The residential status of a company plays a critical role in determining the scope of its tax liability under the Income Tax Act. Whether a company is considered resident or non-resident in India directly affects how much of its global income is subject to taxation in India. This distinction is essential for both domestic and foreign corporations operating or investing in India.
Statutory Framework for Determining Residential Status
Section 6(3) of the Income Tax Act lays down the rules for determining the residential status of a company. The residential status is based on whether the company is incorporated in India or abroad and, in the case of foreign companies, where its place of effective management is located during the relevant previous year.
Indian Company and Its Residential Status
As per Section 6(3)(i), an Indian company is always considered a resident in India. This classification holds true regardless of the location of its shareholders or the control over its business operations. Even if more than 51 percent of the voting power is held by non-residents or if the business is managed entirely from abroad, the Indian company is still deemed to be resident in India for tax purposes. The statutory provision ensures that the residential status of an Indian company is not subject to factual analysis but is determined solely based on its place of incorporation.
Foreign Company and Place of Effective Management
Section 6(3)(ii) deals with the residential status of foreign companies. A foreign company is considered resident in India if its place of effective management during the relevant previous year is in India. The determination of the place of effective management, commonly referred to as POEM, depends on where the key management and commercial decisions necessary for the conduct of the business as a whole are made in substance.
Threshold for Applicability of POEM Test
The POEM test under Section 6(3)(ii) does not apply to foreign companies with turnover or gross receipts not exceeding Rs. 50 crore in a financial year. This exclusion is intended to reduce the compliance burden on smaller foreign entities. Such companies are automatically classified as non-residents in India and are not subject to the POEM analysis, regardless of where the management decisions are made.
Definition and Meaning of POEM
The concept of POEM is rooted in international taxation principles and emphasizes substance over form. According to the guidelines issued in Circular No. 6 of 2017, POEM refers to the place where key management and commercial decisions that are essential for the conduct of the entity’s business as a whole are made. A company may have multiple places of management, but it can have only one place of effective management at any given time. Determination of POEM must be carried out on a year-to-year basis, depending on the specific facts and circumstances of each case.
Active Business Outside India
The determination of POEM involves checking whether the company is engaged in active business outside India. If a foreign company qualifies as being engaged in such business, and the majority of its board meetings are held outside India, then the place of effective management shall be presumed to be outside India.
Criteria for Active Business Outside India
A company is considered to be engaged in active business outside India if it satisfies the following conditions. Its passive income must not exceed 50 percent of its total income. Less than 50 percent of its total assets should be located in India. Less than 50 percent of its employees should be situated in India or be residents of India. Payroll expenses on employees located in India should be less than 50 percent of the total payroll expenditure. The term passive income refers to income from associated enterprise transactions involving both the purchase and sale of goods, and also includes royalty, dividend, capital gains, interest, or rental income. However, in the case of a company engaged in banking or registered as a public financial institution, interest income shall not be considered passive.
Board of Directors Standing Aside
The POEM may be deemed to be in India if the board of directors of a foreign company merely acts as a rubber stamp and does not exercise its powers of management. If key managerial decisions are being made by a holding company or individuals resident in India, then the POEM will be considered to be in India. However, the mere adherence by the board to global policies laid down by the parent group in areas such as payroll, accounting, human resources, or IT infrastructure does not amount to the board abdicating its powers.
Cases Requiring Two-Stage POEM Test
In situations where a company is not engaged in active business outside India, a two-stage process is applied to determine POEM. The first stage involves identifying the individuals or entities who make the key management and commercial decisions for the company as a whole. The second stage involves determining where these decisions are made. The place where decisions are implemented is irrelevant; what matters is where they are substantively taken.
Guiding Principles for Determining POEM
Several guiding principles have been laid out to help determine the POEM of a company. If the board of directors regularly meets and exercises decision-making authority, the location of these meetings may indicate the company’s POEM. If the board merely ratifies decisions made by senior management or others, then the POEM lies where those decisions are made. If decision-making authority has been delegated to committees such as executive teams, the location of those committees becomes critical. The head office location, where key company decisions are made, is another important factor. Use of modern communication technologies has blurred geographical boundaries, so the location of directors’ or decision-makers’ residence may also become relevant. Decisions reserved for shareholders under company law, such as the sale of all assets or liquidation, are not relevant for POEM. Routine decisions by junior and middle-level management are also not relevant.
POEM Not Based on Isolated Facts
POEM cannot be determined based on isolated indicators. For example, the fact that a foreign company is owned by an Indian company, or that it has a permanent establishment in India, or that some of its directors reside in India, is not conclusive proof of POEM being in India. Similarly, having support functions or local management for limited activities in India does not suffice to establish POEM in India. A holistic assessment of all relevant facts related to management and control must be undertaken to determine POEM.
