Taxation depends on residency, at least in most of the countries of the world that levy income tax. Barring a few, most of the countries also tax their residents on worldwide basis. Generally speaking, non-residents are taxed not on worldwide basis but on what they earn from the country in question. The concept of residence thus has a very vital role to play in any country's taxation. And since non-residents are taxed on their limited income, it is important that the contours of residence are properly demarcated as otherwise, anyone having foreign income will try to pass off as non-resident. The problem is particularly acute in the area of corporate residency since setting up companies is becoming increasingly easy in almost all the parts of the world and more so in tax havens. This is a problem that is engaging the attention of the whole world including in the USA whose rules of corporate residency based only on incorporation are triggering what is known as corporate inversions. Unsurprisingly, the OECD BEPS project has also dealt with the aspect of corporate residency and proposes changes in the rules.

In India, the rules of determining the residency are contained in section 6 of the Income Tax Act. Surprisingly, till recently there has not been much change in the provision relating to corporate residency and it was very easy to pass off as non-residents in India. The government has in the last budget taken steps to strengthen the rules in this regard by introducing the concept of POEM. This was long overdue and the need for such a change envisaged in the now defunct DTC was also pointed out in this column long back ('Don't throw the baby out with the bathwater'). But it will be instructive to study why we came to have such a system that was so subject to manipulation.

In India, under the British rule, although residency determined the scope of income, initially, the law did not define 'resident' and the English rulings were made applicable in India. In respect of corporate residency, the test followed in the UK was the seat of direction and control. In those days the UK was the dominant colonial power and UK firms naturally dominated international commerce and most of such international trade was also with the colonies. In the tax literature, one of the very first cases related to corporate residency also involved India. In Calcutta Jute Mills, Limited v. Nicholson, a UK registered company was trading in India. All the operations of the company that produced profits for the company were carried out in India. But it held board meetings and annual general meetings in London in an office lent by a director. The company claimed that it was not resident in the UK. The Court held that the company was resident in the UK since the persons whose labour produced the profit for the company were mere agents of the Company that resided in the City of London where the directors met and where they transacted their business and exercised the powers conferred upon them. The Court held: "… The answer to the question, where does a joint stock company reside is, where its place of incorporation is, and where its governing body is to be met with and found, and where its governing body exercises the powers conferred upon it by the Act of Parliament, and by the articles of association, where it meets and is in bodily and personal presence for the purposes of the concern…" The Court thus laid down a list of criteria all of which were satisfied in this case.

Then came the famous De Beers case that laid down the central management and control test that the Courts applied also in India. In this case, it was held: "In applying the conception of residence to a Company, we ought, I think, to proceed as nearly as we can upon the analogy of an individual. A Company cannot eat or sleep, but it can keep house and do business. We ought, therefore, to see where it really keeps house and does business." Ultimately, it was held a company resides, for purposes of income tax, where its real business is carried on… I regard that as the true role; and the real business is carried on where the central management and control actually abides."

The Court rejected the place of incorporation test in definitive terms pointing out that the same was subject to manipulation. To quote: "An individual may be of foreign nationality, and yet reside in the United Kingdom. So may a Company. Otherwise, it might have its chief seat of management and its centre of trading in England, under the protection of English law, and yet escape the appropriate taxation by the simple expedient of being registered abroad and distributing its dividends abroad."

Soon, however, British companies were organizing their functions in such a way that all the Board meetings were held elsewhere, the books, company seals were kept elsewhere. Thus the anti-avoidance aspect of the central management and control test laid down in De Beers could also be easily subverted. Nevertheless, the central management and control test continued to hold the field in the UK till the year 1988 when following many other countries, the UK also adopted the place of incorporation test as an additional test for the corporate residency. It is also interesting to note that there was no definition of 'resident' in the UK law till 1988.

In India too, initially there was no definition of resident and in so far as companies are concerned the ratio of the British case laws were applied. However, unlike in the UK, we find that through the Indian Income-tax (Amendment) Act, 1939, Sections 4A and 4B were inserted in the 1922 Act. Section 4A relevant for our discussion stated as follows:

For the purposes of this Act - (…)

(b) a Hindu undivided family, firm or other association of persons is resident in British India unless the control and management of its affairs is situated wholly without British India.

(c) a company is resident in British India in any year (a) if the control and management of its affairs is situated wholly in British India in that year, or (b) if its income arising in British India in that year exceeds its income arising without British India in that year.

