GAAR and Tax Treaties

[The following guest post is contributed by Dr. Nigam Nuggehalli, who is an Associate Professor at Azim Premji University, Bangalore]
The General Anti-Avoidance Rules (GAAR), to be in effect from April 1, 2017, were introduced by the government in a fit of frustration. The government found that many profitable companies were successful in avoiding tax even though their tax planning measures were clearly against the spirit, if not the letter ,of tax legislation. The GAAR is the government’s way of saying ‘if you act too clever, we are on to you.’  The way in which the government achieves this result is to establish broad spetrum tests of unacceptable tax avoidance, the language of which is bound to send tax lawyers into a tizzy.
For examples, under the GAAR, the government can attack a taxpayer’s transaction because it ‘misuses’ or ‘abuses’ the law. These are examples of what tax lawyers like to call as subjective tests i.e., dependent on the subjective evaluations of revenue officials, some of whose imaginations, as any harried chartered accountant would tell you, work in mysterious ways. The GAAR rules contain three different kinds of mitigations meant to lighten the harshness of their application. First, income arising out of transfers (of shares or assets) before April 1, 2017 are grandfathered i.e. not subject to GAAR application. Second, certain transactions, whether before or after April 1, 2017, are in any case kept outside the purview of GAAR. For example, certain investments by foreign institutional investors are excluded. Similarly, transactions that result in tax savings below rupees three crores (Rs. thirty million) are outside the scope of GAAR.
Finally, a very different kind of mitigation, one that was included because of taxpayer demands, has been introduced. This relates to the process by which a revenue official imposes GAAR. He or she cannot do so without making a reference to the Commissioner of Income Tax. If the Commissioner agrees with the GAAR application, the tax payer can appeal to a GAAR approving panel, which consists of a retired or serving High Court judge, a senior revenue official and an independent tax scholar.
Despite these mitigating provisions, the taxpayers continue to be worried, for in India it is not the culmination of a tax investigation that is problematic but the tax investigation itself, which really only needs an aggressive tax official and a compliant tax commissioner. The rest would be a blur of documents, hearings, further hearings and stay orders. What taxpayers, especially international investors, would be hoping for are safe harbours, i.e. objective factors laid down in the law that, if complied with, preclude unequivocally the application of anti-tax avoidance legislation.
However, this is precisely where there is cause for confusion. The government in its tax treaty negotiations has begun focusing, albeit sporadically, on providing international taxpayers with safe harbours without actually calling these safe harbours. Consider for instance the ‘Limitation of Benefits’ (LOB) clause in tax treaties. India has signed a number of tax treaties with its trade partners under which investors in India enjoy a favourable tax regime for various items of income such as capital gains, business income, dividends, interest and royalties. However companies began taking advantage of tax treaties without being really resident in the countries with which India had tax treaties. Singapore and India were jurisdictions that were particularly rife with such shell or postbox companies.
In August 2005, India and Singapore agreed to include a LOB clause in the tax treaty between the two countries. The LOB clause mentions that a company has to invest a certain amount of money in its home country in order to avoid being termed as a shell company, a classification that would result in a loss of tax treaty benefits. For instance, a company resident in Singapore can escape shell company status under the India-Singapore tax treaty if it incurs an annual expenditure of at least two hundred thousand Singapore dollars.  As the name suggests, the LOB clause is a limitation on the benefits that a company can avail under a treaty; however, a rose by any other name would smell as sweet – the LOB is also a safe harbour provision; it signals to companies that as long as they comply with the minimum expenditure requirements of the LOB clause they need not be bothered about being labelled as treaty opportunists or worse, treaty abusers. Recently India has introduced a virtually identical LOB clause in its treaty with Mauritius, but as a temporary measure. India decided to withdraw the generous capital gains exemption it allowed under the India Mauritius treaty but has allowed the benefits to continue for a limited period for genuine Mauritius residents i.e. those companies that fulfil the LOB clause.
The GAAR has raised doubts about the impenetrability of the safe harbour in the LOB clause. For example, can the revenue continue to claim that a company is making a spurious tax claim as a Mauritius resident even though it fulfils the expenditure requirements of the LOB clause in the relevant tax treaty?  It would be odd to make such a claim but the vaguely worded GAAR provisions almost invite outrageous claims from the revenue. What makes matters worse is that the GAAR is explicit on the following point: if there is a conflict between tax treaty provisions and GAAR, the GAAR would prevail. It is almost inviting the revenue to play fast and loose with the LOB provisions in tax treaties.
The Shome Committee Report on GAAR anticipated this issue and recommended that the government amend the GAAR legislation to clarify that if a company satisfies LOB provisions, it would not be subject to GAAR. However, the government has not amended the GAAR rules to this effect. It is incumbent on the Indian government to clarify this issue for foreign companies availing treaty benefits. Until then, the GAAR will hang over international taxpayers like a Damocles sword.

– Dr. Nigam Nuggehalli