The Direct Taxes Code, 2010 (DTC 2010) was placed by the Government of India (GO I) before the Parliament on 30 August 2010 and is envisaged to come into force from 1 April 2012. The Direct Taxes Code Bill, 2009 (DTC 2009) was earlier released by the GOI for public comments along with a discussion paper on 12 August 2009. Based on the feedback from various stakeholders, a Revised Discussion Paper (RDP) was released on 15 June 2010 addressing 11 of the major identified issues. DTC 2010 is the outcome of this consultation process. This Tax Alert summarizes some key anti-abuse proposals in DTC 2010.
A General Anti-Avoidance Rule (GAAR) was proposed in the Indian tax legislation for the first time in DTC 2009, apart from Specific Anti-avoidance Rules (SAARs) like transfer pricing (TP) provisions, dividend stripping transactions in securities, disallowance of related party expense etc.
The RDP further suggested introduction of Controlled Foreign Company (CFC) rules, to provide for taxation of passive income earned by a foreign company that is directly or indirectly controlled by a resident in India and whose passive income is not distributed to its shareholders, resulting in deferral of taxes. These CFC rules have been incorporated for the first time in DTC 2010. The present provisions of the Income Tax Law (ITL) do not contain comparable GAAR or CFC rules. This Tax Alert summarizes these GAAR and CFC rules and some changes in the TP provisions which are otherwise largely in line with the ITL provisions.
GAAR is a broad set of provisions that has the effect of invalidating an arrangement that has been entered into by a taxpayer, with the main objective of obtaining a tax benefit. The Tax Authority, in such cases, is granted the power to adjust the taxpayer’s assessment so as to counteract the attendant tax advantage.
It may be recalled that several representations were made on the need to dilute the GAAR proposal, if not drop it altogether. It was felt that GAAR of DTC 2009 did not adequately strike a balance between legitimate tax minimization and abusive tax avoidance. More specifically, there was a need to reconsider the definition of ‘impermissible avoidance arrangement’ and shift the onus onto the Tax Authority for invoking GAAR. However, the RDP only proposed fairly limited safeguards relating to the process for invoking GAAR. DTC 2010 essentially retains the GAAR as proposed in DTC 2009 but has incorporated some of the enabling provisions to carry out the proposed safeguards.
Conditions for invoking GAAR
1. The taxpayer should have entered into an arrangement.
2. Main purpose of the arrangement should be to obtain tax benefit and to fulfill any of the following criteria:
Ø It is not for bona fide business purpose.
Ø It creates rights and obligations which would not normally be created between persons dealing at arm’s length.
Ø It results, directly or indirectly, in the misuse or abuse of DTC 2010 provisions.
Ø It lacks commercial substance, wholly or partly.
3. DTC 2010 defines the term ‘tax benefit’ in a wide manner to cover (i) a reduction, avoidance or deferral of tax or other amount payable under DTC 2010 or under DTC 2010 but for a tax treaty, (ii) an increase in a refund of tax or other amount or (iii) an increase in a refund of tax or other amount as a result of a tax treaty in the relevant or any other financial year. This definition, when compared with that in DTC 2009, has been widened to also cover ’reduction in tax bases including increase in loss’.
4. Any arrangement, or part of it, is deemed to lack commercial substance if:
Ø It results in tax benefit to one party but does not have a bearing on the business risks or cash flows of the other party.
Ø The legal substance or effect of the arrangement, as a whole, differs from the legal form of its individual steps.
Ø It includes or involves round trip financing, an accommodating or tax indifferent party, any element having the effect of offsetting or canceling each other or a transaction which is conducted through one or more persons and disguises the nature, location, source, ownership or control of funds.
5. Furthermore, bona fide purpose does not include any purpose which has created rights or obligations that would not normally be created between persons dealing at arm’s length or would result, directly or indirectly, in the misuse or abuse of DTC 2010 provisions.
Tax consequences on invoking GAAR
1. On satisfaction of the conditions for invoking GAAR, the Tax Authority at the Commissioner level (Commissioner) would be empowered to declare the arrangement as an impermissible avoidance arrangement and, thereafter, determine tax consequences as if the arrangement had not been entered into. For this purpose, the Commissioner is empowered to:
Ø Disregard, combine or re-characterize any step or part or, if required, the whole of the arrangement.
Ø Treat the arrangement as if it had not been entered into or carried out or treat it in such a manner that the Commissioner may deem appropriate for the prevention or diminution of the tax benefit.
Ø Deem connected persons as one and the same person.
Ø Disregard any accommodating party.
Ø Re-allocate income, receipt (both capital and revenue), expenditure, deduction, relief or rebate amongst parties to the arrangement.
Ø Re-characterize income, receipt (both capital and revenue), expenditure, deduction, relief or rebate.
Ø Re-characterize equity into debt and vice versa.
