Under Income Tax Act, 1961, it is very important to determine the residential status of any person as it helps in determining the scope of taxable income in India. Until 2015, the concept of determination of residential status of foreign companies was very simplified.
Most of the companies were using these simplified provisions to prevent the residential status in India. However, the Finance Act, 2015 made a major amendment in Section 6(3) of Income Tax Act by introducing the concept of Place of Effective Management (POEM) while determining residential status of companies in India.
This article contains a detailed discussion of POEM provisions under Income Tax Act for foreign Companies:
- Till 2015, As per Section 6(3) of Income Tax Act, a company is considered as Indian resident if:
- It is incorporated in India; or
- Its control and management is situated wholly in India.
- Therefore, most of the companies used these simplified provisions as a loophole to prevent residential status in India by shifting insignificant or isolated events related to control and management outside India. Since, to qualify as resident, whole control and management was required to be situated in India and by shifting insignificant events outside India, companies escaped the whole control and management in India.
- Most of the countries were using the other effective methods of determining residential status of companies such as the Central Control and Management Test. However, India decided to stick to the concept of whole control and management.
2. Amendment of Place of Effective Management (POEM)
- Finance Act, 2015 amendment the provisions of Section 6(3) of Income Tax Act with effect from 01.04.2016. As per amended provisions, a company is considered as resident if:
- It is an Indian Company; or
- Its place of effective Management in that year is in India
- However, The Finance Act, 2016 has changed the date of applicability of amendment to 1st April, 2017. Therefore, Amendment provisions become effective from Assessment Year 2017-18 onwards.
- Income Tax department issued guiding principles for determination of place of effective management (POEM) vide Circular No. 06/2017 dated 24th January, 2017.
3. Place of Effective Management (POEM) guidelines
‘Place of effective management’ (POEM) is an international method of determination of residential status of a company incorporated in a foreign jurisdiction. Most of the Double Taxation Avoidance agreement entered into by India recognises the concept of ‘place of effective management’ for determination of residential status of a company.
A company incorporated in India is considered as Indian Resident irrespective of its place of effective Management. Therefore, the POEM test is relevant for companies incorporated outside India, i.e., Foreign Company.
As per POEM Guidelines, a foreign company is categories in 2 parts namely:
- Active Foreign Company;
- Passive Foreign Company
3.1 Active Foreign Company
3.1.1 Determination of Active Foreign Company
- A company shall be said to be engaged in “active business outside India” if:
- the passive income is not more than 50% of its total income; and
- Assets situated in India are less than 50% of its total assets; and
- Total number of employees situated in India or resident in India are less than 50%; and
- The payroll expenses incurred on such employees is less than 50% of its total payroll expenditure.
- “Passive income” of a company shall be aggregate of:
- income from the transactions where both the purchase and sale of goods with its associated enterprises; and
- income by way of royalty, dividend, capital gains, interest or rental income;
However, in case of banking companies or Public Financial Institutions, interest income shall not be considered to be passive income.
- For determining active or passive status of a foreign company, “the income” shall be determined as:
- Computed for tax purpose in accordance with the laws of the country of incorporation; or
- as per books of account, where such computation is not required under law.
- the “value of assets” shall be:
- Individual depreciable asset: Average value of the asset at the beginning and at the end of the year, determined for tax purposes in the country of incorporation;
- Pool of a fixed assets (being treated as a block for depreciation): average of its value at the beginning and at end of the year determined for tax purpose in the country of incorporation;
- Any other asset: value as per books of account
- “Number of employees” shall be the average of the number of employees as at the beginning and at the end of the year and shall include persons, who though not employed directly by the company, perform tasks similar to those performed by the employees;
- The term “payroll” shall include:
- cost of salaries,
- bonus; and
- all other employee compensation including related pension and social costs borne by the employer.
3.1.2 Determination of POEM of Active Foreign Company
- Determination of POEM will depend upon the facts and circumstances of each case. The POEM concept is one of substance over form.
- Place of Effective Management of Active foreign Company shall be deemed as “Outside India” if majority meetings of the board of directors of the company are held outside India.
- However, if as per facts and circumstances, it is determined that the Board of directors of the company are standing aside, i.e., they are not exercising their powers of management and such powers are being exercised by either the holding company or any other person resident in India, then the place of effective management shall be considered to be in India.
- Further, merely because the Board of Directors (BOD) follows general and objective principles of global policy determined by parent entity with respect to any function such as Payroll, supply chain etc. then it will not mean that BoD of companies standing aside.
- “Residential status of a company has to be determined for each year. Therefore, POEM will also be required to be determined on a year to year basis.
3.2 Passive Foreign Company
3.2.1 Determination of Passive Foreign Company
- If a company fails any of the above mentioned conditions of Active foreign company shall be considered as Passive Foreign Company.
3.2.2 Determination of POEM of Passive Foreign Company
- In cases of passive foreign company, POEM will be determined through following 2 stage process:
- First, Identify the person or persons who actually make the key management and commercial decision for conduct of the company’s business as a whole.
- Second, determination of place where these decisions are being made.
- The place where these management decisions are taken would be more considered for determining POEM instead of places where these decisions are implemented. For determination of POEM, it is the substance which would be conclusive rather than the form.
4. Guiding principles for determining POEM
Place of Effective management is a substance over form to determine where the effective management of the company is based. Therefore, there can’t be laid any fixed guidelines to determine POEM of the Company.
The Income Tax Department has specified certain guiding principles which are to be checked while determining POEM such as Location of Board Meeting, Location of head office, Location in case of delegation of authority.
Detailed guiding principles can be read here.