Smallwood v. Revenue and Customs Comrs (2010) EWCA Civ 778 (Court of Appeals)

(2010) EWCA Civ 778

(Court of Appeals)

Facts of the case:

This article is based on the judgment of the Court of Appeal of the UK. The case relates to capital gain earned by Mr. & Mrs. T. Smallwood (TS) during the tax year ended on 5th April 2001 (tax year comprised period 6th April 2000 to 5th April 2001). They were domiciled and residents of the UK.

In the year 1989, TS had made settlement for the benefit of himself and his family members (‘the Trust’). The Trust held certain assets, bulk of which comprised shares of two listed companies of the UK.

In April 2000, the trustee of the Trust was a Jersey company (L). The trustee was advised to dispose of the shares of listed UK companies which had appreciated considerably in value and to diversify the trust investment. Had the shares been sold by the Trustee directly, capital gain earned would have triggered significant taxation in the hands of the settlor (TS) in the UK. This is because the UK tax provisions permit taxation of income of a trust in the hands of the settlor if he himself happens to be a beneficiary of the trust.

As against the general provision permitting taxation of income in the hands of the settlor, the UK statute also has a provision which mandates assessment of trust income in the hands of the trustee if at any time during the tax year, the trustees are resident of the UK. As a result, the trust was advised ‘Round the World’ tax scheme by K, according to which (a) for part of the year, residence of its trustee was to be shifted to Mauritius (treaty favoured jurisdiction) by appointing a Mauritius-based corporate trustee (KM) in place of L, and (b) thereafter to be shifted to the UK before the end of the year by resignation of KM and appointment of LTS. This was to ensure that shares of UK companies were disposed of by the Trust while trustee was resident of Mauritius and therefore assessment in the name of the Trustee would permit the Trust to enjoy benefit of the UK-Mauritius treaty.

The following is the schematic description of the scheme.

The Special Commissioners held that residential test had to be applied for a given tax year. The Trust had dual residence and the tie-breaker test of Article 4(3) resolved in favour of the UK since Place of Effective Management (POEM) was in the UK. Factual finding and conclusion of the Special Commissioners were as follows:

    (i) POEM is not defined in the DTA; it is the place which is the centre of top-level management; that is, where the key management and commercial decisions are actually made.

    (ii) In this case the key decision was to dispose of all the shares in a tax-efficient way.

    (iii) The facts surrounding the appointment of KM leads one to the view that the real top-level management, or the realistic, positive management of the Trust, remained in the United Kingdom.

    (iv) It was a representative of K who approached KM and told them about the tax planning proposals and set out the basis of their appointment.

    (v) Although KM’s duties as trustee were laid down in legislation and in the trust deed and KM would only act within the context of what it was allowed to do, and the representative of KM stated on examination that the sale of the shares was not a condition for KM to accept the appointment as trustee and that the trustees only wished to receive appropriate advice and recommendations, nevertheless, it was also accepted by the representative that eventually as part of the tax planning exercise the shares would be sold at some time.

    (vii) All the actions of KM in Mauritius were carried out correctly and were properly documented. The appropriate meetings took place there and the necessary resolutions were passed. However, this merely meant that the administration of the Trust moved to Mauritius, but the ‘key’ decisions were made in the United Kingdom.

    (viii) The decision to sell the shares on the particular day was taken by the directors of KM at the telephone meeting; however, this only meant that if, for example, the price of the shares had fallen to a level as a result of which no gain would be realised on their disposal, the shares would not have been sold, but would have been retained and perhaps sold later. This was a lower-level management decision as there was no doubt that the shares would be sold; the real top-level management decisions, or the realistic, positive management decisions of the Trust, to dispose of all the shares in a tax efficient way, had already been, and continued to be, taken in the United Kingdom. The ‘key’ decisions were made in the United Kingdom.

    (ix) The state in which the real top-level management, or the realistic, positive management of the Trust, or the place where key management and commercial decisions that were necessary for the conduct of the Trust’s business were in substance made, and the place where the actions to be taken by the entity as a whole were, in fact, determined between 19 December 2000 and 2 March 2001, was in the UK.

