Residency Provisions Under Income Tax Act, highlighting contrasts with FEMA, Companies Act and Direct Tax Code Bill, 2010
Introduction To Taxation and Citizenship Rules
Taxation of individuals by a state works on a deeply embedded principle of giving back to the state for the services provided by the state such as good governance, welfare schemes, defense and others which are required for a state for maintenance and expansion. This principle although looks simple and efficient, requires the state to answer the basic question : How to Decide WHO to tax ? And providing theoretically and morally reasons to support taxing such individuals. One such answer given by the United States, Eritrea and Philippines is citizenship-based income tax rules.
Citizenship Rules are one of the simplest, most efficient with minimal administrative cost based rules for taxation, Citizenship rules simply state a person being a citizen of such a country is bound to pay income tax, regardless of their residency and source of the income. If we carefully analyze the premise of this argument, we realize why citizenship rule as a taxation rule fails and is incompetent for a state. The primary argument against this rule can be explained through simple examples: 1) Why should an individual not residing in such a country or such country not being the source of income; be taxed by the country. 2) Non-Nationals sourcing their income from such a country or residing there (using the states functions) according to such rule wouldn’t be liable to pay taxes which violates equality. Hence such rule used solely is non-beneficial for a state.
Therefore, we come to our primary question again, if not citizenship then which criteria to be used for taxing individuals. Therefore, gave rise to residence and source rules which broadly meant taxing individuals on the basis of their residence and/or basis of where the source of the income earned by any individual (resident or non-resident) lies. For the scope of this paper we will only be analyzing residence rule in depth.
Concept of Residence Based Rules
Residence based rules can be considered an elder cousin of citizenship rule who has a higher I.Q. These rules places all the emphasis on the residence of the individual. I.e. In simpler terms if you live in a state you are bound to pay taxes to that state. Therefore, residence-based rules have less administrative costs and provides a higher degree of certainty to ascertain tax liability. In such states a state lays down some criteria like number of days of residence, place of control and management of a company etc., which qualifies an individual as a resident or non-resident of that state
The point of emphasis here is a person although can be a citizen of that state; can still be a non-resident to that state and wouldn’t incur tax liability towards that state. These rules play importance as it can ensure progressive tax rates, which are better for covering socio-economic gaps in a society. The assumption is that ‘ability to pay’ may be determined only by a consideration of total (domestic and foreign) income without having any regard towards source/accrual of such income. Moreover, as Professor Musgrave says “Residence rules allow Capital Export Neutrality (CEN): Which allows domestic players and global entities on same platform”
Introduction to Indian Residency Rules
India follows residency rule under section 6 of the income tax act, which lays down the test for entities such as: Individual, An HUF, Firm or Asc./Body of Individuals, Company and ‘ Every Other Person’. Income Tax Act considers two types of taxpayers: Residents, Non – Residents. Indian Income is taxable for both resident and non-resident, however foreign income is taxable only to resident of India and not non-resident. The point to be noted here is although residency rules seems rigid by diversifying individuals and entities as residents and non-residents, residency rules under income tax act is of a fluid and evolving nature , i.e.: An Individual can have different residential status for different assessment years and Individuals also can have dual-residency for the same assessment year. Before we analyze these residence rules for different entities we should note the onus of proof for whether assessee is a resident or not lies on the assessee itself and not Income-Tax Authorities[1]
Residential Status of Individuals.
Section 6(1) comes into play when we determine residential status of an individual. Income Tax Act divides such people as: 1) Residents – Ordinarily Residents and Non Ordinarily Residents 2) Non – Residents. The process to determine residency starts at section6(1) and 6(6)(a), wherein the act determines whether an individual is resident or not this is done by complying of either of 2 conditions : (1) He is in India in the previous year for a period of 182 days or more (2) He is in India for a period of 60 days or more during the previous year and 365 days or more during 4 years immediately preceding the previous year.
If either of this condition is satisfied, then Income Tax Act considers you a resident of India and then moves to determine whether you are ordinarily or non-ordinarily resident of India. However (2) condition has two special cases/ exceptions for which (2) condition is invalid and residency is determined on (1) condition. First Case being, an Indian Citizen who leaves India during the previous year for the purpose of employment outside India or an Indian Citizen who leaves India as a member of the crew of an Indian Ship. This is because under these cases these individuals are not leaving India for gaining employment outside India but leaving India because of employment(which can be Indian or foreign). Therefore, these people being unemployed when they leave India is not a general rule [2]. Example: An Individual traveling abroad on a ‘business’ visa. The 2nd exception is when an Indian Citizen/Origin comes on a ‘visit’ to India during the previous year, whose total income, other than the income from foreign sources is Up to Rs. 15 lakhs during the previous year. There under both these cases we apply the (1) condition.
Ordinarily and Non-Ordinarily Residency.
Now before we analyze the further differentiation between a resident being ordinarily and non-ordinarily, we have to justify the reason for distinction between both of them. The justification for such distinction lies in the fact that an ordinarily resident pays tax on both foreign and domestic income however non-ordinarily resident is liable to pay tax only on Indian income and not foreign. The conditions are : 1)He has been resident in India in at least 2 out of 10 previous years immediately before preceding the relevant previous year 2)He has been in India for a period of 730 days or more during 7 years immediately preceding the relevant previous year.
Fulfillment of any/every abovementioned conditions makes a resident ordinary resident, and not complying with such conditions makes one not ordinarily resident.
Points To Be Noted.
