From Linklaters to Paul Wurth: The changing contours of the force of attraction rule in tax treaties

Introduction

The recent decision of the Delhi Bench of the Tribunal in Paul Wurth Italia[1] marks an important development in the application of the force of attraction rule under Article 7 of certain tax treaties. The principle permits a source state to tax profits arising from sales or business activities of the same or similar nature as those carried on through a Permanent Establishment (‘PE’) and has long occupied a contested space between source-based taxation and traditional attribution principles.

In Paul Wurth Italia, the Tribunal declined to attribute offshore supply profits to India despite the existence of an admitted supervisory PE, while emphasizing that the application of force of attraction rule cannot be divorced from the factual role played by the PE itself.  The Tribunal held that the PE had no involvement in the activities giving rise to the disputed profits and that the mere existence of a PE could not, by itself, justify taxation of all source-country profits. In doing so, the ruling re-emphasizes the importance of a demonstrable factual and functional nexus between the PE and the income sought to be taxed and signals a more restrained application of the force of attraction principle.

This article examines the conceptual foundations of the force of attraction rule, traces its judicial evolution in India, and evaluates the relevance of the doctrine in an era increasingly shaped by source-based taxation and digital nexus rules.

Understanding the principle

Traditionally, the taxation of business profits under international tax treaties is governed by the general principle that the source state is permitted to tax only so much of the profits of an enterprise as are attributable to a PE situated in that State. This approach, reflected in Article 7 the OECD Model Convention, confines source state's taxing rights to profits arising from activities actually carried on through the PE.

The OECD Model Convention has historically rejected the force of attraction principle and proceeds on the basis that the mere existence of a PE should not permit the taxation of profits arising from activities carried on independently of that PE. By contrast, the UN Tax Model Convention adopts a broader source-based approach. Article 7(1)(b) and (c) of the UN Convention permit the source state to tax not only profits attributable to the PE but also profits arising from sales of goods or merchandise, and other business activities, of the same or similar kind as those conducted through the PE. The rationale underlying this departure lies in the UN Model's preference for preserving greater source-country taxing rights, particularly for developing and capital-importing countries.

The UN Commentary explains that Article 7 adopts a limited force of attraction under which taxing rights of a source state is extended beyond profits directly attributable to the PE and cover sales or business activities of the same or similar nature carried on within the source State. However, the rule stops short of permitting taxation of all profits earned by the enterprise from that State. 

Most Indian tax treaties incorporate the above limited force of attraction language. Consequently, disputes in Indian jurisprudence have centered more on the scope of the rule, particularly whether the profits sought to be taxed bear a sufficient similarity and nexus to the activities carried on through the PE.

Evolution of the Force of Attraction Principle in Indian jurisprudence

Indian jurisprudence on the force of attraction principle has developed through a series of decisions examining the extent to which a source state may tax profits that are not directly attributable to a PE. The principal focus of these decisions has been the degree of connection required between the PE and the income sought to be taxed, as well as the scope of the force of attraction language contained in the relevant tax treaty.

The foundation of the line of authority was laid by the Supreme Court in the case of Ishikawajima-Harima Heavy Industries Ltd.[2], which concerned the taxability of offshore supply and service components of a turnkey contract executed in India. The Court held that profits could be attributed to a PE in India only where the PE was involved in the activity giving rise to such profits and that the mere existence of a PE was insufficient to justify taxation of the entire income arising from a composite contract.

The above principles were reiterated in Hyundai Heavy Industries[3] and thereafter in LG Cables[4] and Roxon OY[5], where offshore supply profits were excluded from Indian taxation notwithstanding the existence of installation or supervisory activities in India.

However, a significant shift occurred in the case of Linklaters[6] wherein the Mumbai Tribunal interpreted the phrase ‘directly or indirectly attributable’ in Article 7(1) of the India-UK treaty as incorporating a force of attraction rule and held that profits arising from Indian projects involving the same or similar activities could be taxed in India even where the relevant services were rendered directly by the head office.

This interpretation, however, did not survive scrutiny in the case of Clifford Chance[7] wherein the Special Bench of the Tribunal distinguished the India-UK treaty from the UN Model Convention and held that the treaty did not incorporate a force of attraction rule. Accordingly, the mere existence of a PE could not extend India’s taxing rights to profits derived from activities undertaken independently of that PE under the India-UK treaty.

The expansive interpretation adopted in Linklaters was subsequently carried forward in the case of Shanghai Electric[8], where the Tribunal viewed the offshore supply and supervisory functions as part of an integrated commercial arrangement and held that profits connected with similar activities undertaken for Indian projects could be attributed to the PE under the force of attraction principle. The decision thus placed greater emphasis on the economic connectedness between the offshore and onshore components of the project than on the direct involvement of the PE in the profit-generating activity.

