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
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.
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.
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.
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.
Introduction of safe harbour rules
|Under-reporting of tax base||100-300% of tax base
|100-200% of tax base under- reported|
|Failure to maintain documentation||2% of value of international transaction||INR
|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
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:
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.