As regards individuals, the residential status under the Income Tax Act is fairly simple and it is based on the number of days stay in India – I’ve discussed it in detail in this post, along with a calculator:
However, in case of companies, the rules are different and depend on the place of effective management (POEM). Residential status for companies is very important because if the company qualifies to be an Indian resident, its global income (irrespective of whether it has a permanent establishment in India) or not will be taxable in India (of course, relief under DTAA can be explored but that is a separate issue). There have been a lot of recent developments on this front over the past one year as well.
In the above context, today I will discuss on the residency rules for companies in India under the Income Tax Act.
Residential status for companies – Main provision
The main and guiding provision for determining residential status for companies is contained in Section 6 of Income Tax Act (ITA) as follows:
3) A company is said to be a resident in India in any previous year, if—
(i) it is an Indian company; or
(ii) its place of effective management, in that year, is in India.
Explanation.—For the purposes of this clause “place of effective management” means 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.]
It may be noted that Section 6 (3) has come into effect very recently i.e. via Finance Act, 2016 and applies from AY 2017-18. Prior to that, for a non-Indian company, it qualified as a resident only if control was WHOLLY in India.
So, from this definition, following points emerge:
- Indian company is straightaway falling into the definition of a resident, no question about it.
- For any other company (i.e. a foreign company), it will qualify as a resident ONLY if its POEM is in India.
It may be noted that to prevent small companies from facing rigours of Indian residency, Circular 15/2017 has made POEM guidelines and Section 6(3) not applicable for companies having turnover or gross receipts up to INR 50 CR – this is a welcome development.
Download links of both Circulars are as follows:
Guiding principles on POEM – Circular 06/2017
As we can see, POEM is a very vast term and can bring into its ambit a vast set of companies where the key management decisions are taken from India. Consequently, if no guiding principles are in place, the Assessing Officer can misuse discretionary authority and try to tax such companies.
Hence, in a good step (though a late one!), the ITD came up with a Circular in January 2017 laying down certain basic guiding principles for determination of a POEM of a company.
Circular 06/2017 laying down guiding principles for POEM states the following:
‘Place of effective management’ (POEM) is an internationally recognised test for determination of residence of a company incorporated in a foreign jurisdiction. Most of the tax treaties entered into by India recognises the concept of ‘place of effective management’ for determination of residence of a company as a tie-breaker rule for avoidance of double taxation.
Active Business Outside India (ABOI) test
The guiding principles on POEM prescribe separate rules for companies having “Active Business Outside India (ABOI)” and other companies. Hence, first thing we need to establish is whether the company has an ABOI.
A company shall be said to be engaged in “active business outside India” if the following conditions are satisfied:
- Passive income is not more than 50% of its total income; and
- Less than 50% of its total assets are situated in India; and
- Less than 50% of total number of employees are situated in India or are resident in India; and
- The payroll expenses incurred on such employees is less than 50% of its total payroll expenditure.
All the above conditions are cumulative – that means, even if one of the conditions are not complied with, the company does not have an ABOI
It may also be noted that for the purpose of above test, the average of the data of the previous year and two years prior to that shall be taken into account (so effectively, in all, an average of 3 years need to be considered)
Residence rules for companies having an “active business outside India”
In such case, residential status shall be presumed to be outside India if the majority meetings of the board of directors of the company are held outside India.
However, the Circular also says that if persons other than BoD are exercising effective control from India, then POEM will be India.
Residence rules for companies having an “active business outside India”
In this case, determination of POEM would be a two stage process, namely:-
Stage I: Identification or ascertaining the person or persons who actually make the key management and commercial decision for conduct of the company’s business as a whole.
Stage II: Determination of place where these decisions are in fact being made.
Secondary criteria
It may happen that due to whatever reason, the POEM of a company is not established through the primary test.
In such case, the Circular prescribes secondary criteria as follows:
- Place where main and substantial activity of the company is carried out; or
- Place where the accounting records of the company are kept.
