Feasibility of GAAR for removing the practice of Tax Avoidance
Internationally, tax avoidance has been recognized as an area of concern and several countries have expressed concern over tax evasion and avoidance. This is also evident from the fact that either nations are legislating the doctrine of General Anti-Avoidance Regulations in their tax code or strengthening their existing code. General Anti-avoidance Rule (herein referred as GAAR) is a concept which generally empowers the Revenue Authorities in a country to deny the tax benefits of transactions or arrangements which do not have any commercial substance or consideration other than achieving the tax benefit. Denial of tax benefits by the Revenue Authorities in different countries, often by disregarding the form of the transaction, has been a matter of conflict between the Revenue Authorities and the taxpayers. Different countries have taken different approaches in this regard. Australia was in the forefront of introducing a GAAR as early as 1981.
In India, the Government proposes to introduce GAAR provisions through the Direct Taxes Code Bill, 2010 (herein referred as DTC) which is largely based on South African GAAR. The DTC after its introduction in Parliament was referred to a Standing Committee of Parliament. The Code, which was planned to be effective from 1 April, 2012 is expected to be delayed. The Finance Bill, 2012 introduced a far-reaching GAAR in the Income-Tax Act, 1961. It is largely modelled on GAAR proposed in the DTC. GAAR provisions in the Finance Act are in some ways wider in scope and application. The provisions of GAAR of Finance Act, 2012 will apply to the income accruing or arising to the taxpayers on or after 1 April 2013.
This paper will deal with the understanding the background due to which need was felt for an effective GAAR provisions. It will further analyse the basic scheme of GAAR with its critical examination.
Tax avoidance is used to describe every attempt by legal means to prevent or reduce tax liability, which would be otherwise incurred, by taking advantage of some provision or lack of provision in the law. It pre supposes the existence of alternatives, one of which would result in less tax than the other. Moreover, motive would be an essential element of tax avoidance. A person who adopts one of the several possible courses to save tax must be distinguished from a taxpayer who adopts the same course for business or personal reasons. A course of action is designed to conflict with or defeat the evident intention of Parliament.
Tax planning may be legitimate, provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay their taxes honestly without resorting to subterfuges.
Tax Avoidance is different from Tax evasion which is generally the result of illegality, suppression, misrepresentation and fraud whereas Tax avoidance is the result of actions taken by the assessee, none of which or no combination of which is illegal or forbidden by the law itself. The GAAR provisions do not deal with cases of tax evasion. Tax evasion is clearly distinct from tax avoidance and is already prohibited under the current provisions of the Income-tax Act.
Tax avoidance is also different from Tax mitigation which is a situation where the taxpayer takes advantage of a fiscal incentive afforded to him by the tax legislation by actually submitting to the conditions and economic consequences that the particular tax legislation entails.
It is this Tax Avoidance which like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner. There is a strong general presumption in the literature on tax policy that all tax avoidance, like tax evasion, is economically undesirable and inequitable. Moreover after the liberalization of the Indian economy, increasingly sophisticated forms of tax avoidance are being adopted by the taxpayers and their advisers.
Further, appellate authorities and courts have been placing a heavy onus on the Revenue when dealing with matters of tax avoidance. In view of the above, it is necessary and desirable to introduce a general anti-avoidance rule which will serve as a deterrent against such practices. This is also consistent with the international trend.
Further few arrangements have been used by various companies for tax avoidance which has created huge revenue loss for the government. For example after the liberalization of the Indian economy, the Indo-Mauritius Double Tax Avoidance Agreement (DTAA), was "discovered" as an effective mechanism to avoid capital gains tax on sale of shares in Indian companies. Article 13 provides for attribution of taxation rights among the two countries for capital gains. Article 13 (4) provides that gains derived by a resident of a contracting State shall be taxable only in that State. And Mauritius has no domestic level tax on capital gains, thus making it exempt. Therefore gains derived by a resident of Mauritius from the sale of shares in an Indian company are taxable only in Mauritius and as it does not tax capital gains, the transaction escapes tax in both countries. This results in double non-taxation.
This channel promoted foreign investment as more investors came in. Most other countries have been plugging these loop holes through their tax codes with anti-avoidance provisions. The GAAR is to activate a set of rules which are very broad in their construction and can effectively strike down most of these types of arrangements, as it (in DTC) overrides the treaties.
