GAAR leaves investors feeling powerless

Author: | Published: 1 Aug 2012
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The General Anti-Avoidance Rules (GAAR) was introduced in the 2012 Union Budget to counteract aggressive tax evasion. Under GAAR provisions, the tax liability of a transaction will be determined by the transaction's substance rather than its form.

Legal practitioners are concerned that the GAAR provisions overly-empower the Government of India (GOI) to determine tax liabilities, which increases tax risk and uncertainty when investing in India. As a result of such concerns, the finance minister decided to defer the tax evasion measures by one year. And yet, concerns remain as to whether the effects of GAAR will apply to transactions that were carried out prior to its date of implementation.

The GAAR was first proposed to become an instrument for the Direct Tax Code 2010 to address issues relating to tax avoidance and evasion. It was expected that the GAAR would become a deterrent to increasingly sophisticated types of tax avoidance schemes. Under the GAAR regime, the Income Tax Department (ITD) is empowered to deny tax benefits to an entity if a transaction is carried out with the sole intention of tax avoidance.

The term 'tax benefit' has been defined to mean: a reduction, avoidance or deferral of tax; an increase in a refund of tax; a reduction, avoidance or deferral of tax that would be payable but for a tax treaty; an increase in a refund of tax as a result of a tax treaty; or a reduction in an entity's tax base, including an increase in loss, in the relevant financial year or any other financial year.

The GAAR places the onus firmly on companies to prove that they are using specific structures for commercial purposes, and not simply to avoid tax. But the ITD will be able to question the claims made by companies and FIIs. This means that deals that are structured to enjoy tax benefits by complying with Indian tax provisions might still be taxed further if the ITD revisits them and reinterprets them based on their substance. Businesses are concerned that this might introduce an element of subjectivity.

Shefali Goradia, a partner at BMR Advisors, says: "The GAAR will be applicable across the board. It will affect every system of investment and thus worries all sorts of investors. The scheme appears to be very litigative and the thresholds for denying tax avoidance are very abstract." She adds: "Investors feel powerless as they plan their transactions. They do not feel that their initial tax liabilities could be assured in the first instance."

Foreign investors are particularly concerned about the GAAR because a large proportion of foreign investment into India is carried out through companies registered in Mauritius that are exempt from tax under a double taxation agreement. The introduction of GAAR could give powers to the ITD to deny double taxation treaty benefits to foreign funds based out of tax-havens such as Mauritius.

Obtaining a residency certificate in Mauritius might not be adequate to avoid tax. For example, an offshore derivative instrument (ODI) holder could be taxed under the GAAR regime because it derives its value from an underlying Indian security. Its hedge is carried out by the counterparty FII, which resides in a jurisdiction with a favourable tax treaty with India.

This concern was further deepened by the 2012 Union Budget, which also proposed to clarify that the withholding tax obligations under Section 195 of the Income Tax Act, which describes the liability to deduct tax in respect of payments made for purchase of capital assets, apply to all non-residents irrespective of whether they have presence of any form in India.

Prospective or retrospective

The GAAR was originally proposed to be implemented on April 1 2012. However, on May 7 2012, the GOI announced it would delay implementation until fiscal year 2013/14. This deferral was widely welcomed by investors who are now granted more time to restructure their deals in order to comply with the new rulings, or exit their funds before the GAAR comes into effect.

However, there still remains concern among investors on the implementation of GAAR, particularly over whether GAAR will affect transactions prior to its date of implementation. Although GAAR is implemented with prospective effect, legal practitioners suggest that its implications might be retrospective because of other clarifications that the GOI has made over the Income Tax Act. In the same Union Budget, the finance minister proposed to amend the 1961 Income Tax Act to tax offshore transactions involving any Indian assets. This amendment will be implemented with retrospective effect from April 1 1962.

Ernst & Young tax partner Rajan Vora says: "The problem with GAAR implementation is that the government is given the power to identify the tax liabilities of investors. It should not be a problem if these provisions are implemented prospectively because investors can then plan their transactions accordingly. However, if the income tax amendments should come into effect retrospectively from 1962, that means that the government, which is now fully empowered by the GAAR to determine and assess tax liabilities, might go back to deals that have happened prior to the date of GAAR implementation and tax parties accordingly."

Despite the fact that investors have now been given an extra year to restructure their transactions in order to comply with the GAAR regime, it remains unclear whether they might be liable to extra taxes for transactions that took place prior to implementation of GAAR. As other retrospective amendments are taking place in conjunction with GAAR, investors continue to face a great deal of uncertainty.

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