Significance of Force of Attraction (\'FoA\') clause in tax treaties

Introduction

This paper is an attempt to analyze various aspects of the FoA principle. The structure of this paper is as follows - the first section focuses on the purpose and various types of FoA rule. In this regard, a flow chart depicting the application of FoA rule with tax positions in different situations has been provided.

Thereafter, this paper analyzes the key guiding principles for FoA, particularly under the OECD Model Convention, United Nation (UN) Model Convention, Indian Income Tax Act, 1961, and the Indian Double Taxation Avoidance Agreement (DTAA).

The last section of the paper takes a closer look at the application of FoA rule to services, explores the interplay of the FoA principle with the arm\'s length principle, and highlights a few challenges in its application. Further, this paper gives an overview of the recent trends regarding the non-inclusion of the FoA clause in Article 7(1), along with situations where the FoA rule cannot be invoked.

Purpose & philosophy of FoA

The FoA rule provides that when a foreign enterprise sets up a PE in a source state, it brings itself within the fiscal jurisdiction of the source state to such a degree that all profits that the enterprise derives from the source state, whether through the PE or not, can be taxed by the source state. Thus, unless a PE is set up, the question of taxability of direct transactions conducted by the foreign enterprise in the source state will not arise.

Three possibilities emerge in the context of taxing jurisdiction of the source state in respect of business profits and application of the FoA rule:

• Full or complete FoA rule: Under the Full FoA rule, once a foreign enterprise has a PE in the source state, the source state has the right to tax all income/profits of the enterprise in the source state irrespective of whether the transactions are managed and organized through such PE or not.
• Limited or restricted FoA rule: Under the Limited FoA rule, if a foreign enterprise has a PE in the source state, the profits of direct transactions made by the head office in the source state-apart from activities of the PE-will be attributed to the PE to the extent that such activities are similar to those managed and organized by the PE.
• No FoA rule: The business profits would be taxed in the source state by treating the PE situated therein as a separate source, while other independently earned business profits of the enterprise in the source state would not be taxed in that state.

In short, the FoA rule applies if the following conditions are fulfilled:

• The foreign enterprise has a PE in the source state.
• The foreign enterprise makes business profits in the source state.
• Goods or merchandise are sold in source state, and such goods are of the same or similar kind as those sold through the PE or business activities carried on in the source state independently of the PE. However, such activities are of the same or similar kind as the business activities carried on in the source state through the PE.
• If the above conditions are fulfilled, the profits attributable to such sales of goods or business activities will be taxable in the source state.

Key guiding principles for the FoA rule

i. Under the OECD Model

a. Scope of the FoA rule

• Only profits attributable to the PE should be taxed in the source state. In other words, the OECD Model does not prefer the application of the FoA rule.
• Other business profits of the enterprise, independently earned in the source state should not be taxed in that state by applying the FoA rule.

b. Scope of Paragraph 1 and Paragraph 2 of Article 7(2)

• Paragraph 1 of Article 7(1) of the OECD Model provides that a contracting state may only tax the profits of an enterprise of the other contracting state to the extent that they are \'attributable to a PE\' situated in the first state. In other words, the purpose of Paragraph 1 is to limit the right of one contracting state to tax the business profits of enterprises of the other contracting state.
• Paragraph 2 of Article 7(1) of the OECD Model determines the meaning of the phrase \'profit attributable to a PE\'. Paragraph 2 may result in no profits being attributed to a PE even though the enterprise as a whole has made profits.

c. Meaning of \'profit attributable to a PE\' and \'only so much of them as is directly or indirectly attributable to the PE\'

• The phrase \'profit attributable to a PE\' referred to in Article 7(1) was understood as profits required to be determined under Article 7(2).
• The concept of \"attributable to\" means a reasonable nexus between the profit and the business activity.
• The profit of an enterprise of a Contracting State is taxable only in the state of residence and it is taxable in another state if the enterprise carries on business through a PE situated therein. The entire profits is not taxable. Only so much is taxable as is attributable to that PE. The attributable profit can be determined by apportioning the total profits of the foreign company to its various parts, if such apportionment is customary. Otherwise, it is calculated on the basis of the hypothesis that the profits which the PE might be expected to make as if it were a distinct and separate enterprise engaged in the same and similar activities under the same and similar conditions, and dealing wholly independently with the enterprise of which it is a permanent establishment. Attributable profits are determined by the same method each year unless there is a valid or sufficient reason to adopt the contrary.
• The expression \'only so much of them as is directly or indirectly attributable to the PE\' narrows the scope of taxability in that other contracting state by excluding profits derived by such enterprises in the source state independently of the PE.

