Double taxation fears are real

Manufacturing and trading subsidiaries of Indian companies may now have to pay taxes in India

The draft guiding principles for deciding the place of effective management (POEM) of a company were issued last week as a follow-up to a Budget 2015-16 proposal to plug loopholes that are used by many companies to skip their tax liability. The principles, which would be used to determine whether a company qualifies as a resident taxpayer, say that POEM would mean a place, where key management and commercial decisions necessary for the conduct of a business or an entity as a whole are made. Under the guidelines, a company would be considered to be engaged in "active business outside India" if its "passive" income - transactions of associated enterprises and income from royalty, dividend, capital gains, interest or rental income - is not more than 50 per cent of its total income. Similarly, it would be considered to be a non-resident firm if less than 50 per cent of its total assets are situated in India or less than half of its employees or of payroll expenses are on employees situated in the country. This means many manufacturing and trading subsidiaries of Indian companies may have to pay taxes in India now; the onus will shift to promoters to prove that they are run truly independently.

The situation these rules respond to is genuine. Companies can too easily avoid paying resident taxes by simply holding a board meeting outside India. This facilitates the creation of shell companies which are incorporated outside but controlled from India. Certainly, POEM is an internationally recognised concept for determination of residence of a company incorporated in a foreign jurisdiction. In fact, an OECD commentary (the POEM change is in line with OECD principles) in describing its meaning suggests that it is the place where key management and commercial decisions of an entity are made.

However, there are genuine concerns, too. Although some tax treaties recognise the POEM concept - many countries prefer the POEM test to be an appropriate one for determination of residence of a company - not all do. Thus, fears of double taxation are real. The danger is that, if there are insufficient safeguards, the tax department could end up creating another messy situation. Although the draft aims at providing a comprehensive set of factors to determine POEM for an offshore company, a more detailed listing of parameters might be necessary. India has already seen a spate of high-profile tax litigation in the past few years and an inadequately explained law can attract new controversies. After all, decisions can be taken over telephonic conversations, web or video conferencing, virtual offices, and so on - how will the tax department handle them? Also, though the guidelines have defined active and passive income, what could create confusion is that trading between parent and foreign subsidiary will be considered as passive income. This justification has been questioned; experts say there is also a significant risk of double taxation especially in the case of US companies managed from India, since the India-US tax treaty does not recognise POEM and such companies may not be able to claim treaty relief. There may be a case for sorting out these contentious issues and implementing it from the next financial year, instead of rushing it through.