Anti-Avoidance Rules Overview and Implications By Naman Shrimal General Anti-Avoidance Rule ( GAAR ) is introduced in Finance Bill 2012 by our Finance Minister. The rule, which were part of Direct Tax Code ( DTC ) have been introduced earlier, in form of Chapter X-A of the Income Tax Act, 1961 ( IT Act ).The newly introduced rules is an attempt to decrease the number of the cases where assesse reduce their tax liability by way of legal means. It is an effect to consider the real substance of the transaction by following the doctrine of substance over form. Wide powers given to the Assessing Officer ( AO ) have raised a lot of apprehension in mind of general people. The rule, in its current form, provides a wide discretion and authority to the tax administration which is prone to be misused. This article has been written in form of a FAQ s to present the overview of anti-avoidance rules in general while keeping GAAR in focus. To learn the implications of anti- avoidance rules we first need to understand the difference between Tax evasion, Tax avoidance and Tax Planning. 1) What is the difference between Tax Evasion, Tax Avoidance and Tax Planning? Difference as per OECD Definitions Tax Evasion A term that is difficult to define but which is generally used to mean illegal arrangements where liability to tax is hidden or ignored i.e. the tax payer pays less tax than he is legally obligated to pay by hiding income or information from tax authorities. Tax Avoidance a Term used to describe an arrangement of a tax payer s affairs that is intended to reduce his liability and although the arrangements could be strictly legal it is usually in contradiction with the intent of the law it purports to follow Tax Planning An arrangement of a person s business and /or private affairs in order to minimise tax liability Difference as per Various Case Laws McDowell v. Commercial Tax Officer (1985) 154 ITR 146 (SC) Usage of Colorable Device not tax planning The appellant was a manufacturer-dealer of liquor. The department claimed that the appellant had failed to include excise duty payable on the liquor. The appellant claimed that it was paid directly to the excise authorities by the buyers of the liquor. Ruling in favor of the revenue, the Court held that payment of excise duty is the primary and exclusive obligation of the manufacturer and if payment be made under a contract or arrangement by any other person it would amount to meeting of the obligation of the manufacturer and nothing more. It was held that if a transaction is structured in such a way that its sole purpose is to avoid tax; the same would be disregarded for determining tax liability.
It was also held that Tax planning may be legitimate provided it is within the framework of law. Colorable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honorable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges. Sunil Siddharthbhai vs. CIT (1985) 4 SCC 19 (SC) The Court held that If the transfer of the personal asset by the assesse to a partnership in which he is or becomes a partner is merely a device or ruse for converting the asset into money which would substantially remain available for his benefit without liability to income-tax on a capital gain, it will be open to the income-tax authorities to go behind the transaction and examine whether the transaction of creating the partnership is a genuine or a sham transaction and, even where the partnership is genuine, the transaction of transferring the personal asset to the partnership firm represents a real attempt to contribute to the share capital of the partnership firm for the purpose of carrying on the partnership business or is nothing but a device or ruse to convert the personal asset into money substantially for the benefit of the assesse while evading tax on a capital gain other pertinent considerations may be taken into regard when the ITO enters upon a scrutiny of the transaction, for in the task of determining whether a transaction is a sham or illusory transaction or a device or ruse he is entitled to penetrate the veil covering it and ascertain the truth. Mathuram Agrawal v. State of Madhya Pradesh 3 (1999) 8 SCC 667 It was held that The intention of the Legislature in a taxation statute is to be gathered from the language of the provisions particularly where the language is plain and unambiguous. In a taxing Act it is not possible to assume any intention or governing purpose of the statute more than what is stated in the plain language. It is not the economic results sought to be obtained by making the provision which is relevant in interpreting a fiscal statute. Equally impermissible is an interpretation which does not follow from the plain, unambiguous language of the statute. Words cannot be added to or substituted so as to give a meaning to the statute which will serve the spirit and intention of the Legislature. CIT vs. B.M. Kharwar (1969) 72 ITR 603 (SC) The Apex Court held that it was now well settled that the taxing authorities are not entitled in determining whether a receipt is liable to be taxed to ignore the legal character of the transaction which is the source of the receipt and to proceed on what they regard as the substance of the matter. The Supreme Court observed that while the authorities should determine the true legal relations resulting from a transaction, yet if the parties have chosen to conceal a legal relationship by a device, it would be open to them to untangle the device and establish the true spirit of the relationship. However, the Apex Court noted that the legal effect of a transaction cannot be displaced by probing into the substance of the transaction. UOI v. Azadi Bachao Andolan (2003) 263 ITR 706 (SC)
The issue in this case was regarding the validity of CBDT Circular No. 786, providing that a tax residency certificate issued by Mauritian authorities was sufficient proof for an entity to avail benefits under the Indo- Mauritius DTAA. The Supreme Court upheld the validity of the circular. Apex Court further held that though the words sham and device were loosely used in connection with incorporation under Mauritius Law, these words could not be used to nullify a legal situation. The Tax Residency Certificate issued by the Mauritian authorities was to be taken as a decisive evidence of residency of the entity and of its beneficial ownership for availing benefits of the DTAA. Vodafone International Holdings vs. UOI While ruling that Azadi and McDowell are not in conflict with each other, it was held that The majority judgment in McDowell held that, tax planning may be legitimate provided it is within the framework of law. It was further held that colorable device cannot be a part of tax planning and it is wrong to encourage the belief that it is honorable to avoid payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes without