gaar india april24 2012no2

8/2/2019 GAAR India April24 2012no2

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GeneralAnti-Avoidance

Rule (GAAR)

in India

kpmg.com/in


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GAAR and its Impact - Important analysis

The Finance Bill, 2012 (Finance Bill) proposes tointroduce a far-reaching GAAR in the Income-Tax Act,

1961 (the Act). Though largely modeled on GAAR

proposed in the Direct Taxes Code Bill, 2010 (DTC),

GAAR provisions in the Finance Bill are in some ways

wider in scope and application. The wide reach of this

Rule, coupled with its largely subjective nature could

make tax planning, implementation and litigation

extremely challenging. Virtually all transactions that

may give rise to tax benefits will have to be evaluated

under GAAR provisions.

It may be appreciated that while the Finance Bill willundergo some changes and safeguards as suggested

by various forums including the Standing Committee

on Finance are likely to be provided, mainly through the

formulation of the statutory guidelines, we thought it

was important to analyse the current GAAR proposals

and bring out some of the likely impacts on a large

number of domestic and foreign corporations. This

hopefully prepares you to carry out a review exercise

within your organisation to identify potential issues

under GAAR. Needless to say, the success of any

organisations long term strategy will depend to a large

extent on how well it is able to adapt and meet the

challenges posed under GAAR regime.

Accordingly, we are pleased to enclose a brief Paperon the current GAAR provisions for your consideration.

We would be delighted to receive your comments on

GAAR as well as discuss the way forward in dealing

with them. Once the Finance Bill is enacted and its

guidelines are prescribed, we will send you an updated

paper.

2012 KPMG, an Indian Registered Partnership and a member rm o the KPMG net work o independent member rms aliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.


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Contents

Background

Brief overview of the mechanics of GAAR

First condition: Main purpose is to obtain

tax benefit

Second condition

Consequences

Applicability of GAAR

Some other impact areas

Way forward

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04

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06

09

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Background

In the Duke of Westminsterv. IRC1, and in several subsequent tax cases including

Ramsayv. IRC2, Furnissv. Dawson3, Craven v. White4and others, 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 Andolan5case and the Vodafone6case. 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.

However, this long standing principle is set to face legislative reversal with the

introduction of GAAR in the Finance Bill largely modeled on South African GAAR, which

seeks to incorporate the substance over formdoctrine in Indian tax law. Broadly

speaking, GAAR will be applicable to arrangements/transactions which are regarded

as impermissible avoidance arrangementsand will enable tax authorities, among other

things, to re-characterise such arrangements/transactions so as to deny tax benefits.

03

1. (1935) All E.R. 259

2. (1981) 1 All E.R. 865

3.(1984) 1 All E.R. 530

4. (1988) 3 All. E.R. 495

5.(2004) 10 SCC 1

6. S.L.P. (C) No. 26529 o 2010, dated 20 January 2012



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Brief overview of the mechanics of GAAR

The mechanics of GAAR are captured in the diagram below:

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.

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 Finance Bill proposes to

empower the tax authorities with wide ranging powers to determine its consequences,

including one or more of the six specified consequences appearing in the above chart.

Source: KPMG in India analysis

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First condition: Main purpose is to obtain tax benefit

First condition for the application of GAAR is that the mainpurpose or one of the main purposesof the arrangement is to

obtain a tax benefit.

The term tax beneftis dened in s. 102 (11) as:

a. a reduction or avoidance or deerral o tax or other amount

payable under this Act; or

b. an increase in a reund o tax or other amount under this

Act; or

c. a reduction or avoidance or deerral o tax or other amount

that would be payable under this Act, as a result o a tax

treaty; or

d. an increase in a reund o tax or other amount under this Actas a result o a tax treaty; or

e. a reduction in total income including increase in loss,

in the relevant previous year or any other previous year.

In this context, the ollowing points are relevant:

Main purpose or one o the main purposes: The main

purpose test depends not on the actual accrual o a tax

benet, but only on the purpose behind entering into an

arrangement. Hence, a transaction may be caught within

GAAR even i it has not yet resulted in a tax benet so long

as it has been entered into or the main purpose (or one o

the main purposes) o obtaining a tax benet, at any time.

