Tax Residency Rule for Foreign Company: Moving from certainty to uncertainty

- By CA Chandan Kumar

1. Introduction:

Transfer pricing and existence of Permanent Establishment (PE) & attribution of

profits have been major area of disputes in case of Multinational Companies. Cases have been very rare regarding corporate tax residency. The reason is not hard to find. Threshold for tax residency for companies incorporated outside India was kept so high that simply holding a single board meeting outside India allowed them remain non-resident-a parallel to which can only be found in Pakistan Income Tax law1 . The relaxed rule allowed many Individuals and Indian companies to lower their overall tax burden by setting up companies in countries like Panama, British Virgin Island, Mauritius, Singapore, Cayman Island and Hong Kong. While in themselves, these countries are neither having large resource base nor do they have significant domestic markets to warrant the amount of investments witnessed over the years, however, they do provide considerable amount of tax incentives (e.g. lower corporate tax rate, capital gain tax exemption, lower withholding tax rate) which make them attractive destinations for onward routing of investments2. This went on for more than 50 years. Thereafter, the Government of India got wiser and plugged the loose ends in 2015. The purpose of this paper is to analyse the newly introduced tax residency rule for companies incorporated outside India based on place of effective management (‘POEM’) in the light of changes proposed in Article 4(3) of the OECD Model under OECD/G20 BEPS Action Plan 63 and Action Plan 144. This paper is broadly divided into five parts. The first part of the paper deals with place of effective management as a residency test under the Income Tax Act, 1961 (the Act). The second part analyses place of effective management as tie-breaker rule for determining the treaty residence of dual-resident. The third part of the paper considers how interpretation of the term ‘place of effective

management’ shall be impacted by the court decisions in other countries. The

1 http://taxsummaries.pwc.com/uk/taxsummaries/wwts.nsf/ID/Pakistan-Overview, last visited 29 October

2016 2 Export-Import Bank of India, Occasional Paper No. 165- Outward Direct investment from India: Trends, objectives and policy perspective, p.14] 3 The Final Action Plan on BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate

Circumstances 4 The Final Action Plan on BEPS Action 14 - Making Dispute Resolution Mechanisms More Effective

fourth part of the paper examines withholding tax issues involving dual resident companies by way of case studies. Finally, the paper will touch upon other important issues like interplay between POEM and PE.

2. Place of effective management- Income Tax Act

2.1 Law concerning the residence of a company Residential status plays an important role in the determination of tax incidence. While resident companies are subjected to tax in India on its global income, non-resident companies are subjected to tax in India only in respect of Indian-sourced income. Any company incorporated in India since 1958 5 is

automatically resident here for tax purposes. And any company which is incorporated outside India was resident here till FY 2015-16 if during the year the control and management of affairs of the company was situated wholly in India. The relevant Section (Section 6(3)(ii) of the Act) was amended by the Finance Act (‘FA’), 2015 (later the provision was deferred by 1 year and thus, applicable w.e.f. FY 2016-17) to provide that a company incorporated outside India shall be resident in India if its place of effective management is in India in that year.

2.2 Introduction of POEM as Residency Test under the Act Before analyzing the provisions of new tax residency rule based on POEM, let us deal with the issue as to whether introduction of POEM as Residency Test was right choice or any other test of residency could have been thought of. As the question of residence is a fundamental one, normally one would have expected public consultation to decide the new basis, like the one happened in Australia6. However, like many other tax provisions, concept of POEM was also imported mechanically from the Direct Tax Code Bill, 2010 & 2013. The question is: why not any other tests of residence like ‘Central management and control’ which is being followed in other commonwealth countries like UK and Australia for which jurisprudence are readily available? While presenting the budget for the year 2015-16, the Hon’ble Finance Minister

5 Prior to the amendment by FA 1958 to Section 4A (b) of the Indian Income Tax Act, 1922, a company

incorporated outside India was resident in India if the control and management of its affairs is situated wholly

in India in that year or if its Indian income in that year exceeds its foreign income. The FA deleted the second

condition so that companies incorporated abroad will be resident in India only if the control and management

is wholly in India. This also the recommendation of the Taxation Enquiry Commission. In the same year, it

was proposed to treat all companies incorporated in India as resident companies, even if in some cases the

control and management is shifted outside India. The same provision was continued in the current Income

Tax Act, 1961]

6 Treasury, Commonwealth, Review of International Taxation Arrangements: Consultation Paper (2002) (RITA

Consultation Paper] which explored the options for reforming the company residency test

