Pune Branch of Western India Regional Council GENERAL

Pune Branch of Western India Regional Council GENERAL ANTI AVOIDANCE RULE (GAAR) CA. SIDDHARTH BANWAT

TAX PLANNING, TAX EVASION & TAX AVOIDANCE

TAX EVASION q It is unlawful and is the result of illegality, suppression, misrepresentation and fraud. Hence unacceptable in law itself. q OECD defines Tax evasion as “illegal arrangements where liability to tax is hidden or ignored, i. e. the taxpayer pays less tax than he is legally obligated to pay by hiding income or information from the tax authorities”. q Examples: o Deliberate failure by a “cash” business to report the full amount of revenue received o Deliberate claiming of a deduction by a business for an expenditure it has neither incurred nor paid. 4

TAX PLANNING Tax Planning q It is a situation where the tax payer uses a fiscal incentive available to him in the tax legislation by submitting to the conditions and economic consequences that the particular tax legislation entails. Tax Planning is thus allowed under tax statutes. q Examples: o Taxpayer’s decision to operate a new business as a company or LLP or a partnership o Choosing between operating a branch or a wholly owned subsidiary 5

TAX AVOIDANCE q It is the outcome of actions taken by the taxpayer, none of which or combination of which is illegal or forbidden by the law as such. It is an arrangement entered into primarily for the purpose of obtaining tax advantage. q Tax Avoidance has various definitions in legal rulings and academic literature: o Justice Reddy (in the legendary decision of Mc. Dowell) calls it the “art of dodging tax without breaking the law” o OECD terms tax avoidance as “an arrangement of a taxpayer’s affairs that is intended to reduce his liability and that although the arrangement could be strictly legal is usually in contradiction with the intent of the law it purports to follow” o The Carter Commission Report (Canada, 1966) stated that tax avoidance is “every attempt by legal means to reduce tax liability which would otherwise be incurred, by taking advantage of some provision or lack of provision in the law” 6

TAX AVOIDANCE q The common theme amongst all the definitions of tax avoidance is that there is a “grey area” of exploiting, albeit legally, the tax laws of countries to maximum benefit. It generally contains elements of artificiality (for e. g. as to the legal form adopted), and may often be considered to be contrary to the spirit of the law. q Examples: o Locating assets in offshore jurisdictions o Conversion of income to non or lower-taxed gains o Spreading of income to other taxpayers with a lower marginal tax rate o Sale and lease-back arrangements o Realizing capital gains from a subsidiary having substantially high book value instead of getting dividend, etc. q Tax avoidance through artificial structures is economically undesirable. Hence, a taxpayer should not be allowed to use legal structure or transactions exclusively to avoid tax. 7

ACCEPTABLE TAX AVOIDANCE V. UNACCEPTABLE TAX AVOIDANCE q A distinction can easily be made between Tax Avoidance and Tax Evasion. The latter is clearly illegal; the former is legal. q Another way to look at it is that tax avoidance maybe considered as a breach of social contract whereas tax evasion can easily be considered as a crime. There is no thin line but a gulf between the two. q Whereas, there is often a thin line between ‘acceptable tax avoidance’ [also known as Tax Planning] and ‘unacceptable tax avoidance’. q It is thin line of difference between acceptable tax avoidance and unacceptable tax avoidance which creates serious problems for taxpayers as well as for revenue authorities for concluding whether a particular tax avoidance proposal is permissible or impermissible in law. 8

ACCEPTABLE TAX AVOIDANCE V. UNACCEPTABLE TAX AVOIDANCE q Law does not require people to arrange their affairs so that they incur the greatest possible tax liability. Taxpayers are legitimately entitled to choose the option that requires them to pay the lesser amount of tax. q There comes a point, where governments begin to think that taxpayers are going too far in their attempts to decrease their tax liability. At this point, taxpayers cease to engage in legitimate tax mitigation and embark on unacceptable tax avoidance. q Tax avoidance transactions tend to have a number of identifiable features, for example, artificiality, lack of business or economic reality, lack of true business risk, and the exploitation of statutory loopholes. q Empirical evidence shows that tax avoidance often involves taxpayers exploiting rules that were designed to reduce unfairness in the tax. 9

IDENTIFYING UNACCEPTABLE TAX AVOIDANCE q Lack of Economic Substance – Here, the taxpayer purports to make a substantial investment. This investment, however, is largely an illusion. Through various devices/schemes, the taxpayer remains insulated from virtually all economic risks, while creating a carefully crafted impression to the contrary. Most tax abusive schemes typically involve little or no economic risk and offer little or no opportunity for pre-tax gain. Rather, the return to the investor takes the form of the significant tax benefits promised by the arrangement. In this manner, a negligible pre-tax profit is transformed into a significant aftertax return. The mismatch between a limited (or non-existent) potential for pretax profit and the promise of very significant tax benefits is often a good indicator of an abusive avoidance scheme. q Use of Tax-Indifferent Accommodating Parties or Special Purpose Entities Accommodating party is typically tax indifferent which can that can either generate offsetting deductions to absorb any income they derive from their participation in a scheme or utilize existing assessed losses. A larger deduction for one party, for example, typically means greater income for the other. Tax indifferent parties, by design, work to disable and defeat that mechanism 10

