PLACE Of EFFECTIVE MANAGEMENT : Corporate Tax Residence in India: Analysis and Safeguards
The India Budget,2015 has proposed the amendment of Section 6 of the Income Tax Act which alters the conditions under which a company is resident in India by including the concept of ‘place of effective management’ or POEM. Instead of the clause “during that year, the control and management of its affairs is situated wholly in India”, the new clause will read “its place of effective management, at any time in that year, is in India”.
Even if for a short time the effective control is in India, that would make the company tax resident.
In the memorandum to finance bill 2015, the hon’ble finance minister has given the following explanation for introduction of POEM:
“The modification in the condition of residence in respect of company by including the concept of effective management would align the provisions of the Act with the Double Taxation Avoidance Agreements (DTAAs) entered into by India with other countries and would also be in line with international standards. It would also be a measure to deal with cases of creation of shell companies outside India but being controlled and managed from India.”
After the amendment, India has become the unique country in the world (other than Malaysia) which:
a. Taxes the Global Income of Its Residents
b. Company is treated as tax resident if it has Place of Effective management in India
c. Place of Effective Management, at Any TIME of the year situated in India will make company tax resident in India.
1. Concept of POEM in OTHER COUNTRIES
Let us see how the tax residency is determined in respect of companies in other countries:
China: A company is considered to be resident in the People’s Republic of China (“PRC”) if it is established under PRC law, or is an enterprise that is established under the laws of foreign countries (regions), but its place of effective management is located in PRC. Tax residents are taxed on their global income.
Note: It does not make foreign enterprise, tax resident using the concept of at any time in the year
France: France has a territorial system of corporate income taxation. Accordingly, French companies and French branches of foreign companies are subject to corporate income tax for profits derived from businesses run in France, i.e. companies, wherever resident, are only subject to corporate income tax on income derived from French source.
Note: Neither there is concept of POEM nor concept of global taxation of residents.
Brazil: A foreign company is resident if incorporated in Brazil. Taxable on global income
Note: No concept of POEM in Brazil
Australia: A company is a resident of Australia if a) it is incorporated in Australia; or b) although not incorporated in Australia it carries on business in Australia and has either i) its central management and control in Australia ii) its voting power controlled by shareholders who are residents of Australia.
Note: No Concept of POEM at any time in the year in Australia as well.
UK: companies are UK tax resident if they are incorporated or centrally managed and controlled in the UK.
Note: UK also does not have concept of POEM
Germany: Corporations with a registered office or a German place of management and control are deemed to be resident in Germany. Foreign companies that have neither their legal seat nor a place of management and control in Germany are deemed to be non-resident.
Note: Germany also does not have concept of POEM.
Italy: Resident companies are those that, for the greater part of the tax year, have had their legal headquarters, place of effective management or main business purpose in Italy. The place of incorporation is not relevant. Resident companies are subject to taxation on their worldwide income
Note: It is different from Indian rule in that it requires place of effective management should be greater part of the tax year whereas india requires POEM at any time of the tax year.
South Africa: A company is regarded as a South African resident if it is incorporated in South Africa or if it has its place of effective management in South Africa. Resident companies are subject to tax on their worldwide income.
Note: It is different from Indian rule as it does not make a company tax resident if place of effective management is situated in SA even for one time during the year.
Malaysia: A company carrying on a trade or business is resident in Malaysia for the basis year for a year of assessment if at any time during the basis year the management and control of its business or of any one of its businesses are exercised in Malaysia.
Note: It comes close to India (now amended) definition for determining tax residency of companies.
Singapore: A company, whether incorporated in Singapore or otherwise, is considered a resident of Singapore for tax purposes if the place of control and management of its business is exercised in Singapore. Generally, a company is treated as a resident of Singapore if, among other things, its directors’ meetings are held in Singapore.
Note: similar to Germany but No concept of POEM at any time.
Russia: Russia has recently introduced in Nov 2014, the concept of Place of Effective management for determining tax residency of companies, however it also does not have concept of POEM at any time.
An analysis of above shows that only Malaysia has the concept of corporate tax residency similar to new India Position effective from 1.4.2015.
2. Concept of POEM in DTAAs
Though, most of the DTAAs have concept of Place of effective management for determining residential status of companies, however, none of the DTAAs nor the OECD model conventions have the concept of “Place of effective management at any time in the year”.
Nowhere, it is found that a corporate is made a tax resident if, it has place of effective management AT ANY TIME IN THE YEAR
Concept of Place of Effective management is commonly used in Article 4-Resident as a tie breaker rule wherein if the company is resident of both contracting states then it shall be considered as resident where place of effective management is situated.