explained three reasons for opting for the POEM test. The first one was that most of the tax treaties entered into by India recognizes the concept of 'POEM' for determination of residence of a company as a tie-breaker rule for avoidance of double taxation. In this respect, it may be pointed out that more than half the tax treaties which India has signed provides that if POEM cannot be determined then the case shall be decided by the competent authorities of both the countries as per Mutual Agreement Procedure (MAP). This is a pointer to the fact that in some cases POEM is not determinative. Further, the Government overlooked the latest development at the International level where under BEPS Action Plan 6, POEM test has virtually been abandoned. The second reason as explained by the Finance Minister was that many countries prefer the POEM test to be appropriate test for determination of residence of a company. In this regard, it may be highlighted that while it is true that many of the other countries are having POEM under their domestic tax laws, it is equally true that none of the countries are as aggressive as India when it comes to tax litigation. Then, it was said that the modification in the condition of residence in respect of company by including the concept of effective management would align the provisions of the Act with the tax treaties entered into by India with other countries and would also be in line with international standards. Regarding this, it is important to note that as more and more countries are adopting POEM (such as Taiwan, Russia, South Africa) as a residency test under their domestic tax laws, it is more likely that the counterpart countries would press for replacing the POEM as a tie-breaker with mutual agreement approach so as to avoid interpretational issues. For instance, Mauritius has revised its tax treaty with South Africa replacing the POEM test with MAP. The reason of which has been explained by the MOU between the two countries which reads as under: The “place of effective management” (POEM) traditionally has been used as tiebreaker test to determine residence under the South Africa-Mauritius treaty. Using POEM created some issues because South Africa uses a test that is geared more toward the “day-to-day running of operations,” as contained in Interpretation Note 6 issued by the SARS. If Mauritius were to follow the definition of “effective management” under the OECD commentary, the two countries could reach different conclusions on residence status, and both could take the position that they have the right to tax an entity as a resident of their own country.” It remains to be seen how change in India’s domestic tax will affect India’s treaty policy regarding the tie-breaker for dual resident companies.

2.3 Definition of POEM and CBDT Draft Guidance on POEM Definition of POEM

Exhaustive Definition of POEM: The term "place of effective management" means 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 of POEM uses the word “means”. Whenever the Legislature uses the word ‘means’, the definition is meant to be delimiting, i.e.,

exhaustive. In that sense, it is indicated that the definition of POEM is hard and fast definition and no other meaning can be assigned to the expression. As we all know this definition has been picked up from Paragraph 24 of Article 4 of the 2008 version of the OECD Model. However, the legislature fails to take note of the next sentence that “All relevant facts and circumstances must be examined to determine the place of effective management”. The OECD was well aware of this fact-centric concept of POEM, therefore, it has always shied from defining it. Countries like South Africa which is also having POEM in its domestic tax law, has stayed away from defining it. Two Definition of POEM: If one looks at the Direct Tax Code, 2013, the term ‘Place of effective management’ has been defined in Interpretations and Constructions Chapter7 so that unless the context otherwise requires it can be applied throughout the Income Tax Act. Therefore, under the DTC 2013 the meaning of term “place of effective management” for the purpose of tonnage tax scheme8 has to be understood in a similar manner as it is understood for residence purpose. However, under the Income Tax Act, the term “place of effective management” is defined separately for the purpose of residence and for the purpose of tonnage tax scheme. This may lead to unwarranted confusion and uncertainty particularly when the revenue has to argue in case of residency issue that company has POEM in India while in case of tonnage tax scheme, it has to prove that company’s POEM is outside India. CBDT Draft Guidance on POEM Since the Government has indicated substantial changes in draft guidance on POEM9, discussion here is restricted to the main issue.

● Separate criteria for Active Company and Passive Company

The draft guidance on POEM broadly categorizes foreign companies into two categories viz. Active Company and Passive Company. For Active company, place of effective management is the place where the majority

of board meetings of the company are held ,however, there is a laundry list of criteria for passive company to determine the place of

effective management. This approach for finding out POEM of a foreign company does not seem to be correct one as statutory definition of POEM does not make any distinction between active company or passive

company. Almost on similar point, the UK High Court in the case of Wood vs. Holden10 held that “What the Commissioners seem really to be

7 Clause 320 (180) of the DTC Bill , 2013

8 Section 115VC of the Income Tax Act, 1961

9http://www.livemint.com/Politics/oWBbJUe0E9SdHdNs5AKhNK/GAAR-wont-be-used-in-transactions-made

-under-tax-treaties.html (last visited 31 October 2016)

10 [2006] EWCA Civ 26;

saying is that, although the only acts of control and management took place outside the United Kingdom, there was not much involved in them. But the test of a company's residence is still the central control and management test: it is not the law that that test is superseded by some different test if the business of a company is such that not a great deal is required for central control and management of its business to be carried out”

The Court further made following observations:

“It is also necessary to keep in mind that, while the cases which I have referred to so far all involved the residence of companies with active continuing businesses, it is possible (and is common in modern international finance and commerce) for a company to be established which may have limited functions to perform, sometimes being functions

which do not require the company to remain in existence for long. Such companies are sometimes referred to as vehicle companies or SPVs (special purpose vehicles). ‘Vehicle’ has a belittling sound to it, but such companies exist. They can and do fulfil important functions within international groups, and they are principals, not mere nominees or agents, in whatever roles they are established to undertake. They usually have board meetings in the jurisdictions in which they are believed to be resident, but the meetings may not be frequent or lengthy. The reason why not is that in many cases the things which such companies do, though important, tend not to involve much positive outward activity. So the companies do not need frequent and lengthy board meetings.”

