September 6, 2012
2.99 Cheers for GAAR Committee’s Report
Moots 3 year deferral, abolition of CGT and relief for Mauritius / Singapore structures
The recent report of the Expert Committee on general anti avoidance rules ("GAAR") has evoked positive sentiments across the industry. The Committee has recommended that GAAR should be deferred for 3 years. It has also suggested that income from sale of listed securities should be fully exempt from tax. Investors from Mauritius and Singapore may also look forward to more certainty on entitlement to tax treaty benefits. While the Committee’s recommendations have largely met investor’s expectations, additional clarity is still required on a few aspects regarding the application of GAAR in India.
The Expert Committee was constituted by the Prime Minister in response to the grievances expressed by investors when GAAR was incorporated into India’s tax legislation earlier this year (for implementation from April 1, 2013). The Committee provided its well-conceived review of GAAR under able chairmanship of Mr. Parthasarathi Shome, a reputed economist and tax policy expert. Mr. Shome was earlier Chief Economist at UK’s HM Revenue and Customs, Chief of Tax Policy at IMF, and also contributed to tax reforms in Brazil, for which he was awarded Brazil’s highest civilian honour.
The GAAR Committee has recognized the right of taxpayers to mitigate taxes through arrangements that are not abusive, contrived or artificial. GAAR should therefore be used as a last resort and not a first recourse. As a measure of fairness, it has been proposed that existing investments should be grandfathered. The Committee is in favour of a targeted approach to GAAR with abundant safeguards, which is a positive step in addressing investor concerns.
The deferral of GAAR is extremely important considering that India is far behind other countries that have introduced GAAR on parameters such as global corruption perception (rank 95), ease of doing business (rank 132) and ease of paying taxes (rank 147). It is necessary to address these systemic deficiencies before introducing GAAR.
For a background on the draft GAAR rules that were reviewed by the Committee please refer to our earlier hotline, Draft GAAR guidelines: More threatening than welcoming to foreign investors, Need to revisit scope and timing of GAAR.
Restrict GAAR to abusive, artificial and contrived arrangements
The Committee has recommended that GAAR should only apply to abusive, artificial and contrived arrangements. This qualitative threshold underscores the taxpayer’s right to plan his affairs and mitigate taxes. For instance, if a taxpayer has to choose between various economic alternatives available under law, he is justified in choosing that alternative which creates the least tax burden. It substantially shifts the focus of GAAR to more complicated tax avoidance strategies and will help ensure objectivity through a targeted approach, which will benefit both taxpayers and the Revenue.
The Committee has made a number of additional recommendations in this regard:
i. GAAR should only be invoked in cases where ‘the main purpose’ (and not ‘one of the main purposes’) of the arrangement is to obtain tax benefit. The focus is therefore on the dominant object of the arrangement.
ii. The Government should issue a negative list of arrangements where GAAR cannot be invoked. This would include intra-group transactions, business reconstruction, share buybacks, dividend distribution, choice of funding through debt or equity and setting up of units in special economic zones.
iii. GAAR cannot be invoked in situations where specific anti avoidance rules (like transfer pricing) are applicable.
iv. As a quantitative threshold, only cases where the tax benefit exceeds INR 3 crore may be scrutinized under GAAR.
Implications for funds, FIIs and structuring investments into India
Mauritius versus Singapore versus other jurisdictions
Significant investment into India is made through jurisdictions such as Mauritius, Singapore, Netherlands and Cyprus for various tax-related, commercial and strategic reasons. The Committee has attempted to reconcile GAAR with India’s tax treaty obligations.
A Revenue circular1 issued in 2000 provides that treaty benefits cannot be denied to Mauritius entities that have received tax residency certificates from the Mauritius Revenue Authority.2 The Committee has recommended that the circular should continue to be effective till capital gains tax on listed securities is eliminated (which is another recommendation by the Committee). Therefore, in cases where the circular is applicable, GAAR should not be applied to question the residential status of the Mauritian entity. However, it must be noted that the Indian Government is currently in discussions with Mauritius for introducing some form of limitation of benefits (“LoB”) or anti-abuse provisions within the treaty.
It has also been recommended that GAAR should not be invoked if the treaty has an LoB provision limiting treaty entitlement in specific cases. For instance, the tax treaty with Singapore has an LoB clause because of which the capital gains tax exemption on share transfers may not be available to a Singapore entity that is a shell or a conduit company. Certain expenditure or listing requirements may be fulfilled so that the entity is not treated as conduit or a shell company.3 To the extent the entity satisfies the LoB criteria, GAAR would not apply to it.
However, several tax treaties such as those with Netherlands and Cyprus do not have an LoB clause, and hence entities investing from such jurisdictions may be subject to the qualifications imposed under GAAR. Interestingly certain tax treaties such as the treaty with Luxembourg, allows domestic GAAR provisions to override the treaty.