resorting to subterfuges. It was observed the fact that a parent company exercises shareholder s influence on its subsidiaries does not generally imply that the subsidiaries are to be deemed residents of the State in which the parent company resides whether a transaction is used principally as a colorable device for the distribution of earnings, profits and gains, is determined by a review of all the facts and circumstances surrounding the transaction. It was further held that Holding Structures are recognized in corporate as well as tax laws. Special Purpose Vehicles (SPVs) and Holding Companies have a place in legal structures in India, be it in company law, takeover code under SEBI or even under the income tax law. When it comes to taxation of a Holding Structure, at the threshold, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and/or use of such structure(s). In the application of a judicial anti-avoidance rule, the Revenue may invoke the substance over form principle or piercing the corporate veil test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant. where the Revenue finds that in a Holding Structure an entity which has no commercial/business substance has been interposed only to avoid tax then in such cases applying the test of fiscal nullity it would be open to the Revenue to discard such interpositioning of that entity. However, this has to be done at the threshold.
It was held that every strategic foreign direct investment coming to India, as an investment destination, should be seen in a holistic manner. While doing so, the Revenue/Courts should keep in mind the following factors: the concept of participation in investment, the duration of time during which the Holding Structure exists; the period of business operations in India; the generation of taxable revenues in India; the timing of the exit; the continuity of business on such exit. In short, the onus will be on the Revenue to identify the scheme and its dominant purpose. The corporate business purpose of a transaction is evidence of the fact that the impugned transaction is not undertaken as a colorable or artificial device. The stronger the evidence of a device, the stronger the corporate business purpose must exist to overcome the evidence of a device. 2) How Anti-Avoidance rules can be classified? This is explained in form of a chart Specific Anti Avoidance Rules Measures based on General Principles of Law General Anti Avoidance Rules Rules applicable to Specifc situations In form of specifc sections as 2(22)(e), Section 56 etc Principles which are not statutory In form of case laws as enunciated above. Principles which are stautory Introduced by Budget 2012 3) What are the examples of Specific Anti Avoidance Rules in Indian Income Tax Act, 1961?
Section 2(22)(e) Section 56 Section 40 A(2) Section 60/61 Section 64 Section 94 Deemed dividend Transfer of Property without adequate consideration Unreason Payments to an related Party Transfer of Income without transfer of assets Clubbing of Income Dividend and Bonus Stripping 4) What are the different scenarios where GAAR is generally applicable? Transfer of residence Tax is avoided by setting up a holding entity in tax friendly jurisdiction. As in case of Vodafone, A company incorporated in a jurisdiction continues to be a tax resident of that jurisdiction even though the effective management is relocated to another country. During exit of the holding company from the subsidiary company capital gains tax can be avoided. By application of GAAR place of effective management is construed as country of residence and thereby sales in its shares taxed in that country. Base erosion -This category includes thin capitalization rules, earnings stripping rules and rules limiting the deduction of interest payments to a percentage of assets. The application if GAAR puts a cap on Interest payments and any payment over and above it is considered as Dividends. Base companies Tax can be avoided by booking income in offshore companies. These rules address the offshore income of base companies. These rules attribute income earned by a Controlled Foreign Corporation (CFC) to the shareholder of that entity or deem the shareholder to have received dividends from the entity. The proposed DTC has incorporated CFC regulations Character of income Character of income is purposely changed in the case where one stream of income is taxed less than the other stream of income. For instance, where dividends are taxed more heavily than capital gains, capital gains are converted into dividends if it is believed that capital gains is paid to avoid tax. The GAAR is applied to recharactersize income depending upon the domestic laws. 5) Why GAAR is introduced? Some transactions, if planned correctly, can be tax advantageous even if they are legal. It is very difficult to deal with aggressive tax planning, where the actual
intention of the legal structure created is to camouflage the real intent and purpose. To consider the real intention of the transaction, GAAR has been introduced. 6) What transactions can be considered as Impermissible avoidance arrangement ( IAA )? As per proposed Section 95 and 96 an arrangement whose main purpose or one of the main purposes is to obtain a tax benefit and which satisfies one of the following four tests, can be declared as IAA- The arrangement creates rights and obligations, which are not normally created between parties dealing at arm s length. It results in misuse or abuse of provisions of tax laws. It lacks commercial substance or is deemed to lack commercial substance. Is carried out in a manner, which is normally not employed for bonfire purpose. 7) When is an arrangement deemed to lack commercial substance? An arrangement will be deemed to lack commercial substance if 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 For e.g. it involves or includes (i) Round trip financing; (ii) An accommodating party; (iii) Elements that have 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 fund which is subject matter of such transaction; or 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 tax benefit for a party. 8) What are the consequences if a transaction is held as IAA? If the transaction is held as IAA, the consequences will differ from case to case basis. However, some of the illustrative list is given below- Disregarding or combining any step of the arrangement. Ignoring the arrangement for the purpose of taxation law. Disregarding or combining any party to the arrangement. Reallocating expenses and income between the parties to the arrangement. relocating place of residence of a party, or location of a transaction or situs of an asset to a place other than provided In the arrangement. Considering or looking through the arrangement by disregarding any corporate structure. Re-characterizing equity into debt, capital into revenue etc.