3. Place of effective management as tie-breaker rule for determining the treaty residence of dual-resident

3.1 Development of POEM as a Tiebreaker criterion - Historical Overview While studying the concept of company’s residence ( called fiscal domicile) in 1956 Working Party No. 2 of the Fiscal Committee of Organization for European Economic Co-operation (‘OEEC’) [predecessor of the OECD] , observed that the possibility of company being a dual resident may be a rare occurrence in practice, but is not theoretically unimaginable. If, e.g., one country attaches importance to the registration and the other to the place where the real management has its headquarters. Therefore, a preference criterion must be established to break the tie. Then the Working Party referred to the work of League of Nation. While the Mexico Model suggested ‘ place of incorporation’ , London Model adopted ‘ real centre of management as a test to determine the residence (fiscal domicile) of a company11 .The Working Party

11 In both drafts, the Model Convention is followed by a Protocol containing definitions of such phrases as

“fiscal domicile”, “permanent establishment” and rules of procedure on such matters as the allocation of business profits. The wording of paragraph 4 of Article II of the Protocol differs in the Mexico and London drafts. London and Mexico Model Tax Conventions Commentary and Text. C.88.M.88.1946.II.A. Geneva,

November 1946 ,http://www.taxtreatieshistory.org/

viewed that it would not be adequate to attach importance to the purely formal criterion such as the place where the company is registered. Accordingly, real centre of management” test was considered more appropriate, however, the same was also rejected because it was not exact and the question might be raised whether the real management of a company was the general meeting (i.e. the shareholders), the board of directors or the managers. In May1957, the said Working Party observed that in a great majority of tax treaties right to tax has been accorded to the country where the corporation is “managed and controlled”. It was also noted by the Working Party that the actual formulation of the criterion varied from one agreement to another; but one country only appears to have been consistent, namely the UK, which in all its tax treaty used the term "managed and controlled”. Accordingly, the Working Party decided to choose the term "managed and controlled” however, it was accepted that the term "managed and controlled" was not in itself clear. However, the question of dual residency thought hardly to be of practical importance, and accordingly resolution was left to the competent authorities. Subsequently, the Working Party came across with the finding of Working Party No.5 on the taxation of income and capital of shipping and air transport wherein the taxation right was allocated in a number of tax treaties to the country in which place of effective management was situated. Further, at that time, UK made clear that the expression ‘managed and controlled’ meant the effective management of the enterprise. Therefore, to summarize, mainly three factors which led to adoption of ‘place of effective management’ test by the Working Party no. 2: (1) Firstly, as a tie- breaker purely formal criterion like place of incorporation would not be adequate solution and in that sense POEM test was found was more suitable. (2) Secondly, POEM test [ as per the Working Party 5 in its report on the taxation of income and capital of shipping and air transport enterprise] was already being used in a number of tax treaties as the key criterion for determining the allocation of taxing rights over income derived from the operation of ships or aircraft. (3) Thirdly, it was clarified by the UK that “management and control” criterion which was being used by it to determine the corporate residency in the tax treaties, at the relevant point in time, had the same meaning as the “effective management” of the enterprise. The POEM as suggested by the Working Party no. 2 formed the basis for Article 4(3) of the OECD 1963 Draft Convention which is still being followed till today.

Here, it is quite interesting to note that when POEM was adopted as a tie-breaker, reference to the MAP was omitted reasoning that it would “hardly ever be required”. With this, one would have thought that the concept of POEM was very clear initially. However, it was not the case and the same has been discussed next paragraph.

3.2 Attempt to clarify the meaning of POEM through amendment to the commentary

The meaning of the term “place of effective management” was not defined [still not defined] in Article 4 of the OECD Model Tax Convention and therefore, as per Article 3(2) of the tax treaty, meaning of any term not defined in a tax treaty needs to be understood as per the domestic tax law. This led to recourse to domestic tax law concept of residence such as “central management and control” and “place of management” to understand the meaning of the term “place of effective management” In 1977 version of the OECD Model, New Zealand made an observation that the term “effective management is practical day to day management, irrespective of where the overriding control is exercised”. This statement was in clear contradiction to the concept of Central management and control test as understood in UK. In 1992 update to the OECD Model, UK withdrew its statement that the term “managed and controlled” meant the same as “place of effective management and thereby suggesting that there was really difference between the two concepts.

In light of these developments, for the first time need was felt to clarify the meaning of POEM by amending the Commentary. In this connection, the Steering Group in its February 1996 meeting recommended the following clarification which was included in 2000 update to the OECD Model Commentary with certain modifications (highlighted in bold) “24... The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business are in substance made. The place of effective management will ordinarily be the place where the most senior person or group of persons (for example a board of directors) makes its decisions, the place where the actions to be taken by the

entity as a whole are determined; however, no definitive rule can be given and all relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.” Later, the OECD realized that traditional approach to determine POEM had started showing limitation in a modern, technologically advanced environment (videoconferencing or electronic discussion group applications via the Internet) as it was no longer necessary for a group of persons to be physically located or meet in one place to hold discussions and make decisions. As such, between 2001 to 2003, the TAG worked upon factors which can be effective in a modern environment and made certain proposals12. However, these proposals of TAG

12 In this connection, in February 2001, the Technical Advisory Group on Monitoring

the Application of Existing Treaty Norms for the Taxation of Business Profits (“TAG”)

[The TAG consisted of OECD Government officials, non-OECD government officials and

individuals from business and academics, but do not represent OECD] proposals

publicly released for comments its discussion draft entitled “The impact of the

Communications Revolution on the Application of ‘Place of Effective management’ as a

Tie Breaker Rule”. The TAG followed this up with a public discussion draft on 23 May

