In Budget 2015 the Government of India has revised the definition for tax residency of companies in order to prevent tax avoidance activities. Some companies tapped on the loophole in the prevailing definition of ‘tax-residency’ and avoided Indian corporate tax by setting up shell companies in low tax jurisdictions. While the shell companies were primarily managed and controlled from India, they managed to pay the competitive corporate tax rate of the foreign country where the shell company was incorporated. They subverted the tax residency condition by holding one or some of their general meetings and board meetings outside India.
According to the latest amendment, a foreigner will be treated as a resident in India if its Place of Effective Management (PoEM) is in India at any time in the year. This will have adverse effect on foreign companies with Indian business operations as well as Indian companies with foreign subsidiaries. The following is an analysis of the impact of the revised definition.
Present Vs Revised Definition
Section 6 (3) of the Income Tax Act presently reads
A company is said to be resident in India in any previous year, if:
- it is an Indian company ( by means of place of incorporation) or
- during that year, control and management of its affairs is situated wholly in .
For the purpose of tax, all companies incorporated in India are Indian resident companies. But the point of interest is sub-clause (ii), which impact the foreign companies and foreign subsidiaries of Indian companies. Accordingly a foreign company is treated as tax resident if during the assessment year its control and management is wholly in India during that year. Even if part of the control and management of its affairs are carried out beyond the jurisdiction of India, subject to facts of the case, it is treated as a non-resident and taxed only on that portion of the income that is sourced in India.
Foreign companies and foreign subsidiaries that have genuine commercial substance benefitted from this definition. Such companies paid the foreign jurisdiction tax and did not face any tax liabilities in India. Indian tax kicked in only if the foreign sourced income was brought into India in the form of dividends.
Dividends received by Indian companies from specified foreign company (holding 26% or more equity shares) are taxable at 15% (surcharge and cess may apply). Otherwise they would be subjected to a tax rate of 30%.
This led to the creation of shell companies outside India, in low tax jurisdiction. While such companies are majorly controlled and managed from India, they escaped from Indian tax liability by diverting part of the control and management outside India, even as simply as by conducting one of their board meetings outside India. The shell companies were brought under the radar of IT law, when they failed to prove substance resulting in litigations.
In order to plug such loopholes and curtail anti-avoidance practices an amendment to the definition of tax residency of companies was proposed in the Finance Bill 2015 and it reads as below:
A Company will be said to be resident in India, if it satisfies the following condition:
- It is an Indian Company or,
- The Place of Effective Management (POEM) is in India, at any time during the year.
Although the above proposal appears as a step in the right direction as an anti-avoidance measure it is shrouded in lot of ambiguity and will pave way for double taxation of companies. Companies with international operations that have setup subsidiaries outside India with genuine objective will also get penalized. The key concern in the amendment is the term ‘at any time’. This will impact a huge number of companies, not only Indian companies with foreign subsidiaries but also multi national companies with Indian business interest. Consequently incomes of such companies will be subjected to double taxation, one at the country of incorporation and another at India.
The Place of Effective Management (PoEM) was defined as 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.
There are several possible scenarios that could inadvertently trigger the PoEM clause and hold a company liable to Indian tax, when in substance it is essentially a foreign company. Many Indian companies, including some of the state owned companies, have foreign subsidiaries, the parent and subsidiaries invariably have some common members on their boards and common executive directors, who may take decisions or participate in meetings of commercial significance from India. Given the present day mobility of talent and ICT aided communication, a teleconference attended by an executive director or board member from India may trigger PoEM. Even if it is an one-off event, the stray event, if with substance, occurring even once at any time during the assessment year it will make the foreign subsidiaries liable to Indian tax.
More importantly the provision will adversely affect MNCs. For instance if a MNC with Indian subsidiary chooses to conduct just one of its board meeting in India as a mark of endorsement and support to its Indian subsidiary and stakeholders, it will trigger the POEM and will subject the global income of the MNC to Indian tax.
The proposed changes will be effective from April 1, 2016 and apply in assessment year 2016-17. The tax department will come out with a set of guiding principles for determining the PoEM.
The Concept of PoEM
The Place of Effective Management means the place where the key commercial and management decisions are taken as a whole and this is taken in substance, that is, substantially the decisions are taken from that place for smooth conduct of business.
If the foreign subsidiaries of Indian companies and foreign companies can effectively prove that all commercial decisions such as those relating to purchase, sales, production etc., that are incidental to the smooth conduct of the business were made outside India and all meetings of the boards were held outside India, it will relieve them of any potential Indian tax liabilities.
