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The “Indian POEM”: A Cacophony!

Published on Tue, Mar 10,2015 | 16:42, Updated at Tue, Mar 10 at 16:50Source : 

By: TP Ostwal, Senior Partner - TP Ostwal & Associates

The Finance Bill 2015 has proposed a far reaching amendment in definition of “Resident” for under section 6(3) of the Income Tax Act, 1961 in so far as it applies to companies. While the earlier definition prescribed the criteria of the control and management of company’s affairs situated wholly in India, the proposed amendment substitutes the same with “Place of Effective Management (POEM) at any time during the year as a tax residency criterion for companies not incorporated in India.

As per Section 6(3) of the Act as it stands presently, 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, control and management of its affairs is situated wholly in India.

Thus, whereas an Indian company is always a resident of India, a foreign company is treated as per sub-clause (ii) as a resident of India only if during that year (i.e. relevant asst year), control and management of its affairs is situated wholly in India. Even if a part of the control and management is outside India, that is sufficient to make the foreign company a non-resident as per the Act and such a foreign company would be taxed only on Indian sourced income – global income is not taxable in India in the hands of a non-resident company.

There are concerns within the Ministry of Finance that above facilitates creation of shell companies which are incorporated outside India but are controlled from India. Such a foreign company still escapes tax ‘residence’ of India by diverting part of control and management outside India.

With the introduction of POEM as a Indian tax residency criterion, stress has been put on cross-border tax planning for multinationals and wealth managers, because both treaty and non-treaty based tax mitigation planning, past and future, face a new “bully” in the block. The new POEM rule states that a person being a company shall be 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.

POEM has been defined to mean 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. Once a company is treated as an Indian resident, the consequence would be that its global income will be taxable in India.

Explaining the government’s rationale to bring in the amendments, the memorandum accompanying the budget documents says that the present definition aids a company to easily avoid becoming a resident. “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”.

POEM was one of the proposal which was pending to be incorporated in IT Act 1961 out of the Direct Taxes Code Bill, 2013. When this was originally proposed in 2009 and again in 2010, there was a huge outcry against this proposal and a lot of representations were made on this proposal. However, the proposed amendment still has loopholes and there would be no POEM impact on companies who structure their businesses by taking advantage of the loopholes.

The POEM concept is also recognized and accepted by OECD in Model Tax Treaties in Article 8 i.e. Profits from the operation of ships or aircraft in international traffic and also to determine “tie-breaker rule” to determine residence in case a company becomes a dual resident of both the treaty countries e.g. in one country due to place of incorporation/registration and in other due to control and management.

On the international front, uncertainty surrounding the concept of corporate residence existed earlier than the 1940’s. Doubt surfaced when the League of Nations (Mexico Model) of 1943 and the League of Nations (London Model) of 1946 were drafted which contained rules which determined the domicile of a person autonomously. The concept of POEM originated from comments submitted by the Swiss Delegation to OECD in 1957. There is very little guidance as to the meaning of the “place of effective management” concept. The lack of a uniform and commonly accepted definition of this concept has led to humongous uncertainty in its interpretation leading to varying results by Countries applying DTAA.

The question of POEM has not been considered in many cases, albeit, some insight to this concept and answers to the uncertainty may be gathered from the following relevant cases:

1)      Trustees of Wensleydale’ Settlement v. CIR [1996] Simon’s Tax Cases (Special Commissioners’ Decisions) p241

2)      Trevor Smallwood Trust v. Revenue & Customs [2008] UKSPC 00669

3)      IBFD Case No. AWB 10/00157 (Supreme Court of Netherlands)

4)      IBFD Case No. 2C-1086/2012, 2C-1087/2012 (Federal Court of Switzerland)

It is said that the quality of a legal provision must always be determined by its competence in solving exceptional cases. The limitations of this concept which became apparent pursuant to the change in organisational structures to new business models as opposed to strict hierarchical systems; and the opportunities being offered by the ever evolving information and communication technologies (ICT). The limitations in determining the place of effective management in these new and constantly evolving models could lead to multiple “places of effective management”, mobility of the “place of effective management” and the problem of treaty dual non-residence encountered in triangular cases.

