Draft modifications to tax provisions applicable to foreign companies with poem in India

Introduction

Finance Act 2016 replaced the test for corporate residency of foreign companies from “control and management being situated wholly in India” to “place of effective management (POEM) in India”. POEM has been defined to mean a place where key management and commercial decisions that are necessary for conduct of business of an entity as a whole are, in substance made.

As per section 115JH of the Income Tax Act, 1961 (IT Act), the Central Government has been empowered to notify exceptions, modifications and adaptations to the provisions of the IT Act relating to (a) computation of total income, (b) treatment of unabsorbed depreciation, (c) carry forward and set off of losses, (d) collection and recovery of taxes, and (e) special provisions relating to avoidance of tax, where a foreign company is said to be resident in India due to its POEM being in India for the first time and the said company has never been resident in India before. The Central Board of Direct Taxes (CBDT) has released a draft notification (Draft Notification) on 15 June 2017 setting out these exceptions, modifications and adaptations. Comments and suggestions have been invited from stakeholders and general public on the Draft Notification.

Draft Notification

The Draft Notification provides the following exceptions, modifications and adaptations:

I. Written Down Value (WDV) of depreciable assets:

In respect of depreciable assets, the opening WDV for the year (1 April to 31 March) in which the foreign company is deemed to be resident in India (Relevant Tax Year) shall be determined as follows:

1. If foreign company is assessed to tax in the foreign jurisdiction: WDV as per the tax records in the foreign jurisdiction as on the first day of the Relevant Tax Year.
2. If foreign company is not assessed to tax in the foreign jurisdiction: WDV as appearing in the books of accounts maintained in accordance with the laws of the foreign jurisdiction.

II. Brought forward loss or unabsorbed depreciation:

The losses and unabsorbed depreciation brought forward as on the first day of the Relevant Tax Year shall be allowed to be set off and carried forward in accordance with the provisions of the IT Act and will be determined as follows:

1. If foreign company is assessed to tax in the foreign jurisdiction: Brought forward loss or unabsorbed depreciation as per the tax records of the foreign company in the foreign jurisdiction, determined on a year wise basis as on the first day of the Relevant Tax Year.
2. If foreign company is not assessed to tax in the foreign jurisdiction: Brought forward loss or unabsorbed depreciation as per the books of accounts of the foreign company which are prepared in accordance with the laws of the foreign jurisdiction shall be determined on a year wise basis as on the first day of the Relevant Tax Year.

III. Accounting year of the foreign company (Accounting Year) being different from the taxable period under the IT Act viz. 1 April to 31 March (Tax Year)

1. Preparation of financial statements (i.e. profit and loss account and balance sheet):

• Where the Accounting Year of the foreign company preceding the Relevant Tax Year does not end on 31 March, it would be required to prepare financial statements for the period following the end of the last Accounting Year to 31 March immediately preceding the Relevant Tax Year.

For instance, if the Accounting Year is 1 January to 31 December, and the foreign company is deemed to be a resident in India for the Tax Year 2016-17, the foreign company would be required to prepare financial statements for the period from 1 January 2016 to 31 March 2016.

• In addition, the foreign company would be required to prepare financial statements for the subsequent Tax Years (i.e. 1 April to 31 March) till the time that such foreign company continues to be a resident in India.

b. Financial statements for the purpose of carry forward of loss:

• Where the period for which financial statements are prepared as per a) above is less than six months: Such period shall be included in the Accounting Year preceding the Accounting Year in which the foreign company is deemed to be a resident in India.

For instance, if the Accounting Year is 1 January to 31 December, and the foreign company is deemed to be a resident in India for the Tax Year 2016 -17 (i.e. Accounting Year 2016) then the relevant period would be 1 January 2015 to 31 March 2016.

• Where the period for which financial statements are prepared as per a) above is six months or more: Such period shall be treated as a separate Accounting Year.

