In our general understanding, in any international transaction, 'Business Income' of an Enterprise is taxed in the country of its Residence unless the company has a 'Permanent Establishment' (PE) in another country wherein the source of the income has arisen i.e. the source country. The amount of profit arisen in the source country is required to be computed by treating such a PE as a separate and distinct entity from the enterprise of which it is a PE. The amount of profit is also calculated to the extent the profit attributable to the involvement and activity of the PE in that transaction. If there is no involvement of the PE in any transaction, there is no profit that gets attributable to the existence of that PE and therefore not taxable in the source country. The profit so computed will be subject to taxation in the source country where the income has arisen and the enterprise is required to pay tax in the source country at a rate that is applicable to a foreign company in that country.
The basic principal underlying the principal of FOA rule is that when an enterprise establishes a PE in another country, it brings itself within the jurisdiction of that country to such an extent that such another country acquires right to tax all profits that enterprise derives from their country, whether through the involvement of that PE or otherwise. Therefore, under the FOA rule, mere existence of PE in another country leads to all the profits, that can be said to be derived from that another country, being treated as taxable in that another country. In substance, such extended scope empowers the source country to tax profits of the enterprise also from the direct sale of similar goods/services in the source country, without involvement of the PE.
Force of Attraction (FOA) in a way expands the rights of the source country to tax such business income of an enterprise. All the Developing countries are supporting applicable of this rule so that they can bring more profits to their tax net of the enterprise from the developed countries that carries on business in their country through establishment of PE.
A typical mention of this rule is found in Article 7 on Business Income of the treaties which is reproduced here:
"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 is attributable to (a) that permanent establishment; (b) sales in that other State of goods and 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."
This essentially mean that if an enterprise has a PE in other country for the purpose of selling goods or merchandise, sales of same or similar kind may be taxed in that other country even if they are not conducted through the PE or even if the PE is not involved in that transaction at all.
In some of the treaties the FOA rule is mentioned indirectly. The para 1 in article 7 in such treaties goes like this:
"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 it directly or indirectly attributable to that permanent establishment."
Therefore, before coming to any conclusion about taxability of a 'business income' especially when there exists a PE in another country, it is important to verify whether there exists a clause on FOA in the article of the treaty. It is also important to check the Protocol and Notes exchanged between the two countries on this clause.
Some of the key countries with which India has FOA rule (directly or indirectly) in the treaties with them are Belgium, Canada, France, Germany, Italy, Japan, Singapore, USA and UK.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.