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Beware The ‘Force Of Attraction’

The author argues that non-residents dread the ‘Force of Attraction’ rule in Double Taxation Avoidance Agreements because it permits the taxation of income arising outside the Contracting State. The ‘Force of Attraction’ rule can also create an anomalous situation where an assessee may be better off under the domestic law than under the tax-treaty law, says the author

The recent judgement of the Tribunal in ITO vs. Linklaters LLP has put the spotlight on the dreaded “Force of Attraction” principle.

In an earlier judgement in DCIT vs. Roxon OY 106 ITD 489 (Mum), the Tribunal explained that the basic philosophy underlying the ‘Force of Attraction’ rule is that when an enterprise sets up a PE 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 through the PE or not. Therefore, under the ‘Force of Attraction’ rule, the mere existence of a PE in another country leads all profits which can be said to be derived from that another country being taxable in that another country.


A classic example of the ‘Force of Attraction’ rule is Article III of the UK-USA Income-tax Convention, 1945 which read as follows:

“(1) A UK enterprise shall not be subject to US tax in respect of its industrial or commercial profits unless it is engaged in trade or business in the United States through a PE situated therein. If it is so engaged, United States tax may be imposed upon the entire income of such enterprise from sources within the United States…”

As is evident from the above, if an enterprise of a contracting country had a PE in the other country, it was taxable not only in respect of the profits attributable to the PE, but in respect of the entire profits arising from sources in that country.


The “pure” ‘Force of Attraction’ rule which taxed income from an activity that was totally unrelated to the PE was unpopular amongst developed and developing nations.

Klaus Vogel explained his preference for a system which did not adopt the ‘Force of Attraction’ rule in the following words (3rd Edition, Vol I, page 410):

“This 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 organizational structure and avoids restricting entrepreneurial freedom of disposition through fictitiously allocating profits by way of generalizing standards. While OECD committee on fiscal affairs recognized that such extensive freedom of entrepreneurial disposition might also involve the risk of being abused, it thought that this risk should not be given undue weight and that much more importance should be attached to ensuring, both for tax purposes and otherwise, that international business contacts can be shaped according to commercial requirement.”

Given the dislike in the developed as well as the developing world for the pure ‘Force of Attraction’ rule, a modified or diluted form of the ‘Force of Attraction’ rule was adopted in 1979 in the UN Model Double Taxation Convention. Article 7 of the said Model Convention which provides for the taxation of “Business Profits” reads as follows:

“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 PE 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 PE;

(b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that PE; or

(c) other business activities carried on in that other State of the same or similar kind as those effected through that PE.”

Clauses (b) & (c) incorporate the ‘Force of Attraction’ principle. They are conspicuous by their absence in the OECD Model Double Taxation Convention.

The raison-d-etre of the modified ‘Force of Attraction’ principle is best understood from the Commentary on UN Model Convention which states thus (paragraph 46):

“This para reproduces art. 7, para 1, of OECD Model Convention, with the addition of the provisions contained in cls. (b) and (c). In the discussion preceding the adoption by the Group of Experts of this para, several members from developing countries expressed support for the “force of attraction” rule, although they would limit the application of that rule to business profits covered by art. 7 of the OECD Model Convention and not extend it to income from capital (dividends, interest and royalties) covered by other treaty provisions. The members supporting the application of the “force of attraction” rule also indicated that neither sales through independent commission agents nor purchase activities would become taxable to the principal under that rule.

Some members from developed countries pointed out that the “force of attraction” rule had been found unsatisfactory and abandoned in recent tax treaties concluded by them because of the undesirability of taxing income from an activity that was totally unrelated to the establishment and that was in itself not extensive enough to constitute a PE. They also stressed the uncertainty that such an approach would create for taxpayers. Members from developing countries pointed out that the proposed “force of attraction” approach did remove some administrative problems in that it made it unnecessary to determine whether particular activities were or were not related to the PE or the income involved attributable to it. That was the case especially with respect to transactions conducted directly by the home office within the country, but similar in nature to those conducted by the PE. However, after discussion, it was proposed that the “force of attraction” rule, should be limited so that it would apply to sales of goods or merchandise and other business activities in the following manner: if an enterprise has a PE in the other Contracting State for the purpose of selling goods or merchandise, sales of the same or a similar kind may be taxed in that State even if they are not conducted through the PE; a similar rule will apply if the PE is used for other business activities and the same or similar activities are performed without any connection with the PE.”