IDENTIFYING UNACCEPTABLE TAX AVOIDANCE q Unnecessary Steps and Complexity - Complex structure may be used to disguise the true nature of a scheme or as a device to cloak the tax shelter transaction from detection. q Tax haven arrangements - Schemes which make use of tax haven generally involve formation of entities like captive insurance companies, captive finance subsidiaries and intangible property holding companies in such tax havens since tax havens typically attract geographically mobile activities. 11

GOVERNMENT RESPONSES TO TAX AVOIDANCE q Legislative Solutions § SAAR – Specific anti-avoidance rules targeted at specific tax avoidance arrangements § TAAR – Targeted anti-avoidance rules such as provisions of newly enacted Sec. 94 A § Bilateral measures are also pursued through the Treaties – o Specific anti-abuse rules found in tax treaties - Beneficial Ownership, LOB Clause, Article on Associated Enterprise o Inclusion of general anti-abuse rules in tax treaties o Article pertaining to Exchange of Information q Judicial Solutions § These include the business purpose, substance over form, economic substance, step transaction, abuse of law and fraus legis approaches. These may alternatively be known as ‘Court-based GAAR (CAAR)’ or ‘Judicial antiavoidance rules (JAAR)’. 12

WHY GAAR ? q Evolution of SAARs and TAARs are typically by judicial rulings or as a reaction to a commonly used avoidance technique in the marketplace. q Rationale for having Statute-based GAAR provisions ? Justice Murphy said it best in FCT v. Hancock (Australian High Court): “The resource of ingenious minds to avoid revenue laws has always proved inexhaustible and for that reason it is neither possible nor safe to say in advance what must be found…. ” q Tax avoidance schemes are becoming increasingly complex and tough to anticipate via SAARs and TAARs q Governments across the world want to stop losing what they perceive as billions of dollars of revenue and so enact GAAR provisions would act as a ‘catch-all’ scheme for tax avoidance in general. 13

DOWNSIDE OF GAAR q GAAR promotes uncertainty which may be construed as contrary to the “Rule of Law” principle i. e. laws are meant to be reasonably certain or predictable. q Taxation Review Committee, 1975, Australia debated: “In framing legislation sufficiently all-embracing to deter tax avoidance, there is always the danger of penalizing those who have a genuine reason for entering into a bona fide transaction, which, if carried out by others, has the objective that ought to be prevented. There is frequently such a very fine line to be drawn between the transaction which offends and the one which merits no condemnation” q Developed countries like USA, UK don’t have statutory GAAR; rather judicial doctrines combined with SAAR’s (prospective & retrospective) and other administrative measures seem to be the right mix for them. 14

DOWNSIDE OF GAAR q Can there be an opposite effect of GAAR? Waincymer’s research lead to his commentary on how when Barwick High Court (Australia) strictly interpreted GAAR, it lead to an increase in the level of tax avoidance in Australia! He states: “One intuitive lesson to learn from the Australian experience is that when tax avoidance became virtually sanctioned by the High Court in the 1970’s, supermarket style off-the-shelf tax avoidance packages reached epidemic proportions. Having the Chief Justice of the High Court propound taxpayer rights would surely be a powerful rationalizing factor for taxpayers and advisers” 15

HISTORY OF GAAR IN INDIA q Apart from a few specific anti-abuse rules in ITA, the development of antiabuse or anti-avoidance principles in India in general has been by way of judge-made law § CIT v. A Raman and Co. ([1968] 67 ITR 11) – SC followed the dictum of Duke of Westminster’s (1936 AC 1) case and held that avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed, is not prohibited § Mc. Dowell & Co. Ltd v. Commercial Tax Officer ([1985] 154 ITR 148) – SC clearly departed from the above views and expressly disassociated itself with the earlier observations of the SC echoing the sentiments of Westminster principle. The court enumerated the evil consequences of tax avoidance. The principles where subsequently followed by SC in CWT v. Arvind Narottam (173 ITR 479) and Union Bank of India v. Playworld Electronics Pvt Ltd (184 ITR 308) 16

HISTORY OF GAAR IN INDIA q A Scheme of Amalgamation framed solely with an object of buying over an asset so as to defeat the provisions of the tax laws would not be sanctioned. “The amalgamation of companies must fulfil some need, some purpose, some object and that must have some relation to public interest. If only purpose discernible behind amalgamation is to defeat certain taxes and if for that purpose assistance is sought for from the Court, the Court would be the last instrument to grant such assistance by way of a judicial process to defeat the tax liability or even to avoid the tax liability. ” These were the observations of the Gujarat High Court in the case of Wood Polymers Limited – [1977] 109 ITR 177 (Guj. ) 17

