- by Pathmanabhan Sooraj & Aadil Muhammed Syed, 3rd year students at The National University of Advanced Legal Studies (NUALS), Kochi
Introduction
Globalisation has led to the rise of corporate giants that have a ubiquitous presence in one country but can extend their roots globally across multiple jurisdictions. This presents the government with a huge opportunity to leverage the resources and economic activity within their borders and raises the questions regarding fair taxation. There exists a compelling argument that they should contribute their fair share of taxes to the nations where they operate and generate revenue, as this growth is a product of the utilisation of resources in those jurisdictions. The Taxation regime in India, while flush with guiding principles like the Place of Effective Management (“PoEM”) guidelines of the Central Board of Direct Taxes (“CBDT”), could benefit from further clarity to enhance the ease of doing business while, at the same time, ensuring that substantial funds that would otherwise be taxed do not go under the radar as “passive income.” This article demonstrates the complexities in the current taxation regime with respect to the determination of tax residency and taxability of global income. It also calls for addressing the conflict arising between PoEM guidelines and DTAAs as well as closing down on mere technicalities that companies can leverage to effectuate tax evasion.
Decoding Corporate Tax Residency: The PoEM Principle
Section 6(3) of the Income Tax Act, 1961 (“IT Act”) provides that a company is said to be a resident in India in any previous year if it is an Indian company or its place of effective management in that year is in India. It provides two tests for determining a company’s residential status in India - if it is an Indian company under Section 2(26) or if PoEM, where the key management and commercial decisions are made, is situated in India during the previous year. In 2017, via Circular No.6/ 2017, the Ministry of Finance brought in the Guiding Principles to determine PoEM.
Determining tax residency and consequent global taxation of a company’s profits necessitates a bifurcated examination, firstly, by ascertaining whether PoEM is situated in India, thereby rendering the company a resident under the IT Act, 1961, and secondly, for foreign companies, evaluating if a significant portion of their global operations is conducted in India, which could trigger the taxability of their income. The Ministry of External Affairs (“MEA”), in its Guidebook for Overseas Indians, states that a “resident and ordinarily resident” pays tax in India on global income; however, basing tax residency solely on incorporation allows companies to situate themselves in low-tax jurisdictions while operating from higher-tax countries like India.
DTAA Trump Card: Dodging Tax Residency
In Saraswati Holding Corporation Inc. vs Deputy Director Of Income Tax, the Income Tax Appellate Tribunal, Delhi Bench (“ITAT”), ruled in favour of the assessee, a company incorporated in Mauritius. The key factor here was that there was a Double Taxation Avoidance Agreement (“DTAA”) between India and Mauritius, which specified that profits of a Mauritius company from capital markets in India are not taxable under the Indian IT Act and shall be taxed in Mauritius only. Here, the ITAT observed that the assessee was not liable to be taxed, being a tax resident of Mauritius; additionally, it was observed that there was no basis for concluding that any income of the assessee accrued or arose in India. While PoEM guidelines aim to tax companies based on their effective management location, their implementation can potentially conflict with DTAAs, which may provide for unintended tax exemptions, and the limited scope of Section 6(3) before PoEM allowed companies to avoid residency tests by not having their control and management wholly situated in India, leading to tax avoidance opportunities. Thus, a conflict arises between the PoEM guidelines and DTAAs. While PoEM determines residency based on the location of a company's effective management, this would not necessarily agree with the criteria outlined in DTAAs, leading to the coexistence of differing yardsticks to this effect.
Role of Board Meetings
The place of residence of a company that is engaged in any business activity outside India and where most of its board meetings are held outside India, such Company would not come under the purview of the IT Act. This was affirmed in Radha Rani Holdings Ltd. vs Additional Director Of Income Tax, where ITAT Delhi held that even if some control and management activities are carried out from outside India, it would not satisfy Section 6(3)(ii) of the IT Act. The company would be regarded as a non-resident for tax purposes. This, however, leads to a conflict policy-wise; the Ministry of Finance, in Circular No.19/2015, via the explanatory note to the provisions of the Finance Act, 2015, recognised that a company can easily avoid becoming a resident by simply holding a board meeting outside of India, and the risk of shell companies being incorporated outside India. Hence, the Finance Act, 2015 was amended to define PoEM as 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, thus making it difficult for companies to avoid taxation by simply holding board meetings outside India. While this marks a positive progression towards addressing loopholes in tax residency, companies could still exploit other aspects for tax evasion as this article shall demonstrate further.