ii. Under the UN Model

a. Scope of the FoA rule

• The UN Model is followed by developing countries preferred to apply the FoA rule. Paragraphs (1) & (2) of Article 7 of the UN Model, 2021 cover the provisions of the FoA rule.
• Article 7(1) of the UN Model, 2021 allows the country in which the PE is located to tax the profits attributable to that PE, as well as other profits of the foreign enterprise derived in that country, to the extent allowed under the article.
• The FoA rule is limited to business profits covered by Article 7 and does not extend to income from capital such as dividends, interest and royalties which are covered by other treaty provisions.

b. The Limited FoA rule

• The UN Model recognizes Limited FoA which is restricted to the profits from sale of goods/merchandise or business activities of the same or similar kind.
• The UN Model does not restrict the right of taxation of the source state only to the profits attributable to the PE situated therein, but such is extended to profits from the direct sale of similar goods and also from those independent business activities which are similar to the business activities carried on by the PE in that state.

c. Meaning of \'same\' and \'similar\'

• Both clauses (b) and (c) of Article 7(1) of the UN Model, 2021 used the expression \"same or similar kind\".
• The word \'same\' may mean \"resembling in every aspect, identical\".
• The expression \'same or similar\' excludes something which is distinct.
• The word \'similar\' means \"relatable\", \"of the same kind in appearance, character or quantity, without being identical.\"

Let\'s understand the concept of \'same\' and \'similar\' with the following example:

Example: There may be a situation where an installation PE may not be covered by the FoA rule even if the installation PE was selling goods which are same or similar to those sold directly by the foreign enterprises due to the following reasons:

• Direct sales by foreign enterprise in the source state will be covered by the FoA rule only when the PE is selling similar goods.
• In the case of an installation PE, because the fact that some goods are locally purchased in the source state used in installation, does not necessarily lead to the conclusion that the foreign enterprise is engaged in selling similar goods as the Installation PE.

d. Scope of clause (b) & clause (c) of Article 7(1) of the UN Model, 2021

• Clause (b) of Article 7(1) of the UN Model restricts the scope thereof only to the sale of goods or merchandise of the same or similar kinds whereas clause (c) of Article 7(1) of the UN Model will only be restricted to other business activities excluding the activities of selling of goods or merchandise.
• The Mumbai Tribunal held that taxability of profit on sale of goods does not fall within the scope of Article 7(1)(c).
• All business activities of any nature whatsoever, directly carried out by enterprises in the source state will not necessarily fall within the scope of such Limited FoA rule. In other words, only when such other business activities or the sale of goods are of same or similar kind will they attract such FoA rule.

iii. Under Indian Income Tax Act, 1961

• Section 9 of the Income Tax, 1961 (\'Act\') recognizes the principle of attribution of income. Explanation 1(a) and Explanation 3 to Section 9(1)(i) provide that the income to be taxed in India is limited to only that part of the income that is reasonably attributable to the operations carried out in India.
• The determination of taxable business profits of a foreign company in India requires an artificial division between profits earned in India and those earned outside India by considering the PE as a separate profit center vis-à-vis the foreign company. This principle is aligned with Article 7(2) of the OECD & UN Model.
• Under the Act, taxability is confined to the profits attributable to operations carried out in India whereas Article 7(1) of the OECD & UN Model provides taxability of the profits attributable to a PE, which may also include profits related to the PE in respect of its operations carried outside India.

iv. Under Indian DTAAs

• Under Indian DTAAs, in the context of the FoA rule, majorly two sets of provisions are found:
  (i) FoA provisions based on the OECD Model guidelines.
  (ii) FoA provisions based on the UN Model guidelines.
• In some Indian DTAAs, the FoA rule is not incorporated directly in Article 7(1), but the same is mentioned in the Protocol to DTAAs.
• There are certain Indian DTAAs where the protocol brings the concept of the FoA rule in DTAA either directly (example, India - Turkey DTAA) or indirectly (example, India - France DTAA).

a. Use of phrase \'directly or indirectly\' in Article 7(1) of Indian DTAAs

Some of the Indian DTAAs use the phrase \'directly or indirectly\' in Article 7(1) which are additional words when compared to the wording of Article 7(1) of the OECD Model.

The terms \'directly or indirectly\' referred to in Article 7(1) are clarified to the effect that where the PE takes an active part in negotiating, concluding or fulfilling contracts entered into by the enterprise, then, notwithstanding that other parts of the enterprises have also participated in those transactions, the proportionate profits of the enterprises from such contracts should also be treated as profit indirectly attributable to the PE.

For example, the India-Japan DTAA uses the phrase \'directly or indirectly\' in Article 7(1) such as:

The profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in that other Contracting State but only so much of them as is directly or indirectly attributable to that permanent establishment.

b. Protocol to DTAAs

There is a possibility that the FoA rule in DTAA may contain some special provisions through protocol. In such a case, the scope of the FoA rule has been clarified in the protocol. For example, the India-Hungry DTAA have special provisions of FoA rules in their protocol in relation to construction work.

c. Right to prove otherwise

Some of the Indian DTAAs provide the \'right to prove otherwise\' in the FoA rule.

