Ambavat Jain & Associates LLP.

Place of Effective Management – A Basic Overview

International Taxation

A. Opening Note:

In order to understand about Place of Effective Management (POEM), let us first briefly touch upon certain basics of International Taxation. While evaluating taxability of any cross-border transaction or any income earned by a person, one of the basic things that we need to determine is the residential status of the person who has earned the income.

The residential status of a person determines as to which country or jurisdiction would have the right to tax the income / transaction. In general, when we deal with international taxation related matters, there are two countries involved – One is the Country of Source (COS) and the Other is the Country of Residence (COR).

The COS is basically the country from which the income has arose to the Person. COR is the country of which the person is a Tax Resident. The International Taxation laws that are in force at this juncture along with domestic taxation laws of most of the countries, attribute the maximum tax collection rights to the COR. In fact, in most cases, COR even has the primary right to collect the taxes.

Thus, it is important to establish the residential status of the Person. There are various tests and parameters laid down in the regulations for determining the COR. In case where the person is an individual, the residential status is preliminarily determined based on the domicile of that individual. In other words, it is determined based on the number of days of physical stay of the individual in a given country during a given period of time.

In case where the Person is a Company, the preliminary test or parameter to determine its COR would be to check as to where or in which country was the Company formed / incorporated / registered. Company being an artificial person, it usually takes birth by registering itself under the laws of any particular jurisdiction. Such a country where the company is born gets the prima facie right to be regarded as COR.

However, this manner of determination of COR does not always yield logical results. With the advent of technology, it is possible that even though a company has been formed in Country A, however it would be carrying out its entire business operations from Country B. In such case, just because the company was formed in Country A, so to regard it as COR would not hold merit. Logically speaking, in such cases, the parameter of country where formation has happened should be overlooked and a more logical parameter needs to be evaluated. This is where POEM as a parameter finds its merit.

With this opening note, let us now dive deep into the concept of POEM and understand it.

B.      Understanding POEM in layman terms:

POEM as a concept evolves from the philosophy of giving more merit to Substance over Form. To understand the concept in a simple way, let us analyse the case of a Living Individual. An individual has a body. One of the most important organs of the body is the Brain. The Brain does all the logical thinking, planning and decision making for the Body and in turn for the Individual.

Thus, without going into medical technicalities and sciences – one can say that Brain is the most critical part of the Individual and responsible for all the activities carried out by the individual and all the decisions taken by the individual. Now – just imagine a case where the Brain of the Individual can be kept in Country A and the Body of the individual is situated in Country B. Considering the basic parameter of domicile, one would say that the individual would be the tax resident of Country B because that is where his body is physically present. Would this sound logical?

I am sure you would all agree that this would not be logical. Merely the physical body staying in country B and doing activities does not reflect the real spirit. It is worthwhile to recognise Country A as well. Because that is the place where the Brain is situated and the Brain is doing all the logical thinking, planning and decision making for the body. So, we ought to give some merit to country A as well. We would want Country A to be treated as the COR as the most important function of the body (brain) is performed from that Country.

Drawing the above analogy to the case of a Company would help us understand the philosophy of POEM in a better way. In a Company – the Board of Directors (BOD) are responsible to plan, strategize and decide for the Company. So, if say a Company would have been a Living Individual, then the BOD would have been considered to be akin to the Brain. Now, consider a situation where a Company’s BOD is situated in Country A. But, for certain commercial reasons the Company has been formed / incorporated in Country B. The Company carries out activities globally. In this case, just for the reason of the Company getting formed / incorporated in Country B, would it be logical to consider Country B as the COR?

I am sure you would all agree that it would not yield a logical answer – just the way it happened in the case of an individual where brain was in different country.

POEM as a parameter tries to address the above situation. It tries to identify where the brain of the Company is situated and thereby enables that country to be regarded as the COR. In our case, using POEM, one might be able to regard Country A as the COR in place of Country B.