Approval Process for POEM-based Classification
In cases where the Assessing Officer intends to treat a foreign company as resident in India based on POEM, prior approval must be obtained from a collegium of three Principal Commissioners or Commissioners. This collegium is constituted by the Principal Chief Commissioner of the concerned region. The foreign company must also be allowed to be heard before any such classification is finalized. This procedural safeguard ensures that the determination of POEM is carried out fairly and with due consideration.
Significance of Case Studies in Determining Residential Status
Practical case studies provide clarity on the application of legal provisions. For example, an Indian company remains resident in India even if it is entirely controlled from abroad or if all its shareholders are foreign. Similarly, a foreign company incorporated in Mauritius with a turnover above Rs. 50 crore and having a POEM outside India will be considered a non-resident. A foreign company with a turnover below Rs. 50 crore is automatically treated as non-resident. If the senior management of a foreign company is based in India and key decisions are made there, POEM may be considered to be in India, thereby altering the residential status. These examples highlight the factual complexity involved in POEM determination.
Incidence of Tax under the Income Tax Act
The extent to which income is taxed in India depends not just on the nature of the income but also on the residential status of the taxpayer. Section 5 of the Income Tax Act lays down the basis of chargeability, indicating that residential status plays a pivotal role in determining whether an income is taxable in India. In the case of companies, especially foreign entities, it becomes crucial to establish whether they are residents or non-residents to assess the scope of their tax liability.
Understanding Indian Income
Indian income refers to income that either arises or is received in India. It includes income that is both received and accrued in India, as well as income that is received in India but accrued abroad. It also includes income that accrues in India but is received abroad. These different combinations help define the scope of Indian income for the purpose of taxation.
If income is received in India during the previous year and is also accrued in India during the same year, it is Indian income. Similarly, if the income accrues outside India but is received in India during the year, it is still treated as Indian income. Finally, income received abroad but deemed to accrue or arise in India also falls under the definition of Indian income. Thus, the place of accrual and the place of receipt both contribute to determining whether an income is Indian in nature.
Understanding Foreign Income
Foreign income, in contrast, refers to income that is neither received in India nor deemed to be received in India, and also does not accrue or arise in India or is not deemed to accrue or arise in India. For income to qualify as foreign, it must satisfy both these conditions. It must be generated outside India and must also be received outside India.
Foreign income is only taxed in the hands of residents. It is not taxed in the hands of non-residents. For a foreign company that is treated as a non-resident in India, only the Indian income is taxable. All foreign income remains outside the purview of Indian taxation unless the foreign company is classified as a resident based on its POEM.
Taxability Based on Residential Status
The scope of total income taxable under the Act depends significantly on the residential status. For companies that are resident in India, their global income is taxable in India. This includes both Indian and foreign income. For non-resident companies, only income that is received in India, deemed to be received in India, accrues in India, or is deemed to accrue in India, is taxable.
The taxation matrix is relatively straightforward. Indian income is always taxable in India, irrespective of whether the company is resident or non-resident. On the other hand, foreign income is taxable only in the hands of companies that are resident in India. This clear distinction has a direct impact on the tax planning and compliance obligations of multinational companies operating in or outside India.
Classification of Income under Section 5
The classification under Section 5 into Indian and foreign income provides the basis for assessing the tax incidence. It focuses on the origin and flow of income to determine its nature. For example, a dividend received from a foreign subsidiary by a resident company is treated as foreign income and becomes taxable in India. The same dividend, if received by a non-resident company, is not taxed in India, assuming it does not fall within the deeming provisions.
It is also important to note that certain types of income, though arising abroad, may be deemed to accrue in India based on specific provisions in the Act. Examples include fees for technical services or royalties paid by a resident in India to a non-resident. These deeming provisions ensure that income connected with India does not escape taxation merely due to its foreign origin.
Receipt of Income and Its Tax Relevance
Receipt of income is another factor influencing taxability. Income received in India is always taxable, whether by a resident or a non-resident. The moment an amount comes under the control of the recipient in India, it is considered received. Even if the income was first received abroad and later remitted to India, the remittance is not treated as a second receipt. The first receipt is the only point of taxability under the head of received income.
The Supreme Court in the case of Keshav Mills Ltd. clarified that once income is received by a person outside India and later brought into India, it does not qualify as received income again in India. Instead, it is merely a transfer or remittance of funds. This principle helps distinguish between actual receipt and subsequent remittances.
Deemed Receipt of Income
The Act also provides for certain incomes to be deemed to be received in India, even if they are not physically or directly received. Examples of such incomes include annual accretions to recognised provident fund accounts, excess contributions to provident funds by employers, and government contributions to pension schemes under Section 80CCD. Additionally, any transfer balances, tax deducted at source, or deemed profits under Section 41 also fall under this category.