HISTORY OF GAAR IN INDIA § Union of India v. Azadi Bachao Andolan ([2003] 263 ITR 706) – SC diluting the principle from Mc. Dowell’s case held that not all legitimate acts of a tax payer which, in the ordinary course of conducting his affairs a person does and under law he is entitled to do, can be branded as of questionable character. SC also clarified that the decision in Mc. Dowell’s case does not mean that any act of an assessee which results in reduction of his tax liability or in expectation of tax benefit in future, amounts to colourable device, a dubious method or a subterfuge to avoid tax and can be ignored if the acts are unambiguous and bona fide. § It was further observed that while the planning adopted as a device to avoid tax has to be deprecated, the principle cannot be read as laying down the law that a person should arrange his affairs so as to attract maximum tax liability, and every act which results in tax reduction, exemption of tax or not attracting tax authorized by law is to be treated as a device of tax avoidance. 18

HISTORY OF GAAR IN INDIA § Bombay HC in the case of Vodafone International Holdings B. V. v. Union of India ([2010]329 ITR 126) reiterated the principles laid down in Azadi Bachao Andolan’s case. It stated the following principles: § Citizens and business entities are entitled to structure or plan their affairs with circumspection and within the framework of law with a view to reduce the incidence of tax. § A transaction which serves no business purpose other than the avoidance of tax is not a legitimate business transaction and in the application of fiscal legislation can be disregarded. § Absent a case of a transaction which is sham or a colourable device, an assessee is entitled to structure business through the instrument of genuine legal frameworks. An act which is otherwise valid in law cannot be disregarded merely on the basis of some underlying motive resulting in some economic detriment or prejudice. 19

HISTORY OF GAAR IN INDIA § The Mumbai Bench of ITAT in the case of Mahindra Telecommunications Investment Pvt. Ltd. (Taxpayer), adopted the principles laid down under GAAR provisions while examining the issue of taxability of an income stream, i. e. , return on equity investment, which in fact arose as a fixed return, based on an agreement. § Here, the revenue authorities asserted that the fixed call option price was akin to interest income on fixed deposits placed with a bank, and was taxable as revenue income on a year-on-year basis. The ITAT ruled in favour of the revenue authorities and held that the return on equity was taxable as revenue income. 20

GAAR UNDER ITA

BASIC SCHEME OF GAAR [Chapter-XA] Sec. 95 to 102 Sec. 95 Basic enabling provision 22 Sec. 96 & 97 Impermissible Avoidance Agreement (IAA) Sec. 98 Consequences • S. 99 – Parameters for determining tax benefit • S. 100 – Provisions in lieu of / in addition to • S. 101 – Guidelines and conditions • S. 102 – Definitions • S. 144 BA – GAAR Assessment

MANDATE OF GAAR q The assessee is bound to not to get into IAA q Entering into IAA is not barred by law q It is only at the instance of AO, can an arrangement be declared as IAA q Unlike Sec. 92, which make a suo motu mandate, here the assessee is not bound to suo motu declare his arrangement as IAA q It resembles the concept in Sec. 14 A read with Rule 8 D which can be invoked only at the instance of revenue : Holcim India P Ltd [Delhi HC 2014 -TIOL 1586 -HC-DEL] q Thus, there should not be any penalty when GAAR is invoked 23

APPLICABILITY OF GAAR As per Rule 10 U, GAAR does NOT applies to: q an arrangement where the tax benefit in the relevant assessment year arising, in aggregate, to all the parties to the arrangement does not exceed a sum of Rs. 3 crore; q a Foreign Institutional Investor, — (i) who is an assessee under the Act; (ii) who has not taken benefit of an agreement referred to in section 90 or section 90 A as the case may be; and (iii) who has invested in listed securities, or unlisted securities, with the prior permission of the competent authority, in accordance with the Securities and Exchange Board of India (Foreign Institutional Investor) Regulations, 1995 and such other regulations as may be applicable, in relation to such investments; q a person, being a non-resident, in relation to investment made by him by way of offshore derivative instruments or otherwise, directly or indirectly, in a Foreign Institutional Investor; 24

GRAND FATHERING q “Any income accruing or arising to, or deemed to accrue or arise to, or received or deemed to be received by, any person from transfer of investments made before 1 st April 2017 by such person” – Rule 10 U(1)(d) Except q “Without prejudice to the provisions of clause (d) of sub-rule (1), the provisions of Chapter X-A shall apply to any arrangement, irrespective of the date on which it has been entered into, in respect of the tax benefit obtained from the arrangement on or after 1 st April 2017. ” – Rule 10 U(2) 25

S. 96 : IMPERMISSIBLE AVOIDANCE AGREEMENT (IAA) Essential two conditions: 1. The Main Purpose + Obtain Tax Benefit (part or whole or in any step of such arrangement) 2. “Either of the given four conditions”: a) Not at Arm’s Length b) Represents Misuse or Abuse of the provisions of the Act c) “Lacks Commercial Substance” d) Entered or carried on in a manner not normally employed for “Bona-fide Purposes”. "arrangement" means any step in, or a part or whole of, any transaction, operation, scheme, agreement or understanding, whether enforceable or not, and includes the alienation of any property in such transaction, operation, scheme, agreement or understanding; 26

TAX BENEFIT : RULE 10 U(3)(IV) V/S. SEC. 102(10) Rule 10 U(3): (iv) "tax benefit" as defined in clause (10) of section 102 and computed in accordance with Chapter X-A shall be with reference to— a) sub-clauses (a) to (e) of the said clause, the amount of tax; and b) sub-clause (f) of the said clause, the tax that would have been chargeable had the increase in loss referred to therein been the total income. 30 Sec. 102: (10) "tax benefit" includes, — 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; or f) an increase in loss, in the relevant previous year or any other previous year; .

