Countries have felt a need to have laws in place to share tax revenues among them. This has led them to enter into double taxation avoidance agreements (tax treaties) with the primary objective of avoidance of double taxation on the same income. Tax treaties say that business profits of an enterprise resident of one state would be taxable in the other state only if there exists a Permanent Establishment (PE). Some treaties include ?force of attraction rule?, which means that when the head office provides goods or services directly to the customers in the country of PE and the PE is also involved in the same line of activity, the profits earned by the head office directly shall be taxed as a profits attributable to PE.
The tax treaties are by and large based on various Model Conventions, namely, UN, OECD or US. These Model Conventions differ with respect to applicability of force of attraction rule. Some provide for taxing profits/ income only to the extent that they are attributable to the PE. Some provide for taxing income/profits from direct transactions effected by the non-resident, provided the transactions are of the same or similar kind as that effected through the PE. Some provide for taxing profits/income 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. The third category is referred to as ?full force of attraction? rule. The second category is known as ?limited force of attraction? rule. The first category is known as ?no force of attraction? rule.
It is interesting to note that some treaties do not contain ?force of attraction rule? whereas some treaties contain either limited or full force of attraction rule. This rule generally does not feature in the tax treaties signed in the UK. Whereas, in tax treaties signed by the USA with various countries this rule applies only if it is established that the transactions were structured in a manner intended to avoid tax in the country of PE. India?s treaties with Indonesia and New Zealand do not contain a clause dealing with ?other activities?. Whereas, certain Indian treaties specifically provide for an exemption clause from this rule provided the enterprise proves that the sale or activity could not have been reasonably under taken by or are not attributable to the PE.
This rule has not been debated much; however, lately some of the Tribunal benches have dealt with this rule. Some of the key decisions are discussed below:
The Tribunal observed that Article 7(1) of the India-Canada tax treaty was based on UN Model Convention and not on OECD Model Convention. The profits that it allows to be attributed to the PE are not strictly limited to those resulting from the PE?s own activities. Rather, they include those from direct transactions effected by the head office, though in the State of the PE to the extent that such transactions are of the same or similar kind as those effected through the PE. Accordingly, the Tribunal held that the whole of the profit in respect of this project was taxable in India.
The Delhi Tribunal observed that Article 12(5) of the Indo-Japan tax treaty is on the lines of the OECD Model Convention. The clause allows the state where PE is located to tax only those profits, which are economically attributable to the PE. It makes a distinction between those incomes, which are the result of activities of PE and the income, which arises by reason of direct dealings by the head office without the aid or assistance of the PE. The state where the PE is located can tax the income only, if a connection exists, between the income and the PE. Thus, article 12(5) of the Indo-Japan tax treaty adopts ?no force of attraction rule?.
The Tribunal observed that Article 7 of India-Finland tax treaty was based on UN Model Convention and thus had a restrictive scope of the force of attraction rule. Further it was observed that that it only extends the scope of transactions, which are to be taxed in the other country and not the nature of transactions. Accordingly, it was held that the Installation PE was not covered by the attraction rule to tax profits from sale of goods. However, the main reasoning of arriving at the decision was that the sale of equipment was concluded much before the installation PE came into existence.
The force of attraction rule leads to uncertainties in taxation of PE. One has to assume how much profits would be taxed on the basis of this rule. Further, what is covered under the rule is ?same or similar? activities. Interpretation of these words would involve subjectivity and multiple interpretations.
The force of attraction rule should be interpreted by giving due respect to the principles of international taxation.
Klaus Vogel, in his book on Double Taxation Conventions, has mentioned that the distribution of taxation according to the economic connection of the profits concerned is preferable to the principle of ?attraction force? because the former method proceeds from the enterprise?s individual organisational structure and avoids restricting entrepreneurial freedom of disposition through fictitiously allocating profits by way of generalising standards.
The writer is with BSR & Co