‘Force of attraction’ has caught the attention of the Tribunals wherein it has been held that activities undertaken by head office, outside the State in which the permanent establishment is located, will still be roped in as attributable to the permanent establishment whether or not the permanent establishment is involved in the activity.  The Tribunals have ruled that so long as the activities are directly or indirectly connected to the other Contracting State and the activities are same or similar to that of the permanent establishment, the activities are liable for being attributed.  The author is of the firm belief that ‘restricted force of attraction’ is more as an anti-evasion measure and cannot be stretched to transactions where the permanent establishment is not involved at all and the services are rendered or activities are undertaken outside the other Contracting State.  The decisions, according to the author, have travelled far beyond the provisions contained in the DTAA.

Introduction:

We are still at the infancy of international taxation as compared to the domestic taxation, from the time the country has opened up to transactions in the external economies in a large way.  Not only is the revenue learning its lessons about taxing international taxations, but also the taxpayers and the judiciary are becoming aggressive in their approach.  Attempts are being made by taxpayers to test waters in several ways, the revenue is sharpening its arsenals to bring transactions into the tax net and the judiciary is braving itself to find answers to the intricate issues that emerge from the volume of international transaction litigations that are reaching its portals.  One such issue that has caught the imagination of tax interpretation community is the ‘force of attraction’ rule.  The author, in this piece of article, has made an attempt to explore the depth of arguments and the decisions of the quasi judicial and the judicial authorities whatever stage they may have reached. Of course, as we all know, it is the Supreme Court that has a final say as the law of the land, and we have to eagerly wait for the issue to reach its corridors.

Model Commentaries:

When an attempt is made to understand a concept, by default the interpretations are culled out from OECD Model Commentary or the UN Model Commentary and sometimes from the US Model.  Depending on what model was used while the DTAA was framed, the Courts appreciate the persuasive nature of such models and interpret the transaction to arrive at its decisions.  Sometimes it may also go into the nuances of both the models to reach its decisions.  In the absence of adequate judicial precedents in the Indian Courts on international taxation, it is often seen that decisions of foreign courts or the commentaries of the above Models are used as tools to reach conclusions in settling disputes.
It would, therefore, be important to delve into the commentaries so as to understand what they have in their store to portray the meaning of ‘force of attraction’ rule, before going into the judicial decisions in the Indian context.
 
Article 7 of OECD Model Convention reads as follows:                     

Article 7 of UN Model Convention reads as follows:
 

In both the Model Conventions it may be observed that ‘attribution’ has an important role to play for the purpose of being taxed in that other State where the PE is present.  However, the UN Model differs from the OECD Model to the extent that it elucidates further to include sales of goods and merchandise and other business activities effected through the PE in the other Contracting State.  It is the author’s opinion that even though the OECD Model does not elaborate further it is enough to bring such activities in the ambit, on account of the rule of attribution.

While having said that, it is to be explored whether all income, irrespective of its characterization, would be brought to tax in the PE State due to the rule of attribution.  It is in this context that the further elaboration of the UN Model scores over the OECD Model.  There is a general understanding that has been accepted in DTAA Conventions that each source of income in the other Contracting State has to be put to test for attributing the source to the PE, subject however, to the application of other Articles of the Convention.  For example earning of dividend, interest and the like are to be excluded from the attribution criteria.  Therefore, any income that has a direct attribution to a PE or it is in the form of sales of goods and merchandise or other business activities carried on in the other Contracting State through a PE becomes important from the view point of narrowing down the attribution rule to all types of income.

Attribution and Force of Attraction Rule:

The ‘attribution’ rule provides itself to be extended to the ‘force of attraction’ rule, which has been adequately dealt in the UN Model Convention but not so elaborately dealt in the OECD Model Convention.  But the OECD Commentary does deal with the ‘force of attraction’ in a limited sense to say that the ‘force of attraction’ does not generally apply to all income arising from sources in the other territory, as long as such income was not attributable to the PE.  The basic principle for exploiting the ‘force of attraction’ is only when activities are attributable to PE and not otherwise.  It is a part of anti-avoidance campaign that is being attempted by various countries in a bid to rope in cloudy transactions.