On appeal by taxpayer to the High Court, the decision of Special Commissioners was reversed. The High Court adopted ‘snap-shot’ view of residential status and concluded as under at para 44:

    (i) The Commissioners erred in creating a simultaneous residence for the trustees.

    (ii) The correct analysis is that there were three periods of successive residence in the relevant UK tax year — Jersey, Mauritius and then the UK.

    (iii)    Article 13(4) gives the right to tax capital gains to the state in which there was residence at the time of the disposition.
    (iv)    That state was, at that date, Mauritius.
    (v)    Since there were no two jurisdictions vying for a claim of residence in that period, there is no tie for Article 4 to break.
    (vi)    Accordingly, Mauritius has the right to tax and the UK does not.

    The matter finally went to Court of Appeals. The Court, inter alia held (by majority) that on the primary facts which the Special Commissioners found, the POEM of the Trust was in the UK in the fiscal year in question. The scheme was devised in the UK by TS on the advice of K. The steps taken in the scheme were carefully orchestrated throughout from the UK. It was integral to the scheme that the trust should be exported to Mauritius for a brief temporary period only and then be returned, within the fiscal year, to the United Kingdom, which occurred. TS remained in the UK. There was a scheme of management of the trust which went above and beyond the day-to-day management exercised by the trustees for the time being, and the control of it was located in the UK.

    The Court of Appeal also adjudicated on a number of other issues. This Article is confined to treaty-related issue of POEM and does not deal with other issues which had an interplay of domestic law and treaty provisions.

    Inferences:

    From the judgment, the following inferences can be drawn:
 

    The OECD Commentary on Article 4(3), India’s observation to the OECD Commentary and the UN Commentary on A. 4(3) are reproduced below:

    OECD Commentary (2005) on Article 4(2):

    The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business are in substance made. The place of effective management will ordinarily be the place where the most senior person or group of persons (for example a board of directors) makes its decisions, the place where the actions to be taken by the entity as a whole are determined; however, no definitive rule can be given and all relevant facts in these circumstances must be examined to determine the place of effective management.

    OECD Commentary (2008) on Article 4(3):

    “24. As a result of these considerations, the ‘place of effective management’ has been adopted as the preference criterion for persons other than individuals. The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.”

    India’s Observation to OECD Commentary on Article 4(3):
    “11. India does not adhere to the interpretation given in paragraph 24 that the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made. It is of the view that the place where the main and substantial activity of the entity is carried on is also to be taken into account when determining the place of effective management.”

    UN Commentary on Article 4(3):

    “10. It is understood that when establishing the “place of effective management”, circumstances which may, inter alia, be taken into account are the place where a company is actually managed and controlled, the place where the decision-making at the highest level on the important policies essential for the management of the company takes place, the place that plays a leading part in the management of a company from an economic and functional point of view and the place where the most important accounting books are kept.”

    Indian Perspective:

    The Indian perspective is explained separately for:
    (a)    the period up to 31st March 2012 (the last date up to which the Income-tax Act, 1961 (‘the Act’) will remain in force), and
    (b)    the period from 1st April 2012 (when the Direct Tax Code (DTC), assuming it will be enacted in the form in which the Bill is presented, will come into force).

    Income-tax Act, 1961:
    There is no definition of POEM in the Act. For the purposes of DTAAs, it has been held as follows by Tribunal/Authority for Advance Rulings (AAR):
    (i)    P. No. 10 of 1996, In re (1996) 224 ITR 473(AAR):
    In this case the Authority dealt with the issue of determining POEM for two companies. In the case of the first company, it was contended that the POEM is in Mauritius on account of the following facts:

            The company has two resident directors of appropriate calibre to exercise independence of mind and judgment.

•             The company’s secretary is a resident in Mauritius;

•             The registered office is in Mauritius;

•             Banking transactions will be channelled through the Hongkong and Shanghai Banking Corporations;

•             Accounting records will be maintained in Mauritius in accordance with the Companies Act, 1984;

•             Board meetings will be held in or chaired from Mauritius;

•             All statutory records, such as minutes and members’ register, will be kept at the registered office;

•             The company has an ordinary status.

    The Authority observed that it is difficult to say that the effective management of the affairs of the company is not in Mauritius in the above situation unless there are facts to at least prima facie indicate that such control emanates elsewhere than from Mauritius.

