Decoding The Consequences of POEM in India

The Finance Act, 2016 substituted section
6(3) of the Income-tax Act, 1961 (the Act), w.e.f. 1^st April 2017.
The “Place of Effective Management” (POEM) was introduced as one of the tests
for determination of the residential status of a company. Various stakeholders
raised concerns that a foreign company which is treated as a “POEM resident” in
India may not be able to comply with the provisions of the Act applicable to a
resident as the determination of POEM transpires during the assessment
proceedings that are usually years after the relevant tax year for which the
foreign company is treated as “POEM resident” in India. To mitigate such
concerns, the Finance Act, 2016 introduced section 115JH which gave the Central
Government power to notify exceptions, modifications and adaptations.
Therefore, laws and regulations applicable to an Indian company for computing the
tax liability would apply to a foreign company, which is a “POEM resident” in
India subject to such exceptions, modifications and adaptations notified by the
Central Government. On 15^th June 2017, the CBDT issued a draft
notification for implementing the provisions of the section 115JH of the Act.
The Central Government has now published the final notification u/s. 115JH of
the Act on 22^nd June 2018, specifying the consequences in respect of
a foreign company treated as “POEM resident” in India for the first time. This
write-up dissects and decodes the transitory consequences for a foreign
company.

1. 
Backdrop:

Prior to the
introduction of Place of Effective Management (POEM), a company was considered
as a resident of India only if its control and management were “wholly
situated in India”. An absolute threshold meant that companies could avoid
being classified as a resident by merely holding one key board meeting outside
India.

Therefore, to
protect India’s tax base and to align provisions of the Income-tax Act, 1961
(‘the Act’) with the Double Taxation Avoidance Agreements (DTAAs) entered into
by India with other countries¹, India introduced the concept of POEM²
vide amendment³ to section 6(3)(ii) of the Act:

“Section
6(3): For the purpose of the Act, a company is said to be a resident
in India in any previous year, if—

(i)  it is an Indian company; or

(ii)  its place of effective management, in that
year, is in India.

Explanation.—For
the purposes of this clause “place of effective management” means a
place where key management and commercial decisions that are necessary for the
conduct of business of an entity as a whole are, in substance made.”

However, the use of
POEM as a test for residency was made applicable from assessment year 2017-18 onwards⁴.

As noted in the
Explanation to section 6(3), POEM is defined as the place where the “key
management and commercial decisions that are necessary for the conduct of
business of an entity as a whole are, in substance made.”

Therefore, the
definition of POEM has four limbs:-

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1   However, as per the 2017 update to the
OECD Model Tax Convention, the OECD has moved away from “POEM” to a
case-by-case resolution using Mutual Agreement Procedure (MAP) for determining
conflicts of dual residency.

2   According to the Explanatory Notes to the
provisions of the Finance Act, 2015. Circular No.- 19 /2015 dated 27^th
November 2015. F. No. 142/14/2015-TPL.

3.  Refer section 4 of Finance Act 2015.

4.    Refer section 4 of
Finance Act 2016.

i.    Key Managerial and Commercial decisions

ii.    Necessary for the Conduct of Business

iii.   Of an entity as a whole

iv.   In substance made.

Since the
introduction of POEM in India, the CBDT has issued three circulars providing guidelines
with respect to POEM. The three circulars can be broadly classified as follows:

The first circular
(i.e. Circular No. 6) issued by the CBDT introduced following:

i.   An objective test –To determine whether a
foreign company has active operations outside India (formally known as “active
business outside India” test)⁵

ii.  Subjective Guidelines – To provide important
factors that may be considered while determining POEM.

A company is
considered to have an “active business outside India” when (a) its passive
income (An aggregate of sale and purchase transactions between related parties,
dividend, interest, royalty and capital gains) is less than 50 per cent of its
total income, and (b) the number of employees in India, value of assets in
India and payroll expenses relating to Indian employees is less than 50 per
cent of the company’s total employees, assets and payroll expenses,
respectively. The determination of these factors is based on an average of the
data pertaining to the relevant financial year and two previous years.