Thus, in India, companies were to be treated as resident only if whole of its affairs were controlled from India whereas in the case of other forms of business, the entity was resident unless the whole of its affairs were outside India. Thus in the case of a company, even if a part of management and control was outside India which in those days were mostly in the UK in most of the cases, the company was not resident in India and its world income could not be taxed in India.

The Ayers Committee report of 1936 that formed the basis of the 1939 amendments to the Income tax Act, 1922, considered the following clause recommended by the Income Tax Codification Committee in 1936 for incorporation into the Indian Income Tax:

"A company shall be treated as resident in the United Kingdom in a year of charge if it is controlled in the United Kingdom, or if it maintains in that year an established place of business in the United Kingdom and any substantial part of the company, whether administrative or other, is conducted in the United Kingdom, but a company shall not be regarded as so resident by reason only of the fact that it has a registered office in the United Kingdom at which is transacted such administrative business only as is necessary to comply with the requirements of Company Act, 1929."

The Ayers Committee however felt that the said clause was too wide and suggested the following formulation for India: "A company shall be treated as resident in British India if it is controlled in British India at any time during the year in which the profits sought to be assessed arise." As to what constitutes control, it added that there was sufficient guidance in the numerous decided cases.

The provision finally added was however completely different as we have seen above. Readily available literature does not suggest why the stipulation of control and management being wholly in India was added.

Subsequent committees examined the concept of residence under the 1922 Act but the discussion seems confined to the second part of 4A©. The 1948 report of the Income Tax Investigation Commission points out that the opposition in the 1939 Legislature insisted that in view of the conditions under which foreign companies carried on business in India with their central control generally abroad, companies though incorporated abroad and managed from abroad should be treated as resident if they earned profits out of operations substantially carried on in British India and hence section 4A© was enacted. However, the second part of the provision meant that a company could manipulate its accounts to be resident in one year and set off its foreign loss but in good years tended to become non-resident. Therefore it suggested the abolition of the second part.

Subsequently, the Income tax Investigation Committee and the Law commission also concentrated on the second aspect but the stipulation of control and management being wholly in India continued for 68 years after independence till 2015 when finally an amendment was made. The Finance Bill, 2015 proposed the following provision:

'(3) A company is said to be resident in India in any previous year, if,-

(i) it is an Indian company; or

(ii) its place of effective management, at any time in that year, is in India.

Explanation. - For the purposes of this clause "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.'

Explaining the proposed amendment, the Memorandum stated: "Due to the requirement that whole of control and management should be situated in India and that too for whole of the year, the condition has been rendered to be practically inapplicable. A company can easily avoid becoming a resident by simply holding a board meeting outside India. This facilitates creation of shell companies which are incorporated outside but controlled from India. 'Place of effective management' (POEM) is an internationally recognized concept for determination of residence of a company incorporated in a foreign jurisdiction. (…) The principle of POEM is recognized and accepted by Organisation of Economic Cooperation and Development (OECD) also. (…)

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 Double Taxation Avoidance Agreements (DTAAs) entered into by India with other countries and would also be in line with international standards. It would also be a measure to deal with cases of creation of shell companies outside India but being controlled and managed from India"

The interval between the introduction of the Bill and the passage thereof saw some fantastic claims that the use of the words 'at any time' would mean that any foreign company holding a single Board meeting in India would become Indian resident and this would damage our attractiveness as a destination for foreign investment. Spurious though the reasoning was since the idea was to catch Indian companies passing off as foreign as is evident from the Memorandum, the government, as usual, succumbed and deleted the offending words.

The Minister sated that the CBDT will come up with suitable guidelines. Accordingly, the CBDT thereafter came up with a comprehensive draft guideline stating the circumstances when a company would be considered to have POEM in India. The provision is clearly aimed at Indian companies either trying to be foreign or parking money abroad. In the absence of CFC rules, the POEM guidelines also attempt to cover the companies parking passive income abroad. Thus a company undertaking active business outside India will not be covered. However, the test for finding out active income is rather complicated - the passive income must not be more than 50% of its total income and passive income includes, apart from items like royalty, interest etc., income from purchase and sale of goods from associated concerns. Following further conditions must be cumulatively satisfied: less than 50% of the company's total assets must be situated in India, less than 50% of its employees should be situated in India or resident of India and payroll expenses on such employees must be less than 50% of the total payroll expenses of the foreign company. If these conditions are satisfied then the company will not be treated as resident in India if the majority meetings of the Board of directors of the company are held outside India. If however, the Board merely rubber-stamps someone else's decision in India then the POEM will be in India.