Thus, the Finance Bill has widened the scope o GAAR as

compared to that under the DTC wherein the criterion

was main purpose is to obtain tax benet. Even the South

Arican GAAR applies the sole or main purpose test and

not one o the main purpose as the key test.

Burden o proo: Where any arrangement results in any

tax benet, it shall be presumed to have been entered into

or the main purpose o obtaining a tax benet, unless it

is proved that obtaining the tax benet was not the main

purpose o the arrangement. Thereore, the burden o proo

would lie on the tax payer.

Part o an arrangement: In any arrangement i the mainpurpose o a step in, or a part o, the arrangement is to obtain

a tax benet, the arrangement will be presumed to have been

entered into to obtain tax benet, in spite o the act that the

main purpose o the whole arrangement is not to obtain a tax

benet.

Determining tax benet: For determining the tax benet:

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.

Conversion into Limited Liability Partnerships (LLP)

Given the tax as well as operational advantages oered by the LLP route, many companies are increasingly considering

converting into a LLP. Considering the tax benets o the LLP orm, i.e. a lower rate (without surcharge) and the

absence o a Dividend Distribution tax (DDT) on repatriations and absence o Minimum Alternative Tax (MAT), it

is quite likely that such conversions may satisy the rst condition and thereore be evaluated under GAAR. Adverse

consequences could ensue i it cannot be appropriately demonstrated that the conversion was entered into with bona

de commercial purpose. Though one could legitimately argue that to acilitate such conversions, tax exemption rom

capital gains tax is also provided on ulllment o specied conditions, such conversions ought not to be aected by

GAAR.



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In order for an arrangement to be classified as an impermissible avoidancearrangement, 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 arms length;

b. It results, directly or indirectly, in the misuse, or abuse, o the provisions o

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 or bona de purposes.

There is little guidance in the Finance Bill as to what constitutes a misuse

or abuse o the Act. However, it may be useul to reer to the recent

decision o the Supreme Court o Canada in Cophorne Holdings Ltd. v.

Canada, 2011 SCC 63 where the Court held that it was not enough that a

transaction is a misuse or abuse o tax policy and that the misuse or abusemust be tied to a specic provision or provisions in the law. According to

the Court, a nding o misuse or abuse will be upheld only:

1. where the transaction achieves an outcome which the statutory

provision was intended to prevent;

2. where the transaction deeats the underlying rationale o the provision;

or

3. where the transaction circumvents the provision in a manner that

rustrates or deeats its object, spirit or purpose.

These observations, though in the context o the Canadian GAAR, may

have a bearing on how the Indian judiciary interprets this provision.

Some issues in this regard are discussed below:

Burden of proof: 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.

Misuse or abuse of the provisions of the Act:

Cross-border inbound mergers- Whether misuse or abuse of provisions of the Act?

The use o cross-border inbound mergers o oreign companies into India as tax ecient cash repatriation

or debt pushdown mechanisms may again trigger an exposure to GAAR. It may thereore be necessary to

ensure that such transactions are not driven purely by tax considerations alone and that there is adequate

commercial/business rationale which has been appropriately documented.

Second condition

Will the tax

authorities apply

Transfer Pricing

provisions to

determine this

condition?

Where the

Act provides

stringent specificAnti-avoidance

provisions such as

those under s. 72A

for carry forward of

losses on merger/

demerger, whether

it can be dubbed

as misuse/abuse

of provisions of the

Act?



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Lacks commercial substance

In addition to the arrangements which lack commercial substance, the following

arrangements are deemed to lack commercial substance:

1. 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

2. it involves or includes (i) round-trip financing; (ii) an accommodating party; (iii)

elements that have the effect of offsetting or cancelling each other; or (iv) a

transaction which is conducted through one or more persons and disguises

the value, location, source, ownership or control of funds which areis the

subject matter of such transaction; or

3. it involves the location of an asset or of a transaction or of the place of

residence of any party which would not have been so located for any

substantial commercial purpose other than obtaining a tax benefit (but for

GAAR provisions) for a party.

Whether location

of transaction

for supply of

equipments in

an EPC contract

outside India would

be impacted?