9) What is the Procedure for invoking GAAR? The Procedure for invoking GAAR is given in new proposed Section 144BA. It can be explained in form of a Chart AO considers a transaction as IAA In case, Commsioner is satisfied than he shall pass order Approving panel shall grant oppourtunity of hering to the asesse AO Reference to the Commisioner In case assessee objects, Commisioner not satisfied then, refernece to approving panel Directions will be binding on AO Commissioner, if satisfied, to grant oppurtunity of hearing of maximum 60 days to the assessee In case, no objection received, then th Commissioner to issue Directions AO's order shall be appleable before ITAT Some points to be taken care of Directions to be passes by approving panel, within 6 months from the end of the month in which the reference was received from commissioner. Approving panel to be constituted of not less than 3 members of the rank of commissioners or above. 10) What is meant by Round trip Financing? Differential tax rates among the countries cause round trip financing. It describes a phenomenon where money is sent outside a country, to come again back in the country via the country which has lower or nil rate of tax. Double Tax Avoidance agreements between nations are also considered for the above.
Company B Favourable Country India Company A Company C 11) Whether DTAA will prevail over Act in case of GAAR or vice-versa? Some countries domestic tax laws provide that the domestic anti-avoidance rules shall remain effective even where the tax treaty is applicable whereas in others they cannot override tax treaty in spirit of international Convention for interpretation of tax treaties. Commentaries to Article 1 of the OECD model convention note that as a general rule, the domestic anti-abuse rules do not conflict with the treaties. It may be noted that the Supreme Court, in the case of Azadi Bachao Andolan, has allowed the right of a tax payer to 'plan' his transactions to moderate tax liability and upheld that tax planning cannot be questioned only because it is 'tax-advantageous' provided 'economic substance' is demonstrated. The position in different countries is shown as follows- GAAR to override treaties Canada, Australia, Germany, United Kingdom (Proposed) Treaties to override GAAR New Zealand, China Later in time to prevail United States (Effectively GAAR overrides treaties) In India, as per the proposed amendment, GAAR will override Treaties. Therefore treaty benefit will not be available in case it is conflicting GAAR. 12) Whether the burden of proving the transaction is a sham or not lies in hand of revenue or assesse? In different countries different position is followed which is explained as follows Canada First Taxpayer needs to prove that the transaction is a genuine one. Then Canada Revenue agency has to establish abusive tax avoidance. Australia Burden on Assesse South Africa- Burden on Revenue
New Zealand- Burden on Assesse China Taxpayer needs to prove that the arrangement has reasonable commercial purpose. Germany Burden on Revenue. Singapore Burden on Assesse In case of India the onus is on the taxpayer to prove that the transaction is a genuine one. It is marked difference from the stand taken in the proposed Direct Tax Code where the onus was to lie on the revenue to prove that the transaction is a sham one. 13) Does GAAR only apply to International Transactions? It is a common myth that GAAR provisions are only applicable to International Transactions. GAAR provisions are mostly applied in case of international transactions; however it is similarly applicable to Domestic Transaction. Any transaction which fits into the definition of Impermissible avoidance arrangement will be under the purview of GAAR. 14) From when GAAR will be applicable? Once budget is passed in both house of Parliament the GAAR provisions will be effective in case of Assessment year 2013-14 and subsequent assessment years.