Force of Attraction Rule Krupal Kanakia 1

Agenda Background & Meaning of FoA Why FoA in Article 7 Practical Applications Key Takeaways 2

Force of Attraction – Background Attribution of profits – (a) General rule Profits arising to F.Co. from activities carried on by and through the PE F.Co India PE. Activities carried on by PE Profit Attribution 3

Force of Attraction – Background Attribution of profits – (b) FoA rule Profits arising to F.Co. from direct activities carried on by F.Co. without any involvement of PE F.Co India PE. Activities carried on by PE Direct activities carried on by F.Co. Profit Attribution 4

Article 7 Para 1 of the UN Model Convention. “The profits of an enterprise of a Contracting State shall be taxable only in that State unless the ……………………………….. may be taxed in the other State but only so much of them as is attributable to (a) that permanent establishment; (b) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or (c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment.” The Article reproduces Article 7 para1 of the OECD – Model Convention, with the addition of clauses (b) and (c). 5 Force of Attraction Rule - Meaning No FoA rule in OECD and US Models

6 FOA – Meaning – 7(1)(b) US India Branch of A Ltd Customers in India Supplies garments directly PE of A Ltd sales garments imported from Head Office A Ltd

7 FOA – Meaning – 7(1)(c) US India Branch of A Ltd Branch undertaking agency business in India Customers in India Provides agency services to non- residents A Ltd

The UN provision covers sales activities of similar goods and other, similar business activities in two different sub-paragraphs. -The provision in para (c) covers all business activities that are similar to the activity pursued through the PE. Thus, the nature of the activity is decisive under this alternative. -If para (c) is applied to sales activities, the result would be that all sales activities would be subject to source – state taxation if an existing PE pursued sales activities of any kind. -However, para (b) is limited to sales of similar goods, and thus emphasizes the nature of the merchandise, in addition to the nature of the activity. -In conclusion, the function of para (b) is therefore to narrow down the scope of para (c) with regard to sales activities. 8 Sales vis-à-vis other activities

9 Types of Force of Attraction FullRestrictedDeemed FoA Limited Restricted

10 Once PE created, all profits sourced through the state gets taxed Types of Force of Attraction FullRestrictedDeemed FoA Limited Restricted

11 Once PE created, all profits sourced through the state from same or similar sales / other activities carried on in that state gets taxed Types of Force of Attraction FullRestrictedDeemed FoA Limited Restricted

12 Once PE created, income attributable to the extent of role played by PE from direct sale by HO taxed in the source state Types of Force of Attraction FullRestrictedDeemed FoA Limited Restricted

13 Once PE created, income which is effectively connected to PE is taxed Types of Force of Attraction FullRestrictedDeemed FoA Limited Restricted

Why FoA in Article 7 14

Reasoning for inclusion of FoA in tax treaties -to Counteract the imperfections of PE definition – six months, 90 days criteria, etc. -to counteract the inefficiency of the arm’s length principle -To facilitation curbing tax avoidance by fictitious contracts, unlawful means of business structure, etc. 15 Reason for FoA Considered to be administratively convenient solution

UN Model is a compromise between taxation in the state of residence and taxation in the state of source. However, it attaches more significance on source state taxation. 16 Reasons for FoA Article 5(3) - Extended PE Definition Article 14(1) - Independent Personal Services clause Article 7(1) - Force of Attraction Rule – Business profits clause Extended Source Taxation in UN Model can be shown by the following differences between OECD MC and UN MC

Practical applications 17

FoA under the Income Tax Act Interest/Dividend/Royalties whether covered under FOA Force of Attraction vis-à-vis Agency clause Extent of Attribution - Agency clause Force of Attraction vis-à-vis Construction clause Extent of Attribution – Construction clause FOA and Attribution – Service PE clause 18 Practical Applications

19 Mitigating FoA Opt for a treaty country not having a FoA clause for doing business in source country Opt for a treaty country where FoA clause applies only if role played by PE Incase there are commercial reasons for doing business directly from outside source, opt for a treaty country where FoA clause does not apply due to existence of business reasons Sell all same and similar goods/activities from one channel and other goods/activities from other channel Avoid constitution of a PE itself Incase of non clarity, go for Advance Ruling

Key Take Aways 20

Different types of FoA in various treaties – proper examination a must FoA most important in structuring the Foreign Investment in India – Study of Business plan vital FoA principle is much wider than the extension of PE principle Attribution of profit under FoA is tricky issue – no ready solutions 21 Key Takeaways

THANK YOU 22