Article_Shefali Goradia_ Jul 121341305754

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GAAR impact on cross-border structuringJuly, 2012

Author: Shefali Goradia, Partner

After much speculation and debate, the controversial General Anti-Avoidance Rule (‘GAAR‘) hasfinally made its way into the Indian tax law. The general anti-avoidance provisions are nowcodified and will become effective from April 1, 2013. This is a turning point for Indian tax systemas till date, India, being a common law country, had adopted a judicial anti-avoidance approach,and followed a form over substance principle , while overruling sham transactions.

History

So far, the Indian judiciary created a dividing line between tax evasion (judged as illegal) and tax avoidance or tax planning (considered legitimate if within the precincts of the law). Upholding thisprinciple, the Indian Supreme Court in the Azadi Bachao Andolan case allowed tax treaty benefitsunder the India-Mauritius tax treaty to holding companies on the basis of a Tax ResidencyCertificate. Even in the recent Vodafone case, the Supreme Court analysed Indian and British

jurisprudence on this issue and observed that tax planning was within the framework of law andonly the use of colourable devices would not become a part of it. In this case, interestingly, theSupreme Court rebuked the Government for not having anti-avoidance provisions in the Indiantax law, in the absence of which it advocated the look at approach while interpreting variousframework agreements pertaining to sale of shares.

Harmful tax competition

The subject of tax avoidance was initially discussed in the Organisation for Economic Co-operation and Development (‘OECD’) report

1on the effects of harmful tax competition on

investment decisions. OECD had then identified two problems facing international taxation (i) tax havens; and (ii) preferential tax regimes, and sought to propagate a tax policy to eliminateboth to preserve tax base of source countries and to provide a level playing field for all countriesto ensure equity between nations. Some key relevant observations in the report covered thefollowing:

Tax havens were identified as jurisdictions which (i) impose no or nominal taxes,

(ii) lack effective exchange of information and transparency, and (iii) do not require

localising any substantial activities.

Countries have the right to impose taxes (even if minimal) depending on their economy

as long as such countries had effective tools for exchange of information with other

1OECD Report on ‘Harmful Tax Competition – An emerging global issue’ released in the year 1998



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countries in order to avoid money laundering and generation and accumulation of black

money.

Identified measures like adopting the controlled foreign corporation rules, inclusion of

Limitation of Benefits (‘LoB’) strictures in tax treaties to restrict abuse, and most

importantly advised re-examination and acceptance of domestic anti-avoidanceprovisions for counteracting harmful tax competition.

Since then, a number of countries (like Australia, Canada, New Zealand and South Africa) haveenacted statutory GAAR while other countries (notably UK and US) have adopted vigorous

judicial anti-avoidance doctrines. In comparison with GAAR introduced by other countries, theIndian GAAR is much broader and is likely to cover within its ambit even transactions which havea primary non-tax motive, as long as one of the main purposes of the transaction is to obtain a tax benefit . In the international context many countries have refrained from adopting GAAR due tohigh cost of tax collection and additional strain this can cause to the legal system. In a recentreport

2submitted to the UK Government, it has been recommended that the UK GAAR be

narrowly focussed on aggressive tax avoidance schemes alone; thereby keeping genuinetransactions out of its scope.

Paradigm shift in tax planning

Internationally, tax authorities have expressed a concern over the use of holding companies tomake investments. The Supreme Court in the celebrated Vodafone case delved into thediscussion on use of overseas holding companies in foreign investments and observed thatmultinational companies need holding companies for many commercial reasons so as toconsolidate regional operations, for ring-fencing high-risk assets so as to avoid legal andtechnical risks to the main group, etc and for these reasons offshore financial centres whichprovide good infrastructure are chosen by them. In the same breath, the Supreme Court alsoexpressed concern on the use of tax havens and offshore financial centres for stashing blackmoney and caveated its observation by restricting tax treaty benefits where black money isinvolved. This issue of using Special Purpose Vehicles (‘SPVs’) to legitimatise black money has

also been raised in the report on Black Money3 issued by the Ministry of Finance this year.

