Written by Shilpa Nagral, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) offered by Lawsikho as part of her coursework. Shilpa is a graduate in B. E. LLB and was working as an Associate in M&A, PwC.
The menace of tax evasion is an issue which has been plaguing economies all over with India not being an exception. Countries all across the world are working overtime to achieve a balance between mitigating tax evasion and not interfering in day to day business of taxpayers. In this context, various anti-avoidance rules have been brought up by various countries. However, with various evolving business transactions, the measures are found to be lacking. For tackling the menace of tax evasion, nations like Australia, the Netherlands, New Zealand, Canada, China, etc. have adopted a wider approach known as the General Anti-Avoidance Rules (“GAAR”)
The introduction of GAAR is a watershed event in the evolution of India’s tax policy and legislation. As on date, any discussion of the structuring of business transactions will be incomplete without discussing the implications of GAAR. GAAR has been made effective in India from April 1. 2017. However, even before the GAAR provisions were made effective, Indian Judiciary dealt with tax avoidance cases by referring decisions pronounced by English courts in cases such as the Duke of Westminster. The English courts laid down that if the documents of any transaction are bona fide, the tax authorities are restricted from dissecting it to arrive at some other underlying substance.
The courts had adopted this principle in case of Azadi Bachao Andolan and the Vodafone case. However, the courts also ruled that, if the transactions are found to be “dubious” or “colourable”, such transactions can be disregarded by applying the doctrine of piercing of corporate veil and substance over form. Therefore, a codified law to address the widespread issue of tax avoidance was needed in India, and hence GAAR was introduced.
What is General Anti-Avoidance Rule (“GAAR”)
GAAR contained in Chapter X-A of the Income Tax Act is a set of rules which codifies the principle of substance over form implemented by courts in several cases. The procedure for application of GAAR and conditions under which it shall not be applicable is contained in Rules 10U to Rule 10UC of the Income Tax Rules. It empowers the tax authorities to re-characterise transactions and re-determine the resultant tax consequences, if such transactions are structured with the main aim of availing tax benefits or if they lack commercial substance.
Difference between Tax evasion and Tax Avoidance
Fraud, Illegality, misrepresentation, willful suppression of facts- all these activities constitute tax evasion which is strictly prohibited under law.
Tax avoidance includes actions taken by the taxpayer, which are not illegal or forbidden by law but are considered as undesirable and inequitable, as they undermine the objective of an effective collection of law.
Run up to GAAR
GAAR was first introduced in the Direct Tax Code Bill, 2009 and a committee was formed by Central Board of Direct Taxes to give its recommendations on formulations of guidelines and circulars to ensure that ruling was not applied indiscriminately.
March 16, 2012: GAAR was introduced for the first time in the Finance Bill 2012 and was to come in effect from April 1, 2012. However, GAAR was deferred till April 1, 2014, on enactment of the Finance Bill 2012. GAAR was deferred to allow additional time for investors sentiments to improve and appropriately refine the law.
June 28, 2012: The Government of India released draft GAAR guidelines.
July 13, 2012: An expert committee headed by Dr. Parthasarathi Shome was constituted to review and rework GAAR guidelines.
September 1, 2012: The Shome committee report was published. Major recommendations of the Shome committee were as under:
- Defer implementation of GAAR for three years on the administrative ground;
- GAAR to be applicable only if the tax benefit to the party is beyond Rs. Three crores;
- GAAR should not be evoked to determine the genuineness of residency of Mauritius taxpayer and Tax Residency Certificate (TRC) as accepted by CBDT should be retained;
- GAAR should only be applied in cases of abusive and artificial arrangements;
- The panel of GAAR should consist of five members- Chairman: retired HC judge, two members outside government drawn from the field of accountancy, economics or business with wide knowledge in matters of Income Tax; 2 members should be Chief Commissioner of Income Tax or 1 Chief commissioner and one Commissioner
January 14, 2013: GAAR was postponed for another two years and was to become applicable from April 1, 2016.
2015: Implementation of Finance Bill 2015 deferred GAAR for one year. It has become effective from April 1, 2017
Impermissible Avoidance Agreement (“IAA”)
GAAR authorises the income tax authorities to tax impermissible avoidance agreements (“IAA”). Moreover, under the provisions of GAAR, certain provisions are deemed to lack commercial substance. As per Section 96 of the IT Act, impermissible agreements are arrangements whose main purpose is to obtain a tax benefit in addition to the satisfaction of at least one of the four tainted elements test as listed below:
- creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
- Results, directly or indirectly, in the misuse, or abuse, of the provisions of Act;
lacks commercial substance partly or wholly;
- is entered into or carried out by means or in a manner, which is not ordinarily employed for bona fide purposes.
