Taxes are mandatory and necessary. Opinion, however, has been divided on the issue that whether taxes are avoidable? The famed Ramsay judgment held that taxes are not avoidable. Tax avoidance was thence made illegal. However, with Macniven, the law changed and tax avoidance, as long as it remained within the four corners of law, was held acceptable. India also saw the period between 1985 (Mc Dowell) and 2003 (Azadi Bachao Aandolan), when tax avoidance was illegal, but subsequently the court changed its viewpoint.
Tax avoidance, as we all know, involves deliberate actions which are not illegal or forbidden by law, and such actions result in reducing tax burden, or avoiding it altogether. The idea is in contrast to ‘tax evasion’, which involves illegality, suppression, and violations of law. For the State, tax avoidance too undermines the objective of collecting revenues in an effective manner and is thus considered to be undesirable and inequitable. This document probes the newly applicable Indian GAAR provisions, while touching upon the provisions in other Asian countries.
Specific Anti-Avoidance Rules (SAAR)
The response of the legislature to avoid tax avoidance has been to enact Specific Anti-Avoidance Rule (SAAR) from time-to-time in several sections. Section 94 of the Income-tax Act, 1961 (‘the Act’), dealing with dividend stripping, bonds stripping, etc., is an easy example of a SAAR. Section 2(22)(e) of the Act is a measure to prohibit shareholders of closely held companies from enjoying the profits of the company without payment of dividend tax.
However, as the name suggests, SAAR is tailor-made to particular situations or particular instance. Businessmen tend to find newer avenues to reduce their liability and the legislature takes long time to realize them and plug the loopholes. Of late, countries are changing their approach to tax avoidance and codifying the ‘substance over form’ doctrine in the form of the General Anti-Avoidance Rule (GAAR). These rules are general in nature, legislatively prohibiting any action resulting in lesser tax liability.
I. Analysis of the Indian GAAR
A. History and inspiration
Clear legislative intent to introduce GAAR in India goes back several years, when the Direct Taxes Code 2009 was introduced for public discussion. GAAR was finally introduced in the IT Act as Chapter X-A by the Finance Act 2012. The same was however never brought into force. Finance Act 2013 modified the provisions substantially; the Indian GAAR, as it stands now, is effective from April 1, 2017.
Indian GAAR is broadly modeled on the South African legislation which in turn is modeled on the Australian, New Zealand and Canadian legislations. If one wants to look for jurisprudence on the subject, South African and Australian laws could be a good starting point. However, Indian courts are quite reserved in attributing to foreign case law anything more than mere persuasive value.
GAAR is based on a principle that transactions have to be real and are not to be looked at in isolation. Merely because the transactions are not illegal does not mean that they will be acceptable with reference to the meaning in the fiscal statute. Therefore, where there is no business purpose, except to obtain a tax benefit, GAAR will be attracted.
B. Overriding effect of GAAR and its effect
The Indian GAAR has an overriding effect on other provisions of the tax law. Section 95 of the Act provides that GAAR would be applicable, irrespective of other provisions of the Act not permitting tax avoidance. For example, if the tax liability of the tax payer under other provisions is calculated at Rs. 100 and the transaction is declared to be impermissible, and on application of Chapter X-A the liability is Rs. 150, then, the tax liability of the tax payer would be determined at Rs. 150 irrespective of the fact that the other provisions of the act clearly provide only for taxation of Rs 100.
Further, the statute provides that GAAR will apply to any step in or part of an arrangement as they are applicable to the whole arrangement. It appears to have been drafted to ensure there is no loophole in the provisions. It is not necessary to impugn every step in the arrangement as impermissible. Even if one step is found to be impermissible, GAAR will apply to the entire arrangement. Therefore, when impermissible arrangement has been referred to, it covers any impermissible step or part of the arrangement. Section 100 is closely related to Section 95, which states that Chapter X-A will apply ‘in addition to, or in lieu of’ any other basis of determination of tax liability.
Therefore, for the purposes of determining tax liability, first an attempt should be made to harmoniously interpret Chapter X-A and other provisions of the Act, and in cases of an irreconcilable conflict, provisions of Chapter X-A will prevail. The question of conflict between special versus general normally presumes that special prevails over general, but Section 100 explicitly provides to the contrary. However, the government seems to be of the view that when SAAR applies, GAAR will not be invoked. This understanding however does not flow from the provisions of the Act.
C. Impermissible avoidance arrangements
The GAAR is applicable to ‘impermissible avoidance arrangements’, that is, an arrangement in which the ‘main purpose’ is to obtain a tax benefit. The main purpose has to be derived from the circumstances, making this determination a highly subjective one. Thus, the first step towards applying GAAR in any tax audit would be to conclude that an arrangement is impermissible.
To be declared as impermissible, the arrangement has to fall in at least one of the clauses listed in section 96 of the Act. This appears to be an exhaustive list, and includes the following. Firstly, the arrangement should create rights or obligations not ordinarily created between persons dealing at arm’s length. So, while the transfer pricing provisions already deal with individual transactions not conducted at arm’s length, GAAR deals with the arrangement which results in such transactions.