Impact assessment of the new residency rules for companies
Till now, there was a lot of tax planning done around ensuring that a portion of control of a company is kept outside India and this would ensure that company is not treated as a resident of India.
For example, an Indian company creates an overseas subsidiary in a nil tax jurisdiction like UAE and deploys one office manager full time in Dubai to show that part control is outside India, whereas effectively, all key decisions were made from India only.
Another case, a company creates a shell company in British Virgin Islands (BVI) and uses that shell company to invest in properties in UK – income from those properties were not taxed in India. It may be noted that BVI companies do not require you to be a director in that company – if you pay an additional fee, the consultant firm will put its employees as nominee directors.
And so, there was a lot of misuse and playing around with these rules, which resulted in loss of revenue to the Indian government.
The new rules change all this. Now, if the place of “effective” management is what matters.
These changes would impact most the foreign companies which not only have a presence in India but also are EFFECTIVELY MANAGED from India
These changes will also severely impact the tax planning being done whereby the companies incorporated in foreign no tax/low tax jurisdictions as mere paper companies to take benefit of the various treaties and/or a planned attempt to shift profits from Indian books to such companies.
Implication of a company treated as Indian resident
In case a foreign company is now treated as a resident in India under these new Rules, some of the implications are as follows:
- Global income of the company will be taxable in India, irrespective of the fact that it is taxed outside India.
- It will have to obtain a PAN as well as TAN.
- The company will have to file an income-tax return in India and pay advance tax and self-assessment tax as applicable.
- The company will have to deduct TDS from payments, deposit in government account, and file TDS returns.
- The company will have to maintain books of accounts in India (even if it is already doing so in its country of incorporation)
- The company will have to undergo statutory, tax, and transfer pricing audit as applicable.
Multiple taxation possibility in case of inter-company dividend payments – A case study
There is a very real possibility that a determination of a foreign company as resident in India can result in multiple taxation. Let us understand with the help of a case study.
A Ltd. is a holding company based out of UAE. It has a subsidiary in India B Ltd. Holding company’s promoters are C, D and E Ltd., all based out of India. I’ve tried to explain visually as below:
Now, if as per the new rules, the POEM of A Ltd. is determined to be in India, following implications will follow:
- B Ltd. will pay tax @ 30% on its profits
- B Ltd. will also pay Dividend Distribution Tax @ 20% on dividend distributions – effective double taxation
- Any dividend paid by B Ltd. to A Ltd. will be taxable to A Ltd. to India (this is in virtue of recent amendment in Section 115BBDA by way of Finance Act, 2017 where even a company receiving dividend > INR 10 lacs will be taxed @ 10%) – effective three times taxation
- Any dividend paid out by B Ltd. to its promoters > INR 10 lacs will be taxed at C and D at slab rates and E Ltd. at a special rate of 15% (by virtue of Section 115BBD of ITA) – effectively four times taxation!!!
So, as we can see from above, there can be multiple taxation on same income in case foreign company is deemed as resident of India. This will impact the externalization structuring done by companies and will necessitate a relook at the structure.
Watch out for GAAR rules also
Before planning residency rules of companies, care should be taken to ensure that it does not fall in the trap of new General Anti Avoidance Rules (GAAR) that are effective from April 1, 2017 which are much more broad in scope – I will very shortly write an overview post on GAAR and post the link here:
So, even where the company re-structures the governance and control etc. outside India to escape the POEM rules, still, if the arrangement or the transaction lacks a commercial substance and the ONLY objective of such an arrangement is to escape tax obligation in India, then the Income Tax Department can invoke the GAAR rules and tax the income of that foreign company as if it is a resident of India.
Section 115JH – Transitional provisions for companies determined as resident for the first time in a previous year
Along with changing the residency rules for companies, Finance Act, 2016 also brought about a corresponding new Section to prescribe certain relaxations for companies which are determined as Indian resident for the first time after these changes. For this purpose, a new Section 115JH has been enacted which says CBDT shall prescribe the relaxations etc. but till date, no notification has been issued so far.
