This excellent article was contributed by Ajay Kumar and Richa Sawhney.
The article elaborates on the following observations, which should be considered for General Anti-Avoidance Rules (GAAR) worldwide:
From a Best Practices perspective, the observations and prior postings should be reviewed to develop Best Practices for future challenges.
With the release of GAAR Rules (Rules) in September 2013 by the Central Board of Direct Taxes (CBDT), India looks set to implement its statutory General Anti Avoidance Rule (GAAR). GAAR provisions were inserted in the Income-tax Act, 1961 (IT Act) by Finance Act, 2012 and would be effective in relation to incomes arising on or after April 1, 2015. Earlier this year, several changes were made in the GAAR provisions by Finance Act 2013. These changes were made based on the recommendations of the Committee set up under the chairmanship of Dr. Parthasarthi Shome (Shome Committee). While it looks as if GAAR implementation is some time away, MNCs in particular need to consider the impact, as the GAAR Rules provide for limited grandfathering.
This Article covers 10 major features of how the Indian GAAR is expected to work and the areas foreign investors need to focus on.
1. Main Purpose
GAAR would be invoked in case of “impermissible avoidance arrangements”. An impermissible avoidance arrangement refers to an arrangement whose main purpose is to obtain a tax benefit. Further in addition to the main purpose one of the four supplementary tests[i] is also required to be met.However where the main purpose is established to be non tax then one is not required to prove that none of four supplementary tests are met.
The term “main purpose”, the touchstone of GAAR, is not defined. So how does one compare “non tax purpose” with “tax benefit purpose”. There could be several purposes/objectives in an arrangement some may be amenable to quantification and it may not be possible to do so in case of others.
Given that GAAR by definition cannot be completely objective, it is extremely important for the taxpayer to document all the factors that were considered to conclude the main purpose. In our view one should document the all objectives behind any arrangement, options evaluated and the basis of selection or rejection of the options considered. The minutes of Board or Committee meetings, profitability projections and feasibility studies could help substantiate the taxpayers claim. Given that guidance will evolve overtime, one should start documenting business advantages alongside the tax advantage of the options considered, particularly in those situations where the tax benefit will accrue over several years.
In our view unless it is a case of pure sham transaction, in most of the cases, it should be possible for the tax-payer to establish that business and commercial reasons outweigh the tax reasons. This could in effect be the potent weapon to counter GAAR.
2. Tainted Elements
The secondary or the supplementary tests, often called the tainted elements are the next important aspect one must be familiar with. Once the main purpose is found to be tax benefit, GAAR provisions will apply only and only if any one of the following tests are met:
(a) The dealings between parties is not at arm’s length,
(b) There is lack of bonafide purpose,
(c) There is misuse or abuse of the provisions of the IT Act,
(d) There is lack of commercial substance.
Except in case of commercial substance where some sort of guidance is provided under the law, there is no guidance available on the parameters for fulfilment/non fulfilment of these tests. The matter is entirely left to the discretion of the tax authorities. To make matters a bit simpler Shome Committee had recommended that at least arm’s length test should be examined only in cases not covered by Transfer Pricing. However it has not been included in the Rules so far.
A plain reading of the GAAR provisions suggests that lack of bonafide purpose test is considered met if an arrangement is entered into, or carried out, by means or in a manner, which are not ordinarily employed for bona fide purposes. As the language suggests, it is more of a manner test rather than a purpose test. So one can only anticipate trouble if the tax officer feels that the arrangement appears to be too complicated and what is sought to be achieved could have been accomplished in a simpler manner. The taxpayer may also have to explain if there is any reason apart from tax reason to justify what might appear to the tax officer as superfluous steps.
As far as the misuse and abuse test is concerned, the question is does it mean the contextual or purposive interpretation of provisions of the IT Act i.e. what was the backdrop in which a particular provision was introduced, what mischief it wanted to remedy, what loophole in law was intended to be covered or the purpose and spirit behind the enactment. In some cases the government does come up with clarificatory Circulars and Memorandum explaining provisions inserted in the law from which this intent can be gathered, but they are not exhaustive. In light of the above, it can be very difficult to analyse and apply misuse/abuse test where the rationale of provisions are not outlined by the government.