2003 which proposed changes to the OECD Commentary, on which comments were

report never saw the light of the day as majority of members disagreed. A significant number of countries, indicated that increasingly, they adopt bilaterally a different approach, based on the facts and circumstance of each case, to solve cases of dual residence of legal persons. This led to birth of alternative to POEM test based on mutual agreement procedure in 2008 update to OECD Model.13Paragraph 24.1 of the Commentary listed a number of factors that the competent authorities are expected to take into account when they apply the case-by-case approach, such as the place where the meetings of the board of directors or equivalent body are usually held, where the chief executive officer and other senior executives usually carry on their activities, etc. Also, in the 2008 update reference to the place where the most senior person or group of persons (for example a board of directors) makes its decisions were removed and stated that all relevant facts and circumstances must be examined to determine the place of effective management without enumerating possible facts and circumstances to take into account. In other words, Commentary practically did not offer any guidance to tax authorities and taxpayers regarding the POEM. Compounding this, many countries (including India) made their reservation to the Commentary. India viewed that the place where the main and substantial activity of the entity is carried on is also to be taken into account when determining the place of effective management of a person other than an individual while countries like Argentina, Armenia, Bulgaria, Russia, Ukraine and Vietnam viewed that term "place of effective management" is practical day to day management, irrespective of where the overriding control is exercised. Lack of any consensus on the meaning of POEM, coupled with the fact that concept of POEM allowed tax avoidance led to adoption of case-by-case approach based on MAP procedure as a tie-breaker criterion.

3.3 Proposed New Article 4(3) -Case-by-case approach based on MAP procedure The BEPS Action 6 recommended deleting the current Article 4(3) of the OECD Model (2014) and proposed determining the residence of a dual resident company for tax treaty purposes via the mutual agreement procedure of Article 25 of the OECD Model. The newly proposed Article 4(3) of the OECD Model would read as follows: “Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavour to determine by mutual agreement the Contracting State of which such person shall be deemed to be a resident for the

requested by 1 September 2003]. This was coupled with an alternative proposal that if

place of effective management could not be determined a hierarchy, similar to that for

the tie-breaker for individuals in article 4(2) might apply. As these changes proposed by

the TAG report have not been adopted by the OECD, it has no official OECD status and

consequently, does not have the status of evidence. [The Special commission in the case

of Smallwood and others vs. Commissioners for Her Majesty’s Revenue and Customs

[2008] STC (SCD) 629]

13 Draft Contents of the 2008 update to the Model Tax Convention 21 April to 31 May 2008, p. 7 and 8]

purposes of the Convention, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by this Convention except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting States.” The Final Report notes that the reason for this change is that “the view of many countries was that cases where a company is a dual-resident often involve tax avoidance arrangements.”14While there are several ways in which the concept of POEM has been used for tax avoidance cases in the past, two illustrations have been provided as under:

Access to tax treaty for capital gain exemption15

Suppose, Company X, a resident of State A, is contemplating the sale of shares of companies that are also residents of State A. Such a sale would trigger a capital gain tax under the domestic law of State A. Prior to the sale, Company X arranges for meetings of its board directors to take place in State B, a country that does not tax capital gains on shares of companies and in which the place where a company’s directors meet is usually determinative of that company’s residence for tax purposes. Company X claims that it has become a resident of State B for the purposes of the tax treaty between States A and B as per Article 4(3) of the treaty. It then sells the shares and claims that the capital gain may not be taxed in State A as per Article 13 (6) of the treaty Access to beneficial tax treaty for lower withholding of tax

Currently, there is no tax treaty between the US and Singapore and therefore the payments received from the US is generally subject to withholding tax at the rate of 30%. However, there is a tax treaty between India and the US and normally the withholding tax is 15% (interest, dividend, Royalty or fees for technical services) as per India-US tax treaty. Technically, it is possible for Singapore Company to shift its place of effective management in India by holding majority of its board meeting in India and thereby avail the lower withholding tax under the India-US tax treaty. Of course, Singapore Company will examine other tax implications in India while moving its tax residency in India.

If these parts of BEPS Action 6 are implemented by countries, the use of the MAP (Article 25 of the OECD Model) as a solution in situations in which companies have dual residence, would become standard. Although, POEM remains one of the criteria that can be taken into account by the competent authorities in concluding a mutual agreement, it is not the exclusive criterion.

14 BEPS Action 6, 2015 Final Report, p.72

15 UN - MTC Commentary 2011 - Article 1, para 41

In case of disagreement between the Competent Authorities, the company shall be treated as tax residence of both the countries and no relief or exemption shall be provided to such companies. Here, to safeguard the concern of person other than dual resident company itself from adverse tax consequences, proposed paragraph 24.4 of the OECD Model Commentary provides that such dual companies for purposes other than granting treaty reliefs or exemptions (that means where treaty benefit is to claimed by the employees of company or shareholder of company), shall continue to be treated as resident of original country of residence and thereby no negative impact on its employees or shareholders. As a result, if a non-resident employee is working in India and employer-company becomes tax resident in India [and become a dual resident due to the lack of consensus between the competent authorities], the OECD Commentary provides that employer-company shall treated as non-resident in India for the purpose of Article 15(2) (b)16 and thus, salary income of the employee shall not be taxable in India.

3.4 Tiebreakers in Indian Treaties from the perspective of MAP India currently has tax treaty with almost 90 countries out of which around 46 tax treaties uses POEM as the primary tie- breaker criterion and in case of doubt, solution is based on MAP procedure. Moreover, about 9 tax treaties leave disputes to be resolved by the competent authority through the mutual agreement procedure out of which tax treaties with Canada [1998], Estonia [2012], Latvia [2014], and Lithuania [2012] contain provisions that approximate the proposed OECD mutual agreement tiebreaker under BEPS Action 6. Further, while in some of tax treaties, it is specifically mentioned what are factors which shall be taken into account by Competent Authorities of both the countries while resolving the issue of tax residency under MAP, other tax treaties are simply silent and thus causing uncertainty about the factors that the Competent authorities shall look into. It may be noted that while article 4 (Residence) of certain tax treaties (e.g. treaty with New Zealand, South Africa) uses the expression “shall settle the question by mutual agreement”, some of the tax treaties (such as treaty with Luxembourg, Norway) usages the expression “shall endeavor to settle the question by mutual agreement”. The use of the words 'shall settle” ordinarily would suggest that competent authorities will be compelled to reach an agreement and resolve the tax dispute. However, the combined reading of Article 4 and Article 25 which deals with MAP would show that they are obliged only to use their best endeavours to reach an agreement17. It is necessary to

resolve the dispute only where treaty provides for mandatory binding arbitration, however, none of the Indian tax treaties has a mandatory arbitration clause.

