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Role of Double Taxation Avoidance Agreement (DTAA) and General Anti-Avoidance Rules (GAAR.) In Treaty Shopping

To understand treaty shopping we need to understand what a DTAA is, A double tax avoidance agreement is a tax treaty agreed by two states to ensure that a tax payer is not taxed twice for the same income, this is primarily because of inconsistency in residency rules and sources rules followed by different countries in the world.

Section 90 of the Income Tax Act allows the government to enter treaties to prevent double taxation. The important point to note is whenever there is a conflict between a domestic tax statute and DTAA, the DTAA will always prevail.

Now coming  back to treaty shopping, the benefits given by certain DTAAs are only applicable to the residents of the state who has entered into a DTAA, therefore when entities wish to take advantage of a DTAA , they setup entities located in that particular state to obtain benefit.

Role of DTAA and GAAR In Treaty Shopping

Therefore the third country resident shops for residency under which he can claim the most of out of the certain DTAA. The main purpose behind treaty shopping is tax avoidance by routing investments through sham/conduit companies located in countries which have absence of taxation system, capital gains, interest income under the DTAA. This can be simply understood under the following example :

A company based in UK wishes to buy  Indian shares and sell it for a profit therefore arises capital gain out of the transaction, now as per Indo-UK DTAA , the company based in UK will have to pay capital gains tax according to residency rule, now if this UK based company sets up a Mauritius resident company which buys and sells such Indian shares, according to Indo-Mauritius DTAA ( Pre Amended Protocol 2016), Mauritius under the residency provision can charge such company, now ironically Mauritius doesn’t tax capital gains , hence the UK based company successfully brought and sold shares of an Indian company without paying any capital gains tax. The process of choosing a treaty beneficial to a third country entity in respect to tax liability is called treaty shopping. Prime examples are Vodafone Case and Tiger Industries (Mauritius resident company although controlled by USA) where shares  of Flipkart (Singapore based however primary assets were Indian bases) were sold to Luxembourg based company SARL, in the whole Flipkart- Walmart deal.

However post Amended Protocol, 2016 plugged the Mauritius route by adding, firstly source rules , included LOB( Limitation of Benefits clause and abolished treaty benefits for a conduit company.

GAAR is a statutory anti avoidance rule which gained importance after the Vodafone case decided in January 2012, the finance minster in march 2012 announced the intent of India to implement GAAR.

The GAAR was added to Income Tax act via Finance Act,2012 into the Chapter XA- General Anti Avoidance Rule.

Although postponed multiple times it came into fore from 1st April 2017.

 Now GAAR was given importance similar to The I.T Act, hence GAAR provisions override all the other provision of the IT Act. Section 95 says that impermissible avoidance agreement for an assessee will be determined by GAAR, therefore it overrides section 90(2), GAAR also overrides SAAR (Example: Transfer Pricing Rules).

GAAR lays emphasis on the intent through which a transaction is completed, that is substance over form test. Section 97 defines arrangements that lack commercial substance, Section 98 determines consequences of impermissible avoidance agreements, section 102 defines various terms and section 101 states GAAR can be applied with guidelines and subject to conditions as prescribed.

The direct comparison GAAR draws is with LOB clauses in a DTAA, LOB is determined for the sole purpose of treaty benefits however GAAR is a more stringent test and investigates not only the transaction but the intent as well. It can be safely said as GAAR is such a stringent test failing GAAR can result into DTAA benefits being revoked.

GAAR is an important statute as it gives statutory backing to such avoidance rules rather than relying on judiciary and their interpretation. GAAR uses substance over form test, dubious instrument test and lifting corporate veils test.

Avoidance is acceptable if intention of legislation is to give benefit however nonacceptable transactions are which give benefits against the spirit of the law.

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May 2024