Dear Dr. Parthasarathi Shome you have been handed a gigantic task. Many believe GAAR (General Anti Avoidance Rules) is a necessity in this day and age of multi jurisdiction business operations, financial complexity and aggressive planning. But no business in this country wants an anti avoidance law and definitely not the kind of GAAR that's currently taking shape in India. So, to your committee falls the task of implementing a more humane GAAR. A fair, less ambiguous GAAR and a GAAR that doesn't scare away legitimate investment. Now you said you will be studying what other countries have done and so we thought we would bring you on this special addition of The Firm, experiences of the oldest and one of the youngest anti avoidance regimes in the world. Here goes.
Ever since the Duke of Westminister Case, revenue authorities across the world have been trying to unravel the tangled strings that connect tax planning and tax avoidance. Specific transgressions have been curtailed by specific anti avoidance rules. But creative tax planning has always been a step ahead. And so in 1988 Canada became the first country to introduce GAAR. It was prospective including a grandfathering clause and aimed at preventing artificial tax avoidance agreements. Canada's GAAR applies to transactions alone or part of a series, that result in a tax benefit, that cannot reasonably have been undertaken for bona fide purposes other than that tax benefit and that can reasonably be considered to result in a misuse or abuse of other tax provisions.
David Duff, Professor & Co-Director, National Centre for Business Law
“But notice the word reasonably. This is an objective test. It is reasonable to conclude that the transaction was primarily tax motivated. So it is not a subjective test and also there has been some discussion in the Indian context about whether the purpose test is subjective because it doesn’t use this word whether it is reasonable to conclude.
One will say you know, yes, you could have achieved those business purposes but in a much more direct way to other kinds of transactions. Then the court will say it is not reasonable to conclude that this was primarily not tax motivated and therefore the GAAR could apply.
Indian draft rule defines an arrangement to include steps in a transaction. Now from a Canadian perspective, we think of a transaction is singular which is why we have a rule which says that the GAAR applies if a transaction or a transaction is a part of a series results in a tax benefit. So in our system, a transaction is only one thing and in your system the way that you have defined arrangement, suggests that the transaction can be composite, I am not sure if that is the case but it is something to pay attention to.”
The US enacted the Doctrine of Economic Substance or the ESD as recently in 2010. Under it, a transaction has substance if it changes in a meaningful way the taxpayers’ economic position besides the tax effect and if there is a substantial purpose for entering the transaction.
Bala Rajaraman, Partner – US International Tax Services, Deloitte
“Taxpayer may rely on profit potential to satisfy both prongs of the conjunctive analysis required by the ESD. But there is no minimum profit or minimum rate of return that the taxpayer needs to demonstrate. Instead, what the loss is, profit potential or change in the economic position of the taxpayer will be considered by comparing the pre-tax profit that the taxpayer stands to gain from undertaking the transaction to the present value of the tax benefits and the pretax profit has to be substantial in comparison to the tax ratings. So it is not as if the taxpayer is precluded from realizing tax savings, from undertaking a transaction, you have to show that there is something else over and above the Federal tax savings that accrues to the taxpayer and that has to be fairly substantial. It is not a defined term so one could argue what substantial means.”
Since the ESD was a codification of common law and not a new law, it’s spared four types of commonly used transactions such as the choice of capitalizing via debt or equity, making a foreign investment via a domestic or foreign corporation, reorganizations and related party transactions. The US ESD was applied prospectively and does not allow for advance rulings.
India’s GAAR is quite different from the US economic substance doctrine. Some say it’s a mix of Canadian and South African GAARs. Two key design principles are already enshrined in the Finance Act 2012. A four part test to determine if a transaction is permissible and a three part commercial substance test.
The more recent draft guidelines distinguish between tax mitigation and tax avoidance and offer 21 illustrations of when GAAR could or could not apply.
Pranav Sayta, Partner, E&Y
“I think two-three things immediately come to mind in terms of the design of the Indian GAAR. One is, unlike maybe Canada or US, we are talking here of not the main purpose being a tax benefit but even one of the main purposes being for tax, that’s one which is very unique I think. The other is there is the second requirement or condition which has four alternatives and that makes things extremely wide and broad for the Revenue to act on. So we have not only the misuse or abuse of the law test which I guess is there in Canada as well and probably to some extent is derived in the US as well. But when it comes to the other three tests we see them missing, so the commercial substance, the bonafide purpose or the fact that the transaction is not -----(Interrupted)
Rajaraman: The four part test, if you will, in terms of where the Indian rules look to see whether or not there was an abusive purpose or related party transaction those things, we don’t have that significant level of detail in the US ESD rules. US ESD rules simply have a two part test that would say, ok did the tax payer have a business purpose? Did they have economic substance to undertake the transaction? So it’s a simpler test in that sense.