Secondly, the arrangement should result in a misuse or abuse of the provisions of the Act, or is carried out in a manner which is not bona fide. This requires the tax authority to decipher the intent of the taxpayer, and is rather a subjective condition.
Thirdly, the arrangement should lack commercial substance. Thus, if the very existence of a business arrangement is imprudent (e.g. shell companies incorporated in tax havens), it’ll be considered as lacking commercial substance and would be hit adversely. Section 97 of the Act deems some arrangements to lack commercial substance. It covers those situations wherein if you take individual steps, they appear perfectly valid and independent, but they may not be consistent with the transaction as a whole. It seems to be in accordance with the Ramsay case wherein it was observed that transactions with effect of offsetting and canceling each other result in impermissible avoidance.
The section, as originally enacted, excluded certain circumstances which cannot be regarded as sufficient causes for existence of commercial substance. These circumstances were in the nature referred to by the Supreme Court in the case of Vodafone as the reasons for treating the transaction as genuine, namely length of investment, payment of tax, etc. In other words, the section, as originally enacted, nullified the reasons given by the Supreme Court in determining existence of commercial substance. The Shome Committee Report of 2012 recommended the section to be amended, considering it was in blaring contrast with the law declared by the court.
The section now states that conditions laid down in the section shall be ‘relevant but not sufficient’ to determine commercial substance. The difference between the two seems to be that, earlier these were wholly irrelevant to the matter, but now are important factors to ascertain the ‘the lack of commercial substance or not’.
Therefore, when a tax payer has been holding investment for a considerable period, has continued the business in India, has continued to pay taxes, etc., it indicates a business sense behind the whole transaction indicating a commercial substance.
D. Consequences of application of GAAR
The consequence of application of the GAAR is significant. Section 98 of the Act empowers the tax authority to look at the impermissible arrangement in substance, and strip off the parts which were giving rise to the undue tax benefit. Effectively, this enables the tax authority to rearrange portions within the arrangement to the best of his judgment. The section lists down certain consequences as well, including disregarding of corporate structure, treating debt as equity or capital as revenue and vice versa, and recharacterization of any deduction or expenditure. But the list is not exhaustive – it is more in the nature of a broad guide to the tax authority.
Of the above, disregarding the corporate structure has far reaching consequences. The provision allows the tax authority to lift the corporate veil and treat multiple legal entities as one. The jurisprudence around lifting corporate veils so far was restricted only to cases involving mala fide intent. With GAAR now codified, this receives statutory sanction.
It is important to note, nonetheless, that the consequences under the GAAR are only in relation to income-taxation and would not extend to other laws such as foreign exchange. To illustrate – say, an Indian company imports goods from a sister company in Dubai, which in turn buys such goods from an unrelated third party. If under GAAR this arrangement is held to be impermissible, the foreign exchange authorities in India could not require repatriation of the Dubai company profits to India.
Section 101 provides the Government with the power to frame guidelines, subject to which the provisions of Chapter X-A shall apply. Draft guidelines have been issued by the government under this section, laying down illustrations of facts in which GAAR would apply.
E. Meaning of ‘tax benefit’
As aforesaid, an arrangement is impermissible if the main purpose to enter into it is to obtain a ‘tax benefit’. The Act defines ‘tax benefit’ inclusively. A reduction, avoidance or deferral of tax, an increase in refund, a reduction in taxable income or an increase in loss, are instances of tax benefits as statutorily laid down. Tax benefit could arise from an application of domestic laws or any treaty. Thus, treaties are specifically covered under the ambit of GAAR. The definition of ‘tax benefit’ is in relation to the relevant previous year or any other previous year. What follows is that even if the transaction was entered into in any other previous year which results in a tax benefit in the previous year, the provisions of GAAR will be attracted to that extent. Therefore, even though the arrangement has been entered into prior to April 2017, tax benefit being availed after April 2017 will be governed by Chapter X-A. GAAR seems to have a retrospective application to that limited extent.
F. Corresponding adjustments for GAAR
The consequence of application of GAAR would always be to increase the taxable income of a taxpayer. It might be contended that where such an increase is effected, there should be a corresponding reduction in the income of the other person, otherwise it would lead to double taxation. However, the tax department has repeatedly asserted in its circulars that such corresponding adjustments will not be given. This view of the circulars may not be accurate in law and is possible to argue so, at least in certain situations. The logic behind the same is that once a legal fiction is created, it has to be taken to its logical end.