Inbound investment structures- Use of holding

companies in favourable treaty jurisdictions

The use o holding companies in countries such as

Mauritius, Cyprus and Singapore which have avourable tax

treaties with India is likely to come under increased scrutiny

under GAAR provisions.

Specically, i it can be alleged that such transactions

involve locating assets or the place o residence (o the

intermediate holding company) in a avourable treatyjurisdiction mainly or availing o tax benets without

substantial commercial purpose. Thereore, the corollary

being that i it can be established that the location o the

asset/transaction/place o residence is or a substantial

non-tax commercial purpose, the arrangement should not

be regarded as lacking in commercial substance or the

purposes o GAAR.

The term substantial commercial purpose should be

distinguished rom the term commercial substance; the

ormer goes to the motive behind an arrangement, and the

later implies commercial apparatus or running operations

in an entity.

Inbound investment structure- Migration of India

investments to favourable treaty jurisdictions

A migration o Indian investments rom a holding company

in a non-treaty/non-avourable treaty country to a avourable

treaty country, especially through giting o shares, could

also be scrutinised under GAAR provisions.

In addition to establishing that there is a substantial non-tax

commercial purpose or such migration, it may also be

necessary to demonstrate that a git o shares by thecompany meets the bona de and arms length test in

GAAR provisions.

Use of favourable treaty jurisdictions for royalty

payments/fees for technical services

Similarly, use o avourable treaty jurisdictions to house

intellectual properties such as copyrights, trademarks,

patents, etc. (IPR) may also come under GAAR scrutiny.

This could lead to an investigation o the ultimate ownership

o the IPR as well as the commercial purpose behind

housing such IPR in avourable treaty jurisdiction.

Outbound structure - Use of SPVs Controlled Foreign

Company (CFC) and GAAR

Full-fedged CFC rules have been proposed in the DTC,

but have not been brought into the Finance Bill. However,

considering the wide scope o GAAR provisions, a question

may arise as to whether the proposed CFC like taxation

can result through application o GAAR. For instance, under

GAAR, the expression location o an assetor tax benets

is potentially wide enough to support a challenge by the tax

authorities that the objective o having an SPV/intermediate

holding company in the outbound investment context, is

designed to delay/avoid Indian taxes on dividend income.

Under the CFC regime, taxation motive is irrelevant.

Whereas under GAAR, it may still be open to the taxpayer

to prove that the main purpose o investing in the overseas

jurisdiction through a SPV was not to obtain a tax benet

and hence the threshold criteria or the applicability o

GAAR is not satised.



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Consequences

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-characterising 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) anyaccrual, 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 is also expressly provided that:

a. equity may be treated as debt or vice versa.;

b. any accrual or receipt of a capital nature may be treated as of

a revenue nature or vice versa;

c. any expenditure, deduction, relief or rebate may be re-

characterised.

Inbound investment structure - Use of Compulsorily

Convertible Debentures (CCD) to capitalise Indian

entities

Instruments such as CCDs to und Indian entities arelikely to come under GAAR scrutiny i excessive debt is

used as a part o the capital structure. Such scrutiny can

potentially take one o the two orms:

a. A subjective evaluation o the terms o the instrument

to determine whether it can in act be considered as

true debt. For instance, actors such as the commercial

ability o the Indian entity to raise comparable debt

rom third parties, the terms thereo, etc. could be

used to contend that the instrument is more in the

nature o equity, rather than debt.

b. An objective evaluation based on a prescribed debt-

equity ratio to re-characterise interest expenditurein excess o the threshold limits as dividends (Thin

Capitalisation Norms).

Similarly, the use o treaty riendly jurisdictions like

Cyprus, etc. to route debt into India may also be subject

to scrutiny under GAAR.

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It must be noted 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.

On account of the wide powers vested with the tax authorities,

virtually every transaction (or its part) entered into by the tax

payer could come under scrutiny and be potentially hit by GAAR.

Cash extraction through buyback

Assuming that investments made by holding companies

in jurisdictions with avourable capital gains provisions

(such as Mauritius, Singapore and Cyprus) satisy GAAR

criteria, a urther question may arise as to characterisation

o buyback payments or Indian tax purposes.

