Expert Committee recommendations on General Anti Avoidance Rules

The Finance Act, 2012 had incorporated anti‑avoidance provisions in the form of General Anti Avoidance Rules (“GAAR”) under Chapter X-A of the Income-tax Act, 1961 (“the Act”) which were proposed to be implemented with effect from April 1, 2013. 

In February 2012, the Central Board of Direct Taxes (“CBDT”) constituted a committee for formulating guidelines for

the implementation of GAAR and to provide clarity on the provisions to safeguard taxpayers against the indeterminate use of the said provisions.  The draft guidelines and recommendations of the committee were released for public consultation and recommendations on June 28, 2012.

Subsequently, in July 2012, the Prime Minister, in order to address concerns of foreign and domestic investors on GAAR, constituted an Expert Committee under the chairmanship of Dr Parthasarathi Shome to engage in extensive consultation process and finalize the GAAR guidelines.  The terms of reference of the Expert Committee were as follows:

·          Receive comments from stakeholders and the general public on the draft GAAR guidelines.

·          Vet and rework the guidelines based on this feedback and publish the second draft of the GAAR guidelines for comments and consultations.

·          Undertake widespread consultations on the second draft GAAR guidelines.

·          Finalise the GAAR guidelines and a roadmap for implementation and submit these to the government. 

On September 1, 2012, the Expert Committee submitted its draft report[1] (“Expert committee report”) after analyzing the GAAR provisions and noting the concerns expressed by various stakeholders.  In this newsletter, we have highlighted the notable recommendations of the Expert Committee.  Broadly, our comments have been summarized under the following heads:

A.     Recommendations for amendments in the Act;

B.     Recommendations for guidelines to be prescribed under the Income Tax Rules, 1962 (“Rules”);

C.    Recommendations for clarifications and illustrations through circular;

D.    Other recommendations; and

E.     Guidance provided through key illustrations. 

A.     Recommendations for amendments in the Act

·          The implementation of GAAR to be deferred by three years with an immediate pre-announcement of the date of implementation to enable appropriate training of tax authorities as well as development of adequate processes/procedures to remove uncertainty from the minds of stakeholders. In effect, the GAAR provisions would apply from the Financial Year (“FY”) 2016-17. 

·          Abolish tax on gains arising from transfer of listed securities for both residents as well as non-residents irrespective of the nature of such income (ie capital gains or business income). Additionally, the Expert committee report suggests that this proposal could be made tax neutral by appropriately increasing the rate of Securities Transaction Tax (“STT”).

·          The GAAR provisions introduced in the Finance Act, 2012 seek to cover transactions whose “main purpose or one of the main purposes was to obtain tax benefit”.  The Expert Committee has recommended that GAAR should cover only arrangements where the main purpose is to obtain tax benefit as against those arrangements where obtaining a tax benefit is merely one of the purposes. 

·          One of the principal concerns on GAAR was a lack of definition of key terms such as “commercial substance”.  The Expert committee report provides a definition for the said term in line with the definition in the provisions of the original version of the Direct Tax Code (“DTC”) 2009 and 2010.  The reinstatement of this definition would be important to ensure that the illustrations provided in the Expert committee report would become clarificatory and would act as a secondary aid for interpretation of this key term. 

·          The Expert committee has recommended that factors like existence of an arrangement, payment of taxes, exit route may be relevant but may not be "sufficient" in forming a holistic assessment to apply GAAR to any arrangement.  It may be noted that the GAAR provisions specifically provided that the said factors will not be relevant in determining the applicability of GAAR.  

·          Expert committee has recommended that the GAAR approving panel should consist of five members (including Chairman) and has proposed that the Chairman should be a retired judge of the High Court and in addition has proposed that 2 members of the approving panel should be outside the government and should be persons of eminence drawn from the fields of accountancy, economics, business, etc. 

B.     Recommendations for guidelines to be prescribed under the Rules

·          GAAR provisions should be subject to an overarching principle that tax mitigation should be distinguished from tax avoidance before invoking GAAR and that GAAR should be applicable only in cases of abusive, contrived and artificial arrangements. 

·          The Expert committee has recommended the introduction of the concept of a “negative list” where GAAR would not be invoked.  The negative list includes:

§   Selection of one of the options offered in law (examples include – dividend versus buy back of shares, setting up a branch versus a subsidiary, funding through debt or equity and purchase or lease of assets);

§   Timing of a transaction (example – sale of a property at a loss to offset profits from other transactions);and

§    Amalgamations and de-mergers as approved by the High Court

·          Further, GAAR should not to be invoked on intra-group transactions (i.e. transactions between associated persons or enterprises) that are in totality revenue neutral (both in terms of actual loss as well as deferral of revenue).

