22 January 2016

Draft guidelines for determination of PoEM - A incongruous note to an intended harmonious provision?

Section 6(3) of the Income Tax Act, 1961 (‘Act’) has been amended vide Finance Act, 2015 to introduce the concept of Place of Effective Management (‘PoEM’) to determine residential status of companies. Memorandum to Finance Bill, 2015 provided that the amendment has been brought to align the provisions of the Act with the internationally accepted principles and to plunge the loopholes in the existing tax regime. It was further provided in the memorandum that a set of guiding principles would be issued for the benefit of tax administration and taxpayers. 
On 23rd December 2015, CBDT notified a draft of guiding principles for determination of PoEM of Company. The main highlights of the guidelines are as follows:

1.         Definition: PoEM has been defined to be a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made. The definition is in line with the meaning of PoEM provided in the Act (vide Explanation to section 6(3) of the Act) as well as in paragraph 24 of the OECD Commentary on Article 4 (which was included in the 2000 update to the Model). In line with the commentary to the OECD model convention, the guidelines also recognize the fact that a company can have many places of management but only one PoEM.


Classification into ‘Active’ or ‘Passive’ business outside India

The guidelines propose to classify the business of the companies outside India into active or passive category. For the purpose of doing so, the guidelines propose that the following shall be considered to be passive incomes:
i)          Income from transactions where both purchase and sale of goods is from/to its associated enterprise
ii)         Income by way of royalty, dividend, capital gains, interest or rental income
Further, the guidelines provide that a company will be said to be engaged in active business outside India if the passive income of the company is less than 50% of its total income and if all the following conditions are satisfied:
i)          If less than 50% of its total assets are situated in India, and
ii)         If less than 50% of total number of employees is situated in India or resident in India and
iii)        If the payroll expenditure incurred on employees situated in India and resident in India is less than 50% of its total payroll expenditure.

It is provided that for the purpose of determining whether the company is engaged in active business outside India (i.e. 50% of the criteria specified above) the average of the data of the previous year and two years prior to that shall be taken into account.

The guidelines provide that a company engaged in active business outside Indian shall be presumed to be a non-resident if the majority of meetings of the board of directors of the company are held outside India. However, it is proposed that if on the basis of facts and circumstances it is established that the board of directors of a company engaged in active business outside India are standing aside and not exercising their powers of management and such powers are being exercised by either the holding company or any other person(s) resident in India, then the PoEM of such company shall be considered to be in India.


Determination of PoEM for companies engaged in passive business

The guidelines prescribe a two stage process to determine the PoEM for companies engaged in passive business. The first stage would be identification of persons which actually make the key management and commercial decisions for conduct of company’s business. The second stage would be determination of place where these decisions are in fact being made. The guidelines clarify that the place where these decisions are taken is of more importance than the place where these decisions are implemented.

The guidelines recognize various locations such as the place where the board ordinarily meets, place of operation of a committee which has been delegated key business decisions by the board of directors and locations of company’s head office as relevant places where the PoEM may be located.


Principles for guidance only

The guidelines provide that the set of the principles are directive in nature and that no single principle will be decisive in itself.


PoEM deemed to be in India

It is provided that if by applying the principles specified in the guideline, PoEM is in India as well as outside India, it shall be presumed that the PoEM is mainly in India.  

Ever since the introduction of PoEM vide Finance Act, 2015, India Inc had been waiting with antsy nerves for the guidelines for PoEM to be notified with a belief that the guidelines will notify a set of blanket rules or safe harbor principles  for determination of PoEM in India. The draft guidelines are far away from that proposition. The guidelines are clarificatory in nature and principles are non binding. The only take away from the guidelines seems to be the fact that the substance shall prevail over form.

The classification of business into ‘active’ and ‘passive’, is a relatively fresh concept and does not find place in DTAA. The classification clarifies that the department wants to tax the ‘letter–box’ companies while intending to avoid litigation to determine the residential status of genuine companies which may have some sort of business connection with India but are managed from outside India. However, presumably with intent of plunging any loophole supplied by this deeming fiction (i.e. active companies holding majority of meetings outside India shall be non-residents), CBDT has notified that the concept of substance over form shall prevail even for active companies as even these companies can be declared residents if the board meetings are conducted merely on paper to hoodwink the department and actual decisions are taken from India.

Though such provision has been inserted with a prudent mind, this stand complicates rather than simplifying the current structure. This is because even when the assessee has satisfied that it is an active company, the department would still contest that it has its PoEM in India. Since the criteria as to when the PoEM of an active company will be in India have not been highlighted separately, the principles provided for determining PoEM of passive company shall apply to an active company as well. Thus this would make the entire exercise of classification of ‘active’ and ‘passive’ business redundant. The only breather to an assessee who is an ‘active’ company would thus, be that once it has been established by the assessee that it has active business outside India and that majority of board meetings have been held outside India, the burden to prove that the PoEM is in India will shift to department. 

Another difficulty with the proposed guidelines is that though they provide that the average of 3 years data is to be considered while determining as to whether the business of the company is active or passive, at what point of time the average for each year is to be taken has not been clarified. E.g. if one needs to find out whether 50% of total assets were outside India, at what point of time in each year, the average needs to be calculated has not been provided. Since the assets and employees are not constant throughout the year, a clarification with respect to this calculation would be welcome.

In general parlance, the term ‘passive income’ is used for incomes which can be earned without active participation or effort. Royalty, dividends, capital gains and rental incomes should and have been classified as passive incomes. However, the guidelines provide that where a company is engaged in the business where both sale and purchase are from/to related parties, the same shall be classified as passive business. It seems that the intent for introducing this provision is to curb the practice where companies create intermediary shell companies and park profits outside India by using provisions of DTAA. It is however pertinent to note that the Board has included only purchase and sale of goods within the ambit of passive income transactions. Provision of services to and from related parties has not been covered within the scope of passive incomes.

The major drawback with the guidelines however, is the fact that the principles are non binding and that the PoEM shall be deemed to be in India if the application of principles imply that PoEM is India as well as outside India. Firstly, it is a settled principle which is recognized by the OECD and endorsed by the guidelines issued by CBDT itself that there can be only one PoEM. Thus, the fact that application of principles notified by CBDT can lead to more than one place of PoEM cannot be appreciated. If the intent was to align the Act with the internationally accepted principle, the guidelines should have been drafted to deal with a situation where PoEM ‘cannot be determined’ rather than providing a situation where PoEM is ‘in India as well as outside India’. Secondly, such a deeming provision can lead to disastrous results as DTAA does not recognize such a deeming provision and application of such a provision will lead to double taxation. It is understood that the credit of taxes may be available but supplying such a provision without providing for any basis of doing so is difficult to digest.  Thus, inserting such a deeming guideline is in variance with internationally accepted principles.



The draft guidelines issued by CBDT are not only open ended but contradictory to the internationally accepted principles for determination of PoEM. The guidelines should have been in harmony with the OECD commentary which was one of the intent of introducing the provision. The corporate sector would thus wait for the final guidelines hoping that the final version of the guidelines include some sort of safe harbor principles for determination of PoEM.

 [The author is an Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Delhi]

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