Indian tax laws, though providing for specific anti avoidance measures, do not have any general anti avoidance rules or regulations. The Courts have over the years drawn out the general parameters and principles in outlining whether a transaction or scheme would be considered as tax avoidance/tax evasion or tax planning under the tax laws, though the uncertainty continues.
In the Duke of Westminster v. IRC, and in several subsequent tax cases including W.T. Ramsay Ltd. v. IRC, Furniss v. Dawson, Craven v. White, English Courts have consistently affirmed the cardinal principle that if a document or a transaction is genuine, Courts cannot go behind it to some supposed underlying substance.
This principle has been applied in India too in several cases, the more recent among them being the Azadi Bachao Andolan case, Mathuram Agrawal case and the Vodafone case. The Supreme Court in the McDowell case frowned only upon the use of colourable devices and resort to dubious methods and subterfuges, and, as clarified by the Supreme Court in the Vodafone case, not on all tax planning in general. Courts have evolved doctrines such as piercing the corporate veil, substance over form, etc. enabling taxation of underlying assets in cases of fraud, sham, tax avoidant etc. However genuine tax planning is not ruled out.
In the application of a judicial anti-avoidance rule, the Revenue may invoke the ‘substance over form’ principle or the ‘piercing the corporate veil’ test only after it is able to establish, on the basis of the facts and circumstances surrounding the transaction, that the impugned transaction is a sham or tax avoidant.
Therefore the revenue authorities are not permitted to go into the substance of an otherwise legal tax planning, they are not allowed to conduct an enquiry into the underlying economic interest. Thus the government of India loses a great amount of tax due to the application of form over substance rule. A recent example is the Vodafone case where government lost revenue of around Rs 11,000 crores.
However, this long standing principle is set to face legislative reversal with the introduction of GAAR in the Finance Bill largely which seeks to incorporate the ‘substance over form’ doctrine in Indian tax law. Broadly speaking, GAAR will be applicable to arrangements/transactions which are regarded as ‘impermissible avoidance arrangements’ and will enable tax authorities, among other things, to re-characterise such arrangements/transactions so as to deny tax benefits.
The substantive provisions of GAAR are enumerated under Sections 123-125 of DTC Bill, 2010. Also the provisions relating to GAAR appear in Chapter X-A (sections 95 to 102) of the Finance Act, 2012.
In a nutshell, the whole scheme of GAAR revolves around the question of whether an arrangement qualifies as what is termed an ‘impermissible avoidance arrangement’. An ‘arrangement’ means any 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.
It non-obstante clause which means, if there is a conflict with provisions, in other sections, then those of this section shall prevail over other conflicting provisions. The provisions allow the tax authority to, notwithstanding anything contained in the Act, declare an arrangement which an assessee has entered into, as an ‘impermissible avoidance arrangement’. Once an arrangement has been declared as an ‘impermissible avoidance arrangement’, the consequence as regards tax liability would also be determined.
This term in turn comprises of two distinct components - the main purpose test and the specified conditions test. If upon application of the above tests, an arrangement qualifies as an ‘impermissible avoidance arrangement’, the GAAR proposes to empower the tax authorities with wide ranging powers to determine its consequences.
For the application of GAAR is that the main purpose or one of the main purposes of the arrangement is to obtain a tax benefit.
The term ‘tax benefit’ is defined as:
a) a reduction or avoidance or deferral of tax or other amount payable under this Act; or
b) an increase in a refund of tax or other amount under this Act; or
c) a reduction or avoidance or deferral of tax or other amount that would be payable under this Act, as a result of a tax treaty; or
d) an increase in a refund of tax or other amount under this Act as a result of a tax treaty; or
e) a reduction in total income including increase in loss, in the relevant previous year or any other previous year.
The ‘main purpose’ test depends not on the actual accrual of a tax benefit, but only on the purpose behind entering into an arrangement. Hence, a transaction may be caught within GAAR even if it has not yet resulted in a tax benefit so long as it has been entered into for the main purpose (or one of the main purposes) of obtaining a tax benefit, at any time.
