Draft Place of Effective Management (PoEM) Rules

Residential status of the companies is an important factor in deciding their tax liabilities. The income tax act provides that a company is resident in India if it fulfils either of the following two conditions:

• It is an Indian company
• During a particular financial year, the control and management of its affairs is situated wholly in India.

The second requirement above that whole of control and management should be situated in India and that too for whole of the year was seldom met and was easily avoided. For example, the company could easily avoid becoming Indian resident by just holding its board meeting outside India. A foreign company whose control and management was even partly located outside India was considered as non-resident. The result formation of shell companies {Shell company means a company created not for business but only as a vehicle for various financial manoeuvres} and tax avoidance leading to loss of exchequer.

In the last year budget, the Finance Act 2015 had proposed to amend the second condition given above and put in place a test of residence for foreign companies. This test of residence provides that a company would be treated as resident in India if its Place of Effective Management (PoEM) in the previous year was in India. Thus, the Income Tax act stands amended and a company is said to be resident in India if either of following two conditions are met:

• It is an Indian company;
• Its place of effective management in that year is in India

Thus the objective of introducing the concept of PoEM was to bring a change in the definition of residential status of companies.

What is Place of Effective Management?

As the term suggests, place of effective management is a place where key management and commercial decisions for the business of a company are made. This is the broad definition. There was a need for setting some guiding principles as to what exactly would be factors to determine the PoEM. In the last week of December 2015, the income tax department has released the draft guidelines for place of effective management (PoEM) rules.

How the concept of PoEM is used in international context?

The domestic tax laws of many countries have incorporated the concept of PoEM for determination of residential status of foreign companies. The OECD recognises the concept of PoEM as a tie breaker rule for determining residential status. The concept of POEM also used in most of the tax treaties for determining taxability of shipping and airline entities.

What are the draft PoEM guidelines?

The place of effective management of a company conducting active business outside India shall be considered to be outside if majority of board of directors meetings of the company are held outside India or it its assets, employees, income, and employee expenses are from outside India.

For a company whose directors are not involved in decision making and such decision making powers are exercised by a holding company or a person resident of India, then the company is considered as a resident under the place of effective management rules.

• For determining whether a company is active outside India, the average of past 3 years data are taken into consideration.
• In case if a company’s board delegates its powers to a committee, then the location where the members of the committee formulating the key decisions is considered as the place of effective management of the company.

In case of use of technology such as telephone or video conferencing by the board members in conducting meetings, the location of head-office is considered as place of effective management. It is not necessary for the person taking decisions to be physically present at a particular location.

Implications for Revenue

• The PoEM puts in place a test of residence for the companies to define if a company is resident in India. While the non-resident company is generally taxed only on its Indian sourced income; a resident company is taxed for its global income. PoEM would thus allow India to tax such company on its global income also. This would bring more tax revenue and increase tax-GDP ratio.
• It would serve as an anti-avoidance measure and is thought to bring the passive income of foreign subsidiaries of domestic companies and Indian subsidiaries of foreign companies under tax net.

Criticism

The PoEM have been criticized mainly on three grounds. Firstly, the amended law is applicable since April 2015. The retrospective applicability of any tax related matter has always created issues. The department could come a little earlier with the guidelines to avoid such issue.  Secondly, most of the tests used for deciding place of effective management in these guidelines are subjective and the provision such as use of modern technology has been left to discretion. The rules itself says these provisions are for guidance only. Thirdly, the rule of looking into past 3 years data makes the rules applicable retrospectively. The rules will discourage MNCs form locating their headquarters in India or holding meetings in India.

Critics say that the rules may affect “ease of doing” business in India as the companies are subjected to burdensome compliances. The primary question to be answered before implementation of the rules is what the cost-benefits in implementation of rules are? Instead of raising the tax collection, the provisions may lead to increased litigations in the country and raise disputes with treaty partners in situations of double taxation.