India’s POEM – Further clarifications
The Finance Act, 2016 brought in an important amendment. As per this, some foreign companies could be deemed to have their Place of Effective Management (“POEM”) in India and as a consequence, would be deemed to be an Indian tax resident having to pay tax on global income. A POEM for a foreign company would mean a dual tax residency, one in its home country and the other in India. By definition in the Indian tax law, POEM “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”. The POEM rules apply from the Financial Year (“FY”) 2016-17.
The key theme of POEM is substance over form. The two critical aspects (rather test) in determination of POEM are (i) the “active business outside India” test and (ii) “majority meetings of the Board of Directors outside India” test. This will determine whether a foreign company can be said to be resident outside India for seeking exemption from POEM. However, an administrative circular dated 24th January, 2017 issued by CBDT, for guidance of its field officer in determination of POEM, also mentions that there can be no single decisive test and the circumstances have to be examined in entirety. Therefore, the administrative guidance is quite subjective.
To put the other machinery rules in working for determining the tax liability of a POEM-hit foreign company, a new section 115JH was introduced in the Indian Income Tax Act, 1961 by Finance Act 2016. This section lays down that all the laws and rules which are otherwise applicable to other Indian companies for computing the tax liability will apply subject to such conditions, exceptions, modification and adaptations that the Government will notify by a Notification.
The Government has now, albeit with a delay, issued Notification 29/2018 dated June 22, 2018 which lays down such conditions, exceptions, modification and adaptations. Without getting into too much detailing, the said Notification essentially provides for certain clarification with regard to the general tax rules which otherwise apply to all Indian companies –
- Manner of working out the depreciation allowance - The POEM hit foreign company has to compute the Written Down Value (“WDV”) of the depreciable asset as on first day of the Previous Year (“PY”) as per the tax laws prevailing in its home country. In case if the foreign company is not assessed to tax in its home jurisdiction, value as appearing on first day of the PY in the books of accounts shall be taken as WDV.
- Manner of calculating brought forward loss and unabsorbed depreciation:
|Where the company is assessed to tax in the foreign jurisdiction||Figures as per tax laws of the foreign jurisdiction as on first day of the PY.|
|Where the company is not assessed to tax in the foreign jurisdiction||Figures as per the books of account prepared in accordance with the laws of that country shall be determined on the first day of the PY|
- Such brought forward loss and unabsorbed depreciation shall be allowed to be set off and carried forward in accordance with the provisions of the Indian Income Tax Act, 1961 for the remaining period. However, such set off is allowed only against income chargeable to tax in India on account of such foreign Company becoming Indian resident.
- Further, a POEM hit foreign company is required to re-cast its Profit and Loss account and Balance Sheet and re-work the numbers for the purposes of aligning the same to the Indian tax year.
- Indian withholding tax provisions (on all payments, if any, made to such a foreign company) will apply based on the withholding rules applicable for payments to a foreign company rather than withholding tax rules applicable for payments to residents.
- The notification has further clarified that such foreign company shall be granted credit of taxes paid by it in the home jurisdiction as per Section 90 and 91.
- Further, the notification clarifies that, status quo of a transaction with such a foreign company shall not change, merely because of the foreign company’s deemed tax residency in India. Therefore, tax compliance and reporting requirements of other parties transacting with such foreign company shall not change, merely because of the foreign company’s deemed tax residency in India.
- Notification has further clarified that such foreign company shall continue to be treated as a foreign company for all other Indian tax purposes even if it is deemed to be a resident in India. Importantly, it has been clarified, by virtue of the above thumb-rule, that the headline tax rate applicable to such a foreign company will be 40 percent, as against the headline tax rate of 25 percent applicable to other Indian companies. The last clarification indeed appears to be a case where the Government wanting best of both worlds!
- However, the notification has given huge respite to such foreign companies by way of allowing relief or deduction of taxes paid in accordance with the provisions of section 90 or section 91 of the Act.
- Further, if a foreign company is deemed to be a tax resident for any Indian tax year under the POEM rules for the first time by reason of the Indian tax authority holding so, then the main section as well as the notification provides that the same rules will apply for all the succeeding Indian tax years as well (in which it is held to be an Indian tax resident) ending before the first determination date.
For example, let’s say, a foreign company is considered as an Indian resident by the Indian tax authority for the first time for the FY 2016-17. This determination happens only during the assessment proceedings, which happens with a lag, say, in December 2019 (by virtue of section 153 limitation rules). In such a case, as per the aforesaid rule, the same rules will also apply to future FYs 2017-18 and 2018-19. Therefore, effectively, the deemed tax residency rules are applied for three years (since the foreign company will be oblivious to this Indian audit aspect till then and two more years would have also lapsed). In fact another FY 2019-20 would have also almost completed without the foreign company having any opportunity to comply with the Indian tax rules, even if it had wanted to. In other words, there is no sufficient notice to the foreign company of the Indian tax authority’s intention.
Although, theoretically POEM is to be separately determined for each tax year, it is more likely than not that the position will be continued for the succeeding three years as well by the tax authority. This will result in attracting onerous compliance, reporting and other penal consequences for the foreign company.
The said notification towards the end clarifies that subject to the clarification made in the notification, the foreign company shall continue to be treated as a foreign company even if it is said to be resident in India and all the provisions of the Act shall apply accordingly. Accordingly, although not expressly clarified, it can be inferred that such foreign companies shall not be required to maintain books of account in India and also get it audited as per Indian tax law requirements. An express clarification in this regard would be much appreciated. Similarly for exemption from Minimum Alternate Tax (“MAT”), Dividend Distribution Tax (“DDT”) and Transfer pricing compliances, including reporting.
Notification well before the filing season (November 2018) is a welcome move, however, owing to the applicability of this rule and notification from FY 2016-17 onwards, (which amounts to giving retrospective effect) will indeed cause a lot of hardship on the foreign company doing business in India and in-turn will harm India’s reputation on ‘ease of doing business’ and global ranking which recently broke into top 100.
Further quite a few finer aspects have not been addressed. Definitely, the tax rate of 40 percent needs a re-consideration. Manner of addressing dual residency under the Double Tax Avoidance Agreement (“DTAA”) –Owing to the conflict arising on account of India’s POEM rules, the tie-breaker rule in the DTAA may have to be invoked. As per most of India’s DTAAs, the residency will be determined by the “place of effective management”. Owing to each country having its own tax residency rules, there is bound to be a conflict and should ideally be addressed by the Mutual Agreement Procedure (“MAP”) under the DTAA.
While India has been quick enough to introduce radical changes to the tax rules, for example, changes to accommodate the BEPS initiatives, GAAR, MLI, etc., it appears that too many things are happening too soon and at the same time. It is important that sufficient preparation time and notice is given to the impacted parties to enable them to comply with the fast changing rules. This is important Government of India’s flagship ‘Make in India’ vision and policy.