The Government has just released draft guidelines for the implementation of the newly introduced general anti avoidance rules (“GAAR”) in India. Unfortunately, the guidelines fail to provide adequate guidance to investors who are increasingly concerned with the prevailing uncertainty in India’s legal and tax environment.
The draft was prepared by an internal committee of the tax department and released without clearance from the office of the Prime Minister who has recently taken charge as the Finance Minister. Whether in terms of depth or quality of analysis, the guidelines are far behind international standards set by countries such as UK, Australia, New Zealand and South Africa, which have provided detailed guidance on the application of GAAR.
The GAAR provisions which will be effective from April 1, 2013 (and proposed to be deferred to 2014) are replete with obscure terms and confer wide discretionary powers to the tax authorities without sufficient accountability as suggested by the Standing Committee of the Parliament in their report on DTC. Considering the far reaching impact of these provisions, the Government should re-consider whether India is ready for GAAR. It is internationally accepted that GAAR should not be introduced unless the Government can assure a transparent, non-corrupt, unbiased, judicious and fair administration that recognizes the fundamental rights of taxpayers.
Due to the slowdown in the Indian economy, the Prime Minister had appealed to the tax department to come out with clear guidance on GAAR that will spread positive signals and once again instill confidence in foreign investors. The draft guidelines however seem to have achieved the opposite result. Ambiguities continue to exist with respect to the impact of GAAR on foreign institutional investors (“FIIs”), offshore holding companies and other legitimate structures for investing and doing business in India. Highlighted below are a few critical issues with the draft GAAR guidelines that require immediate attention.
GAAR continues to remain ambiguous: The GAAR provisions use vague terminology such as ‘direct or indirect’ ’misuse or abuse’, ‘bona fide purpose’ and ‘commercial substance’ which make it difficult for the average investor or taxpayer to comprehend the law and make rational economic choices.
Sadly, the draft guidelines do not even attempt an explanation or analysis of the meaning and scope of these terms. Instead, it provides 21 illustrations where the applicability of GAAR is examined. The analysis provided in the draft is very subjective and does not provide the much needed guidance.
It would be useful for the Government to emulate best practices followed by countries such as South Africa, New Zealand and Australia whose tax authorities have provided detailed and comprehensive guidance on each term used in the GAAR provisions along with tools for interpretation and analysis of relevant judicial precedent.
Implications for funds and inbound investment structures: From the observations and analysis in the draft guidelines, it is clear that GAAR will adversely impact several perfectly legitimate structures for investment into India. The illustrations provided in the draft are likely to increase the uncertainty for foreign investors.
For instance, in one illustration, it is clarified that GAAR would not be applicable to an offshore holding company that employs ‘sufficient’ manpower, capital, infrastructure and commercial substance. In the absence of clearer guidance, the sufficiency of these factors will always be a subject matter of controversy and litigation. Another illustration suggests that an offshore holding company may be disregarded merely because it received its entire funding from its parent company.
In another illustration, sale of Indian securities by an entity located in a low tax jurisdiction with a favorable tax treaty with India is treated as a misuse or abuse of the treaty and an impermissible avoidance arrangement. No further justification or analysis is provided for such treatment.
In a case where an offshore holding company incurs certain expenditure on office expenses and interest payments to its parent company, the draft notes that the entity lacks economic substance without analyzing the activities of the entity, its assets or number of employees. With respect to the choice between debt and equity, the draft clarifies that interest may potentially be characterized as dividend if the payment is made to a related party situated in a low tax jurisdiction. Clearly, the nature of guidance provided in the draft is extremely limited.
Impact on FIIs: GAAR is likely to impact FIIs in the same manner as other categories of investors. FIIs and their sub-accounts investing into India may face the risk of being denied tax treaty benefits if the offshore entity does not satisfy the various subjective tests including that of economic substance.
On a positive note, the draft guidelines recommend that GAAR should not be applicable to investors of the FIIs. This clarification seems to have been provided as a result of apanic reaction when FIIs started to exit from India as a silent protest to GAAR and the indirect transfer tax. In any case, this may provide some relief to foreign investors who have invested into derivative instruments such as participatory notes (“P-Note”) issued by the FII. However, it is not fully clear whether P-Note holders may still be impacted by the other 2012 amendment that seeks to tax transfer of foreign interests the value of which is substantially derived (directly or indirectly) from assets situated in India.Though, from the language of the amendment, it may be possible to interpret it as excluding P-Note holders from the reach of the indirect transfer tax.
Composition of drafting committee: Contrary to international best practices, the departmental committee that prepared the draft guidelines did not include any representative from the profession or industry. The committee was constituted on February 27, 2012 and submitted the 29 page draft guidelines on May 28 2012.
GAAR is a very serious provision. Ideally, complicated provisions such as GAAR having a wide impact should be thoroughly reviewed by a law commission comprising lawyers, accountants, industry representatives, policy thinkers and revenue officials. For instance, the proposal to introduce GAAR in the 2012 UK Budget was based on recommendations by a high profile study group comprising a member of the judiciary, a senior lawyer, an industry representative and leading tax academicians. The group spent around a year to deliberate upon the scope of a GAAR and in preparing a detailed 77 page report.
Limited terms of reference: The internal committee that drafted the guidelines was requested to (i) formulate guidelines for implementing the GAAR provisions and (ii) draft a circular providing guidance so that GAAR is not applied indiscriminately in every case.
This may be contrasted with the superior terms of reference provided to the UK study group on GAAR which was asked to make recommendations ensuring that (i) the GAAR provisions work fairly; (ii) they do not erode UK tax regime’s attractiveness to business; (iii) ensure certainty; and (iv) minimize compliance and enforcement costs. The Indian GAAR guidelines should seek to achieve such important policy objectives that are characteristic of an evolved tax system.
The draft guidelines do not seem to provide even the basic inputs for understanding the scope and impact of GAAR. It is far from meeting the expectations of investors and professionals who seek clear, comprehensive guidance and certainty.
At a more fundamental level, it is necessary for the Government to revisit the timing of introduction of GAAR.
Before implementing such a difficult and complex policy measure, it is necessary to first reform the tax administration and enforcement machinery. India is far behind other countries that have introduced GAAR when one considers parameters such as corruption, ease of paying taxes and ease of doing business. Boosting investor confidence and taxpayer morale is definitely the need of the hour.
- International Tax Team