serves the purpose is a question that few pay attention to. Discussion in the following paragraphs surrounds the force that a PE may attract, and the Indian payer may be ignoring it unconsciously.

3. What is the Force of Attraction Rule?

The UN Model Convention contains a rule - that the state in which PE is present is entitled to tax the profits not only of that PE but profit from sale in the PE state of similar kind business activities, even if not undertaken by the PE. This rule of connecting the non-PE income to the PE is known as the Force of Attraction (FOA) rule. The FOA rule is not straight forward and is challenging to clarify or state in generic terms. Correct interpretation of the FOA rule requires navigating through multiple layers of complex factual and legal analysis to determine the exact scope. The way in which the FOA rule will or will not apply depends on the text mentioned in the treaty between the two states (countries).

4. Variants of Force of Attraction Rule?

5. Force of Attraction Rule as appearing in various treaties

Let’s try and understand the rule in further details with the help of few Double Taxation Avoidance Agreement’s (“DTAA”) and the judicial precedents available.

A. India – Saudi Arabia DTAA

ARTICLE 7

BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

(Rest of the Clauses are not reproduced here)

Under this treaty, only profits directly attributable to the PE may be taxed in India, which encompasses the income derived from the sole activity of the PE in India, having no FOA rule.

B. India – Japan DTAA

Another variant of FOA rule can be traced to the India-Japan treaty which reads as follows:-

ARTICLE 7

BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in that other Contracting State but only so much of them as is directly or indirectly attributable to that permanent establishment

(Rest of the Clauses are not reproduced here)

The relevant extracts of the Protocol of DTAA between India and Japan is also reproduced below.

6. With reference to paragraph 1 of article 7 of the Convention, it is understood thatby using the term 'directly or indirectly attributable to the permanent establishment', profits arising from transactions in which the permanent establishment has been involved shall be regarded as attributable to the permanent establishment to the extent appropriate to the part played by the permanent establishment in those transactions. It is also understood that profits shall be regarded as attributable to the permanent establishment to the above-mentioned extent, even when the contract or order relating to the sale or provision of goods or services in question is made or placed directly with the overseas head office of the enterprise rather than with the permanent establishment.

The question on applicability of FOA under India – Japan treaty arose before the apex court in case of Ishikawajima Harima Heavy Industries Ltd. (SC) 288 ITR 408. The Hon’ble Supreme Court referred to paragraph 6 of the Protocol to the India - Japan DTAA and held as under:-

Paragraph 6 of the Protocol to the DTAA is not applicable, because, for the profits to be "attributable directly or indirectly", the permanent establishment must be involved in the activity giving rise to the profits.

Thus, full FOA was not triggered due to the phrases appearing in the protocol to the treaty, (refer text of the protocol presented in bold above).

C. India – UK DTAA

Let’s now see another variant of FOA rule that can be located in India-UK treaty.

ARTICLE 7

BUSINESS PROFITS

3.Where a permanent establishment takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, notwithstanding that other parts of the enterprise have also participated in those transactions, that proportion of profits of the enterprise arising out of those contracts which the contribution of the permanent establishment to those transactions bears to that of the enterprise as a whole shall be treated for the purpose of paragraph 1 of this Article as being the profitsindirectly attributable to that permanent establishment

(Rest of the Clauses are not reproduced here)

The relevant extracts of the Protocol of DTAA between India and UK is also reproduced below.

b) that, in applying paragraph 3 of Article 7, for the purpose of determining whether a permanent establishment has taken an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, the Contracting States shall take into consideration all relevant circumstances and, in particular, the fact that a contract or order relating to the purchase or provision of goods or services was negotiated or placed with the head office of the enterprise, rather than with the permanent establishment, shall not preclude them from determining that the permanent establishment did take an active part in negotiating, concluding or fulfilling that contract;

Special Bench of Mumbai Tribunal in the case of ASSISTANT DIRECTOR OF INCOME-TAX VERSUS CLIFFORD CHANCE [TS-6863-ITAT-2013(Mumbai)-O], also interpreted the term "indirectly attributable to Permanent Establishment". The issue was whether as per Article 7(1) of the India-UK DTAA - it is correct in law to hold that the consideration attributable to the services rendered in the State of residence is taxable in the source State"?

The special bench was of the view that where a PE takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, notwithstanding that other parts of the enterprise have also participated in those transactions, profits of the enterprise arising out of those contracts shall be apportioned in the ratio of the contribution of the PE to those transactions and the contribution of the enterprise as a whole and such profits as apportioned to the contribution of the PE shall be treated for the purposes of Article 7(1) as being the profits indirectly attributable to that PE. Consequently, the profits apportioned to the contribution of other parts of the enterprise to the transactions cannot be treated as profits indirectly attributable to the PE for the purpose of Article 7(1) so as to bring the same to tax in the source country. Thereby limiting the applicability of the FOA rule.

D. India – Germany DTAA

The articulation changes when we see treaty between India and Germany.

Question on applicability of FOA under India – Germany treaty arose before the Hon’ble Income Tax Appellate Tribunal, Delhi Bench in the case of M/s Lahmeyer International [ITA No.4960/Del/2004].

The contention of the assessee was that as per protocol of the treaty, the force of attraction rule in this treaty restricts the application of the rule to a case where the PE is involved in the transaction and the transaction is restored to avoid taxation in the source state; and both these contention needs to be satisfied so as to attract the rule.

The Hon’ble Tribunal observed that for applying force of attraction, there should be:

• Some common link to each of the contracts/projects such as the common expats,
• the common nature of the contract/projects,
• the commonality of the location,
• the common contracting parties etc.

As the same were absent in the present case, the tribunal held that FOA rule does not apply. Thus, the application of the FOA rule was limited.

E. India – Belgium DTAA

Another variant of force of attraction is present in the treaty between India and Belgium.

ARTICLE 7

BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to(a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment.

This treaty also does not embody full force of attraction, as profits other than those arising from what is stated in Article 7(1)(b)/(c) are not to be included. Article 7(1)(b)/(c) extends taxation by the State of the PE, say, India, to direct activities of a Belgian assessee which are not from Indian PE's own activities. Rather, they include those from direct transactions effected by the Belgian Head Office to the extent that such transactions are of the same or similar kind as those effected through the PE in India.

Since this rule does not require all of the profits derived by the Belgian tax resident from sources in India to be attributed to the Indian PE, this arrangement also falls in the category of the limited FOA principle.

It is important to note that Treaty’s with full application of FOA rule are not common nowadays. More and more countries have moved away from it as the same is not deemed ‘equitable’.

6. Conclusion:-

As is evident from the article above, this rule has been expressed differently in different DTAA’s. It can be observed from the judicial precedents mentioned in this article above, that the courts while limiting the applicability of the FOA have laid down certain principles/guidelines which need to be tested before concluding that no profits will be attributed to Indian PE circuitously. And even those guidelines are diverse for different DTAA’s.

Thus, the potential application of the force of attraction rule requires businesses to review their current transactions with foreign suppliers. Application of this rule can result in enhanced tax exposure than generally anticipated. There is a possibility that a portion of the payment made by India Tax Resident that is currently not treated as Income could be recharacterized as Income subject to tax withholding due to the FOA rule. Understanding and navigating through DTAA’s has always been difficult but with additional uncertainties and challenges imposed by rules such as FOA, it has become even more important to carefully consider these issues.