Countries enter into double taxation avoidance agreements (tax treaties) with the primary objective of avoiding dual tax on the same income. Tax treaties state that the business profits of an enterprise resident in one State would be taxable in the other only if a permanent establishment (PE) exists.

Some treaties include the ‘force of attraction rule’ — when the head office provides goods or services directly to customers in the country of permanent establishment, and the PE is also involved in the same line of activity, the profits earned by the head office directly shall be taxed as profits attributable to the PE. Interestingly, some treaties do not include this rule, while some contain either limited or full force of attraction rule.

The concept of PE vis-à-vis the force of attraction rule and the issues concerning the attribution of profits, as contained in the Organisation for Economic Co-operation and Development (OECD) model tax convention, have been debated extensively. With increasing globalisation and fiscal pressures in most countries, attribution of profits to PEs has attracted the attention of revenue authorities around the world, including in India.

In the case of Roxon OY [2007], the Mumbai Bench of the Income-tax Appellate Tribunal held that the scope of Article 7 extends only to activities carried out by a foreign enterprise in a source State — which are similar to those carried on through its PE in the source State — and not to all the activities of such an enterprise.

Further, in the case of Linklaters & Paines, the Mumbai Tribunal held that the words ‘profits indirectly attributable to the PE’ incorporates a force of attraction principle in the India-UK tax treaty. The basic philosophy underlying the force of attraction rule is that when an enterprise sets up a PE in another country, that country can tax all profits that the enterprise derives there, whether or not the transactions are routed and performed through the PE. Thus, entire profits related to services rendered by the taxpayer, whether rendered in India or outside, with respect to Indian projects is taxable in India.

On the other hand, the special Bench of the Mumbai Tribunal recently delivered a decision in the case of Clifford Chance, where the taxpayer is a firm of solicitors with its principal office in the UK, and it did not have an office or fixed base in India. The taxpayer had rendered legal consultancy services for various projects in India. On the basis of some part of the work performed by the taxpayer in India, income attributable to the services rendered in India was offered to tax here.

The Special Bench held that the provisions under the United Nations Model Conventions are different from the provisions of Article 7(1) read with Article 7(3) of the India-UK tax treaty. Article 7(3) clearly explains the scope and ambit of the profits indirectly attributable to the PE. Accordingly, the force of attraction principle would not be applicable to the India-UK tax treaty.

It is interesting to note that India recently amended its tax treaty with Norway, wherein the force of attraction rule has been removed. Similarly, India has also amended its tax treaty with Australia and signed a new protocol that seeks to remove the force of attraction rule and which is yet to come into force. The decision in the case of Clifford Chance, as well as the recent trend of removing the force of attraction rule from tax treaties will provide relief to foreign companies carrying on business through PEs in India.Punit Shah is Co-Head of Tax, and Mrugen Trivedi is Technical Director, KPMG in India

Punit Shah is Co-Head of Tax, and Mrugen Trivedi is Technical Director, KPMG in India

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