Thus, the Finance Bill has widened the scope of GAAR as compared to that under the DTC wherein the criterion was ‘main purpose is to obtain tax benefit’. Even the South African GAAR applies ‘the sole or main purpose’ test and not ‘one of the main purpose’ as the key test.
In any arrangement if the main purpose of a step in or a part of, the arrangement is to obtain a tax benefit, the arrangement will be presumed to have been entered into to obtain tax benefit, in spite of the fact that the main purpose of the whole arrangement is not to obtain a tax benefit.
Where any arrangement results in any tax benefit, it shall be presumed to have been entered into for the main purpose of obtaining a tax benefit, unless it is proved that obtaining the tax benefit was not the main purpose of the arrangement. Therefore, the burden of proof would lie on the tax payer.
For determining the tax benefit:
i. the connected parties may be treated as one and the same person;
ii. any accommodating party may be disregarded;
iii. such accommodating party and any other party may be treated as one and the same person;
iv. the arrangement may be considered or looked through by disregarding any corporate structure.
In order for an arrangement to be classified as an ‘impermissible avoidance arrangement’, in addition to meeting with tax benefit test, it must satisfy any one or more of the following four conditions:
a) It creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
b) It results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act;
c) It lacks commercial substance or is deemed to lack commercial substance in whole or in part; or
d) It is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.
Unlike in the case of the ‘tax benefit’, there is no presumption in connection with the above conditions. Hence, the burden of proving the existence of one or more of the above conditions should lie with the Revenue.
The phrase ‘arrangement to lack commercial substance’ has not been defined. It is noted that earlier version of GAAR in the DTC Bill defined the commercial substance as “an arrangement shall be deemed to be lacking commercial substance if it does not have a significant effect upon the business risks, or net cash flows, of any party to the arrangement apart from any effect attributable to the tax benefit that would be obtained but for the provisions of section…”
It implies that besides having a commercial purpose, the taxpayer should also have commercial substance in the arrangement, which mean change in economic position of the taxpayer by altering the business risks or net cash flow to him.
Also certain arrangements have been deemed to lack commercial substance as under:
a) the substance or effect of the arrangement as a whole, is inconsistent with, or differs significantly from, the form of its individual steps or a part; or
b) it involves or includes:
· round trip financing;
· an accommodating party;
· elements that have effect of offsetting or cancelling each other;
· transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction; or
c) it involves the location of an asset or of a transaction or of the place of residence of any party which is without any substantial commercial purpose other than obtaining a tax benefit (but for GAAR provisions) for a party.
Clause (a) is the codification of substance over form doctrine. It implies that where substance of an arrangement is different from what is intended to be shown by the form of the arrangement then tax consequence of a particular arrangement should be assessed based on the substance of what took place. In other words, it reflects the inherent ability of the law to remove the corporate veil and look beyond form.
‘Round trip financing’ would include financing in which funds are transferred among parties resulting in tax benefit but for the provisions of GAAR or significantly reduce, offset or eliminate any business risk incurred by any party.
GAAR provides wide powers to the tax authorities to deal with ‘impermissible avoidance arrangements’. It provides that if an arrangement is declared to be an ‘impermissible avoidance arrangement’, the consequences in relation to tax of the arrangement, including the denial of a tax benefit or a benefit under a tax treaty, shall be determined in such manner as is deemed appropriate in the circumstances of the case, including by way of but not limited to:
a) disregarding, combining or re-characterizing any step in, or a part or whole of, the impermissible avoidance arrangement;
b) treating the impermissible avoidance arrangement as if it had not been entered into or carried out;
c) disregarding any accommodating party or treating any accommodating party and any other party as one and the same person;
d) deeming persons who are connected persons in relation to each other to be one and the same person for the purposes of determining tax treatment of any amount;
e) re-allocating amongst the parties the arrangement (i) any accrual, or receipt, of a capital or re venue nature; or (ii) any expenditure, deduction, relief or rebate;
f) treating (i) the place of residence of any party to the arrangement; or (ii) the situs of an asset or of a transaction, at a place other than the place of residence, location of the asset or location of the transaction as provided under the arrangement; or
g) considering or looking through any arrangement by disregarding any corporate structure.
