Place of Effective Management : Concept and Impact
The Indian economy has been growing at a relatively fast pace over the past decade or so, and is still growing resulting in a market that represents an enormous opportunity for global businesses who have responded by making a beeline to set up operations in the country. Local businesses too have grown and have begun to aggressively expand their footprint across the world.
Thanks to the liberal policies of the Reserve Bank of India (RBI) Indian nationals and Indian companies can invest in offshore companies through the Overseas Direct Investment (ODI) route. As per the guidelines Indian nationals can invest up to specified percentages of their net worth to acquire either a stake in a Joint Venture company (JV) or set up a wholly owned subsidiary company (WOS) outside of India under the automatic route without the need for any permission from the RBI. Further, individual investors can invest up to a total of USD 2,50,000 annually to set up companies abroad under the automatic route without the need for any permission from the RBI!
This has resulted in many individuals and companies setting up offshore entities using a variety of structures (see our report here) for various reasons including, Investor participation, Access to foreign markets and , importantly, Tax mitigation..
The United States of America and Singapore have proven themselves to be the most popular investment destinations for Indian businesses the former on account of the market and the investment opportunities available there. Whilst Singapore finds favour as a gateway to South East Asia and as a low tax jurisdiction. As mentioned earlier, access to new markets or global expansion remain some of the key reasons for businesses to establish subsidiaries or associated entities outside of India. There are legitimate business concerns that push some of these businesses outside of India for instance, imagine you are at the helm of a B2C SAAS entity and a significant majority of your customers are located outside of India you would invariably need to provide such customers with an international payment gateway which is more robust that the solutions available in India. Such an exercise would involve setting up a subsidiary or an associated entity abroad. Typically speaking should not seem like such a challenge, however the complexities of international tax make themselves known in several unimaginable ways as we shall soon explain.
Residential concepts under the Income tax Act 1961
Traditionally under the income tax act, companies situated outside of India would be considered non-residents and taxed only on incomes that accrue from India or have a business connection with India, since as per the income tax act ( the act) a company was said to be a resident in India in any previous year if :
- it is an Indian company; or
- during that year, control and management of its affairs is situated wholly in India
A company would be deemed to be a resident in India if it satisfied one of the two alternative tests specified. Thus every Indian company as defined in section 2(26) of the act (being a company incorporated in India) was considered to be a resident in India even if its control and management was situated wholly or partially abroad. On the other hand a foreign company was liable for reclassification as an Indian company if its management and control was situated fully in India. As held in the cases of De Beers v Howe ” A company cannot eat or sleep but it can keep house and do business, and for the purposes of income tax a company resides where it really keeps house and does business, i.e. where the control and management actually abides. Therefore, a company registered abroad is a foreign company but a foreigner can reside in India and so can a foreign company. Upon such reclassification the global income of such foreign company would be subjected to tax in India at the rate of taxation applicable to foreign companies being 40%.
Control and Management
The expression “Control and Management” is used in terms of the “affairs” of the company this leads to the inference that the affairs of a company can lie in a place which is separate and different from the “business” of the company, a term which refers more to the activities that generate money for the company. Making use of this expression, the management and control of the company are situated in a place where the directors meetings are held. Therefore for a foreign company whose owners are situated in India the company shall be deemed to be resident in India if the meetings of directors who manage and control the business are held here. While this may seem surprising reclassification of the nationality of a company is very much a possibility and notoriously easy for a taxman looking to tax greater revenue in his own jurisdiction.
The concept of control and management too has lost a bit of its sheen in the connected age and has now been officially put to pasture in the Indian context with the introduction of the Place of Effective Management ( POEM) rules.
The changes : Introduction of Place of Effective Management
As per the changes proposed in the Union Budget of 2015, the definition of a resident company has been altered with prospective effect from 1st April 2016. As per the new norms a company shall be said to be a resident of India if :
- It is an Indian company, or
- Its place of effective management (PoEM), at any time in that year, is in India
Place of Effective Management (PoEM) has been defined in the finance bill to mean a place where the key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are made. As per the budget memorandum “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”.
The concept of POEM has been accepted and recognised by the OECD in its model tax treaties along with “tie breaker” clauses in the case of a country being a tax resident in more than one country. In the Indian context, POEM provisions were due to be introduced as part of the Direct Tax Code. As things stand the code has been shelved, however key elements from the proposed code have been incorporated into the existing tax strictures.
The provision effectively means that if at any point of time during the year the decisions necessary for the conduct of the business as a whole are taken in India then the entity would be classified as an Indian resident and taxable as such. The ramifications for this shift in thresholds are immense, for example consider the following situations:
- An American company holds a board meeting in India
- Two directors of a Singapore company take a significant decision impacting the in all of the following cases while on Holiday in India
- Indian company sets up a subsidiary unit in Mauritius with the same directors as the parent unit and the management takes all decisions from India
In all the above cases the foreign companies can be deemed by virtue of the new provisions to be tax residents in India and their global incomes can be taxed in India at the rate of 40%.
The parties most impacted by this amendment shall be Indian individuals and companies which have set up foreign JV’s and or WOS and routinely take decisions for such entities from India, also affected will be groups where the executives of the Indian entity are also on the board of the foreign subsidiary. These companies shall soon see that their legitimate foreign companies are now deemed to be Indian residents and are subject to taxation in India, this imposes a huge cost in the form of taxes ( incomes of foreign companies are taxable at 40% in India) on such companies and the group as a whole.
The consequence of this provision, unless amended or clarified is going to be a large uptick in tax disputes, where the department will invariably look at a foreign entity owned by Indians and tax it at the maximum marginal rates. That there is no established jurisprudence on this matter in India also means that litigation on this matter will only increase. Start-ups and established Indian players have few options by way of recourse, one option would be to decouple ownership and management/Control and ensure that such management is situated only outside of India and no overlaps exist. This is easier said than done and will certainly be a challenge for all businesses looking to go global.
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