GAAR impact on cross-border structuring

July, 2012 Author: Shefali Goradia, Partner

After much speculation and debate, the controversial General Anti-Avoidance Rule (GAAR) has finally made its way into the Indian tax law. The general anti-avoidance provisions are now codified and will become effective from April 1, 2013. This is a turning point for Indian tax system as till date, India, being a common law country, had adopted a judicial anti-avoidance approach, and followed a form over substance principle, while overruling sham transactions. History So far, the Indian judiciary created a dividing line between tax evasion (judged as illegal) and tax avoidance or tax planning (considered legitimate if within the precincts of the law). Upholding this principle, the Indian Supreme Court in the Azadi Bachao Andolan case allowed tax treaty benefits under the India-Mauritius tax treaty to holding companies on the basis of a Tax Residency Certificate. Even in the recent Vodafone case, the Supreme Court analysed Indian and British jurisprudence on this issue and observed that tax planning was within the framework of law and only the use of colourable devices would not become a part of it. In this case, interestingly, the Supreme Court rebuked the Government for not having anti-avoidance provisions in the Indian tax law, in the absence of which it advocated the look at approach while interpreting various framework agreements pertaining to sale of shares. Harmful tax competition The subject of tax avoidance was initially discussed in the Organisation for Economic Cooperation and Development (OECD) report1 on the effects of harmful tax competition on investment decisions. OECD had then identified two problems facing international taxation (i) tax havens; and (ii) preferential tax regimes, and sought to propagate a tax policy to eliminate both to preserve tax base of source countries and to provide a level playing field for all countries to ensure equity between nations. Some key relevant observations in the report covered the following: Tax havens were identified as jurisdictions which (i) impose no or nominal taxes, (ii) lack effective exchange of information and transparency, and (iii) do not require localising any substantial activities. Countries have the right to impose taxes (even if minimal) depending on their economy as long as such countries had effective tools for exchange of information with other

OECD Report on Harmful Tax Competition An emerging global issue released in the year 1998 Our Locations:
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countries in order to avoid money laundering and generation and accumulation of black money. Identified measures like adopting the controlled foreign corporation rules, inclusion of Limitation of Benefits (LoB) strictures in tax treaties to restrict abuse, and most importantly advised re-examination and acceptance of domestic anti-avoidance provisions for counteracting harmful tax competition.

Since then, a number of countries (like Australia, Canada, New Zealand and South Africa) have enacted statutory GAAR while other countries (notably UK and US) have adopted vigorous judicial anti-avoidance doctrines. In comparison with GAAR introduced by other countries, the Indian GAAR is much broader and is likely to cover within its ambit even transactions which have a primary non-tax motive, as long as one of the main purposes of the transaction is to obtain a tax benefit. In the international context many countries have refrained from adopting GAAR due to high cost of tax collection and additional strain this can cause to the legal system. In a recent report2 submitted to the UK Government, it has been recommended that the UK GAAR be narrowly focussed on aggressive tax avoidance schemes alone; thereby keeping genuine transactions out of its scope. Paradigm shift in tax planning Internationally, tax authorities have expressed a concern over the use of holding companies to make investments. The Supreme Court in the celebrated Vodafone case delved into the discussion on use of overseas holding companies in foreign investments and observed that multinational companies need holding companies for many commercial reasons so as to consolidate regional operations, for ring-fencing high-risk assets so as to avoid legal and technical risks to the main group, etc and for these reasons offshore financial centres which provide good infrastructure are chosen by them. In the same breath, the Supreme Court also expressed concern on the use of tax havens and offshore financial centres for stashing black money and caveated its observation by restricting tax treaty benefits where black money is involved. This issue of using Special Purpose Vehicles (SPVs) to legitimatise black money has also been raised in the report on Black Money3 issued by the Ministry of Finance this year. GAAR is becoming a reality in many countries. The advent of GAAR is expected to significantly change the Indian tax landscape and it is important that the international investor community is not only aware of but also prepares for GAAR. Indian GAAR Under Indian GAAR, an arrangement whose main purpose or one of the main purposes is to obtain a tax benefit4 and which satisfies certain prescribed conditions such as lack of commercial substance, abuse of treaty provisions, etc would qualify as an impermissible avoidance arrangement on which GAAR could be applicable.

