Taxability of a company depends on its residential status. Historically, a company was considered a resident of India if it was an Indian company (i.e. incorporated in India) or if its control and management in that year was situated wholly in India. Consequently, if a single board meeting of a foreign company was held outside India, it would not qualify as a resident for Indian tax purposes, even if it was otherwise controlled and managed from India.
With effect from Financial Year 2016-17, the place where a company’s Place of Effective Management (POEM) is located will determine its tax residency. POEM has been defined to mean ‘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’.
Foreign company’s POEM is in India - Consequences
- The global income of the foreign company becomes taxable in India.
- The foreign company retains the status of a ‘foreign company’ for Indian tax purposes. Hence, the global income will be taxable at the rate of 40%, rather than 30% that applies to Indian companies. However, such a foreign company which has its POEM in India, is not regarded as a ‘domestic company’ under the Income-tax Act, 1961, and hence neither the Dividend Distribution Tax under section 115-O, nor the Buyback Tax under section 115QA ought to apply to it.
- Although credit for taxes paid in the foreign country (i.e. the country of incorporation) may be available, many of the foreign companies which have their POEM in India may be incorporated in low tax jurisdictions. Hence, despite the availability of credit, the incremental tax costs in India may be significant.
- The foreign company’s ability to claim benefits under tax treaties entered into by its country of incorporation may be affected.
Determination of POEM
The definition of POEM as stated above is subjective. The Central Board of Direct Taxes issued a set of Guiding Principles to be followed for determination of POEM. Subsequently, some guidance was also issued on the computation of income and treatment of losses, depreciation, etc. in cases where the POEM of a foreign company is considered as being situated in India.
The manner for determining POEM depends on whether the foreign company is engaged in an Active Business outside India or not. If it is engaged in an active business, the rules for determining POEM are relatively simpler and objective and are based on where the board meetings of the company are held. If not, then a subjective and fact specific approach must be followed to determine its POEM. This is based on identifying the persons who take the key management decisions and determining where these decisions are infact made.
Conditions for a company to be regarded as engaged in Active Business outside India are:
- Its passive income (dividend, capital gains, interest, royalty, etc.) should not be >50% of its total income;
- < 50% of its total assets must be situated in India;
- < 50% of its total number of employees must be situated in India or are resident in India;
- Payroll expenses incurred on such employees should be < 50% of its total payroll expenditure.
POEM test will not apply to companies whose turnover or gross receipts is INR 500 million or less in a financial year.
Impact on the IT / ITES Sector
The POEM rules will primarily affect outbound investments. Since India’s IT/ITES sector is highly globalized, the impact of POEM test could be considerable.
Having said this, the risk of POEM may be highest in case of subsidiaries set up to hold investments / IP or to act as group financing vehicles in low tax jurisdictions. Here, income of such subsidiaries largely comprises of dividends, interest or royalties, all of which are ‘passive’ in nature.
Other situations which could lead to POEM risks include:
- Where financial and strategic decisions are routinely elevated to the executives / directors of the ultimate parent entity;
- Where the board of directors of overseas subsidiaries largely comprises of directors based in India, and board meetings are not often physically held abroad;
- Board meetings are not held at all (for e.g. when local law in the foreign country does not envisage or require holding of frequent board meetings)
The determination of POEM is a complex, time consuming and fact-specific exercise. Although the burden of establishing that the POEM of a company is situated in India is on the tax authorities, practically, it is important for the company to demonstrate from where it is being managed. This depends on factors such as its legal structure, management/reporting structure, actual conduct as well as available documentation.
Since the determination of POEM goes to the root of how a company is managed, much of the documentation required to substantiate this will contain significant confidential information. These could potentially be required to be submitted to the tax authorities and courts, if the question of POEM were to become contentious.
Takeaways and Next Steps
Three broad steps that are needed to to mitigate potential risks are:
Undertake a detailed assessment of any potential risks associated with POEM, including identification of entities that qualify for the active trade or business.
Put in place processes to ensure that appropriate documentation to substantiate the place of management is maintained. These could include ensuring that the Board Minutes and other supporting documents are maintained in sufficient detail along with back up information.
The introduction of POEM could set the stage for possible restructuring of the organisational reporting structure. Reconstituting and strengthening boards and redrawing of reporting structures could be considered. The introduction of POEM does not necessarily envisage that a decentralised model of decision making is followed. But it does mean that functions are performed in accordance with a well-thought out governance framework, rather than on an ad hoc basis.
Though the risks and challenges posed by the POEM are quite considerable, with well thought out strategies significant litigation and associated tax costs could be avoided.
Article contributed by:
Hariharan Gangadharan, Partner, Dhruva Advisors LLP