Preparing For GAAR!

India first met the General Anti-Avoidance Rule or GAAR in the Direct Taxes Code Bill, introduced in parliament on August 30, 2010. But before the Bill could become law, GAAR did; hurried along by then Finance Minister Pranab Mukherjee in the 2012 Budget. But its severity shocked the stock markets and drew intense criticism; forcing the incoming Finance Minister to send it back to an expert committee headed by Dr Parthasarathi Shome. This week P Chidamabaram accepted many of the Shome Committee recommendations giving India a milder GAAR that will come into effect from April 1st 2015.

This week, 'The Firm' asks experts how to GAAR proof business structures and investments? We speak to Vineet Agrawal, Group Head-Taxation at JSW Steel to understand how companies can GAAR proof domestic transactions.
 
Doshi: Let me start by asking you- given that we have now had several iterations of GAAR drafts over the course of the last three years. Do you believe that this last one, that is the final report of the Shome Committee and those recommendations that were accepted by the Finance Minister constitute a far milder version of GAAR than the Central Board of Direct Taxes (CBDT) draft that we started off with two years ago?
 
Agrawal: I will partially agree because as far as domestic companies are concerned, there are so many specific anti avoidance rules, which are already existing. Second thing, what has been postponed, its applicability has been postponed but all the transactions which were there in 2009 are already covered; only the investments which were made prior to 2009 or the introduction of Direct Tax Code (DTC) have been exempted from invocation of GAAR.
 
Doshi: Prior to August 2010, right?
 
Agrawal: Yes, mid 2009. So, only those have been exempted. As far as domestic companies are concerned, it is mostly structures. So I do not think there is any GAAR proofing which can be done right now with those structures.
 
Doshi: So what kind of structures should we keep an eye out for because they will eventually have to find closure between now and FY16?
 
Agrawal: As far as domestic companies are concerned, broadly I see two or three major areas. One is employee compensation, second is group transactions and three tripartite transactions where third parties are involved and certain rights and obligations are created.
 
Doshi: Let us go one by one- employee compensation 
 
Agrawal: In certain employee compensation schemes, certain benefits are extended to employees for instance like vehicles, like residences, which strictly speaking are legal but these structures - now they maybe considered tax avoidance scheme vis-à-vis employees and ultimately burden maybe casted on companies and employees both because mutual offsetting is not allowed.    
 
Doshi: But wouldn’t the value of the house or wouldn’t the value of the car in that scheme have to exceed Rs 3 crore for GAAR to apply?

Finance Minister
GAAR would only be invoked if a minimum tax benefit of Rs 3 crores is obtained due to the arrangement

Agrawal: If there is a larger scheme of a company covering all the employees, God knows whether it may exceed Rs 3 crore because all the interconnected transactions may be clubbed together.
 
Doshi: Which means that you do not offer any such benefits to your employees or if you do, then they are fully taxable?
 
Agrawal: Exactly. You sensitize your employees that they have to pay tax on this.
 
Doshi: The second you mentioned was group transaction, which you want to refer to as domestic transfer pricing. Explain to me the kinds of structures that exist, how GAAR will impact and hence how they will have to change?
 
Agrawal: When I am talking about group transactions, I am talking about large corporate houses where there are certain group companies which may not be covered under domestic transfer pricing regime because of lack of common ownership or lack of common management. So, so far as far as domestic pricing scheme is concerned they are not covered under the documentation but still there exist certain inter-corporate transactions and under GAAR- since Specific Anti-Avoidance Rules (SAAR) will not be invoked- GAAR will certainly be there. So, I suggest these transactions have to be identified and a commercial substance has to be built in those transactions or either they have to be avoided.
 
Finance Minister
Where GAAR & SAAR are both in force, only one of them will apply and guidelines will be made regarding the applicability of one or the other Doshi: What do you understand as commercial substance because that in itself also has to be defined, right?
 
Agrawal: What I understand from commercial substance is timing, business sense as well as economic risk. If these three things are there, then it makes commercial substance.
 
Doshi: Explain to me how a new structure regarding group transactions will have to design keeping these principles of commercial substance in mind and hence it would be GAAR safe?
 
Agrawal: I will say like a commission payment to a group company. The group company, if it is not in regular business transaction, how will you justify that there is a commercial substance or there is a third party available in the market, who is readily available to give you those kind of services for much cheaper rate, certainly GAAR has to be invoked in such cases.
 
Doshi: The third point that you wanted to talk about were tripartite agreements. Explain to us what you see will have to change for these agreements to be GAAR safe?
 