Other points
- Since “residence” is to be determined for each year, POEM will also be required to be determined on year to year basis.
- Any determination of the POEM will depend upon the facts and circumstances of a given case. The POEM concept is one of substance over form.
- It may be noted that an entity may have more than one place of management, but it can have only one place of effective management at any point of time.
- Mere formal holding of board meetings at a place would by itself not be conclusive for determination of POEM being located at that place. If the key decisions by the directors are in fact being taken in a place other than the place where the formal meetings are held then such other place would be relevant for POEM
- In case BoD has delegated the powers to a committee, the place where such committee meets and takes decisions will be relevant.
Day to day routine operational decisions undertaken by junior and middle management shall not be relevant for the purpose of determination of POEM.
Precautions to take in the new scenario
In view of these rule changes, it is advisable for corporates to re-look at their overseas structures and ensure compliance of these new rules at the earliest. If the key decisions are made in India, start complying with Indian tax laws.
As regards maintaining a non-resident structure, the basic principle is that the key decisions need to be taken outside India – an occasional decision can be taken from India but major chunk has to be outside India.
In this context, some pointers I can think are as follows:
- Purchase/rent a physical office (small/big does not matter) outside India – take care to ensure that the jurisdiction is either a nil tax one or does not impose tax on overseas income (examples – UAE, Hong Kong, Singapore)
- Prefer a jurisdiction geographically closer to India so that in case Indian senior management people travel, it saves on time and money
- Ensure that majority of senior management in those companies stay in that country preferably near to that office – get them a resident visa
- Document, document, document – in minutes of meetings, the location of the attendees should come out very clearly.
- Ensure that on the date of these meetings, the attendees are actually outside India – in case AO comes to know that meeting was shown as conducted in UAE but passport entries of attendees show they were in India, it can create a big problem
- For senior management personnel travelling from India, preserve flight tickets, boarding passes and copy of relevant pages of passport centrally in that head office
- Senior management personnel should preferably avoid phone calls from India to discuss strategic matters – ITD can even access call records to prove frequent conversations from India to people in overseas jurisdiction and it can cause a problem
- Only key management decisions are covered in POEM, not day to day and routine decisions – prepare a policy for the same and disseminate to the concerned – take special care to ensure content of e-mails do not fall within definition of “key management decisions/directions”
- If the above steps are not practical, do not persist any further and either start treating the foreign company as if resident in India and start following all compliances accordingly or revisit the structure and evaluate the incremental tax benefit of persisting with this overseas structure anymore as compared to the investment in office and travel cost.
Implementation of POEM in India – Some issues
- In case for a particular year, the company is adjudged as resident of India, what will happen to its past year pending assessments – if an assessment is over, can this be a ground for reopening an assessment?
- Onus to prove POEM in India should ideally be on revenue – what if revenue gives some flimsy reasons and shifts burden to assessee (way it happens in practical scenario)
- Provision mandating seeking approval from CIT before initiating a determination of POEM in India is not a sufficient safeguard – There should ideally be an INDEPENDENT approving panel as in case of GAAR provisions
- The Advance Ruling provisions are of little use for foreign companies as the determination of POEM is to be done every year
- There are some DTAA (notably India USA DTAA) which excludes dual residence cases from scope of treaty – in such case, there is a very real double taxation risk – so, before choosing overseas jurisdiction, it is important to check the DTAA provision also.
- If a company’s residence is deemed in India, the company will need Tax Residency Certificate (TRC) to claim treaty benefits in foreign jurisdiction – how easy it will be to get TRC in such a situation?
- POEM came into effect from FY 2016-17 and the notification on Section 115JH are still awaited – there is a strong case of deferring these new rules till those notifications are issued – CTC has made a representation in this regard Link – Is the government listening?
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