GAAR is becoming a reality in many countries. The advent of GAAR is expected to significantlychange the Indian tax landscape and it is important that the international investor community isnot only aware of but also prepares for GAAR.

Indian GAAR

Under Indian GAAR, an arrangement whose main purpose or one of the main purposes is toobtain a tax benefit

4 and which satisfies certain prescribed conditions such as lack of commercial

substance, abuse of treaty provisions, etc would qualify as an impermissible avoidance arrangement on which GAAR could be applicable.

2 GAAR Study – A report by Graham Aaranson QC dated November 2011

3White Paper on Black Money issued by the Ministry of Finance, Department of Revenue, Central Board of Direct

Taxes dated May 20124

Defined to include a reduction or avoidance or deferral of tax as a result of a tax treaty



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The tax effect of such impermissible avoidance arrangement s is to be determined by the IndianRevenue Authority (‘IRA’) in any manner it sees appropriate , which would include disregarding or combining or re-characterising any step / parties in the arrangement, ignoring the arrangement,re-allocating income and expenses, re-characterising equity as debt and vice versa, re-locatingthe place of residence of any party or situs of an asset, etc.

While it is expected that some guidance on manner and conditions of applying GAAR will beissued, it may still be very broad and may not give any specific direction on the substancerequirements to be satisfied. Recently, the Committee constituted for reviewing GAAR provisionsunder the proposed Direct Taxes Code

5(‘DTC‘) issued its recommendations

6(the ‘Draft

Guidelines’) to the Indian Government for the implementation of GAAR under the Indian tax law. As the Draft Guidelines have been provided to the Government for approval and are not the finalguidelines to be applied while evaluating GAAR, we have incorporated only the relevantrecommendations in our analysis below which could be indicative of the thinking of theGovernment. As of now, Indian GAAR does not contain a specific carve out for genuinecommercial transactions, and where GAAR is invoked, tax treaties will be overridden by theIndian tax law.

Providing a silver lining to the dark GAAR cloud, the Indian Government while enacting thelegislation as part of Finance Act 2012, has shifted the burden of proof from the taxpayer to the

IRA.

Potential impact of Indian GAAR

Before delving into the discussion on the impact of GAAR on different kinds of cross-border transactions, it would be pertinent to note that transactions completed before April 1, 2013 shouldbe outside the purview of GAAR. The taxability of such transactions should be governed by theexisting provisions of the Indian tax law absent GAAR, along with the extant judicial principles.The Indian Government, in its recently issued Supplementary Memorandum to Finance Act 2012has affirmed the above position, and noted that GAAR would apply only to income chargeable totax from April 1, 2013.

We now look at different types of structuring and impact of GAAR on a few popularly used cross-

border investment structures.

Relevance of holding company structures

Multinationals use holding companies for various reasons as these provide the benefit of retainingcapital abroad for future expansion, listing in other jurisdictions, flexibility for future re-structuring,facilitating regional management and controls, assisting in cost effective fund raising, availing taxbenefits under tax treaties, avoiding the need to follow onerous laws in multiple jurisdictions insituations where regulatory / securities laws of the investee company are rigorous, etc. In anutshell, a holding company in an appropriate jurisdiction seeks to achieve overall group taxrationalisation combined with non-tax and corporate commercial benefits.

Unlike India, many countries do not impose capital gains tax on non-residents. A holding

company structure assumes relevance for an investor who is unable to take a tax credit in hishome jurisdiction for taxes paid in India, due to the difference in the tax system followed by the

5The Indian Government proposed a draft DTC in the year 2010 which is proposed to replace the existing Indian tax

law.6

Draft Guidelines regarding implementation of GAAR in terms of Section 101 of the Indian tax law



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source country and the country of residence. For example, in the US capital gains earned fromsale of shares of an Indian company is regarded as US sourced income, whereas India regardssuch income to be sourced in India. The difference in the tax system of both the countries givesrise to a technical difficulty in claiming a tax credit and the investor may thus end up paying tax inboth jurisdictions. However, if use of an intermediate jurisdiction provides tax exemption in India,the investor in that situation pays tax only as applicable in his home country.

