GENERAL ANTI AVOIDANCE RULE READY OR NOT, HERE I COME

Shefali Goradia1

With the introduction of the Direct Taxes Code (the Code), India will for the first time implement the general anti-avoidance rule (GAAR). Given the concerns raised by the Revenue relating to the aggressive tax planning by tax payers and its futile attempts to amend certain Double Tax Avoidance Agreements (DTAAs), the Direct Taxes Code Bill, 2009 proposes to introduce anti-avoidance measures in the domestic tax laws by according wide powers to the Revenue to invoke GAAR. The fundamentals of Shefali Goradia the proposed GAAR in Indian context are premised broadly in line with the internationally accepted standards of anti-avoidance measures, though deviating in some aspects. This article discusses the international experience in introducing anti-avoidance provisions in the domestic laws in various countries and the manner in which these provisions have been implemented and applied by the courts. International practices Whilst most of the international instances of anti-avoidance measures manifest as GAAR, some countries have prescribed more specific or targeted anti-avoidance rules (SAAR or TAAR) in their domestic tax law. The global approach towards enacting anti-avoidance measures can be broadly categorized as (1) statute based general anti-avoidance2; and (2) court-based general anti-avoidance measures3. There are some countries that have neither statute based GAAR nor court-based GAAR4. Regardless of its advent and scope, GAAR is viewed as a necessary evil which needs to be calibrated based on the attitudes of taxpayers to avoidance. Under an old economic theory, the taxpayers were assumed to be amoral profit seekers, who disregard tax laws where the anticipated fine and probability of being caught are small 5 relative to the anticipated profits . However, in a more recent study done in Australia, it was found that the taxpayers were more compliant when they thought that they had been treated fairly and respectfully by the tax officers. It is therefore believed that the overall effectiveness of statutory GAAR will depend upon the manner in which it is administered. GAAR is sought to be applied where there is (a) a transaction or a set of transactions that is solely or predominantly aimed at tax avoidance, and (b) if given effect, the object and purpose of the applicable tax law would be violated. In most countries, sham and substance over form doctrines are applied. The approach to interpretation of GAAR and their application to constitute a treaty override is different in each country, and the features of such rules are also varied in nature. However most GAAR impute income regardless of its realization, reattribute income, recharacterize income, and disallow deductions. 88

Scope of anti-avoidance rules Most of the anti-avoidance rules are fairly comprehensive not only from income tax perspective but also from corporate and business taxation point of view6. Rules / doctrines of other jurisdictions are much more restricted in their scope and applicability; UK is a perfect example of a jurisdiction applying antiavoidance rules to certain circular and linear step transactions only. General anti-avoidance rules in Italy are an interesting example of how anti-avoidance rules can be more 'specific' or 'quasi-general'; Italian rules apply only to certain listed transactions (such as mergers and similar transactions, contribution of capital to companies, etc). There are a plethora of anti-avoidance provisions prevailing across the world; however, the more ordinary provisions can be distinguished into the following four groups7: 1. Transfer of residence These entail fictitious (continued) residence upon the transfer of residence abroad (deeming provisions) and exit taxes. For instance, a company incorporated in a country continues to be a tax resident of that country even though the effective management is relocated to another country. Exit taxes may relate to specific assets, such as substantial interest in the share capital of a company8, or pension rights or a combination of assets9. 2. Base companies These rules address the offshore income of base companies and are embodied in Controlled Foreign Companies (CFC) legislation. The US was the first country to introduce CFC regime. These rules attribute income earned by a CFC to the shareholder of that entity or deem the shareholder to have received dividends from the entity. These rules may be adopted either for certain specific low-tax jurisdictions or in respect of tainted income. 3. Base erosion This category includes thin capitalization rules, earnings stripping rules and rules limiting the deduction of interest payments to a percentage of assets. Thus, deductibility of expenses paid to non-residents may be restricted or exemptions, otherwise applicable to non-resident companies, may be disallowed if such companies are held, as stipulated, by residents. 4. Character of income This entails recharacterization of income depending upon the domestic laws of each country. For instance, where capital gains are taxed more heavily than dividends, dividends are converted into capital gains if it is believed that dividend is paid to avoid tax. In Australia, thin capitalization rules may recharacterize disallowed interest into dividend, but for withholding tax purposes, dividends may be recharacterized as interest as well. Whilst each country invokes GAAR based on specified conditions, a larger question that needs to be addressed by each jurisdiction implementing anti-avoidance rules is whether such conditions are essential 89