The consequence is that Article 7(1) of the UN Model is much wider in scope as compared to the corresponding article in the OECD Model. The UN Model does not restrict the attributable profits to those arising from the PE’s own activities but also includes profits from direct transactions effected by the head office in the other Contracting State. Of course, not all profits arising to the head office are assessable because the principle is restricted to transactions which are of the same or similar kind as those effected through the PE.

This restriction came to the rescue of the assessee in DCIT vs. Roxon OY 106 ITD 489 (Mum).

The assessee, a Finnish company, entered into a contract to “design, manufacture, deliver, erect, test and commission certain bulk handling facility at the Nava Sheva Port Trust (NSPT), and to impart training to the NSPT”. There was no dispute that the assessee had a PE in India. The question arose whether the sum of Rs. 25.61 crores received by the assessee for making supplies outside India was also aggregating to Rs. 25,61,29,696. The AO held that as the assessee was required to supply the equipment and install it in India as part of a turnkey contract, the supply was linked to the installation and chargeable to tax under the ‘Force of Attraction’ principle.

The Tribunal took a different view. The Tribunal pointed out that under Article 7(1) of the India – Finnish DTAA, if an enterprise of a Contracting State carries on business in the other Contracting State through a PE, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to (a) that PE; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that PE; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that PE.

The Tribunal considered in detail each one of the three segments of Article 7(1). As regards Article 7(1)(a) (“profits attributable to the PE”), the Tribunal gave three reasons why profits from supplies did not fall within its ambit. The first is because the PE comes into existence after the transaction giving rise to supplies materialized. If the installation or construction PE came into existence after the supplies were made, how could the profits on supply be said to be attributable to such PE the Tribunal asked. The second reason given by the Tribunal was that under Article 7(2) one has to compute the profits attributable to a PE on an “arms’ length” basis i.e. “the profits which it 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 PE”. The result was that the PE had to be deemed to have purchased the supplies at their market value and to have sold it at their market value to the customer. The Tribunal succinctly put it “The hypothetical sale to and the hypothetical sale by the PE being at the same price, there cannot be any profits on account of the transaction” and added “No such taxability can, therefore, arise in the case before us because the sales are directly billed to the Indian customer and also because there is no suggestion that the prices at which billing is done includes any element for services rendered by the PE”. The third reason was that “in the case of a turnkey contract, which includes offshore supply of machineries, etc. the profits which are to be taxed will only be the profits which can be attributed to the work effectively carried out by the PE”. The Tribunal referred to the protocol clauses in other DTAAs which provide for this and held that to be clarificatory.

As regards Article 7(1)(b) (“sales in that other State of goods or merchandise of the same or similar kind as those sold through that PE”) the Tribunal made two important points. It pointed out that under Article 7(1)(b) direct sales by an enterprise of one Contracting State to customers in the other Contracting State were covered by the force of attraction rule only when that enterprise has a PE in the other State (i) for the purpose of selling goods or merchandise and (ii) the direct sales by the enterprise is of the same or similar kind of goods or merchandise. It held that an installation PE would be excluded ab inito because it was not set up “for the purpose of selling goods or merchandise”. The supplies, if any, by the PE were “incidental” to the main activity of installation and commissioning of the project. It also pointed out that the words ‘same’ and ‘similar’ were restrictive and the result was that not all profits of the assessee were taxable in India but only so much of profits as had an economic nexus with the PE in India were taxable in India.

As regards Article 7(1)(c) (“other business activities carried on in that other State of the same or similar kind as those effected through that PE”), it was evident that the same was not applicable, the controversy being confined to taxability of profits from sale of equipment.

The Tribunal made an important point on the conceptual framework of the force of attraction rule. It pointed out it was the act of setting up the PE that triggered the rule and that, therefore, unless the PE was set up, the question of taxability – whether of direct transactions or of transactions routed through the PE – did not arise. It noted that in the case of a turnkey project the PE was set up at the installation stage while the entire turnkey project including sale of equipment embedded in the turnkey project was essentially finalized much before the installation stage begins. If so, the setting up of the PE was at a stage subsequent to the conclusion of contract and it was as a result of the sale of equipment that the installation PE came into existence. By this logic, it was held that the setting up of the PE did not result in earlier direct transactions being held as taxable in the source country.