It should be duly noted when calculating number of days under residency rule, it is not necessary the assessee should be at the same place[3] , moreover being in territorial waters of India is also considered in India when determining residency [4]. Trekking on the same tracks we have certain unique precedents set by the courts in determining residency which are :1) When a person is in India for a part of a day(also broken periods) , calculation for days under residency rule is made on an hourly basis[5] . 2)Duration of unauthorized impounding of passport is excluded when counting days[6]
Deemed Residency
Finance Act 2020 through clause 1A in Section 6 brought a concept of deemed resident (non-ordinarily resident). This concept is very unique and debated because of the conditions required for being a deemed resident, which are:
1) An individual who is the citizen of India,
2) Whose Income exceeds 15 lakhs in the previous year other than the income from foreign source
3)‘WHOSE INCOME IS NOT TAXABLE IN ANY OTHER COUNTRY SHALL BE DEMED TO BE RESIDENT IN INDIA.’
The last condition was initially considered very vague primarily for the reason gulf countries tend to have certain tax-free income, now whether such income would be taxable by India seemed vague. However later CBDT clarified that foreign income wouldn’t be taxable.
Residency on an HUF
Section 6(2) lays down condition for an HUF being a resident of India, which is the place for control and management of the HUF being in India will make it resident in India, and outside India will make it a non-resident. Control and Management have been given various interpretations by the courts:1) De facto control: There should be de facto control and not merely right to control and manage[7]. 2) Place of control and management: The place where the deciding power resides is the place of control and management of the HUF[8]. However, one should always note, mere residency of a Karta doesn’t determine the residency on an HUF moreover occasional visit of non-resident Karta to India wouldn’t make the residency of the HUF to India. The test is ‘Real’ place for control and management of the HUF. Same rules for determining ordinarily resident and non- ordinarily resident apply to HUF as an Individual.
Residential Status of A Company
Section 6(3) covers residential status of company. This section is of utmost importance because this is the section which gathers high taxes for the state. Section 6(3)(i) at the outset clears the doubt whether an Indian company can be a non-resident? The answer is no, regardless where the company is controlled from ( even outside India), the rigidity of this sub-section extends to companies which although are Indian have more than 51% voting powers with non-residents, still the company would be treated as an Indian company. Then this section divides foreign companies into two categories: 1) Turn-Over in prev. year less than 50Cr. 2) Turn-Over in prev. year more than 50Cr. In the first scenario it is automatically treated as a non-resident hence no tax liability (Circular No.8/2017 by CBDT). However in the 2nd case scenario, we apply a widely known and internationally recognized POEM Test (Place of Effective Management Test). Some guiding principles for POEM test are : 1) The location where a company’s board regularly meets and makes ‘Controlling and Important Decisions’.(2) Company’s Head Office. (3) In modern technologically advance times when board meetings are done through videoconferencing, the place where directors usually reside is taken into consideration.
Therefore, through these principles we note, importance is given to substance over form. Therefore, the place of real control of the company is looked for and then is regarded as its residence. It is also important to note day to day decisions done by lower management would not be regarded as significantly important decisions hence will be neglected by POEM Test.
Active Business Outside India :
Then treading in tracks laid down by POEM Test, we look for whether company concerned is engaged in active business outside India, and in such cases POEM for the concerned company is outside India. To determine ‘Active Business Outside India’ we determine:
1) Passive Income is not more than 50% of total income
2) Less than 50% of total assets are situated in India
3) Less than 50% of total employees are situated in India, and payroll expenses of such employees is less than 50%
There are certain points to be noted which are : Mere Foreign Company being owned by Indian doesn’t suffice POEM to India, Existence of P.E.( Permanent Establishment under DTAAs) wouldn’t suffice for POEM, Place of residence of one or some directors in India doesn’t suffice for POEM in India.
Difference in Approach By Various Legislation
Companies Act: Companies Act,1961 Clause(e) of Schedule XIII provides that a resident in India includes a person who has been staying in India for a continuous period of not less than 12 months immediately preceding the date of his appointment as a managerial person. Here we see the contrast taken in approach towards residency, as Income Tax Act takes into account 182 days, which can/cannot be continuous when counting days for residency.
FEMA: FEMA on the outset differs from Income Tax, as residency in India requires more than 182 days compared to just 182 days under Income Tax Act. Secondly FEMA considers the preceding financial year, however Income tax act considers current financial year. Now things get interesting with FEMA, as it considers the reason of stay in India or visit abroad to determine residency, which is not the case for Income Tax act . Under FEMA you can be resident for part of a year and non-resident for a part of year, however the status is fixed under income tax act for the financial year.
Direct Tax Code Bill, 2010: Direct Tax Code Bill,2009 wishes to change things up for Income Tax. Firstly, this is done by doing away with the classification of RNOR in Income Tax Act, which implies Indians working abroad would still be resident, and their income would be taxable here in India. It also changes the POEM test by amending the POEM test from ; a company is resident in India in any ‘previous year’ if the control and management of its affairs is situated wholly in India , to a company is resident in India if control and management ‘at any time of the year’ is situated wholly or ‘partly’ in India. Therefore a single meeting conducted in India, could hypothetically make the company liable to corporate tax in India. One is made to think to a conclusion, that through direct tax code bill, Govt of India aims to widen the tax base considerably and increase taxation boundaries a lot.
[1] Rai Bahadur Seth Teomal V. CIT [1963] 48 ITR 170 (Cal.).
[2] British Gas India(P.) Ltd, In Re[2006] 155 Taxman 326
[3] Kinloch V IRC 14 TC 736
[4] Baryard Brown V Burt 5 TC 667
[5] Walkie V IRC [1952] 1 AER 92
[6] CIT V. Suresh Nanda
[7] CIT V Nandlal Gandalal [1960] 40 ITR 1 (SC)
[8] San Paulo Railway Co. V Carter [1886] AC 31 (HL)
Also Watch: Direct Tax Code 2025: Simplified Taxation, Key Updates & Impact on Taxpayers
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