Establishing commercial substance
The Committee has sought to define ‘commercial substance’, in terms of an arrangement which has a “significant effect upon the business risks, or net cash flows, of any party to the arrangement apart from any effect attributable to the tax benefit that would be obtained”.
It has been suggested that factors such as the time period of the arrangement, the fact that the arrangement provides for an exit route and the fact that there has been payment of taxes under the arrangement are relevant and should be taken into account while evaluating commercial substance. These factors were considered by the Supreme Court in the Vodafone case4 while determining that the offshore transfer of shares of a foreign company by a seller in the Cayman Islands could not be viewed as impermissible tax avoidance.
Funds and multinational groups investing into India use elaborate horizontal and vertical holding structures for various strategic reasons including protection of investments, ring fencing of risks and legal liabilities, corporate governance, operational efficiency, consolidation, leverage and ensuring mobility of investments. Normally, GAAR should not apply in cases of genuine investments where the offshore holding company has been set up to achieve such key commercial and strategic objectives.
Some of the illustrations in the Committee’s report however create some ambiguity on the application of the commercial substance test. For instance, one of the illustrations suggests that GAAR may be invoked irrespective of the presence of employees or an office in a low tax jurisdiction. Structures for investing into India will therefore have to be carefully planned based on the final shape of the GAAR guidelines.
Impact on FIIs
The Committee has recommended that GAAR would not apply to investors of FIIs, which should cover holders of participatory notes and offshore derivative investments.
It has also been recommended that GAAR shall not apply to cases where the FII chooses to subject itself to domestic taxation. However, this may not provide substantial relief unless the Government accepts the Committee’s recommendation of exempting income arising from sale of Indian listed securities. At the same time, FIIs and subaccounts investing into India may also seek to demonstrate commercial substance and take advantage of a beneficial tax treaty.
Abolition of capital gains tax on listed securities
The Committee has recommended that income arising from sale of listed securities should not be subject to capital gains tax. The object is to boost investments into Indian capital markets and also provide an incentive for fund managers to operate from India without exposing the FII to tax exposure which would normally arise if it has a permanent establishment in India.
To offset the loss in revenue, the Committee has recommended that the Government may increase the securities transaction tax (“STT”) applicable to stock market transactions. Currently, STT is payable by the buyer and seller at the rate of 0.1% on the value of the transaction. The Government should be mindful that a significant increase in STT would increase transaction costs and may not achieve the incentive effect that is intended.
Existing investments grandfathered
The Committee has recommended that existing investments would be grandfathered and GAAR would not be invoked to challenge exits from such investments. However, new investments made through an existing structure or arrangement may be scrutinized under GAAR.
Independent and un-biased review of GAAR
The invocation of GAAR involves a review by an Approving Panel, which under current law, would only consist of members from the Government. To ensure independence, the Committee has recommended that the Chairman of the Approving Panel should be a former High Court judge and the members should include two independent experts in addition to the two members from the Revenue. This reflects best practices followed in countries such as Canada and Australia and proposed in the UK. It will ensure a more fair, objective and judicious review of GAAR cases.
In the interest of certainty, the Committee has recommended that both residents and non-residents should be entitled to obtain an advance ruling on the application of GAAR. However to ensure that such rulings are issued on time within the statutory prescribed period of 6 months, it is necessary to improve the infrastructure and capacity of the Authority for Advance Rulings (“AAR”).
Shifting to a trust based taxation regime
Ambiguous legal provisions such as GAAR will create further tension in the existing adversarial environment in India characterized by the large backlog of cases at the tax tribunals and appellate Courts. The estimated INR 45,000 crores of transfer pricing adjustments currently disputed in litigation is evidence of a regime based on distrust and suspicion.
Like any other challenging legal reform or fiscal measure, optimal timing is the key factor that will determine the successful implementation of GAAR. Introduction of GAAR in haste will increase uncertainty and corruption in India, worsen the investment climate, further erode investor confidence, and add to the woes of the Indian economy.
To introduce GAAR and obtain a buy-in from stake holders it is essential to eliminate adversarial approach of the Revenue which has drastically affected India’s investment environment. The focus is to eliminate high transaction costs caused by onerous compliance requirements, ambiguous legal standards and litigation. It is essential to introduce a charter of taxpayer rights which guarantees enforcement of tax laws in a fair, equitable and non-arbitrary manner.
The Expert Committee’s report is a positive step in the direction of ensuring certainty and stability in India’s tax regime. A final report is expected towards the end of the month. The ball would then fall on the Government’s court to deliver its promise of boosting investor confidence and re-instating India’s position as a preferred investment destination.
1 CBDT Circular 789 of 2000.
2 This circular was upheld by the Supreme Court in Union of India v. Azadi Bachao Andolan,  263 ITR 707.
3 Under the protocol to the treaty a resident of Singapore should not be treated as a conduit as long as it incurs annual operational expenditure of SGD 200,000 in the two years preceding the sale of shares.
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