Choice of holding company jurisdiction

This section analyses illustrative situations where GAAR could possibly be invoked by the IRA totreat a holding company as a mere conduit, especially depending on the jurisdiction where such aholding company has been set up.

Impact on treaty vs non-treaty jurisdictions: Investment through a jurisdiction whose tax treaty

with India does not have a LoB clause 7

Figure 1 is an illustration of a vanilla inbound investment structure where investment is madethrough an SPV in an intermediate jurisdiction. While globally it is debated on what kind of substance is required for an investment holding company; in most jurisdictions, such a companywill be managed by a Board of Directors comprising a few local directors and a few foreigndirectors. Having an office and a few employees will lend more substance but there will remain

ambiguity and uncertainty over tax treaty access. In such a case if GAAR is applied then the IRAcan – (i) disregard the intermediate company alleging lack of substance and bring to taxParent Co under Indian tax law or India-Parent Co tax treaty; or (ii) retract tax treaty benefits suchthat Hold Co could be brought to tax in India under Indian tax law; or (iii) re-locate the place of effective management of Hold Co to Parent Co’s jurisdiction on the basis that key personnel of Parent Co control Hold Co and thereby applying the India-Parent Co tax treaty.

Under the Indian GAAR, any of the aforesaid may be resorted to by the IRA on the basis that theinvestment was routed through the intermediate jurisdiction by Parent Co only to avail a taxbenefit afforded by the intermediate tax treaty. It would therefore become essential to defend thecapital gains tax exemption (as above) under the tax treaty by clearly substantiating thebusiness / commercial rationale for choosing one jurisdiction over any other, by supportingdocumentation clearly suggesting so.

It may be useful to note that the Draft Guidelines state that tax treaty benefits may be denied toHold Co under GAAR in case Parent Co has funded the entire investment in Ind Co, and Hold Co

7An LoB clause consists of certain conditions which need to be satisfied in order to take benefit of under a tax treaty

that apply to certain articles such relating to capital gains, etc. This operates as an in-built substance requirement

negotiated by tax treaty partners to prevent abuse of the tax treaty.



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has not made any other investment. In such a situation, as per the recommendations, the realand beneficial ownership of the shares in Ind Co held by Hold Co may be deemed to lie withParent Co, which controls Hold Co. In such a specific situation, GAAR could be invoked.

Impact on treaty vs non-treaty jurisdictions: Investment through a jurisdiction whose tax treaty

with India has a LoB clause

Staying with the illustration in Figure 1, it would be interesting to see how the IRA would react toinvestments made through a jurisdiction which has a LoB clause in its tax treaty with India,eg Singapore. The India-Singapore tax treaty restricts the capital gains exemption only to thoseSingapore residents which are either listed on a recognised stock exchange or expend more thanSGD 200,000 per annum in the immediately preceding 24 months in which the gains arise. Asthere is an in-built substance requirement under the India-Singapore treaty which also restrictsthe misuse / abuse of the tax treaty, one may argue that GAAR should not apply to suchsituations. However, no such carve-out is provided and it is likely that the IRA would apply GAARequally to such tax treaties and grant tax treaty benefit only if there is adequate substance, whichit may consider acceptable.

In the Draft Guidelines, the Committee has also made a reference to capital gains exemption

sought under tax treaties where the requirements of the LoB clause such as under the India-Singapore tax treaty are satisfied. The Draft Guidelines state that for meeting the expensethreshold under the LoB clause, only the operational expenses incurred in the offshore jurisdictionshould be considered (specifically, interest expenses on borrowings from a shareholder should bedisregarded).

An interesting argument on this basis would be that using the rationale of the LoB clause in theIndia-Singapore tax treaty, one may argue that if a similar expenditure is incurred by a holdingcompany set up in another intermediate jurisdiction, such as Mauritius, it should be sufficient tosatisfy the substance test under GAAR. It would however remain to be seen how the IRAresponds to such an overture and similarly, remain to be seen how the IRA responds to a re-domiciliation of the intermediate company from Mauritius to Singapore, if that were to be possible

– would they regard this act of protecting treaty benefits as taking benefit of a treaty which itself requires application of GAAR?

