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The GAAR Guidelines

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First published in the Indian Corporate Law Blog [http://indiacorplaw.blogspot.in/2012/07/gaar-guidelines.html] on Jul 5, 2012

Mihir Naniwadekar

One of the major changes implemented by the Finance Act has been the introduction of the General Anti-Avoidance Rules (GAAR). The Government has recently issued draft GAAR Guidelines in this connection, which can be downloaded from here.
It is proposed to introduce a monetary threshold for invocation of the GAAR provisions, and time limits (such as time limits for making references to the Approving Panel) have been introduced. Substantively, the Guidelines clarify that GAAR will apply to income accruing or arising on or after 1.4.2013.
Further, it is stated that (in para 1.1, Annexure D) the GAAR “is a codification of the proposition that while interpreting the tax legislation, substance should be preferred over the legal form… These propositions have otherwise been part of jurisprudence in direct tax laws as reflected in various judicial decisions. The GAAR provisions codify this substance over form ‘rule’…”  Thus, the Guidelines clarify that the purpose behind GAAR is not to change the landscape, but to only codify the existing law. Thus, it is arguable that in a situation where a Court (under current law) has upheld a type of transaction as having commercial substance, the GAAR should (so far as possible) be interpreted in line with that view. For example, in the Vodafone case, the Supreme Court did examine the factual matrix of the transactions, and concluded that there was commercial substance: it is at the very least arguable that the GAAR would not hit a similar transaction. However, the Guideline then goes on to indicate that there is no mere codification prescribed: the intent is to tackle avoidance, as distinct from both evasion and mitigation.
It is further clarified that the burden of proving the existence of an arrangement, the fact of tax benefit, and the purpose behind the arrangement being to obtain that benefit is on the Revenue.  The draft guideline then gives a number of illustrations where the provisions of GAAR could be invoked, and where the provisions would not be invoked. If one examines these illustrations, it appears that in most cases where there is no DTAA involved, GAAR would not really result in an outcome different from one which could be expected under current law. The provisions would make a major difference in cases where there is a DTAA. A few examples are seen below:
Example Number as per Guideline
Facts
Whether under current law this arrangement would be disregarded?
Whether GAAR would be invoked under the Guideline?
1
A business sets up an undertaking in an under developed area by putting in substantial investment of capital, carries out manufacturing activities therein and claims a tax deduction on sale of such production/manufacturing
No
No – this is to be treated as a case of tax mitigation. Taking advantage of a fiscal incentive granted by statute would not amount to an impermissible tax avoidance arrangement.
2
A business sets up a factory for manufacturing in an under developed tax exempt area. It then diverts its production from other connected manufacturing units and shows the same as manufactured in the tax exempt unit (while doing only process of packaging there)
[It is not clear from the illustration what ‘diverts its production means’]
Yes: if the statutory condition is that the tax exempt unit must manufacture, and if there is a diversion of production in the sense that production is carried on in one unit but disclosed in the books of another, then it is open to examine the true facts.
Yes [but see the comments as to what is intended by ‘diverts its production’]
If ‘diversion’ means that production in one unit is stopped and production in the tax-exempt unit is started, then there would not be any interference under current law. Even under the GAAR, under example 1, this is arguably a case of tax mitigation
3
A foreign investor has invested in India through a holding company situated in a low tax jurisdiction X. The holding company is doing business in the country of incorporation, i.e. X, has a Board of Directors that meets in that country and carries out business with adequate manpower, capital and infrastructure of its own and therefore, has substantial commercial substance in the said country X.
No
No: there is commercial substance
5
The merger of a loss making company into a profit making one results in losses off setting profits, a lower net profit and lower tax liability for the merged company.
No
No – set off would be allowed as per normal provisions, which have in-built measures to check abuse
6
A choice made by a company between leasing an asset and purchasing the same asset. The company would claim deduction for leasing rentals rather than depreciation if it had their own asset.
In the case of leasing transactions, the Courts have been open to look into the “true nature” of the transaction, to determine who gets the benefit of depreciation, as recently discussed in this post.
If there is a circular lease, the Revenue would invoke GAAR
7
A company has raised funds from an unconnected party through borrowings, when it could have issued equity. Would interest payments be denied as expenditure?
If the borrowed funds are used for the purposes of business then deduction would be allowed. Payments to connected parties may be disallowed to the extent possible u/s 40A(2)(a)
Whether a business should have raised funds through equity instead of as a loan should generally be left to commercial judgment. GAAR would not typically be attracted.
GAAR may be attracted if this is a case of connected party transaction.
[Arguably, here, disallowance if any should be left to 40A, and there is no need for invoking GAAR principles.]
10
Y company, a non- resident, and Z company, a resident of India, form a joint venture company X in India. Y incorporates a 100%subsidiary A in country ABC of which Y is not a resident. The India-ABC tax treaty provides for non-taxation of capital gains in the source country and country ABC charges a minimal capital gains tax in its domestic law. A is also designated as a “permitted transferee” of Y. “Permitted transferee” means that though shares are held by A, all rights of voting, management, right to sell etc., are vested in Y. As provided by the joint venture agreement, 49% of X`s equity is allotted to company A (being 100% subsidiary and “permitted transferee” of Y) and the remaining 51% is allotted to the Z company. Thereafter, the shares of X held by A are sold by A to C (connected to the Z group).
Arguably the transaction could be disregarded: see Aditya Birla Nuvo’s case in the Bombay High Court
Yes
11