2. DTC 2010 clarifies that between DTC 2010 and tax treaty provisions, the rule of whichever is beneficial to the taxpayer will not apply when GAAR is invoked. Therefore, the taxpayer cannot take protection under the tax treaty once GAAR is invoked.
3. One of the safeguards recommended by the RDP is for the Indian tax administrative authority, the Central Board of Direct Taxes (CBDT), to issue guidelines for application of GAAR provisions. DTC 2010, accordingly, provides for the CBDT, in consultation with the GOI, to provide for guidelines on conditions and manner of application of GAAR provisions. The RDP also indicated that GAAR would be invoked only where tax avoidance is beyond a specified threshold. This threshold, presently, does not find mention in the text of DTC 2010 and is expected to be provided for in the guidelines.
Procedure in applying GAAR
- DTC 2010 provides for the Commissioner to serve notice on the taxpayer to enable it to provide any evidence or particulars on which it may rely in support of its claim that GAAR does not apply. Thereafter, the Commissioner shall pass an order declaring whether the arrangement is an impermissible avoidance arrangement or not.
- Once the arrangement is declared to be an impermissible avoidance agreement, the Commissioner issues directions to the Assessing Officer (AO), the first level of the Tax Authority, for making appropriate adjustments. The AO is bound to follow these directions and issue a draft order to the taxpayer.
- The taxpayer can, on receipt of the draft order from the AO, within a period of 30 days, file objections before the Dispute Resolution Panel (DRP), a collegium of three Commissioner-level tax officers, constituted by the CBDT. The DRP may call for and examine the record of any proceeding relating to the draft order and make such further inquiry, as it thinks fit. Thereafter, the DRP, after giving an opportunity to both the taxpayer as well as the AO, may confirm, reduce or enhance the variations proposed in the draft order. The direction of the DRP is binding on the AO. The taxpayer can appeal against this directly with the second appellate authority i.e. the Income Tax Appellate Tribunal.
Burden of proof :-The burden of proof vests with the taxpayer to establish that the tax benefit was not the main purpose of the arrangement. Furthermore, an arrangement is presumed to have been entered into/carried out for the main purpose of obtaining tax benefit, if the main purpose of a step or part of the arrangement is to obtain a tax benefit, even if the main purpose of the whole arrangement may not be to obtain the tax benefit.
TP provisions
The TP provisions in DTC 2010 are broadly similar to that contained in the ITL. However, there have been changes to expand the definition of the term ‘Associated Enterprises’ (AEs) and to introduce Advance Pricing Arrangements (APAs) provisions.
AEs
1. An international transaction means a transaction between two or more AEs, either or both of which are non-residents. The ITL provides for specific circumstances when two enterprises would be deemed to be AEs. It may be recalled that DTC 2009 had proposed a 10% voting power threshold for being regarded as AEs. DTC 2010 now reverts to the existing ITL provisions of 26% voting power as the threshold. However, the definition of AEs has been expanded to include the following situations:
Ø Provision of services by one enterprise to another, either directly or indirectly, where the conditions are influenced by such other enterprise.
Ø Any specific or distinct location of either of the enterprises, as may be prescribed.
APAs
- APA is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g., method, comparables and appropriate adjustments thereto, critical assumptions as to future events) for determining the TP for those transactions, over a fixed period of time, which, in this case, is a maximum of five years.
- The ITL currently does not provide a mechanism for entering into APAs. DTC 2010 broadly provides for the following mechanisms:
Ø The CBDT, with the approval of the GOI, may enter into an APA with any person, specifying the manner in which arm’s length price (ALP) is to be determined in relation to an international transaction.
Ø The manner of determination of ALP in an APA can be any method, including one of the prescribed methods in the TP provisions, with such other adjustments as may be necessary or expedient to do so.
Ø The ALP determined under the APA shall be deemed to be the ALP in relation to the international transaction, in respect of which the APA has been entered into and shall be binding on both the taxpayer and the Tax Authority.
Ø The APA has validity for the period specified in it, subject to a maximum period of five consecutive financial years, and, shall remain in force as long as there are no changes in DTC 2010 having a bearing on the APA.
3. DTC 2010 also empowers the CBDT to formulate a scheme for APAs in respect of an international transaction.
TP Assessment
- An Accountant’s report on TP is required to be filed directly with the Transfer Pricing Officer (TPO) (under the ITL, it is required to be filed with the AO) within the due date of filing the tax return. However, the TP assessment is done based on a reference made by the AO. Upon determination of the ALP, the TPO shall forward a copy of his report within 42 months from the end of the financial year in which the international transaction is entered into by the AE and the taxpayer.
- The AO is then required to pass a draft order after taking into account adjustments proposed by the TPO. The taxpayer can file its objections to the draft order with the DRP as explained in the GAAR provisions.
Introduction of safe harbour rules
- The theory of a TP-safe harbour is that the burden imposed in applying the ALP can be relieved by providing for circumstances under which a Tax Authority would automatically accept the transfer price. In effect, a safe harbour is a defined parameter. If the TP result falls within that parameter, the Tax Authority would not be allowed to make any adjustments.
