Dr. Rakesh Gupta, FCA, FCS, AICWA, MBA, LLM, PhD
Ex-Member, Income Tax Appellate Tribunal
Somil Agarwal, ACA, ACS, ACMA, DISA, LLM (U.K.)
RRA TaxIndia, Tax Advisors & Advocates
Taxability of income under the Income Tax Act is dependent, interalia, on residential status of a person. According to section 5(2) of the Income Tax Act, 1961, the total income of a non-resident would include only such income which is received or deemed to be received in India or accrues or arises or is deemed to accrue or arise in India to that person in such year. Since the taxable income of the non-resident in India broadly is India related income only, attempt is, therefore, made by a person to come out from the definition & meaning of ‘resident’ & become ‘non-resident’. Once a foreign company becomes tax- resident, its global income becomes the subject matter of tax in India and the taxes paid by such company in different jurisdictions can, subject to the treaty provisions, be claimed as tax credit.
Background & Journey of section 6(3)
In case of a company-assessee, section 6(3) lays down as to when can a company be said to be ‘resident’.
Section 6(3) before this was substituted initially by the Finance Act, 2015 and later on, by the Finance Act, 2016, stood as under:
A company is said to be resident in India in any previous year, if—
(i) it is an Indian company; or
(ii) during that year, the control and management of its affairs is situated wholly in India.
Judicial precedents in our country have consistently held that the control and management of a company is situated at the place where the direction, management and control, the head and seat & directing power of the company’s affairs is situated. This could be a place where directors’ meetings are held and based on this fact, it could be said that the company would be resident in that country where the meetings of the directors who manage and control the business are held.
Provision of section 6(3) while referring to the phrase ‘control and management of the affairs situated wholly in India’ created problem in as much as, if the control and management of such company was not wholly situated in India during a year & even if it was partially situated outside India, such company would have, in that situation, become ‘non-resident’. Instances were not uncommon where companies were found to have held few of the Board meetings out of India so as to overshoot & overcome the hurdle of ‘control and management situated wholly in India’.
Moreover, the decision of Delhi bench of Income Tax Appellate Tribunal in the case of Radha Rani Holdings vs. ACIT 110 TTJ 920 (Del) brought the issue of Shell Companies incorporated outside India, to the limelight even though such companies were being controlled & managed from India in reality. Therefore, legislature chose to do away with the concept of ‘control and management’ and sought to make ‘place of effective management’ as the criteria for determining the residential status of the company-assessee. Such shell companies after the introduction of the concept of ‘place of effective management’ (‘POEM’ in short) were to face the heat & would fall in the Indian tax net on account of their residential status eventually becoming tax-resident of India.
In fact, the criteria of ‘place of effective management’ was relevant in determining the residential status of shipping companies in terms of section 115VC wherein a company to be called a qualifying company must have had its ‘place of effective management’ in India but this phrase ‘place of effective management’ was differently explained in case of shipping company under Explanation to section 115VC.
The concept of ‘place of effective management’ was prevalent in various countries in order to determine the residential status and was one of the criteria for determining the residential status in case of tie-breaker rule.
Amendment proposed in Finance Bill, 2015
(3) A company is said to be resident in India in any previous year, if,—
(i) it is an Indian company; or
(ii) its place of effective management, at any time in that year, is in India.
Explanation.—For the purposes of this clause “place of effective management” means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made.’.
Memorandum explaining the provisions of Finance Bill, 2015 gave following reasons for the amendment in section 6(3) as under:
a. Condition & threshold of residency linked with ‘control and management wholly situated in India’ is too strict & practicably inapplicable due to which companies may avoid residency by holding one or more meeting of the Board of Directors outside India.
b. Existing section was prone to the creation of Shell Companies outside India.
c. POEM is an internationally recognised concept which is adopted in tie-breaker rule of Indian treaties and is also adopted in many jurisdictions.
d. Even OECD recognises and accepts POEM which means the place where key management and commercial decisions necessary for the conduct of the business of the entity as a whole are in substance made.
e. POEM is internationally recognised facts-dependent exercise with well recognised guiding principles for POEM determination.
f. Many countries prefer the POEM test to be more appropriate test for determination of residence of a company
Thus, legislative attempt behind the concept of POEM introduced through the proposed amendment was interalia to check tax avoidance and to enact it as an anti-abuse measure. POEM provisions would detect such cases where companies though were incorporated outside India but, in effect, were controlled and managed from India.