Addressing grievances of the international community to a unilateral treaty override

The Vienna Convention on the Law of Treaties provides that a tax treaty can be terminated or suspended either if it is provided in the tax treaty itself or by consent of both parties to the taxtreaty. It remains to be seen how tax treaty partners like Mauritius now respond to a unilateraloverride of its long standing tax treaty. As a responsible treaty partner, a better way to deal withthis would be to re-negotiate the tax treaty to include in-built substance requirements like anactivity provision, stock exchange listing provision or a bona fide business purpose provision suchthat the tax treaty abuse is minimised or prevented. It would be interesting to see how the Courtsview a unilateral treaty override which could be in violation of the Vienna Convention on the Lawof Treaties.

Choice of entity

As GAAR is wide in scope, it empowers the IRA to determine the consequences in an appropriate manner, the form of an entity used for making investments may also be open to re-characterisation. For instance, by application of GAAR, a Limited Liability Partnership (‘LLP‘)which is to be treated as a partnership for tax purposes, may be treated as a company. This may



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be since LLPs, when used for onward investments in India vis-a-vis companies, allow repatriationof profits to its partners without attracting Dividend Distribution Tax (‘DDT’). Therefore, the IRAmay want to treat an LLP as a company and levy DDT on distributions to foreign investors wherethe motive of choosing an LLP is found to be driven by a tax benefit.

In addition, for computing Alternate Minimum Tax (‘AMT’) to LLPs as compared to parallelMinimum Alternate Tax (‘MAT’) to companies, the number of adjustments to be made are muchfewer resulting in a lesser scope of difference between accounting profits and book profits. TheIRA may however attempt to treat LLPs as companies to give effect to the larger adjustmentsprescribed for companies.

Choice of instrument and repatriation of profits

The Indian exchange control regulations do not prescribe a limit on the amount of interest whichcan be repatriated on Compulsorily Convertible Debentures (‘CCDs‘) annually. However, on aconservative basis, a position is generally taken that the interest should be pegged at the limitprescribed for dividend payable on Compulsorily Convertible Preference shares (‘CCPs‘). Anaggressive position that in the absence of a limit under the exchange control regulations, anyamount of interest which can be freely repatriated could also be adopted. The following could bethe potential outcomes under GAAR:

Re-characterisation of interest on CCDs as dividend

Where a foreign investor thinly capitalises an Indian company and mostly invests through CCDswith the objective of drawing profits from the Indian company in the form of interest so as to –(i) avoid DDT, and (ii) obtain a tax deduction for the interest paid, it will be interesting to seewhether GAAR can be applied in such a situation.

In such cases, the CCDs may be treated as equity or CCPs for tax purposes and the interestcould be re-characterised as dividend (also refer to impact on real estate structures for such re-characterisation).

It may be relevant to note that the Draft Guidelines state that raising funds through debt or equityshould be a commercial choice of the company and GAAR should not be applicable. It further states that where a debt has been raised from a related party then the Transfer Pricing (‘TP’)would apply and GAAR would not be required. At the same time, it has been stated that locationof the connected parties in low tax jurisdictions and source of funds may be relevant in order tobring such arrangements within the ambit of GAAR.

Re-characterisation of capital gains as dividend



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Many Indian companies choose to buyback shares (as illustrated in Figure 2) as a mechanism toreduce capital and distribute profits to shareholders. In such cases, the IRA could potentially re-characterise the transaction as that of payment of dividend to the extent of accumulated profits of Ind Co at the time of the transaction. Such re-characterisation would be subject to DDT for Ind Co. This re-characterisation may be done especially in cases where no dividends aredeclared and Ind Co has accumulated profits in its books. Also in cases of pre-ordainedtransactions where other investment partners of the holding company do not accept the buybackoffer then the risk of application of GAAR may increase. This situation has also beencontemplated in the Draft Guidelines which state that such buyback undertaken to repatriateprofits while avoiding DDT and capital gains tax (under the tax treaty) would be in the nature of acolourable device subject to GAAR.