2 3

GAAR Study A report by Graham Aaranson QC dated November 2011 White Paper on Black Money issued by the Ministry of Finance, Department of Revenue, Central Board of Direct Taxes dated May 2012

Defined to include a reduction or avoidance or deferral of tax as a result of a tax treaty Our Locations:
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The tax effect of such impermissible avoidance arrangements is to be determined by the Indian Revenue Authority (IRA) in any manner it sees appropriate, which would include disregarding or combining or re-characterising any step / parties in the arrangement, ignoring the arrangement, re-allocating income and expenses, re-characterising equity as debt and vice versa, re-locating the place of residence of any party or situs of an asset, etc. While it is expected that some guidance on manner and conditions of applying GAAR will be issued, it may still be very broad and may not give any specific direction on the substance requirements to be satisfied. Recently, the Committee constituted for reviewing GAAR provisions under the proposed Direct Taxes Code5 (DTC) issued its recommendations6 (the Draft Guidelines) to the Indian Government for the implementation of GAAR under the Indian tax law. As the Draft Guidelines have been provided to the Government for approval and are not the final guidelines to be applied while evaluating GAAR, we have incorporated only the relevant recommendations in our analysis below which could be indicative of the thinking of the Government. As of now, Indian GAAR does not contain a specific carve out for genuine commercial transactions, and where GAAR is invoked, tax treaties will be overridden by the Indian tax law. Providing a silver lining to the dark GAAR cloud, the Indian Government while enacting the legislation as part of Finance Act 2012, has shifted the burden of proof from the taxpayer to the IRA. Potential impact of Indian GAAR Before delving into the discussion on the impact of GAAR on different kinds of cross-border transactions, it would be pertinent to note that transactions completed before April 1, 2013 should be outside the purview of GAAR. The taxability of such transactions should be governed by the existing provisions of the Indian tax law absent GAAR, along with the extant judicial principles. The Indian Government, in its recently issued Supplementary Memorandum to Finance Act 2012 has affirmed the above position, and noted that GAAR would apply only to income chargeable to tax from April 1, 2013. We now look at different types of structuring and impact of GAAR on a few popularly used crossborder investment structures. Relevance of holding company structures Multinationals use holding companies for various reasons as these provide the benefit of retaining capital abroad for future expansion, listing in other jurisdictions, flexibility for future re-structuring, facilitating regional management and controls, assisting in cost effective fund raising, availing tax benefits under tax treaties, avoiding the need to follow onerous laws in multiple jurisdictions in situations where regulatory / securities laws of the investee company are rigorous, etc. In a nutshell, a holding company in an appropriate jurisdiction seeks to achieve overall group tax rationalisation combined with non-tax and corporate commercial benefits. Unlike India, many countries do not impose capital gains tax on non-residents. A holding company structure assumes relevance for an investor who is unable to take a tax credit in his home jurisdiction for taxes paid in India, due to the difference in the tax system followed by the
5

The Indian Government proposed a draft DTC in the year 2010 which is proposed to replace the existing Indian tax law.

Draft Guidelines regarding implementation of GAAR in terms of Section 101 of the Indian tax law Our Locations:
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source country and the country of residence. For example, in the US capital gains earned from sale of shares of an Indian company is regarded as US sourced income, whereas India regards such income to be sourced in India. The difference in the tax system of both the countries gives rise to a technical difficulty in claiming a tax credit and the investor may thus end up paying tax in both jurisdictions. However, if use of an intermediate jurisdiction provides tax exemption in India, the investor in that situation pays tax only as applicable in his home country. Choice of holding company jurisdiction This section analyses illustrative situations where GAAR could possibly be invoked by the IRA to treat a holding company as a mere conduit, especially depending on the jurisdiction where such a holding company has been set up. Impact on treaty vs non-treaty jurisdictions: Investment through a jurisdiction whose tax treaty with India does not have a LoB clause7

