The Shome GAAR - Lob(bing) Back to The Committee

Transcription

1 The Shome GAAR - Lob(bing) Back to The Committee By D P Sengupta Nov 02, 2012 READING the Report of the Shome Committee on GAAR, it seems that the Committee gave itself the task of shielding two jurisdictions Singapore and Mauritius from being adversely affected by the application of the provisions relating to the proposed GAAR. This is ironic since one of the unstated objectives of bringing in GAAR was in fact to check the misuse of the tax treaties involving these two jurisdictions. The committee's effort to protect the current 'holy cow' - foreign investment from being affected, however, suffers from flawed logic. The entire justification for the recommendation of the Shome Committee that the GAAR provisions should not apply in the application of the tax treaties with Singapore and Mauritius rests on two principles invented by the Committee (i) Where there is SAAR, GAAR should not apply; (ii) Limitation of Benefits (LOB) being a treaty SAAR, trumps any domestic GAAR. So different from the international practice was the principle adopted by the Shome Committee that I decided to cross check with some former colleagues from OECD countries who are indeed experts' in the field. One of them says I know of no GAAR which provides that it cannot apply if there is specific anti-avoidance. This, of course, does not mean that domestic GAAR should apply in each and every case where there is a SAAR but that is a matter where judgement has to be exercised by the implementing authorities. But here we are questioning the general principles laid down by the Committee. In the last episode we have seen that the theory that GAAR should not apply where there is SAAR is flawed and is not in accordance with the international practice. In this episode, we propose to examine whether the other theory of the committee that in case of a LOB provision GAAR does not apply, holds good when judged from an international perspective. First, let us try to understand the logic adopted by the Committee. Under the heading Treaty Override', in paragraph 3.16 at page 40 of the report, it is mentioned as follows:- On the issue whether specific provisions of the domestic law of a contracting state that are intended to prevent tax abuse conflict with tax treaties, the OECD in its commentary on Model Convention has stated as under-

2 9.2 For many States, the answer to the first question is based on their answer to the second question. These States take account of the fact that taxes are ultimately imposed through the provisions of domestic law, as restricted (and in some rare cases, broadened) by the provisions of tax conventions. Thus, any abuse of the provisions of a tax convention could also be characterised as an abuse of the provisions of domestic law under which tax will be levied. For these States, the issue then becomes whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law. As indicated in paragraph 22.1 below, the answer to that second question is that, to the extent these antiavoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule, there will be no conflict between such rules and the provisions of tax conventions. (emphasis added) Thus, the view of the OECD is that if domestic law that covers GAAR provisions is not reflected in a tax treaty, then GAAR can be invoked since there is no conflict with the treaty. However, the OECD does not address the case in which tax avoidance matters are directly or indirectly addressed in a treaty. It may, therefore, be presumed that, in the latter case, the treaty provisions, rather than domestic law, would apply. This has particular relevance for the Indian GAAR with respect to the Mauritius and Singapore treaties." (Emphasis supplied) Based on such a presumption (erroneous, as we shall see shortly), the committee then recommends: In view of the above, the Committee recommends that where the treaty itself has anti-avoidance provisions, such provisions should not be substituted by GAAR provisions under the treaty override provisions. The committee presumes that the OECD prescription is that in case there is a specific anti avoidance provision in a tax treaty itself, the domestic anti avoidance rules should not apply. We then need to examine how well founded such a presumption is. A modern tax treaty contains quite a few specific anti-abuse provisions. The reason for the same is the fact that the extension of double tax convention increases the risk of abuse by facilitating the use of artificial legal constructions aimed at securing the benefits of both the tax advantages available under certain domestic laws and the relief from tax provided double tax convention. This is as per paragraph 8 of the OECD commentary on Article 1 under the heading 'improper use of the Convention'. Most important of such anti-abuse provisions contained in tax treaties is the concept of beneficial ownership' which is an anti-abuse provision and which is found in the provisions relating to passive income (dividends, interest and royalties and FTS) in almost all treaties. Then there are special relationship rules in interest and royalties/fts. There are also provisions against abuse in Article 17 for rent a star companies in the case of sportspersons. If the reading of the Shome committee is correct then the domestic anti-abuse provisions cannot apply in any such case. However, as is mentioned in the UN Model Commentary such rules can usefully supplement general anti-avoidance rules or judicial approaches. That application of domestic anti- abuse provisions supplements the specific anti abuse provision in a tax treaty is also apparent from the following observation of the OECD commentary.

3 9.6 The potential application of general anti-abuse provisions does not mean that there is no need for the inclusion, in tax conventions, of specific provisions aimed at preventing particular forms of tax avoidance. Where specific avoidance techniques have been identified or where the use of such techniques is especially problematic, it will often be useful to add to the Convention provisions that focus directly on the relevant avoidance strategy In Para 9.1, the OECD commentary (on Article 1) mentions that two fundamental questions arise in the context of the discussion about improper use of tax treaties. These are Whether the benefits of tax conventions must be granted when transactions that constitute an abuse of the provisions of these conventions are entered into (see paragraphs 9.2 and following below); and Whether specific provisions and jurisprudential rules of the domestic law of a Contracting State that are intended to prevent tax abuse conflict with tax conventions ( see paragraphs 22 and following below) As we have seen earlier, the Shome committee itself has quoted Para 9.2 of the OECD commentary and it is very clearly mentioned therein that there is no conflict between domestic ant-abuse provisions and tax treaty. This is then reiterated in Para 9.5. After cautioning that it should not be lightly assumed that the taxpayer is entering into abusive transaction, Para 9.5 of the OECD commentary on Article 1, states as follows: A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions. The UN model commentary also reiterates the same view. Thus the consensus of opinion even in the developed world is that treaty benefits should not be given in abusive situations which also include treaty shopping. Now, coming to the specific issue raised by the Shome committee, i.e. whether OECD MC addresses the situation when treaty itself contains some anti-abuse provision, it is not clear why the committee did not go to Para 22.1 when the same is specifically mentioned in Para 9.2 as noted by the committee. Let us see what is stated in Para 22 of the commentary. 22. Other forms of abuse of tax treaties ( e.g. the use of a base company) and possible ways to deal with them, including "substance-over-form", "economic substance" and general anti-abuse rules have also been analysed, particularly as concerns the question of whether these rules conflict with tax treaties, which is the second question mentioned in paragraph 9.1 above 22.1 Such rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability; these rules are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule and having regard to paragraph 9.5, there will be no conflict. For example, to the extent that the application of the rules referred to in paragraph 22 results in a recharacterisation of income or in a redetermination of the taxpayer who is considered to derive such income, the provisions of the Convention will be applied taking into account these changes." (Emphasis added)

