Potential impact of GAAR and tax treaty override on inbound investments into India

Author:

NC Hegde and Surojit Ray
Deloitte Haskins & Sells
Mumbai

India's Income Tax Act (ITA) is set to be replaced by a new legislation known as the Direct Taxes Code (DTC) with effect from April 1 2012, a change that is being effectuated to bring about more clarity and simplification of the existing tax law. However, the DTC also envisages some far-reaching changes to the overall Indian direct tax structure, which potentially could be detrimental to investments made into and from India. Two controversial proposals are the introduction of a General Anti-Avoidance Rule (GAAR) and a tax treaty override provision in cases where the GAAR is invoked.

Broadly, the GAAR is a mechanism to dissuade taxpayers from entering into any arrangement, the main purpose of which is tax avoidance. Objectively understood, the GAAR could be triggered in circumstances where an arrangement has been entered into or is carried on in a manner not normally used for bona fide business purposes, is not at arm's length, abuses the provisions of the DTC or lacks adequate "economic" substance. To prevent the applicability of the GAAR, the taxpayer would be obliged to demonstrate that obtaining a tax benefit (that is to say, tax avoidance) was not the main purpose of the arrangement under scrutiny. This, in itself, is a highly subjective proposition that could result in protracted litigation. Further, if the GAAR is triggered, it is proposed that the tax authorities would be empowered to disregard the form of the transaction and determine the tax consequences for the taxpayer as if the arrangement had not been entered into.

Although the current scope of the proposed GAAR seems to be fairly broad, it has been clarified that every arrangement for tax mitigation would not necessarily fall within its ambit. Further, it is proposed that adequate safeguards (in the form of detailed guidelines) would be introduced to ensure the limited applicability of the GAAR. Thereapart, minimum thresholds for triggering the GAAR would be notified and the benefit of approaching the Dispute Resolution Panel (that is to say, a fast track appellate authority which can be referred to in prescribed circumstances) should be available in cases in which the GAAR is invoked.

According to another proposal in the DTC, if the GAAR is invoked, the taxpayer would not be eligible to claim benefits under an applicable tax treaty and, hence, would be subject to tax in India based on provisions of the DTC. By contrast, taxpayers now have the option to be governed by the provisions of the applicable treaty or the ITA, whichever is more beneficial.

Given the above background, it is important to understand the possible ramifications of these proposals on existing and future inbound investments into India.

To date, most foreign investments into India has been routed through intermediary holding companies (IHCs) situated in tax-favoured jurisdictions such as Cyprus, Mauritius and Singapore. The inherent advantage of using an IHC is that any capital gains derived by the IHC on the sale of shares of the Indian operating sub-sidiary are exempt from tax in India under the relevant tax treaty provisions.

Given the OECD's initiative to crack down on tax havens and the desire of such jurisdictions to be considered as being compliant with international standards, a few tax havens (for example, Mauritius) have introduced rules under their domestic law as regards issuance of tax residence certificate. This indirectly ensures some degree of substance in IHCs established in such jurisdictions. Further, subject to the production of a tax residence certificate, IHCs are generally granted treaty benefits in India (in fact, the revised draft of the DTC indicates that the possession of a valid tax residence certificate is a prerequisite to claiming treaty benefits).

Although it may be premature at this stage to reach at any definitive conclusions since guidelines for the applicability of the GAAR have not yet been issued, once the DTC is implemented, the IHC route is likely to be subject to greater scrutiny (given that most IHCs generally have limited substance). As noted above, treaty benefits may be denied where the GAAR is invoked and, consequently, capital gains arising to the IHC on a transfer of the shares of the Indian operating subsidiary may be subject to tax in India. (The capital gains tax rate proposed under the DTC on a transfer of shares of an unlisted company is expected to be much higher than the current 20% rate {plus applicable surcharge and education cess, assuming the shares transferred have been held for more than one year.} The treaty override proposal also could create issues for the taxpayer in its home jurisdiction if it is denied a tax credit for tax withheld in India on the premise that treaty benefits should have been duly considered by the Indian tax authorities when determining the taxpayer's taxability in India.

The availability of a tax-free exit mechanism clearly has been instrumental in enhancing the inflow of investments into India in the last couple of decades, so it goes without saying that any impediment to this option could have a far-reaching effect on the way the world views India as an "investment destination." Further, India is already facing stiff competition from China and other emerging Asia-Pacific countries in terms of attracting inbound investments. It is therefore essential that Indian lawmakers visualise a long-term perspective and adopt a pragmatic approach when framing the final rules for the applicability of the GAAR (such that the GAAR can be resorted to only in apparent cases of tax evasion). An aggressive stance with respect to the implementation of the GAAR would not only adversely impact the (already volatile) stock markets, but also have a devastating effect on inbound investments into India and the broader economy.

(c) Deloitte Haskins & Sells, India

The views expressed herein are the personal views of the authors.

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