16 UN MTC Convention 2011

17 Refer discussion, Jacques Sasseville, History and interpretation of the Tie-breaker Rule in Art. 4(2) of the

OECD Model Tax Convention, p. 166

There are certain important issues about MAP procedures: (1) MAP procedure are notoriously slow. (2) The proposals for the competent authorities to resolve cases by MAP introduce a high level of uncertainty and potentially subjectivity. (3) There is no higher authority to give case directions. (4) There are very few tax treaties with mandatory binding arbitration clause.

3.5 BEPS Action Plan 14 - Making Dispute Resolution Mechanisms More Effective

In order to bring efficiency in the MAP process, Countries have been asked to commit to a minimum standard comprising a number of specific elements that are intended to ensure that treaty-related disputes are resolved in a timely and efficient manner. Further, to bring transparency, it has been provided that Countries’ compliance with the minimum standard will be reviewed by their

peers (i.e. the other members of the FTA MAP Forum18 .To bring in more transparency, Countries have been asked to publish their country MAP profiles on a shared public platform. Further, report urges Countries not to use performance indicators for their competent authority functions in charge of MAP processes based on the amount of sustained audit adjustments or maintaining tax revenue19. Although no fixed time line has been provided for resolving the tax disputes, countries have been asked to commit to a timely resolution of MAP cases within an average time-frame of two years. Countries’ progress toward meeting the time line target will be periodically reviewed. Also, the OECD recommends for a suspension of collections procedures during the period a MAP case is pending20. However, it is pertinent to note that this aspect (relating to suspension of tax payment) is not a part of minimum standard and thus, not part of peer based monitoring process. Further, taxpayers will be invited to provide input on their experience on the MAP process. The steps to which India opposed initially accepted ultimately, in a spirit of compromise21. Regarding the mandatory binding arbitration, the report says that there is still no consensus among all OECD and G20 countries on the adoption of arbitration as a mechanism to ensure the resolution of MAP cases.

4. Interpretation of the term POEM based on Certain Jurisprudence

4.1 Interpretation of the term POEM to be influenced by jurisprudence on Central Management and Control? Both the UN and the OECD Commentaries on Art. 4(3) are rather short and thus, leaving the test of POEM confusing and unclear. In the UK, the Courts have already dealt with the issue as to whether POEM has to be understood

18 The OECD Forum on Tax Administration (FTA) brings together the top tax officials in 44 countries

including India]

19 The Final Action Plan on BEPS Action 14, para 28

20 Ibid, best practice 6

21 BEPS Action 14 on More Effective Dispute Resolution Mechanisms – Peer Review Documents,(Oct,2016),

p.22 ( see footnote)

something different from the Central management and Control. Chadwick L J in the case of Wood and another v Holden22expressed the view that it was difficult to draw any meaningful distinction between the two tests. Thus, it is more likely that India will follow the same path and relies on cases decided in the context of Central Management and Control to decide on POEM matters. Some of the important judicial precedents on corporate residence based on Central Management and Control are mentioned hereunder: The first articulation of Central Management and Control occurred in De Beers Consolidated Mines Limited v Howe (Surveyor of Taxes)23. Lord Loreburn LC said that a Company's tax residence will be where the Company has its Central Management and Control, and a Company's Central Management and Control will be located where the company's real business is carried on. This is a pure question of fact to be determined, not according to the construction of this or that regulation or bye-law, but on a scrutiny of the course of business and trading. In Koitaki Para Rubber Estates Limited v The Federal Commissioner of Taxation 24 [Australian High Court], it was held that the crucial test is to ascertain where the real business of the Company is carried on, not in the sense of where it trades but in the sense of from where its operations are controlled and directed. In the Australian case of Esquire Nominees Ltd v Federal Commissioner of Taxation25 the Court held that “The directors in fact complied with the wishes of Messrs…[the accountants who recommended actions to the directors in relation to trusts of which the company was trustee] because they accepted that it was in the interest of the beneficiaries, having regard to the tax position, that they should give effect to the scheme. If, on the other hand, Messrs…had instructed the directors to do something which they considered improper or inadvisable, I do not believe that they would have acted on the instruction.” The UK Special Commissioners in the case of Untelrab Ltd v McGregor26 held that although a board might do what it was told to do, it did not follow that the control and management lay with another, so long as the board exercised its discretion when coming to its decisions and would have refused to carry out an improper or unwise transaction. Although the subsidiary was complaisant to do the parent's will, it did function in giving effect to its parent's wishes and the parent did not usurp the control of the subsidiary27.

