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The Force of Attraction rule
October, 20th 2007

The concept of Force of Attraction under the treaty has not been a matter of much debate before the appellate authorities till now, presumably because taxpayers have been so arranging their affairs so as not to attract the amorphous Force of Attraction rule.

This rule has been forming part of very limited number of treaties that India has entered into, and has been hardly enforced by the tax authorities.

The underlying principle of the Force of Attraction rule, in its pure form, envisages that when an enterprise is said to have a permanent establishment (PE) in another country, it exposes itself to taxation the entire gamut of income that it earns from carrying on activities in that other country, whether or not through that PE.

As this rule has not been judicially analysed, there is less clarity on aspects such as when does the rule apply; to which transaction could it apply to; the extent of income that it could entail into, and so on.

The Roxon case

Recently, the Mumbai Tribunal delivered its decision in the DCIT vs Roxon OY (291 ITR AT 275) case. This case relates to an entity of Finland having a PE in India and thus the Bench was concerned with the Double Tax Avoidance Agreement (DTAA) with Finland.

In this case, a Finnish entity was awarded a turnkey contract by Nava Seva Port Trust (NSPT) to design, manufacture, deliver, erect, test and commission, certain bulk-handling facility. As per the terms of the contract, the taxpayer entity supplied the required equipment from outside India and sent its employees for erection, commissioning and training purposes.

In the return of income filed by the assessee, the profits from supplies outside India were not included. The Revenue, in the assessment, added the profits from supply of equipment on the contention that since the supply was essentially linked to erection and installation activities, as without supply there cannot be any installation carried out in India, the profits from supply were liable to tax in India.

The treaty provisions were neither resorted to during the assessment proceedings nor before the Commissioner of Income Tax (Appeals). The CIT(A) allowed the appeal of assessee, but set aside the matter to the assessing officer to examine the taxability vis--vis provisions of Article 7 of the DTAA.

The provisions of Article 7 were, therefore, looked upon for the first time before the Tribunal. The Revenue contended that the scope of Article 7 of Indo-Finnish DTAA is wider in scope inasmuch as it incorporates the Force of Attraction rule, according to which all profits of an entity having a PE in India is taxable in India, whether or not it arises from a transaction carried on through that PE.

More restricted

The Tribunal has elaborately analysed Article 7 and the Force of Attraction rule to determine the taxability of profits derived from supplies made from outside India.

At the outset it has been observed that in the modern tax treaties there has been a paradigm shift in the Force of Attraction rule inasmuch as this rule now appears in a very subdued, improvised and highly restricted form.

To explain this, the Tribunal referred to the commentary on Article 7 of the UN Model Convention.

It observed that in the discussion preceding the adoption of the commentary on Article 7, several member-countries expressed their view that they would adopt but limit the scope of application of the Force of Attraction rule to business profits only and not to income from capital.

Some members from the developed countries pointed out that the Force of Attraction rule was abandoned by them in recent treaties, as they found it undesirable to tax profits totally unrelated to the PE of the taxpayer and it was stressed that such an approach would create uncertainty amongst the taxpayers.

It was, therefore, proposed to adopt a restrictive scope of Force of Attraction rule such that it applies only in respect of such activity which is same or similar in nature as those carried on by the PE of the taxpayer in that other country.

The Tribunal observed that Article 7 of Indo-Finnish DTAA was based on UN Model Convention and thus had a restrictive scope of the force of attraction rule.

Although the main reasoning of arriving at the decision of not taxing the profits from supplies outside India under Article 7(1)(a) was that the sale of equipment was concluded much before the installation PE of the taxpayer came into existence, the Tribunal has addressed the Revenues contention in respect of the rule for each of the clauses (b) and (c) of Article 7(1).

Important observation

Elucidating Article 7(1)(b), the Tribunal made a very important observation on the applicability of the Force of Attraction rule that it only extends the scope of transactions which are to be taxed in the other country and not the nature of transactions.

Expounding this proposition, the Tribunal held that due to use of the words same or similar in Article 7(1)(b), the profits from sale of equipment could be taxed only if the PE of the taxpayer is for the purpose of selling goods or merchandise. It was held that the Installation PE was not covered by the attraction rule to tax profits from sale of goods.

In other words, it was held that as per the attraction rule, not all profits of a PE would be taxable in India but only so much of the profits as has economic nexus with the PE in India, would get taxed in India.

The Tribunal also observed that certain treaties which India has entered has protocol explaining that in case of contracts for supply, installation or construction, the profits are required to be determined only on the basis of that part of contract which is effectively carried out by the PE in the other country.

It has been held that these protocol provisions are clarificatory in nature and would apply in general. Taking recourse to this explanation, it was held that supplies made outside India being not connected to the PE in India were not taxable in India.

Alternative plea

In the concluding paragraph, though the Tribunal has mentioned about the alternative plea raised by the assessee, it has not adjudicated upon the same. The Appellant contended that as per explanation to Section 9(1)(i) of the Income-Tax Act, if a non-resident has a business connection in India, only so much of the profits are taxable in India which could be reasonably attributed to operations carried out in India. Since the supplies made outside India cannot be considered to be attributable to the operations carried on in India, the profits were not taxable under the domestic law.

In the absence of any decision taken on this alternative plea, it remains to be seen how far this proposition finds favour with the judicial authority, in cases where the Force of Attraction rule is not so restrictive.

Girish Mistry
Jitesh Jhankharia

(The authors are Executive Director and Manager, respectively, PricewaterhouseCoopers.)
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