GAAR India April24 2012no2

General Anti-Avoidance Rule (GAAR) in India
kpmg.com/in
GAAR and its Impact - Important analysis
The Finance Bill, 2012 (Finance Bill) proposes to introduce 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 will undergo 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 Paper on 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 firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.
Contents
Background
03
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
04 05
06 09 11 12 13
03
Background
In the Duke of Westminster v. IRC1, and in several subsequent tax cases including Ramsay v. IRC2, Furniss v. Dawson3, Craven v. White4 and 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 Andolan5 case and the Vodafone6 case. 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 form doctrine in Indian tax law. Broadly speaking, GAAR will be applicable to arrangements/transactions which are regarded as impermissible avoidance arrangements and will enable tax authorities, among other things, to re-characterise such arrangements/transactions so as to deny tax benefits.
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 of 2010, dated 20 January 2012 .
04
Brief overview of the mechanics of GAAR
The mechanics of GAAR are captured in the diagram below:
Source: KPMG in India analysis
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.
05
First condition: Main purpose is to obtain tax benefit
First condition for the application of GAAR is that the main purpose or one of the main purposes of the arrangement is to obtain a tax benefit. The term tax benefit is defined in s. 102 (11) as: a. a reduction or avoidance or deferral of tax or other amount payable under this Act; or b. an increase in a refund of tax or other amount under this Act; or c. a reduction or avoidance or deferral of tax or other amount that would be payable under this Act, as a result of a tax treaty; or d. an increase in a refund of tax or other amount under this Act as a result of 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 following points are relevant:
Main purpose or one of the main purposes: The main
Part of an arrangement: In any arrangement if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit, the arrangement will be presumed to have been entered into to obtain tax benefit, in spite of the fact that the main purpose of the whole arrangement is not to obtain a tax benefit. Determining tax benefit: For determining the tax benefit: 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.
purpose test depends not on the actual accrual of a tax benefit, but only on the purpose behind entering into an arrangement. Hence, a transaction may be caught within GAAR even if it has not yet resulted in a tax benefit so long as it has been entered into for the main purpose (or one of the main purposes) of obtaining a tax benefit, at any time. Thus, the Finance Bill has widened the scope of GAAR as compared to that under the DTC wherein the criterion was main purpose is to obtain tax benefit. Even the South African GAAR applies the sole or main purpose test and not one of the main purpose as the key test.

Burden of proof: Where any arrangement results in any tax benefit, it shall be presumed to have been entered into for the main purpose of obtaining a tax benefit, unless it is proved that obtaining the tax benefit was not the main purpose of the arrangement. Therefore, the burden of proof would lie on the tax payer.
Conversion into Limited Liability Partnerships (LLP) Given the tax as well as operational advantages offered by the LLP route, many companies are increasingly considering converting into a LLP Considering the tax benefits of the LLP form, i.e. a lower rate (without surcharge) and the . absence of a Dividend Distribution tax (DDT) on repatriations and absence of Minimum Alternative Tax (MAT), it is quite likely that such conversions may satisfy the first condition and therefore be evaluated under GAAR. Adverse consequences could ensue if it cannot be appropriately demonstrated that the conversion was entered into with bona fide commercial purpose. Though one could legitimately argue that to facilitate such conversions, tax exemption from capital gains tax is also provided on fulfillment of specified conditions, such conversions ought not to be affected by GAAR.
06
Second condition
In order for an arrangement to be classified as an impermissible avoidance arrangement, 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, of the provisions of 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 for bona fide purposes.
Will the tax authorities apply Transfer Pricing provisions to determine this condition?
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:

