Place of Effective Management (POEM)

CA Dhwani C. Shah

The Finance Act 2015 has introduced a major change to the definition of residential status of companies vide amendment to Section 6(3) of the Income Tax Act, 1961 (‘Act’) which is likely to have significant impact with respect to foreign companies.

A foreign company, which was previously considered as resident if ‘control and management of its affairs is wholly situated in India during the year’, is now to be considered as resident if ‘its place of effective management (POEM), at any time during the year, is in India’.

POEM has been defined 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”, in line with definition appearing in Commentary to Organization for Economic Co-operation and Development (‘OECD’) Model Tax Convention. This article attempts to analyse the definition of POEM and the criteria that could be relevant in determination of POEM in light of the concepts adopted internationally.

Evolution of POEM in Indian context

Prior to the amendment, foreign companies were considered as tax resident in India if during and throughout the year under consideration, their control and management was “wholly” situated in India. Accordingly, if control and management of a foreign company was even partly situated outside India, it was regarded as non-resident.

The definition of residence was thus considered as too high a threshold compared to the definition of residence in tax treaties. Therefore, a need to revise the same was envisaged under the DTC and accordingly the concept of POEM for determination of residential status was introduced in Direct Taxes Code Bill (DTC) released on 15 June 2010. The principle survived with modifications in DTC revised draft circulated in 2013.

Recognising that, the requirement of “whole” of control and management in India for the entire year as a criteria to determine residential status was a very restricted definition and avoidance of residence became easy by even holding a single board meeting outside India, the Finance Bill 2015 proposed the amendment. With a view to align provisions of the Act with DTAAs and other international standards and prevent avoidance of tax by shell or conduit companies incorporated outside India, the concept of POEM was introduced under the Act.

Background of POEM in International context

Most countries determine residential status of a company based on criteria such as place of incorporation / registration, place of management / principal place of management / place of management and control / location of central management and control / POEM.

POEM as one of the criteria for determination of residential status of foreign companies is incorporated in domestic laws of various countries including South Africa, China, Italy, Denmark, Netherlands, Switzerland, Greece, Slovenia and Korea. Though, none of these consider a foreign company as a resident if its POEM “at any time during the year” is in that country, except Greece.

OECD, in its commentary on Article 4 of the Model Tax Convention on Income and Capital recognises POEM as an internationally recognized concept as a tie breaker rule for determining residential status. OECD observes that all relevant facts and circumstances must be examined to determine POEM. OECD suggests that in determining POEM, various factors should be taken into account including factors such as where the board meeting are usually held; where the chief executive officer and other senior executives usually carry on their activities; where the senior day-to-day management of the person is usually carried on; where the person’s headquarters are located; which country’s law govern the legal status of the person; where its accounting records are kept; whether determining that the legal person is a resident of one of the contracting states but not of the other would carry the risk of an improper use of the Convention.

The 2014 report of OECD on Base Erosion and Profit Shifting (BEPS) Action Point 6 on preventing the granting on treaty benefits in inappropriate circumstances mentions that initially, it was considered that it would not be an adequate solution to attach importance to a purely formal criterion like registration and preference was given to a rule based on the POEM, which was intended to be based on the place where the company is actually managed. However, in 2014, the Committee on Fiscal Affairs recognised that there had been a number of tax avoidance cases involving dual resident companies.

The BEPS report therefore concluded that a better solution to the issue of dual residence of entities was to deal with such situations on a case-by-case basis instead of having POEM as test. Dealing with dual residence cases on basis of facts and circumstances of the case is thus preferred over POEM test. Further, countries considering POEM as preferable to deal with dual residency cases need to ensure that these provisions are not abused.

The concept of POEM also appears in most of the tax treaties for determining taxability of shipping and airline entities and also as a tie breaker rule under Article for residence.

The Concept of POEM

While the concept of POEM appears in domestic laws of various countries and is used in many tax treaties as a tie breaker rule and also in determining taxability of companies engaged in shipping and aircraft business, the phrase has multiple interpretations across different countries. The term POEM has no universal meaning.

There are primarily two tests that are applied when determining the location of an entity’s POEM, i.e. the place where the board of directors meets (also referred to as referred to as the “board-centric” or “Anglo-American” approach) or the place where the senior management of the company operate (also referred to as “Continental” approach).

In this context, reference can be drawn from Interpretation Note 6 on POEM issued by South Africa, which details that place can be distinguished into three categories based on level of management –

• Top level management – The place where central management and control is carried out by a board of directors;
• Executive / Mid-level Management – The place where executive directors or senior management execute and implement the policy and strategic decisions made by the board of directors and make and implement day to day/ regular! operational management and business activities;

• Operational level Management – The place where the day to day business activities are carried out / conducted.