II. GAAR in Asia
In Hong Kong, since 1947 the tax law had a provision to disregard any transaction which reduces the amount of tax payable, if such transaction is artificial or fictitious . This general power to disregard transactions has now largely been superseded by more comprehensive and effective anti-avoidance powers introduced in 1986 . The new law is designed to hit at transactions which are carried out for the ‘sole or dominant purpose’ of obtaining a tax benefit. While determining this, regard shall be given to the manner of carrying out the transaction, and the form and substance of the transaction. Thus, this law also is founded upon the main-purpose test. It is notable that in Hong Kong, with the introduction of the new law, the taxpayer has not fared well. It has been held that both the old and the new provisions could simultaneously apply depending on the facts of a case – at times resulting in a double whammy for the taxpayer.
Another country of interest is Malaysia. The Malaysian Income Tax Act has had an anti-avoidance provision since 1967. The law provides that if a transaction directly or indirectly alters the incidence of tax payable, or relieves tax liability of any person, or evades or avoids any duty or liability, or hinders the operation of the tax law, such transaction shall be countered by tax authorities. The provision is wide, and is not based on the modern main-purpose logic that India and other countries have adopted.
The Singapore anti-avoidance provision is modeled like that of Malaysia. It was introduced in 1988, and states that if the ‘purpose or effect’ of any arrangement is to directly or indirectly alter the incidence of tax, or relieve tax liability of any person, or reduce or avoid any tax liability, then such arrangement is to be countered.
Notably, hindering the operation of tax law is missing from the list compared to Malaysia, but that’s something that the courts will read into the provisions while interpreting the law. Nepalese GAAR provisions were introduced in 2001. A tax avoidance scheme is defined therein to mean any arrangement, ‘one of the main purposes’ of which is the avoidance or reduction of tax liability. Thus, the definition is wide, as it covers transactions and arrangements wherein one of the main purposes (in contrast to the main, sole or dominant purpose) is to obtain a tax benefit. In 2008, China made major changes to its income tax law. It unified its foreign and domestic tax law, while also simultaneously adding anti-avoidance provisions into the new law.
Article 47 of China’s Corporate Income Tax Law (‘China CIT’) mandates that when the taxable income or amount of income of an enterprise is reduced as a result of arrangements with no reasonable commercial purposes implemented by the enterprise, the tax authorities have a right to make adjustments according to a reasonable method. The catchphrase here is ‘arrangement with no reasonable commercial purpose’. Article 120 of the Regulations for the implementation of China CIT further lays down that no reasonable commercial purpose means that the main purpose is to reduce, exempt or postpone tax payments. Reading together, the China CIT brings an arrangement, the main purpose of which is to reduce, exempt or postpone tax payments, within the purview of GAAR. This is similar to the main-purpose test that India has also adopted for its new law on general anti-avoidance.
The effectiveness of the Chinese GAAR is yet to be evaluated. The Administrative Measures for GAAR have been introduced in 2014, providing for the procedural law, and making the legislation in respect of GAAR in China complete. With China already having a comprehensive set of SAARs [see end note 1] in place for transfer pricing, advance pricing arrangements, cost sharing agreements, CFC, and thin capitalization, the interplay between GAAR and SAAR is to be watched out for.
Japan is a major Asian economy that does not have GAAR. The reason possibly could be that Japan is not as much a victim of treaty shopping or treaty abuse, since it is not a favored choice as a country of residence or place of effective management (POEM) of corporate entities.
One of the requirements for transforming from a developing economy to a developed economy is a well codified law to protect tax leakage. Introduction of the GAAR is one such move. With GAAR in place, Indian businesses need to have a re-look at all their business arrangements, not merely the ones made for tax avoidance. Every arrangement, either with a related party or an unrelated party, if resulting in a tax benefit, whether intentionally or un-intentionally, has to be relooked into. So far, taxpayers were not required to maintain any documents to prove business purpose of a transaction or arrangement. Going forward, however, the onus would lie on the taxpayer to establish that a transaction is not undertaken with the objective of tax avoidance.
Since GAAR overrides tax treaties as well, this exercise has to be extended to transactions entered into with non-residents as well. Given that GAAR is an anti-avoidance measure and that the revenue authorities have been given wide powers under the statute, the taxpayer would have to be proactive to ensure that revenue authorities do not arbitrarily exercise their jurisdiction. The taxpayer would have to preemptively identify explanations for each and every business transaction. Undoubtedly, this would consume significant time and resources, but would definitely protect against high-pitched and adverse tax adjustments.
From an Asian perspective, India and China are taking the legislative and administrative lead in implementing anti-avoidance laws. The specific focus has been on GAAR (and in specific, treaty abuse), transfer pricing, and indirect share transfers. Tax reforms in other countries have also focused on anti-avoidance, with Japan, Indonesia, Korea, Thailand and Vietnam specifically tackling anti-avoidance through SAARs on various aspects, including transfer pricing, CFC Rules, thin capitalization, beneficial ownership, besides others.
Contrary to popular belief, GAAR is not enacted only to take care of mega cross-border business deals, involving millions of dollars between Indian companies and foreign companies or between foreign companies. These provisions apply even for routine day-to-day transaction within Indian companies, within the country itself. In the wake of these new provisions, in-house legal and finance teams will have to look at transactions from the perspective of GAAR also.