There is little guidance in the Finance Bill as to what constitutes a misuse or abuse of the Act. However, it may be useful to refer to the recent decision of the Supreme Court of 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 of tax policy and that the misuse or abuse must be tied to a specific provision or provisions in the law. According to the Court, a finding of 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 defeats the underlying rationale of the provision; or 3. where the transaction circumvents the provision in a manner that frustrates or defeats its object, spirit or purpose. These observations, though in the context of the Canadian GAAR, may have a bearing on how the Indian judiciary interprets this provision.
Where the Act provides stringent specific Anti-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?
Cross-border inbound mergers- Whether misuse or abuse of provisions of the Act? The use of cross-border inbound mergers of foreign companies into India as tax efficient cash repatriation or debt pushdown mechanisms may again trigger an exposure to GAAR. It may therefore 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.
07
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 of holding companies in countries such as Mauritius, Cyprus and Singapore which have favourable tax treaties with India is likely to come under increased scrutiny under GAAR provisions. Specifically, if it can be alleged that such transactions involve locating assets or the place of residence (of the intermediate holding company) in a favourable treaty jurisdiction mainly for availing of tax benefits without substantial commercial purpose. Therefore, the corollary being that if it can be established that the location of the asset/transaction/place of residence is for a substantial non-tax commercial purpose, the arrangement should not be regarded as lacking in commercial substance for the purposes of GAAR. The term substantial commercial purpose should be distinguished from the term commercial substance; the former goes to the motive behind an arrangement, and the later implies commercial apparatus for running operations in an entity.
Use of favourable treaty jurisdictions for royalty payments/fees for technical services Similarly, use of favourable 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 of the ultimate ownership of the IPR as well as the commercial purpose behind housing such IPR in favourable treaty jurisdiction.
Outbound structure - Use of SPVs Controlled Foreign Company (CFC) and GAAR Full-fledged CFC rules have been proposed in the DTC, but have not been brought into the Finance Bill. However, considering the wide scope of GAAR provisions, a question may arise as to whether the proposed CFC like taxation can result through application of GAAR. For instance, under GAAR, the expression location of an asset for tax benefits is potentially wide enough to support a challenge by the tax authorities that the objective of 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 of investing in the overseas jurisdiction through a SPV was not to obtain a tax benefit and hence the threshold criteria for the applicability of GAAR is not satisfied.
Inbound investment structure- Migration of India investments to favourable treaty jurisdictions A migration of Indian investments from a holding company in a non-treaty/non-favourable treaty country to a favourable treaty country, especially through gifting of shares, could also be scrutinised under GAAR provisions. In addition to establishing that there is a substantial non-tax commercial purpose for such migration, it may also be necessary to demonstrate that a gift of shares by the company meets the bona fide and arms length test in GAAR provisions.
06 08
09
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) any accrual, 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
It is also expressly provided that: a. equity may be treated as debt or vice versa.;
Inbound investment structure - Use of Compulsorily Convertible Debentures (CCD) to capitalise Indian entities Instruments such as CCDs to fund Indian entities are likely to come under GAAR scrutiny if excessive debt is used as a part of the capital structure. Such scrutiny can potentially take one of the two forms: a. A subjective evaluation of the terms of the instrument to determine whether it can in fact be considered as true debt. For instance, factors such as the commercial ability of the Indian entity to raise comparable debt from third parties, the terms thereof, etc. could be used to contend that the instrument is more in the nature of equity, rather than debt. b. An objective evaluation based on a prescribed debtequity ratio to re-characterise interest expenditure in excess of the threshold limits as dividends (Thin Capitalisation Norms). Similarly, the use of treaty friendly jurisdictions like Cyprus, etc. to route debt into India may also be subject to scrutiny under GAAR.
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 recharacterised.
g. considering or looking through any arrangement by disregarding any corporate structure.
10
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.
Cash extraction through buyback Assuming that investments made by holding companies in jurisdictions with favourable capital gains provisions (such as Mauritius, Singapore and Cyprus) satisfy GAAR criteria, a further question may arise as to characterisation of buyback payments for Indian tax purposes. It is possible that a regular resort to buyback instead of dividends as a cash repatriation tool may pose a significant risk of such payments being re-characterised as dividends under GAAR.
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.
11
Applicability of GAAR
The following are the key points in connection with the applicability of GAAR:

GAAR: Retrospective/Retroactive GAAR is to be effective only prospectively i.e. from 1 April 2012. Hence, in respect of arrangements that have been concluded prior to that date, the question of applying GAAR should not arise. However, while applying this rule in the context of inbound investment structures, it is possible that investments made prior to the enactment of GAAR may be hit by it at the time of exit made on or after April 1, 2012. In other words, even though the provisions of 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 of GAAR. This is depicted in the chart below:
The provisions of GAAR are to be made effective from 1 April 2012. The provisions of GAAR begin with a non-obstante clause i.e. they have been made applicable notwithstanding anything contained in the Act. The provisions of GAAR are to override provisions of tax treaties.
Source: KPMG in India analysis
12
Some other impact areas
Secondary consequences Though 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 recharacterised 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.
13
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.
KPMG in India
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Dinesh Kanabar Deputy CEO & Chairman Tax T: + 91 22 3090 1661 E: dkanabar@kpmg.com Uday Ved Head of Tax T: + 91 22 3090 2130 E: uved@kpmg.com
kpmg.com/in
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2012 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated 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 of KPMG International. Printed in India.

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GAAR India April24 2012no2

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General Anti-Avoidance Rule (GAAR) in India

GAAR and its Impact - Important analysis

Brief overview of the mechanics of GAAR

The mechanics of GAAR are captured in the diagram below:

Source: KPMG in India analysis

First condition: Main purpose is to obtain tax benefit

Some issues in this regard are discussed below:

Lacks commercial substance

g. considering or looking through any arrangement by disregarding any corporate structure.

Source: KPMG in India analysis

Some other impact areas

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