to be satisfied for applicability of GAAR or they just outline important aspects of a transaction which need to be considered before invoking GAAR. An analysis of international practices indicates that some older statutory rules are more general in nature and do not provide guidance as to determining factors which are more decisive in applying GAAR to a particular transaction or series of transactions. On the other hand, in countries with modern antiavoidance legislations, the 'structure' of transaction is more often an important condition for invoking GAAR. While in certain countries mere existence of an 'arrangement' undertaken for the purpose of tax avoidance is sufficient to invoke GAAR, in some countries it is required that the transaction should have been undertaken with the main motive of tax advantage in a manner that defeats the purpose of the legislation. Interplay with the DTAAs It is undisputed that GAAR provisions have an international effect. It is imperative to understand if these domestic anti-abuse provisions can override the tax treaties. In some cases, domestic tax laws specifically provide that the domestic anti-avoidance rules shall remain effective even where the tax treaty is applicable11 whereas in others they cannot override tax treaty in spirit of international Convention for interpretation of tax treaties. Commentaries12 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. Some countries believe that the taxes are imposed through the domestic tax laws, as restricted by the provisions of DTAAs and that to the extent that the anti-avoidance rules are set by domestic laws to determine the facts which give rise to a tax liability, they are not affected by the DTAAs. At the same time, some other countries13 hold a view that considering the object and purpose of tax conventions as well as the obligation on the part of the countries to interpret them in good faith14, proper construction of the DTAAs would allow them to disregard abusive transactions entered into with a view to take unintended benefits of the DTAA. However, one needs to read these commentaries with caution as there are some countries such as the Netherlands, Ireland, Luxembourg, Switzerland, Portugal, Mexico etc. which have expressed contrary observations on this position. In the context of 'treaty shopping' the commentaries also provide that countries wishing to address this issue in a comprehensive way, may consider including 'limitation to benefits' provisions in the respective DTAAs. Finally, the commentaries state that so long as there is no clear evidence that the treaties are being abused, member countries should carefully observe the specific obligations enshrined in tax treaties to relieve double taxation. In the Indian context, as a general rule the tax treaty overrides the domestic law; however, the Code proposes to introduce limited treaty override provisions in the domestic law; one of the instances proposed for treaty override provisions to apply is cases where the domestic general anti-avoidance rules have been invoked. Whilst the limited treaty override provisions are in line with 'substance over form rule' or 'economic substance rule' (as envisaged under the OECD Commentary and global practice for antiavoidance measures), it however is unclear as to how such interplay between the tax treaty provisions and the domestic override provisions would be balanced by tax administration. For instance, if a particular 90

transaction is eligible for tax treaty relief (especially in cases where the tax treaty already has a 'limitation to benefit' clause), could the domestic anti-avoidance rules still be invoked by the Revenue to pierce the corporate veil and deny tax treaty relief to taxpayers? It may be noted that the Supreme Court, in the case of Azadi Bachao Andolan, has endorsed the right of a tax payer to 'plan' his transactions to mitigate tax liability and upheld that tax planning cannot be questioned only because it is 'tax-advantageous' provided 'economic substance' is demonstrated. To what extent India will succeed in invoking GAAR in treaty abuse situations will ultimately be tested before the courts. The international experience on this is divided. In Canada, in MIL as well as Garron's case, the courts have held that the plain language of the treaty restricts the applicability of GAAR under the domestic law whereas in Yanko-Weiss Holdings case the Israeli court, in a preliminary proceeding has confirmed that treaty benefits could indeed be denied in a sham transaction. The Dutch Supreme Court on the other hand has taken a strict view in a case where the effective management of a company was transferred to a treaty jurisdiction just before liquidation and refused to deny the treaty benefits15. Principle of pacta sunt servanda seems to hold up against the anti-abuse provisions in the Netherlands, India (based on current law) and Canada whereas in Israel, Korea and China, the general anti-abuse provisions seem to prevail over the DTAAs. Indian GAAR As per the proposed provisions in the Code, a transaction shall be considered to be a tax avoidance transaction, if it is undertaken with the main purpose of obtaining a 'tax benefit' and it: (a) (b) (c) (d) creates rights or obligations, which would not be created if the transaction was implemented at arm's length; or results in, directly or indirectly, misuse of the provisions of the Code; or lacks commercial substance in whole or in part; or is implemented by means, which would not be normally adopted for bonafide purposes.