·          While determining the tax consequences of an impermissible avoidance arrangement, the Expert committee has also recommended a corresponding adjustment, if any, for the same tax payer in the same or different years. 

·          A monetary threshold of Rs 30 million of tax benefit (including tax only, and not interest etc) annually to a taxpayer prescribed for the applicability of GAAR provisions. Further, the Expert committee has recommended that the tax audit report may be amended to include reporting of tax avoidance schemes above a specific threshold of tax benefit of Rs 30 million or above which are considered by the tax auditor as more likely than not to be held as an impermissible avoidance arrangement under the Act. 

·          It has been recommended that all investments made by a resident or non-resident and existing as on the date of commencement of the GAAR provisions be grandfathered such that the provisions of GAAR are not invoked at the time of exit in a post GAAR era.

·          The Expert Committee has recommended that where Specific Anti Avoidance Rules (“SAAR”) are applicable to a particular transaction, then GAAR shall not be invoked to look into that transaction. Similarly, where anti-avoidance rules are provided in a tax treaty in the form of limitation of benefit as in the case of India Singapore tax treaty, the GAAR provisions will not apply overriding the treaty. 

·          Where only a part of the arrangement is impermissible, the tax consequences of an impermissible avoidance arrangement will be limited to that portion of the arrangement.

C.     Recommendations for clarifications and illustrations through Circular

·          GAAR would apply to income of the previous year, relevant to the Assessment Year in which GAAR becomes effective and the subsequent years.

·          GAAR provisions shall not apply to examine the genuineness of the residency of entities set up in Mauritius, if Mauritius Tax Residency Certificate (“TRC”) is obtained pursuant to Central Board of Direct Taxes (“CBDT”) circular no 789/2000. 

D.      Other recommendations

·          Authority for Advance Ruling (“AAR”) mechanism should be strengthened so that an advance ruling may be obtained within the statutory time frame of six months.

·          GAAR should not be invoked during withholding tax stage where the taxpayer submits a satisfactory undertaking to pay tax along with interest in case it is found that GAAR provisions are applicable.

In relation to Foreign Institutional Investors (“FII”), the Expert Committee has recommended that provisions of GAAR will not apply where a FII chooses not to claim any treaty benefit and chooses to subject itself to the provisions of the Act.  Further, the GAAR provisions will not apply to direct or indirect investments by non resident investors in FIIs where the underlying investments by the FIIs are in the form of listed securities.  To minimize the deficiency of trust between the tax administration and taxpayers, concerted training programmes should be initiated for the tax authorities placed, or to be placed, in the area of international taxation. 

E.     Guidance provided through key illustrations

The Expert Committee has also provided 27 illustrations which are intended at providing clarity on applicability of GAAR provisions under various situations.  A gist of some of the important illustrations has been provided below:

Tax mitigation or negative list

Illustrations - GAAR cannot be invoked

·          Fiscal incentive - Setting-up of a unit in Special Economic Zone (“SEZ”) which results in a tax benefit is a case of tax mitigation since the taxpayer is taking advantage of a fiscal incentive offered by submitting to the conditions and economic consequences of the provisions in the legislation. 

·          Dividends vis-à-vis buy back - To pay dividend to its shareholder, or buy back its shares or issue bonus shares out of the accumulated reserves is a business choice of a company.  Such decisions cannot be questioned under GAAR on the ground that there is a deferral of tax liability.

·          Purchase versus Lease – GAAR should not apply to a company which chooses to obtain an asset on lease over an outright purchase and consequently claims higher deduction for lease rentals rather than depreciation. In such case, the GAAR provisions would not apply as the taxpayer is merely making a selection out of the options available.

·          Thin capitalization - An Indian Company raising funds from a foreign company incorporated in a low tax jurisdiction outside India through borrowings, when it could have issued equity is not covered by GAAR. In such case, there is no specific provision dealing with thin-capitalization in the Act.  An evaluation of whether a business should have raised funds through equity instead of debt should generally be left to commercial judgment of a taxpayer. 

However, GAAR would apply to a case where the interest rate is linked to actual profits and it appears that an actual equity investment is disguised as debt to obtain a tax benefit. 

Similarly, GAAR would apply to a case where a loan is assigned to a resident of a country which has favourable treaty with the view of avoiding withholding tax in India on interest.

·          Tax Evasion – Cases of tax evasion wherein tax benefit is taken by misrepresentation of facts e.g. diversion of profits to a subsidiary set up in tax exempt jurisdictions for import and export of goods when actually the business is being done from India, showing production of non-SEZ unit as production of SEZ unit could be directly dealt by law without invoking GAAR.