\'Right to prove otherwise\' means where the FoA provisions give the enterprise the right to prove that:

• profit from sale of similar goods or carrying on other business activities of the enterprise is not attributable to the PE, and
• such activity could not have been undertaken by the PE.

For example, the India-Sri Lanka DTAA has the provision of \'right to prove otherwise\' in the FoA rule.

d. Only part of the Limited FoA

In some Indian DTAAs, only part of the provisions of the UN Model has been incorporated. In such cases, the scope of Limited FoA rules gets further restricted.

For example, the India-Indonesia DTAA does not incorporate the provisions contained in the Article 7(1)(c) of the UN Model, 2021.

e. Broad analysis of the Limited FoA in Article 7(1) in Indian DTAAs

Based on Article 7(1) and Article 7(2) of Indian DTAAs, the following tables provide a broad overview of the Limited FoA available or not available in the Indian DTAAs:

Table 1: No Limited FoA in Article 7(1)

Table 2: Available Limited FoA in Article 7(1)

Whether FoA rule is applicable to services

The FoA rule is appliable to profits derived from the sale of goods or merchandise of the same or similar kind, or from other business activities of the same or similar kind.

The phrase \'other business activities\' includes services. Further, it has been held that reference to sale of goods or merchandise in Article 7(1)(b) of the UN MTC includes rendering of services also.

The following tables depict the FoA rule under some of the Indian tax treaties applicable either to \'goods and merchandise\' or to both \'goods and services\':

FoA rule vis-a-vis the arm\'s length principle

The adoption of the FoA rule would lead to a wider tax base and thereby larger share of revenues arising out of the same, whereas complete rejection of the FoA rule would be tantamount to adoption of the arm\'s length principle in the strictest sense which again is not free from flaws.

As the arm\'s length principle would call for the treatment of the head office and the PE as two independent entities and thus, a probability of double non-taxation may arise wherein the activities carried out in the PE would neither be taxable in the source country and the activities carried out in the source country may also escape the taxation scanner owing to the domestic laws of the country. Therefore, the same would not certainly be within the interests of either of the countries.

Challenges in application of the FoA rule

An imposition of the force of attraction would certainly lead to a greater amount of uncertainty to the taxpayer. As the UN model which talks about the taxation of the income attributable to the PE involving sales and business activities of the \'same or similar kind\', ipso facto calls for judicial interpretation and ambiguity in the minds of the taxpayers.

Further, the very essence of an economic nexus would be lost in case the entire array of activities of the foreign enterprise is brought under taxation through the FoA rule. This would only lead to abuse by generalization of standards and activities irrespective of the fact whether the same has been carried out in the territory where it is being taxed.

Klaus Vogel distinctly criticizes the applicability of the force of attraction as it leads to the generality of income irrespective of the fact whether it has been generated out of the PE or not.

Recent trends regarding non-inclusion of the FoA clause in Article 7

It has been observed that in the new Indian treaties, the FoA clause has not been included or has been omitted in the existing tax treaties:

Table 3 depicts the recent trends regarding non-inclusion of the FoA clause in Article 7:

Table 3: Recent trends regarding the non-inclusion of the FoA clause in Article 7

Exemptions from the FoA rule

The FoA rule does not apply in the following cases:

• when sales are made by a foreign principal through independent agents in the source state.
• where foreign enterprises are able to demonstrate that the sales of goods or merchandise or business activities were carried out in the source state other than through the PE for legitimate business purposes and there is no objective to obtain treaty benefits.

Concluding remarks

The principle of the FoA rule has been a matter of immense interest and deliberation in the field of international taxation. Tax treaties provide that business profits of an enterprise resident of one state would be taxable in the other state only if there exists a PE in the other state. The FoA rule is basically an anti-avoidance measure which is implemented in varying degrees. The tax treaties are by and large based on the UN, OECD or the US Model Conventions. These Model Conventions differ with respect to applicability of the FOA rule.

Developing countries are supporting the application of the FoA rule. Some countries provide for taxing profits/income (i) only to the extent that they are attributable to the PE, (ii) from direct transactions effected by the non-resident, provided the transactions are of the same or similar kind as that effected through the PE and (iii) from all transactions whether they are attributable to the PE or not, or whether they are of the same or similar kind of transactions carried on by the PE or not. From the above discussion in this article, one principle emerges: that most Indian DTAAs are on the lines of the OECD MTC i.e., the FoA rule should not be invoked. However, on the other hand, when the relevant provisions of the Indian DTAAs are on the lines of the UN Model, which particularly provide for the Limited FoA rule, in such a case, one has to find out the scope of each provision and its effect thereof. Finally, in each such case, the issue of the FoA rule will have to be decided on the facts of that case.