- The term “arrangement” has a wide ambit and also includes a step or part of any arrangement. Hence, even if the main purpose of a step of arrangement is to obtain a tax benefit, the provisions of GAAR would be applicable even if the main purpose of the arrangement is commercial in nature.
What are the arrangements that lack commercial substance?
If apart from the motive of availing tax benefit, an arrangement or any step in arrangement does not have any significant effect on net cash flows of the parties to the arrangement or the business risks, the arrangement will be deemed to be lacking commercial substance under the GAAR provisions. The following factors can be referred to determine if, an arrangement lacks commercial benefit:
- The substance or effect of the arrangement as a whole differs significantly from the individual step taken
- It does not have any significant effect on the business risk or cash flow of any party other than the tax benefit to it
- Round-trip financing, accommodating party, elements that offset or cancel each other, transactions conducted through one or more persons to disguise the value of the deals, location, source, ownership, source or control of an arrangement
- Involves the location of asset, transaction or residence of any party without any substantial commercial purpose
The factors that are relevant but not adequate for a decision if arrangement lacks commercial substance or not are:
- The period for which an arrangement has existed
- Payment of taxes, directly or indirectly, in an arrangement
- The existence of an exit route
Safe harbour rule (exemptions from GAAR) apply to:
- Where tax benefit arising to all parties in an arrangement does not exceed Rs. Three crores in a financial year;
- Arrangements due to which income accrues or arises to person from transfer of an investment prior to April 1, 2017. However, it should be kept in mind, even if investments prior to April 1, 2017, are grandfathered, any corporate arrangement which is implemented starting April 1, 2017, can come under the scrutiny of GAAR provisions.
- Foreign Institutional Investors (FIIs) and Non-residents investors who are directly or indirectly investing in offshore derivate instruments such as P notes issued by FIIs. However, FIIs claiming the benefit under the Double Taxation Avoidance Agreements (DTAA) can be scrutinised under the GAAR provisions.
Consequences of invoking GAAR
While applying GAAR, tax authorities may deny benefits available to parties in arrangement under double taxation avoidance agreement, deem connected parties as one and the same, reallocate expenditure and income between the parties to the arrangement, treat debt as equity and vice versa, alter tax residence of the parties involved and also the legal situs of the assets involved in the transaction.
Procedure for invoking GAAR:
Tax Officer: The Tax officer may examine an arrangement for an IAA enquiry. If he feels the need, he can refer the arrangement to Principal Commissioner or Commissioner of Income Tax (CIT) to declare an arrangement as IAA.
Principal Commissioner/ Commissioner of Income Tax (CIT): The CIT will issue show cause notice to the taxpayer if he is satisfied that GAAR is to be invoked. The taxpayer has to furnish his objections within 60 days. If still satisfied that the arrangement is IAA shall refer it to the approving panel or pass an order favouring taxpayer for non-applicability of GAAR.
Tax office and CIT can recommend invocation of GAAR not only for the tax year for which the proceedings are pending but also for past and future years.
Approving Panel: If approving panel is satisfied that the arrangement is IAA, it shall issue directions declaring arrangement as IAA or pass an order favouring taxpayer for non-applicability of GAAR. Panel to provide the taxpayer with the opportunity to be heard. The declaration is to be passed within six months from the date on which reference was received from the CIT. The decision of the Approving Panel is binding on CIT, and no appeal is permitted against its order.
The taxpayer can either appeal to Income Tax Appellate Tribunal (“ITAT”), or a writ can be filed before the jurisdictional High Court against the decision of Approving Panel if the decision violates the principle of natural justice or there is any misapplication of the law.
Advance Ruling Authority:
The GAAR provisions also provide for setting up advance ruling authority, where there would be a mechanism on obtaining an advance ruling on whether the arrangement is permissible or not.
How will GAAR affect M&A transaction?
M&A transactions are undertaken mostly for commercial purposes and not for the sole motive to derive tax benefits. To ensure that the transactions remain away from the purview of GAAR implications, certain issues should be carefully considered and included in transaction structuring. Some of the ways in which M&A transactions would be affected by
GAAR invocation are listed below
1. Invocation of GAAR in cases where the appointed date is prior to April 1, 2017: Tax authorities may choose to invoke GAAR provisions in case of Scheme of Arrangements, which are post-April 1, 2017 but have appointed date before April 1, 2017. Tax authorities may choose to invoke GAAR provisions in such scenario and deny any tax benefits accruing to the parties to the arrangement. However, in doing so, the tax officers must bear in mind, that they would be going contrary to the principle of appointed date as laid down by Apex Court in the case of Marshall and Sons Ltd. Upholding the concept and relevance of “Appointed Date” in Scheme of Arrangements.