Also, concept of POEM is also commonly used in article 8 pertaining to Shipping and airline business.
However, the India DTAA with the following countries still does not have concept of POEM: Canada, China, Greece, Libya, Thailand, Turkey, USA.
DTAA with Greece is unique in the sense that it clearly defines the tax residency of companies for the purpose of DTAA and does not leave the issue of determination of tax residency to be determined on the domestic laws of the country.
It does not mention the concept of POEM , it specifically mentions that ‘a company resident in India if it is incorporated in India or its business is wholly managed and controlled in India. ‘
So, the present change in definition will not impact companies operating with Greece.
3. OECD commentary on Article 4- 2014 – Determination of Residence
OECD commentary on Article 4 of model convention on Residence mentions as under:
- The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity's business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.
- Some countries, however, consider that cases of dual residence of persons who are not individuals are relatively rare and should be dealt with on a case-by-case basis. Some countries also consider that such a case-by-case approach is the best way to deal with the difficulties in determining the place of effective management of a legal person that may arise from the use of new communication technologies.
- Competent authorities having to apply such a provision to determine the residence of a legal person for purposes of the Convention would be expected to take account of various factors, such as where the meetings of its board of directors or equivalent body are usually held, where the chief executive officer and other senior executives usually carry on their activities, where the senior day-to-day management of the person is carried on, where the person's headquarters are located, which country's laws govern the legal status of the person, where its accounting records are kept, whether determining that the legal person is a resident of one of the Contracting States but not of the other for the purpose of the Convention would carry the risk of an improper use of the provisions of the Convention etc.
- Countries that consider that the competent authorities should not be given the discretion to solve such cases of dual residence without an indication of the factors to be used for that purpose may want to supplement the provision to refer to these or other factors that they consider relevant.
Reservations on the Article
- Japan and Korea reserve their position on the provisions in this and other Articles in the Model Tax Convention which refer directly or indirectly to the place of effective management. Instead of the term "place of effective management", these countries wish to use in their conventions the term "head or main office".
- Turkey reserves the right to use the "registered office" criterion (legal head office) as well as the "place of effective management" criterion for determining the residence of a person, other than an individual, which is a resident of both Contracting States because of the provisions of paragraph 1 of the Article.
- The United States reserves the right to use a place of incorporation test for determining the residence of a corporation, and, failing that, to deny dual resident companies certain benefits under the Convention.
- Israel reserves the right to include a separate provision regarding a trust that is a resident of both Contracting States.
- Estonia reserves the right to include the place of incorporation or similar criterion in paragraph 1.
4. Adverse Consequences of POEM:
The government believes the current conditions are practically inapplicable and contends they can be easily subverted by simply holding a board meeting outside India, leading to the creation of shell companies, which are incorporated outside but controlled from India. However, the change also will involve practical difficulties as under:
4.1 Consequences for Indian MNCs.
- Many executives are associated with the Indian parent company function as directors of its foreign subsidiaries. Now the power will have to be entirely delegated to an independent board abroad, only associated with the foreign entity. This may increase compliance cost for Indian companies
- If an Indian company has a subsidiary in another country where it has certain operations and pays taxes to the local authority there, it will have to pay tax back home in India if key decisions with respect to the foreign business are determined to have been taken in India, or if key management personnel like a director on the board of the overseas firm resides in India.
- Many overseas subsidiaries are created for the purpose of facilitating business activities like fund-raising and did not have any operations of their own, and these may be especially impacted as a consequence of the proposed amendment law.
4.2 Consequences for Foreign MNCs
- Foreign companies with legitimate business operations outside India would end up being treated as Indian tax residents and consequently, be subjected to tax in India on their global income. This could occur if, for example, a board member of the foreign company is present in India and participates in the decision-making process from India only in that single board meeting. This anomalous situation will result in double taxation of income which may not be mitigated by tax treaties as both countries (viz. India and the country of incorporation) will seek to tax the global income of the foreign company.
4.3 Other Areas of litigation in determining POEM in India
- Mobile places of effective management- It is not too difficult, for example, to envisage a situation where the managing director of a company who is responsible for the management of that company is constantly on the move. In some extreme cases, that person may consistently be making the decisions while flying over the ocean or while visiting various sites in different jurisdictions where his business is conducted.
- Similarly, a board of directors may arrange to meet in different places throughout the year. For example, the board of a multinational enterprise may agree to meet at the offices of the enterprise around the globe on a rotational basis. This can also lead to an enterprise having a mobile place of effective management.
- Place of effective management in multi-jurisdictions: The characteristics of effective management may exist in a number of jurisdictions and it may be said to exist simultaneously in more than one jurisdiction without a specific single jurisdiction being dominant. Thus to the extent that the place of effective management test fails to provide a clear allocation of residence to one country, albeit in a limited number of cases, it may be seen to be an ineffective rule.