Such income, though not received in cash, is considered constructively received by the assessee and becomes taxable in the relevant year. The concept of deemed receipt widens the tax base and ensures that income attributable to Indian sources is taxed appropriately.
Income Received in Kind
Income need not be received in cash to be taxable. If it is received in kind, such as rent-free accommodation, vehicles, or any perquisite, it is still taxable under the relevant head of income. For example, a free residential house provided to an employee is treated as salary and taxed accordingly, even though there is no cash flow. This concept underscores the substance-over-form principle in Indian tax law.
Income Accruing in India
Income accruing or arising in India is chargeable to tax in the hands of both residents and non-residents. The terms accrue and arise refer to the right to receive income. Income is said to accrue when the right to receive it becomes vested in the assessee. The actual receipt may happen later, but the accrual creates the tax liability.
For instance, if a foreign company renders consultancy services to an Indian company and becomes entitled to payment, the income accrues in India even if payment is received later. The right to receive such income triggers taxation in India under the accrual concept. This principle ensures that income derived from Indian sources is taxed at the point of accrual and not deferred until receipt.
Importance of Source and Situs of Income
The source of income plays a crucial role in determining its taxability. Income is generally taxable in the jurisdiction where it is sourced. For example, business income arising from a contract executed in India is taxable in India. Similarly, salary for services rendered in India, rent from Indian properties, and capital gains from transfer of assets located in India are all considered Indian income.
The situs of income, or the place where the income is situated, can be determined based on various factors such as the location of the asset, the place of activity, the place of payment, or even the residence of the payer. In many cases, determining the situs requires careful examination of contractual terms and the flow of value in a transaction.
Interaction between Tax Treaties and Domestic Law
In cases involving foreign companies, the provisions of Double Taxation Avoidance Agreements (DTAAs) also come into play. A company may be treated as a resident under Indian law but could be treated differently under a treaty. In such situations, the company is entitled to apply the provisions of the Act or the treaty, whichever is more beneficial.
Most DTAAs provide for tie-breaker rules to determine the tax residence in cases of dual residency. These may include factors such as the place of incorporation, the place of effective management, or even mutual agreement between competent authorities. Accordingly, even though a company may be resident under the domestic law, it may still claim relief under a treaty if it qualifies as a resident of another country under treaty provisions.
Tax Incidence based on Residential Status
Once the residential status of a company has been determined, the next important aspect is understanding the tax incidence, i.e., the scope of income that becomes taxable in India based on whether the company is a resident or a non-resident.
Scope of Total Income for a Resident Company
A company that is resident in India is liable to pay tax on its global income. This means that:
- Income earned or accrued in India is taxable.
- Income deemed to accrue or arise in India is taxable.
- Income earned or accrued outside India is also taxable.
This comprehensive tax base ensures that resident companies report and pay taxes on income earned anywhere in the world. They may, however, avail themselves of relief under Double Taxation Avoidance Agreements (DTAAs) to avoid being taxed twice on the same income in two different countries.
Scope of Total Income for a Non-Resident Company
A company that is not a resident in India is taxed only on the income that:
- Is received or is deemed to be received in India, or
- Accrues or arises or is deemed to accrue or arise in India.
In simpler terms, non-resident companies are taxed only on income that has a direct nexus to India. This could include:
- Income from business connections in India.
- Capital gains arising from the transfer of assets situated in India.
- Fees for technical services or royalties paid by Indian residents.
- Interest income from Indian entities.
Taxable Categories of Income
The Income Tax Act classifies income under various heads for tax purposes. The taxability of these heads also depends on the residential status of the company:
Income from Business or Profession
- For resident companies: Global business income is taxable.
- For non-resident companies: Only income arising through a business connection or a permanent establishment in India is taxable.
Income from House Property
- Resident companies are taxed on all income from house properties owned globally.
- Non-resident companies are taxed only on income from properties situated in India.
Capital Gains
- Resident companies are taxed on all capital gains, irrespective of where the asset is located.
- Non-resident companies are taxed only on capital gains arising from the transfer of capital assets located in India.
Income from Other Sources
This head includes interest, dividends, royalties, and fees for technical services.
- Resident companies: Global income under this head is taxed.
- Non-resident companies: Tax applies only if the income is received in India or is deemed to accrue or arise in India.
Illustrative Examples
Example 1: Resident Company
XYZ Pvt. Ltd., incorporated in India, earns:
- ₹50 lakhs from sales in India.
- ₹30 lakhs from exports to the UK.
- ₹20 lakhs as investment income from foreign assets.
Since it is a resident company, all ₹100 lakhs will be taxable in India.