2. Set off of tax losses against tax profits: In order to promote the revival of loss-making entities, the IT Act, subject to fulfilment of certain conditions, allows the continuity of losses after consolidation with other company. Hence, the consolidation of loss-making companies with profitable companies is a common structuring arrangement undertaken. Post the GAAR becoming effective; the tax officers can strike down such arrangements as lacking commercial substance if the parties to the arrangement are unable to prove the commercial substance of transactions leading to set off of tax losses against the tax profits.
3.Share buyback from overseas: Companies usually do share buybacks for their capital reorientations. In the context of an Indian company doing share buyback from overseas investors, it has to be kept in mind that buy back from tax-friendly jurisdictions such as Mauritius, Singapore, Cyprus, etc. is tax-free. In such a scenario the tax officer can choose to invoke GAAR provisions as he can put forward a contention that the buyback is undertaken to save the dividend distribution tax but at the same time distribute profits to its overseas investors. The same view has been taken in the case of Otis Elevators even before the GAAR became effective, which gives an idea of the times to follow.
4. Conversion of Company into LLP: To better facilitate the conversion of a Company into Limited Liability Partnership (LLP), the IT Act provides various incentives one of them being that such conversions are to be considered as tax neutral. Many companies convert into the LLP form as the LLP structure provides the benefit of limited liability alone with the benefit of providing of providing flexibility in doing business. LLP is also a beneficial structure as profit distribution is not taxed and only is very specified conditions can its book profits be taxed.
Post the GAAR regime such conversions to be considered tax neutral would be very difficult. Unless the parties do not establish the commercial rationale for conversion to LLP, the tax authorities may contend that it is done for the sole purpose of availing tax benefits and may disregard tax neutrality on conversion.
5. Thin capitalisation situation: In the present scenario there are no thin capitalisation rules in India. Thin capitalisation rule is reducing the investment through debt instruments so that the investee company does not maximise tax break on interest payout. The interest reduction benefit would not be available to investee company if the investment was made in the form of equity. After the GAAR provisions becoming effective, the tax authorities are now empowered to regard debt as equity or vice versa. Hence if a strategic investor plan to invest in form of convertible debts so that the promoters share is not diluted, the tax officer can disregard such an investment unless the commercial rationale for debt investment is proved.
6. Investments by Private Equity (PE) or Angel Investors (AI): Many PE and AI investments are done at a very high premium. The high premium is not based on the underlying asset base or to even predicated cash flows of the company. The investment in the startup is purely on the idea. In such cases, the investee company will have a very hard time explaining to the tax officials the commercial rationale behind the high premium on the share capital and to prove the fact that the amount paid is not in excess of the fair value of the company.
7. The interplay between GAAR and SAAR: Through recent clarification circular issued, the government has clarified that GAAR and SAAR will co-exist. They will be applicable according to the facts and circumstances of each case. While the CBDT has said that GAAR and SAAR will operate simultaneously, the court in certain cases has held that certain provisions of SAAR will override GAAR. Hence courts may hold GAAR and SAAR mutually exclusive. This aspect of law may be strongly litigated.
8. Tax treaty benefits: One of the major issues that could arise is the benefits that investors enjoy under the tax treaties especially countries such as Mauritius, Singapore, Cyprus, etc. Vide a recent amendment, the India- Mauritius tax treaty was amended, and it was stated that investments prior to April 1, 2017, would be grandfathered and no capital gain tax would be levied on such investments. Also, any investments made post-April 1, 2017 would be taxed as per the Limitations of Benefit (LoB) clause. Even though the government has clarified that if LoB adequately addresses the issue of tax avoidance, GAAR provisions cannot be invoked. This means only if and when the tax authorities are satisfied that the LoB clause addresses the issue of tax benefit satisfactorily, the GAAR provisions will not be evoked. However, scrutiny of LoB clauses should not be open to tax authorities when they are mutually discussed and settled between the countries. Tax treaties is a commitment made by Indian Government, and if such treaties are overruled by unilateral amendments done by Government of India to the domestic tax laws, then it would be a matter of great concern for the international investors.
The government has to come up with more clarifications and better guidelines, to maintain a balance between investors interest in the Indian economy and at the same time fight with the anti-abusive provisions. This has to be done keeping in mind that no these provisions do not result in unnecessary hardship to investors. At the same time, the tax authorities and the taxpayers have to get accustomed to the provisions of GAAR as they evolve gradually. The tax authorities should also keep in mind the ground realities while doing business and not arbitrarily invoke GAAR provisions. If the government wants to attract foreign investments and at the same time maintain positive sentiments among the investors, it should provide clarity on the ambiguities in the GAAR provisions and most importantly, adopt the global best practices in the implementation of GAAR.