Many countries are continuing to embrace anti-abuse rules for cross-border transactions that pose material hurdles for global tax planning.  India provides an example of the issues that multinationals must factor into their tax planning structures.

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As with several other countries, India proposed in 2009 a general anti-avoidance rule (GAAR).  The essence of a GAAR is an effort by the tax administration to declare that the benefits of a statute should not be allowed because the taxpayer has applied its provisions in a manner that, according to the tax administration, was not contemplated by the legislative body.  In this sense, a GAAR is similar to common law doctrines, such as “sham transactions” and “business purpose” rules, that require the taxpayer to have undertaken bona fide transactions.  In the wake of the 2009 proposal, multinational enterprises (MNEs) have expressed concern that the proposed GAAR could be used to override transfer pricing guidelines, as well as treaty obligations.  In an effort to allay these concerns, India’s Central Board of Direct Taxes in 2010 issued a discussion paper, which indicated that the Indian tax authority in fact intended such treaty overrides.

Indian officials have announced that the 2012 Direct Tax Code will contain a GAAR.  It was unclear whether the tax authority would issue an “angel list” identifying transactions not subject to the GAAR.  The courts in India have generally reflected a consistency with overall international jurisprudence.

In June 2012 India’s Ministry of Finance issued draft guidelines on its GAAR, clarifying that it will not apply retroactively and that the burden of proving tax liability will rest on the Indian tax authority rather than the taxpayer, as foreign investors had previously feared.

The draft guidelines address the GAAR following some modifications made in the 2012 Finance Bill (as proposed by a committee appointed to prepare the draft).  The essence of the guidelines are as follows.The guidelines acknowledge MNEs’ complaints that the legislation was unclear and vague in potential operation.  Accordingly, the draft recommends the following:

  1. A monetary threshold should be stated.
  2. Time limits should be clarified for taking actions relating to GAAR.
  3. Special rules be established for Foreign Institutional Investors, seemingly exempting investors in the funds.
  4. The GAAR rules should be prospective in application, for income accruing on or after April 1, 2013.
  5. Where specific anti-avoidance rules apply, the GAAR will normally not be invoked.  In the case of exceptionally abusive behavior, it may be invoked. 
  6. Where only part of an arrangement is impermissible, application of GAAR will be limited to only that part of the arrangement. 
  7. A number of examples are provided.

An impermissible avoidance arrangement is defined as follows (bold in original):

[A]ny step in or a part or whole of any transaction, operation, scheme, agreement or understanding, whether enforceable or not.  It also includes the alienation of any property in such a transaction etc.  The onus of proving that there is an impermissible avoidance arrangement is on the Revenue.

An arrangement would be an “impermissible avoidance arrangement” if its main purpose is to obtain a tax benefit and it also has one of the following characteristics: 

  • It creates rights and obligations, which are not normally created between parties dealing at arm’s length 
  • It results in misuse or abuse of the provisions of the tax law
  • It lacks commercial substance
  • It is carried out by means or in a manner which is normally not employed for an authentic (bona fide) purpose

Many of the examples focus on efforts to take advantage of provisions in Indian treaties where it is deemed that the substance of the transaction is that GAAR should override the treaty.  Other examples are focused on the situation of the now infamous Vodafone case.

The potential application of GAAR to common MNE planning arrangements is indicated by three Examples:

Example-3:

Facts: 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 X, the country of incorporation, and has a board of directors that meets there and carries out business with adequate manpower, capital and infrastructure of its own and, therefore, has substantial commercial substance in X.  Would GAAR be invocable or would the arrangement be permissible?

Interpretation: In view of the factual substantive commercial substance of the arrangement,  Revenue would not invoke the GAAR provisions. 

Example-8:

Facts: A large corporate group has created a service company to manage all its non-core activities.  The service company then charges each company for the services rendered on a cost plus basis.  Can the mark up in the cost of services be questioned using GAAR?

Interpretation: There are specific anti-avoidance provisions through transfer pricing as regards transactions among related parties.  GAAR will not be invoked.

Example-10:

Facts: Y company, a non-resident [of India], and Z company, a resident of India, form a joint venture company X in India.  Y incorporates a 100 percent 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 percent of X’s equity is allotted to company A (being 100 percent subsidiary and “permitted transferee” of Y) and the remaining 51 percent 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).

Interpretation: The controlling rights of company A were with Y.  A direct transfer of these shares by company Y to company C would have attracted capital gains tax in India read with the relevant treaty of Y’s country of residence.  The company A was interposed with the main purpose of taking advantage of India-ABC treaty.  The arrangement results in misuse or abuse of tax provisions.  Revenue would invoke GAAR as regards this arrangement.

Example 3 reflects a normal foreign holding company structure.  It frames the issue as a holding company having substance, which, in turn, frames the ultimate issue of substance versus form.

Example 8 addresses a common transfer pricing arrangement for inter-company services.  The examples indicate that if the underlying arm’s length criteria are satisfied, there would be no invocation of GAAR.  Needless to say, such comments do not provide a great deal of comfort, since examiners are notorious for finding the absence of arm’s length pricing, which could mean that there are transfer pricing adjustments as well as transfer pricing anti-avoidance and GAAR penalties.

Example 10, again, focuses on economic substance in a structure perceived as being intended to avoid Indian capital gains taxation.

The response of the MNE community to the draft guidelines has been, appropriately, a plea for clarity of potential application.  The draft guidelines continue to be vague and uncertain, as indicated in our brief comments above about the examples.  The guidelines are also silent on whether application of GAAR is intended as an override to the Indian treaties.  For instance, in Example 10, would the taxpayer be entitled to request Competent Authority assistance for any assertion of GAAR?  This is a critical question.

In response to the criticism, the Indian government panel focusing on GAAR indicated that it would re-evaluate the proposals. 

Comment

From an MNE planning standpoint, there is an obvious trend occurring in the world of international taxation.  Over the past 20 or so years, common international structure and tax planning regimes have evolved, largely based on the interpretations and policies of the Organisation for Economic Co-operation and Development (OECD) and its member countries.  India, Brazil and other source countries have made it quite clear that they will develop their own tax policies to protect their own tax base.  Even for some OECD member countries, the policies applied (whether in the form of withholding regimes, permanent establishment, transfer pricing, GAAR or other policies) have little correlation to OECD principles.

In planning for the future, in such countries, it is important that an MNE either seek advance agreement on material transactional pattern or take the potential tax liabilities (and defense costs) into account in evaluating business opportunities.