Attempts were made to introduce the concept of PoEM in the Indian Income Tax Act as early as 2009, however severe oppositions kept the attempts at bay. The concept finds recognition and acceptance in OECD model tax treaties. It is also in line with the Avoidance of Double Taxation Agreement (DTA) concluded internationally. The test of PoEM is applied as a tiebreaker in cases where a company is resident of both the treaty countries.
The definition of PoEM is however ambiguous and there are several international interpretations, rendering the concept incompetent in providing simplicity, certainty and clarity – the crucial elements of a tax regime. Business models have evolved and company structures have become more complex and the operations of the management cannot be strictly isolated.
Who will be affected?
- Foreign companies having Indian branches or subsidiaries
- Foreign subsidiaries of Indian companies
- Special Purpose Vehicles of Indian companies
- Foreign companies having global reporting structure with Indian connection and regional headquarters etc.
How it will impact Singapore Subsidiaries of Indian Companies?
The Government of Singapore and the Republic of India have a DTAA in place and the PoEM test features in Article 4 Section 3 of the DTA, which defines Residency. Now that the latest amendment has the phrase “any time of the year”, it is bound to create lot of confusion in determining the resident status of such companies.
In the case of Singapore, a company is resident of Singapore, whether it is incorporated in Singapore or otherwise, if the place of control and management of its business is exercised in Singapore. Generally, a company is treated as a resident of Singapore if, among other things, its directors’ meetings are held in Singapore. Since the subsidiaries are generally incorporated in Singapore they will obviously be subjected to Singapore income tax rates on chargeable income.
If the Singapore subsidiaries become a dual resident of Singapore and India, by means of the latest PoEM clause in the Indian IT Act, as there exists a DTAA between Singapore and India, the affected companies will receive a deduction, which is equal to the Singapore tax paid, on Indian tax payable on their chargeable income.
However it must be noted that there is a triangular element involved. Singapore taxes companies on a territorial basis, meaning only the incomes generated in Singapore and only that portion of the overseas earnings that are repatriated to Singapore are subjected to local corporate tax. However India levies tax on global incomes of tax resident companies. In the new PoEM scenario, affected Singapore subsidiaries will be paying the Singapore tax on chargeable locally generated income and repatriated global income and on top of it will pay the tax of other jurisdiction in which their global income was generated and also the applicable Indian tax after double tax relief. Unless there exists a DTAA with India and the other jurisdiction the affected companies will be paying double tax.
Singapore’s FSIE Scheme may provide respite
Although the IT Act states that the foreign-sourced income if received in Singapore will be subjected to tax there are exemptions available under the Foreign-sourced income exemption (FSIE) scheme. Under the FSIE scheme, specified resident taxpayers who receive:
- foreign-sourced dividends;
- foreign branch profits; or
- foreign-sourced service income
would be given tax exemption if they meet these qualifying conditions:
- Subject to tax;
- Foreign headline tax rate of at least 15%;and
- Beneficial tax exemption
In the event of a company facing such triangular tax situation as discussed above, where there is no DTAA with India and the said foreign jurisdiction, such foreign sourced income can be repatriated to Singapore and gain exemption from FSIE as well as leverage on the Singapore – India DTAA. The DTAA states “Singapore tax paid” for the purpose of double tax relief, shall be deemed to include any amount of tax which would have been payable but for the reduction or exemption of Singapore tax granted under the Singapore IT Act.
Cautions to Exercise
- It is prudent for the foreign subsidiaries of Indian companies and Indian subsidiaries of foreign companies to have separate, exclusive and autonomous Board of Directors (BOD).
- All decisions of the BOD and meetings of the BOD must be accurately documented. Decisions of strategic importance and commercial significance must be made outside India, in the registered office.
- All meetings the BOD of foreign subsidiaries of Indian companies must be held outside India and the MNCs must refrain from conducting their BODs in India.
- All books of accounts and registers to be kept outside India and roles, activities and the autonomy of the subsidiary to be clearly documented in the charters.
- The parent company’s control of the subsidiary must be limited to protecting its interest as a shareholder. AGMs must be held outside India and parent company should stop short of making decision for their subsidiaries by merely restricting to making recommendations regarding key appointments. The subsidiary must actively and independently deliberate and decide on such recommendations.
India’s recent anti-avoidance measure has rattled not only the corporate India but also the international business community with stakes in India. Singapore enterprise players are also keenly observing the developments. Lot of uncertainty and debate is bound to be there until the Indian tax authorities release further explanations and clarifications regarding the PoEM, which is a highly mystified and debated concept internationally. The latest amendment will lead to lot of litigations and more importantly it will jack up the compliance cost of companies. In the meantime the existing DTAA between Singapore and India may provide some kind of reassurance.
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