PoEM not the only solution
The change in definition of an Indian resident company under the Income-Tax Act—from one whose affairs are wholly controlled and managed in India to one whose Place of Effective Management (PoEM) is in India—and the subsequent draft guidelines are giving anxious moments to votaries of simplifying the investment climate in India.
The new definition and its interpretation by tax authorities can lead to raising the cost of compliance and stymying investments. The purpose of the change as explained while introducing the Finance Bill in Parliament in 2015 was to “…deter the creation of shell companies which are incorporated outside but controlled from India.” It was stated that most of the tax treaties entered into by India recognise the concept of PoEM as a tie-breaker rule for determining the residence of companies. In addition, that many countries incorporate the PoEM test in their domestic tax legislations and that the principle of PoEM is recognised and accepted by the Organisation of Economic Cooperation and Development (OECD)—which represents the views of the developed, capital-exporting countries.
While all these are fair arguments, they do not mirror India’s current economic reality as a capital-importing country seeking long-term foreign investment and job creation. Another cause of concern is that while the PoEM legislation is applicable for the current fiscal year, the draft guidelines are likely to be finalised only by the end of the fiscal year, leaving no time for companies to review their affairs for prospective compliance.
Companies incorporated in India are taxed, as Indian residents, on their global income, and foreign companies only on their India-sourced income. The motivation behind re-characterising a foreign company as a company resident in India (through the PoEM rule), as reflected in the draft guidelines, is primarily to tax their passive foreign income (interest, royalties, rentals). It is obvious that such an attempt, if actively pursued, would entail substantial tax administration and taxpayer-compliance cost, subsequent litigation costs and delays, and the thorny issue of sorting out the resultant double taxation of such a company both in India and abroad.Management (PoEM)
A better solution which balances tax administration and taxpayer concerns is the introduction of controlled foreign company (CFC) rules instead of actively pursuing a PoEM route. Both the PoEM and the CFC have been simultaneously proposed in the draft Direct Taxes Code (DTC) released for public discussion and therefore balance the PoEM concerns. A CFC rule aims to target situations where a foreign company owned and controlled by Indian resident shareholders accumulates passive incomes abroad. A CFC rule targets such deferred incomes of the foreign company by deeming them to be the income of the Indian shareholder and taxing it in his hands. Such a rule does not make the foreign company an Indian taxpayer, but isolates its passive income and taxes such income in the hands of the Indian resident shareholder.
It may be noted that the Income-Tax Act already incentivises the declaration of dividends by foreign companies and their repatriation to the resident Indian corporate owner by taxing them at a lower rate (of 15%) in the hands of such corporate shareholders. While this incentive is a ‘pull’ factor, a suitably-crafted CFC would be a ‘push’ factor for hastening the repatriation of such incomes. The double taxation of such incomes under a CFC could be mitigated by allowing for credit of taxes paid abroad on such incomes.
Therefore, a suggested path to mitigating foreign investment concerns could be to first defer the PoEM legislation by at least two years (as was done by the government for the GAAR legislation which has been deferred by five years); second, provide in the guidelines that the fact-finding exercise regarding the PoEM of a foreign incorporated company will only be applicable if its foreign passive income exceeds a certain financial threshold (as has been done earlier in the case of applicability of transfer pricing scrutiny audits and GAAR guidelines); and third, undertake an exercise to quantify the amount of such passive income of companies owned by Indian shareholders to decide whether activating a PoEM and CFC regime is relevant at this stage of the Indian economy’s growth path.