Force of Attraction…. Attracts? 

Force of Attraction Rule (hereinafter called as ‘Rule’) in any DTAA is something which is dreadful for non-residents tax assessees as it allows for the taxation of income outside the Contracting State. The ‘force of attraction’ rule supports the philosophy that when an enterprise sets-up a permanent establishment (‘PE’) in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country can tax all profits that the enterprise derives from that country – whether through the Permanent Establishment (PE) or not. This rule can cause taxability on all profits derived from another country in that another country due to mere existence of PE in that another country.

The Rule can be categorized in following three categories based in extent of coverage of profits subject to chargeability in another country:

  • Pure Attraction – taxing profits/incomes from all transactions whether they are attributable to PE or not or whether they are of the same kind of transactions carried on by the PE or not.
  • Amended Attraction – taxing profits/incomes from direct transactions effected by the non-resident, provided the transactions are of the same or similar kind as that effected through the PE.
  • No Attraction – taxing profits/incomes only to the extent that they are attributable to PE.

The pure attraction rule that taxed income of non-resident by virtue of mere existence of it’s PE in that country, was disliked among developed and developing countries. Given the dislike for the pure attraction rule, a modified or diluted form of the attraction rule was adopted in the UN Model Double Taxation Convention.

The relevant article adopting such amended attraction rule in UN Model Treaty is as follows:

Article 7(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 are attributable to:

  1. that permanent establishment;
  2. sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or
  3. other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment.

In this case clause b & c are the example of amended attraction rule. To the contrary, OECD Model Double Taxation Convention eradicate even the amended attraction rule by eliminating the above said clauses. The similar article in OECD Model Treaty reads as follows:

Article 7(1) – 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 that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State

Some DTAA are straight forward to have force of attraction rule like DTAA between India & USA, its article 7 is similar to UN Model Treaty and hence have amended attraction rule in force. While some DTAA raises a doubt whether the treaty aims to apply attraction rule or not, like DTAA between India & UK. Let’s analysis the position on existence or absence of force of attraction in article 7 of DTAA entered by India with UK. The relevant extract of the article is as follows:

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 enter price may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment.

2. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, the profits which that permanent establishment might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment shall be treated for the purposes of paragraph 1 of this Article as being the profits directly attributable to that permanent establishment.

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 profits indirectly attributable to that permanent establishment.

4. Insofar………

Even though scope of term ‘directly’ or ‘indirectly’ attributable to PE is also clarified by clause 2 & 3 respectively, the matter has been controversial and has been knocking the doors of judiciary all time. There has been a doubt whether connotation of term ‘indirectly attributable to’ used in the tax treaties can be regarded as existence of ‘force of attraction rule’ as defined in UN Model?

Some of the judicial pronouncements concerning this doubt are given below:

Linklaters LLP vs. ITO (ITAT Mumbai)

The assesse was a UK based law firm. It has rendered services to various clients in regards to operations / projects in India. The assessee did have other offices worldwide but did not have any office in India. However, its’ partners and employees used to visit India for rendering such services. The assessee took the view that as it did not have a permanent establishment (PE) or fixed base in India, its income was not assessable to tax under Articles 7 or 15 of the India-UK DTAA. The AO took the view that as the assessee had furnished services in India for more than 90 days, it had a PE under Article 5(2)(k) of the DTAA. On the quantum, he held that the entirety of the invoices raised by the assessee was assessable in India. On appeal, the CIT (A) upheld the existence of the PE though he held that only the income attributable to the PE was assessable to tax. On appeal to the Tribunal, HELD:

The extension of taxability of profits of PE by including profits directly or indirectly attributable, is akin to the provisions of Article 7(1)(b) and 7(1)(c) of the UN Model Convention which provides that in addition to the “profits attributable to the permanent establishment” the taxability of PE profits will also extend to “(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”. In our considered view, the connotations of “profits indirectly attributable to permanent establishment” will extend to these two categories. These categories clearly incorporates a force of attraction rule. The basic philosophy underlying the force of attraction rule is that when an enterprise sets up a permanent establishment in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country can properly tax all profits that the enterprise derives from that country ‐ whether the transactions are routed and performed through the PE or not.

The main basis of above decision was as under:

“The extension of taxability of profits of PE by including profits directly or indirectly attributable, is akin to the provisions of Article 7(1)(b) and 7(1)(c) of the UN Model Convention which provides that in addition to the “profits attributable to the permanent establishment” the taxability of PE profits will also extend to “(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”. In our considered view, the connotations of “profits indirectly attributable to permanent establishment” will extend to these two categories. These categories clearly incorporates a force of attraction rule. The basic philosophy underlying the force of attraction rule is that when an enterprise sets up a permanent establishment in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country can properly tax all profits that the enterprise derives from that country ‐ whether the transactions are routed and performed through the PE or not.”