TAX BENEFIT : RULE 10 U(3)(IV) V/S. SEC. 102(10) q Sec 102(10)(a) to (d) consider tax or any other amount while Rule 10 U(3)(iv)(a) limits it to the amount of tax q Sec. 102(10)(e) considers reduction in total income while Rule 10 U(3)(iv)(a) limits it to the amount of tax q Therefore, Rule 10 U(3)(iv)(a) significantly reduces the scope for application of GAAR by reducing the scope of Tax Benefit 31

TAX BENEFIT q I Co. is a company incorporated in India engaged in providing management consultancy services to clients in India as well as abroad. Management Consultancy services I Co. Fees for professional services Brazilian Co. (Client) q For foreign contracts, I Co. outsources work to foreign consultants to reduce costs. q During Financial year 2016 -17, I Co. earned a contract to render management consultancy services to a Brazilian entity for a value equivalent to INR 100 million. q As per estimates of I Co. , the consultancy service would go on for a period of four months during financial year 2016 -17. 32

TAX BENEFIT : EXAMPLE q Income earned from Brazilian company : INR 100 million. q WHT in Brazil as per DTAA : INR 15 million. But due to tax sparing under Art. 23(2) of India-Brazil DTAA, ITA is entitled to a deemed credit of 25%. Particulars INR in Mn. Income earned in Brazil 100 Less: Expenses on payment to foreign consultant (30) Net foreign income taxable in India 70 Tax @ 30% as per ITA 21 FTC entitlement of INR 25 million thus restricted to INR 21 million under ITA q Income from Indian contracts : INR 100 million. q Withholding Tax on Fees for Professional Services under ITA : 10% q Expenditure incurred for earning the income from Indian contracts : INR 80 million. 33

TAX BENEFIT : EXAMPLE Details of the computation of total income of I Co. for FY 2016 -17 Particulars Total Income taxable in India (100+100) Less: Expenses (30+80) Total income earned from Ordinary Sources Tax @ 30% as per ITA Less: FTC & TDS (21+10) Tax payable by / (Refund to) I Co. INR in Mn. 200 (110) Indian tax payable in respect to foreign income < Indian income tax payable on total income 90 27 (31) (4) Therefore, as per S. 90 r. w. R. 128, there is no bar on availing FTC up to INR 21 million. q If Deeming Tax Credit provision absent under India-Brazil DTAA, then: Total tax credit (consisting of FTC+TDS) would have been 15+10=25 Tax payable would have been INR 2 million. q Since Deeming Tax Credit benefit availed under DTAA, a refund of INR 4 million is arising to I Co. . 34

TAX BENEFIT : EXAMPLE q India-Brazil DTAA – No FTS clause Dividend – Exemption Method [Art. 23(1)] Refer Art. 23(2) Refer ‘Para 2’ of Protocol q Is the transaction entered into to take the tax benefit? q Expenses are lower in Brazil- Is it a case of GAAR? q The term “Arrangement” and “Tax Benefit” has been very widely defined CAN THE AFORESAID BENEFIT PROVIDED UNDER A TAX TREATY QUALIFY TO BE A ‘TAX BENEFIT’ UNDER GAAR? - YES 35

S. 96 : RIGHTS AND OBLIGATION NOT AT ARM’S LENGTH (a) creates rights, or obligations, which are not ordinarily created between persons dealing at arm's length; q This condition aims to test the motive of the parties getting into an arrangement. However, the word arm’s length is too subjective. Perhaps, an interesting comparison can be made on the scope of the term ‘arm’s length’ when used in the context of transfer pricing provisions (which are SAAR) whereas in the context of GAAR. q Under the TP, arm’s length principle is applicable where arrangement is between two associated enterprises, whereas in light of the present definition even the arrangement between parties (un-associated), dealing in normal commercial terms, may be construed to be not at arm’s length. q Hence, will uncontrolled transactions are required to be bench marked with other uncontrolled transactions ? 36

S. 96 : ABUSE OR MISUSE OF PROVISIONS (b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act; q In order to understand the difference between the word ‘misuse’ and ‘abuse’ reference can be had to Canada Ruling in case of OSFC Holdings wherein court stated that: “…the misuse analysis looks to specific provisions in isolation from the broader scheme of the ITA, while the abuse analysis looks to the purpose, scheme or policy reflected in the provisions of the ITA as a whole…” 37

S. 97 : ARRANGEMENT TO LACK COMMERCIAL SUBSTANCE (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 q This condition is essentially an articulation of the internationally known “substance over form doctrine”, where the legislative intent is to prevent transactions entered merely to avail the tax benefit with no legal substance thereby resulting into abuse of provision of the law. (d) 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 this Chapter). q It is unclear as to what is the meaning of the word ‘significant’ as it is used in connection with effect on the business risk or net cash flow. The overall concept of the aforesaid provision is to cover within its scope the arrangements or transactions which are internationally known as sham transactions and is essentially an articulation of the “economic substance doctrine”. 38