- ‘Safe harbour’ has been defined in DTC 2010 to mean the circumstances in which the Tax Authority shall accept the transfer price declared by the taxpayer. DTC 2010 also empowers the CBDT to notify safe harbours, a provision comparable to the ITL, though no safe harbour has been notified as yet in the ITL.
Miscellaneous provisions
- A TPO, under the ITL, is authorized to use any information in his possession for determining the ALP. This provision often raises concerns on the TPO’s ability to use secret comparables or information which the taxpayer does not have access to. DTC 2010 proposes to introduce a safeguard against this by providing that such information cannot be used by the TPO unless an opportunity of being heard is provided to the taxpayer.
- DTC 2010 includes a specific definition of the term ’intangible property’ in the chapter dealing with anti-abuse provisions. This definition would have applicability while dealing with TP aspects of intangible property. The term ’intangible property’ is defined to include know-how, patents, goodwill, copyrights, trademarks, brand names, licenses, franchises, any business or commercial right, leasehold interest, exploration and exploitation rights, easement rights, air rights, water rights or any other thing that derives its value from its intellectual content instead of its physical attributes.
- A comparative analysis of the penalties under the ITL and DTC 2010 is summarized below:
| Particulars | ITL | DTC 2010 |
| Under-reporting of tax base | 100-300% of tax base
under- reported |
100-200% of tax base under- reported |
| Failure to maintain documentation | 2% of value of international transaction | INR
50,000- 200,000 |
| Failure to furnish documents | 2% of value of international transaction | No specific provision |
| Failure to obtain or furnish Accountant’s report | INR 100,000 | INR
50,000- 200,000 |
CFC rules
CFC rules, introduced for the first time in DTC 2010, are designed to prevent tax deferral and tax avoidance by residents, including domestic companies looking to establish foreign entities/subsidiaries, in low tax jurisdictions and diverting income to them. Such income is taxed in the hands of the resident shareholder as residuary source income. Key provisions in the CFC rules are briefly provided below:
- CFC rules apply to foreign companies over which a resident taxpayer has ‘control’. Control can be de jure (50% or more control over voting power or capital) or de facto or a combination thereof, of substantial interest/influence or control over income or asset of the CFC.
- CFC rules allow deferral of ’active’ business income which is generally not taxed until it is repatriated by way of a dividend. However, ’passive’ income earned by a CFC is usually taxed on an accrual basis. Passive incomes not only include interest, royalty, rent, capital gains, dividends but also income from active trading with related parties (commonly referred to as ’base company income’ in international taxation).
- CFC provisions adopt an ’entity approach’. Under this approach, the focus is on the CFC as an entity rather than on its income, although the nature of its income is an important factor in the determination of whether or not the CFC rules apply. Once a foreign company qualifies as a CFC (and none of the exemptions apply), all of the income of the CFC is taxed in the hands of the resident-controlling shareholder on a proportionate basis. The future dividend distribution of the attributed income by the CFC is deductible.
- CFC provisions do not apply if tax paid by the foreign company in its country of residence is less than 50% of the tax it would have paid under DTC 2010 if it were a domestic company. An exemption is also available if the CFC is listed or if the CFC income does not exceed INR 2.5m.
- Shares held in a CFC are considered as assets and their value included in the computation of wealth tax in the hands of the resident. Wealth tax is levied at the rate of 1% on net wealth that exceeds INR 10m.
Comments
The proposal to codify GAAR in the tax legislation represents a new approach by the GOI in dealing with tax avoidance. While policy makers worldwide have extensively debated the advantages and disadvantages of GAAR, the most common argument against a statutory GAAR is that it promotes uncertainty for taxpayers. In framing the legislation that is sufficiently all-embracing to deter tax avoidance, there is always the danger of penalizing those who have genuine reasons for entering into a bona fide transaction. Furthermore, by including elements of ’anti-tax deferral’ principles, GAAR recognizes deferral of tax as a tax advantage, although, to address tax deferral, it has also introduced CFC rules. These proposals of GAAR and CFC rules have far reaching consequences and could have significant impact even on genuine business transactions. The intention to apply GAAR and CFC rules by overriding India’s tax treaties could impact the stability provided to foreign investors by an applicable tax treaty.
The TP provisions were introduced in the ITL with effect from 1 April 2001. Since then, TP disputes have emerged as a significant challenge faced by multinational companies doing business in India. While the definition of AEs is proposed to be widened to enlarge the scope of TP, the proposal to put in place a mechanism for APAs is welcome and would benefit taxpayers. The APAs, along with safe harbour rules, should help in reducing TP controversies and disputes and also in providing a basis which is fair and impartial to both the Tax Authority and the taxpayers.
DTC 2010 is slated to come into force on 1 April 2012. Accordingly, it would be important for taxpayers to get familiar with the above proposals and also assess how these proposals could impact their businesses.
