Different countries may have different ways in which they choose to set the jurisdiction for tax under the residence principle. However, there is a degree of consensus on the basic principle that there should be a fairly strong economic nexus with that country. Two basic approaches are used in establishing a personal jurisdictional connection for corporations. One is to focus on some formal legal connection to the jurisdiction such as incorporation. The other is to select some economic or commercial connection such as the place of management or principal business location. Many jurisdictions combine these approaches, treating a corporation as resident if either test is satisfied.
Prior to the amendment by the Finance Act, 2015, the Indian tax law defined a resident company as a company incorporated in India, or a company whose control and management is situated wholly in India. The main criticism of this definition was that it was subject to relatively simple, formalistic criteria. The Finance Act, 2015 has sought to amend the definition by regarding a company incorporated outside India as resident in India, if the territorial nexus of that company with India is established by virtue of its place of effective management (POEM) being in India.
On 23 December 2015 the Central Board of Direct Taxes (CBDT) issued draft guidelines for public comments (the draft) for determination of POEM. The draft emphasizes that the test of POEM is one of “substance over form” and is to be determined with regard to the facts and circumstances of each case on a yearly basis. The draft provides that the determination of POEM is primarily based on whether or not a company has “Active Business Outside India” (ABOI). The ABOI test needs to be evaluated on the basis of— (i) passive income of the company; and (ii) the asset base, number of employees and payroll expenses of the company. For such companies, the POEM is deemed to be outside India if a majority of board meetings are held outside India, unless facts suggest that the board of directors (BOD) is not the de facto decision-making authority. For companies other than those engaged in ABOI, the draft prescribes a twin test — (a) identification of persons who take key management and commercial decisions; and (b) determining the place where these decisions are, in fact, made. With regard to this, the draft also provides relevant factors, such as determination of the location of Board meetings, or location of the Head Office (HO), who constitutes senior management etc. It is also stated that the place of implementation of decisions or the place where routine day-to- day decisions are taken are not relevant for determination of POEM. Furthermore, Place of Effective Management (POEM) is not to be determined by taking a “snapshot” view, but by considering activities performed over a period of time during the year for which POEM is determined. The draft also deals with determination of POEM where participation in decision making is by use of telephone or video conferencing. As a safeguard, the draft requires the tax officer to seek prior approval from a senior tax authority and also gives an opportunity of hearing before deciding the issue of residency of the foreign company. The draft seeks to strike the right balance between providing certainty to taxpayers as well as ensuring that offshore companies with no substance or activities, which are controlled from India, are subject to Indian tax jurisdiction.
This is however, not to suggest that the draft is not without challenges. The communications and technological revolution is fundamentally changing the way people run their business. Due to sophisticated telecommunication technology and fast, efficient as well as relatively cheap transportation, it is no longer necessary for a person or a group of persons to be physically located or meet in any one particular place to run a business. This increased mobility and functional decentralization may have a significant impact on POEM. Given that POEM is one of substance over form, in theory it should always produce results, which reflect the true policy intention. In the modern environment, however, the application of the traditional POEM factors may not result in a clear determination of POEM, or may result in an outcome, which does not appear to be in accordance with policy intentions. If senior management adopt conferencing through the internet, for example, as a key medium for making management and commercial decisions and the management personnel are located throughout the world, it may be difficult to determine a POEM. In such cases, a place of management might be regarded as existing in each jurisdiction where management personnel is located at the time of making decisions; however, it may be difficult (if not impossible) to point to any particular location as being the one POEM. The guidance from the CBDT should therefore, seek to address some of the practical situations, which arise by providing illustrations or examples, rather than merely outlining factors that are indicative of POEM.
One of the main consequences of creating tax residency in India is that the company will be taxed on worldwide income. As such a company with POEM in India will still qualify as a “foreign company,” and will be taxed at the rate of 40%. Furthermore, risk of double taxation on account of “residence-residence” conflict as well as on account of “residence-source” conflicts may be exacerbated. An effective foreign tax credit (FTC) mechanism is required to remove the harmful effects of double taxation caused as a result of these conflicts.