Tax avoidance like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner. The concept of GAAR gains ground here. The General Anti Avoidance Rule, or GAAR, was proposed in mid-March as part of the budget for fiscal 2013. It aims to target tax evaders, partly by stopping Indian companies and investors from routing investments through Mauritius or other tax havens for the sole purpose of avoiding taxes. However, the ambiguous language, the lack of details, and the sudden onset of the provisions have been among the factors that have upset foreign investors. A broad spectrum GAAR carries a real risk of undermining the ability of business and individuals to carry out sensible and responsible tax planning and that on the other hand introducing a moderate rule which does not apply to responsible tax planning, and is targeted at abusive arrangements would be beneficial.
Definition: A general anti avoidance rule (GAAR) is a set of broad and general principles-based rules enacted in the tax code aimed at counteracting avoidance of tax. The UK and others does not currently have a GAAR, but instead a series of targeted anti avoidance rules (TAARs) which aim to prevent tax avoidance in specific areas of the legislation.
Proposed GAAR – DTC 2010
Under the Code, GAAR will be invoked if the following conditions are satisfied:
a) The taxpayer should have entered into an arrangement.
b) The main purpose of the arrangement should be to obtain a tax benefit and the arrangement:
i) Has been entered into, or carried out, in a manner not normally employed for bonafide business purposes.
ii) Has created rights and obligations which would not normally be created between persons dealing at arm’s length.
iii) Results, directly or indirectly, in the misuse or abuse of the provisions of this Code; or
iv) lacks commercial substance, in whole or in part.
Meaning of arrangement
An ‘arrangement’ will mean any transaction, conduit, event, trust, grant, operation, scheme, covenant, disposition, agreement or understanding, including all steps therein or parts thereof, whether enforceable or not. Therefore, if the motive behind individual steps is to obtain a tax benefit, but the overall scheme is not so, the individual steps will nevertheless be treated as an arrangement and the GAAR may be invoked.
An arrangement will also include any interposition of an entity or transaction where the substance of such entity or transaction differs from the form given to it.
Lack of commercial substance
The lack of commercial substance, in the context of an arrangement, shall be determined, but not limited to, by the following indicators:
i) The arrangement results in a significant tax benefit for a party but does not have a significant effect upon either the business risks or the net cash flows of that party other than the effect attributable to the tax benefit.
ii) The substance or effect of the arrangement as a whole differs from the legal form of its individual steps.
iii) The arrangement includes or involves:
a) Round trip financing.
b) An ‘accommodating party’, as defined.
c) Elements that have the effect of offsetting or cancelling each other.
d) A transaction which is conducted through one or more persons and disguises the nature, location, source, ownership or control of funds; or
e) An expectation of pre-tax profit which is insignificant in comparison to the amount of the expected tax benefit.
Tax consequences of impermissible avoidance arrangements
If the conditions specified above are satisfied, the Commissioner will be empowered to declare the arrangement as an impermissible avoidance arrangement and determine the tax consequences of the taxpayer as if the arrangement had not been entered into. For this purpose, he may:
i) Disregard, combine, or re-characterize any steps in, or parts of, the impermissible avoidance arrangement;
ii) Disregard any accommodating party or treat any accommodating party and any other party as one and the same person;
iii) Deem persons who are connected persons in relation to each other to be one and the same person for purposes of determining the tax treatment of any amount.
iv) Re-allocate any gross income, receipt or accrual of a capital nature, expenditure or rebate amongst the parties.
v) Re-characterize any gross income, receipt or accrual of a capital nature or expenditure.
vi) Re-characterize any multi-party financing transaction, whether in the nature of debt or equity, as a transaction directly among two or more such parties.
vii) Re-characterize any debt financing transaction as an equity financing transaction or any equity financing transaction as a debt financing transaction.
viii)treat the impermissible avoidance arrangement as if it had not been entered into or carried out or in such other manner as the Commissioner in the circumstances may deem appropriate for the prevention or diminution of the relevant tax benefit; or
ix) Disregard the provisions of any agreement entered into by India with any other country under section265.
An arrangement declared as an impermissible avoidance arrangement shall be presumed to have been entered into or carried out for the main purpose of obtaining a tax benefit unless the party obtaining the tax benefit proves that obtaining a tax benefit was not the main purpose of the avoidance arrangement.
