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.

Linklaters: Fiscally Transparent Entities

In my previous post I had discussed one of the findings in Linklaters (one relating to S. 9 and territorial nexus). In this post I shall discuss the finding in linklaters with regard to treaty benefits extended to fiscally transparent entities. The case is extremely important in this respect due to the absence of any specific adjudication on this point in India and very few in other jurisdictions.


The fundamental question before the tribunal was whether the partnership firm (linklaters LLP) which is treated as a fiscally transparent entity in the UK but is taxable as a separate entity in India under the Income Tax Act, 1961 eligible for the India UK treaty benefits. Before discussing the findings of the tribunal it is important to briefly elucidate on why this issue had arisen at the first place. Art. 1(1) of the India UK treaty stipulates that the convention shall apply to “persons who are resident of one or both the contracting states”. Further, Art 3(2) stipulates that a “partnership firm” which is a taxable unit in India shall be “treated as a person” for the purposes of the India UK treaty. It is very clear from the aforementioned provisions that a partnership firm is treated as a person under the impugned treaty. Thus, the only point that needs to be established for a partnership firm to avail treaty benefits is to essentially show that it is a resident of atleast one of the contracting states. For this purpose Art. 4(1) is important and it reads as under:

For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the law of that State, is liable to taxation therein by reason of his domicile, residence, place of management or any other criterion of a similar nature.

On the basis of this provision the question that the tribunal had to address inorder to answer the larger question of treaty benefits was whether Linklaters meets the test embodied under art.4(1) of the treaty. The tribunal answering in favour of the assesse held that fiscally transparent entities or specifically partnership firms are entitled to treaty benefits. In reaching this conclusion the tribunal adopted two distinct lines of reasoning.

The first line of reasoning was primarily based on the contextual interpretation of art.4(1) of the treaty. The tribunal after citing several authorities on the interpretation of tax treaties stated that if the literal interpretation of a provision in a treaty leads to unreasonable results, the courts or tribunals should resort to contextual interpretation. In this case if art. 4(1) was to be interpreted literally then linklaters would not have qualified as a resident of UK as the income of the firm was taxed at the hands of the firm and the firm was not taxed per se in the UK (resident country). This interpretation in the tribunal’s opinion and correctly so would have been unreasonable as even though there would be no juridical double taxation (same entity taxed twice), there would in substance be an economic double taxation (same income taxed twice). As a result the tribunal adopted a contextual reading of art.4(1) and held that test embodied under the said article was that the “income of the person should be subjected to residence based taxation on account of some locality related attachment” in that contracting state. The following observations are apposite:

“Viewed in the light of the detailed analysis above, in our considered view, it is the fact of taxability of entire income of the person in the residence state, rather than the mode of taxability there, which should govern whether or not the source country should extend treaty entitlement with the contracting state in which that person has fiscal domicile. In effect thus, even when a partnership firm is taxable in respect of its profits not in its own right but in the hands of the partners, as long as entire income of the partnership firm is taxed in the residence country, treaty benefits cannot be declined.”

The second line of reasoning adopted by the tribunal proceeded on the premise that the actual payment of tax in one of the contracting states is not a condition precedent to avail the benefits of the tax treaty in the other contracting state. In light of this principle the tribunal held that the test laid down under art.4(1) is embodied to ascertain the fiscal domicile of an person (see heading to art.4), hence it is sufficient to show that the resident state has a right to tax the income of the partnership firm irrespective of the fact whether such a right is exercised by the resident state. The following observations are apposite in this regard:

“In our humble understanding, as long as de facto entire income of the enterprise or the person is subjected to tax in that tax jurisdiction, whether directly or indirectly, the taxability test must be held to have been satisfied. Of course, the other possible approach to such a situation is that as long as the tax jurisdiction has the right to tax the entire income of the person resident there, whether or not such a right is exercised, the test of fiscal domicile should be satisfied.”

In my view though the final conclusion reached by the tribunal on this point seems to be correct and will surely encourage professional services, the second line of reasoning requires further investigation as it is against the OECD report on partnerships.

Linklaters LLP: Territorial Nexus and International Tax Regime

In Ashapur Minichen ITAT Mumbai had confirmed that Ishikawajima-Harima ([2007] 288 ITR 408) does not continue to be good law in light of the retrospective amendment brought about by the Finance act, 2010.