S. 97 : ARRANGEMENT TO LACK COMMERCIAL SUBSTANCE (b)(i) it involves or includes round trip financing; S. 97(2): Round trip financing includes any arrangement in which, through a series of transactions— (a) funds are transferred among the parties to the arrangement; and (b) such transactions do not have any substantial commercial purpose other than obtaining the tax benefit (but for the provisions of this Chapter), F. Co. FDI ODI without having any regard to— (A) whether or not the funds involved in the round trip financing can be traced to any funds transferred to, or received by, any party in connection with the arrangement; (B) the time, or sequence, in which the funds involved in the round trip financing are transferred or received; or (C) the means by, or manner in, or mode through, which funds involved in the round trip financing are transferred or received. 39 I. Co.

S. 97 : ARRANGEMENT TO LACK COMMERCIAL SUBSTANCE (b)(ii) it involves or includes an accommodating party S. 97(3): A party to an arrangement shall be an accommodating party, if the main purpose of the direct or indirect participation of that party in the arrangement, in whole or in part, is to obtain, directly or indirectly, a tax benefit (but for the provisions of this Chapter) for the assessee whether or not the party is a connected person in relation to any party to the arrangement. I Co. [India] I Co. will be able to get back its own funds and can claim interest deduction on loan from C Co. Loan Equity M Co. [Mauritius] 40 Loan C Co. [Cyprus]

S. 97 : ARRANGEMENT TO LACK COMMERCIAL SUBSTANCE (1)(b)(iii) it involves or includes elements that have effect of offsetting or cancelling each other (1)(b)(iv) it involves or includes a 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 (1)(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 the provisions of this Chapter) for a party; or (4) For the removal of doubts, it is hereby clarified that the following may be relevant but shall not be sufficient for determining whether an arrangement lacks commercial substance or not, namely: — i. the period or time for which the arrangement (including operations therein) exists; ii. the fact of payment of taxes, directly or indirectly, under the arrangement; iii. the fact that an exit route (including transfer of any activity or business or operations) is provided by the arrangement. 41

S. 96 : BONA FIDE PURPOSE (1)(d) is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes. (2) An arrangement shall be presumed, unless it is proved to the contrary by the assessee, to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit, notwithstanding the fact that the main purpose of the whole arrangement is not to obtain a tax benefit. 42

DEFINED / UNDEFINED TERMS “ARRANGEMENT” “TAX BENEFIT” UNDEFINED TERMS “MAIN PURPOSE” “LACKS COMMERCIAL “SIGNIFICANT SUBSTANCE” EFFECT” “ROUND TRIP FINANCING” “FUNDS” “BONA FIDE PURPOSE” “MISUSE OR ABUSE” “ACCOMMODATING PARTY” 43

S. 98 : TAX CONSEQUENCES 44

S. 98 : TAX CONSEQUENCE Tax Consequence Means Consequences in relation to tax, of the arrangement Shall be determined In such manner as deemed appropriate 45 Including Denial of (a) Tax benefit (b) DTA Benefit

TAX CONSEQUENCE 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 …. 46

TAX CONSEQUENCE e) reallocating amongst the parties to the arrangement — (i) any accrual, or receipt, of a capital or revenue 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. 47

TAX CONSEQUENCE Manner of determining Tax Consequences May include [Sec. 98(2)] a) any equity may be treated as debt or vice versa b) any accrual, or receipt, of a capital nature may be treated as of revenue nature or vice versa; or c) any expenditure, deduction, relief or rebate may be re-characterized 48

GAAR V. SEC. 4 & 5 q GAAR provisions, though override Sec. 90, does not override the Sec. 4 & 5. Sec. 5 read with Sec. 4 creates a charge on the Scope on Income of an assessee and Income u/s 2(24) does not include Capital Receipts unless specially mentioned therein. q Sec. 98(2)(ii) which read as “any accrual, or receipt, of a capital nature may be treated as of revenue nature or vice versa; ”, permits any capital accrual to be treated as a revenue accrual. Does it thus permit to convert a non-income as an income? q However, GAAR does not enable to advance an accrual or make a nonaccrual an accrual. But GAAR covers tax deferral in its scope by defining it under the definition of Tax Benefit 49

DETERMINING EXISTENCE OF TAX BENEFIT Sec. 99 i. the parties who are connected persons in relation to each other 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 50

S. 144 BA : PROCEDURE Section 144 BA AO a) Makes reference to CIT – S. 144 BA(1) b) Where direction of AP relates to any PY, AO to proceed as per directions / Chapter X-A without having to make reference to AP for such PY – S. 144 BA(11)… 51 Approving Panel Commissioner a) Issues notice to assessee – S. 144 BA(2) a) Issues direction upon reference – S. 144 BA(6) b) Issues direction, if assessee doesn’t object –S. 144 BA(3) b) Hearing to be granted – S. 144 BA(7) c) c) If not satisfied with objection, refers case to AP – S. 144 BA(4)… Power to cause further enquiry, call for & examine records…

d. c. 52 Pass assessment / re-assessment order to give effect to tax consequences– S. 144 BA(12) e. If satisfied, passes an Order dropping proceeding – S. 144 BA(5) Grants prior approval to order passed under S. 144 BA(12) d. Decision by majority – S. 144 BA(9) e. Directions are binding on AO – S. 144 BA(10)

