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GAAR: Take 2!

Published on Thu, Sep 13,2012 | 12:32, Updated at Thu, Sep 13 at 13:01Source : 

By: Payaswini Upadhyay, CNBC-TV18

It recognizes fiscal incentives, distinguishes between tax avoidance and tax mitigation and defines commercial substance- Dr Shome’s Committee strives to achieve these objectives in their Draft report on General Anti Avoidance Rules. Well begun but its only half done!

First, the well begun part.

In the 27 examples of commonly used business structures, Dr Shome's committee clarifies

1.  Tax mitigation by availing fiscal incentives provided by law is allowed
2.  Business risk or net cash flow effect on a transaction will determine commercial substance. Period of holding, taxes paid and exit route, incidentally tests laid down by the Supreme Court in the Vodafone judgment, will also determine commercial substance 
3.  GAAR should not be allowed to override Treaty provisions- so a Tax Residency Certificate in the context of Mauritius and a Limitation of Benefits Clause, for instance in the context of Singapore, will be respected. If tax avoidance has to be tackled, amend the treaty; don't use GAAR.
 4.  Taxpayer will have the right to organize his tax affairs legitimately from the options that the law provides. So taxpayers have the right to choose whether they want to go for a buyback vs declaring a dividend; create subsidiary or set up a branch; operate in a SEZ or any other place; raise money via debt or equity; or buy an equipment or decide to lease it.
 5.  If Specific Anti Avoidance Rules can take care of a tax avoidance situation, GAAR should not be applied. So, for instance, tax avoidance by shifting or reconstruction of existing business from a SEZ unit to a non-SEZ unit is covered by provisions of Section 10AA of the Income Tax Act and so GAAR should not be invoked.

"It provides greater clarity regarding the application of GAAR in a variety of commercial circumstances that Indian companies encounter everyday.  Although some questions remain, this is a very positive step forward to provide additional certainty that Indian corporates and international investors are looking for." says Thomas Britt, Partner, Debevoise & Plimpton.

To illustrate Tom's point on clarity, consider Example 12 that has two parts- part A where an Indian company, subsidiary of a foreign company, has allowed the dividends to accumulate since the DDT became applicable in India. It then offers a buyback of shares. The parent participates in the buyback and pays capital gains at the applicable rate. The draft says that GAAR should not be invoked here even if the foreign entity can avail capital gains tax benefits under a Tax Treaty. The Committee takes this situation a little further in part B. With everything else remaining the same, if the shareholders of the Indian company are in 3 different jurisdictions and the only entity that participates in the buyback is the one that can claim capital gains benefit under the Treaty, then the tax department should be allowed to examine the arrangement under GAAR to ascertain the economic substance.

But some are not convinced with the rationale behind this interpretation. Thomas Britt  says "it is unclear to me how GAAR would necessarily be invoked under this fact pattern as there could be numerous reasons why D and E (D&E: not the residents of low-tax jurisdiction) do not accept the buyback offer other than their interest in avoiding application of capital gains tax.  For example, if they believe that X's (Indian company) offer did not reflect the true value of the company or if they simply wished to continue to be a long-term shareholder in that company, then applying GAAR under those circumstances would appear inappropriate."

But Mukesh Butani, Managing Partner, BMR Advisors says that the Committee's apprehension in this case is well founded. "The situation envisaged here is that the buyback is exercised by selective shareholders who are associated enterprises depending on the relevant tax treaty provision for taxing capital gains. In that situation, it gives a right to the Indian revenue under GAAR to examine the transaction for assessing the substance."

Dr Shome's Committee has also provided clarity on transactions that involve an assignment of a loan by one branch of a multinational financial institution to another branch located in a different country- Example 14. This, says Mr Butani, is a situation where the branch that arranges the loan assigns the loan to a treaty resident of a country that does not have source based ( and instead has resident based ) taxation rules. The underlying assumption is that the entity to whom the loan is assigned is indulging in tax evasion. But Mr Britt disagrees. "There could be numerous reasons for the financial institution doing this, such as compliance with local capital adequacy requirements that could be facilitated by such asset transfers.  The interpretation concludes that this asset transfer is made mainly to avoid withholding tax provisions without consideration of other possible rationales for doing so."

The Draft finds pre-ordained arrangements of preferential shares with employees unsavory. So if an employee accepts preferential shares which are redeemable at a premium in lieu of a bonus, GAAR can be invoked. This example deals with a scenario where the objective is to get the consequential gain (on redemption ) taxed as capital gains which would have otherwise been taxed as ordinary income, explains Mr Butani. But Mr Britt opines that such a transaction is a common practice and should not invoke GAAR. "Many companies provide employee remuneration packages consisting of both cash and shares.  Equity incentive plans such as this are considered by many companies to be important to align the interest of the employees with the interest of the company's shareholders and to provide the employees with a vested interest in the company's future growth and expansion.  These are important commercial purposes underlying the rationale for equity incentive plans that are distinct from any interest on the part of the company in avoiding tax that would have been required to be paid on salary.  If that is the case then the main purpose of the plan would not be to obtain the tax benefit and, accordingly, I would have thought that GAAR ought not be invoked."

The Half-Done Part

Dr Shome's Committee widened its mandate in this Draft report and has commented on FII taxation. But it's silent on indirect transfers and the illustrative cases do not dwell on structures similar to that of Vodafone. "Given that the Vodafone case was a principal driver of the Indian government's initiative to address GAAR, more illustrative cases focusing on commonly used offshore investment structures would have been a welcome addition to the second draft.", says Mr Britt.


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