Finance Bill, 2015 used the expression in the proposed section 6(3) that if POEM is in India at any time during the previous year, the company would become the resident. Flurry of suggestions were sent to Central Board of Direct Taxes (CBDT) regarding the likely consequences of such phrase which would result in case when POEM even for a day in the previous year would make a foreign company as tax ‘resident’ in India. Thereafter, the phrase ‘at any time’ was removed from the language of the enacted section 6(3).
Finance Act, 2015
Bill when enacted brought the following section 6(3) on the statute with effect from 1st April, 2016:
‘(3) A company is said to be resident in India in any previous year, if—
(i) it is an Indian company; or
(ii) its place of effective management, in that year, is in India.
Explanation.—For the purposes of this clause “place of effective management” means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole, are in substance made.’
In fact, section 6(3) before its substitution by the Finance Act 2015 provided a company to be resident in India if it was an Indian company or during the previous year, the control and management of its affairs was situated wholly in India. In so far as the condition of the company to be an Indian company is concerned, it has remained so even in post amended provision, but condition of the ‘control and management of its affairs’ has been replaced by the ‘place of effective management’.
But, section 6(3) amended as above by the Finance Act 2015 to come into effect from 1.4.2016 was omitted by the Finance Act 2016 before the amended provision could see the light of the day and new section 6(3) which was essentially the same, was brought by the Finance Act 2016 effective from 1.4.2017.
Finance Act, 2016
Residence in India
6. For the purposes of this Act,—
(3) A company is said to be a resident in India in any previous year, if—
(i) it is an Indian company; or
(ii) its place of effective management, in that year, is in India.
Explanation.—For the purposes of this clause “place of effective management” means a place where key management and commercial decisions that are necessary for the conduct of business of an entity as a whole are, in substance made.
As per thus finally substituted section 6(3), a company would be a resident in India in any previous year if it is an Indian company or its place of effective management (POEM) in that year is in India. ‘Explanation’ appended to section 6(3) provides the meaning of the ‘place of effective management’ to be a place where key management and commercial decisions necessary for the conduct of the business of an entity as a whole are made in substance.
The terms used in the Explanation to section 6(3) viz. ‘key’, ‘management’ and ‘commercial decisions’ show that the focus is on managerial and commercial decisions to be seen cumulatively and not in isolation. ‘Place of effective management’ as per the ‘Explanation’ to section 6(3) requires determination of a place where ‘key management and commercial decisions necessary for the conduct of business are in substance made’ which would be, in turn, be determined having regard to the ‘decision test’, ‘necessity test’, ‘pervasiveness test’ & ‘substance test’ and that too when all these conditions are satisfied during the relevant year.
A company which is incorporated in India would always be a resident company but a foreign company may be resident in India if it has a POEM in India but such foreign company would continue to be termed as foreign company only and would not be treated as domestic company. Such foreign company would remain a resident foreign company.
Residential status is not a static concept and is required to be determined every year which may in turn depend on factual aspects obtaining in a particular year.
Guidelines for determination of POEM
Determination of POEM is facts-based, facts-centric & facts specific on case to case & year to year basis. There are no & in fact cannot be fixed yardsticks for this purpose.
CBDT however came out with a detailed circular no. 6/2017 dated 24.01.2017 prescribing the guidelines for the purpose of determining ‘place of effective management’ (POEM). These guidelines are meant to act as directive principles to the tax payers and the tax administrators alike. These tests are not conclusive and there may be other factors which may be considered while determining the POEM. However, it was made clear by CBDT by another circular no. 25/2017 dated 23.10.2017 that these guidelines would not apply to companies having turnover or gross receipts of Rs. 50 crores or less in a financial year.
Circular prescribes the guidelines for determination of POEM:
(A) In case of a company which is engaged in ‘active business outside India’ (‘ABOI’ in short) and
(B) Company other than those which are engaged in ABOI.
(A) As to the company engaged in ABOI, circular guides that POEM would be assumed to be out of India if majority of meetings of the Board of Directors (‘BOD’ in short) of the company are held outside India. But, if the facts indicate that BOD are standing aside and not exercising their powers of management but such powers are being exercised by the holding company or any other person(s) resident in India, then, POEM of such company even if it is engaged in ABOI, would be considered to be in India.
Therefore, the first step is to find out as to whether the company under consideration is a company which is engaged in ABOI. The guidelines have provided quantitative tests to determine a Company which can be said to be engaged in ABOI. Such tests are:(i) if passive income of such company is less than 50% of its total income &
(ii) if less than 50% of its total assets are situated in India &
(iii) if less than 50% of total number of employees are situated in India or are resident of India &
(iv) if payroll expenses of such employees is less than 50% of its total payroll expense.