Example 2: Non-Resident Company
ABC Ltd., incorporated in the US, earns:
- ₹40 lakhs from a project executed in India.
- ₹25 lakhs from sales in the US.
- ₹10 lakhs from dividends received from an Indian company.
Only ₹50 lakhs (₹40 lakhs from the project and ₹10 lakhs from dividends) is taxable in India, since the other income is foreign-sourced.
Role of Double Taxation Avoidance Agreements (DTAAs)
To prevent the same income from being taxed twice (once in India and once in the home country), India has DTAs withed DTAswith several countries. Key aspects include:
- Relief from double taxation.
- Reduced rates of tax on certain income (like interest, royalties).
- Conditions for claiming tax credits.
DTAAs are especially relevant for non-resident companies tareree otherwise exposed to Indian tax on their India-linked income.
Importance of Accurate Determination
Given the stark difference in tax incidence between resident and non-resident companies, it is critical that companies:
- Correctly determine their residential status.
- Maintain documentation to support their central management and control.
- Structure cross-border operations with tax implications in mind.
Failure to determine the correct residential status can lead to penalties, tax litigation, or unintended tax liabilities.
Recent Developments and Judicial Interpretations
Over the years, there have been significant developments in how the residential status of a company is interpreted under the Income Tax Act. Judicial rulings, CBDT clarifications, and legislative amendments have all contributed to shaping the understanding of what constitutes “control and management” and how the Place of Effective Management (POEM) is to be determined.
Judicial Precedents on Control and Management
Judicial pronouncements have historically played an important role in interpreting the phrase “control and management wholly situated in India.” Some notable principles laid down by courts include:
- If a company’s key decisions are taken outside India, then the company may not be a resident, even if some routine operations are carried out in India.
- A company is treated as having its control and management in India only when its head and brain—the decision-making authority—lies in India.
- Board meetings held in India alone do not necessarily make a company resident unless actual strategic control is exercised within India.
These interpretations emphasize substance over form, focusing on where genuine decision-making takes place rather than merely relying on procedural elements.
CBDT Guidance on POEM
To help companies and tax authorities understand how to apply the POEM test, the Central Board of Direct Taxes (CBDT) issued a set of guiding principles in 2017. Key points include:
- Active Business Outside India (ABOI) test: If a company is engaged in active business outside India, its POEM shall be presumed to be outside India unless it is established that the company is controlled from India.
- The location of board meetings, the role of Indian residents in decision-making, and the existence of group structures are all considered while evaluating POEM.
- The approach is to assess the substance of control rather than mere legal formality.
The guidelines provide operational clarity and help reduce litigation by establishing standard practices for evaluation.
Implications for Multinational Companies
The residential status rules and POEM provisions are especially relevant for multinational companies operating in or through India. These companies must carefully assess whether:
- Strategic decisions for Indian subsidiaries or group entities are made in India.
- There are Indian residents on the boards of foreign companies with significant decision-making powers.
- There is a central group structure that controls entities spread across multiple countries in India.
In cases where POEM is deemed to be in India, even foreign-incorporated companies may become Indian residents and face taxation on their global income.
Tax Planning and Compliance Considerations
Companies, especially those with cross-border operations, must undertake careful tax planning to ensure they comply with residential status rules without unnecessarily increasing their tax burden. Some key strategies include:
- Maintaining clear documentation of where key decisions are made.
- Separating Indian operations from global strategic control.
- Avoiding overlapping roles for Indian executives in foreign companies.
- Reviewing board resolutions, meeting locations, and management hierarchies.
Proper structuring can help companies avoid being deemed residents of India under the POEM rule while maintaining compliance with global tax obligations.
Penalties for Misreporting Residential Status
Incorrect determination or misreporting of a company’s residential status can have severe tax consequences, including:
- Taxation of global income in India for companies wrongly treated as non-residents.
- Imposition of interest and penalties for concealment of income.
- Transfer pricing scrutiny for transactions between associated enterprises.
- Reputational damage and increased regulatory scrutiny.
To mitigate these risks, companies must ensure accurate tax filings and proactive legal compliance with residential status guidelines.
Conclusion
The concept of residential status of a company is fundamental under the Income Tax Act, as it directly determines the extent of income liable to tax in India. The transition from a simple test of control and management to the nuanced POEM test reflects the evolving complexity of global business structures. For resident companies, taxation is on global income, while for non-resident companies, only India-linked income is taxable. With increasing cross-border operations, it has become crucial for companies to analyze their operational structure, board compositions, and decision-making patterns to correctly determine residential status and align their tax strategies accordingly. Judicial interpretations and regulatory guidelines further reinforce the need for companies to approach the determination of residential status with transparency, substance, and legal diligence.