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POEM: Need More Clarity

Published on Mon, Dec 28,2015 | 18:29, Updated at Mon, Dec 28 at 18:29Source : 

CBDT’s POEM Draft Guidelines: Impact Assessment For India Inc.

By: Jayesh Sanghvi, Partner & National Leader – International Tax Services, EY India

Last week the Central Board of Direct Taxes (CBDT) offered the industry something to ponder over by issuing draft guidelines on determination of Place of Effective Management (POEM). The guidelines have been long awaited, since the introduction of the POEM concept in the 2015 Union Budget, to determine the residence of a foreign company for tax purposes.

Indian multinationals and outbound investors should be taking close note, as they are the ones who are going to be most impacted, in view of their overseas holding structures. Where the management and decision making of the foreign subsidiaries is effectively in the hands of the Indian parent or its personnel, POEM may get triggered in India.

At the outset, the fact that draft guidelines have been issued as part of a consultative process should be lauded. Stakeholders have a brief window to provide their comments and suggestions until 2 January 2016. And now since these guidelines suggest the likely approach that the tax authorities are going to follow, the debate around POEM has been reignited.

Essentially, the guidelines are not very descriptive and emphasis is on the principle of ‘substance over form’. This is aligned to how the POEM concept is applied internationally. However, the dominant approach followed is based on whether there is sufficient active business outside India, measured by a 50% passive income threshold. This was somewhat unexpected, as the active business concept is generally associated with Controlled Foreign Company (CFC) regulations, not currently in force in India.

A broad definition of passive income, without providing for any exceptions, is likely to give rise to issues, as it ignores the nature of commercial activity and focuses merely on the nomenclature of income earned. As per the guidelines, passive income consists of dividend, interest, royalty, rent and capital gains, as well as income from transactions where both sale and purchase of goods is with related parties.

Therefore, illustratively, even where interest, royalty and rent are earned from real commercial activity by financial institutions, IP holding R&D companies and leasing companies, respectively, the classification of such income may be passive. This is an area that would require further clarity.

Given the framework of the guidelines, the active business test is important, because if passed, the presumption, although rebuttable, is that the POEM is outside India if majority meetings of the board are held outside India. This is a significant threshold from the taxpayer’s perspective.

Further, calculation for the active business test is proposed to be based on three years data, making the guidelines retrospective, in a sense. This would also mean that exceptional capital gains income in one year, say on account of sale of a subsidiary, would continue to be factored in for another two years, resulting in an unfavourable skew.

By having a presumption linked to active business, the CBDT has stopped short of providing a safe harbour. Though the relevance of a safe harbour while trying to determine the substance of an arrangement may be questioned, it could help in reducing administrative burden to a fair extent. This could especially be true in cases where the foreign company is not located in a low tax jurisdiction.

The guidelines have also not distinguished shareholder activity from management activity, in terms of how stewardship or providing policy frameworks would be treated. Thus, if we were to extend the above example of sale of a subsidiary, wherein certain important decisions are taken by the Indian parent, the exposure on account of POEM is unclear. This would indicate that having examples and illustrations in the guidelines would be of significant use to taxpayers and tax officers alike.

Though the guidelines are centred on determination of POEM, certain operational factors in case POEM is held to be in India have not been discussed. Issues of foreign tax credit, income inclusion, recovery, amongst others are very pertinent. In this regard, it may also be recommended that recourse of appeal directly to the ITAT be provided with mandatory abeyance of any consequential action.

At this stage, the legal status of the guidelines is not clear. Additionally, there are new terms including active business, head office and senior management that do not feature in the definition of POEM or the Income tax law. Depending on the form in which the final guidelines are issued, how they will be used for interpretation and whether the assessee is bound by them would need to be ascertained.

At the time of introducing the POEM provision, the Government had stated that one of the intents of POEM was to deal with cases of creation of shell companies outside India that were being controlled and managed from India. Therefore, the guidelines that would finally be issued must align with this intention and be targeted enough to capture such cases, without putting undue compliance and administrative burden on others.

(Amish Behl, Senior tax professional, EY India contributed to the article)

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