Enlarging the scope of ‘force of attraction’ rule

Over the past few decades, globalisation has created opportunities for MNCs to operate in and with India. While many MNCs establish their presence through local entities, there are others who work on projects/ service contracts without creating a legal presence.

Taxability of income generated by the foreign companies has been a subject of intense debate. Indian tax treaties are largely based on the UN model convention, which seeks to tax such income on source rule basis.

The domestic income-tax law as well as tax treaties often try to balance out the division of taxing rights between source and resident countries for such cases. Whilst there are rules for taxing foreign companies on gross basis at a lower rate for certain types of income (royalty, interest, technical fees, and so on), the issue of applicability of higher rate often arises when a larger economic presence (leading to a permanent establishment) is created. There are several types of permanent establishments, which are generally created as a result of on-ground activities carried on in India by the foreign companies or their Indian representatives.

Once a permanent establishment is created, a key issue that needs to be addressed is the computation of the income attributable to it. Attribution of profits has been the subject of litigation. A detailed FAR (functions, assets and risks) analysis of various activities plays a significant role in such cases to ring-fence the exposures involved.

An interesting principle on attribution of profits to a permanent establishment is force of attraction rule, which has been adopted by India in few of its treaties, such as those with the US or Finland.

Force of attraction rule, in essence, expands the taxation in the source country resulting in additional attribution of profits in the source country, in relation to business activities carried on in the source country, which are “same or similar” to those of the permanent establishment, although the Indian permanent establishment may not have played any active role in performing those activities.

The practical issue that requires clarity is the meaning of “same or similar” used in the rule. The word “same” may mean resembling in every aspect, or identical; on the other hand, the word “similar” may mean almost resembling, or alike. A reference can be a customs notification which provides meaning of the term “similar goods”. However, the basis on which “sameness” or “similarity” has to be determined is a question of debate. In another context, the Supreme Court had held that common management, administration, fund, and so on could result in two businesses being treated as “same business”.

There are divergent views from the courts as to whether the scope of force of attraction is wider from the expression “profits directly or indirectly attributable to the permanent establishment” used in certain Indian treaties (such as Japan, the UK, Singapore). The Japan and UK treaties provide for the meaning of this expression to include profits attributable to the contribution of the permanent establishment in relation to contracts entered into by the foreign company directly.

Some tribunal decisions have held that the expression “profits directly or indirectly attributable to the permanent establishment” does not mean any specific or implied force of attraction, as embedded in the UN model convention. In the case of Ishkawajima-harima Heavy Industries Limited, in the context of the India-Japan treaty, the Supreme Court held that income can be taxed in India only to the extent it is attributable to the part played by the Indian permanent establishment.

However, a contrary decision was pronounced by the Mumbai Tribunal, in the case of Linklaters LLP in 2010. The Tribunal held that entire profits with respect to an Indian project relating to services rendered by the foreign entity in India and outside India was taxable in India. This results in ambiguity for tax payers regarding their taxability for their India projects, where the tax treaty does not specifically provide for force of attraction rule, but uses the expression “directly or indirectly attributable to permanent establishment”.

While there are Tribunal decisions in which the application of force of attraction have been restricted to Indian activities only, the Linklaters decision has expanded its application by seeking to tax profits attributable to off-shore services for the Indian project as well. Under domestic law, in case a foreign company is held to have business connection in India, taxability is based on the operations carried on in India.

Considering the above, attribution of income to an Indian permanent establishment for off-shore services seems unintended. A decision from a higher court could bring much needed certainty to the issue.

Sandeep Ladda is Executive Director - Tax & Regulatory PwC India

COMMENT NOW