Duff: I think in common wealth countries there are lot of similarities in the GAAR. Canada has had three aspects to its GAAR and India has followed elements of them, but with some differences. One the idea of a tax benefit which is in the Indian GAAR very similar to the Canadian language. Secondly the requirement of a tax purpose or tax motivated transaction which is also similar to the Canadian GAAR. Where the Indian version departs from the Canadian GAAR is the third aspect of the Canadian GAAR focuses solely on misuse or abuse and so there is a question of whether you violated the spirit of the Act while adhering to the words of the Act. India has that element but then has added on these other so called four tests; one of which is a broad commercial substance test which doesn’t appear in the Canadian GAAR and doesn’t appear in most other GAARs that you see in the common wealth or the English draft GAAR, for example, is a more narrowly targeted GAAR focused on abuse like the Canadian GAAR.
Doshi: You made the point that India has a substance test which other GAARs don’t necessarily share. What are the consequences of trying to test substance as the Indian GAAR attempts to do?
Duff: I guess it depends on what you are aspiring to accomplish in your GAAR. I think the GAAR that we have in Canada- it really plays a very residual role. We have a number of specific anti-avoidance rules layout the scheme of the Act and the GAAR is there as a back stop for things that couldn’t have been contemplated, that tax payers design clever way around the rules. Here it seems to me as though that the focus on commercial substance is attempting to do a lot more.
Rajaraman: I would echo Professor Duff’s sentiment in the sense that the US already has a number of rules -other types of anti-abuse provisions- that specifically target certain types of transactions. So, when the US economic substance doctrine came into play, it focused on transactions that where not necessarily covered by these rules. So it was more of a residual test and it was the way that I understand the Indian GAAR rules, it could be wielded to basically attack different types of transaction and so I think that’s a fundamental difference between the two systems.
Sayta: The commercial substance test is further widened by saying in certain situations; it will be deemed that there is lack of commercial substance. So, we are in a matter of GAAR, where we are saying that we have to look at commercial substance- is there scope to say that in certain situations it will be deemed to lack commercial substance. Commercial substance is something, which one has to look at under the general principles of whether there is a business reason, you can’t deem something to lack a business reason if there actually is one, there shouldn’t be a fiction created around that.
The first GAAR litigation in Canada came some 7 years after GAAR was first enacted in that country. In Canada a field officer is the first to determine if a transaction is to be subject to GAAR. His report is then sent to a head office that centralizes nationwide GAAR cases to ensure uniformity in application. A tax officer, in the Head office, is the next level of scrutiny and his decision to apply or not to apply GAAR is rated by a 12 member GAAR panel that has the final say.
Dale Hill, Partner, Gowlings, Canada
“This is where I was located in head office. So when I would get to see all these reports and remember like it was pointed out earlier, 867 cases were presented to the GAAR Committee. Thousands of cases that came into head office never made it. To give you an example I could be working on 15-20 cases in head office on GAAR proposals by a field examiner and I may only recommend that one, two or three of them go to the GAAR Committee because the stopgap was at the head office. I didn’t have a final decision on whether GAAR applied then. I may make a recommendation. If I determine that it didn’t apply and then my manager at that time disagreed with me because there was independence in head office as it would still go to the GAAR Committee as well then. But just assume on the premises I agreed with the field officer and GAAR should apply, then I would have to prepare report. In every Wednesday afternoon I would go present in front of a panellist of 12 senior officials of the Canada Revenue Agency from Gowlings’ to Minister, to Finance, to interpret legislation, to appeals, to every specialty that that particular transaction related to. For example, if it was a financing transaction, then we would have the person responsible at the Department of Finance dealing with that. That person would be sitting on the GAAR Committee. If you noticed, it’s a broad group of people at GAAR Committee; it’s not one or two or three people, it was a large group.”
Promila Bhardwaj, Director General, Department of Income Tax (International)
“Panel for GAAR that is a part of the decision making process. The AO only has formed an opinion, he feels it is a fit case then his opinion on his belief gets filtered by the Commissioner level officer and then the matter goes to the Approving Panel - they are officers senior to the Commissioner and the panel consists of whole time members. This is the recommendation. They would not have any other job to do except to function as the approving panel. With DRP, there is not much of flexibility. If the workload is high then we can setup another DRP, but for the panel there is a provision that we will review the number of panels to be setup as and when the workload increases or decreases as a case maybe.”
In Canada the consequences of a GAAR invocation could range from a denial of that specific tax benefit that the transaction sought to a re-characterization of the transaction. In the US, it’s a 40% penalty.
Rajaraman: When ESD was formally put into the statute I don’t think taxpayers were significantly alarmed or concerned about it, but what was new about the provision was that there was this 40% penalty that now applied if the taxpayer’s transaction was found not to have ESD and there was tax that was underpaid as a result of that. So that aspect of this has given taxpayers some pass and has made them rethink whether or not certain transactions that they would have otherwise potentially undertaken and possibly contended with a challenge by the courts will now have to overcome this potential hurdle of okay, what if I am wrong, I am going to have to pay this 40% penalty over and above my tax liability. So I think that has probably been the key impact I would say of the ESD program.
Sayta: The consequences of what would happen if GAAR is invoked- the Indian Law is very wide and it gives powers to the Revenue authorities which could enable them to do anything and everything - virtually meaning thereby that what they could do maybe far too disproportionate and not commensurate with what has been probably alleged to be the tax avoidance motive.