Procedure for applying GAAR
The power to invoke GAAR is bestowed only upon the Commissioner of Income Tax (CIT). For this purpose, the Code empowers him to call for such information as may be necessary. He is also required to follow the principles of natural justice before declaring an arrangement as an impermissible avoidance arrangement. He will determine the tax consequences of such impermissible avoidance arrangement and issue necessary directions to the Assessing Officer for making appropriate adjustments. The directions issued by him will be binding on the Assessing Officer.
The key issues / implications under the proposed GAAR are:
- Tax avoidance has been widely defined with the objective to encompass a number of circumstances and instances of tax avoidance, leading to uncertainty and extensive litigation.
- GAAR can be invoked where obtaining a tax benefits the ‘main purpose’, and it is not clear as to what is meant by ‘main purpose’; the courts would be left to decide whether in the given facts the main purpose of the transaction/arrangement was to obtain tax benefit.
- Where an adjustment is made (invoking GAAR), it is not clear whether the full effect of the same would be given to ensure that there is no double taxation.
- The onus of proving that an arrangement has not been carried out for the main purpose of obtaining a tax benefit is with the taxpayer, while the tax authorities may not have any evidence of tax avoidance.
- There is no cut-off date for applicability of GAAR provisions to any arrangement and, therefore, where the impact of past arrangements continues in Direct Tax Code regime; the same may still be covered by GAAR irrespective of the fact that the arrangement has been approved by the tax officer or subjected to judicial review.
GAAR – Tax Treaty
It has been provided that the GAAR provisions would apply to a taxpayer notwithstanding that the treaty provisions are more beneficial. Considering the approaches as outlined before (under the Vienna Convention and the OECD wherein the underlying principle would be that GAAR could override the provisions of a treaty), it is important to note that OECD Commentary on Article 1 of the Model Tax Convention also clarifies that a general anti-abuse provision in the domestic law in the nature of ‘substance over form rule’ or ‘economic substance rule’ would not be in conflict with the treaty.
However, as enshrined in the Vienna Convention “every treaty in force is binding upon the parties to it and must be performed by them in good faith”, ‘Pactasunt servanda’ is based on good faith. This entitles states to respect obligations. This good faith basis of treaties implies that a party cannot invoke provisions of its domestic law as a justification for a failure to perform. Thus, if a legislature unilaterally enacts new domestic tax laws which are contrary to an existing treaty, without the treaty having been amended or terminated, such action is violation of international law and also violates the principles of ‘pacta sunt servanda’. This type of treaty violation is known as ‘treaty override’. Further, according to rules of legislative interpretation, specific legislation overrides general legislation. Therefore, changes of a domestic law generally, which could be the case with GAAR, may not affect the treaty. Considering the same, in the absence of an anti-avoidance provision under the treaty, it remains to be seen whether the provisions would be able to override the treaty.
Specific anti-abuse rules
In addition to the GAAR provisions, the Code provides for specific anti-avoidance rules to deal with some of the following circumstances. These are similar to the provisions under the Income-tax Act, 1961:
i) Certain payments deemed to be dividend [Clause 314(4) r.w 314(81)].
ii) Clubbing of income arising to other person by virtue of a transfer without transfer of the asset [Clause 8(1)];19 Article 27 iii) Denying tax benefits to a business formed by General Anti-Avoidance Rules India and International perspective 19splitting up, or the reconstruction or a business already in existence [Schedule 11, 12 & 13].
iv) Denying tax benefits to a business formed by transfer to a new business of machinery or plant previously used for any purpose [Schedule 11, 12, 13].
v) Expenditure incurred in relation to income not includible in total income [Clause 18].
vi) Payment to associated persons in respect of expenditure [Clause 115].
vii) Transfer of shares to a firm or closely held company without or for inadequate consideration [Clause 58(2)(j)].
viii) Carry forward and set off of losses in the case of certain companies [Clause 66].
ix) International transactions not at arm’s length [Clause 116].
x) Transactions resulting in transfer of income to nonresidents [Clause 119].
xi) Avoidance of tax in certain transactions in securities [Clause 120].