The purpose of the newly adopted POEM rule is two-fold. On one hand, to give India a chance (if not the upper hand) in the application of treaty tiebreak rules in tax residency conflict scenarios. On the other hand, as a specific anti-avoidance mechanism to prevent abuse and fiscal evasion, both in a treaty and a non-treaty context.

I can foresee a huge amount of uncertainty and unending litigations being faced by taxpayers as regards interpretation of this new provision. The treaty definition of POEM was itself vague and by adding the words “at any time during the year” a lot of fuel has been proposed to be added to the fire by the Revenue Dept.

The proposed amendment has reversed the position of taxability of Indian Group of companies setting up companies abroad for genuine business purposes. Earlier, the requirement was whole of control and management was to be located in India for taxing the company as Indian Resident. However, after the amendment, at any time of the year, the company’s POEM was located in India, entire income of such shall be taxable in India as Indian Resident. This will definitely be a highly litigated issue in years to come as the identification of place of effective management leaves much to the discretion of Income tax officers.

Quite often Indian business houses take decisions regarding their overseas subsidiaries from abroad. However, being an India centric group, key approvals of various decisions taken abroad are routinely in substance approved by promoters in India. This may now trigger POEM and thereby tax residency in India. Also, the language of the amendment is such that even if a big multinational entity decides to hold its board meeting in India on one day with presence of all group key executives and take certain important and key decisions for implementation at group level, then such a group of companies would be deemed to be tax residents of India and worldwide income for that year shall become chargeable to tax in India apart from other compliance burden.

Subsidiaries incorporated abroad pay tax in the foreign country and the income is not taxable in India unless it is brought into India by way of dividend in which case a dividend distribution tax of 15% is levied. However, such income may now be taxable at 30% in India, in addition to the tax paid in the overseas country and even dividend when remitted could further be taxed and may lead to increased litigation. This cataclysmic amendment could lead to unintended consequences and result in a situation where 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.

Another example is many executives 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 not only increase compliance cost for Indian companies but also increase risk of carrying on business abroad.

The lack of a common international meaning of the concept “place of effective management” highlights a fundamental limitation of the current tie-breaker rule. With no constructive conclusion in the OECD and UN Model Tax Convention and its Commentary, but a mere confirmation that “the place of effective management is the place where key management and commercial decisions…as a whole are in substance made.”

No indication is made as to what level of management is the appropriate level for determining the “place of effective management”. It may be interpreted as the country in which the Board of Directors meet or that in which the executive officers operate. Further the limitations mentioned above would exacerbate the problem in the determination of POEM.

The proposed amendment runs contrary to the aim of the present government to rationalise and simplify the taxation regime. The behaviour of Revenue has vitiated the climate of taxation regime because of several factors — extreme complexity of income tax laws, combative and rent seeking attitude of tax officers, aggressive pursuit of revenue targets, an anti-FDI mindset that was promoted by previous Govt, over dependence on judicial remedy, extensive recourse to retrospective measures, and contentious interpretations of legal provisions. However, the Revenue Dept, which earned opprobrium for unleashing ‘tax terrorism’ during the last few years, should be prevented from driving away both domestic and foreign investors from India.

Section 6 of the IT Act 1961 is one of the few provisions of the Act which had not resulted in any significant litigation in last six decades. The amendment proposed would lead to enormous and infructuous litigation for Indian corporates globalising themselves, as well as structures set up for legitimate personal wealth and succession planning as well as carried interest purposes. Double taxation issues will arise and tax credits may not also be available.

May be the remedy lies in the Controlled Foreign Corporation regulations to tax the shell companies rather than driving out honest Indian tax residents who have control and management abroad.

An environment of great uncertainty and outright harassment which was unbridled during the previous Govt and seems to continue to prevail even under the New Govt. It can be undoubtedly stated that the Revenue Dept would make vague interpretation of the amendment so proposed under section 6 of the IT Act and thereby lead a spate of litigation.

There is a dire need of review of the amendment so proposed by Mr. Jaitley and his entourage vide the Finance Bill 2015!!

(Views expressed are personal and not necessarily of the firm. Shreyash Shah assisted the author to this article)


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