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5   The “active business outside India” test and
‘passive income’ clause are akin to provisions or objectives of a Controlled
Foreign Corporation (CFC) Rule. It is pertinent to note that no country in the
world has such conditions for determination of POEM that tries to achieve dual
purposes.

A company having an
active business outside India is presumed to be non-resident as long as
majority of its board meetings are held outside India.

For companies that
fail the active business outside India test, the determination of residence
would involve identification of (a) persons who are responsible for management
decisions, and (b) place where decisions are actually made.

If a foreign
company gets hit by the POEM provisions, it becomes a resident and all
provisions of a resident company would apply to it. However, various
stakeholders raised concerns that a foreign company which is treated as a “POEM
resident” in India may not be able to comply with the provisions of the Act
applicable to a resident as the determination of POEM transpires during the
assessment proceedings that are usually years after the relevant tax year for
which the foreign company is treated as “POEM resident” in India. To mitigate
such concerns, the Finance Act, 2016, amongst other things, introduced special
provisions in respect of a foreign company said to be “POEM resident”⁶  in India by way of insertion of a new Chapter
XII-BC consisting of section 115JH in the Act with effect from 1^st
April 2017. Section 115JH of the Act, inter alia, provides that the
Central Government may notify exception, modification and adaptation subject to
which, provisions of the Act relating to computation of total income, treatment
of unabsorbed depreciation, set off or carry forward and set off of losses,
etc., shall apply.

On 15^th
June 2017, the CBDT issued a draft Notification for implementing provisions of
the section 115JH of the Act. The draft Notification invited comments from
stakeholders and the public. The Central Government, vide Notification dated 22^nd
June 2018, released the final Notification⁷ under section 115JH(1)
of the Act. The final guidelines take forward the concept laid down in the
draft guidelines. It further provides clarification on other areas which were
not mentioned in the draft guidelines such as deemed computation of Written
Down Value (WDV) when WDV is not available in tax records, allowing carry
forward of unabsorbed depreciation on a proportionate basis when the accounting
year followed by the foreign company is different, explicitly defining “foreign
jurisdiction” etc. The consequences of a foreign company attracting POEM
provisions for the first time have been summarised below.

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6   “POEM resident” is a term coined by the
authors for companies that become “resident” as per the Income Tax Act, 1961
due to the attraction of the “POEM” provisions.

7     Notification No. S.O. 3039(E) dated 22^nd
June 2018. The Notification is applicable from 1^st April 2017.

2.  Key
takeaways from the Final Notification

The key takeaways
of the Notification are summarised below and a hypothetical case study of Ace
Ltd., is used to elucidate the takeaways in a more comprehensive manner.

2.1 Determination of WDV, brought forward
losses and unabsorbed depreciation for the relevant year

When the
foreign company is assessed to tax in the foreign jurisdiction

a)  The WDV of the depreciable asset shall be
determined as per the company’s tax records in the foreign jurisdiction.

b)  When WDV of the depreciable asset is not
available in tax records, the WDV is to be calculated as per the provisions of
the laws of that foreign jurisdiction.

c)  The brought forward loss and unabsorbed
depreciation shall be determined (year wise) on the basis of the foreign tax
records of the company.

When the
foreign company is NOT assessed to tax in the foreign jurisdiction

a)  The WDV of the depreciable asset, the brought
forward loss and unabsorbed depreciation (year wise) is to be determined on the
basis of the books of account maintained in accordance with the laws of the
foreign jurisdiction.

Other
miscellaneous provisions

a)  The brought forward losses and unabsorbed
depreciation determined above shall be allowed to be set-off and carry forward
in accordance with the provision of the Act for the remaining period,
calculated from the year in which brought forward loss and unabsorbed
depreciation occurred for the first time.

b)  The brought forward losses and unabsorbed
depreciation will be allowed to set off only against such income that has
become chargeable to tax in India on account of the foreign company becoming a
“POEM resident” in India.

c)  If there is a revision or modification in the
amount of brought forward loss and unabsorbed depreciation in the foreign
jurisdiction, then such revisions will also be made in India for set-off and
carry forward.