The ‘force of attraction’ rule has two limbs to it, one which is ‘full or complete’ and the other being ‘restricted’ in its approach.     The ‘full force of attraction’ rule applies to profits earned by the foreign enterprise whether through its PE or otherwise.  The other Contracting State will have the right to tax all profits made from transactions in that territory.  On the other hand if ‘restricted force of attraction’ rule is applied, then profits from the activities of PE and also the profits from the direct activities of the foreign enterprise in the other Contracting State carried on through a PE and those activities that are same or similar to the activities of the PE will be attributed as profits of PE and become taxable in the other Contracting State.

‘Full force of attraction’ rule is akin to Section 5, read with Section 9 of Income-tax Act, 1961.  Section 5(2) provides that subject to the provisions of this Act, the total income of a person who is a non-resident shall include all income from whatever source derived which-

Clause (1) of Section 9(1) provides that all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India or through the transfer of a capital asset situate in India, is deemed to accrue or arise in India.

Further there has been a retrospective amendment to the Section 9 by the insertion of an Explanation as follows-

‘’For the removal of doubts, it is hereby declared that for the purpose of this section, income of a non-resident shall be deemed to accrue or arise in India under clause (v) or clause (vi) or clause (vii) of sub-section (1) and shall be included in the total income of the non-resident, whether or not,-

But the saving grace for non-residents is the availability of Section 90(2) of the Income-tax Act, 1961, which states as hereunder:

‘’Where the Central Government has entered into an agreement with the Government of any country outside India or specified territory outside India, as the case may be, avoidance of double taxation, then, in relation to the assessee to whom such agreement applies, the provisions of the Act shall apply to the extent they are more beneficial to that assessee.’’
If they find that the retrospective amendment is regressive, they will fall back on the DTAA if that appears to be more beneficial.  Having attempted to toe that line, it must not end up being equally harsh as that of the provisions contained in the domestic laws.

If the agreements provide for ‘restricted force of attraction’ rule, profits of head office from transactions undertaken in the State in which the PE is present, to the extent they are similar to those carried on by PE, will be attributed for being taxed in the hands of PE.  It only means that, so long as the head office carries on activities that are not same or similar as that of the activities carried on by the PE it will not be taxable as business profits in the hands of PE, but may be subject to other Articles in the treaty provisions.

Restricted Force of Attraction:

In view of the above, there may be a necessity or a compulsion to really understand the phrase ‘restricted force of attraction’ and the interpretations that may emerge under different circumstances.  We may have to analyse this subject under multiple situations that arise in the course of international trade and commerce when the head office and PE operate in different taxing jurisdictions.  Some such situations that have come to the mind of the author include:

In order to provide brevity to the above assumptions, the other Contracting State is with reference to HO where the PE is carrying on its normal business activities.
In situations where treaty provisions have ‘full or complete force of attraction’ rule, income arising from activities contained from item (i) to (v) would get attributed to the PE in the other Contracting State and hence would become taxable there.  As long as the nexus exists, there is no escape route other than attribution it to the PE.

The problem is more profound in the ‘restricted force of attraction’.  This when subjected to a thread-bare analysis would throw out the following possibilities:

The situation contained in point (v) above is the one that needs to be addressed in the light of available judicial decisions.  Under the ‘restricted force of attraction’ rule it is evident, that even if some activities are undertaken within the other Contracting State, it will remain outside the attribution rule so long as the activities are not similar to that of the PE.  With equal force it can be argued, that so long as the activities are not same or similar to that of PE in the other Contracting State, the transactions of HO would remain outside the clutches of attribution or ‘force of attraction’ when it undertakes activities in third party States though they may be connected or associated with the other Contracting State.

What ultimately remains for discussion, are the activities undertaken by HO that are same or similar to the activities of the PE and are undertaken in third party States, but are connected are associated with the other Contracting State.