In SNC-Lavalin / Acres Inc vs. ACIT 110 TTJ (Del) 13 the ‘Force of Attraction’ rule was held applicable to services as well. There, the assessee entered into a contract with NHPC for execution of the Chamera project. The assessee claimed that it had performed work relating to the project even prior to setting up of the PE in India but that the bills for that work were raised after the PE was established. It was claimed that the profit not attributable to the PE had to be excluded. However, the Tribunal held that Article 7 of the India-Canada DTAA incorporated the restricted ‘Force of Attraction’ principle and that the reference to sale of goods or merchandise in Article 7(1)(b) included the rendering of services. It was held that as there was a composite contract for rendering services in connection with setting up of the Hydroelectric project, the work carried out outside India was deemed to have arisen in India as it was the same as the services rendered by the PE in India. The fact that the invoices for the said off-shore work was raised through the PE in India and accounted for in the books of project office set up in India sealed the fate of the assessee.

In Sumitomo Corporation vs. DCIT 114 ITD 61 (Del), the assessee, a Japanese company, secured several contracts for supply of various equipments to Maruti Udyog Ltd for its car project and also undertook to supervise the installation of the equipments. The contracts were independent and not commercially a coherent whole. The period of supervision in the case of individual contracts did not exceed 180 days. The department argued that there was a supervisory PE on the basis that the period of all contracts had to be aggregated. It was also argued that as the supervisory services were “effectively connected” with the PE, Article 12(5) applied and the fees thereof had to be assessed as business profits and not as fees for technical services.

On the applicability of Article 12(5), the Tribunal held that as the State where the PE was located was entitled to tax only those profits which were economically attributable to the PE and arose as a result of activities of PE, Article 12(5) adopted the “No Force of Attraction Principle”. It held that Article 12(5) made a distinction between income which was the result of activities of the PE and income which arose by reason of direct dealings by the enterprise from the head office without the aid or assistance of the PE. The term “effectively connected” was held not to be the opposite of “legally connected” but as being “really connected”. It was held that the connection had to be seen not in the form but in real substance.

The argument of the department that there was a supervision PE by aggregating the period spent on different contracts was also repelled with regard to the “Force of Attraction” rule. It was held that as the different contracts were not part of a “coherent whole”, aggregating them would violate the “Force of Attraction” Rule. The Tribunal quoted Klaus Vogel (Vol.1 3rd Edition page 308) where he said “…If, in contrast, all building sites maintained in one State were treated as one single PE, this would in effect be tantamount to applying the force of attraction principle”.

In ITO vs. Linklaters LLP, the question was whether the services rendered by the assessee, a UK law firm, from outside India to Indian clients was assessable to tax in India given that the assessee had a PE. The India-UK DTAA does not have a “Force of Attraction” clause in the usual format but simply provides that if an enterprise of one Contracting State carries on business in the other Contracting State through a PE, “the profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment“.

The Tribunal held that the connotation of the phrase “profits indirectly attributable to permanent establishment” incorporated the force of attraction rule being embedded in Article 7(1). It held that in addition to taxability of income in respect of services rendered by the PE in India, any income in respect of the services rendered to an Indian project, which is similar to the services rendered by the PE is also to be taxed in India in the hands of the assessee – irrespective of the fact whether such services are rendered through the PE, or directly by the general enterprise. It observed that there could not be any professional services rendered in India which are not, at least indirectly, attributable to carrying out professional work in India and held that this indirect attribution, in view of the specific provisions of the India-UK tax treaty, was enough to bring the income from such services within the ambit of taxability in India. The Tribunal emphasized that the twin conditions that had to be satisfied for taxability of related profits are (i) the services should be similar or relatable to the services rendered by the PE in India; and (ii) the services should be ‘directly or indirectly attributable to the Indian PE’ i.e. rendered to a project or client in India. The effect of the judgement is that the entire profits relating to services rendered by the assessee, whether rendered in India or outside India, in respect of Indian projects became taxable in India.

The irony of the ‘Force of Attraction’ rule is that there may be situations where owing to the rule, an assessee may be better off under the Act than he is under the DTAA. In other words, the DTAA, intended to be beneficial to an assessee, may actually prove detrimental. For instance, if a non-resident sold goods from the HO outside India to a customer in India and there was no business connection u/s 9(1)(i), the profits from the off-shore supply would not be assessable to tax in India. The fact that a non-resident had a PE in India which sold the same or similar goods would not make a difference to the matter so long as the PE played no part in the off-shore sale. However, under the ‘Force of Attraction’ rule, such profits would be assessable to tax in India.

CA Vellalapatti Swaminathan Iyer
Hyderabad

3 comments on “Beware The ‘Force Of Attraction’
  1. k Meenatchi Sundaram says:

    Good articles with precise focus on the Topic.

  2. Surendra says:

    judgement would be different if meaning of ‘indirectly’ is considered.

  3. Surendra says:

    wish tribunal considered meaning of ‘indirectly’ in UK treaty

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