4 Article 22 and the anti-abuse provisions of domestic law complement each other, as Article 22 effectively determines whether an entity has a sufficient nexus to the Contracting State to be treated as a resident for treaty purposes, while domestic anti-abuse provisions (e.g., business purpose, substance-over-form, step transaction or conduit principles) Paraphrasing the same, what this Para tells us is that if, for example, by applying the domestic anti-abuse rules, there is a recharacterisation of income, say of dividend into interest or interest into dividend, then the treaty provision relating to dividend or interest, as the case may be should apply. This is the meaning of the expression these rules are not addressed in tax treaties and therefore are not affected by them.' From this it cannot be concluded that if domestic law that covers GAAR provisions is not reflected in a tax treaty, then GAAR can be invoked and by consequence when some anti-abuse provision is contained in the treaty itself, then domestic GAAR should not apply. Based on the two faulty hypothesis - that when there is SAAR, GAAR should not apply and when there is a treaty SAAR, GAAR should not apply, the committee makes a valiant attempt to justify the abuse of the India- Singapore and India- Mauritius tax treaty. In Para 3.19, of the Shome committee report under the heading GAAR vs. SAAR; and GAAR vs. LOB, the committee propounds the theory that when there is a SAAR, GAAR should not apply. In the last episode, we have seen that this proposition is incorrect. Coming to Limitation of Benefits, the committee says that the LOB clause in some of India s tax treaties is a specific anti-avoidance rule to prevent tax abuse. The committee then gives the example of India- Singapore LOB clause. For instance, the India-Singapore treaty provides that a company A, resident of a Contracting State, is deemed not to be a shell/conduit company if: (a) it is listed on a recognized stock exchange of the Contracting State; or (b) its total annual expenditure on operations in that Contracting State is equal to or more than S$200,000 or Indian Rs. 50,00,000 in the respective contracting state as the case may be, in the immediately preceding period of 24 months from the date the gains arise. So, if a company incorporated in Singapore incurs operating expenditure equal to, or in excess of, the aforesaid limits, then GAAR cannot be invoked to look into the genuineness of the company. But if there are SAAR elements that are revealed in its operations, then SAAR would be invoked. In view of the above, the Committee recommends that that where SAAR is applicable to a particular aspect/element, then GAAR shall not be invoked to look into that aspect/element. Similarly where anti-avoidance rules are provided in a tax treaty in the form of limitation of benefit (as in the Singapore treaty) etc., the GAAR provisions shall not apply overriding the treaty. If there is evidence of violations of anti-avoidance provisions in the treaty, the treaty should be revisited, but GAAR should not override the treaty. The reasoning of the committee for such recommendation is not clear at all. In fact, there is just a recommendation. Apparently, the committee relied on the OECD commentary to come to the conclusion that if there is a SAAR in a treaty GAAR should not apply. As we have seen in the earlier, the conclusion drawn by the committee from the OECD commentary is not at all correct. As all the tax experts know- Limitation of Benefits is a concept invented by the United States of America. Gradually, the OECD sanctified the practice and other countries also started to use this concept. It will therefore be interesting to examine what practice is adopted by the United States and what its views are on the subject. The United States has its own model tax treaty. It also brings out a technical explanation to its model. The limitation of benefits clause is contained in Article 22 of the US model. The 2006 Model technical explanation to the US Model tax treaty states as follows:

5 owner of an item of income, and Article 22 then will be applied to the beneficial owner to determine if that person is entitled to the benefits of the Convention with respect to such income. Moreover, the US, which created the LOB, does not apply the Shome rule and this is why it has adopted the conduit financing regulations, which deal with treaty shopping situations that are not covered by the LOB. Very briefly, the conduit financing regulations state: Pursuant to the authority of section 7701(l), this section provides rules that permit the district director to disregard, for purposes of section 881, the participation of one or more intermediate entities in a financing arrangement where such entities are acting as conduit entities As regards, the effect of disregarding the conduit, it is stated: C) Effect of income tax treaties. Where the participation of a conduit entity in a conduit financing arrangement is disregarded pursuant to this section, it is disregarded for all purposes of section 881, including for purposes of applying any relevant income tax treaties Even the recently codified economic substance doctrine which is mentioned by the Shome committee itself at page 95, does not say that it will not apply to treaty situation since there is already an LOB in the treaty. To sum up, according to the inventor of the concept of LOB, LOB as a treaty concept complements the domestic antiabuse provisions. LOB is not, as the committee would like us to believe, antithetical to the concept of a domestic GAAR. Also See: The Shome GAAR - The Dilution Shome GAAR - The Deferment; It Pays To Be Foreign in India