SCN Lavlin/Acres v. Asstt.CIT  

This matter came up for discussion in SNC Lavlin /Acres Inc. v. Asstt. CIT [2007] 15 SOT 1 (Delhi), wherein SNC Lavlin claimed that monies received towards services rendered outside India should not be attributed to PE in India and taxed under Article 7(1) of the Inndia-Canadian DTAA.  The facts of the case were as follows-

SNC Lavlin Inc. and Acre Inc. established a joint venture company in Canada to execute a project in India along with JP Industries Ltd. awarded by NHPC.  A site office was opened in India, which served as the project office, and it fulfilled the requirements of Article 7 to come within the ambit of a PE of the relevant DTAA. Since the DTAA was framed on the basis of UN Model Convention, the provision of bringing transactions within the rule of attribution was more elaborate as has been explained earlier.  It was argued for the appellant, that for services rendered outside India by the joint venture company, there can be no attribution of income arising from such services to the PE, as the services have not been rendered in India.  There can be no ‘force of attraction’ for transactions that have not taken place in the other Contracting State, but outside it.  What the provisions of Article 7 (b) and 7(c) envisage and contemplate in the Indo-Canadian Treaty is that, the activities whether directly or indirectly should have been carried out in the other Contracting State which is same or similar as that of the PE.  It may be noted that the activities had to be necessarily carried out in the other Contracting State.  Hence, a distinction has to be drawn between profits from transactions in the other Contacting State and profits from transactions or activities carried out beyond the borders of the other Contracting State.  The Assessing Officer did not appreciate the submissions, and turned down the assessee’s   contentions that activities beyond the borders of the other Contracting State are not taxable, whether or not they are similar or same as that of the PE. The first Appellate Authority too, having been convinced the stand taken by the Assessing authority, passed an order against the appellant.  The matter reached the portals of the Delhi Tribunal, which also ruled in favour of the revenue and against the appellant.

The issues that were laid down by the Tribunal while coming to the above conclusion were as follows:

The ‘restricted force of attraction’ was invoked to bring into the ambit of taxation, profits derived from offshore services of the HO.

It is an interesting observation that, although certain activities have been carried out In Canada and not in India, the Tribunal has gone on to rope such activities and transactions as attributable to PE in India.  The reasons for such classification may be because that the activity related to a project in India, such activities were similar to what was being carried on by PE in India, the PE was used to raise invoices for such work, such work was possibly allocated to HO only because of the PE, with PE acting as the conduit.  Probably, the consideration received by HO for services rendered outside India would not have been taxed had such projects been situated outside India, whether or not they were same or similar activities as carried on by PE in India.  This subtle difference in understanding the services rendered outside India, has a great deal to do as to why the Tribunal came to the present conclusion.  Any nexus with activities in India, irrespective of where the services are rendered, will be deemed to be attributed to the permanent establishment and therefore the ‘force of attraction principle.’  The only proposal, under the present circumstance, when profit of HO will not be taxable in India, is where the projects of PE are outside the territories of India and services on such projects are rendered by HO in its own right.

Linklaters LLP V. ITO International Transaction:

This matter has also been dealt by the Mumbai Tribunal in Linklaters LLP v. ITO, International Taxation [2010] 040 SOT 0051 (Mumbai).  The facts of the case were as follows:

The assessee was a partnership firm engaged in the practice of law, based in UK.  The firm did not have any practising outfit or establishment in India.  It rendered certain services to Indian projects and Indian clients.  It was sometimes rendered directly from London and sometimes partners or the staffs were physically present in India. The UK firm contended that there was no continuity of activities in India, and the partners and staff members of the assessee firm visited India only on as and require basis.  The activities of the assessee were considered to be sporadic or isolated.  The stand of the assessee thus was that there was no framework or infrastructure, no continuity and no stability so as to result in a permanent establishment.  Not having fulfilled the requisites of a PE and the fact that the assessee was not involved in furnishing of services as envisaged Article 5(2)(k) read with Article 5(1), and the assessee cannot be taxed under Article 15 as the said article applies only to services rendered by individuals whereas the assessee was a partnership firm.   It was contended that since the provisions of the tax treaty were beneficial to the assessee, these treaty provisions will override the provisions of the Indian Income-tax Act, 1961, and the income of the assessee cannot be brought to tax under the provisions of the Indian Income-tax either.

The Assessing Officer invoked the provisions of Article 5(2)(k) and negated the contentions of the assessee on the grounds that ‘rendering’ and ‘furnishing’ were synonymous in the given context.  He went on to add that if the submissions of the assessee were to be accepted that Article 5(2)(k) would not have existence without Article 5(1) coming into existence, then Article 5(2)(k) would be rendered redundant if a person not opening a branch or establishment would contend that a PE does not exist in spite of the extended period of time in India.  The First Appellate Authority, CIT (A), reversed the order of the Assessing Officer on the grounds that under Article 7(1) of India-UK Treaty, profits attributable to the operations in the PE are taxable in India.