For instance, if the Accounting Year is 1 July to 30 June, and the foreign company is deemed to be resident in India for the Tax Year 2016-17, then the relevant period would be 1 July 2015 to 31 March 2016.

IV. Provisions relating to withholding of taxes

1. The provisions applicable to a “foreign company” shall apply if more than one withholding tax provision of the IT Act is applicable to the foreign company due to its dual status as a “foreign company” as well as that of a “resident of India”.

For instance, as per Section 195 of the IT Act, withholding tax obligation arises in relation to payments made to a non-resident (not being a foreign company) or a foreign company. Further, as per some other provisions such as Section 194J of the IT Act, certain payments made to persons who are residents of India attract withholding tax. Thus, to address the potential overlap, it is clarified that the provisions dealing with payments to a “foreign company” shall be attracted, and therefore, tax is to be withheld in accordance with the provisions of Section 195 of the IT Act using the rates prescribed for foreign companies; and not under the other provisions which are applicable to payments to residents.

1. The opportunity available to a payer of any sum to a non-resident to make an application for a lower / “nil” withholding tax order shall also be applicable for any payments made to a foreign company who is deemed to be a resident in India due to its POEM in India.

V. Relief / Deduction of taxes paid outside India:

A foreign company deemed to be resident in India shall be entitled to relief or deductions of tax paid in offshore jurisdictions in accordance with the relevant provisions of the IT Act.

VI. Rate of exchange for conversion of foreign currency into Indian Rupees:

The rate of exchange for the conversion of income earned in foreign currency into INR, shall be in accordance with the provisions of Rule 115 of the Income Tax Rules, 1962.

VII. Tax status as a foreign company

Subject to the provisions of the Draft Notification, a foreign company shall continue to be treated as a foreign company for tax purposes, irrespective of the fact that it is deemed to be a resident in India, on account of its POEM being in India. Accordingly, the provisions which are applicable to a “foreign company”, shall continue to be applicable to such a foreign company. This means that, inter alia : (a) the general corporate tax rate applicable to a foreign company viz. 40% shall apply to the global income of a foreign company which is deemed as a resident of India; and (b) the special tax rates applicable to a foreign company such as in case of income in the nature of long term capital gains shall continue to apply (viz. 10% in case of unlisted shares instead of 20% applicable to residents).

The Draft Notification (once finalized) shall be applicable from the Tax Year beginning 1 April 2016.

Comment

While the Draft Notification clarifies certain aspects, it is silent on some critical aspects such as applicability of “special provisions relating to avoidance of tax” which include transfer pricing provisions and the newly introduced thin capitalisation norms. Though the Draft Notification mentions that the transactions undertaken by a such a foreign company which has become resident in India due to its POEM being in India, with any other person would not be altered only on the ground that the said company has turned resident, it is not expressly clear if the transfer pricing regulations would continue to apply to such transactions (where other triggers of transfer pricing rules are fulfilled). Note that the transfer pricing provisions apply to transactions between “associated enterprises” either or both of whom are “non-residents”. Thus, a foreign company which is deemed as an Indian tax resident entering into transactions with other residents may technically not attract transfer pricing provisions. It is a ‘resident’ though continues to be a “foreign” company. Further, the Draft Notification deals with preparation of financial statements for the specific purpose of arriving at WDV, losses and unabsorbed depreciation. However, aspects such as applicability of Minimum Alternate Tax (MAT) being the minimum tax payable based on book/ accounting profits (after prescribed adjustments) and the basis for computation of such book profits for the purposes of MAT are unclear. Where a foreign company has been subject to withholding tax as per rates prescribed under section 115A (which prescribes special rates for certain income streams such as interest, royalty fees for technical services), it needs to be clarified whether such income of a foreign company having POEM in India will still be subject to the general corporate tax rate of 40% applicable to a foreign company as a part of its total income.

The rigors of POEM related provisions could be far reaching and hence, one expects the implementation of this law to be as unambiguous as possible so that the taxpayer is not unnecessarily burdened.