Company A, is incorporated in country ABC as a wholly owned subsidiary of company B which is not a resident of ABC or of India. The India-ABC tax treaty provides for non-taxation of capital gains in the source country and country ABC charges a minimal capital gains tax in its domestic law. Some shares of an Indian Company C were acquired by A. The entire funding for investment by A in C was done by B. A has not made any other transaction. These shares were subsequently disposed of by A, thus resulting in capital gains which A claims as not being taxable in India by virtue of the India- ABC tax treaty.
[Example 18 is similar]
Probably not, under the ratio of Azadi Bachao Andolan
Yes: it appears that limitation of benefits clauses would be read in to existing DTAAs if GAAR were to apply in this manner.
12
An Indian Company A is a closely held company and its major shareholders are connected companies B, C and D. A was regularly distributing dividends but stopped distributing dividends from 1.4.2003, the date when Dividend Distribution Tax (DDT) was introduced in India. A allowed its reserves to grow by not paying out dividends. As a result no DDT was paid by the company. Subsequently, all its shareholders buyback [sic] of shares was offered by the Indian Company A to its shareholder company B based in country ABC and the other shareholders C and D who are not resident of ABC. The India-ABC tax treaty provides for non-taxation of capital gains in the source country and country ABC charges very low capital gains tax in its domestic law. The buyback offer was only accepted by the entity B. The accumulated reserves of A were used to buyback the shares from the B entity.
The department has already taken the ground in a few cases that this buyback amounts to a payment of dividend. The department has also taken the contention that the amounts can be considered as deemed dividend u/s 2(22)(d)
Yes
14
A foreign bank F’s branch in India arranges loan for Indian borrower from F bank’s branch located in a third country. The loan is later assigned to F bank’s branch in XYZ country to take benefit of withholding provisions of India-XYZ treaty (India-XYZ Treaty provides no source based withholding tax on interest to a bank carrying out bona-fide business.)
Probably not, unless the assignment is shown to be a sham
Yes.
17
An Indian company is in the business of import and export of certain goods. It purchases goods from Country A and sells the same in country B. It sets up a subsidiary in Country X – a zero/ low tax jurisdiction. The director of the Indian company finalizes the contracts in India but shows the documentation of the purchase and sale in Country X. The day to day management operations are carried out in India. The goods move from A directly to B. The transactions are recorded in the books of subsidiary in country X, where the profits are tax exempt.
It is arguable that this is a case of sham transactions/entries under current law
Yes
20
A company had a disputed claim with Z company. A transferred its actionable claims against Z for an amount which was low, say, for example 10 % of the value of the actionable claim against Z to a connected concern B by way of a transfer instrument. B transferred such claim to C company and C further gifted it to D company, another connected concern of A. Upon redemption of such actionable claims, D showed it as a capital receipt and claimed exemption
Under current law, even in a far less convoluted assignment of actionable claims, the Department has taken the stance that the arrangement must be disregarded. It appears that if there is some commercial substance behind the assignment then the assignment will be upheld. As assignment inter-se group companies where there is no possible commercial substance could arguable be disregarded even under current law.
The manner of the transactions indicates a lack of commercial substance: GAAR would be invoked
These illustrations indicate that the GAAR provisions would in several cases not have a drastic effect on the result of a tax-effective arrangement. Even under current law, Courts in several cases have been willing to disregard transactions which absolutely lack commercial substance. To an extent, due to the decision in Azadi Bachao, a greater amount of deference has been provided to the use of tax treaties; and the GAAR intends to tackle what it sees as abuse of the treaties. The wisdom of this policy is debatable; and once the policy has been decided on it is debatable whether a GAAR is appropriate to achieve this end instead of incorporating appropriate clauses in DTAAs. Furthermore, the guidelines (if finally incorporated) into a relevant Rule or Circular would unquestionably be binding on the Department. Thus, assuming that the examples above are incorporated in a Circular, the Revenue would not be able to invoke GAAR where the example says that there would be no recourse to GAAR. However, where the Circular provides for the application of GAAR, it would still be open to assessees to challenge this, if factually, commercial substance is shown.
Unfortunately, several concerns raised relating to the GAAR (including problems pertaining to excessive discretion, procedure for approving panels etc) have not been clearly addressed in the Guidelines. The attitude of the Department appears to be of looking at the arrangement and determining the ‘substance’: an approach which is only likely to encourage roving enquiries. Another view to approach the GAAR is to begin not with the transaction/arrangement, but with the section conferring the relevant tax benefits. After a purposive analysis of the section, the GAAR could be invoked to defeat those transactions which obviously militate against the purpose of the tax benefit. This is the approach adopted by the Supreme Court of Canada in Canada Trustco Mortgage: “A transaction may be considered to be ‘artificial’ or to ‘lack substance’ with respect to specific provisions of the Income Tax Act, if allowing a tax benefit would not be consistent with the object, spirit or purpose of those provisions.  We should reject any analysis under s. 245(4) that depends entirely on ‘substance’ viewed in isolation from the proper interpretation of specific provisions of the Income Tax Act or the relevant factual context of a case.   However, abusive tax avoidance may be found where the relationships and transactions as expressed in the relevant documentation lack a proper basis relative to the object, spirit or purpose of the provisions that are purported to confer the tax benefit, or where they are wholly dissimilar to the relationships or transactions that are contemplated by the provisions… The GAAR may be applied to deny a tax benefit only after it is determined that it was not reasonable to consider the tax benefit to be within the object, spirit or purpose of the provisions relied upon by the taxpayer…” For other approaches to GAAR, interested readers may also wish to refer to this report from the United Kingdom, prepared by Graham Aaronson QC.
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