The subject of this blog post is the Ministry of Finance’s Draft Guiding Principles for Determination of Place of Effective Management of a Company (“Draft Guidelines”), and their impact on the taxability of the gains made by offshore funds that have an onshore advisory/investment manager entity. The Draft Guidelines do not yet have the force of law, but they will most likely come into force (possibly in a modified form) after a public consultation.

The Income Tax Act, 1961 (“ITA”) decides whether an offshore company is ‘resident’ in India or not for tax purposes by looking at whether the company’s place of effective management (“POEM”) is in India. In the event an offshore company is deemed to be a ‘resident’ in India under the ITA, a ‘tie-breaker’ test will be triggered under the relevant double tax avoidance agreement (“DTAA” or “treaty”) to determine the offshore company’s treaty residency and thus, its eligibility for treaty protection. The ‘tie-breaker’ test used by India’s DTAAs with Mauritius, Singapore, Netherlands, Luxembourg etc., is also a POEM test – however, these DTAAs do not define the term ‘POEM’, but state that terms not defined in the DTAA will be given the meaning they have under the domestic law of the treaty partner state applying the DTAA, unless the context of the DTAA requires otherwise (emphasis added; each DTAA employs a slightly different formulation of this language).

Until 2015, the ITA’s definition of POEM was quite narrow, and offshore companies could easily avoid being found to have their POEM in India. The Draft Guidelines now propose to widen the ITA’s definition of POEM by putting in place an aggressive ‘substance-over-form’ test to determine an offshore company’s POEM, with the intent being to align the scope of the term under the ITA with its meaning under India’s tax treaties (where the term, though undefined, has been understood to have a wider scope). As per the Draft Guidelines, an offshore company’s POEM will be the place where the key management and commercial decisions of the entity’s business are, in substance, made. The Draft Guidelines also state that a de facto delegation of decision making authority by an offshore company’s board of directors will ordinarily result in the POEM being the place where the delegates of such authority make decisions.

In the context of offshore funds, this could be an issue because, while such funds may formally take investment decisions offshore, deal sourcing, evaluation, & negotiation, and numerous other important functions may be carried out by their affiliated onshore advisory entities. The Draft Guidelines give the Revenue the power to reject evidence such as board meetings held offshore, or other similar document trails, and instead look into the actual fact situations underlying the management of the offshore fund – such as the activities of its onshore investment advisory entity, to determine the offshore fund’s POEM. This can potentially expose an offshore fund to the risk of being deemed a ‘resident’ of India under the ITA, and possibly under the relevant DTAA as well – an undesirable tax outcome.

It must be added that the Draft Guidelines do contain a few safe harbours that might be utilized by offshore funds: for example, the Draft Guidelines propose that the existence in India of support functions that are preparatory and auxiliary in character will not be conclusive evidence that an offshore company’s POEM is in India.

There are other complications at play here: offshore funds always hold a tax residency certificate (“TRC”) from a treaty partner state. This is in part because the Supreme Court (“SC”), in the landmark Azadi Bachao Andolan v Union of India decision (“Azadi”) upheld the Central Board of Direct Taxes’ (“CBDT”) Circular No.789/2000 (“Circular 789”), which stated, inter alia, that a TRC is sufficient evidence of its holder’s residency in Mauritius, thus effectively providing that the treaty residency of Mauritian funds holding a TRC cannot be questioned by the Revenue (a proposition recently reiterated by the High Court of Punjab & Haryana in Serco BPO Private Limited v The Authority for Advanced Rulings). Interestingly while Azadi was pending before the SC in 2003, the CBDT, presumably in an attempt to strengthen the Revenue’s arguments before the SC, published another circular, Circular No.1/2003 (“Circular 1”) which seems to state that if an entity is found to be resident in both India and Mauritius (emphasis added), the TRC will no longer be the final word on such entity’s treaty residency, but the POEM test will be applied to determine the same.

While Circular 1 carries weight, at that time it did not really have teeth because the POEM concept under the ITA was not wide enough to capture offshore funds as residents in India. An illustrative case is an Income Tax Appellate Tribunal (“ITAT”) ruling from 2007, Saraswati Holding Corporation v DDIT: in this case, the Revenue tried to deny treaty benefits to a TRC-holding Mauritian company by applying Circular 1. The ITAT held that the Revenue first had to show that the Mauritian company was a resident in India by applying the POEM test as it then stood under the ITA, and observed that the POEM test under the ITA and the India-Mauritius DTAA are “materially different”. Upon finding that the Mauritian company was not ‘resident’ in India because its POEM was not in India, the ITAT allowed the Mauritian company to take the benefits of the India Mauritius DTAA.

Keeping the above paragraphs in mind, these are some issues to ponder:

i. Due to the Draft Guideline’s expansion of the POEM concept, Circular 1 may not so much gain teeth as grow fangs – the Revenue may now be able to apply Circular 1 on the back of a determination that a Mauritian company is resident in both India and Mauritius, and potentially render TRCs held by Mauritian funds ineffective. However, given the strong judicial support for Circular 789 and the proposition that a TRC-holding Mauritius based fund is a Mauritian resident for treaty purposes, and the fact that Circular 1 is largely untested, this is a grey area.

ii. While the ITA imposes a ban on ‘treaty override’ i.e., anti-abuse rules from domestic tax law prevailing over a DTAA, the expansion of the POEM concept in the ITA proposed by the Draft Guidelines may function as a ‘back door’ treaty override because DTAAs themselves provide that the meaning of the term POEM, for treaty purposes, is to be taken from domestic tax law. That said, it is not clear whether courts will interpret the words ‘place of effective management’, which is employed as a ‘tie-breaker’ in the

DTAAs, in line with the POEM concept under the ITA since the intent is quite different in each case; the words ‘unless the context requires otherwise’, or variations thereof found in DTAAs, may become significant.

Further, I would like to highlight two points regarding the policy choice of using the ‘substance-over-form’ approach in the Draft Guidelines. First, the yet-to-be-implemented General Anti Avoidance Rule, and the extant judicial anti avoidance rule both allow the Revenue to apply a ‘substance-over-form’ approach – however, if taxpayer can demonstrate that the structuring it has put in place has a commercial rationale, the Revenue will not be allowed to apply a ‘substance-over-form’ approach. In contrast, the Draft Guidelines do not limit the Revenue’s ability to apply the ‘substance-over-form’ approach if the taxpayer demonstrates a commercial rationale. Second, the ‘substance-over-form’ approach is a highly subjective one that is antithetical to a stated goal of tax policy: to ensure that taxpayers have a high degree of certainty regarding tax outcomes.

In conclusion, it is hoped that the Government will further the pro-funds industry thrust of the last Budget and provide a safe harbour from POEM risk to offshore funds that have onshore advisory/investment management entities when the final guidelines on POEM come out. In the event the Government chooses not to do so, the Revenue will gain one more tool in its arsenal to challenge the treaty residency of offshore funds that use favourable DTAAs to attain tax efficiency.