The matter obviously travelled to the Tribunal for its decision.  The Tribunal, after going into the provisions and commentaries of OECD Model Convention and UN Model Convention, ruled as follows:

‘’ In our considered view, therefore, the connotations of ‘profits indirectly attributable to permanent establishment’ do indeed extend to incorporation of the force of attraction rule being embedded in article 7(1).  The way it intends to be implemented, on the facts of the present case, is like this.  In addition to taxability of income in respect of services rendered to an Indian project, which is similar to services rendered by the permanent establishment, is also to be taxed in India in the hands of the assessee- irrespective of whether such services are rendered through permanent establishment, or directly by the general enterprise.  There cannot be any professional services rendered in India which are not, at least indirectly, attributable to carrying out professional in India.  This indirect attribution, in view of specific provisions of India-UK tax treaty, is enough to bring income from such services within the ambit of taxability in India. 

The twin conditions to be thus satisfied for taxability of related profits are (i) the services should be similar are 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.  In effect thus, entire profits relating to services rendered by the assessee, whether rendered in India or outside India, in respect of Indian projects is taxable in India.

This is precisely what the assessing officer has done.  The grievance of the assessing officer is indeed justified and we uphold the same.  We, therefore, vacate the relief granted by Commissioner (Appeals) and restore the order of the Assessing Officer in this regard.’’

From both the above decisions, it may be concluded that the services rendered by HO in India or otherwise, would be taxable in India as attributable to PE under ‘force of attraction’ rule, if it is associated with a project or client in India.  This is so even if the PE is not associated in rendering the service, suffice it would be that the activities so undertaken are same or similar to the activities undertaken by PE in India.

What is the other argument that one can take in situations like the above?  Since PE is in no way involved in the activities or the transactions, and the fact that services were rendered outside India, why should the efforts and the benefits relating to them be attributed to PE?  If the relevant portions of Article 7 of UN Model Convention, is reproduced to recapitulate as to what they have got to say, it reads as follows-

It is clear from the above that sub-clause (b) and (c) cannot be invoked, for, sales or other business activity of the HO has not taken place in that other Contracting State but outside it.  If sub-clause (a) was to be examined for attribution, it is but an informed understanding that, PE should have actually participated in delivering a service directly or indirectly either with HO or without it.  It is also not relevant whether the service was rendered within the other Contracting State or outside it, as long as the PE was involved, to bring it within the ambit of ‘force of attraction’ rule.  What the Tribunal has done was to rope in one more dimension to the ‘force of attraction’ rule, wherein it has ruled that whether or not PE participates, all services rendered to Indian projects and Indian clients by HO, which are similar or same as the activities of the PE would be considered as though the PE has performed it and gets attributed to it for being taxed in India.  This draws parallel to the retrospective amendment of Section 9 with an Explanation, that income from transactions of non-residents are deemed to accrue and arise in India, whether or not they have a place of business in India and whether or not the services are rendered in India.

‘Force of attraction’ was an anti-evasion measure and was not intended to cast its shadow beyond that.  If the intention of the Model Convention was to bring the transactions of HO having direct or remote connection with the other Contracting State, while the services were rendered outside such State, the wordings of the Articles had to definitely be different from what they are now.  The ‘force of attraction’ steps in only to understand whether PE was involved at all in the transaction or was there an intention to evade.  Unless these are established beyond doubt, it would be difficult for the courts to draw transactions of HO executed outside the other Contracting State (without involving PE), even if the projects are having a connection with the other Contracting State and that such transactions or activities are same or similar to the activities of PE.

Conclusion:

Having travelled so far with respect to ‘force of attraction’ rule by the above judicial decisions, it is yet to be seen how many more decisions will toe this line of thinking.  It is also to be seen whether the subtle issues underlying this principle will test waters at higher portals, and whether the Tribunal’s line of thinking will find favour with decision makers at the higher judicial levels.  Till then, the ‘force of attraction’ rule is not a lover’s paradise in the realm of international taxation.