- Videoconferencing: If senior managers adopt conferencing through the Internet, for example, as a key medium for making management and commercial decisions and those managers are located throughout the world, it may be difficult to determine a place of effective management. In such cases, a place of management might be regarded as existing in each jurisdiction where a manager is located at the time of making decisions, but it may be difficult (if not impossible) to point to any particular location as being the one place of effective management.
5. POEM: Safeguards to be adopted
Given the new definition of corporate tax residence in India , it is important for foreign companies, particularly for overseas joint ventures, or subsidiaries of Indian entities to review the corporate decision making process. Further it is also relevant to appropriately document the process and demonstrate adherence thereto in substance at the ground level to mitigate any potential tax risks arising in the tax proceedings.
Highlighted below are some of the illustrative practical suggestions that might help in substantiating the POEM of a foreign subsidiary or joint venture in foreign jurisdiction:
5.1 Independent Board of Directors(BOD) of the foreign entity
- The BOD of the foreign entity should be an Independent and autonomous body.
- The decisions of the BOD should be well informed and duly deliberated upon. The deliberations undertaken by the BOD should be documented and recorded appropriately in the minutes of the meeting.
5.2 Place of BOD and Nature of Decisions:
- The BOD meetings of the foreign entity should be held only in the foreign country.
- Strategic and major commercial decisions should be taken in such meetings held outside India.
- All the directors should attend these meetings outside India.
- No BOD meetings should be held in India and no strategic decisions should be taken from India.
- In case the BOD meeting is conducted through video or teleconferencing, the host country’s corporate law is relevant for determining place of meeting in such cases.
5.3 Clarity on Key roles and activities
- There should be absolute clarity on the key business role and activities of the foreign subsidiaries or JVs in foreign jurisdiction as evidenced in its Charter documents
- Charter documents of the foreign subsidiary should adequately provide all powers to run the business activities on its own.
- Foreign corporate law compliances to be undertaken- minutes, quorum, registers, secretarial records, etc. should be maintained in the registered office of the foreign country.
5.4 Extent of parent company support and stewardship function
- Ensure that the parent company’s influence on subsidiary is restricted to only to give visionary direction to its business and shall, at no time, extend to the actual steering of the subsidiary’s key activities.
- Regarding the Indian Parent company’s involvement in the foreign subsidiary, it must be noted that exercise of powers by the parent company must be in the capacity of majority shareholder to protect its interest and not to take control of subsidiary and run it.
- The role of parent’s nominee (preferably non-resident Indian and not having any exceptional powers to run the subsidiary) acting on behalf of the parent company can only be limited to giving strategic direction and co-ordination to protect the shareholder’s interests.
- The general meeting of the shareholders, where the parent company, being the majority shareholder, can decide on matters like declaration of dividend, sale of undertakings etc. should preferably be held in the country of incorporation.
- The parent company shall not act in a steering role to carry out day to day management of the subsidiary.
- The decision of the appointment of directors of the foreign subsidiary should not be taken in India; however a recommendation may be made by the representative directors of the parent company in India.
- Any recommendations made by the parent company should be actively and independently discussed and decided by the subsidiary company.
5.5 Functioning of Executive Directors and officers
- Executive directors, CEOs, COOs, CFOs and other key management personnel of the foreign subsidiary should be based outside India.
- The foreign company should make proper orientation and create awareness amongst the executive directors, officers and board members about the issues related to POEM by conducting regular sessions for them highlighting key dos and don’ts while with regard to conducting business, their international mobility, meetings, video conferencing, work permit documents, communicating through emails etc.
- Various working documents in relation to these executive directors and officers like appointment letters, titles of designations offered, work visas, business cards, service records, domicile proofs, and social security compliances should be critically examined from the POEM perspective and should be regularly reviewed.
- The information posted on the websites of the foreign subsidiary or the Indian parent company about the foreign company’s operations as well as about the key functions and role of the executive directors and officers of the foreign company should be regularly reviewed.
- The powers of the respective executive directors and officers about taking any strategic or commercial decisions should be documented adequately and such decisions should be subjected to BOD approval which should be in foreign jurisdiction.
- Communication flow regarding management decisions and functions should be appropriately documented.
The above stated points are only illustrative safeguard measures and specific course of action will need to be determined based on the specific facts of each case.
Still a long way to go for India tax system
Thanks and best regards
CA Rohit Gupta
Certificate In International Taxation
Paschim Vihar, Delhi-63
(Author is a chartered accountant and can be reached at firstname.lastname@example.org)
Tags Income Tax