‘PoEM’ or a puzzle

Background

The Finance Act, 2016 introduced the “Place of Effective Management” (PoEM) regime for determining the residential status of companies incorporated in foreign jurisdiction. PoEM provisions have replaced the conventional methodology of determining tax residency based on control and management of the company.

Under the erstwhile provisions, a foreign company was considered as resident in India only if its control and management was wholly situated in India during a year.

However, as per the amended provisions, a foreign company will be considered as resident in India if its PoEM is in India. Further, PoEM is defined as “the 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.” The definition of PoEM under the Indian Income-tax provisions is in line with OECD commentary on model convention.

On 24 January, 2017, the Ministry of Finance issued a press release and a circular laying down the final guidelines for the determination of PoEM.

The PoEM guidelines emphasise substance over form and lay down tests for determining the residency of foreign companies based on the concept of “Active Business outside India” (ABOI) as follows:

1.       Companies engaged in ABOI and fulfilling certain conditions – For companies engaged in ABOI, PoEM shall be presumed to be outside India subject to the condition that the majority of the BoD meetings of the company are held outside India (provided the directors are not standing aside), irrespective of where the key management and commercial decisions are made.

2.       Other companies – In cases of companies not covered above, the PoEM test requires ascertaining the person(s) who actually make the key management and commercial decisions and determining the place where such decisions are in fact being made.

The guidelines also provide the fundamentals basis which a company is said to be engaged in ABOI.

Computational aspects

A foreign company with its PoEM in India will become a tax resident of India and its global income will be subject to tax in India.

The government vide the Finance Act, 2016 had inserted Chapter XII-BC in the Income Tax Act, 1961, as per which, special provisions in relation to computation of income, treatment of unabsorbed depreciation, set off and carry forward of losses, etc., of such Indian resident foreign companies were to be notified. The draft notification dealing with above income computational aspects was issued recently on 15 June, 2017. The notification provides clarity in relation to various aspects, such as:

· Determination of written down value of depreciable assets;

· Determination of losses and unabsorbed depreciation for set off and carry forward thereof;

· Preparation of Profit/ Loss & Balance sheet by resident foreign companies having accounting year different from financial year;

· Applicability of withholding tax provisions relating to resident vis-à-vis foreign company – the notification clarifies that the provisions relating to foreign companies shall apply;

· Availability of foreign tax credit in accordance with provisions of section 90/ 91;

· Impact of qualification of foreign company as resident in India on its other transactions – the notification clarifies that the change in tax residency of foreign company will not alter its other transactions;

· Impact on status of foreign company and applicability of other provisions – the notification clarifies that the status of foreign company will remain as such and the specific provisions dealing with foreign companies, such as the rate of tax, etc., will apply accordingly;

· Applicability of provisions dealing with resident vis-à-vis non-residents – the notification clarifies that the provisions dealing with residents will apply.

The government through these draft directions has tried to address the computational aspect of income of resident foreign companies; which undoubtedly is a welcome move; however, as these directions will apply for computation of income for FY 2016-17, this may create hardships for the taxpayer.

Further, uncertainty remains in some areas and a clarification on these aspects is necessary to avoid litigation, for example:

– Computation of capital gains tax in the hands of resident foreign companies – The benefit of foreign exchange fluctuation under the first proviso to section 48 would not be available in case of foreign companies qualifying as tax resident, even though investments are made in foreign currency. However, indexation benefit under the second proviso to section 48 may be available, which may not be intended, as investment is in foreign currency and not in Indian rupees.

– Applicability of beneficial taxation provisions for certain specific income of foreign company – It remains to be seen whether the beneficial taxation provisions as applicable for the determination of income of foreign companies on account of dividend, interest, royalty, etc., would continue to apply to foreign companies that have become resident in India.

– Applicability of international transfer pricing regulations for transaction between resident foreign companies and their Indian and foreign associated enterprises.

– Applicability of thin capitalisation norms on loan transactions between Indian companies and their resident foreign associated companies.

– Quantum of disallowance in case of default in withholding of taxes on payments made to such resident foreign companies, whether the same can be restricted to 30%, as in the case of resident payees.

Although the intention of the draft directions seems to treat the foreign companies as such, more clarity on the above aspects is warranted.

Additionally, listed below are issues that remain unanswered by the PoEM guidelines, and thus, require more deliberation and consideration:

– No guidance has been provided for determination of ABOI in case of companies having losses instead of total income.

– One of the parameters for the determination of ABOI provides that passive income shall be less than 50% of the total income. Further, “passive income” and “income” are defined as follows:

o Passive income means the aggregate of (i) the income earned by a company from transactions wherein both purchase and sale of goods are from/ to its associated enterprises and (ii) the income earned by way of royalty, dividend, capital gains, interest or rental income.

o Income shall be the income as computed for tax purposes in accordance with the laws of foreign jurisdiction or as per the books of accounts where such laws do not require such computation.

Income computed for tax purposes may exclude certain passive income that is exempt from taxation under the laws of foreign jurisdiction (such as dividend), even though such exempt passive income is the majority income of the foreign company. This may result in certain foreign companies having major part of its income as exempt passive income, such as dividend income, to qualify ABOI.

As the PoEM guidelines have been in effect from FY 2016-17 and the tax liability of resident foreign companies needs to computed, the aforesaid pertinent aspects would need to be addressed immediately for more clarity, smoother implementation of the said framework, reduction in risk of future tax litigations and promotion of the government’s initiative of a non-adversarial tax regime.

Authors: Hiten Kotak, M&A Tax Leader, PwC India and Amit Bahl, M&A Tax Partner, PwC India

Disclaimer: Views expressed are personal to the author. Article includes inputs from Harsh Biyani, Associate Director, M&A Tax PwC India; Raashi Agarwal, Manager, M&A Tax PwC India & Mehak Ahuja, Assistant Manager, M&A Tax PwC India.