Case Study:

Ace Ltd., a foreign
company, was incorporated on 1^st April 2016. It follows the same
financial year as India i.e. 1^st April-31^st March. It
acquired a fixed asset worth Rs 10 crores on 1^st April 2016 itself.
The company attracts POEM provisions in India for financial year 2017-18. The
facts of the company are summarised below:

Depreciation as per
tax law – 10%.

WDV as per tax law
– 9 crores

Depreciation as per
company law – 20%.

WDV as per company
law – 8 crores

Business Loss as
per tax law – Rs 1,00,000/-

Business Loss as
per company law – Rs 1,50,000/-

Q1) What would be
the WDV of Ace Ltd.’s fixed assets as on 1^st April 2017?

Scenario 1: Ace
Ltd. is incorporated in Singapore and the Singapore tax laws provide 10 rate of
depreciation.

Scenario 2: Ace
Ltd. is a Singapore company; however, the Singapore’s tax laws don’t provide
any specific rates for depreciation.

Scenario 3: Ace
Ltd. is incorporated in UAE.

Q2) What loss Ace
Ltd. can set off in the previous year 2017-18 in India?

Scenario 1: Ace
Ltd. is incorporated in Singapore.

Scenario 2: Ace
Ltd. is incorporated in UAE.

Solutions:

Answer 1:

Scenario 1: Since
Ace Ltd. is assessed to tax in Singapore and the Singapore tax laws specify the
rate of depreciation for the fixed asset, the WDV of such asset as on 1^st
April 2017 will be Rs 9 crores (computed as per Singapore’s tax law).

Scenario 2: Since
Ace Ltd. is assessed to tax in Singapore and the Singapore tax laws do not
specify the rate of depreciation for the fixed asset, the WDV of such asset as
on 1^st April 2017 will be Rs 8 crores (computed as per
Singapore’s company law).

Scenario 3: Since
Ace Ltd. is not assessed to tax in UAE, the WDV of such asset as on 1^st
April 2017 will be Rs. 8 crores (determined on the basis of the books of
account maintained in accordance with UAE’s company law).

Answer 2:

Scenario 1: Since
Ace Ltd. is assessed to tax in Singapore, the loss in accordance with
Singapore’s tax law will be considered. Therefore, the brought forward loss
of Rs. 1,00,000/- will be allowed to be set off for eight consecutive years.

Scenario 2: Since
Ace Ltd. is not assessed to tax in UAE, the loss as determined in the books
of account maintained in accordance with the company law will be considered. Therefore,
the brought forward loss of Rs. 1,50,000/- will be allowed to be set off for
eight consecutive years.

Note: The loss calculated in both scenarios was from the year in which
brought forward loss occurred for the first time (i.e. previous year 2016-17).
It is important to always calculate the remaining period of set off from the
year the loss first occurred and not from the year in which the foreign company
becomes “POEM resident” in India.

2.2   Preparation of Profit and Loss and Balance
Sheet

a)  The foreign company will have to prepare
financial statements⁸
for the period immediately following its accounting year to the period in which
the foreign company becomes “POEM resident” in India.

b)  The foreign company shall also be required to
prepare financial statements for succeeding periods of twelve months till the
year the foreign company remains resident in India on account of POEM.

In other words, the
foreign company needs to prepare its financial statements for India on a
financial year basis consistently till it remains a “POEM resident” in India.

c)  For carry forward of loss and unabsorbed
depreciation, the following provision will apply:

–   If the “split period” is
less than six months, then such loss and unabsorbed depreciation will be
included in the year in which the foreign company becomes “POEM resident” in
India. Additionally, the financial statements will be extended to include the
split period.

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8   Profit and Loss Account & Balance Sheet.

For example:
Assuming Ace Ltd. is following a calendar year, then with a “split period” of
three months it does not have to prepare a “split” financial statement of three
months and financial year 2017-18 financial statement of twelve months
INDIVIDUALLY. It can combine both the financial statements and prepare a
fifteen month statement from 1^st January 2017 to 31^st
March 2018.

Furthermore, the
loss of previous year 2016-17 (Rs 1,00,000/- or Rs 1,50,000/- as the case may
be) will be now considered as current year business loss for the previous year
2017-18 in India.

–    If the “split period” is
equal to or greater than six months, then the split period would be classified
as a separate accounting year and consequently, the financial statements for
such split period need to be prepared.