S. 144 BA : PROCEDURE Role of AO/ CIT/ AP Declaring IAA CIT Determining Tax Consequence AP AO S. 144 BA(3) S. 144 BA(6) S. 144 BA(11) S. 144 BA(12) S. 98 53

SEVERAL PARTIES TO GAAR q If several parties enter into arrangement and some only get the tax benefit, then AO of which party would initiate GAAR? q The scheme of Sec. 144 BA would apply only to the assessee whose AO has invoked GAAR and tax consequences would be determined only for that assessee q For other parties, there is no enabling provision to determine the tax consequences. q Can Sec. 147 be invoked in respect of other parties when they are party to Sec. 144 BA proceedings? 54

GAAR <> POEM An Indian company, I Co. , has set up a holding company, M Co. , in a low tax jurisdiction outside India which has set up further subsidiary companies, M 1 Co. and S Co. , which pay dividends to M Co. and such dividends are not repatriated to the I Co. . Would the deemed dividend be treated as income using GAAR Declaration of dividend is business decision. Hence, should not be invoked. However, chances of invoking POEM are high. I Co. [India] No Dividend 100% 51% M Co. [Mauritius] 100% Dividend 55 M 1 Co. [Mauritius] S Co. [Singapore]

REVERSE MERGER The merger of a profit making company into a loss making one results in losses off setting profits, a lower net profit and lower tax liability for the merged company. Would the losses be disallowed under GAAR ? A Co. [Amalgamating Co. ] Profit making Merges R Co. [Amalgamated Co. ] Loss making Though the merger is covered by SAAR (NCLT approval), the CBDT circular clarifies that GAAR would not be invoked if the NCLT has adequately and explicitly considered the tax implication while sanctioning the arrangement. 56

CONVERSION OF COMPANY INTO LLP I Co. has a assets less than Rs. 5 crores but its turnover exceeds Rs. 60 lakhs. So as to take the benefit of Sec. 47(xiiib), I Co. merges with New Co. (which is a tax neutral arrangement) and thus starts with fresh turnover and converts the New Co. into LLP before the turnover exceed Rs. 60 lakhs. I Co. to merge into New Co. to be converted into LLP 57 This arrangement is solely for availing tax benefit by avoiding capital gains. Hence GAAR shall be invoked as during the merger, the NCLT would not have analyzed the tax implication of the future intent of the New Co. to get converted into LLP. However, if the arrangement of merger and conversion is concluded before 1 April 2017, then GAAR would not be invoked as the Tax Benefit of conversion is before 1 April 2017

SALE AND PURCHASE TRANSACTION I Co. is in the business of import and export of certain goods. It purchases goods from Country A and sells the same in country B. It sets up a subsidiary S Co. in Mauritius - a zero/ low tax jurisdiction. The director of the Indian company finalizes the contracts in India but shows the documentation of the purchase and sale in Mauritius. The day to day management operations are carried out in India. The goods move from A directly to B. The transactions are recorded in the books of subsidiary in Mauritius, where the profits are tax exempt. I Co. Purchases from Country A Sells to Country B Purchases from Country A S Co. [Mauritius] Sells to Country B By this arrangement, the I Co. has obtained a tax benefit. The substance or effect of the arrangement as a whole is inconsistent with, or differs significantly from, the forms of its individual steps and hence, lacks commercial substance. Revenue would invoke GAAR with regard to this arrangement. Further POEM provisions shall also come into picture. 58

INTERPOSING A CO. TO AVOID CAPITAL GAINS Y Co. , a non- resident, and Z Co. , a resident of India, form a JV company X Co. in India. Y Co. , incorporates a WOS A Co. in country Mauritius of which Y Co. is not a resident. The India – Mauritius tax treaty provides for non-taxation of capital gains in the source country and country Mauritius charges a minimal capital gains tax in its domestic law. A Co. is also designated as a “permitted transferee” of Y Co. “Permitted transferee” means that though shares are held by A Co. , all rights of voting, management, right to sell etc. , are vested in Y Co. As provided by the JV agreement, 49% of X Co. ’s equity is allotted to company A Co. (being WOS and “permitted transferee” of Y Co. ) and the remaining 51% is allotted to the Z Co. company. Thereafter, the shares of X Co. held by A Co. are sold by A Co. to C Co. (connected to the Z Co. ’s group). 59

INTERPOSING CO. TO AVOID CAPITAL GAINS Y Co. [UK] Z Co. [India] 100% 51% A Co. [Mauritius] 49% Sells 49% stake Z Co. X Co. (JV) [India] Connected party C Co. The controlling rights of A Co. were with Y Co. . A direct transfer of these shares by Y Co. to C Co. would have attracted capital gains tax in India read with the relevant treaty of Y Co. ’s country of residence. A Co. was interposed with main purpose of taking advantage of India-Mauritius treaty. The arrangement results in misuse or abuse of tax provisions. Revenue would invoke GAAR as regards this arrangement. 60

