ARTICLE 7

Business Profits

This Article provides the rules for the taxation by a Contracting State of the business profits of an enterprise of the other Contracting State. The general rule is found in paragraph 1, that business profits (as defined in paragraph 7) of an enterprise of one Contracting State may not be taxed by the other Contracting State unless the enterprise carries on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment)) situated there. Where that condition is met, the State in which the permanent establishment exists may tax the income of the enterprise, but only so much of the income as is attributable to

(a) that permanent establishment; (b) sales in that 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 State of the same or similar kind as those effected through that permanent establishment.

This limited force of attraction rule is similar to the rule in Article 7 of the U.N. Model. The rule in Article 7 of the U.S. Model is different, limiting the taxation of business profits to income attributable to that permanent establishment.

Paragraph 2 provides rules for the proper attribution of business profits to a permanent establishment. It provides that the Contracting States will attribute to a permanent establishment the profits which it would have earned had it been an independent entity, engaged in the same or similar activities under the same or similar circumstances and dealing wholly at arm’s length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by, or subject to the same control as that enterprise. The computation of the business profits attributable to a permanent establishment under this paragraph is subject to the rules of paragraph 3 for the allowance of expenses incurred for the purposes of earning the income. The profits attributable to a permanent establishment may be from sources within or without a

Contracting State. Thus, certain items of foreign source income described in section 864(c)(4)(B) of the Code may be attributed to a U.S. permanent establishment of an Indian enterprise and subject to tax in the United States. The concept of "attributable to" in the Convention is narrower than the concept of "effectively connected" in section 864(c) of the Code. The limited "force of attraction" rule in Code section 864(c)(3), therefore, is not applicable under the Convention.

Paragraph 2 concludes with two sentences not found in the comparable provision of the U.S. Model. These sentences state that the profits attributable to the permanent establishment may be estimated on a reasonable basis if the correct amount is either incapable of determination or exceptionally difficult to determine and if the result is in accordance with the principles contained in the business profits article. The United States expects that this rule would be applied only in unusual cases.

Paragraph III of the Protocol elaborates on paragraphs 1 and 2 of Article 7, paragraph 4 of Article 10 (Dividends), paragraph 5 of Article 11 (Interest), paragraph 6 of Article 12 (Royalties and Fees for Included Services), paragraph 1 of Article 15 (Independent Personal Services), and paragraph 2 of Article 23 (Other Income). This Protocol paragraph incorporates the principle of Code section 864(c)(6) into the Convention. Like the Code section on which it is based, Paragraph III of the protocol provides that any income or gain attributable to a permanent establishment (or, in the context of Articles 10, 11, 12, 15, and 23, a fixed base as well) during its existence is taxable in the Contracting State where the permanent establishment (or fixed base) is situated even if the payments are deferred until after the permanent establishment (or fixed base) no longer exists.

Paragraph 3 provides that in determining the business profits of a permanent establishment, deductions shall be allowed for expenses incurred for the purposes of the permanent establishment. Deductions are to be allowed regardless of where the expenses are incurred. The paragraph specifies that a deduction is to be allowed for a reasonable allocation of expenses for research and development, interest, executive and general administrative expenses and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment). The language of this paragraph differs from that in the U.S. Model in one significant respect. Under the U.S. Model deductions are not subject to the limitations of local law which may conflict with the general principle of the paragraph. Paragraph 3 in the Convention provides for such deductions in accordance with the provisions of and subject to the limitations of the taxation laws of the State in which the permanent establishment is situated.

Indian law limits certain deductions of a permanent establishment with respect to head office expenditures. The deduction of amounts characterized as executive and general administration expenditures (not interest) is capped at five percent of the adjusted total income of the permanent establishment. This limitation was included in the Convention because of the difficulties India has had in verifying claimed deductions for head office expenses and because of the desire of the Indians to avoid litigation on this issue. In practice, the Indian taxing authority does not inquire extensively into deductions that do not exceed the five percent cap. The amount permitted to be deducted is understood by India to be an approximate average of head office executive and general administrative expense incurred by non-Indian companies for

the purpose of their permanent establishments in India. However, the rule does not provide absolute certainty that U.S. companies with a permanent establishment in India will be able to deduct from their income subject to Indian tax the entire amount of head office expense incurred for the purpose of the permanent establishment.