For example: If Ace
Ltd. was incorporated in Australia where the previous year is from 1^st
July – 30^th June, then the split period for Ace Ltd would be nine
months  (1^st July 2016 to 31^st
March 2017).

Therefore, in such
a case, Ace Ltd. would have to file two separate financial statements i.e. (a)
split financial statement of nine months, and (b) previous year 2017-18
financial statement of twelve months.

It is pertinent to
note that the loss of previous year 2016-17 (Rs 1,00,000/- or Rs 1,50,000/- as
the case may be) will be allowed as a carry forward of business loss for eight
years in the previous year 2017-18 in India.

d)  Further, the Notification provides that in
case when separate split period accounts are prepared, the loss and unabsorbed
depreciation as per tax records or books of account, as the case may be, shall
be allocated on a proportionate basis.

2.3 Applicability of TDS Provisions (Chapter
XVII-B)

a)  Prior to becoming “POEM resident” in India, if
the foreign company has complied with the relevant provisions of Chapter XVII-B
of the Act, then it is considered to be compliant with the provisions of the
said Chapter.

b)  If more than one provision of Chapter XVII-B
of the Act applies to such foreign company as a:

–   resident, and

–    foreign company

then the provisions
applicable to a foreign company shall apply.

c)  Any payment to a foreign company who is “POEM
resident” in India – section 195(2) will still be applicable.

For example: If Ace
Ltd., a foreign company who is “POEM resident” in India, entered into a
management consultancy contract with an Indian entity, Soham Pvt. Ltd., then,
Soham Pvt. Ltd. (the payer) can make an application to the AO to determine an
appropriate sum chargeable to tax and to determine the liability for
withholding tax.

Since section
195(2) explicitly mentions that the payee i.e. Ace Ltd must be a
“non-resident”, (in the instant case Ace Ltd., being a “resident” due to the
POEM in India), the Notification specifically clarifies that the beneficial
provisions of section 195(2) will be applicable to the foreign company which is
resident in India due to its POEM in India.

Interestingly, it
is pertinent to note that the provisions of section 195 specifically mention
applicability to a foreign company. Therefore, any person making payment to Ace
Ltd. would be covered by the provisions of section 195 notwithstanding the fact
that Ace Ltd. has become resident of India by virtue of its POEM in India.

2.4  
Rate of Tax

a)  The rate of tax in case of the foreign company
shall remain the same even though the residential status of the foreign company
changes from non-resident to resident on the basis of POEM.⁹  

Therefore, Ace Ltd.
would be taxed at 40 per cent plus surcharge and cess. POEM, being in the
nature of
anti-avoidance to prevent base erosion, the high tax rates acts as a deterrent.

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9   This is a derivation of key takeaways
explained in paragraphs 2.7 and 2.8.

2.5  
Foreign Tax Credit

a)  A foreign company will be eligible to avail
the benefits of India’s DTAA after it becomes “POEM resident” in India.

b)  In a case where income on which foreign tax
has been paid or deducted, is offered to tax in more than one year, credit of
foreign tax shall be allowed across those years in the same proportion in which
the income is offered to tax or assessed to tax in India in respect of the
income to which it relates and shall be in accordance with the provisions of
Rule 128 of the Rules.

2.6  
Limitation on setting off against India sourced Income

a)  The exceptions, modifications and adaptions
referred to in Para A of the Notification shall not apply to India sourced
income of a foreign company. Therefore, brought forward loss, unabsorbed
depreciation and foreign tax credit will not will available for India sourced
Income of a foreign company.

For example: Ace
Ltd, a Singapore entity, follows calendar year (1^st January – 31^st
December), and the income earned and tax paid by Ace Ltd. in Singapore and in
India is summarised below:

How much foreign
tax credit can Ace Ltd. claim, assuming that Ace Ltd. gets hit by POEM
provisions in financial year 2017-18?

Solution:

Sine Ace Ltd. is
struck by POEM provisions in financial year 2017-18, it will be considered as a
resident in India and consequently, its global income will be taxed in India.

Furthermore, it
will be taxed at the rate applicable for foreign companies.