    In case of the second company, the Authority observed that the POEM of a company is the place where its board of directors takes the decisions; the position would remain the same even if the board would rely, to a considerable extent, on advisors if these advisors are not decision-taking bodies and regardless of the delegation, the company remains responsible for all decisions and acts of any delegate as if it has been done by itself.

    (ii) P. No. 9 of 1995, In re. (1996) 220 ITR 377(AAR)

    The Authority held that the word ‘Place of ef-fective management’ refers to place from where factually and effectively, the day-to-day affairs of the company are carried on and not to the place in which may reside the ultimate control of the company (shareholder).

    (iii)    DLJMB Mauritius Investment Co., In re (1997) 228 ITR 268 (AAR):

    The applicant contended that its place of effective management was situated in Mauritius under Article 4(3) of India-Mauritius Tax Treaty on account of the following facts:

•             At least two directors of the company were resident in Mauritius and such directors had appropriate caliber to exercise independence of mind and judgment.

•             The company secretary of the company was resident in Mauritius.

•             The registered office of the company was in Mauritius.

•             Banking transactions were channeled through an offshore bank account in Mauritius.

•             Accounting records were maintained in Mauritius in accordance with the Mauritian Companies Act.

•             Director’s meetings were held in Mauritius.

•             All statutory records, such as minutes and members’ register were kept at registered office.

•             The auditors were Mauritian residents.

•             The company had a Mauritian custodian for its assets.

•            The company was regulated by the Mauritius

    Offshore Business Activities Authority of Mauritius (MOBAA).

•             The company was required to report on a quarterly basis its investments operations to MOBAA.

•             The company was subject to such enactments and conditions as may from time-to-time be adopted Mauritian authorities in relation to investment funds, collective investment schemes and conduct of investment business.

•             The company was incorporated for investment in Indian companies and investors from different jurisdictions were investing in the Mauritian company and directors in the company were appointed from different jurisdictions.

•             Dividends were remitted from India to the Mauritian company.

    The Authority quoted the observations in P. No. 9 of 1995, In re (1996) 220 ITR 377 (AAR) [see(ii) above] and held that the said reasons were equally applicable. Accordingly, it held that the POEM of the applicant was in Mauritius. It did not comment on the aforesaid factors pointed out by the applicant.

    (iv)    Integrated Container Feeder Service v. JCIT, (96 ITD 371) (Mum.):

    The appellant, a shipping company incorporated in Mauritius and carrying on activity of operating ships in international traffic from India contended that its POEM was in Mauritius. The Tribunal observed that:

    The term ‘place of effective management’ has neither been defined in DTAA, nor defined in Income Tax Act, 1961. Therefore, the said term should be understood in its natural meaning. It is plausible to say that the words ‘place of effective management’ refer to a place from where factually and effectively the day- to-day affairs of the company are managed and controlled and not to the place in which may reside the ultimate control of the company. In the context of the Company, it observed that it refers to a place where ships are put into service.

    It held that the company’s POEM was not in Mauritius on the following grounds:

• No business activity was carried out in Mauritius.

• The directors’ meetings were held in Mauritius only as a necessary formality to maintain its corporate status and to obtain tax residency certificate.

•  The owners were from Dubai and entire business correspondence was made from Dubai.

• Operating instructions were received only from Dubai.

• The place of management was in UAE since all the staff, officers and captains were sitting in Dubai.

    The Tribunal observed that determination of the existence of effective management at a particular place is a question of fact which has to be determined according to facts of a particular case and that the certificate from Mauritian Authorities that the company’s POEM is in Mauritius is not sufficient.

    (v)    Saraswati Holding Corporation Ltd. v. DDIT, 16 SOT 535 (Del.):

    The appellant executed power of attorney in favour of Indian residents who conducted transactions through stock-brokers in India. The Assessing Officer held that the appellant had its POEM in India on the following grounds:

•             The POA holders were in India; they were entitled to carry on activities on behalf of the appellant and that decisions regarding investments were taken by them.

•             The share transactions were either concluded through one share-broker in India (V) who was managing investments of the appellant or through other brokers, in which case V was kept updated.

•            The shares were being purchased and sold within a short span of three to four days and such decisions required close monitoring of the mood of the market.

