GAAR vs. DTAA: Clash of Domestic Anti-Avoidance Provisions and International Commitments

Abstract

GAAR which India introduced to stop aggressive tax evasion, has led to a lot of debate, mainly because it contrasts with Double Tax Avoidance Agreements (DTAAs). This article looks into whether GAAR might take precedence over provisions in DTAA and what this might mean. It looks at the laws, important court rulings and what other nations do to examine the balance between a nation’s right to collect taxes and its duties under international tax treaties.

KEYWORD: GAAR, DTAA, OECD, Treaty Shopping, Round Tripping.  [1]

Introduction [2]

Tax treaties are important in international taxation because they avoid double taxation, encourage cross-border investments and ensure the law is followed to prevent tax evasion. They help to maintain fairness and predictability for multinational enterprises and foreign investors around the world. In addition, India and other countries are using General Anti-Avoidance Rules (GAAR) and similar laws to defend their tax base against complex tax avoidance and treaty abuse.

GAAR moves away from focusing on the form of a transaction and instead looks at the main reason for it. Yet, this situation leads to a difficult relationship between tax avoidance measures in the country and obligations under international treaties. When GAAR is used in cases related to treaty benefits, it might seem to go against the special concessions given in the DTAAs. [3]

As a result of this connection, important questions arise: Can a country’s anti-abuse policies take priority over its treaty rights? To what degree can a sovereign country use its revenue protection measures without violating international agreements? This article attempts to solve these issues by exploring the legislative, judicial and international aspects of GAAR-DTAA interaction. [4]

General Anti-Avoidance Rules (GAAR)

GAAR was created as part of India’s wider plan to improve its tax system and match global rules like the OECD’s BEPS framework. Chapter X-A of the Income Tax Act, 1961 gives tax authorities the authority to ignore or change the nature of transactions or arrangements if they are found to be IAAs. [5]

An arrangement is not allowed if:

• The main reason for it is to get a tax advantage.
• There is not enough commercial substance in it.[6]
• It makes rights and obligations that would not normally be established between people dealing in the open market.
• It uses the law in a way that was not intended.[7]

GAAR requires a focus on the real purpose of the transaction, rather than just how it is structured. Because its reach is wider than SAAR, tax authorities have a lot of power which has made some investors worry about the reliability of the tax system and its fairness.

The Framework of DTAAs

DTAAs are signed between India and other countries to stop income from being taxed twice, in the place where it is earned and in the place where the taxpayer lives. They outline how tax rights should be divided, what it means to be a tax resident and procedures for resolving disagreements (such as MAP). [8]

Key features-

• According to Section 90 of the Income Tax Act, the Central Government can sign DTAAs. The section also says that an assessee can choose the DTAA rules if they are more advantageous than the rules under domestic law.
• Under the Vienna Convention on the Law of Treaties, DTAAs have the force of law in international relations.[9]
• Tiebreaker rules, credit or exemption methods and ways to prevent tax evasion are usually found in these treaties.[10]

Among the nations with DTAAs with India are Mauritius, Singapore, the Netherlands and Cyprus and these agreements have often been involved in treaty shopping and round-tripping which is why GAAR is needed. [11]

The Dispute – GAAR and DTAA

A. Taxpayers must follow GAAR when there is possible treaty abuse.[12]

The Finance Act, 2012 added Section 90(2A) which was a major change in India’s international tax policy. It is clear from this provision that Parliament wants GAAR to work even for taxpayers who have DTAA benefits which used to mean that treaties took priority over domestic laws if they were more helpful.

[13]

The non-obstante clause which says “even if sub-section (2) applies,” is very important. Section 90 (2) allows taxpayers to use the provisions of domestic law or treaty that give them the greatest benefit. However, Section 90(2A) limits this discretion by adding that GAAR may be used to cancel this benefit if there is abuse. [14]

For this reason, it is understood that-

• The government knows that treaty shopping is leading to misuse of treaty benefits.[15]
• GAAR is considered a tool that helps protect tax fairness and integrity for the public.[16]
• It also prevents claims that treaties offer total protection no matter what the real purpose and impact of the transaction are.

Principle of Treaty Override- Fitting National Law with International Obligations [17]

Even though international tax treaties are binding and part of the “special law,” India’s Parliament has the power to make or change its own laws to deal with tax evasion and avoidance. A later law is considered to take precedence over an earlier one, especially if it is written with a non-obstante clause.

Hence, GAAR (Chapter X-A) and Section 90(2A) were introduced after most of India’s DTAAs were signed, they have precedence in cases of conflict. Still, the override is used only when abuse happens and not for all proper DTAA claims. [18]

Important Points about Treaty Override

This was meant to happen, not by accident. It was made clear by Parliament that GAAR was designed to deal with treaty misuse, mainly caused by round-tripping, shell entities and conduit arrangements. The override is done on purpose and not by chance. [19]

The main difference between treaty abuse and genuine benefit is clear.

GAAR does not eliminate all the benefits that come from treaties. A genuine foreign investor who makes commercial investments in a DTAA country, with economic substance and business purpose, is protected from GAAR. Was the main reason for the transaction to save taxes? Does the plan not make sense from an economic or commercial point of view? MLI and PPT are in line with the GAAR.