3. SAAR v. GAAR – Simultaneous applicability
The IT Act contains several Specific Anti Avoidance Rules (SAARs)[ii]. They target specific areas of tax avoidance. In case of conflict between general provisions and specific provisions courts in India have laid down than specific provisions overrule general provisions. Departing from this maxim the GAAR provisions state that GAAR would to apply” in addition to, or in lieu of, any other basis of determination of tax liability”.
The Shome Committee had recommended that for the sake of clarity and certainty, in case SAAR is applicable in any particular situation then GAAR should not be invoked in that case. The government had a different view. It was indicated that if in situation both GAAR and SAAR are applicable, guidelines would be made to clarify that only one of them will apply. The existing Rules do not deal with this issue.
4. GAAR override on Treaty
The provisions lay down that in situations where GAAR is invoked any Tax treaty benefits claimed by the taxpayer would be denied.
Consider a case where in GAAR is invoked and the undesirable tax advantage being claimed by the taxpayer is denied. Now post this treatment by the tax authorities, the impermissible avoidance agreement can no longer be considered impermissible. One would want to know if Tax treaty benefit is still not available for this “treated” arrangement. Say in case GAAR is invoked and part of the equipment price paid to the foreign parent gets re-characterised as Royalty. Now in such situations after the tax consequences have been determined under GAAR, would the beneficial withholding tax of 10% provided in the Tax treaty apply to such Royalty or withholding @ 25% specified under the IT Act would have to be carried out.
Another related issue arises in case of Tax treaties which have anti- avoidance provisions in form of Limitation of Benefits (LoB) clause, say the India- Singapore Tax treaty. The Shome Committee was of the view that GAAR should not be invoked to deny Tax treaty benefit in case the Tax treaty itself has a LoB clause. Cases of avoidance in such cases, should be left to be dealt by the LoB clause. If need be, i.e. the LoB clause fails to deliver, the Government should look at re-negotiating the Tax treaty. However the GAAR Rules and law are silent on this point. Hence MNCs should be ready to subject themselves to additional GAAR tests even though they may otherwise fulfil LoB tests given under the relevant Tax treaty.
5. Applicability to existing investments/structures
Immunity has been provided only to income from transfer of investments made before August 30, 2010, i.e. date of introduction of Direct Taxes Code Bill 2010. Hence even if the same structure or arrangement is used by the taxpayer to route further investments post August 31, 2010 that would be subject to GAAR tests.
All the other existing and proposed arrangements will be subject to GAAR tests. In the context of investments from Mauritius, Singapore, Cyprus etc. made before August, 30 2010, income from transfer of such investments will continue to enjoy Tax treaty benefits without having to go through the rigours of GAAR. But where there is other income accruing on such investments e.g. interest income earned on Compulsory Convertible Debentures it will be subject to GAAR test even though such investments were made before August 30, 2010.
6. When can one apply for Advance Rulings
Under the GAAR regime, the taxpayer can obtain Rulings in advance, as regards applicability of GAAR on the specifics of their case. The Authority for Advance Ruling (AAR) could be approached for such Rulings. Further,though the GAAR provisions do not provide any immunity to arrangements proposed to entered into before April 1, 2015, one can approach the AAR for a Ruling only after March 31, 2014. Given the current backlog of applications pending at AAR, one can only expect to see such Rulings coming out around December 2014. In essence, the point is that the MNCs will have limited time to make their arrangements GAAR compliant, before GAAR provisions kick off in April 2015.
7. Safe harbors
The current provisions do not contain any other safe harbors except the monetary threshold.
The Rules stipulate that GAAR will apply if the tax benefit is more than INR 3 crore (equivalent of US$ 500000) in a financial year after taking into account all parties to an arrangement. The other way to look at it is that given the corporate tax rate is 30% and capital gains rate is 10%, or 0% in case of listed securities, it is only small value transactions which will be out of the purview of GAAR. In case of tax deferral ShomeCommittee had suggested that the tax benefit amount should be worked out on the basis of present value of money, taking the interest rate as that applicable for shortfall of taxes. The Rules are silent on this aspect.
Though from the legislative intent of GAAR provisions[iii] it appears that GAAR would target only aggressive tax planning through use of sophisticated structures, clarity on use of fiscal incentives provided under the IT Act would have been really appreciated. In fact the Shome Committee, taking into account the concerns of stakeholders had recommended that cases of selection of one of the options provided under law such as purchase v. lease, dividend v buyback, funding through debt or equity, timing of a transaction in case of capital gains, mergers and amalgamation approved by Court should be clearly out of the purview of GAAR. It was felt that considering India does not have Thin Cap Rules yet, choice of funding either through debt or equity should be left to the taxpayer and tax officer should not question it. However the Rules are silent on this aspect.