A transaction is deemed to lack commercial substance if the transaction results in a significant tax benefit without having a significant impact on the business risks, or net cash flows from a situation where the transaction would have been implemented at arm's length. A transaction could also be deemed to lack commercial substance if the form of the transaction significantly differs, in whole or in part, from its legal substance or involves round tripping. In case a transaction is regarded as an avoidance transaction, such transaction could be disregarded, combined with any other step in the transaction or re-characterized, or the parties to the transaction could be disregarded as separate persons and treated as one person. The provisions are drafted in a manner to permit application of principles relating to lifting corporate veil, substance over form test, economic substance test, controlled foreign corporation rules and thin capitalization rules (ie re-characterization of debt into equity or vice versa). 91

The original proposal conferred sweeping powers on the Revenue to invoke GAAR even in bonafide cases and therefore was highly criticized by the taxpayers. The Revised Discussion Paper toned down the rigors of the rules by proposing the following safeguards: (a) (b) (c) Issue of specific guidelines for stipulating specific circumstances under which GAAR may be invoked; Quantification and stipulation of a specific threshold in respect of the amount of tax sought to be evaded for the applicability of GAAR; and Availability of Dispute Resolution Panel as a forum for appeal for GAAR cases

However, one important aspect which needs deeper thinking in the Indian context and better alignment with global standards is the 'subjective intent' manifest in the GAAR provisions. Whilst, agreeably most anti-avoidance rules may seem to require some level of subjective 'intent to avoid taxes', and 'lack of business purpose', in Indian context this analogy assumes significance given the pro-Revenue record of tax litigation in past. Even where the subjective 'intent to avoid taxes' is required to be demonstrated, the question arises whether this must be the sole intent of the transaction; if not, then how to balance avoidance and non-avoidance intent manifest in the same transaction. Another significant aspect in implementation of GAAR provisions is how would the administration go about determining the intent of the taxpayers in such instances whether the intent of transaction should be determined on a subjective basis or an objective basis. In the first instance, it is a determination based on evidence of the state of mind of taxpayers; while in latter instance, it is a legal question of drawing consequences from objective circumstances surrounding the transaction. To illustrate, Swedish rule considers it sufficient that the Revenue authorities can demonstrate that based on circumstances, it can be assumed that obtaining a tax advantage was the sole motive underlying the transaction, and hence the GAAR should be applied. On the other hand, Australia perhaps has the most elaborate objective rules for deciding whether the intent of a particular transaction was to avoid tax or not. Given the added complexity of operationalizing the anti-avoidance rules in the Indian context, the apex administrative body for administration of direct taxes in India, should lay down more objective criteria and specific administrative guidelines for invoking GAAR and determine the tax consequences in cases where GAAR is invoked. GAAR versus SAAR It is important to mention that the extant domestic tax law contains a set of SAARs (especially in context of tax incentive provisions) to discourage taxpayers from planning their business decisions with the sole objective of obtaining tax advantage. Introduction of a general anti-avoidance rule in the domestic law would pose a question as to whether such general anti-abuse provisions shall apply in cases which have already been subject to specific anti-avoidance test under provisions of the domestic law. There are varied international precedents when it comes to interaction between general and special antiabuse provisions, with some jurisdiction ruling out applicability of general anti-avoidance measure in 92

cases where more specific anti-abuse provisions have been applied (eg Germany). The approach of other countries is quite different, with common law countries espousing a view that existence of special antiavoidance measures by itself can not preclude overarching general anti-avoidance rule. However, in the Indian context, such overlap between GAARs and SAARs could be avoided with the help of clear administrative guidelines. Conclusion The intent of the Government to legislate GAAR provisions in the domestic tax law can be hailed as a progressive move insofar as tax policy is concerned. However, an important question which needs more deliberation is whether in the current context, introduction of general anti-avoidance measures is well timed, or whether these measures are still premature given the size of Indian cross-border trade and the state of its administrative and judicial reforms. Considering the long drawn litigation process, over-burdened courts and pro-litigation mindset of both, the Revenue and the tax payers, GAAR could trigger more hardship and defeat the objective of the Code to simplify the tax regime and bring in more certainty. The detailed rules on safe harbours could help in bringing in some level of certainty. As far as the objective of stopping treaty abuse is concerned, the correct approach ought to be to amend the tax treaties and introduce limitation to benefits provisions and not to let the domestic laws override the tax treaties.

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Partner, BMR Advisors The views expressed in this article are personal. The author would like to acknowledge contributions from Sumit Singhania and Sima Shah Australia, Canada, France, Finland, Germany, Hungary, Italy, New Zealand and Spain Denmark, India, Switzerland, US and UK Japan, Colombia and Mexico Legislating against tax avoidance by Rachel Anne Tooma Danish or Norwegian Court-based rules and Swedish statute based rules : 'Form and substance in tax law' - IFA Cahier 2002 General Report by Prof. Steef van Weeghel 'Tax Treaties and tax avoidance: application of anti-avoidance provisions' -IFA Cahier 2010 Netherlands Belgium, Netherlands Denmark Australia, France, Denmark, New Zealand and US Paragraph 9.2 E.g. Switzerland Article 31 of the Vienna Convention on the Law of the Treaties General Report by Prof. Steef van Weeghel 'Tax Treaties and tax avoidance: application of anti-avoidance provisions' -IFA Cahier 2010

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