Figure 1 is an illustration of a vanilla inbound investment structure where investment is made through an SPV in an intermediate jurisdiction. While globally it is debated on what kind of substance is required for an investment holding company; in most jurisdictions, such a company will be managed by a Board of Directors comprising a few local directors and a few foreign directors. Having an office and a few employees will lend more substance but there will remain ambiguity and uncertainty over tax treaty access. In such a case if GAAR is applied then the IRA can (i) disregard the intermediate company alleging lack of substance and bring to tax Parent Co under Indian tax law or India-Parent Co tax treaty; or (ii) retract tax treaty benefits such that Hold Co could be brought to tax in India under Indian tax law; or (iii) re-locate the place of effective management of Hold Co to Parent Cos jurisdiction on the basis that key personnel of Parent Co control Hold Co and thereby applying the India-Parent Co tax treaty. Under the Indian GAAR, any of the aforesaid may be resorted to by the IRA on the basis that the investment was routed through the intermediate jurisdiction by Parent Co only to avail a tax benefit afforded by the intermediate tax treaty. It would therefore become essential to defend the capital gains tax exemption (as above) under the tax treaty by clearly substantiating the business / commercial rationale for choosing one jurisdiction over any other, by supporting documentation clearly suggesting so. It may be useful to note that the Draft Guidelines state that tax treaty benefits may be denied to Hold Co under GAAR in case Parent Co has funded the entire investment in Ind Co, and Hold Co
7

An LoB clause consists of certain conditions which need to be satisfied in order to take benefit of under a tax treaty that apply to certain articles such relating to capital gains, etc. This operates as an in-built substance requirement

negotiated by tax treaty partners to prevent abuse of the tax treaty. Our Locations:
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has not made any other investment. In such a situation, as per the recommendations, the real and beneficial ownership of the shares in Ind Co held by Hold Co may be deemed to lie with Parent Co, which controls Hold Co. In such a specific situation, GAAR could be invoked. Impact on treaty vs non-treaty jurisdictions: Investment through a jurisdiction whose tax treaty with India has a LoB clause Staying with the illustration in Figure 1, it would be interesting to see how the IRA would react to investments made through a jurisdiction which has a LoB clause in its tax treaty with India, eg Singapore. The India-Singapore tax treaty restricts the capital gains exemption only to those Singapore residents which are either listed on a recognised stock exchange or expend more than SGD 200,000 per annum in the immediately preceding 24 months in which the gains arise. As there is an in-built substance requirement under the India-Singapore treaty which also restricts the misuse / abuse of the tax treaty, one may argue that GAAR should not apply to such situations. However, no such carve-out is provided and it is likely that the IRA would apply GAAR equally to such tax treaties and grant tax treaty benefit only if there is adequate substance, which it may consider acceptable. In the Draft Guidelines, the Committee has also made a reference to capital gains exemption sought under tax treaties where the requirements of the LoB clause such as under the IndiaSingapore tax treaty are satisfied. The Draft Guidelines state that for meeting the expense threshold under the LoB clause, only the operational expenses incurred in the offshore jurisdiction should be considered (specifically, interest expenses on borrowings from a shareholder should be disregarded). An interesting argument on this basis would be that using the rationale of the LoB clause in the India-Singapore tax treaty, one may argue that if a similar expenditure is incurred by a holding company set up in another intermediate jurisdiction, such as Mauritius, it should be sufficient to satisfy the substance test under GAAR. It would however remain to be seen how the IRA responds to such an overture and similarly, remain to be seen how the IRA responds to a redomiciliation of the intermediate company from Mauritius to Singapore, if that were to be possible would they regard this act of protecting treaty benefits as taking benefit of a treaty which itself requires application of GAAR? Addressing grievances of the international community to a unilateral treaty override The Vienna Convention on the Law of Treaties provides that a tax treaty can be terminated or suspended either if it is provided in the tax treaty itself or by consent of both parties to the tax treaty. It remains to be seen how tax treaty partners like Mauritius now respond to a unilateral override of its long standing tax treaty. As a responsible treaty partner, a better way to deal with this would be to re-negotiate the tax treaty to include in-built substance requirements like an activity provision, stock exchange listing provision or a bona fide business purpose provision such that the tax treaty abuse is minimised or prevented. It would be interesting to see how the Courts view a unilateral treaty override which could be in violation of the Vienna Convention on the Law of Treaties. Choice of entity As GAAR is wide in scope, it empowers the IRA to determine the consequences in an appropriate manner, the form of an entity used for making investments may also be open to recharacterisation. For instance, by application of GAAR, a Limited Liability Partnership (LLP) which is to be treated as a partnership for tax purposes, may be treated as a company. This may
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be since LLPs, when used for onward investments in India vis-a-vis companies, allow repatriation of profits to its partners without attracting Dividend Distribution Tax (DDT). Therefore, the IRA may want to treat an LLP as a company and levy DDT on distributions to foreign investors where the motive of choosing an LLP is found to be driven by a tax benefit. In addition, for computing Alternate Minimum Tax (AMT) to LLPs as compared to parallel Minimum Alternate Tax (MAT) to companies, the number of adjustments to be made are much fewer resulting in a lesser scope of difference between accounting profits and book profits. The IRA may however attempt to treat LLPs as companies to give effect to the larger adjustments prescribed for companies. Choice of instrument and repatriation of profits The Indian exchange control regulations do not prescribe a limit on the amount of interest which can be repatriated on Compulsorily Convertible Debentures (CCDs) annually. However, on a conservative basis, a position is generally taken that the interest should be pegged at the limit prescribed for dividend payable on Compulsorily Convertible Preference shares (CCPs). An aggressive position that in the absence of a limit under the exchange control regulations, any amount of interest which can be freely repatriated could also be adopted. The following could be the potential outcomes under GAAR: Re-characterisation of interest on CCDs as dividend Where a foreign investor thinly capitalises an Indian company and mostly invests through CCDs with the objective of drawing profits from the Indian company in the form of interest so as to (i) avoid DDT, and (ii) obtain a tax deduction for the interest paid, it will be interesting to see whether GAAR can be applied in such a situation. In such cases, the CCDs may be treated as equity or CCPs for tax purposes and the interest could be re-characterised as dividend (also refer to impact on real estate structures for such recharacterisation). It may be relevant to note that the Draft Guidelines state that raising funds through debt or equity should be a commercial choice of the company and GAAR should not be applicable. It further states that where a debt has been raised from a related party then the Transfer Pricing (TP) would apply and GAAR would not be required. At the same time, it has been stated that location of the connected parties in low tax jurisdictions and source of funds may be relevant in order to bring such arrangements within the ambit of GAAR. Re-characterisation of capital gains as dividend

