Redefining tax residence of companies: a lever to tax more

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The concept of tax residence identifies the scope of a taxpayer’s taxable income.  It is a commonly-adopted principle internationally, also applied under the Indian income tax law.

Under Indian law, a resident is taxable on his worldwide income for that year.  A non-resident, on the other hand, is taxable only in respect of income sourced from India or received in India.  The scope of taxable income of a non-resident is, therefore, more restricted than that of a resident.

This principle also applies to companies.  Until April 1, 2015 (a) an Indian company or (b) a company, the control and management of whose affairs were wholly situated in India, were regarded as tax residents in India.  For foreign companies, the second condition was easily bypassed as the test required ‘whole’ of control and management of affairs to be situated in India in a year. This facilitated creation of shell companies outside India, but effectively controlled from India or conducting a single board meeting outside India. Considering this loophole, it was desired that this condition be tightened to prevent abuse.

Internationally, the concept of Place of Effective Management (POEM) is a commonly applied test to determine tax residence. From April 1, 2015, condition (b) has been replaced by the test of POEM.

POEM has been defined under Indian law as a place where key management and commercial decisions of an entity are made. While introducing this amendment, the finance minister indicated that guidance on interpretation will be notified in due course.

While a much prevalent concept internationally, POEM has been introduced in the Indian income tax law for the first time. This also raises the chances of controversies due to its various interpretations. We first consider the international guidance available on this concept and then consider some emerging aspects in the Indian context.

The international guidance International conventions typically adopt the concept of POEM to determine tax residency in situations where a taxpayer qualifies as a tax resident of two countries simultaneously.  The tax treaties do not define the term, but the OECD commentary in describing its meaning, suggests that it is the place where key management and commercial decisions of an entity are made. The definition under Indian law is similar to the description in the OECD commentary, allowing this international guidance to be used in interpreting the concept in India.

The commentary further suggests that POEM will ordinarily be the place where the most senior person, or group of people (for example the board of directors), make decisions, the place where the actions to be taken by the entity as a whole are determined.  It however cautions that no definitive rule can be given on this matter and that all relevant facts and circumstances must be examined.  The OECD further establishes that an entity may have more than one place of management, but it can have only one POEM at any one time.

International jurisprudence suggests that the place where the top-level management is located and place where controlling shareholders make key management and commercial decisions in relation to a company are the key determinants.  Legal factors such as place of incorporation, location of registered office and public officer are also important.

The locus standi in India
India is not a member of the OECD and has an observer status.  India has expressed some reservation in applying the OECD commentary to POEM and has stated that in addition to the above, determination of POEM should also be guided by the place where main and substantial activity of the entity is carried on.  This may be read into the manner in which India may interpret POEM under Indian law.

The rationale for introduction of POEM under Indian law appears to be, firstly, to bring more foreign companies (which could be regarded to have a POEM under tax treaty principles in India) in the Indian tax net, and secondly to bring consistency in the tax residency rules under Indian and international laws.

Before April 1, 2015, foreign companies would generally not qualify as tax residents in India (owing to the loophole discussed earlier) and hence the requirement to apply the POEM test to them under the tax treaty hardly ever arose.  This amendment is therefore set to increase the tax base of international taxpayers in India.

The amendment is also directed to attack outbound offshore holding entities that are effectively managed, or administered, within India. However, There could be some subjectivity in applying the test owing to increased global mobility of human capital with senior personnel being positioned or travelling to India temporarily  and stray decisions being taken by them while being physically in India.

There is also the likelihood of challenges in situations where decision making is disaggregated resulting in multiple locations becoming POEMs. The ability to clearly identify the difference between management and operational decisions, and evidence that must be regarded as sufficient to establish decision making authority.  In case of multi-national enterprises, personnel residing in India and providing management services under a group inter-company framework could lead to potential scrutiny and difficulties. While these are not issues unique to the Indian avatar of POEM, these matters supplement the need for a clear set of rules in interpreting POEM under Indian law.

While one would await the guidance to be issued by the Indian tax administration, some pertinent factors in relation to POEM may be composition of board of directors, meetings of board of directors, location of key management personnel, place of negotiation and decision making, place of execution of documents, reporting in other compliances, etc.

As a consequence of POEM, certain potentially undesirable transfer pricing consequences may also ensue. Currently, different thresholds are set for international and domestic transfer pricing compliances.  Regarding a foreign company as a tax resident in India (owing to it having a POEM in India) could lead to a greater or lower threshold or number of transactions being subject to Indian transfer pricing.

Introduction of POEM under the Indian income tax law is an interesting development.  While it appears to be well intended, ‘the proof of the pudding is in the eating’.  India has been a hotbed for high-profile tax litigation in the past few years and an inadequately explained law can become the cynosure of new controversies.  It also remains to be seen how the government addresses some of the concerns relating to technological revolutions of today's age (for example, use of sophisticated technology for meetings held via telephonic participation, web or video conferencing, virtual offices, etc).

- By Sumeet Hemkar, Partner, BMR & Associates LLP with inputs from Anuj Agarwal.  
(Views expressed are personal)

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