Note for determining Source wise
Foreign Tax Credit

2.7  
Transacting with a foreign company who is “POEM resident” in India

Any transaction of the foreign company with any other person or entity
under the Act shall not be altered only on the ground that the foreign company
has become Indian resident.

For Example: Ace Ltd. has an associated enterprise Beta Private Limited
in India. Will transfer pricing provisions apply to “international
transactions” between Ace Ltd. and Beta Ltd.?

As per section 92B,
an “international transaction” means a transaction between two or more
associated enterprises, either or both of whom are non-residents. Therefore, it
is important for one of the associated enterprises to be a non-resident.

In the instant
case, since Ace Ltd. has become a “resident” in India due to the applicability
of POEM provisions, ideally, transfer pricing provisions should not be
applicable. However, the language of the Notification creates confusion and
needs clarity.

2.8   
Conflict between Provisions

a)  Subject to the paragraph 2.7 above, a foreign
company shall continue to be treated as a foreign company even if it is said to
be “POEM resident” in India and all provisions of the Act shall apply
accordingly.

b)  It is pertinent to note that the provisions of
the Act which are specifically applicable to either a foreign company or a
resident assessee will apply to such companies. The provisions relating to
non-resident assessees will not apply to such companies. It has been further
clarified that any conflict between provisions of the Act applicable to it as a
foreign company and provisions of the Act applicable to it as a resident
assessee, the former shall prevail.

For example: Act
Ltd., a foreign company, who is “POEM resident” in India, is taxed on:

3. 
Issues

The final
Notification has provided much-needed clarity regarding the consequences of
POEM for foreign companies who are “POEM resident” in India for the first time.
However, there remains ambiguity in the applicability of POEM for cases where
POEM is applied for the second or more time. Determination of POEM is an annual
exercise which needs to be conducted for every assessment year. Therefore, it
is always possible that the facts of the case may reveal that a foreign company
might attract POEM provisions in Year 1, not attract POEM provisions in Year 2
and again attract POEM provisions in Year 3. In such a case, there are no
guidelines about the consequences of POEM for foreign companies who are “POEM
resident” in India for multiple times.

Furthermore, there are some issues which have not been addressed by the
final Notification such as the applicability of advance tax, transfer pricing,
etc. For example, according to Para D of the Final Notification, transactions
of a foreign company with any other person or entity under the Act shall not be
altered only on the ground that such foreign company has become a “POEM
resident” in India. This Para implies that transfer pricing provisions will
continue to apply even if a foreign associated enterprise has become “POEM
resident” in India. Therefore, such a foreign company will have to comply with
transfer pricing provisions while transacting with its Indian associated enterprise.
This concept is irrational because transfer pricing provisions were introduced
in India to prevent shifting of profits from India to another tax jurisdiction.
Transfer pricing should not apply when both the entities are taxed in India, as
there is no opportunity for tax arbitrage.

4. 
Conclusion

Section 4 of the Act empowers the Central Government, to specify the
rate of tax. As per the Act, a company is differentiated either as a “domestic
company”¹¹ or a “foreign company”¹².  A higher rate of tax is provided for the
foreign company as its scope of tax is limited to Indian sourced income only. A
domestic company, however, is liable to tax on its worldwide (global) income
and therefore subject to a reduced tax rate. Thus, the principle seems to be
that as the scope of tax widens, the rate of tax reduces.¹³  However, in the case of a foreign company who
is “POEM resident” in India, not only is its scope of tax broader but also its
rate of tax.

The consequences of
POEM of a foreign company in India are harsh and punitive. Since the
Explanatory Memorandum to the Finance Bill 2015 provides that the POEM rule is
targeted towards shell companies which are incorporated outside but controlled
from India, POEM should be used as an anti-avoidance tool and be resorted only
in exceptional cases. It is hoped that this provision will be used in the
spirit of the Explanatory Memorandum.  

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10  Excluding surcharge and cess

11  Read section 2(22A).

12  Read section 2(23A).

13  This principle might be based on the principle
of equity.

14  Excluding surcharge and cess.

15   A domestic company is taxable at 30 per cent.
However, the tax rate is 25 per cent if turnover or gross receipt of the
company does not exceed Rs. 50 crore.