Against this backdrop, the recent ruling in Paul Wurth Italia marks an important development in the application of the force of attraction rule. The assessee, an Italian company, had entered into separate contracts with Indian customers for offshore supply of equipment and designs, as well as onshore supervisory services relating to blast furnace projects. While the assessee admitted the existence of a supervisory PE in India in respect of the supervisory activities, it contended that the profits arising from offshore supplies could not be brought to tax in India as the PE had no role in the activities giving rise to such profits. The Tribunal held that, notwithstanding the existence of an admitted supervisory PE, offshore supply profits could not be attributed to India because the PE had no involvement in the activities generating those profits. In doing so, the Tribunal did not reject the force of attraction principle as such. Rather, it re-emphasised that its application remains contingent upon a demonstrable functional nexus between the PE and the income sought to be taxed. The significance of the decision therefore lies in reaffirming that the force of attraction rule cannot operate independently of the underlying attribution tests.

Interplay with the Indian domestic law and the changing source-based paradigm

In light of the above developments, the force of attraction principle appears to be evolving rather than diminishing. The legislative trajectory under Indian domestic law has steadily moved towards broader source-based taxation. Finance Act, 2010 introduced retrospective amendments with effect from 1976 clarifying that income by way of interest, royalty and fees for technical services would be deemed to accrue or arise in India irrespective of whether the non-resident had a residence, place of business or business connection in India, or had rendered services in India. This legislative intervention was intended to neutralise the territorial nexus requirement reflected in Ishikawajima and substantially expanded India's source-based taxing jurisdiction insofar as the taxation of income covered by Sections 9(1)(v), 9(1)(vi) and 9(1)(vii) is concerned. Nevertheless, the broader attribution principles discussed in Ishikawajima continue to influence the jurisprudence relating to Section 9(1)(i) and treaty-based PE attribution.

What also emerges from the foregoing judicial developments is that attribution remains a central enquiry even where a treaty incorporates force of attraction language. This assumes particular significance in the context of Rule 10 of the Income-tax Rules, 1962, which operates as an attribution mechanism for determining profits reasonably attributable to operations carried out in India. Unlike a force of attraction provision, Rule 10 does not expand the category of profits that may be taxed but merely provides a method for quantifying profits once a taxable nexus has already been established. This raises an interesting question as to whether the scope of taxation must first be determined by reference to the relevant treaty provision before attribution principles are applied, or whether attribution provisions themselves can influence the extent to which profits are brought within the tax net.

The emergence of Significant Economic Presence (‘SEP’) in the Indian domestic laws raises a further issue. While SEP and the force of attraction principle operate through different legal mechanisms, both seek to address situations where economic value is generated within a jurisdiction without a commensurate physical presence. While SEP expands domestic nexus standards through economic and digital participation, business profits in treaty situations continue to be governed by PE provisions. This raises an important question as to what extent can the expansion of domestic source-based taxation through SEP coexist with treaty provisions that continue to predicate taxing rights on the existence of a PE and, in some cases, on the operation of a force of attraction clause.

Concluding remarks

Thus, the significance of Paul Wurth lies not in rejecting the force of attraction rule but in recalibrating its application. The decision moves the jurisprudence away from a presumption that the mere existence of a PE is sufficient and towards a more principled enquiry centred on nexus, involvement and attribution. Whether this approach will continue to shape the interaction between force of attraction provisions, Rule 10 and emerging nexus standards such as SEP remains a question that future jurisprudence may be called upon to answer.

[First two authors are Principal Associates, while the third author is an Associate, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]

---

[1] DCIT v. Paul Wurth Italia SPA – ITA No. 5254/Del/2017 & others

[2] Ishikawajma-Harima Heavy Industries Ltd. v. DIT, [2007] 288 ITR 408 (SC)

[3] CIT v. Hyundai Heavy Industries Company Limited, [2007] 291 ITR 482 (SC)

[4] DIT v. LG Cable Ltd., IT Appeal No. 703 of 2009

[5] DCIT v. Roxon OY, IT Appeal No. 8174 (BOM.) of 1991

[6] Linklaters LLP v. ITO, International Taxation, IT Appeal Nos. 4896 and 5085 (Mum.) of 2003

[7] ADIT v. Clifford Chance, IT Appeal nos. 5034, 5035 & 7095 (MUM.) of 2004, 3021 (MUM.) of 2005 and 2060-61 (MUM.) of 2008, C.O. NOS. 41-44 (MUM.) of 2008

[8] Shanghai Electric Group Co. Ltd. v. DCIT, ITA No. 224/Del/2015, ITA No. 225/Del/2015, ITA No. 226/Del/2015, ITA No. 227/Del/2015, ITA No.3552/Del/2015, ITA No. 58/Del/2017 And ITA No. 59/Del/2017