[Opinion] ‘Effective Connected’ and ‘Attribution’ – Are They the Same? A Myth

Kunal Arora & Aakanksha Bansal – [2025] 180 taxmann.com 145 (Article)

1. Background

Attribution of income to a permanent establishment (‘PE’) and the connection of income with a PE are often used interchangeably. However, these terms may appear similar, though have distinct implications. The attribution of income to a PE is a more advanced concept, involving a deeper level of assessment than merely establishing a connection between income and a PE.

The interconnected nature of activities carried out by the foreign company’s head office (‘HO’) and the PE often blurs the line between what constitutes business profits and what qualifies as passive income. While every income attributable to a PE inherently has some connection with it, the converse is not always true.

This nuanced distinction plays a crucial role in determining the taxability of multinational companies operating across borders. Understanding this difference is key to ensuring compliance with applicable tax laws and mitigating potential litigation on taxation of PE.

2. Understanding Term PE

PE is defined as a fixed place of business through which the business of a foreign company is wholly or partly carried on or through an agent who habitually exercises an authority to conclude contracts or habitually secures orders or customarily maintains stock of goods/merchandise on behalf of a foreign company. In addition, PE may arise from employees working in source country on behalf of the foreign company.

This is where the international tax concepts of PE and profit attribution come into play. These determine the right of a country to tax the business profits earned by the foreign company through a PE in the source country. They lay down the principles and factors to be considered for the constitution of a PE, and the consequent profit attribution methods.

3. Effective Connection – Meaning and Scope

India’s bilateral tax treaties allocate passive income’s primary right of taxation to the resident state which provides that such income may also be taxed in source state but at a limited rate of tax. An exception to this allocation right exists where such passive income earned in source state is effectively connected with PE in source state. In such cases, provisions of Article 7 shall apply.

This arises the need to address whether the ‘permanent establishment exception’ in passive income articles will apply only where such passive income is fully attributable to the PE and hence taxable in the source state.

Placing reliance on the judicial precedents, ‘effectively connected’ is not merely the opposite of ‘legally connected’; it connotes a real and substantive nexus between the PE and the assimilated passive income. Cosmetic staffing or fleeting site visits cannot suffice.

Effective connection pertains to the degree to which a foreign company’s income is directly or indirectly linked to its PE. For income to be construed as effectively connected, the PE must play a significant role in generating, facilitating, or holding the asset from which the income arises. This becomes pertinent when a foreign company earns passive income such as royalties, interest or fees for technical services (‘FTS’), in a jurisdiction where it also maintains a PE.

Further, India acknowledges the aforesaid concept under its domestic tax laws through section44DA of the Income Tax Act,?1961 (‘Act’ or ‘ITL’). Under this provision, passive income such as royalties or FTS earned from India and that income is effectively connected with a Indian PE or fixed place of profession, the income shall be taxed on a net profit basis under the head ‘Profits and gains of business or profession’, allowing only those expenses that are wholly and exclusively incurred for the PE while disallowing the HO allocations.

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