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Many Indian companies choose to buyback shares (as illustrated in Figure 2) as a mechanism to reduce capital and distribute profits to shareholders. In such cases, the IRA could potentially recharacterise the transaction as that of payment of dividend to the extent of accumulated profits of Ind Co at the time of the transaction. Such re-characterisation would be subject to DDT for Ind Co. This re-characterisation may be done especially in cases where no dividends are declared and Ind Co has accumulated profits in its books. Also in cases of pre-ordained transactions where other investment partners of the holding company do not accept the buyback offer then the risk of application of GAAR may increase. This situation has also been contemplated in the Draft Guidelines which state that such buyback undertaken to repatriate profits while avoiding DDT and capital gains tax (under the tax treaty) would be in the nature of a colourable device subject to GAAR. Substance requirements for PE funds Specifically, in context of Private Equity (PE) Funds, the substance requirement becomes more intricate. Considering that Funds are set up as Collective Investment Vehicles (CIV), mostly in low tax countries, with a limited duration life and a specific objective of holding investments, substance requirements need to be inherently different. Imposing the compulsion of having an establishment or employing people may be burdensome and inappropriate considering that most CIVs are managed by investment managers who may be set up in the same or another jurisdiction. It would seem reasonable that for strengthening the commercial substance, the existence of an independent and skilled management company and capable Directors on the Board of the investing entities should be viewed as adequate for claiming tax treaty benefits. Nonetheless, in situations where Funds are set up in one location and SPVs are established in another location only for investing in India, chances of GAAR applicability may increase especially in a case where there are no operations or there is no substance in such intermediate CIV / SPV jurisdiction. In such a case, the SPV may be disregarded and the tax treaty with the individual investors may be sought to be applied. Impact on intellectual property holding structures In order to provide additional incentives for companies to retain and commercialise existing patents and to develop new innovative patented products, a number of developed countries like the Netherlands, Belgium, UK have introduced or propose to introduce special incentives such as patent box or innovation box regimes. Such jurisdictions also have a favourable intellectual property regime, low corporation tax rates, a highly skilled IT workforce, and a mature and sophisticated legal framework in place to provide appropriate legal protection for Intellectual Property (IP). Under these special regimes, profits from the patented intangibles are taxed at a concessional rate (eg 10 percent) instead of a significantly higher corporate tax rate. Some jurisdictions like the Netherlands do not even require development of patents within their country as long as the ownership lies within such jurisdiction.