In another case Linklaters LLP v. ITO the Mumbai ITAT has reiterated that the amendment made by the Finance Act, 2010 has negated the judgment in Ishikawajima. The important point though is that the court in Linklaters has stated that rendering of service in India is no more an essential ingredient for taxability of service in India u/s 9 of the IT Act, 1961. In other words the service can be taxed in India even if it is only “utilized” in India. However some of the observations in Linklaters can also be possibly interpreted to mean that “no territorial nexus” is required at all. For instance the court observes as under:

“It is fallacious to proceed on the basis that territorial nexus to a tax jurisdiction being sine qua non to taxability in that jurisdiction is a normal international practice in all tax systems”- Para. 17

“ ………in consonance with the school of thought discussed above and these amendment unambiguously negate the principle of territorial nexus which is the understructure of the line of reasoning adopted by the honorable courts above”- Para. 18

An interesting point that emerges is again with regard to India’s compliance with the international tax regime. In Ishikawajima Harima the court had noted that territorial nexus (utilized+ rendered) is a well accepted international tax principle. The court had further noted that “having regard to the internationally accepted principle and DTAA, no extended meaning can be given to the words ‘income deemed to accrue and arise’ in India. Considering this observation and the subsequent ruling in Linklaters where the court holds that Ishikawajima Harima is not good law, it is submitted that the impugned amendment in the Finance Act, 2010 is against well accepted international principles. However, this is subject to an investigation whether at the first place the concept of territorial nexus as suggested in Ishikawajima Harima (utilized+rendered) is indeed a well accepted international tax principle.
India’s compliance with the international tax regime has been a matter of previous discussion on this blog here. A further analysis of linklaters and Ashapur is available on the legal developments blog here and here.

International Tax Regime and India's Compliance

In this post I shall put forth some questions in regard to India’s compliance with the international tax regime. However before I proceed with any analysis three important questions needs to be addressed; firstly Is there any International tax regime, arguendo, does this regime qualify as international customary law and lastly if there exists a regime then what is the nature of such a regime.


These questions have been a matter of intense debate and controversy over the years amongst leading scholars and tax practitioners. One of the leading scholars H. David Rosenbloom relies heavily on the archaic state of cross border transactions (anecdotal evidence) to argue that international tax regime is an “imaginary” and “utopian” idea. He argues that due to the varying socio-economic situation of states, it is impossible to imagine that all states will adopt the same rules of taxation (See H. David Rosenbloom, International Tax Arbitrage and the “International Tax System,” 53 TAX L. REV. 137, 166 (2000); See also Nancy H. Kaufman, Fairness and the Taxation of International Income, 29 LAW & POL’Y INT’L BUS. 145, 148 n.23 (1998)). Per Contra, Reuven Yonah relies on experiences of various countries but primarily the United States to argue that indeed an “international tax regime” does exist ( Reuven S. Avi Yonah INTERNATIONAL TAX AS INTERNATIONAL LAW (Cambridge, 2007)). Let us assume for the purposes of this post that Reuven is correct.

Now, I shall move to the second question that I had outlined above i.e. does this regime qualify as international customary law. Simply put, an international rule qualifies as customary international law if the states practice the rule (state practice) and they do so under the notion of a legal obligation (opinio juris). Reuven agrues that international tax regime does indeed qualify to be customary international law. Reuven reasons that though the international tax regime is spread over myriad of bilateral treaties, they incorporate harmonized rules as they are based on primarily the UN or the OECD model tax treaty. To illustrate this Reuven investigates the rules relating to Jurisdiction to tax, non discrimination (Mihir’s article on this blog on non discrimination) and transfer pricing and concludes that these rules are primarily the same or atleast have the same underlining principles across all the bilateral tax treaties. Reuven also discusses some of the legislative and policy changes in the US and how the US found it difficult to adopt certain rules which were against basic international principles; hence recognizing the presence of a harmonized international tax regime.

But merely putting forth an argument that an international tax regime exists and it qualifies as customary international law is not enough. Having established both these points it is imperative now discuss the nature of international tax law. Reuven points out that the nature of the international tax regime is broadly based on two principles namely single tax principle and the benefits principle. Single tax principle postulates that an income should be taxed only once (no less and no more). In other words both double taxation and double nontaxation is undesirable under the international tax regime. On the other hand the benefits principle stipulates that the active income (business income) should be taxed at source and the passive income (investment income) should be taxed at residence.

In light of this background we need to ponder upon the question, whether India has complied with the above discussed international tax regime. Let us take a contemporary example to further discuss this issue. The first draft of the DTC proposed that in case of a conflict between the tax treaty and domestic tax law whichever came latter in time shall prevail (“latter in time” doctrine). This was a massive divergence from the current position under the income tax act, 1961 wherein in case of a conflict between the tax treaty and domestic law whichever is beneficial prevails. Although, the revised direct code proposes to restore the current position of law, it also stipulates that treaty provisions can be overridden in cases when the provisions relating to GAAR and CFC are invoked. The exceptions to when a treaty can be overridden are too wide (see the discussion on GAAR provisions here and here) and it is submitted that if that be the case then India certainly does not recognize any international tax regime, leave alone complying with the principles embodied therein. One may argue that the correction in the revised tax code i.e. the restoration of the “beneficial” doctrine was a manifestation of India recognizing its international obligation, but in my view the correction in the code was made based on pragmatic economic consideration (after the release of the first code it was feared that there would be a heavy outflow of foreign capital) and not on any international legal obligation.