ADIT vs. M/s Clifford Chance (ITAT Mumbai Special Bench)

The assessee, a U.K. partnership firm of Solicitors, provided legal consultancy services in connection with different projects in India and claimed that the taxability of the income arising there from had to be processed under Article 15 (“independent professional services“) of the India-UK DTAA. The AO rejected the claim regarding applicability of Article 15 and held that as the assessee had a PE in India as per Article 5 and as the services had been rendered in India, the entire income was chargeable to tax in India under Article 7. In AY 1996-97, the Tribunal (82 ITD 106 (Mum)) accepted the claim of the assessee that if the aggregate period of stay of the employees/ partners did not exceed 90 days, the income was not taxable under Article 15 of the DTAA and if it exceeded that period, only the Indian activity was taxable u/s 9(i). The said verdict was affirmed by the Bombay High Court in 176 Taxman 485. Later, another Bench in Linklaters LLP vs. ITO 40 SOT 51 (Mum) held that as the aforesaid verdicts of the Tribunal & High Court in Clifford Chance turned on the basis that fees for technical services rendered outside India were not chargeable to tax u/s 9(1)(vii) and that they were not good law in view of the retrospective amendment to s. 9(1) by the Finance Act, 2010 w.e.f. 1.6.1976 which provided that “fees for technical services” would be taxable in India even if they were rendered outside India. InLinklaters LLP it was also held that the expression “directly or indirectly attributable” in Article 7(1) triggered the “force of attraction” rule and that the entire earnings relatable to the projects in India would be chargeable to tax in India. As there was doubt as to the correctness of the view in Linklaters, the Special Bench was constituted to consider two issues (i) whether the verdict of the High Court in Clifford Chance was good law after the retrospective amendment to s. 9 & (ii) whether the expression “directly or indirectly attributable to the PE” in Article 7(1) meant that the consideration attributable to the services rendered in the State of residence is taxable in the source State. HELD by the Special Bench:

(i) The view taken by the Tribunal and the High Court in Clifford Chance was that if Article 15 of the India-UK Treaty is not applicable because the stay of the partner exceeded 90 days, then the taxability of the income would be determined by s. 9(1)(i) of the Act. It was held that for determination of income u/s 9(1)(i), the territorial nexus doctrine plays an important part and if the income arises out of operations in more than one jurisdiction, it would not be correct to contend that the entire income accrues or arises in each of the jurisdictions. The High Court applied the law laid down by the Supreme Court in the context of s. 9(1)(i) that if all the operations are not carried out in the taxable territories, the profits and gains of business deemed to accrue in India through and from business connection in India shall be only such profits and gains as are reasonably attributable to the operations carried out in the taxable territories. Accordingly, the view expressed in Linklaters LLP that the judgment of the Bombay High Court is based on the premise of s. 9(1)(vii) and that the said premise no longer holds good in view of the retrospective amendment is not correct. The law laid down by the High Court continues to be good law;

(ii) As regards the rule of “force of attraction“, Article 7(1) provides that the profits of the UK enterprise “directly or indirectly attributable to the PE” may be assessed in India. The connotation of what is “directly attributable to the PE” is set out in Article 7(2) while the connotation of what is “indirectly attributable to the PE” is set out in Article 7(3). When the connotation of “profits indirectly attributable” to the PE is defined specifically in Article 7(3), one cannot refer to Article 7(1) of the UN Model Convention which is materially different from Article 7(1) & 7(3) of the India-UK DTAA. The reliance placed in Linklater on the UN Model Convention to come to the conclusion that the connotation of “profits indirectly attributable to PE” in Article 7(1) incorporates the “force of attraction” rule thereby bringing an enterprise having a PE in another country within the fiscal jurisdiction of that another country to such a degree that such another country can properly tax all profits that the enterprise derives from that country – whether the transactions are routed and performed through their PE or not – is clearly misplaced and not acceptable.

Our view:

The comparison of Article 7 of India-UK treaty with Article 7 or UN Model Treaty by Mumbai bench of Tribunal in the case of Linklaters (supra) wasn’t reasonable. When the language used in tax treaty wasn’t ambiguous, there was no need to take meaning of this term from the UN Model convention. The meaning of directly and indirectly attributable is defined in the article itself so taking reference from other source for the meaning of the same was not called for. The verdict of Mumbai Tribunal in case of Clifford Chance (supra) would come to rescue of non-resident taxpayers, as it resolved the controversy to some extent regarding the applicability of ‘force of attraction’ principle, as it provided that the connotation of term ‘indirectly attributable to’ used in the Indian tax treaties couldn’t be regarded as existence of ‘force of attraction principle’.

Disclaimer: The write-up has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this write-up without obtaining specific professional advice. Author accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this write-up or for any decision based on it.

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