Tax liability under the Income-tax Act, 1961 (‘the Act’) of any person is determined based upon his residential status. A person resident of India is taxable on his income accruing across the globe [see End Note 1] while a non-resident is taxable only on the income accruing or arising or deemed to accrue or arise or is received in India [see End Note 2] . Residential status of a company was historically being determined under the Act based on the test of ‘control and management’ being situated in India, during the ‘whole’ of any previous year [see End Note 3] . In order to align with international best practices on taxation, the test for determination of residential status of a company was amended by the Finance Act 2017 to examine the ‘Place of Effective Management’ (‘PoEM’) is located in ‘India in that year [see End Note 4]. The phrase PoEM has been defined as
"a place where the key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are in substance made
This definition is verbatim reproduction of second sentence in para 24 of the Commentary by Organisation for Economic Co-operation and Development (OECD) on Model Tax Convention."
Determination of the ‘place’ from where effective management is exercised
Managing the affairs of a company would involve undertaking several activities simultaneously, and in many times at different places across the globe. Broadly, based on judgments of Indian Courts [see End Note 5] while interpreting erstwhile provisions of the Act and Foreign Courts [see End Note 6] on interpreting provisions similar to erstwhile provisions of the Indian Act, as well as the guidance given by OECD, the following factors are useful in determining the PoEM;
a. Place where the Board Meetings are held and the business transacted by the Board
b. Categorization of the decisions taken by the Board as critical policy decisions and routine operational decisions and identifying (i) the person or the Body taking such decisions and (ii) the place where such decisions are so taken
c. Whether the Board deliberates intensively on the proposals or do they, as a formality, approve the proposals put forth before it
d. Place where the Executive Officers exercise their functions
e. Place where the accounting records are kept
f. Place where the company is incorporated and the laws of the jurisdiction on functioning of the company from a place outside the jurisdiction
Additional statutory safeguards
Apart from change brought out from examination of place of control and management to the place of effective management, the Act has also made two other significant changes in determination of residential status of a company. Firstly, the amended statute now explicitly provides that the test would require a ‘substance’ test for control as against the form in which the control is shown to be exercised. Though the amendment has only legislatively incorporated a requirement which has been emphasized by the Courts [see End Note 7] over the years, in the absence of legislative mandate, every decision of Revenue Authorities in according value to substance over form were subject to challenge before a Court of law.
Additional safeguards postulated by the CBDT
The Central Board of Direct Taxes (‘CBDT’), in exercise of the power vested in it to make rules for carrying out the purposes of the, has issued various Circulars explaining the concept and effect of PoEM. In Circular No. 6 of 2017 [see End Note 8] the CBDT had issued certain administrative guidelines to the Revenue Authorities on practical aspects to be examined in determination of PoEM. A few of them include analysis of active and passive income earned by the foreign company, examination of delegated powers of the Board of Directors, etc. These guidelines, though stringent in some aspects, provides some light on a relatively new challenge being faced by foreign companies in India.
Effect of having PoEM in India
If a foreign company is regarded as a resident of India due to its PoEM being located in India, it would be subject to taxation in India on its global income. But, the computation of the taxable income is not easily done as said. Unlike an Indian Company that regularly maintains its books in India and files annual returns in India claiming the eligible deduction, assessing the income or loss of a Foreign Company would be difficult absent any accounting records in India.
This would post practical challenges in the following aspects
a. Determination of depreciation claim for any year
b. Quantifying credit for taxes paid in the country of incorporation
c. Allowability of accumulated losses incurred in the country of incorporation
d. Treaty entitlement
Section 115JH of the Act was introduced by the Finance Act, 2017 to specifically empower the CBDT to issue guidelines on these aspects. The CBDT has accordingly issued ‘draft guidelines’ [see End Note 9] on the entitlement of a foreign company that would be regarded as a person resident of India. The guidelines are broadly as under
(i) Allowability of depreciation
Depreciation is a deduction allowable to a person earning taxable business income. The deduction is based on various factors like cost of the asset, the use of the asset, prescribed rate of depreciation, effect of disposal of assets, etc. These facts cannot be determined or verified in the case of a foreign company which would be subject to tax in India, more so when the assets have been used by the company for many earlier years. In addition, India follows an unique system of allowing depreciation on the ‘Written Down Value’ [see End Note 10] of a ‘block of asset [see End Note 11]. The CBDT has decided to rely on the tax records maintained by the foreign company in its home jurisdiction and has proposed that the value on which depreciation would be allowed shall be,
(a) If the foreign company is assessed to tax in the foreign jurisdiction, the written down value (WDV) of the depreciable asset as per the tax record in the foreign country on the 1st day of the previous year shall be adopted as the opening WDV for the relevant previous year, and
(b) If the said foreign company is not assessed to tax in the jurisdiction where it is based, then WDV of the depreciable asset as appearing in the books maintained in accordance with the laws of that foreign jurisdiction shall be adopted.
Though the recommendation seems to solve many a trouble, it presupposes that the foreign jurisdiction follows the same taxation system as that of India, requiring the foreign companies to maintain records of WDV and block of assets. Many countries however do not follow this system. It is therefore expected of the CBDT to specify rules for determination of depreciation in the case of companies incorporated in countries where the concept of WDV and block of asset does not exist.
(ii) Set off of losses
Generally, tax is levied on the income of a person after allowing for set off of losses incurred in the earlier years. The CBDT proposes to allow set off of brought forward losses of the foreign company in the following manner;
(a) If the foreign company is assessed to tax in the foreign jurisdiction, its brought forward loss or unabsorbed depreciation as per the tax record shall be determined year wise on the 1st day of the previous year in which it is said to be resident in India.
(b) Where the foreign company is not assessed to tax in the foreign jurisdiction, its brought forward loss or unabsorbed depreciation as per the books prepared in accordance with the laws of that country shall be determined year wise on the 1st day of the previous year in which it is said to be resident in India.
The allowability of set off of losses would however be subject to conditions as contained in the Act, which would include provisions restricting intra head set off [see End Note 12], requirements on minimum share holding [see End Note 13], etc.. Here again, the CBDT has presumed that the foreign jurisdiction would have the same manner of classification of income into different heads, which does not happen in many countries. The CBDT shall have to provide for alternate mechanisms for setting off of losses in cases where the home jurisdiction of the foreign company has laws that are divergent with Indian taxing laws.
(iii) Other clarifications
India follows April to March as the tax year while countries across the globe use calendar year as their tax year. The CBDT has provided that, where the financial year of the foreign company is other than the tax year adopted by India, the foreign company has to prepare its accounts for the Indian tax year and compute its tax liability accordingly.
The CBDT has also provided that the foreign company regarded as being resident of India will be entitled to credit for taxes paid in other countries in accordance with the Double Taxation Avoidance Agreement entered into by India with the country of source of income, and where no such agreement exists, in accordance with the Act [see End Note 14].
The CBDT has sought to clear the air on determining the tax liability of a foreign company being regarded as resident of India due to the new PoEM rules. However, regulations are required on much larger aspects and scope, which are still awaited from CBDT.
[The author is a Joint Partner, Direct Tax Practice, Lakshmikumaran & Sridharan, Mumbai]