Under the Board-centric approach, POEM is determined based on place where board of directors meet, whereas, under the continental approach, place where the senior management of the company operates is preferred in determination of POEM.

As per the amendment, POEM has been defined 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”. The definition can be interpreted through the following key words.

• Key management and commercial decisions

It appears that the definition focuses on management alone. The word “control” appearing in the earlier provisions of the Act is missing from the amended definition. Thus it may be possible to take a view that location of shareholders or shareholder meetings or the place where the control of the entity exists may not be relevant in determination of POEM.

Further, focus is on key decisions relating to management and commercial aspects of the entity. Thus, the day-to-day operations may not be significant as the same may not form part of the “key” decisions.

• Necessary for the conduct of the business

It appears that the definition is inclined towards a continental approach as focus is on ‘management and commercial decisions for the conduct of the business’. Thus, it is tilted to focus on the executive level management decisions which involve decision making for overall conduct of the business in line with the broad strategies and policies formulated by the board of directors.

• Of an entity as a whole

This phrase indicates that isolated day-to-day operations may not be relevant in determination of POEM. POEM would be determined based on overall decision making for conduct of business of the entity as a whole. This also indicates that third level of management i.e. operational management may not be relevant in determining POEM.

• In substance made

POEM would be determined based on the principle of “Substance over form”. Thus, in line with the intention to cover shell companies under this provision, it appears that substance would be given emphasis before determining POEM. Accordingly, it may be possible that even though the board meetings are conducted in and minutes are signed in Country X, but decisions are in substance taken in Country Y, Country Y be considered as POEM.

DTC 2010 defined POEM for determination of residential status, as –

• the place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or
• in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.

However, the Standing Committee on Finance, in its report on DTC 2010, observed that the reference to Executive Directors (ED) in the POEM definition led to ambiguity, as the term was not defined either in the DTC or in the Companies Act, 1956. Further, inclusion of “officer” in the second limb of the definition could increase uncertainty, as commercial and strategic decision making is spread at various levels in modern day organizations. Further, the Committee recommended that “determining POEM on the basis as to where such officers perform their functions was not an objective criteria of deciding fiscal residency”. The Committee, therefore, recommended that the definition of POEM should be amended, by removing reference to ED or officer. The Committee advised that the residency should be determined on the basis of internationally accepted standards and judicially settled principles, where the ‘focus is on the place, where the key management and commercial decisions as a whole are made or where the “head and brain” of the company is situated’. The definition of POEM was thus modified in line with OECD Commentary based on recommendations of the Committee.

This also indicates that the proposed law does not intend to determine POEM based on place where the day-to-day functions are performed or executed by the officers of the Company but based on the place where key management and commercial decisions are taken.

In light of the above analysis, it appears that the India would align with continental approach and location of mid-level of management may be considered for identifying POEM. However, there is no clarity as yet and different interpretations are possible to the current definition. It may also be possible to interpret that location of both top as well as mid-level management would be relevant. The memorandum to the Finance Bill 2015 acknowledges that POEM is a fact dependant exercise and also proposes to prescribe guiding principles for determination of POEM.

Since India borrows definition of POEM from OECD, it may also be relevant to note that previously, OECD 2000 Model defined POEM as “POEM is the place where key management and commercial decisions that are necessary for the conduct of the business of the entity’s business are in substance made. The POEM 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.” However, the reference to Board of directors appearing in OECD 2000 was deleted in OECD 2008. The definition is now open to difference levels of management.

Internationally, POEM is interpreted differently by different countries. South Africa follows a Continental approach and considers that the concept of effective management is not the same as shareholder control or control by the board of directors. Amongst above, South Africa considers POEM based on the second level management i.e. the place where the company is managed on a regular or day to day basis by the directors or senior managers of the company, irrespective of where the overriding control is exercised, or where the board of directors meets. It thus identifies POEM based on location of senior officers or executives who are responsible for (i) actually developing or formulating key operational or commercial strategies and policies for, or taking decisions on key operational or commercial actions by the company and (ii) ensuring that those strategies and policies are carried out. South Africa also provides for further tie breakers in case management functions may be executed in multiple locations. Further, certain highly taxed Controlled Foreign Corporations (CFCs) are excluded from being considered as resident based on POEM.

