Government introduces “Place of effective management” (POEM) in IT Act

• Shell companies are the companies located abroad but controlled from India, to evade taxes.
• Government aims to curb them by introducing “Place of effective management” (POEM) in IT Act.
• Thereby, such offshore companies will be taxable in India, if key Management decisions are taken from India.
• Shell companies based abroad would have to pay taxes on their global income for a year if their place of effective management (POEM) is India.

• According to the Union Budget 2015-16, shell companies would be considered tax resident of India if their POEM is India, even for one day in a financial year.
• The key companies likely to be impacted are the Indian groups that have overseas subsidiaries that lack substance.
• Many Indian companies have subsidiaries in tax havens abroad which, in turn, do businesses in other countries.
• With this amendment — proposed to be made effective from the next financial year — all these companies will be bought under the Local tax jurisdiction.
• The requirement of the POEM being in India at any time during the fiscal year defeats the very essence of the concept, since it is supposed to be determined after an evaluation of the affairs of the company throughout the year.
• This anomalous situation will result in double taxation of income which may not be mitigated by tax treaties as both countries — India and the country of incorporation — will seek to tax the global income of the foreign company.
• Considering that POEM is a well-accepted concept under the Organisation for Economic Cooperation and Development (OECD), it will be interesting to see if the prescribed guidelines will be in line with the principles enunciated by OECD in its commentary.
• Till now, the shell companies outside India, easily bypass the condition of “controlled and managed” as even holding one board meeting outside India puts it outside the purview of being resident in India.
• The introduction of POEM test for residential status determination is a welcome move and would curtail the practice of opening of shell companies by Indian companies outside India and also would align the provisions of the Act with the Double Taxation Avoidance Agreements (DTAAs) entered into by India with other countries.

• It is proposed to amend the provisions of section 6 to provide that a person being a company shall be said to be resident in India in any previous year, if:
  1. It is an Indian company; or
  2. Its place of effective management, at any time in that year, is in India .
• Further, it is proposed to define the place of effective management to mean 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.

Background:

• In a vibrant economy with Indian companies and families looking to explore different opportunities globally, Indian residents often look to set up offshore holding companies either for:

1. strategic and operational reasons (easier global expansion of business),
2. personal finance reasons (as in the case of fund managers who may receive carried interest from offshore funds and wish to diversify their personal portfolio); or
3. personal wealth planning reasons (For example, in order to buy property abroad it is often required to pool funds in an offshore entity on account of the upper limits under the liberalized remittance scheme, or for protection against exchange rate fluctuations etc).

• The Budget proposes two key sets of provisions which could impact offshore assets and structures.
  1. Firstly, the residency rule for offshore entities has been changed to bring in the place of effective management (POEM) rule, which could subject several offshore entities to tax in India.
  2. Secondly, strict penal consequences have been introduced for failure to disclose offshore assets (including shares). Both these measures are expected to have a significant impact on outbound investments by Indian residents.

Place of Effective Management (POEM)

• Till date, offshore companies have been treated as “non-resident” in India unless wholly controlled and managed from India.
• The consequence of this is that the income of such offshore company is not taxable in India unless distributed to an Indian resident shareholder.
• Further, even in situations where the offshore company is 100% owned by Indian residents and has majority Indian directors, it has been held that there should be no residence in India if board meetings are held outside India.
• The Bill proposes moving to a more subjective test of place of effective management (POEM), and considers a foreign company resident in India if its POEM is in India at any time in the relevant financial year.
• POEM has been defined to mean “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”.
• Therefore, in the situation where an offshore company has 100% Indian resident shareholders, majority of Indian directors and one director offshore, the company could now be considered Indian resident under the POEM test.
• In that case, the worldwide profits of the offshore company would be taxable in India.
• Even if the shareholding is less than 100%, with some portion held by non-Indian investors, Indian promoters may still want ownership and management control, which could create exposure.
• While the change has been introduced based on international standards (particularly OECD), the deviation is that the Indian threshold is triggered even if POEM exists for a certain period during the financial year, whereas the OECD standard looks for the predominant POEM during a given year.
• This makes it possible that an offshore company could be considered “resident” and taxable on a global basis in 2 or more countries at a given time (India, where a part of the POEM exists, the OECD country with substantial POEM and the country of incorporation if it does not recognize the country of management).
• Further, there is still not enough clarity on what would constitute the place where “key management decisions are in substance made” i.e. whether the residence of directors will be looked at, location of board meetings or other criteria such as expansive veto rights by Indian resident shareholders.

Disclosure and Tax on Offshore Assets

• Offshore holding structures will also be impacted by the stringent disclosure requirements and penal consequences introduced by this budget, which are discussed below.
• In 2012, it was made compulsory for Indian residents to disclose all offshore assets (including bank accounts, beneficial interest in trusts, etc.) in their tax returns, irrespective of whether any income has accrued to the resident in the relevant financial year.
• As part of the Modi Government’s commitment to identify and stem the generation of ‘black money’, the Finance Minister has proposed to introduce a Bill in the Parliament to deal solely with offshore black money, with the following key features:

1. Income and asset concealment and tax evasion in relation to foreign assets will be a non-compoundable offence punishable with a penalty of 300% of tax due; 10 years’ rigorous imprisonment and no recourse to the Settlement Commission;
2. Not filing returns or filing returns with inadequate disclosure of foreign assets will also be an offence punishable with upto 7 years’ rigorous imprisonment. The prosecution and penalty provisions will equally apply to individuals or entities that abet such offences;
3. Undisclosed income from foreign assets or income from undisclosed foreign assets will be taxable at the maximum marginal rate (30%) and will not be eligible for any statutory exemptions or deductions;
4. Beneficial owners of foreign assets or beneficiaries of foreign assets will be mandatorily required to file returns even if there is no taxable income;
5. The taxpayer is mandatorily required to specify the date of opening of the foreign account in the return of income.

• The Finance Minister also announced corresponding changes to related legislations of the Prevention of Money Laundering Act, 2002 (PMLA) and the FEMA indicating the Government’s intention to have a comprehensive regime in place to tackle offshore black money.
• The Finance Minister has proposed to include ‘concealment of income or evasion of tax in relation to a foreign asset’ as a predicate offence under the PMLA, thus enabling the confiscation of foreign assets unaccounted for and prosecution of persons involved.
• Provisions of the PMLA and FEMA are also proposed to be widened to enable attachment and confiscation of equivalent assets in India where contraventions have occurred and the foreign asset cannot be forfeited.
• In addition, such contraventions are punishable with up to 5 years imprisonment and penalty.
• The measures have a laudatory aim and may also prove to have a deterrent effect.
• There were no details provided on the safeguards to ensure legitimate accounts are not sealed and honest taxpayers harassed, as there are legally permissible circumstances when assets obtained abroad can be retained abroad.
• There is also need for more clarity on how beneficiaries of foreign discretionary trusts will be treated.
• In many instances, individuals are not aware they have been named beneficiaries especially in the case of testamentary trusts.
• Imposing a mandatory filing requirement in such cases will end up causing hardship.

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