OECD as well as UN Model Convention provide for broadly the same general rules for allocation of taxing rights between Residence and Source-States in respect of passive income from dividend, interest and royalties ((articles 10, 11 and 12). Both the Model Conventions presently do not refer to income from fees for technical services (though UN Model earlier did). The above rules have been adopted by India in all her seventy odd DTAAs with other countries.

Paragraph 1 of the relevant Articles of Both the Models for taxation of dividend, interest and royalty allots the primary right of taxation to the Residence-State of the beneficial owner of income (‘may be taxed in the Residence State') Paragraph 2, however, provides that such income ‘may also be taxed in the Contracting State in which it arises and according to the laws of that State' on gross basis, not exceeding a stipulated limit (OECD Model, however, presently does not grant any secondary right to the Source-State in respect of royalty income). India has consistently ensured the secondary right of taxation for Source-State and followed the same pattern for royalties and fees for technical services.

There is, however, a common exception to the above rule in the Articles 10, 11 and 12 dealing with dividend, interest, royalty and fees for technical services income. This is popularly known as ‘permanent establishment proviso'. If this proviso is applicable, the Residence-State loses its right of taxation and the income is fully taxable in the Source-State. The proviso runs in near -identical language in all the above articles in OECD and UN Model Convention (with minor differences), as under :--

“The provisions of paragraphs 1 and 2 shall not apply, if the beneficial owner of the dividends/interest/royalties, being a resident of a Contracting State, carries on business in the other Contracting State, of/in which the company paying the dividend is a resident /the interest arises/ the royalties arise, through a permanent establishment situated therein or performs independent personal services from a fixed base situated therein and the holding in respect of which the dividends are paid/debt-claim in respect of which interest is paid/the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 or 14, as the case may be, shall apply.”

The India-US DTAA, however, following US Model, uses the term “attributable to” in place of “ effectively connected with”. The interpretation of the term “attributable to” in this paragraph is most likely to proceed on the same lines as in paragraph 5 of article 7 relating to taxation of profits of a permanent establishment, meaning ‘ profits derived from the assets and activities of the permanent establishment'. The OECD Commentary on Model Convention also proceeds on similar lines to state:--

“Paragraph 3 is not based on a conception which is sometimes referred to as “the force of attraction of the permanent establishment”. It does not stipulate that royalties arising to a resident of a Contracting State from a source situated in the other State must, by kind of a legal presumption, or fiction even, be related to a permanent establishment which that resident may have in the latter State, so that the said State would not be obliged to limit its taxation in such a case. The paragraph merely provides that in the State of source the dividends, interest or royalties are taxable as part of the profits of the permanent establishment, there owned by the beneficiary, which is a resident of the other State, if they are paid in respect of shares, debt claims or right or property forming part of the assets of the permanent establishment or otherwise effectively connected with that establishment. In that case, the paragraph relieves the State of source of the dividends, interest or royalty from any limitations under the Article. The foregoing explanations accord with those in the Commentary on Article 7.”

According to Claus Vogel (3 rd Edition, pages- 565 to 569, 803) – “The right or property giving rise to the dividend etc. must be effectively connected. According to the OECD Commentary it must form part of the assets of the Permanent Establishment or be ‘otherwise' effectively connected with the permanent establishment. According to OECD Commentary this goes to show that the force of attraction of the permanent establishment is rejected. The connection of the assets to the permanent establishment is decisive. The term ‘effectively connected' should not be understood to mean the opposite of ‘legally connected' but rather something in the sense of ‘really connected'. The claim should be connected to the permanent establishment not only in form but also in substance. The holdings, debt-claims etc. must serve the purposes of the permanent establishment. USA uses the term ‘attributable'. Claus Vogel believes that in substance this does not result in any difference from the rules of OECD model Commentary.

But it is difficult to visualize how an asset can be effectively connected with the permanent establishment otherwise than by forming part of its assets. This however would be the case if the participation is functionally connected with the activity exercised in the permanent establishment, and, therefore, the proceeds from the holding appear to be secondary….”