Ad Article 7 under Paragraph II of the protocol states the understanding of the Contracting States that the deduction of executive and general administrative expenses shall in no case be less than that allowable under the Indian Income Tax Act as on the date of signature of the Convention (September 12, 1989).

Paragraph 3 also states that, with two exceptions, a permanent establishment will not be allowed to deduct amounts it pays to the head office, or any other office, of the enterprise as royalties, fees or other similar payments in return for the use of patents, know-how or other rights, as commissions or other charges for specific services performed or for management, or as interest on moneys lent to the permanent establishment. The rule denying deductions for such payments does not apply to amounts paid as reimbursement of actual expenses or as interest on moneys lent to the permanent establishment of a banking enterprise. Such payments made by the head office or any other office of the enterprise to a permanent establishment are similarly treated in determining the permanent establishment's profits. This provision is similar to the rule in Article 7(3) of the U.N. Model.

Paragraph 4 provides that no business profits will be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it is a permanent establishment. This rule refers to a permanent establishment which performs more than one function for the enterprise, including purchasing. For example, the permanent establishment may purchase raw materials for the enterprise's manufacturing operation and sell the manufactured output. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable with respect to its purchasing activities. If the sole activity were the purchasing of goods or merchandise for the enterprise the issue of the attribution of income would not arise, because, under subparagraph 3(d) of Article 5 (Permanent Establishment), there would be no permanent establishment.

Paragraph 5 states that the business profits attributed to a permanent establishment are only those derived from its assets or activities. As noted in connection with paragraph 2 of this Article, the Code concept of effective connection, with its limited "force of attraction", is not incorporated into the Convention except to a limited extent as described in connection with paragraph 1 of this Article.

Paragraph 6 explains the relationship between the provisions of Article 7 and other provisions of the Convention. Under paragraph 6, where business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will take precedence over the provisions of Article 7 except where those articles provide otherwise. Thus, for example, the taxation of interest will be determined by the rules of Article 11 (Interest), and not by Article 7, except where, as provided in paragraph 5 of Article 11, the interest is attributable to a permanent establishment, in which case the provisions of Article 7 apply.

Paragraph 7 defines the term "business profits" as used in the Convention to mean income derived from any trade or business including income from services other than "fees for included services" as defined in Article 12 (Royalties and Fees for Included Services) and including income from the rental of tangible personal property other than income from the rental of property described in paragraph 3(b) of Article 12. Thus, service income (other than fees for included services) is subject to tax in a Contracting State to the extent provided under Article 7, subject to the principle of paragraph 6, described above. Also, rental income from tangible personal property (other than payments received for the use of, or the right to use, any industrial, commercial, or scientific equipment) is subject to tax in a Contracting State to the extent provided under Article 7. The comparable provision in the U.S. Model provides a general definition which says that the term "business profits" means income derived from any trade or business. The definition in the Convention specifically identifies the residual categories of income from services and tangible personal property as business profits in order to clarify the interaction of Articles 7 and 12. The exclusion from the term "business profits" of fees for included services defined in Article 12 and rental of property described in paragraph 3(b) of Article 12 is intended to apply only in cases where paragraph 6 of Article 12 is inapplicable to such income items. In other words, where such income items are attributable to a permanent establishment in a Contracting State, such items shall be considered business profits to which Article 7 applies.

This Article is subject to the saving clause of paragraph 3 of Article 1 of the Convention. Thus, if, for example, a citizen of the United States who is a resident of India derives business profits from the United States which is not attributable to a permanent establishment in the United States, the United States may tax those profits as part of the worldwide income of the citizen, notwithstanding the provisions of this Article under which such income derived by a resident of India is exempt from U.S. tax.