For companies not engaged in active business, the guiding factor seems to be the factual determination of where the key commercial and management decisions necessary for the conduct of the business as a whole are taken. If the same were done in fact by the Board Of Directors, then the place of such meetings would be considered the POEM. In case of delegation of authority to an executive committee of key decisions, the location of such committees may be the POEM. The draft guidelines also say that the location of the head office may also be considered the POEM in certain circumstances. It also lists certain factors that are not relevant for determination of the POEM.

While the guidelines seem to be quite comprehensive, there are a few problems. First, in some places, the guidelines seem to make a new law, for example in the area of deeming passive business. The guidelines also seem to put the burden on the taxpayer to show that it is engaged in active business. Honorable though the intentions are, question may be asked as to whether the language of the section itself authorizes what may amount to a new legislation.

Secondly, the phrase 'place of effective management' has been judicially noticed. The AAR in a number of cases involving India-Mauritius treaty particularly P-9 of 1995, P-10 of 1996, DLJMB Mauritius Investment Company had the occasion to consider the meaning of the term 'place of effective management' in the treaty context and according to the AAR, the term refers to the place from where, factually and effectively, the day-to-day affairs of the company are carried on and not to the place in which may reside the ultimate control of the company. By ultimate control in these cases, the AAR meant the shareholder control. It does not seem that there are any challenges to these findings. The Tribunal in the case of Integrated Container Feeder Service also took the same view in the context of article 8 and held that the POEM was not in Mauritius even when Board meetings were held in Mauritius. Thus while these cases talk of day-to-day affairs, the guidelines seems to give primacy to the control exercised by the Board of Directors.

Thirdly, in relation to the OECD Commentary that POEM is the place 'where key management and commercial decisions that are necessary for the conduct of the entity's business as a whole, are, in substance, made', India had stated its position in no uncertain terms as follows: "India does not adhere to the interpretation given in paragraph 24 that 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 as a whole are in substance made. It is of the view 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." Having bodily lifted the sentence from the OECD Commentary, it may be now difficult to assert otherwise.

Ironically, the OECD itself is now having doubts about the effectiveness of POEM. There is also no consensus even among OECD countries as to what exactly is the place of effective management- is it the top level management by Board of directors or is it management by a supervisory body as found in Continental Europe or is it shop floor management? The Indian position on the OECD Commentary also took the same position.

In the context of preventing abuse of tax treaties under action 6, the OECD now proposes to change both article 4 and the Commentary. The final document on Action 6 points out that although situations of double residence of entities other than individuals were relatively rare, there had been a number of tax avoidance cases involving dual resident companies. Most probably the reference is here to the double Irish Dutch Sandwich situations. The OECD therefore concluded that a better solution to the issue of dual residence of entities other than individuals was to deal with such situations on a case-by-case basis and it proposes to delete the lines: "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 as a whole are in substance made. 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."

Therefore, although we may keep POEM as the criterion of corporate residence, its definition is what perhaps needs to be altered.

More importantly, we need to keep track of what is happening elsewhere. The USA that uses only the place of incorporation for determining corporate residency has now come up with a new weapon in its armoury to fight abuse involving corporate residency and that is known as the 'primary place of management and control'. This is found in some of its tax treaties (USA-Netherlands) in its LOB clause. Naturally, the same has also found place in the OECD paper on action 6. As explained in the paper, the concept of the primary place of management and control is different from the concept of the place of effective management as used in article 4 and refers to the place where the day-to-day responsibility for the management of the company (and its subsidiaries) is exercised. A company's primary place of management and control will be situated in the State of residence of that company only if the executive officers and senior management employees exercise day-today responsibility for more of the strategic, financial and operational policy decision making for the company (including direct and indirect subsidiaries) in that State than in the other State or any third State, and the staff that support the management in making those decisions are also based in that State. Thus, the test looks to the overall activities of the relevant persons to see where those activities are conducted. In most cases, it will be a necessary, but not a sufficient, condition that the headquarters of the company (that is, the place at which the chief executive officer and other top-level executives normally are based) be located in the Contracting State of which the company is a resident.

Accordingly, the definition proposed in the paper is as follows: "a company's "primary place of management and control" will be in the Contracting State of which it is a resident only if executive officers and senior management employees exercise day-to-day responsibility for more of the strategic, financial and operational policy decision making for the company (including its direct and indirect subsidiaries) in that Contracting State than in any other State and the staff of such persons conduct more of the day-to-day activities necessary for preparing and making those decisions in that Contracting State than in any other State." The USA may be the leading exporter of capital but it is second to none when it comes to defending its own taxing rights. It is therefore worth considering whether in view of the recent developments we should adopt this definition in our law as well.