22 [2006] EWCA Civ 26

23 [1906] AC 455

24 (1941) 64 CLR 241

25 (1971) (1973) 129 CLR 177

26 [1996] STC (SCD) 1

27 Quoted from Wood vs. Holden [2005] EWHC 547 (Ch)

In Unit Construction Co Ltd v Bullock (Inspector of Taxes)28

This case involved three wholly owned subsidiary companies which were incorporated in Kenya. By their articles of association, powers of management were vested in the directors who were located in Kenya and who could not validly hold meetings in the United Kingdom. However, these management powers were not in fact exercised by the local directors who stood aside in all matters of real importance, so that it was the board of directors of the parent company in the UK which effectively made all the decisions. This resulted in the subsidiaries being held to be UK residents. It was immaterial that this usurpation of power was contrary to the subsidiaries’ corporate constitutions.

In this case, Judge Viscount Simonds held as follows:

● Nothing can be more factual and concrete than the acts of management which enable a court to find as a fact that central management and control is exercised in one country or another. It does not in any way alter their character that in greater or less degree they are irregular or unauthorized or unlawful.

● Business is not the less managed in London because it ought to be

managed in Kenya. Its residence is determined by the solid facts, not by the terms of its constitution, however imperative.

● If the facts (as they are), are disregard because they are irregular,

Company will be found without any central management at all.

Wood v Holden [UK, Court of Appeal]29

The question in that case was about a company called Eulalia which was incorporated in Netherlands and had directors there. Eulalia was the subsidiary of another foreign company, CIL, which, in turn, was owned by a foreign trust, the beneficiaries of which were in the UK. The Revenue maintained that Eulalia was resident in the UK. If that was right, capital gains tax was payable by Mr and Mrs Wood. The Court concluded that Eulalia was and remained tax resident in the Netherlands. The Court made the following observations:

● Directors of Eulalia were not by-passed nor did they stand aside since their representatives signed or executed the documents. That finding

28 High Court of House of Lords (1959) 3 ALL ER 831, quoted from TAG discussion draft- discussion draft

entitled “The impact of the Communications Revolution on the Application of ‘Place of Effective management’

as a Tie Breaker Rule, P, 6]

29 [2006] EWCA Civ 26;

takes this case outside the class exemplified by the facts in Unit Construction Co Ltd vs. Bullock.

● Management decision does not cease to be a management decision

because it might have been taken on fuller information. Ill-informed or ill-advised decisions taken in the management of a company remain management decisions.

● There is a difference between, on the one hand, exercising management

and control and, on the other hand, being able to influence those who exercise management and control. There is another difference, highlighted by Unit Construction vs. Bullock, between, on the one hand, usurping the power of a local board to take decisions concerning the company and, on the other hand, ensuring that the local board knows what the parent company desires the decisions to be.

● The essential ground of distinction was that, whereas in Unit

Construction vs. Bullock the parent company itself exercised central control and management of the African subsidiaries, effectively by-passing the local boards altogether, in the four cases30 the parent companies or their equivalents, while telling the local boards what they wished them to do, left it to the local boards to do it.

● If directors of an overseas company sign documents mindlessly, without

even thinking what the documents are it would be difficult to say that the national jurisdiction in which the directors do that is the jurisdiction of residence of the company. But if they apply their minds to whether or not to sign the documents, it is a very different matter.

Laerstate BV v. HMRC31 In the case of Laerstate BV vs. HMRC, a Company incorporated in the Netherlands was held to be a tax resident of the UK because director ( also 100% shareholder) who continued to make strategic decision in the UK even when he had resigned as director . The activities of other director were found limited to signing documents when told to do so without having minimum information necessary for anyone to be able to decide whether or not to follow them. The Tribunal made the following observations: ● There is no assumption that central control and management must be found

where the directors meet. It is entirely a question of fact where it is found.

Where a company is managed by its directors in board meetings, it will normally be where the board meetings are held. But if the management is carried out outside board meetings, one needs to ask who was managing the

30 Those cases were In re Little Olympian Each Ways Ltd [1995] 1 WLR 560, Esquire Nominees Ltd v

Commissioner of Taxation (1971) 129 CLR 177, New Zealand Forest Products Finance NV v Comr of Inland

Revenue [1995] 2 NZLR 357 and Untelrab Ltd v McGregor (Inspector of Taxes) [1996] STC (SCD) 1

31 [2009] UKFTT 209 (TC)

company by making high level decisions and where, even where this is contrary to the company's constitution.

● Just as for an individual, for example, where a temporary departure from

the UK would not of itself give rise to a change of residence, the residence of a company will not fluctuate merely by reason of individual acts of management and control taking place in different territories. The whole picture must be considered in each case.

Further, the Tribunal explained the difference between the usurpation of power vs. Influence as under:

Usurpation

of power

Usurpation of

power

There is a decision

by the directors, although an ill-informed one. (Influence)

There is a decision

by the directors of Subsidiary Co (Influence)

Where agreement is put in front of directors of Subsidiary Co open at the signature page and they sign it regardless. This is an example of the mindless signing.

Where directors of Subsidiary Co. know what they are signing, for example that it is an agreement for the sale of shares, and sign it without considering whether it would be better to sign it or not. Directors do not even have absolute minimum amount of information that a person would need to have in order to be able to make a decision at all on whether to agree to follow the

shareholder’s wishes or to decide not to sign.

Where directors of Subsidiary Co. follow the wishes of the Holding Co. after considering whether or not to follow them and have at least the absolute minimum information referred above but less information than a reasonable director would require in order sensibly to decide whether or not to follow the shareholder’s wishes.

