When the countries enter into tax treaty with the primary purpose of avoiding double taxation. An enterprise resident in one State would be subjected to tax on the income derived in the other State only if those business profits attributable to a permanent establishment situated in the other State. Normally, a permanent establishment is considered to exist in a country through which the trade or business of an enterprise is wholly or partly carried on through various activities including 1.) a fixed place of business or 2.) a dependent agent.
The Force of Attraction Rule
The force of attraction rule supports the doctrine that once an enterprise established a permanent establishment in another country, it brings itself within the fiscal jurisdiction of that another country to such a degree that such another country has the right to tax all profits that the enterprise derives from that country regardless of the income attributable to the permanent establishment or not. The ability of that another country to tax all profits derived from that country is created by mere existence of permanent establishment in that another country.
The primary purpose of the force of attraction rule is to prevent tax avoidance resorted due to business arrangements, specially between related entities resulting in tax leakages in the source country. For instances, the force of attraction rules also cover bona fide business transaction to widen the source state’s tax base. Moreover, members of developing countries make an argument that some administrative obstacle has been removed by the force of attraction approach which make it unnecessary to determine whether the activities of nonresident are related to the permanent establishment or not and whether the incomes are attributable to that permanent establishment.1
1) Three Categories of the force of attraction rule
The force of attraction rule can be categorized in following three categories based in extent of coverage of profits subject to taxability in another country2:
A) Pure Attraction – taxing profits from all transactions regardless of the profits are attributable to permanent establishment or not or whether the profits derived from the same kind of transactions carried on by the permanent establishment or not.
B) Amended Attraction – taxing profits from direct transactions effected by the non-resident, provided the transactions are of the same or similar kind of goods or merchandise or of the same or similar other business activities as those effected through the permanent establishment.
C) No Attraction – taxing profits/incomes only to the extent that they are attributable to PE.
A) The pure attraction rule that taxed the entire income of non-resident in the source state by virtue of mere existence of permanent establishment in that country even if those income derived from an activity that was totally unrelated to the permanent establishment, has not been popular among developed and developing nations. While this type of attraction rule has now been eliminated in international tax treaty, a modified or diluted form of the attraction rule was adopted in 1979 in the UN Model Double Taxation Convention3 which it is described below.
B) Amended attraction rule in UN Model Treaty has the relevant article is as follows:
Article 7(1) – The profits of an enterprise of a Contracting State shall be taxable only in that 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 the other State but only so much of them as are attributable to:
1) that permanent establishment;
2) sales in that other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or
3) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment.4
This type of attraction rule is restricted and only applies to the income derived from the transactions similar to those carried on by a permanent establishment. A limited anti-avoidance rule is now generally accepted in double conventions. It is reasoned that the intent of the force of attraction principle is to deal with the inefficiency of the arm’s length principle and viewed that the force of attraction rule is instrumental in preventing tax avoidance or evasion through artificial contracts or other business arrangements which should be allocated to the permanent establishment anyway5.
C) No Attraction – This category is generally found in the general concept of permanent establishment in the OECD Model Double Taxation Convention which expressly rejects the application of the force of attraction principle that is applied in the U.N. model treaty reads as follows:
Article 7(1) – Profits of an enterprise of a Contracting State shall be taxable only in that 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 that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State6.
Article 7 of the OECD model generally provides that business profits earned by a foreign enterprise in another state shall not be taxed by that another state unless it carries on business through a Permanent Establishment in the source state. Usually the extent of taxing power of the source state is limited to the profits attributable to the PE. The OECD has the view that the tax authorities of the source country should be determined at the separate sources of income that a foreign enterprise derives from the source country and should be applied to each the permanent establishment test7.
1 BOOK : The Taxation of Permanent Establishments: An International Perspective
4 Article 7(1) of U.N. Model Double Taxation Convention Between Developed and Developing Countries, 1980.
5 Prof Dr Irene JJ Burgers & Giammarco Cottani (eds) The Taxation of Permanent Establishments (2007; loose-leaf) in par 4.1.2; Skaar op cit note 3 at 336; Rawal op cit note I at 35.
6 Article 7(1) of OECD, Model Tax Convention on Income and on Capital, 1977.
7 Annet Wanyana Oguttu, The Challenges of Taxing ProfitsAttributed to Permanent Establishments: A South African Perspective, 21 S. Afr. Mercantile L.J. 773, 803(2009)