Agrawal: The simplest tripartite agreement which I look at is subcontracting where a big corporate gives a contract to a major contractor and then that contract is either subcontracted or assigned to third party. The revenue authorities can always challenge these big corporates that they can directly reach the subcontractor who is ready to give them services at a lower price. As of now there is no provision in the law where these kind of transactions can be challenged but under GAAR there is always a possibility because it can always be alleged that the major intension is to evade tax or to save tax in this transaction. To just bring in, there has to be a commercial substance in the first transaction itself- maybe the big contractor is ready to give performance guarantee which the subcontractor may not be able to give or there is a contract which is larger in nature and only a part of that has been given to a subcontractor and that particular subcontractor is not able to perform all the terms of that large contract. These kind of transactions, I think will be GAAR proof but if it is only one to one, back to back transaction then it will be difficult to sustain. 
 
This is a special episode on how to GAAR proof your business and investments. It is investments that we are going to discuss in this segment both inbound as well as outbound. To do that I am joined by Pranav Sayta, Partner at EY. Doshi: What do you make of this version of GAAR especially keeping in mind that investments made before August 30, 2010 have been grandfathered, a kindness that the Central Board of Direct Taxes (CBDT) draft did not extend upon us but this version has made no explicit mention of whether a treaty override stands or not. At least the finance minister (FM) did not whereas the Shome Committee report voted against any sort of treaty override, your views?
 
Sayta: FMs statement is really silent on this. But what I make out of all that is that he does want to probably attack even treaty situations if the investment had been made after August 30, 2010. That seems to be the flow of where he is going. We'll find out as this has to be legislated anyways. This is a part of his statement, probably the law has to be changed accordingly and the guidelines have to come out accordingly. But my sense is that investments made after August 30, 2010, treaties may not be made available unless one is able to justify from a GAAR standpoint that the treaty benefit should indeed be available.
 
Doshi: Which means you have to be able to prove substance?
 
Sayta: Yes and prove that the main purpose was probably not just taking tax advantage of a treaty.
 
Doshi: What will amount to substance in an offshore transaction?
 
Sayta: That would come out of the guidelines to a large extent. The way I would look at it is apart from substance, one will have to demonstrate that the purpose of having invested into India through a particular jurisdiction was primarily not just tax but something else or the main purpose was something else. For example if we look at a private equity investor, if there has been pooling of funds and one does need a vehicle to be situated in some location or jurisdiction for pooling funds together and if for that purpose a vehicle was in any case required to be formed and if that vehicle is located lets say in a tax friendly jurisdiction- can it be said that the main purpose was tax avoidance, probably not.
 
Doshi: The classic question in this will be what will be the fate of investments routed through Mauritius?
 
Sayta: If the Circular 789 continues, probably that might indicate that even subsequent investments via Mauritius should be fine. But if Circular 789 is withdrawn which is what I think will happen and GAAR comes into play on April 1, 2015 and if an exit happens thereafter, unless the tax payer is able to establish that there was a good commercial business purpose or reason for having invested through Mauritius which is going to be a tall order. Circular 789, 2000
Wherever a certificate of residence is issued by the Mauritian Authorities, such certificate will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the India-Mauritius tax treaty
 
Doshi: Can you use the intervening time between now and FY16 to find a way to re-route that transaction through another lower tax jurisdiction; for instance can the Mauritius ownership be moved to Singapore?
 
Sayta: Very true. That is something that is very much possible- if any transaction of movement or migration happens between now and April 1, 2015, since GAAR would not have kicked in, that should still be protected by Azadi Bachao decision of the Supreme Court and the Circular and so on unless that is changed. Therefore one should be able to move the investment from Mauritius to may be Singapore. The question is when Singapore finally exits, which is after April 2015, Singapore will have to demonstrate that the investment into Indian entity which was made through Singapore was for good commercial or business reasons. Under the Singapore-India treaty, there is a special Anti-Avoidance Rule called the Limitation on Benefits (LOB) article and one would feel that if that Article is satisfied, then GAAR should not be invoked.
Again one of the things under the Singapore LOB also is- was the primary purpose of that entity to get access to the Singapore-India treaty and therefore it needs to be demonstrated. Singapore certainly is a jurisdiction with far more substance, things can actually be happening, operations could be there, employees could be there, decision makers could be found and so on. So there is a much better case for Singapore to be able to get treaty access. But the FM is not clear here, he said he will come out with guidelines, either GAAR will apply or Specific Anti-Avoidance Rules (SAAR) and in what situation GAAR or SAAR would apply is something he is silent on in his statement. He says that will come out via the guidelines; so one has to wait and see. Government has filed an affidavit in the SC to constitute a larger Bench to settle McDowell vs Vodafone/ Azadi debate
 