India joined the OECD’s Multilateral Instrument (MLI) to adjust its double taxation agreements so they comply with BEPS Action Plans, especially Action 6 (Preventing Treaty Abuse). One important part of the MLI is the Principal Purpose Test (PPT) which serves the same purpose as GAAR.

Principal Purpose Test (PPT) [20]

If the main reason for the arrangement or transaction is to get a tax benefit, the treaty benefit may be refused unless it fits with the treaty’s purpose.

Implications-

• PPT means that treaty partners can choose not to provide benefits, not only the domestic tax authorities.[21]
• It reduces disagreements between GAAR and treaty rights by including anti-abuse terms in the treaty agreements.
• India has used the MLI to update its agreements with Singapore, Mauritius and the Netherlands, adding PPT clauses.[22]

The law enforcement side of the story, from allowing planning to preventing abuse. Decisions made by Indian courts have greatly influenced the way tax avoidance, treaty benefits and what is allowed in tax planning are discussed. Examining important cases makes it clear that the courts moved from valuing treaty rights to accepting the requirement for anti-abuse measures, resulting in GAAR being recognized.

Azadi Bachao Andolan Case (2003)- Treaty Shopping is Allowed [23]

In this case, the respondents said that foreign investors were using the India-Mauritius DTAA to set up shell companies in Mauritius just to avoid paying capital gains tax in India. The Supreme Court, nevertheless, decided that the government was in the right.

Simply because a Mauritian company was formed to enjoy tax breaks, the treaty’s benefits could not be ignored. Though treaty shopping is not wanted, it is not always a crime unless it is expressly forbidden by law or treaty. The court found that the CBDT’s Circular No. 789/2000 which treated TRCs from Mauritius as sufficient proof of residence, was proper. [24]

Vodafone International Holdings Case (2012): Is It Enough to Plan Taxes or Should There Be Real Substance? [25]

Vodafone acquired Hutchison Essar Ltd. by completing an offshore transaction. The revenue claimed that the transaction had a connection to India and included indirect transfer of Indian assets.

The Supreme Court’s decision was- What was done in the transaction was tax planning, not tax evasion. Vodafone did not have to withhold tax, as the transaction involved non-residents outside India. Indian law at the time permitted the transaction. This decision was made before GAAR was put into place. The Court pointed out that the government should make its laws clearer if it wanted to address this issue.

[26]

B. GAAR After the Changes: GAAR as a Means to Prevent Treaty Abuse

After the Finance Act, 2012 and the implementation of GAAR from April 1, 2017, Indian law now allows the tax department to deny treaty benefits if there is abuse, artificial arrangements or no commercial purpose. CBDT Circular No. 7/2017 explained several important points. GAAR is designed to stop aggressive tax planning and treaty shopping. It will not affect real business transactions that have a business purpose. It gives tax officials the ability to ignore or change arrangements that are mainly designed to get a tax advantage. The Circular stresses that GAAR may be applied when DTAAs are superseded by Section 90(2A). [27]

Additionally-  Rule 10U of the Income Tax Rules, 1962, introduced a threshold of INR 3 crore and requires the Approving Panel’s approval to stop GAAR from being used in a random way.

Recommendations from International Practices and the OECD

Both the OECD BEPS Action Plan and the Principal Purpose Test (PPT) [28]

The OECD’s BEPS Project, under the Organisation for Economic Co-operation and Development (OECD), created 15 action plans to stop multinational enterprises (MNEs) from using aggressive tax planning.

Action Plan 6- Stopping Treaty Abuse

The focus is on treaty shopping which is when companies use tax treaties to get tax breaks they did not intend to receive.  [29]

The Principal Purpose Test (PPT) in treaties means that tax officials can reject treaty benefits if it is clear that a main aim of the deal was to save taxes, unless that aim is in line with the treaty’s intentions.

C. India’s Participation Using the Multilateral Instrument (MLI)

In 2017, India joined the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). What MLI Means for India. India included PPT clauses in its DTAAs with Singapore, Mauritius, the Netherlands, Luxembourg and a number of other countries. [30]

Similar to GAAR, the treaty uses a substance-over-form approach to close the gap between national and international anti-avoidance rules. Because GAAR and PPT now work together, there is an anti-abuse system in place both in domestic law and in international treaties. What Matters for Taxpayers and Investors Now that GAAR is in place and India follows the MLI and PPT, taxpayers and foreign investors must deal with a different tax environment.

D. More Uncertainty and a Risk of Lawsuits

How GAAR is applied depends on the views of the authorities about the commercial purpose and tax impact of a deal. Since there are few precedents after the GAAR, legal issues can lead to many disputes and appeals. Retrospective review- Even with GAAR used only for future transactions, the authorities could review earlier events linked to the present transaction which could result in lawsuits.

E. The need for clear documentation and a solid reason for the project’s value.

Taxpayers can defend themselves from GAAR by ensuring that their transactions- Your business should have a real commercial reason other than tax benefits. There are detailed documents available, including board minutes, financial statements, business plans and reports from outside sources. Show that the transaction is supported by real economic activities such as employees, an office and operations, in the country where the transaction takes place.