Where directors of Subsidiary Co. follow the wishes of the Holding Co. after considering whether or not to follow them and have sufficient information to make an informed decision

Summary: The judicial authorities while determining the corporate residency seem to give

lot of importance to place where Board meets. The fact that there is not much involved in the Board's acts amounting to management or control seems irrelevant. It also looks irrelevant that the Board is acting on professional advice and is influenced by that advice. It also looks irrelevant that the Board does exactly what the other persons connected with the transactions expects them to do. It looks equally irrelevant that the Company is set up only for the transaction in question even as part of a predetermined and complex scheme of tax avoidance. It seems also irrelevant that at the time of making its decision the Board was ill-informed or ill-advised. Only circumstances where place of board meeting are to be ignored are: (i) in a scenario of the type considered in Unit Construction vs. Bullock, where Board has in fact been usurped so that some third party (including a parent company) is taking the decision then, (ii) where the company’s directors sign documents that are put in front of them without reading them, and (iii) director does not have even absolute minimum level of information that would enable them to consider whether or not they should make a decision.

4.2 POEM under Domestic tax law vs. POEM as tie-breaker under the tax treaty Purpose wise there is a difference between a POEM which is a domestic residency test and the POEM acting as tie-breaker32. On one hand, the focus of enquiry of POEM Test under the domestic tax law is to find out whether a Company is resident in India or not. On the other hand, the purpose of POEM as tie-breaker is to resolve cases of dual residency and determine the single Country of residence by weighing up the level of activities performed in both the Countries. Having said that, the terms of the test lead to inevitably to the same question where the effective decisions were taken33. In that sense, POEM as a tie-breaker is more likely to be interpreted in the similar way as POEM is understood under the domestic tax law. This is likely to cause interpretational issues if two countries are considering the POEM as per their domestic tax laws. It is pertinent to note that Countries like China, Russia, South Africa, Taiwan, Switzerland, Italy, Spain, Colombia, have issued their internal guidance on POEM wherein indicia for deciding POEM vary significantly34 . In order to avoid this kind of scenario, Prof. Klaus Vogel, suggest that the term ‘place of effective management’ must be interpreted ‘autonomously’35

5. Withholding tax in dual residency case - Case studies

32 This is based on the decision of the Special Commissioner decision in the case of Smallwood v HMRC

[2008] STC (SCD) 209 wherein distinction between Central management and control and place of effective

management has been explained]

33 Court of Appeal , HMRC vs. Smallwood & Anor [2010] EWCA Civ 778

34 CII-Deloitte Publication on POEM -Recommendations on Guidelines to be introduced, Published in

September 2015, Appendix-1, p.21-25

35 Prof. Klaus Vogel on Double Taxation conventions, p.262

With the introduction of concept of POEM under the domestic tax law in India and the replacement of POEM test with MAP as a Tie-breaker is likely to cause increased instances of dual resident companies. Keeping in mind the dual resident companies, withholding tax requirement has been analyzed herein below:

5.1 Dual Residency Triangular cases

Case -1. Company BC is incorporated in Country C. However, the tax authority in India establishes that this company is effectively managed in India. Assume that Company A which is a tax resident of Country A has to make interest payment to Company BC. In this scenario, the issue is-under which tax treaty Company A will be required to withhold tax? In this case, the solution will depend upon the following assumptions:

● Tie- breaker rule provided in India and Country C tax treaty resolves the dispute regarding the tax residency by allocating country of residence to India.

● Tie- breaker rule provided in India and Country C tax treaty is unable to resolve the dispute regarding the tax residency.

In the first scenario, the withholding tax shall be as per the India-Country A tax treaty. And in the second scenario, since the tie-breaker rule could not decide the single country of residence, Company BC can use whichever tax treaty (India- Country A or Country C -Country A) provides for lower withholding tax rate.

5.2 Reverse Dual Residency Triangular cases

Case-2.Company BC is incorporated in Country C. However, the tax authority in India establishes that this Company is effectively managed in India. Assume that Company BC has to make interest payment to Company A which is a tax resident of Country A. In this scenario, the issue is-under which tax treaty Company BC will be required to withhold tax? In this case, the solution will depend upon the following assumptions:

● Tie- breaker rule provided in India and Country C tax treaty resolves the dispute regarding the tax residency by allocating country of residence to India.

● Tie- breaker rule provided in India and Country C tax treaty is unable to

resolve the dispute regarding the tax residency. In the first scenario, withholding tax shall be as per the India-Country A tax treaty as losing Country C will be prevented from levy any withhold tax. In this respect, it may argued that Company BC continues to remain a tax resident of Country C under the domestic tax law irrespective of the position under the tax treaty. This gets supported by the views of Prof. Klaus Vogel36 who explains that “a person other than an individual continues to be subject to the domestic rules on taxation of residents even in those cases where by virtue of Art.4 (3) its treaty residence is situated in other contracting State”. Therefore, one would find that there is a specific provision in some countries like South Africa 37 ,

36 Prof. Klaus Vogel on Double Taxation conventions [First Indian reprint, 2007 published by Wolters Kluwer

(India) Pvt. Ltd, p. 260]

37 [Proviso to Section1 of the income tax Act, 1962 in SA ]

Canada38, UK39 which provides that a resident Company shall be treated as non-resident if such person is deemed to be exclusively a resident of another country under the tie-breaker rule of any tax treaty.