Guidelines further explain in respect of above variables as to how ‘income’, ‘value of assets’, ‘number of employees’, ‘pay roll expenses’, ‘passive income’ shall be computed:
(i) ‘Income’ is to be computed in accordance with the laws of country of incorporation from tax perspective or where no such computation is required under the laws of that country, then, ‘income’ shall be as per books of account.(ii) ‘Value of assets’ whether depreciable individually or block of assets shall be computed on average basis by taking the figures at the beginning and at the end of the year whereas in case of any other assets, its value has to be taken as per books of accounts.
(iii) ‘Number of employees’ shall be taken on average basis by taking such numbers at the beginning and at the end of the year and would include such persons also who were not directly employed by the company but who were performing tasks similar to those performed by the employees.
(iv) ‘Payroll’ expenses would include cost of salaries, wages, bonus & other employee compensation, pension and social costs borne by the employer.
(v) ‘Passive income’ of a company would mean the aggregate of income from such transactions where both the purchase and sale of goods is from/ to its associated enterprises and income is by way of royalty, dividend, capital gains, interest or rental income. Further, interest income shall not be passive income in case of a banking company or public financial institution where its activities are regulated under the laws of country of incorporation.
Guidelines go on specifying further that average of the data of the previous year and two preceding years would be taken into account for the purpose of determining ABOI status of a company. If such company has been in existence for shorter period, then, the data of such period shall be considered. If accounting year as per the laws of the country of incorporation is different than the previous year, then data of the accounting year that ends during the relevant previous year and two preceding accounting years shall be considered.
Having laid down the comprehensive criteria for determining as to whether the company is engaged in ‘active business outside India’ (ABOI), it is reiterated as submitted earlier too that that POEM in case of such ABOI-company would be assumed to be outside India if the majority meetings of the Board of Directors of the company are held outside India but, if it is found that BOD of such company is standing aside and is not exercising its powers of management but such powers are being exercised by either the holding company or any other person(s) resident in India, then, POEM of such ABOI company would be considered to be in India.
(B) In case of a company other than ABOI company determination of POEM would be 2 stage processes i.e.
(i) Identification of the persons making the key management and commercial decisions for conduct of the company’s business as a whole &
(ii) Determining the place where these decisions are made.
Circular-guidelines in this regard prescribe that:
a) Location where the Board of the Company regularly meets and makes decision would be POEM if the Board retains & exercises its authority to govern the company & make the key management & commercial decisions necessary for the conduct of the company’s business as a whole.
But, if Board are taking key decisions at a place other than the place where formal meetings are held, then such other place would be relevant for POEM.
If Board has delegated the authority to make the key management and commercial decisions to the senior management or any shareholder, promoter, strategic or legal or financial advisor and merely ratifies routinely the decisions made by such persons, then place where these senior managers or other person make decisions would be relevant for POEM.
If Board has de facto or de jure delegated some or all of its authority to one or more committees consisting of key members of senior management, then, location where the members of the executive committee are based and where key strategies & policies are formulated for mere formal approval of the Board would be considered to be company’s POEM.
b) Location of Head Office would determine POEM of the company as it is the Head Office where key decisions are made by the company.
‘Head office’ of a company is a place where the senior management and their direct support staff are located or are primarily or predominantly located & it is not necessary that the head office of the company is to be called the head office where the majority of its employees work or where its board meets.
‘Senior management’ means person(s) responsible for developing and formulating key strategies and policies for the company, ensuring or overseeing the execution & implementation, and implementation of those strategies on a regular and on-going basis and these persons may be Managing Director or CEO, FD or CFO, COO and heads of various divisions.
Where ‘senior management & their support staff’ are based in a single location which is held out to the public as principal place of business or headquarters, such location would be treated as location of the Head office.
If senior management of the company operate from different offices located in various countries, Head Office of the company would be the location where the senior managers are primarily or predominantly based or normally return to following travel to other locations or meet when formulating or deciding key strategies and policies for the company as a whole.
If the senior managers operate from different locations almost on permanent basis & participate in various meetings via telephone or video conferencing, Head office in such a case would be such location where highest level of management and their direct support staff are located.