Now that we have understood the philosophy of POEM, let us try and see how does POEM finds it way into the regulations which lay down the parameters of determining the residential status.

C.      POEM and Indian Income-tax Act, 1961:

Under the Indian Income-tax Act, 1961 (the Act), section 6(3) lays down the parameters of how to decide whether a Company would be treated as tax resident of India or no. As per section 6(3), there are two sub clauses which lay down two parameters for this purpose.

The two parameters are broadly divided based on the point as to whether a Company is an Indian Company[1] or not. The basic parameter states that all Indian Companies would be considered as tax resident of India.

The second parameter talks about Companies which are not Indian Companies. Such companies would usually be companies which would have been formed / incorporated under the laws of any other foreign country. So, the Act states that where the POEM of such a company is established to be in India, then India would act as the COR for such a company.

The term POEM has also been explained under the explanation of section 6(3) as under:

“Place of effective management" 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”

Let us discuss certain key terms discussed in the above meaning. The first term that would warrant our attention is the term “key”. This term emphasizes that while shortlisting the decisions that had been made during the period, one has to be cautious enough to focus only on the important decisions taken. Routine, day-to-day decisions required for any operations are not to be considered while evaluating POEM.

The next term that needs our attention is “entity as a whole”. This term guides us to only focus on decisions that have impact on the entire entity or company. In a business there are many decisions that might turn out to be critical. However, that decision might have impact only on a particular function of the business, but might not have any significant bearing on the Company or Entity as a whole. So, such decisions are not to be considered while evaluating POEM. Decisions which have bearing or impact on the entire company / entity needs to be considered.

The last term that we wish to highlight is “substance”. This term specifically reminds us of the basic philosophy of “Substance over Form” that we discussed above. This term lays down that while evaluating POEM one would have to ignore the legal form of the structure and dive deep into the actual facts so as to evaluate the place where the key decisions of the company are made.

Putting together all the above points, one can say that – POEM is a test to identify the location from which the important decisions that have bearing on the entire company are actually made. Once this location is identified and if say that is in India, then India would be considered as COR for the company for that particular period.

Another important point that would need to be highlighted here is that POEM is a concept that needs to be evaluated for a given span of time. In case of IT Act, POEM needs to be evaluated for a financial year. While doing this evaluation, one must consider all the actual facts only pertaining to that given year. One should consider the entire year from a macro angle and should not end up focusing on stand alone moments or facts. In other words, one should not adopt a snapshot approach. One should look at things from a macro perspective thereby evaluating all the facts and events of the year. Further, this would also mean, that a fresh evaluation should be made every year. There is a possibility that a Company might have POEM in a particular country in year 1. But in year 2, based on facts may be the POEM might not end up in the same country.

The parameter of POEM has been made effective from 1-Apr-2017 vide Finance Act 2016 thereby making it applicable from AY 2017-18 onwards.

D.      Guidance laid down by CBDT circulars:

CBDT had issued three circulars in the year 2017 as under:

1.       CBDT Circular number 06 of 2017 dated 24-Jan-2017

2.       CBDT Circular number 08 of 2017 dated 23-Feb-2017

3.       CBDT Circular number 25 of 2017 dated 23-Oct-2017

The first circular no 06 gave detailed guidance on how should POEM be practically applied or evaluated while determining the tax residency of a company. If one were to discuss the structure of this evaluation test as laid down by the circular at a macro level then one can say that:

I.      As Step 1, we need to first evaluate whether a Company has been carrying out Active Business in India or no. If the company is carrying out active business in India, then one should check if the majority of BOD meetings are conducted in India. If this answer is also Yes, i.e. majority board meetings are conducted in India, then the company would be said to have its POEM in India.

The circular also lays down pointers to check whether Active Business is carried out in India or no. The circular states that if a company fulfils all the following conditions, then it would be considered to have active business outside India:

a.   The passive income (transactions with related party, royalty, dividend, capital gains, interest, rentals) earned by the company should be less than 50% of its total income;

b.    Less than 50% of its assets should be situated in India;

c.    Less than 50% of its employees should be situated in India and should be resident of India;

d.    Payroll cost of such employees should be less than 50% of the total payroll cost.