SHELL / CONDUIT COMPANY q A Co is a resident company in country R and is WOS of X Co. in country T. X Co. is a financial company with substantial reserves and looking for investments in India. q X Co. uses its WOS A Co. to route its investment in an Indian company B Co. whereby A Co. purchases the shares of B Co. After sometime, A Co. sells the shares of B Co. to another company C Co. and realizes capital gains. q As per the provisions of relevant DTAA Protocol between country R and India, a shell/conduit company is not eligible for capital gains exemption in India. However, a company shall not be deemed to a shell/conduit company if its total annual expenditure on operations in country R is equal to or more than Rs. 1, 00, 000/- in the immediately preceding period of 24 months from the date the gains arise. q A Co. claims that capital gains are not taxable in India as it is not a shell company as per the relevant DTAA Protocol and that it incurred Rs. 1, 20, 000/- (Rs. 40, 000/as license fees and local office expenses, Rs. 80, 000/- as interest payments to X Co. , its parent holding company) as business expenses as per P&L A/c to show its economic presence in country R as it claimed expenditure exceeding the limit prescribed therein and for it not to be shell/conduit company. 61

SHELL / CONDUIT COMPANY X Co. 100% License fee 40 L Interest to X Co. 80 L A Co. Country T Country R 20% C Co. Sells investment to C Co. B Co. India A Co. has incurred only Rs. 40, 000/- on operations in country R. Interest payments of Rs. 80, 000/- outside country R cannot be taken into account for the purposes of computation of Rs. 1, 00, 000/- limit of expenses incurred on operations in country R. A Co. will be deemed to be a shell/conduit company. The treaty benefit may be denied under LOB clause of the treaty itself. As it is an arrangement for claiming benefits of DTAA and it lacks economic substance, therefore, Revenue may also invoke GAAR with regard to this arrangement. 62

TREATY BENEFIT q A Co. , is incorporated in country AB as a WOS of B Co. which is not a resident of AB or of India. The India-AB tax treaty provides for non-taxation of capital gains in the source country and country AB charges a minimal capital gains tax in its domestic law. q Some shares of an Indian Company C Co. were acquired by A Co. The entire funding for investment by A Co. in C Co. was done by B Co. A Co. has not made any other transaction. These shares were subsequently disposed of by A Co. , thus resulting in capital gains which A Co. claims as not being taxable in India by virtue of the India- AB tax treaty. 63

TREATY BENEFIT B Co. XY Country WOS A Co. AB Country “A” acquires some shares of “C” funded by “B” C Co. India The beneficial ownership vests with the connected B Co. which had played a crucial role in the transaction conducted by A Co. Though the legal ownership ostensibly resides with the A Co. , the real and beneficial owner of the capital gains is the B Co. which controls the connected A Co. . This is an arrangement which has been created with the main purpose of avoiding capital gains tax in India through misuse or abuse of treaty provisions. Hence it is impermissible arrangement. Revenue would invoke GAAR as regards this arrangement. 64

BANK FINANCING A foreign bank “F”s branch in India arranges loan for Indian borrower from “F” bank’s branch located in a third country “AB”. The loan is later assigned to “F” bank’s branch in XY country to take benefit of withholding provisions of India-XY treaty (India-XY Treaty provides no source based withholding tax on interest to a bank carrying out bona-fide business. ) F Bank PQ Country AB Country Branch F Bank AB Branch Loan India XY Country F Bank XY Branch AB Branch assigns loan to XY Branch I Co. Since there is no withholding provision on interest earned by XY residents under the India. XY treaty, the above arrangement of finalizing the loan from one country and assigning it to another country has been made to avoid withholding provisions. This is a misuse of tax treaty and thus will be treated as an “impermissible avoidance arrangement”. Revenue would invoke GAAR with regard to this arrangement. 65

TREATY BENEFIT q An Indian Company I Co. , is a closely held company and its major shareholders are connected companies B Co. , C Co. and D Co. q I Co. was regularly distributing dividends but stopped distributing dividends from 1. 4. 2003, the date when Dividend Distribution Tax (DDT) was introduced in India. q I Co. allowed its reserves to grow by not paying out dividends. As a result no DDT was paid by the company. Subsequently, all its shareholders buyback of shares was offered by the I Co. to its shareholders. q B Co. based in country ABC and the other shareholders C and D who are not resident of ABC. The India-ABC tax treaty provides for non-taxation of capital gains in the source country and country ABC charges very low capital gains tax in its domestic law. q The buyback offer was only accepted by the B Co. and therefore the accumulated reserves of I Co. were used to buyback the shares from the B Co. 66

TREATY BENEFIT B Co. Origin- “ABC” “ I Co. Major Shareholders C Co. Origin- “XY” D Co. Origin- “TU” The arrangement is a colourable device designed to avoid tax in India. No dividends were distributed by I Co. since 1. 4. 2003, the day the DDT was implemented for non bona fide purpose. Thus I Co. obtained tax benefit by not declaring dividend and passing this on as exempt capital gain in the hands of B Co. The buyback of shares was accepted only by B Co. and not by the C Co. and D Co. as they would have invited capital gains tax by accepting such offer. Revenue would invoke GAAR as regards this arrangement. 67