The need for POEM Guidelines to have a Binding Effect
PoEM guidelines, while still in its nascent stage in India, are not binding as it has not yet been incorporated into the IT Act. Additionally, Circular No.8/2017 by the Ministry of Finance provides a 50 crore threshold below which PoEM guidelines would not apply to the assessee. This can affectcompanies structuring their investments through different establishments and income being distributed over subsequent years. This ultimately leads to companies being controlled within India and left out of the PoEM guidelines. At the same time, business interests should be kept in mind as specified by the Supreme Court in the Union of India v. Azadi Bachao Andolan, which accentuated the importance of DTAA’s in promoting a fair taxation regime and in preventing double taxation. Nevertheless, the current tax regime favours tax avoidance by both domestic and foreign companies, and the introduction of PoEM guidelines serves as an initial step towards preventing such tax avoidance practices.
Exclusive Agency and Permanent Establishment
Another concept relevant to the taxation of companies is the Permanent Establishment (“PE”) under Section 92F of the IT Act, which determines a foreign company’s tax liability based on its business connection in India. In CIT v. Bay Line, which dealt with the concept of PE through its agent, ITAT Mumbai had held that the agent’s activities were not exclusively for Bay Lines, and hence, it could not be considered that the company’s agent has PE in India. Consequently, its global shipping profits were taxable only in Mauritius, the resident country under the DTAA, not in India. This decision affirmed that for constituting a PE through an agent, the agent’s activities must be wholly or almost wholly for the foreign enterprise. Contrastingly, ITAT Delhi in ULO Systems LLC C/O v. CIT , advocated for a substantive approach to determine PE status and established three key criteria:
Fixed tangible assets at the company’s disposal,
Duration only as a minor factor,
Control over the agent is crucial, with the required degree varying based on business activity.
This contrasts with Bay Line’s narrower interpretation, which could facilitate treaty shopping and allow companies to use loopholes like appointing multiple agents, diversifying agent activities, utilising independent contractors, or splitting functions to avoid constituting a dependent agent with PE, potentially depriving governments of rightful tax share. The tension created thus has necessitated the need to formulate tax policies and treaty provisions towards preventing revenue leakage while simultaneously maintaining an environment conducive to legitimate cross-border business activities.
Characterisation of payments
DTAA clauses, such as the "make available" condition, influence the classification and taxation of fees for technical services rendered by non-residents, offering another area for strategic adjustments for companies to avoid taxes. In Global Vectra Helicorp Ltd. v. Deputy Commissioner of Income-tax, ITAT Delhi held that the taxation of fees paid by Indian companies to non-residents hinges on the nature of services rendered to the company and DTAA. It also held that although the IT Act has provisions like FTS, defined as consideration for managerial, technical, or consultancy services, it is subject to DTAA clauses that can supersede domestic provisions. The “make available” clause in some DTAAs mandates technical expertise transfer for FTS classification, limiting taxable payments in countries like the UAE lacking such a clause. Broader FTS definitions in DTAAs with Netherlands, Spain, and France do not require this condition, but services must possess a technical/consultancy character. Companies can, thus, bypass taxes by characterising services as routine maintenance/repairs, which do not qualify as taxable, or by splitting payments into instalments to hide within routine fees.
Conclusion
The mushrooming of shell companies, especially in Mauritius, has elicited the need for stringent application of PoEM guidelines, especially in light of decisions such as Radha Rani and Saraswati Holdings, underscoring the need for incorporation of the former into the IT Act, which would provide clarity as to the taxability of global income of an Indian as well as foreign residents, as a decisive step towards anti-tax avoidance. The tax regime must adopt a more unified and substantive approach, as proposed in the ULO Systems, that addresses actual business conduct and economic substance over mere legal formalities. Additionally, payments claiming exemptions under a DTAA need scrutiny by analysing multiple payments collectively to ensure they do not conceal other payments within routine maintenance/repair payments. It is crucial to re-negotiate DTAA treaties and ensure that they do not allowmisuse by way of incorporation only in name. The incorporation of PoEM guidelines into the IT Act creates a more robust tax regime that can eliminate tax avoidance practices.
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