Azadi Bacho Andolan
SC held Tax Residency Certificate to be a conclusive proof of residency Shome Committee
Where Circular No. 789 of 2000 with respect to Mauritius is applicable, GAAR provisions shall not apply to examine the genuineness of the residency of an entity set up in
Mauritius
 
FM
Silent on Circular 789
 
India-Singapore DTAA
Limitation of Benefit Clause
• Company must prove its commercial substance
• It must be listed on recognized stock exchanges of the contracting country
• Its total annual expenditure on operations in the residence State is equal to or more than S$ 200,000 or Indian Rs. 50, 00,000 in the respective contracting country, as the case may be, in the immediately preceding period of 24 months from the date the gains arise. India- Singapore Protocol
Treaty benefits not available if affairs arranged with the primary purpose to take advantage of the benefits  Doshi: If a structure is to put in place right now even if as we speak, are you suggesting those structures steer clear of Mauritius and Singapore together or all and every lower tax jurisdiction just so that they can be safe of GAAR which means reconcile yourself to paying tax?
 
Sayta: Right. I would look at this in two parts. One is, one never knows, if this is going to get further extended. Clients are probably going to say that – if I am going to have to pay tax anyways- assuming I am not going to be able to build substance- what is the harm in trying Singapore or Mauritius; probably GAAR’s applicability might get extended for all you know.
 
Doshi: I do not want to ignore the aspect of outbound investments which is Indian groups, Indian companies making investments offshore and the structures they use to do that, how they repatriate income – all of those. How will that change with this GAAR architecture in place.
 
Sayta: The one thing when it comes to outbound investments which has been a subject of debate is whether the income of an overseas SPV which is not distributed to the Indian entity as dividend can be pulled into India and taxed what we call CFC which was there as part of Direct Taxes Code (DTC).
 
Doshi: But we do not know when it will become effective?
 
Sayta: Right. The Finance Minister makes no statement about whether GAAR will be invoked in a CFC like situation. But based on the reports that we have seen, one could feel that since CFC was separate and distinct piece of legislation, part of the DTC and since that is not introduced right now, the CFC kind of situation would not be taxed by invoking GAAR.
 
Doshi: There won’t be subject to GAAR?
 
Sayta: Correct. That is what I would feel and the choice remains with the tax payer- Whether or not to distribute dividend from that foreign SPV into India is a choice as much as buyback is a choice.
 
Doshi; I remember the CBDT draft which said any such buyback structure will attract GAAR, but that was the CBDT draft – this GAAR architecture, do you think, has the same kind of structure. It is a disputed area; we have had several judgments as well?
 
Sayta: I do not think so. There has been considerable dilution; there is more understanding and appreciation that when the tax payer has choices, merely because he adopts the choice or the route which minimizes his tax, does not mean that GAAR can be invoked. In a case of this type where the tax payer has a choice, whether to do a buyback or dividend for example and he chooses to do a buyback unless it is a glaring case of abuse, I would not feel that GAAR should apply. Shome Committee
Recommended that a negative list of tax mitigation cases should be included
Eg: Funding through debt or equity
 
Shome Committee
Recommended that a negative list of tax mitigation cases should be included
Eg: Purchase or lease of a capital asset
        
Doshi: The Foreign Institutional Investor (FII) community was the most vocal in voicing its displeasure last year when faced with the Pranab Mukherjee’s version of GAAR. This P Chidambaram version of GAAR, though, should make them a happy because not only does it say that GAAR will not apply to such FIIs that do not take treaty tax benefits but it also says that GAAR will not apply to non-resident investors in FIIs. To talk about how FIIs will here onwards prepare themselves to deal with the onset of GAAR, I am joined by Nishith Desai, Founder of Nishith Desai Associates and Anand Rengarajan, Head-Direct Securities at Deutsche Bank.

Finance Minister
GAAR will not apply to such FIIs that choose not to take any treaty benefit
GAAR will not apply to non-resident investors in FIIs

Doshi: Anand, your client should be a happy lot?
 
Rengarajan: For sure this has been welcomed very positively and some of the things that they have proposed, which is accepting the Shome Committee recommendations are definitely very welcome from an FII standpoint for example specifically excluding P-note investors; besides the fact that they are now giving them additional timeframe of two years to plan out investments accordingly.

Finance Minister
GAAR applicability deferred to the financial year beginning 1 April 2015 Shome Committee
Recommended GAAR should be deferred for 3 years

Doshi: I hear a big ‘but’ in your answer?
 