To summarise, in step 1, we are trying to evaluate companies that are carrying out active business outside India. For such companies, if even the majority of the BOD meetings are conducted outside India, then it would be established that such Companies are controlled and operated outside India and thus, their POEM would also be outside India.

 

II.   As Step 2, we deal with such companies which are carrying out active business from India. These are the companies that have significant presence and level of operations in India. The circular states that for such companies, we need to identify two critical factors:

a.       Who are the Individuals which are responsible for taking key management and commercial decisions;

b.       Determine the place where the above-mentioned individuals take the key management and commercial decisions.

Once the above identification is done, and if the answer to point b above is India, then one can say that the POEM of such a company is in India.

For point a, sometimes it might get challenging to identify as to who is the person responsible for taking key decisions. Say for eg. the BOD forms a committee, lets call it Strategy Committee. The role of the committee is to formulate and plan strategies for the Company. At first look, one might feel that BOD has delegated their authority of decision making to such a committee. However, many a times such committees though enjoy powers, but they do not have ultimate powers or authority. The ultimate power or ultimate authority might still be with BOD. So, the place where committee meets and takes decisions would not hold much importance. One would still have to check the place where the BOD meets and takes decisions.

To summarise – its important to identify who is the ultimate authority. Once that is identified, place where such authority meets and takes decisions is important for POEM.

For the point b mentioned above, one needs to be careful to identify the place where the decisions are taken. The place where such decisions would actually be implemented is not material for POEM.

The circular also gives more examples and guiding principles. All of them revolve around the spirit of Substance over Form and Identifying where the Brain of the Company is situated. Those are very well explained in the circular and hence for brevity, we are not discussing them here again.

III.   This is not exactly a Step 3. The circular gives two secondary factors which can be used to arrive at a conclusion, if say we are unable to derive any conclusive answer by following the above two steps. One must note that these factors should not be considered on a stand-alone basis. They need to be referred to as complementary factors to the first two steps. The two secondary factors are:

a.       Place where main and substantial activity of the company is carried out; or

b.       Place where accounting records of the company are maintained and kept.

One can use the above secondary factors and complement their analysis of Step 1 and 2 to arrive at the conclusion of where the POEM is located.

The second circular number 08 of 23-Feb-2017, introduced a safe harbour. It laid down that the parameter of POEM would not apply to a company whose annual turnover or gross receipts for a given financial year is equal to or less than INR 50 crores.

The third circular number 25 of 23-Oct-2017, brought about certain clarifications on various guiding principles that had been laid down in the circular no 06. This circular was released in response to various representations received from the industry.

E.       POEM and International Tax treaties:

POEM as a concept or parameter to establish the residency of a Company was always present in Article 4 of the Double Taxation Avoidance Agreements. The article 4 is almost similarly worded in both the UN Model as well as the OECD model. The philosophy of Substance Over Form even resonates in these agreements.

We are not discussing the finer aspects of POEM in these agreements as part of this article. This reference has been made just to highlight that the concept of POEM has been present in the International Taxation regime since long time and it has received wide acceptance.

F.       Author’s closing remarks:

The philosophy of “Substance Over Form” has been receiving a lot of traction in not just the taxation laws, but also in various other facets of finances like the accounting systems, etc.

Though, this philosophy always draws merits, but it creates a huge litigation risk. This philosophy is a Subjective matter. No definite points, principles can be laid down for it. Thus, there would always be a challenge for two different persons with different objectives to have same perception over the same situation. This would lead to huge litigations. Since this concept has been brought about in the domestic laws only in 2017, we are yet to see how the senior courts of the countries decide on disputes around POEM.

G.      About the Author:

CA Dhruv Shah is Partner at Ambavat Jain & Associates LLP. He heads the practice of International Taxation & FEMA.

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