In Russia, POEM is governed by it domestic laws and POEM is considered to be in Russia if any of the following conditions is fulfilled –

• Majority of meetings of BOD (or a similar body of the company other than an executive body) are held in Russia, wherein, majority means meetings held in Russia exceed meetings held in any other country
• Executive body regularly carries on its activities in relation to that organization from Russia. Activities, are however, deemed not to be carried on regularly in Russia if activities are carried on in Russia to a substantially lesser extent than in other states.
• CEO primarily carry out their activities in the form of executive management in Russia

Russia thus looks at BOD meetings, management functions and activities of main executive personnel, subject to various additional conditions.

China defines effective management as substantial and overall management and control over manufacturing and business operations, human resources, accounting, properties, etc. of the entity.

France, in its observations to OECD commentary, mentions that it interpret POEM as ‘the place where the person or group of persons who exercises the most senior functions (for example a board of directors or management board) makes its key management and commercial decisions, the place where the organs of direction, management and control of the entity are, in fact, mainly located.’

Hungary is of the opinion that in determining the POEM, one should also take into account the place where the chief executive officer and other senior executives usually carry on their activities as well as the place where the senior day-to-day management of the enterprise is usually carried on.

Impact of the amendment

The intention of the amendment seems to be to prevent avoidance of taxes by shell companies incorporated outside India and controlled and managed from India. However, the specific guidelines explaining the meaning of the phrase are still awaited.

The amendment proposed under the Finance Bill 2015, included the words “at any time” and proposed to consider a company having its POEM at any time during the year in India to be a resident of India. This had widened the scope of taxation probably even beyond what was comprehended by the Finance Minister. The phrase “at any time” had created complexities and questions arose as to whether even a single commercial and strategic decision approved in India or a single board meeting conducted in India could tantamount to the POEM (for the purpose of determining tax residency) being in India. This was a concern more specifically in case of outbound investments of Indian persons, wherein most of the directors and shareholders would be Indian persons.

Apart from foreign subsidiaries of Indian companies, even in case of Foreign companies, questions arose as to whether a board meeting held by a Foreign Holding Company in India to formulate India Business Strategy along-with its Indian subsidiary, could also be considered as POEM in India? This could have serious consequences, including taxation of world-wide income of the foreign company considered as resident in India. There could also be cases where Indian persons are on the board of overseas entities, due to their skill and expertise. Considering such foreign companies as resident and taxing it on its world­wide income if its POEM is in India at any time, would have also discouraged appointment of Indian directors as board members of such MNCs. Considering the concerns raised, the Finance Act 2015 as enacted did not include the phrase “at any time”.

Though removal of the words “at any time” did reduce the complexities, in absence of clear guidelines for determination of POEM, ambiguity still remains. The proposed amendment would have severe implications for multinational companies having board members across different countries. With growing importance of digital economy, there could be numerous cases where decisions are over video conferences. Issues arise as to whether participation in meetings through conference calls or circular resolutions could also lead to an exposure of having POEM in India. Indian persons being executive directors of foreign companies may need to ensure that they do not take any decision while they visit India.

Also, a company may become resident of two countries, if it has its place of effective management at any time during the year in two countries. The provisions of the DTAAs generally do not incorporate provisions like Tie Breaker Rule to deal such a situation of dual residency due to POEM in both the countries in case of a company. Further, various DTAA do not have tie breaker rules for companies which are residents of both the contracting states. For instance as per the DTAA between India and USA, if a company is a resident of both India and USA, it will not be eligible to tax treaty benefits. Accordingly, the amendment in the definition of the residence may lead to double taxation in case of foreign companies, except in cases like India-China DTAA, where as per the tie breaker rule, company will be resident of the contracting state in which its head office is situated.

It seems that POEM intends to be the place where key decisions “for the business as a whole” are made “in substance” and importance would be attached to the substance, however, the current law requires clarity and certainty. The existence of POEM should be determined based on facts and circumstances. Factors determining POEM should be incorporated in the law, which could include:

• Location of the centre of top level management personnel;
• The scale of and a comparative analysis of onshore as opposed to offshore operations;
• Place of residence of the directors or senior personnel, who are responsible for the overall management;
• The frequency and location of the meetings of the entity’s directors or senior personnel;
• The experience and skills of the directors or managers who purport to manage the entity;
• The actual activities and physical location of senior employees; etc.

Let us hope that the guiding principles proposed to be framed and introduced would bring more clarity, set some time threshold as well as carve exceptions for genuine operating companies and the provisions would be set in line with the intention to penalise only the shell companies and not create hardships for operating companies.