F. Effect of Deterrents on Treaty Shopping and Round-Tripping

Using GAAR and PPT together has made it harder for people to use round-tripping and treaty shopping. Now, Mauritius, Cyprus and Singapore which were once preferred for their tax treaties with India, require companies to do real business there to get treaty benefits.

Now, investors are choosing where to invest based on compliance, transparency and lasting benefits and not just on tax savings.

Conclusion

The relationship between GAAR and DTAAs is found at the point where domestic laws and international treaties meet which can bring both difficulties and advantages to India’s tax system.

GAAR was put in place to defend the tax base from smart schemes that try to avoid taxes by exploiting loopholes, so that taxes are charged based on the real outcome of transactions. At the same time, DTAAs are a key part of India’s international tax policy, trying to prevent double taxation, offer predictability to investors and encourage economic cooperation with other countries. It is clear from Section 90(2A) in the Income Tax Act that the legislature wants GAAR to take precedence over treaty rules when there is treaty abuse. Nonetheless, GAAR must be used carefully, logically and openly in treaty matters, because too much or rough use could make investors doubtful and might harm India’s reputation as a reliable country in treaty relations.

By joining the Multilateral Instrument (MLI) and Principal Purpose Test (PPT), India is demonstrating its intention to match its domestic anti-abuse rules with those used internationally. Even though this convergence is positive, it calls for both GAAR and PPT to be applied and enforced clearly, together and consistently. In addition, the rules for tax planning have been shaped by important judicial precedents. Even so, the outcome of GAAR cases will depend greatly on how the courts interpret the rules, so as to balance the tax authority’s rights with those of the taxpayer.

For India to address tax avoidance well while remaining a respected part of the global tax community, it must make its domestic anti-abuse tools consistent with its treaty obligations. Besides strong laws, this also needs strong institutions, oversight from the courts and consistent policies. Sustainable tax government around the world relies on a tax system that is fair, predictable and transparent and supported by both national and international efforts.

REFERENCES

1.OECD, Action Plan on Base Erosion and Profit Shifting (2013)

2. Finance Act, No. 23 of 2012, § 90(2A) (India)

3. Vienna Convention on the Law of Treaties, art. 26, May 23, 1969, 1155 U.N.T.S. 331

4. Azadi Bachao Andolan v. Union of India, (2004) 10 SCC 1 (India)

5. Vodafone Int’l Holdings B.V. v. Union of India, (2012) 6 SCC 613 (India)

6. CBDT Circular No. 7/2017, May 27, 2017 (India)

7. Income-tax Rules, 1962, Rule 10U (India)

8. OECD, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 Final Report (2015)

9. Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, OECD (2017)

10. Jinyan Li, Tax Avoidance and the Rule of Law, 50 Can. Tax J. 1 (2002)

11. M.P. Lasserre, Treaty Override and the Principle of Pacta Sunt Servanda, 60 Bull. Int’l Tax’n 5 (2006)

12. Richard Vann, General Report, in GAARs – A Key Element of Tax Systems in the Post-BEPS World? (IFA Cahiers 2016)

13. Peter Harris, The Principle of Substance over Form in Tax Law, 18 Austl. Tax F. 36 (2003)

14. United Nations Model Double Taxation Convention between Developed and Developing Countries (2017)

15. OECD Model Tax Convention on Income and on Capital (2017)

16. Michael Kobetsky, International Taxation of Permanent Establishments (Cambridge Univ. Press 2011)

17. Arvind Datar, Commentary on the Constitution of India (LexisNexis 2018)

18. Klaus Vogel, Klaus Vogel on Double Taxation Conventions (Kluwer Law Int’l 2015)

19. BNA Tax Management Portfolio, Income Tax Treaties – Overview and Current Issues (2021)

20. G.S.A. Wheatcroft, The Interpretation of Double Taxation Agreements, 7 Brit. Tax Rev. 240 (1963)

21. Rohatgi, A., Basic International Taxation: Volume I – Principles (Taxmann 2018)

22. Rohatgi, A., Basic International Taxation: Volume II – Practice (Taxmann 2018)

23. Gaurav Jain, GAAR: An Indian Perspective, 36 Comp. L. J. India 112 (2016)

24. Nishith Desai Associates, GAAR Implementation: The Indian Perspective (2017)

25. Ernst & Young, Worldwide Corporate Tax Guide (2021)

26. Sullivan, M.A., Economic Substance Doctrine Evolves, 119 Tax Notes 235 (2008)

27. Jeffrey Owens, International Tax Cooperation: A New Beginning, 69 Bull. Int’l Tax’n 1 (2015)

28. James R. Hines Jr., Do Tax Havens Flourish?, 19 Tax Pol’y & Econ. 65 (2005)

29. Michael Lang, Introduction to the Law of Double Taxation Conventions (IBFD 2013)

30. Alexander Rust, The Principle Purpose Test (PPT) in the Multilateral Instrument, 72 Bull. Int’l Tax’n 6 (2018)