The Force of Attraction principle

In an earlier post, Ankit had discussed on the findings of the ITAT in the Linklaters judgement on the application of the principle of territorial nexus and subsequently on extension of Treaty benefits to fiscally transparent entities. A third dimension to the judgement discusses the computation of profits attributable to a Permanent Establishment in consonance with the Force of attraction principle. The objective of this post is to understand the nature and recognition of this principle.

The underlying principle of the Force of Attraction rule envisages that when an entity has a Permanent establishment in another country, the host country will have the right to tax the PE for all its activities which take place either inside its territory or in other territories in so far as it is either directly or indirectly attributable to the P.E. In other words it expands the Source rule for taxability. Illustration- a Company X has a P.E in India which is involved with construction work. It undertakes a contract with a party outside India for undertaking a construction business. The profit which may generate from the contract is liable to be taxed in India on the basis of this principle.

Pertinent to note is the fact that this principle is amorphous in its applicability in the International platform. In this regard attention needs to be paid to two key points of debate. Firstly, most developed countries subscribe to the view that the principle is absurd as it unnecessarily expands the scope of taxation under the Source rule whereby it gives the right of taxation to a country which is not concerned with the activity undertaken by the P.E. The other point of contention being that there still exists a lacuna in so far as the existence of the P.E. is concerned to which the activity can be extended to. Thus most recent tax treaties have abandoned the use of this principle. On the flipside, the basic contention for upholding the principle is that the country in which the P.E is located provides an opportunity to the P.E to undertake transactions thereby creating a territorial nexus between the activities of the P.E and income generated. The principle has a varied applicability In the U.N Model Convention and the OECD Model Report. The OECD does away completely with the application of this principle whereas the U.N Model Convention allows for restrictive use of the principle. The Restrictive use of this principle under the Model Convention states that the rule will apply only to business profits and not to income from capital. To put it simply according to the U.N Model Convention( Article 7(b) and (c) ) the source country will have the right to tax the P.E. in so far as sales are made of goods or merchandise of the same or the similar kind as those sold through the P.E, irrespective of it being effected by the P.E. These will be deemed to have an economic nexus to the source country thereby making it taxable by the source country. A similar approach will be undertaken if the P.E is involved in other business activities and the same or similar activities are performed without any connection to the P.E.

The use of the principle has been undergoing a paradigm shift globally. However it is interesting to note that India has adhered to the use of the Force of Attraction rule in both its pure application as well as in its restrictive application. In the Roxon case, the AAR had the opportunity to discuss at length the application of the Force of Attraction rule in India. In a nutshell, it held that the basis of this principle was that the as long as a Permanent Establishment was not set-up in the source state, no right of taxation could be attributed to the same. Further the scope of the Indo- Finnish treaty is restricted to the sale of ‘same or similar’ goods. Only those sales of goods which are same or similar to the business of sale of goods by the P.E in India will be taxable in India. It can therefore be concluded that the treaty uses the restrictive rule of Force of Attraction. Concluding, only those business profits which have an economic nexus to the P.E in India will be taxable in India.

In the Linklaters judgment, the Force of attraction rule was strictly adhered to. Article 7 of the Indo-U.K tax treaty explicitly states that only profits of the enterprise which are directly or indirectly attributable to the P.E will be taxed by the source state. Therefore it can be inferred that the Indo-U.K treaty embodies the Force of Attraction principle and does not limit its applicability to the restrictive use of the aforementioned principle. In effect all the profits which are generated by the P.E irrespective of the service being rendered or utilised in another country, India being the host country will have a right to tax the P.E.

In today’s globalised economy, tax treaties do not subscribe to the principle of the Force of Attraction in its pure form as it has become increasingly difficult to justify its application. It would only result in unfair tax advantages to the source country which would thereby result in lowering investment for such countries which subscribe to an unrestricted use of this principle. In effect this principle tries to expand the principle of territorial nexus. Further there seems to be an inconsistency in its application in so far as its incorporation in tax treaties is concerned. Although countries have started adopting the restrictive use of this principle there still exists no threshold for determining under which circumstances can this principle be applied in its pure form or its restrictive form. This has led to countries applying the principle without any uniformity in different treaties. Ultimately what needs to be determined is whether the application of this principle in its pure form is justified and if not then whether there should be a uniform application of the two forms of this principle as adopted by a country.