AVOIDING MAT LIABILITY ON 10(38) LTCG q I Co forms a partnership firm and gifts the investments in listed shares to the firm. q After a year, the firms sells these shares and realises the tax exempted capital gains (LTCG STT paid). q Subsequently, the firm is dissolved and the share of I Co in the firm is transferred back along with the profits, which is exempt from tax. I Co. Hold Gifts investment to LLP I 2 Co. The only purpose of such arrangement is to save tax from MAT liability on 10(38) LTCG of I Co. Hence, revenue could invoke GAAR and capital gains may be taxed under MAT in the hands of I Co. 68

TAX MITIGATION – GAAR CANNOT BE INVOKED q Setting-up of a unit in SEZ which results into a tax benefit, is a case of tax mitigation since the taxpayer is taking advantage of fiscal incentive offered to him by submitting to the conditions and economic consequences of the provisions in the legislation q A company chooses asset on lease over outright purchase and consequently claims higher deduction for lease rentals rather than depreciation. Being an investment decision of the company, GAAR provisions shall not apply q An Indian Co. has raised fund from a foreign company incorporated in a low jurisdiction outside India through borrowings, when it could have issued equity. An evaluation of whether business should have raised funds through equity instead of debt should generally be left commercial judgement of a taxpayer. Further, the newly introduced thin capitalization provisions are enough to act as a safe harbour for the Revenue. q A company sets off losses in the stock market against gain which is aimed to balance the portfolio. In such case, sale/purchase through stock market transaction and timing of transaction would not come under GAAR provisions. 69

OTHER DOMESTIC TRANSACTION UNDER GAAR TRANSACTION TAX BENEFIT OBTAINED? Sale of shares instead of assets/ business Yes (on account of beneficial rate of tax) Results in misuse abuse of ITA Sale on 1 st April while negotiations fully completed in third week of March Yes (as it achieves deferment of tax) Carried out in manner which would not normally be employed for bona fide purposes Disregard the step of postponement of date Gift of house to sons so as to enjoy benefit S. 54 F exemption Yes (as it achieves reduction in tax) Results in misuse or abuse of ITA Or Creates rights and obligations which would not normally be created between persons dealing at ALP Treat sons as accommodating parties Or Deem persons who are connected to be one and the sham person 70 ADDITIONAL CONDITION CONSEQUENTIAL REACTION or Re-characterization income of

OTHER DOMESTIC TRANSACTION UNDER GAAR TRANSACTION TAX BENEFIT OBTAINED? Lease of equipment by US Co to I Co through SPV in Netherlands Yes (As India. Netherlands does not have equipment royalty clause) Lacks substance commercial Disregard the accommodating party (SPV in Netherlands) Issuance of bonus shares and sale of original shares Yes (Due to reduction in profit or increase of loss) Results in misuse or abuse of ITA Or Carried out in manner which would not normally be employed for bona fide purposes Re-characterize as if it is proportionately sale of bonus shares 71 ADDITIONAL CONDITION CONSEQUENTIAL REACTION

GAAR CONCERNS EXPRESSED BY VARIOUS BODIES

GAAR CONCERNS EXPRESSED BY VARIOUS BODIES q The GAAR confers vast and discretionary powers to the tax authorities to disregard any business transactions including for instance, a tax neutral merger, or holding company structures, especially those which involve countries with which India has entered into favourable tax treaties. This would lead to significant uncertainty with respect to conducting business in India. q A tax treaty override (without any objective parameters) under GAAR could raise concerns about the sanctity of benefits conferred under treaties and affect India’s credibility as a reliable treaty partner. q Structures that are currently in place could potentially be challenged under the new legislation causing significant hardship to existing investors. q The application of GAAR to a specific structure by the tax authorities could change from year to year, resulting in significant fiscal uncertainty. q Transactions/ structures that have been specifically upheld by Courts could also potentially be targeted under the GAAR. q The GAAR could lead to cumbersome, time-consuming and costly litigation each time a transaction or structure is sought to be tested under the GAAR by the tax authorities. 73

ASSURANCES

ASSURANCE BY STANDING COMMITTEE q It is not a revenue raising measure but is there to prevent loss of revenue [para 15. 31] q A mere tax benefit under DTA would not lead to application of GAAR unless other conditions prescribed are also fulfilled [para 15. 31] q Since GAAR would be operational under a set of guidelines framed by CBDT, there should be no cause for concern in this regard. [para 15. 33] q Further, the guidelines to be prescribed shall also be placed in the public domain before finalization [para 15. 33] q A reasonable threshold limit for invoking GAAR to be prescribed 75

ASSURANCE IN MEMORANDUM TO FINANCE BILL q The basic criticism of statutory GAAR which is raised worldwide is that it provides a wide discretion and authority to the tax administration which at times is prone to be misused. q This vital aspect, therefore, needs to be kept in mind while formulating any GAAR regime 76

SOLUTION TO GAAR

Only solution Is Substance 78

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