It is possible that a regular resort to buyback instead

o dividends as a cash repatriation tool may pose a

signicant risk o such payments being re-characterised

as dividends under GAAR.

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Applicability of GAAR

The ollowing are the key points in connection with theapplicability o GAAR:

The provisions o GAAR are to be made eective rom 1 April

2012.

The provisions o GAAR begin with a non-obstante clause i.e.

they have been made applicable notwithstanding anything

contained in the Act.

The provisions o GAAR are to override provisions o tax

treaties.

GAAR: Retrospective/RetroactiveGAAR is to be eective only prospectively i.e. rom 1 April

2012. Hence, in respect o arrangements that have been

concluded prior to that date, the question o applying GAAR

should not arise. However, while applying this rule in the

context o inbound investment structures, it is possible that

investments made prior to the enactment o GAAR may be

hit by it at the time o exit made on or ater April 1, 2012. In

other words, even though the provisions o GAAR are not

intended to be retrospective, they could nonetheless apply to

post-1 April 2012 transactions in investment structures set up

prior to the enactment o GAAR. This is depicted in the chart

below:

Source: KPMG in India analysis

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Some other impact areas

Secondary consequencesThough not explicitly provided in GAAR, a question may arise as to whether secondary

adjustments could also be made under GAAR. For instance, if additional income

is deemed to arise in the hands of an Indian company from its overseas parent by

application of GAAR or where excessive interest on debt is re-characterised as dividend,

whether further tax consequences can be determined so as to impute a deemed

distribution of this income to the overseas parent, leading to an additional DDT liability

in India.

A similar question may arise as to whether book profits can be increased on account of

re-characterisation of interest as dividend or revenue expenditure as capital expenditure

in cases where the taxpayer is under the MAT regime.

Withholding obligations and GAAR

A question may also arise as to the applicability of withholding tax provisions in respect

of payments made under impermissible avoidance arrangements. For example, if

a payment which is otherwise not subject to the withholding tax provisions is re-

characterised under GAAR as being of a nature which is subject to withholding tax, can

proceedings under s. 201 of the Act be initiated against the person making payment

for failure to deduct tax. Further, whether disallowances of such amounts can be made

under s. 40(a)(i) for failure to withhold such tax.

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Way forward

The introduction of GAAR is without doubt one of the most

radical changes in the Indian tax regime since its inception.

Considering the inherent subjectivity in GAAR coupled with the

fact that the taxpayer has to discharge the burden of proving that

the transaction was not entered into with a view to obtain tax

benefits, it is critical to evaluate and assess the impact of GAAR

on a taxpayers long term tax strategy, particularly in the context

of transactions that give rise to tax benefits.

In particular, structuring of transactions in a post-GAAR world will

necessarily have to be fact specific and tailored based on specific

circumstances of each taxpayer. However, as a general rule, it

will be critical to ensure that transactions are based on a strong

commercial rationale and that such rationale is appropriately

documented.

The provisions of GAAR are to be applied in accordance with

such conditions and guidelines to be prescribed. While these

will undoubtedly play a crucial role in the interpretation and

application of GAAR to specific arrangements/transactions, it

will be critical for organisations to review concluded, ongoing

and proposed transactions to assess the possible impact of

GAAR on them. It should also be assessed whether the current

documentation of commercial rationale for such transaction is

sufficient and robust enough to withstand GAAR scrutiny.

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kpmg.com/in

The inormation contained herein is o a general nature and is not intended to address the circumstances o any particular individual

or entity. Although we endeavor to provide accurate and timely inormation, there can be no guarantee that such inormation isaccurate as o the date it is received or that it will continue to be accurate in the uture. No one should act on such inormation

without appropriate proessional advice ater a thorough examination o the particular situation.

2012 KPMG, an Indian Registered Partnership and a member rm o the KPMG network o independent member rms aliated

with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

The KPMG name, logo and cutting through complexity are registered trademarks or trademarks o KPMG International.

P i t d i I di

Contact us

Dinesh Kanabar

Deputy CEO & Chairman Tax

T: + 91 22 3090 1661

E: [email protected]

Uday Ved

Head o Tax

T: + 91 22 3090 2130

E: [email protected]

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