However, if senior managers are so decentralized that company’s Head Office cannot be determined, location of Head Office would not be of much relevance in determining POEM.
c) Physical location of the Board Meeting or executive committee meeting or meeting of the senior management may not be relevant to determine the location of key decisions taken if such decisions are taken through the use of modern technology and in such situations, place where the directors or persons taking decisions or majority of them usually reside may be a relevant factor for determination of POEM.
d) Location of the parties involved may be relevant factor for determination of POEM in case decisions are taken based on circular resolution or round robin voting. The frequency with which it is used, the type of decisions made in that manner and the Proposer of the decision alone would not be relevant but it would be required to determine the location of such person based on past practices and general conduct who has authority and who exercises the authority to take decisions. In such a case, location of such person may be relevant for the determination of POEM.
e) Decisions as to sale of company’s assets, dissolution, liquidation or deregistration of the company, or the modification of the rights attaching to various classes of shares or the issue of new class of shares made by a shareholder on matters reserved for shareholder decision under the company laws are not relevant for determination of POEM as these decisions though may affect the existence of the company or the rights of the shareholders but do not affect the conduct of the company’s business from a management or commercial standpoint and thus are not relevant for determination of POEM.
But if shareholders limit the authority of BOD and senior managers and thereby remove the company’s real authority to make decision, then, the shareholder guidance becomes usurpation and such undue influence may result into effective management being exercised by the shareholder and it would be an important factor in determination of POEM.
f) Routine operational decisions undertaken by junior & middle management would not be relevant for the purpose of determination of POEM unless the person responsible for operational decision is the same person who is responsible for the key management and commercial decision and in that case, the location where the key management and commercial decisions are taken would be relevant for determination of POEM.’
g) The circular further provides that place where these management decisions are taken would be more important than the place where such decisions are implemented and for the purpose of determination of POEM it is the substance which would be conclusive rather than the form.
h) Still, if these factors do not lead to clear identification of POEM, then the secondary factors such as place where main & substantial activity of the company is carried out or place where the accounting records of the company are kept may be relevant for the determination of POEM.
So, in case of a company which is not engaged in ABOI, POEM would be determined having regard to above factors.
(C) Guidelines provide that determination of POEM is to be based on the consideration of all the relevant facts taken together and isolated facts by themselves would not establish POEM. In fact, circular reiterates at more than one place that determination of POEM is facts-specific and no single principle would be decisive and the facts and circumstances over a period of time would go to establish and determine the existence of POEM in India.
Few illustrations were also given to drive home this point by the guidelines as under:
(i) The fact that a foreign company is completely owned by an Indian company will not be conclusive evidence that the conditions for establishing POEM in India have been satisfied.
(ii) The fact that there exists a Permanent Establishment of a foreign entity in India would itself not be conclusive evidence that the conditions for establishing POEM in India have been satisfied.
(iii) The fact that one or some of the directors of a foreign company reside in India will not be conclusive evidence that the conditions for establishing POEM in India have been satisfied.
(iv) Fact of the local management being situated in India in respect of activities carried out by a foreign company in India will not, by itself, be conclusive evidence that the conditions for establishing POEM have been satisfied.
(v) The existence in India of support functions that are preparatory and auxiliary in character will not be conclusive evidence that the conditions for establishing POEM in India have been satisfied.
(D) Circular further states that depending upon the facts and circumstances of each case, if it is determined that in a given year, POEM is in India as well as outside India, in that situation, POEM shall be presumed to be in India if POEM has been mainly/ predominantly in India.
(E) The circular in order to inject objectivity and ensure adequate safeguard against the arbitrary exercise of this provision provides that before initiating any proceeding for determination of POEM to hold a foreign company as resident in India, the assessing officer would seek approval of the Principal Commissioner of Income Tax.
Further, any finding that a foreign company is resident in India based on POEM shall be given after seeking the prior approval of the collegium consisting of Principal Commissioners or Commissioners to be constituted by Principal Chief Commissioner and such collegium shall provide an opportunity of being heard before issuing any direction in the matter.
Thus, guidelines prescribed by the Circular seek to provide quantitative and qualitative tests for objective determination of POEM
Consequences in Brief if a foreign company becomes tax-resident due to POEM
a) Foreign company would be termed as Resident Foreign-company under section 6(3) of the Act..
b) Global income of such foreign company would become taxable in India under section 5(1) of the Act.
c) Tax rate applicable on such resident foreign company would continue to be 40% plus surcharge & Cess as is applicable on Foreign Company. Tax rate applicable on domestic company would not apply to such resident foreign companies.
d) Other implications as per the provisions of section 115JH read with the notification issued by CBDT would be applicable on such resident foreign company.
POEM guidelines are not binding on the taxpayers as well as tax authority but may act as directive principles to be applied to the facts of each case while evaluating POEM. But, it is hoped that this anti abuse provision should not itself be abused as a sweeping sword-wielding mechanism for revenue generation.