8. Wide powers conferred on Tax Authorities
Wide powers have been conferred on the tax authorities to nullify the tax benefit being sought by the taxpayer. This includes lifting of corporate veil, clubbing or disregarding entities, treating capital receipts as revenue, debt as equity etc. Here again it can be seen that the power of re-characterization of debt into equity has been given, despite the absence of any formal Thin Cap Rules in India. However, the tax officer who issues a notice alleging that GAAR should apply to an arrangement has to provide detailed reasoning behind his belief.
The other major safeguard is that a GAAR Panel which would comprise a High Court Judge, Chief Commissioner of Income-tax and a Scholar of repute would review the cases. The directions issued by this Panel would be binding on taxpayer and tax authorities. Time lines have also been laid down for each step in this process.
9. Compensatory Adjustment
If GAAR gets invoked in case of one party to an arrangement; there is no provision to effectuate any compensatory adjustment in respect of other parties to the arrangement.
Let us consider a situation where Company A makes interest payment to Company B. Let us now assume that GAAR gets invoked in this case and the payment gets re-characterised as dividend. Company A would now be required to pay dividend distribution tax (DDT) on the same. Now the question is, should this be treated as dividend in the hands of Company B and be taken to be tax exempt or should it be continued to be taxed as interest. Under the current GAAR provisions it would continue to be taxed as interest. The intent is to ensure that GAAR does not lose its deterrent value. The government has however indicated that the same income would not be taxed twice in the hands of one taxpayer because of GAAR adjustments.
10. GAAR on FIIs
As per the Rules, GAAR provisions would not be applicable in case of FIIs registered with Securities Exchange Board of India (SEBI) which are not availing any Tax treaty benefit. Further, investment made by non-resident investors in FIIs, whether by way of offshore derivate instruments or otherwise, either directly or indirectly also do not get covered under the provisions of the GAAR.
Coming to the point
Coming to the point, changes made by Budget 2013 and the recently released GAAR Rules have ironed out a number of issues that stakeholders were really concerned about, but clarity is still required on several key aspects. It s not clear as to whether the open issues will be addressed anytime before GAAR provisions become effective which is April 1, 2015. MNCs would be well advised to have a GAAR test applied to current structures. They should clearly analyse and assess whether their arrangements fulfil the main purpose test being tax benefit or are the other business purposes predominant. Though the Rules do not provide guidance and are unlikely to provide any guidance before these provisions become effective, one should apply a common business sense test to analyse non-tax advantages of the current arrangements. Documentation of all facts and other business purposes will help MNCs defend any GAAR related enquiry. In case the assessments reveal that arrangements fail on account of main purpose test and one of the supplementary tests, MNCs should plan to restructure entities or restructure business dealing to ensure that the structures are GAAR compliant. As MNCs will be able to apply for Advance Rulings after March 31, 2014, one can expect to get some guidance on how the judiciary interprets these new not so legal but economic concepts.
[i]As per section 96 of the IT Act – An impermissible avoidance arrangement means an arrangement, the main purpose of which is to obtain a tax benefit, and it:
(a) creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
(b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act;
(c) lacks commercial substance or is deemed to lack commercial substance in whole or in part; or
(d) is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.
[ii]E.g. the transfer pricing provisions which ensure that international transactions between related parties or certain specified domestic transactions are at arm’s length, Income clubbing provisions in case of certain transfers, deemed dividend provisions etc
[iii]Memorandum explaining provisions of Finance Bill, 2012
2014 Update to the OECD Model Tax Convention
The 2014 Update, as adopted by the OECD Council on 15 July 2014, includes changes that were previously released for comments, including the meaning of “beneficial owner.” Numerous additions and deletions to Commentaries on various Articles, including positions of non-member countries, are also included. A link to the Update is provided for reference:
The Update requires a comprehensive review to determine potential implications, including beneficial ownership restrictions and ways of working by competent authorities. Such review should distinguish changes to the Articles versus additions or deletions to the Commentary interpreting such Articles. Note that the OECD BEPS changes will be an addition to this Update.
OECD / UN