Concluding, whether India has complied with the international tax regime (if there exists one) needs closer scrutiny. Nevertheless I have attempted to argue in the course of this post that there exists a prima facie case that India does not recognize any so called “international customary tax law”.

Computation of the PE "Duration Test" under the India- Mauritius Tax Treaty

In a recent decision in ADIT (Int’l taxation) v. Valentine Maritime (Mauritius) Ltd., ITAT Mumbai has thrown some light on the computation of PE “Duration test” under art. 5(2)(i) of the India-Mauritius tax treaty. In the present dispute the assesse, a Mauritian entity engaged in the business of marine and general engineering and construction had executed three contracts in the India. The duration of these contracts individually were less than “nine months” however if the contracts were taken cumulatively then the entire period would exceed the “nine month” threshold limit under Art. 5(2)(i) of the Indo- Mauritian Tax treaty.
The issue before the tribunal was whether the duration of the projects in the present dispute shall be taken cumulatively or separately. The contention of the revenue was that unlike the India UK DTAA, the India- Mauritius treaty does not specifically incorporate the provision that for the purposes of applying the “Duration test” each project site is to be considered separately. Thus, the revenue contended that under Art. 5(2)(i) of the India Mauritius tax treaty the duration of project sites are to be construed cumulatively and if such a period exceeds nine months then the assesse shall be deemed to be having a permanent establishment in India (PE). As a starting point it is first important to reproduce Art. 5(2)(i) of the India- Mauritius treaty:

Article 5 - Permanent Establishment

1. For the purpose of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of enterprise is wholly or partly carried on.

2. The term 'permanent establishment' shall include:

(i) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or supervisory activity continues for a period of more than nine months.

On a plain reading of the above quoted provision it is clear that Art 5(1) lays down a general test of “permanence” for establishing an entity as a PE. On the other hand Art 5(2)(i) lays down a specific “duration test” for establishing a building site, construction or assembly project as a PE. In the present dispute the tribunal has laid down the scope and application of this “duration test”. The tribunal while rejecting the contention of the revenue stated that under art. 5(2)(i) the “duration test” is to be applied to individual projects separately and not cumulatively. The apposite part of the judgment is reproduced as under:

“In other words, each of the building site, construction project, assembly project or supervisory activities in connection therewith is to be viewed on standalone basis. Broadly, the underlying rationale of this approach is that various business activities performed by one and same enterprise, none of which constitutes a PE, cannot lead to a PE, if combined. In our humble understanding, the very conceptual foundation of this approach rests on the assumption that various business activities of the enterprise in different locations are not so inextricably interconnected that these are essentially required to be viewed as a coherent whole. The locations are thus separate places of business, and activities at different locations are, therefore, required to be viewed on standalone basis. In a typical building site, assembly or installation project, or supervisory activities in connection therewith, each of site or project is an independent unit, and the approach to these types of PEs recognize this normal business practice.”- Para. 9

The court also rejected the argument of the revenue that since the India- Mauritius treaty does not specifically exclude (like the India UK treaty) the application of the “duration test” to all projects taken cumulatively, it would necessarily mean that the duration of the projects should be tabulated together inorder to ascertain whether an entity qualifies to be a PE. The court stated as under:

“The provisions set out in protocol to the tax treaties need not necessarily be substantive provisions, and these can also be, and often are, merely clarificatory provisions 'ex abundanti cautela'. What is stated in the said protocol to Indo UK tax treaty is nothing other than what is anyway within the scope of the construction PE clause, as analyzed in the OECD Model Convention Commentary (adopted by the UN Model Convention Commentary as well) - an analysis, with which we are in considered agreement. The protocol provision is merely clarificatory in nature and is apparently set out as a measure of abundant caution. The absence of similar protocol clarification in other tax treaties entered into by India would not, therefore, warrant a different interpretation of the treaty provision.”- Para. 10

The tribunal further lays down two grounds under which the aggregation principle (duration of all the project sites taken together in computing the threshold duration) can be applied. Firstly, where the contracts have been artificially divided inorder to reap the benefits of the tax treaty. The onus of showing such an artificial division would be on the revenue. Secondly, when there is an inextricable interconnection and interdependence between the project sites so that they form a coherent whole. The test of “interconnection and interdependence” is an expanded version of the test laid down in the OECD commentary i.e. “coherent whole- geographically and commercially” test.