Tax Residency in India Set for POEM Test
When Indian President Pranab Mukherjee gave Finance Bill 2015 his assent on May 14, most provisions were largely hailed as improvements to the business environment in India. Others, while seen as primarily positive, have been the cause of some concern. One such provision changes the residency test for companies doing business in India from a ‘central control and management’ test to a ‘place of effective management’ (POEM) test.
From Central Control and Management to POEM
There appear to be a couple of reasons that the government made the change.
First, the new law aligns Finance Bill provisions with India’s double taxation avoidance agreements (DTAAs) with other countries as well as international standards provided by the Organization for Economic Co-operation and Development (OECD). India, which is not an OECD country, has been making moves towards adopting OECD standards in residency and transfer pricing issues for several years.
This is a business-friendly gesture that will eventually make it easier to interpret Indian tax law and streamline it with the standards of the countries of India’s major investors. Ironically, the OECD is itself moving away from the POEM framework towards a more rounded definition of place of residency that includes place of incorporation and other relevant factors.
It is the second reason for the change that appears to have foreign investors nervous. In the memorandum accompanying the budget documents, the government notes that the change to the POEM framework was made in part “to deal with cases of creation of shell companies outside India but being controlled and managed from India”.
Under the previous law, India used a central control and management test to determine whether a foreign company is deemed to be resident in India. Under this test, a company was an Indian resident for tax purposes only if the control and management of its affairs was situated wholly in India during that year. These conditions were seldom met and easily avoided.
The new law introduces the OECD concept of POEM to determine residency for tax purposes. Under the POEM framework, a company is considered a resident in India in any year in which its POEM is in India. OECD guidance recommends that the place of effective management should be the place where key management and commercial decisions for the conduct of the business of an entity, as a whole, are made.
When the draft Finance Bill was introduced, it said that if a company’s POEM was deemed to be in India “at any time” during the tax year, it would be considered a resident for tax purposes. This wording led to widespread concern that even one meeting held by an international company in India during the year could lead to taxation on worldwide income, and possibly double taxation between countries. As a result of industry outcry, the Indian government removed the words “at any time” from the draft bill.
Domestic or OCED Guidance?
Abandoning the idea that a company could be considered an Indian resident for tax purposes if its POEM was in India “at any time” during the year was a significant boon to foreign companies. However, India has not yet indicated whether it will follow the OECD framework or whether it will provide its own guidance for POEM.
Indian law has little definition along these lines. This is significant because a foreign company being brought to tax in India under POEM could be taxed as high as 40 percent (domestic resident companies are taxed at 30 percent). Plus, income distributed to Indian shareholders is subject to another 30 percent tax. This uncertainty, in an already uncertain tax environment, impedes the predictability and certainty necessary for foreign companies to conduct business in India.
Additionally, in some cases where physical presence has little to do with geography – such as when directors dial in from a variety of places in the world using conferencing services – the traditional POEM interpretation could involve a complicated web of treaty interpretations and economic double taxation.
While the effort to bring India’s tax residency laws in line with international standards is significant, the law as written leaves too much uncertainty in implementation. Guidance from the OECD on tax residency can be a useful tool for interpretation, but the Indian government should provide guidance of its own.