    The Tribunal held that the reasons assigned by the Assessing Officer were insufficient to come to a conclusion that POEM of the appellant was in India. It observed that:

    The law is well settled that control and management of affairs does not mean the control and management of the day-to-day affairs of the business. The fact that discretion to conduct operations of business is given to some person in India would not be sufficient. The word ‘control and management of affairs’ refers to head and brain, which directs the affairs of policy, finance, disposal of profits and such other vital things consisting the general and corporate affairs of the company.

    It held that the place of effective management was not in India on account of the following reasons:

•             The POA merely empowered the persons in India to conduct the day-to-day affairs of the company.

•             Directions were issued by the two non-resident shareholders as evidenced by the telephone bills recording the calls made to India from time to time.

•             The board of directors of the appellant had passed a resolution whereby the authority to take decisions was only with one of the two non-resident shareholders.

    (vi)    SMR Investments Ltd. v. DDIT, 2010 TII 66 ITAT Del-Intl:
    In this case, the orders for sale of shares held by the appellant were placed by a shareholder holding 99% of the shares in the appellant and who was a resident of India. The telephone calls were made from India. The appellant was asked to furnish the passport of the shareholder to verify whether the telephone calls were made from India or not. The passport was not furnished in spite of various opportunities. The AO held that it is the actual place of management of a company and not the place where it ought to manage and control the company that determines the POEM and accordingly he held that the appellant was resident of India. The appellant filed passport copies of a former director of the company and contended that from the passport it was clear that the director was in Mauritius on the dates on which the Board meetings of the Appellant were held. An affidavit of the director was also placed on record. Accordingly, the appellant indicated that the effective control was in Mauritius. The Revenue doubted the authenticity of the signatures. In view of this, the Tribunal restored the matter to the AO for examining the authenticity of the documents and deciding the issue afresh/ de novo. The facts and the Tribunal’s decision suggest that the Tribunal accepted that it was not the place where the orders were placed but the place where the board meetings were held that decided the POEM.

    DTC:

    The DTC Bill proposes to introduce a definition of POEM as follows:

    “(192) ‘place of effective management’ means —

    (i)    the place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or
    (ii)    in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.”

    Summary:

    The OECD Commentary of 2008, specifically re-moves the reference to the board of directors. It reiterates the emphasis on the place where the decisions are made in substance. The UN Commentary provides for a number of circumstances to be taken into account for determining the POEM. It also uses the word ‘actually manage and control’ suggesting that it is the place of actual management which is relevant. The Commentary also states that the place that plays a leading part in the management of the company from economic and functional point of view is also a circumstance to be considered. It is not clear from this, whether the Commentary alludes to top management or the day-to-day management. It is also not clear as to how the place where the accounting books are kept could constitute a circumstance in deciding the POEM.

    5.2 So far as the judgment in Smallwood is concerned, it provides a useful guidance in inter-pretation of POEM, a concept which will acquire paramount significance in the DTC regime. A finer reading of the judgment reveals that the Court has accepted both OECD and UN Commentary’s (partly) understanding of concept of POEM. It has given weightage to the place where key and real topmost-level decisions were made in substance and held that place to be POEM. This place need not necessarily be the same place where Board meetings are conducted. In the Court’s view, the place where the whole tax planning scheme was orchestrated constituted the POEM.

    In the Indian context, the AAR/Tribunals have taken diverse views on the matter?: On the one hand it has been held that the place where the board of directors takes the decision is the POEM. On the other hand it is also been held that POEM refers to a place from where the day-to-day affairs of the company are managed and controlled. Again, factors other than the directors e.g., Company Secretary, Registered Office, etc. have also been considered to hold that the POEM was in Mauritius. Further, the Tribunal has held that the POEM refers to the place where all the employees were based and from where the revenue generating assets (ships) are put in service. In that case, the Tribunal went behind the Board meetings.

    It appears that:

    (a)    the POEM is at the place where the key man-agement decisions are actually taken. This is also supported by the dictionary meaning of the word ‘effective’ as ‘existing in fact, actual’ (www.thefreedictionary.com) and ‘real’ [see Worley Persons Services Pty. Ltd., In re (2009) 312 ITR 273 (AAR) interpreting ‘effectively connected’].