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Different from a conduit structure, the Dutch IP Sub Co (refer Figure 3) may typically be the legal owner of the IP which may either be developed in a low cost jurisdiction such as India or in countries like the Netherlands etc. The licensees of such IP can either be non-related parties or group companies (including Ind Co). The motive for using a Dutch IP holding company could be tax driven (reduction in foreign withholding taxes by using network of tax treaties) or operationally driven (advanced laws for protection of IP, excellent infrastructure for the exploitation and development of IP). In practice, a combination of these two motives may drive the structure. Under this IP structure, the royalty received on licensing IP to Ind Co and other parties would suffer almost no tax / minimal tax owing to the tax treaties with other countries and concessional tax rate in the Netherlands. In this regard, the beneficial ownership test (under which royalty would be taxable at the rate provided in the tax treaty only if Dutch IP Sub Co is the beneficial owner of the royalty instead of Ind Co), would need to be satisfied in order to claim the tax treaty benefits. Under such structures, where the IRA alleges that the IP was housed in the Netherlands with the intention to move / retain profits outside India to keep them away from the Indian tax ambit, and such profits suffer no / minimal tax under the special tax regime in the Netherlands or under the tax treaties between the Netherlands with other countries, it could bring to tax the entire royalty income of Dutch IP Sub Co in India. It is relevant to note that under the draft DTC, a provision to tax income of Controlled Foreign Companies8 (CFCs) has been included. However, in the absence of a CFC provision under the Indian tax law, income retained offshore could be covered by GAAR. In such cases, it would be pertinent to substantiate that the Dutch IP Sub Co was managed and controlled by appropriately skilled Directors and was not controlled by Ind Co. It would be relevant to see if the satisfaction of the beneficial ownership test is not considered as a sufficient substance requirement. Further, in some countries, saving foreign taxes is considered or is viewed as a legitimate commercial reason. One will though have to test out such an argument in the Indian Courts! Impact on real estate holding structures

The draft DTC, defines a CFC as a foreign company which (i) is a resident of lower tax jurisdiction, (ii) is an

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Foreign investment in the Indian real estate sector has been restricted under the Indian exchange control regulations. Investors typically invest in Indian companies undertaking construction and development activities with an expectation of ongoing payout (for the lease rentals generated) along with capital appreciation at the end of the investment period. Hence, foreign investment is typically made through debt instruments like CCDs and loans which allow a regular interest payout. Considering this typical form of investment, investors which hold their investment through jurisdictions like Cyprus (refer Figure 4) for onward investment in project SPVs in India with the intention of reducing the withholding tax rate on interest, will now need to pass the GAAR test. On application of GAAR, the IRA could re-characterise the debt into equity (especially in the case of CCDs since these are considered equity from an exchange control perspective) and recharacterise the interest on them as dividend. By doing this, the IRA could (i) take away the lower rate of tax available under the tax treaty with jurisdictions like Cyprus, (ii) levy DDT on the income flows, and (iii) disallow the tax deduction on interest payment claimed by the Indian SPVs. It would be useful if thin capitalisation ratio is prescribed in the GAAR rules. On the other hand, if the surplus is not repatriated by the SPVs to Hold Co and is instead reinvested in new projects, then the IRA can potentially argue that the SPV is deferring taxes in India, calling for application of GAAR. Conclusion While the Indian Government has not provided any (much) clarity on GAAR yet, one aspect which nevertheless is crucial would be documentation. It is at the back of the documentation that the real intent behind a transaction would be examined, and it would be the documentation that would assist in making assertions for defence during a tax audit. In addition to this, it would become pertinent to strengthen substance in the intermediate jurisdiction, measured amongst others, in terms of expenditure incurred by the holding company in the intermediate jurisdiction, employment of local Directors with appropriate skills and experience, etc. GAAR is therefore undoubtedly set to overhaul the conventional ways of doing business not only in India but globally. With countries asserting their taxing rights more strongly than before, extra efforts to rationalise your own tax outgo seems to be the need of the hour. A change, requiring existing investors to appropriately improvise their current structures before the implementation of GAAR and the new investors to approach with caution seems inevitable to avoid tax litigation in India.

This article has been written by Shefali Goradia, Partner with BMR Advisors, who specialises in Direct Taxes. Shefali has been supported by Parul Jain, Director with BMR Legal, and Esha Vatsa, Senior Associate with BMR Advisors, in compiling this article.

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