Doshi: The key concern here in India is, however moderate GAAR is in design, it is the implementation which is subjective that is going to really bite and I am wondering what the experience has been in the US ever since the ESD has come into force?
Rajaraman: Again the ESD in my view hasn’t really changed the way the IRS or the field agents if you will will behave in a sense that if prior to ESD being put into the statute if an IRS agent were to come in out of the taxpayers filings and if they raise this issue it will work its way up the system and if the position that the field officer took was unreasonable, he or she is going to be told pretty quickly that no this is not an issue that we are going to litigate through the courts. Let’s not concern ourselves with this, let’s settle with the taxpayer. With the implementation of the ESD rules, I don’t think that has altered or modified the IRS’ behaviour significantly in my view because they would again go through the same process with the same approach. So in my view the concerns that Pranav has with respect to how Indian GAAR would be implemented is probably not as severe from a US perspective.
Doshi: Proffesor Duff you spent sometime today on how the Canadian revenue department looks at GAAR, examines cases and takes them all the way up to the committee level at which point a final decision is made. What do you make of the role that process has played in implementing GAAR in a fair or unfair manner in Canada and actually bringing more certainty to the tax payer on what constitutes avoidance because this is so subjective?
Duff: I think there are couple of things- one is what happens internally within the revenue department. We all live in rule of law, ultimately it’s the courts that decide whether the rules apply or not. So, we have to remember that, that’s an important check on excessive applications of GAAR. In Canada there have been a number of internal processes, a government committee that backs all decisions and I presented some statistics- since the GAAR existed something like 800 cases have been considered. Ultimately the GAAR committee has tossed aside a number of them and so it has played an important role of filtering and at least ensuring consistency across the country in application of GAAR. Interestingly enough in the UK, in their GAAR proposal, they have actually suggested a quasi-independent committee including people from private industry involved in the panel to decide whether a GAAR assessment would be made.
Doshi: But the 12 member GAAR committee is entirely government officials?
Duff: Yes, in Canada its entirely government. In fact, there is a concern about having a quasi-independent committee to decide whether the GAAR will apply because in some sense its taking away the power ultimately from the courts that should be deciding whether the GAAR applies.
Doshi: In the 24 years of its existence, Canada’s GAAR committee has examined 867 cases and applied GAAR 614 times - that’s a 47% strike rate for the head office. Revenues success rate has also been good in the 40 cases that reached court. 33% wins at the Tax Court level, over 50% at the Federal Court of Appeal and 75% of the cases in the Supreme Court have gone in favour of revenue.
You have experienced GAAR in Canada since 1988. So, you have a better ability to understand what other countries should or should not do? What do you recommend based on what you have seen of our draft guidelines of whether we are going down the right road or not and what we need to fix?
Duff: I prefaced my comments earlier today saying its always dangerous to make this kind of advice to a country that you don’t know that well. You don’t know the legal system as well to make those kinds of recommendations. That said, we do come from a common English traditional legal system, share values around the rule of law and we have the benefit of experience. I guess looking at the India GAAR proposal, those four factors that we have talked about do make me a little bit anxious. In fact one of the great innovations of the Canadian GAAR was to add this misuse and abuse test. To my mind, the idea of tax avoidance, the hallmark of tax avoidance is you are doing something contrary to what the legislation is intending. So, an abuse test gets at the essence of that. You are avoiding what was intended by the legislation. You are managing to get around and its that abuse that I think a GAAR properly is designed to prevent. But GAAR is not a broad brush tool to change all sorts of features of the tax system that you don’t like. Instead you should have detailed legislative amendments, if there are treaties that are causing a concern, renegotiate the treaties, introduce limitation of benefits provisions, if there are rules about buybacks that are causing a concern, there are rules in US and Canada. So, there are specific ways of dealing with specific problems and GAAR is a residual rule. It’s a bit of a concern that it seems to me as though the Indian GAAR is potentially much broader than that and is may be attempting to accomplish other things.
Doshi: I know India would have preferred many SAARs as opposed to one GAAR, but I think based on all the global experiences that we have discussed through the course of the day what are the few things that you are hoping in the discussion process that will now take place regarding these draft guidelines will get fixed?
Sayta: I would feel 2-3 things very clearly. One, that if I am doing something which is already envisaged in other provisions of the Act, then those should not be disturbed or get impacted by GAAR. For example, if there is something like buyback as David just mentioned, that’s something that the Income Tax Act specifically deals with as to how it is to be taxed. The definition of dividends specifically excludes a buyback. There should not be a question then of GAAR being applied to re-characterize that buyback into a dividend when the Act itself categorically says that a buyback done in a certain manner will be excluded from the meaning of the term they have said.
This is my no means a comprehensive review of the many GAAR experiences. We would have loved to do China and South Africa, but this is all time will allow today. By the way Dr Shome, your team can also access many of these IFA presentations on our website and a very interesting one by GEs Rupak Saha on how GAAR will change M&A in India.