Prime Minister Manmohan Singh has asked a committee headed by Parthasarathi Shome to look into the General Anti-Avoidance Rules (GAAR) regime. This is a good time to reassess the government’s proposal on GAAR and re-think why these proposals were introduced in the first place. It appears inevitable that there will be a set of amended GAAR rules by the end of this year once the Shome Committee submits its report. The need now is to focus on simplifying the rules and regulating the discretion of the revenue in applying these rules.
The current GAAR provisions are meant to address limitations in the judicial interpretation of tax statutes that allows taxpayers to escape taxation even if the spirit or intent behind the statute was not meant to allow for such tax avoidance techniques. A case in point is the high-profile Vodafone judgment where the government felt short-changed because overseas holding company structures were used to escape capital gains tax in connection with a transfer of control over corporate assets in India. The Supreme Court made it clear that the Income Tax Act could not be interpreted as imposing a tax on the transfer of control over corporate property in India since this transfer of control was effectuated indirectly by a transfer of shares in overseas companies that were outside the jurisdiction of the Indian tax authorities.
Although GAAR was a response to the failure of the revenue department to tax Vodafone-like structures, that failure ought not to encourage the government to frame wide-ranging and vague GAAR provisions that would result in taxpayer uncertainty in structuring legitimate business transactions. The current GAAR provisions are applicable to impermissible avoidance arrangements (which, presumably, means that there are permissible tax avoidance arrangements), and there is a threshold test for such arrangements: whether the purpose of the arrangement or any part of the arrangement is a tax benefit (reduction or deferral of tax). Given that the rules require the threshold test to be applied to any part of the arrangement rather than just the arrangement as a whole, the threshold test is wide enough to include most transactions that have received the benefits of basic tax planning.
Once the threshold test has been fulfilled, there are four alternate scenarios that can make the arrangement an impermissible tax avoidance transaction. Despite appearances, it would be very easy for a transaction to be identified as one of the four types of impermissible arrangements. The first impermissible arrangement refers to the arrangement being a non arms-length transaction. The second and third impermissible arrangements relate to transactions that amount to a misuse of the code and transactions that are not conducted in a bonafide manner. These two provisions present tricky issues of interpretation precisely because the language in which they are couched is inherently vague. For example, what constitutes a “misuse” of the code? The Income Tax Act does not attempt to clarify this term further.
The fourth problematic transaction is familiar to all tax lawyers: transactions that lack commercial substance. In the US, this falls within the economic substance doctrine (recently codified) according to which legitimate tax planning can work so long as the taxpayer has a business purpose for his transaction and the transaction meaningfully changes the economic position of the taxpayer apart from the tax benefits arising from the transaction. The current GAAR goes beyond this two-pronged test. While the Indian GAAR mentions certain typical features of commercially suspect transactions – such as “accommodating parties” whose presence in a transaction is solely to provide tax benefits – there are two problems with the commercial substance rules. First, the GAAR mentions that where the substance of an arrangement differs materially from its form, such an arrangement would be without commercial substance. Given the flexibility in financing where the differences between debt and equity or between a sale and a lease consist almost entirely of legal form rather than substance, more guidance would be required to understand what would make a form /substance problem significant.
Further, the GAAR commercial substance rules also mention round-tripping and transactions that disguise the ownership and control of funds as transactions that lack commercial substance. Although it is accurate to describe such transactions as lacking economic substance, that’s not the main problem with them. These transactions are, at best, sham transactions because they purport to be something that they are not, and, at worst, these are fraudulent transactions. The judiciary has already signalled that such transactions would not be tolerated for tax avoidance purposes and it would be an overreach for the GAAR to cover transactions that are already being dealt with currently by the judiciary.
In the US, the problems created by tax avoidance have been dealt with legislatively by codifying the economic substance doctrine. If the GAAR regime in India adopts the economic substance test exclusively and does away with vague terminology such as “abuse” and “bonafide”, it will go a long away in establishing certainty in tax planning for business activities. Most taxpayers would be willing to accept that they should not receive tax benefits for sham transactions and for transactions that lack economic substance. The GAAR regime should, therefore, focus only on the economic substance doctrine and introduce a test along the lines of the American experience.
Simplifying and rationalising the GAAR requirements alone will not ensure the smooth functioning of these rules. Careful attention also needs to be paid to the regulation of official discretion in the application of GAAR. In this respect, it is worrying that currently the power to regulate revenue discretion is proposed to be in the hands of a panel that consists of officials from the revenue department and from the law ministry. It would be better from the point of view of administrative discretion if the GAAR were to be implemented with reference to a panel that has independent members as well as members from the banking and finance industry who are familiar with sophisticated financing techniques. The latter is particularly important because once financing techniques become more sophisticated, there is a possibility that the revenue department may tend to view such techniques as disguised attempts to avoid taxation. The idea of a panel that includes independent members with expert financial and commercial knowledge has already been mooted in GAAR proposals in the UK.
The author is Senior lecturer in Tax Laws, BPP Law School, London