It has also been provided that:
i. any equity may be treated as debt or vice versa;
ii. any accrual, or receipt, of a capital nature may be treated as of revenue nature or vice versa; or
iii. any expenditure, deduction, relief or rebate may be re-characterized.
It should be noted here that the ten consequences listed above are only illustrative in their scope, and the power of the tax authorities to determine other consequences to the transaction is not restricted.
Ø It was felt that GAAR provisions would give unbridled powers to tax officers, allowing them to question any tax saving deal. It has also generated fear due to lack of accountability in the manner in which tax officers conduct business.
Ø Foreign institutional investors (FIIs) in particular were worried that their investments routed through other countries (such as Mauritius, Singapore) could be denied tax benefits enjoyed by them under the tax treaties.
Net FIIs have been illustrating an inflow since December, 2011. Net FII inflows peaked to $7 billion in February, 2012. However, foreign institutional investments have declined post the announcement of GAAR on 16th March, 2012. March saw a net inflow of mere $0.4 billion while April registered an outflow of $8 billion. This clearly indicates that the adoption of GAAR by India was not found to be favorable by foreign investors.
Ø At the initial stage of introducing any Anti-avoidance Rule, it would be better to introduce SAARs (Specific Anti- Avoidance Rules) with reference to certain specific arrangements which the Government may have perceived to be tax avoidance arrangements and confine the application of Anti-avoidance Rule to such cases. As against a GAAR, specific rules (SAAR) give confidence to the taxpayers and also help in reducing litigation.
Ø A broad spectrum GAAR would undermine certainty and make the country less attractive to multinationals, it carries a real risk of undermining the ability of business to carry out sensible and responsible tax planning. However, introducing a moderate rule which does not apply to reasonable tax planning, and instead targets abusive arrangements, would be beneficial.
It is very common for taxpayers to arrange their affairs in a way that will give them tax benefits, which are through genuine and legitimate actions. Over the past few years it has been noticed that the Revenue Authorities have attempted to deny tax benefits, whether under the tax treaty or domestic law, by disregarding the form and looking through the transactions.
However, genuine transactions consummated in a tax efficient manner need to be distinguished from sham transactions or colourable devices used for evading tax. The approach of Revenue Authorities has resulted in protracted litigation and uncertainty. The Revenue Authorities’ attempts in this regard have not succeeded in most cases, especially in the Supreme Court, the most recent being in the Vodafone case.
Therefore the importance of the GAAR provisions from the Government’s perspective and the developments by way of the judicial outcomes of some important matters over sometime have made the way for GAAR provisions to be introduced in the current laws.
Due to GAAR now, the revenue authorities have got power to go into the substance of any arrangement and deny the tax benefits and also impose various consequences as discussed above, therefore in a way GAAR comes as a legislative overruling of various judicial pronouncements including Vodafone’s case.
Moreover the need for a GAAR should shape its form and administration. Inevitably GAARs have significant and punitive consequences when applied. It must follow that GAARs should be enacted carefully so that they are designed to address real mischief only and go no further. To ensure the tax system does not fall into disrepute, GAARs must be administered transparently and with abundant due process commensurate with their often draconian consequences.
*** B Jayant Kumar, 3rd Year Student, Hidayatullah National Law University, Raipur, email- firstname.lastname@example.org
# IRC v. Willoughby  BTC 393.
# Latilla v. IRC 11 ITR Suppl. 78 (HL).
# (1935) All ER 259.
# (1981) 1 All ER 865.
# (1984) 1 All ER 530.
# (1988) 3 All ER 495.
# McDowell & Co. Ltd. v. C.T.O.  154 ITR 148 (SC).
# Mathuram Agrawal v. State of Madhya Pradesh (1999) 8 SCC 667.
# Vodafone International Holdings B.V. v. Union of India  341 ITR 1 (SC).
# McDowell & Co. Ltd. v. C.T.O.  154 ITR 148 (SC).
# Supra note 9.
# § 95 of Finance Act, 2012.
# Id. § 102 (11).
# Id. § 96(2); § 125 of Direct Tax Code Bill, 2010.
# § 96(1) of Finance Act, 2012.
# Id. § 97.
# Id. § 98(1).
# Supra note 9.
The author can be reached at: email@example.com