It has to be appreciated that the provisions of paragraph 1 of Articles 10, 11 and 12 presupposes that the shares, debt claims or technical know-how etc. are owned and held by the non-resident. The State of source is granted a limited and secondary right of taxation because of passive income generated from the asset arises in the said country. In such taxation it is not possible to resort to net income taxation, as in the case of a permanent establishment, because the asset has been acquired and held abroad and it is not possible to identify the expenses incurred in connection with acquisition and exploitation of the assets. Hence, a presumptive taxation is done at a stipulated percentage of the gross income. However where the asset is owned by the permanent establishment in the State of source, and it has been acquired and exploited in the State of source by the permanent establishment so that the income is solely attributable to the permanent establishment, it will be only proper to follow Article 7(1) and tax such income in the State of source on net basis, as a part of the income attributable to the permanent establishment. In such a case there will be no difficulty in computation of net income as all expenses as well as all incomes arise in the State of source. The terms ‘effectively connected' and ‘attributable' are synonymous. Only when the assets giving rise to incomes in the form of dividend, interest and royalty are effectively connected or belong to the permanent establishment, the said incomes can be said to be attributable to the permanent establishment. It will defeat the purpose of the provisions if it is claimed that the assets are effectively connected with the permanent establishment but the income from the said assets are not attributable to the permanent establishment. In case of royalty or fees for technical services, to be attributable to the permanent establishment, it is necessary that the technical know-how giving rise to royalty should be owned by the permanent establishment and all expenses in connection with development/acquisition of such technical know-how should have been borne by the permanent establishment or the technical services should be rendered by the permanent establishment through its technical personnel. Apart from being owned by the permanent establishment, the only example of being “otherwise effectively connected”, which comes to mind is a case of lease or assignment of shares, debt claims or intellectual right or property to the permanent establishment, i.e., when the permanent establishment has an economic ownership to exploit the assets.

A.A.R in Advance Ruling P. No. 13 of 1995, In re - (2002-TII-04-ARA-INTL) explained the meaning of the term ‘effectively connected' as follows:- “All the outside activities are directed towards the installation of the manufacturing plant and industrial complex in India. Though carried out elsewhere, they are integrally connected with the project in India. The designs, basic engineering services and other services are based on information collected in India and the use of the process and technologies have to be adapted to the needs of, and prove workable in, Indian conditions. The permanent establishment in India has an undoubted voice over the outside activities as well and the royalties and fees for technical services cannot but be described as effectively connected with it.” A.A.R, while holding that the activity of design, basic engineering services and other services carried out abroad, in connection with the contract of supply of manufacturing plant to India from abroad and installation, erection and commissioning of the plant in India was effectively connected with the activity of the permanent establishment in India, namely installation, erection, commissioning of the plant in India, was of the opinion that the fees for technical services receivable for design, basic engineering services and other related services would not be assessable under Article 12 but under Article 7. But on the issue of assessability of such income under Article 7, A.A.R took a contrary view holding that since the activities of preparation of design, basic engineering services etc were carried out abroad, the income from such services cannot be said to be attributable to the permanent establishment. In the result, the income escaped taxation altogether in the Source State. The above decision of the A.A.R seems to be self defeating in purpose.

There is another aspect of the matter. A bare reading of the ‘permanent establishment proviso' in OECD and UN Model Convention and also the treaties entered into by India indicates a literal meaning that the beneficial owner of dividend etc. income should otherwise carry on business or perform independent personal services through a permanent establishment or fixed base in the Source-State and dividend or interest income must arise from assets owned or held by the permanent establishment etc, i.e., dividend yielding shares or debt-claims yielding interest. Similarly the income from royalties must arise from the rights or properties (intellectual properties) owned by the permanent establishment or fixed base.

An issue arises in respect of fees for technical/included services. For the ‘permanent establishment proviso' to be applicable, should the beneficial owner of income from fees for technical/included services have a pre-existing permanent establishment or fixed base, as in the case of dividend, interest or royalty income, and the technical/included services should be rendered by the personnel of the said permanent establishment etc; or whether personnel of the beneficial owner of the fees for technical/included services, if they come from the Residence-State to the Source-State to render technical/included services and such services continue for an appreciable period, can constitute a permanent establishment, so as to attract the provisions of ‘permanent establishment proviso' on its own, leading to taxation of fees for technical/included services on net basis.

In this regard, it is to be noted that there is a clause for ‘service P.E.' in UN Model, but not in OECD Model. Some of the treaties entered into by India with other countries contains a service P.E. clause, particularly USA and other countries, which follow the US Model, namely UK, Canada, Australia, Netherlands etc., while other countries like France, Japan, Italy, Germany, South Africa etc do not have this clause. The clause (b) of article 5(3) of UN Model provides – “The term permanent establishment also encompasses furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve-month period.”

On the other hand, c lause (l) of Article 5(2) Indo-US treaty states - "Permanent establishment includes especially the furnishing of services, other than included services as defined in Article 12 (Royalties and Fees for Included Services), within a contracting State by a enterprise through employees or other personnel, but only if such services are rendered (for more than a stipulated time period)..."

The presence of the personnel of a foreign enterprise in a Source-State for an appreciable period to render services, which fall within the purview of the technical/included services in article 12, will not constitute a service P.E. for USA, UK and other countries mentioned above, because the definition of service P.E, in the treaties excludes services under article 12. In other cases where there is no deeming provision in the treaty for service P.E, the presence of the employees in the Source-State to render services may not constitute a fixed place of business in the absence of the deeming clause. In such cases there will be no scope for application of the proviso, unless there is a pre-existing P.E., whose personnel render the service.