However, the other view is also possible. There is a Supreme Court Decision in case of CIT v. P.V.A.L. Kulandagan Chettiar 40 although rendered in the context of an Individual is relevant. The Court held that: “Reading the treaty in question as a whole, when it is intended that even though it is possible for a resident in India to be taxed in terms of sections 4 and 5, if he is deemed to be a resident of a Contracting State where his personal and economic relations are closer, then his residence in India will become

irrelevant, the treaty will have to be interpreted as such and prevails

over sections 4 and 5 of the Act.” (Emphasis added) Similar view has also been expressed by Dutch Supreme Court41. The Supreme Court ruled that the company [incorporated in the Netherlands] did not qualify as a resident of Netherlands because as per the tie-breaker rule it was subject to tax in the Netherlands only in respect of Dutch-source income and not for its worldwide income. It was a tax resident of the Netherlands Antilles under the tiebreaker of Netherlands- Netherlands Antilles tax treaty. Therefore, the Netherlands did not have the right to levy its dividend withholding tax according to Article 10(2) of the Netherlands-Belgium treaty. And in the second scenario, since the tie-breaker rule could not decide the single country of residence, both the Countries (India and Country C) will impose withholding tax on the interest income payable to Company A. Country A will be obliged to provide the tax credit of taxes withheld in India and Country C. Since the tax credit shall be limited to the tax liability in Country A, there is a possibility of unrelieved double taxation.

6. Other Important Issues

6.1 Interplay between POEM and PE Both these concepts are relevant for foreign Company as existence of either of is likely to impact tax outgo in another country. However, they are different in application and scope. While PE allows source based taxation (only the profit attributable to PE), POEM enables residence based taxation (Global Income taxable). On one hand, PE is created when there is strong nexus with a source country i.e. economic activity in the source country reaches certain threshold (i.e. via physical presence or through its employees or dependent agent concluding contracts on its behalf in the source country). On the other hand,

38 [ Section 250(5) of the Income Tax Act, 1985

39 [Section 249 of the Finance Act 1994 (UK) states]

40 [2004] 267 ITR 654 (SC)

41 [The Mutual Agreement Tiebreaker — OECD and Dutch Perspectives by Jean-Paul van den Berg and

Bart van der Gulik, Tax Notes, International ,4 May 2009, P. 420]

when it comes to POEM, the emphasis shifts from ‘place of economic activity' to ‘place where strategic decisions are taken'. Thus, POEM is not created irrespective of the level of economic activity in the source country as long as key business decisions of the company are taken outside. India in its draft guidance on POEM provides that place where main and substantial activity of the company is carried out can be a place of effective management. Basically, this approach makes a presumption that decision maker will be necessarily be present in the country where major and substantial business activities are taking place, and thus, it shall create POEM. However, most often than not, this may not be true considering the present environment of mobility and ease of transportation. It may be pointed out that more than 100 years ago in the case of De Beers Consolidated Mines Ltd v Howe42, Calcutta Jute Mills Co Ltd v Nicholson43 and Cesena Sulphur Co Ltd v Nicholson44 trading operations were carried on overseas, but because the central control and management of the business operations was carried on in the UK, the companies were held to be resident in the UK. Moving ahead, it is likely that assessment of a foreign company will start with issue of PE and end up with determination of POEM. Consider an example, where a Bermuda company which is a group company of an Indian company selling products in India. However, Bermuda Company does not have any office, staff in Bermuda, most of the directors of the company are Indian. The Assessing Officer comes to know that employees of Indian company concludes contracts for products sold by Bermuda company in India and thus, he issues notice for re-opening for determination of PE and profits attributable to it. During the assessment, it is found that majority of directors sitting in India are taking strategic decision on behalf of the Bermuda Company, bulk of documents and accounting records relating to the Bermuda Company’s activities are found in the office of Indian company and therefore, Bermuda Company is treated as a resident in India.

6.2 Interplay between General Anti Avoidance Rules and POEM Concept of POEM is one of substance over form and in that sense it is ,itself, a kind of specific anti-avoidance provision and therefore, normally GAAR 45 should not be applied. However, concept of POEM itself can be subject to manipulation as Company intending to shift its POEM in low tax jurisdiction purposefully holds its board meeting there. In such case, the question arises as to whether GAAR can be invoked. GAAR empowers the Indian Tax Authorities to declare any transaction as an impermissible avoidance arrangement and

determine the tax consequences thereof in accordance with the relevant provisions of the Act. The consequences of a transaction being considered as an

42 [1906] AC 455

43 1 TC 83

44 ibid

45 Effective from Financial year 2017-18

impermissible avoidance arrangement and thus subject to GAAR have been defined in an inclusive manner and amongst others it includes treating the residency at a place other than place of residence. Thus, it appears that in such case, GAAR can be invoked to avoid any domestic tax abuse.

7. Conclusion: It is a time when POEM , a fact based test, has been brought in under the Act and on the other hand, MAP which is by far more difficult test than POEM has been introduced in the tax treaty provision. Thus, there is a clear change in the way corporate tax residency will be determined in the coming years. With the change in the residency rule based on POEM in India, it is expected that there will be marked increase in the number of case regarding corporate tax residency. While the final guideline on POEM is yet to be issued, it will be challenging for the Government to provide clear guideline, given the factual and circumstantial complexity involved in the determination of residency under the POEM test. As all the facts remains with companies, initial onus of proof is on them and accordingly, they should retain the necessary evidence to support their view that place of effective management is outside India. Once they discharge the onus that lay upon them, the burden then lies on the revenue to prove that the place of effective management is India. .