Rengarajan: The reason is very simple, we would have ideally preferred if they had stuck to the Shome Committee recommendation, which had promised implementation up to 2016 whereas this is now kicking in 2015.
 
Doshi: So what is the problem? You have three or two years, what is the difference?
 
Rengarajan: One year makes a big difference because they are talking about very complicated structures; it will take some time to change, shift investment strategies etc.
 
Desai: I think two years may not be sufficient because suppose you want to move to Singapore, you have to incur USD 200,000 in two years prior to your sale of investment. That could be one of the things.
 
Doshi: You made the point that transactions or investments that take place before August 2010 do not need to worry, they are grandfathered. Investments that take place after August 2010 but exit before April 2015 are safe from GAAR at least. It is only those investments that take place after August 2010 but exit after April 2015 that need to worry. So, will it be only the FII prop book transaction or investment that will get taxed because here it says that GAAR will not apply to the non-resident investors in FIIs?
 
Rengarajan: At this point of time that is the understanding that it would be applicable only to the prop books but there is some clarity that needs to come from there because there is a little bit of ambiguity in the current construct.
 
Doshi: If FII investments be taxed, will that tax cost pass on in some indirect fashion to their secondary and tertiary investors even though on the face of it this GAAR architecture says the non-resident investor will not be taxed?
 
Rengarajan: That cost will have to inevitably be passed on in some form or the other, which will impact in the form of return to the investor or as a cost to the investor.
 
Desai: How will you structure a contract- if I want to draft a contract, a P-note and if I say whatever tax is payable in India will be borne by you. Tomorrow from 10%, government increases tax to 20% or 30%- how will I incorporate my cost and how will the P-note holder or anybody else for that reason investor in the FII. So the contractual arrangement will go for a toss because there is no guarantee that taxes will remain stable.
 
Doshi: More than half of all FII investment comes through lower tax jurisdictions. Mauritius is predominant in that. As of now, the Certificate equals substance but we do not know what it is going to be a few years from now. Do you expect that many people will want to shift out of Mauritius and to other countries to make their structures permissible so that when they exit after April 2015, they are unlikely to have to face GAAR?
 
Desai: What has been stated here is that you will not be entitled to treaty benefits if there is LOB Article- limitation of treaty benefit Article. If it is not there, then GAAR will apply. Now in Mauritius, let us say in next few weeks or next month, there is going to be some kind of negotiation and discussion that is going. Hopefully if some LOB Article comes, then even the Mauritius investments will continue to stay. So, decisions will be made based on what happens to these discussions.    
 
Doshi: But suppose the LOB doesn’t come in because it hasn’t come in with all these years.
 
Desai: Then people will say we should shift to Singapore.
 
Doshi: But there are two other reasons why you told me that you think many people will not want to leave Mauritius even if LOB doesn’t come into play?
 
Desai: US investors in particular are the largest investors. There are two reasons why Mauritius is important- one there is no bilateral investment protection treaty between India and the US. We in India always assume that foreign investment is safe in India and that was our position but in the last one year, we have got five claims against India and there are many more maybe in the pipeline. Now what is the obligation of the fund managers in the US- to protect the capital and investment first; tax is a secondary thing.
 
Doshi: So they come through Mauritius because we have a Bilateral Treaty?
 
Desai: Yes and Mauritius has a very well negotiated treaty with India. So, commercial justification exists there. The next point- under the system of US tax law, Section 865 says that the source of capital gains - when you sell an Indian company shares is US and not India whereas India considers that if you sell shares of an Indian company, it is Indian source income. There is a source conflict; as a result the tax credit for the taxes paid in India is a big problem between the two countries because US says we have first right to tax, India would say we have first right to tax. So, US is not going to give tax credit or there will be issues on that and tax exempt investors will have a bigger problem because they are tax exempt in the US like pension plans and other kinds of entities. Internal Revenue Code
Section 865 deals with Source of Income for international taxation
Gains from the sale of certain stock or intangibles would be U.S. source income under Section 865
 
Doshi: They would end up paying tax?
 
Desai: Yes. Double taxation of the same income was the reason rather than avoidance of income tax altogether.
 
Doshi: What are FIIs telling you- what are they going to do? Are we going to see, if this architecture prevails and if these timelines prevail, serious large exits before April 2015 because people will want to close out their investments and then adopt new structures for fresh investments once GAAR comes into effect?    
 
Rengarajan: Yes. The question is exits will happen but whether they come back in some other form, structure will depend on how they are able to find another alternate structure to that or if India is still attractive enough, not withstanding the payment of the tax and they will still come to India. So, that is also possible.