GAAR versus SAAR

Illustrations - GAAR cannot be invoked

·          Presence of anti-abuse provisions in the tax treaty - Where a company satisfies the SAAR conditions [Limitation of Benefit (“LOB”) clause under the tax treaty], GAAR provisions cannot be invoked on the ground that the company is a conduit company or that it lacks commercial substance.  An example for this would be the LOB clause in India – Singapore treaty.  In such cases, GAAR should not be invoked. 

·          Fiscal incentive coupled with applicability of transfer pricing provisions

-       A case where a taxpayer transfers the product of non-SEZ unit to SEZ units, at a price lower than the fair market value in order to a show higher profits in SEZ unit  is not covered under GAAR as such a tax avoidance is specifically dealt with through transfer pricing regulations that deny tax benefits in such a case. 

-       GAAR would also not apply to a case where a taxpayer gradually migrates business from a non SEZ unit to a SEZ unit as the same is covered by a SAAR in section 10AA of the Act.

·          Composite contracts coupled with applicability of transfer pricing provisions – GAAR would apply in a composite contract where the fair market value for design were under invoiced (payment is taxable at 10 percent on gross basis) and offshore supplies (payment is not taxable) were over invoiced. In this case, such artificial allocation of price has been done to reduce tax liability of the foreign in India. However, determination of arm‘s length price should be based on transfer pricing regulations under the Act. 

Business restructuring

Illustrations - GAAR cannot be invoked

·          Merger of profit making company into a loss making company and vice versa - This results in setting off losses against the profits viz., a lower net profit and lower tax liability for both companies taken together. In such a case, there is no specific anti-avoidance safeguard. However, since such a merger would be under the order of High Court, GAAR cannot be invoked as it falls in the negative list (as recommended) for invoking GAAR

Illustrations - GAAR can be invoked

·          Selective buy-back – GAAR may apply where a buyback offer is made to a group of shareholders, but the offer is accepted only by the shareholder entitled to the tax treaty benefit as it appears to be a dubious method which may or may not be driven by genuine commercial reasons. 

Holding and funding structures

Illustrations - GAAR cannot be invoked

·          Special Purpose Vehicle (“SPV”) formed for pooling resources: GAAR would not apply to a case where 2-3 companies set up in different jurisdictions intend to set up an SPV for pooling their resources and such a company is set up in a specific jurisdiction based on various factors including ease of set up, cost of compliance, low/no tax in the said jurisdiction, treaty network, etc as obtaining a tax benefit is not the main purpose.

 

·          Dividend distribution, a business choice – Non repatriation of dividends received by a holding company (set up in a no tax jurisdiction) from its subsidiaries is a business choice and cannot be subjected to GAAR as India does not have anti-deferral provisions in the form of Controlled Foreign Company (“CFC”) rules in the Act. 

A case of such holding company merging with the Indian parent is also not subject to GAAR despite possible tax savings as the timing and sequencing of the merger is a business choice and such a merger is specifically exempt under the provisions of the Act. 

Illustrations - GAAR can be invoked

·          Lack of commercial substance

-       Shares in an Indian company held by a non resident entity through a holding company set up in a low tax jurisdiction where such a holding company is a mere “permitted transferee” (ie a case where all right of voting, management, right to sell, etc vest with the non resident entity) would be covered by GAAR as this is an arrangement which has been created with the main purpose of avoiding capital gains tax in India by routing investments through a tax friendly jurisdiction. 

However, it is pertinent to note that even in this illustration, the Expert committee has stated that if this is a case where circular 789 (relating to TRC in the case of Mauritius), or LOB clause in India-Singapore treaty is applicable, the Revenue cannot invoke GAAR and consequently deny treaty benefit. 
Interestingly, the Expert Committee in another illustration where such a holding company in a tax friendly jurisdiction was funded entirely by its parent (which is located in a jurisdiction which does not have capital gains exemption in India on sale of shares) has held that GAAR would apply and has observed that the fact that the parent has employees or an office in the holding company’s jurisdiction would be immaterial in determining the applicability of GAAR to such a case. 

·          Round tripping – An arrangement involving a loan by an Indian company to another Indian company but routed through an offshore subsidiary in a no tax jurisdiction where such a subsidiary does not have any other business or commercial substance would attract GAAR. 

·          Avoiding Minimum Alternative Tax (“MAT”) – An arrangement involving avoidance on MAT by an Indian company which forms a partnership firm and transfers shares in a listed company to such a firm which then sells the said shares would be covered by GAAR. 

Others

Illustrations - GAAR can be invoked

Employee remuneration - An arrangement where an employee is given an option to choose from either salary or shares such that shares are agreed to be purchased back at pre-agreed rates which gives an opportunity to earn capital gain to the employees is an arrangement not for bonafide purposes and GAAR provisions would be invoked with regard to this arrangement.  However, a genuine option where there is an element of risk to the employee would not be covered under GAAR.