Substance requirements for PE funds

Specifically, in context of Private Equity (‘PE’) Funds, the substance requirement becomes moreintricate. Considering that Funds are set up as Collective Investment Vehicles (‘CIV‘), mostly inlow tax countries, with a limited duration life and a specific objective of holding investments,substance requirements need to be inherently different.

Imposing the compulsion of having an establishment or employing people may be burdensomeand inappropriate considering that most CIVs are managed by investment managers who may beset up in the same or another jurisdiction. It would seem reasonable that for strengthening thecommercial substance, the existence of an independent and skilled management company andcapable Directors on the Board of the investing entities should be viewed as adequate for claiming tax treaty benefits.

Nonetheless, in situations where Funds are set up in one location and SPVs are established inanother location only for investing in India, chances of GAAR applicability may increaseespecially in a case where there are no operations or there is no substance in such intermediateCIV / SPV jurisdiction. In such a case, the SPV may be disregarded and the tax treaty with theindividual investors may be sought to be applied.

Impact on intellectual property holding structures

In order to provide additional incentives for companies to retain and commercialise existingpatents and to develop new innovative patented products, a number of developed countries likethe Netherlands, Belgium, UK have introduced or propose to introduce special incentives such aspatent box or innovation box regimes. Such jurisdictions also have a favourable intellectualproperty regime, low corporation tax rates, a highly skilled IT workforce, and a mature andsophisticated legal framework in place to provide appropriate legal protection for IntellectualProperty (‘IP‘). Under these special regimes, profits from the patented intangibles are taxed at aconcessional rate (eg 10 percent) instead of a significantly higher corporate tax rate. Some

jurisdictions like the Netherlands do not even require development of patents within their countryas long as the ownership lies within such jurisdiction.



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Different from a conduit structure, the Dutch IP Sub Co (refer Figure 3) may typically be the legalowner of the IP which may either be developed in a low cost jurisdiction such as India or incountries like the Netherlands etc. The licensees of such IP can either be non-related parties or group companies (including Ind Co). The motive for using a Dutch IP holding company could betax driven (reduction in foreign withholding taxes by using network of tax treaties) or operationallydriven (advanced laws for protection of IP, excellent infrastructure for the exploitation anddevelopment of IP). In practice, a combination of these two motives may drive the structure.

Under this IP structure, the royalty received on licensing IP to Ind Co and other parties wouldsuffer almost no tax / minimal tax owing to the tax treaties with other countries and concessionaltax rate in the Netherlands. In this regard, the beneficial ownership test (under which royaltywould be taxable at the rate provided in the tax treaty only if Dutch IP Sub Co is the beneficialowner of the royalty instead of Ind Co), would need to be satisfied in order to claim the tax treaty

benefits.

Under such structures, where the IRA alleges that the IP was housed in the Netherlands with theintention to move / retain profits outside India to keep them away from the Indian tax ambit, andsuch profits suffer no / minimal tax under the special tax regime in the Netherlands or under thetax treaties between the Netherlands with other countries, it could bring to tax the entire royaltyincome of Dutch IP Sub Co in India.

It is relevant to note that under the draft DTC, a provision to tax income of Controlled ForeignCompanies

8(‘CFCs’) has been included. However, in the absence of a CFC provision under the

Indian tax law, income retained offshore could be covered by GAAR. In such cases, it would bepertinent to substantiate that the Dutch IP Sub Co was managed and controlled by appropriatelyskilled Directors and was not controlled by Ind Co. It would be relevant to see if the satisfaction

of the beneficial ownership test is not considered as a sufficient substance requirement. Further,in some countries, saving foreign taxes is considered or is viewed as a legitimate commercialreason. One will though have to test out such an argument in the Indian Courts!

Impact on real estate holding structures

8The draft DTC, defines a CFC as a foreign company which – (i) is a resident of lower tax jurisdiction, (ii) is an

unlisted company, (iii) residents of India exercise control over it, (iv) is not engaged in active trade or business, etc.



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Foreign investment in the Indian real estate sector has been restricted under the Indian exchangecontrol regulations. Investors typically invest in Indian companies undertaking construction anddevelopment activities with an expectation of ongoing payout (for the lease rentals generated)along with capital appreciation at the end of the investment period. Hence, foreign investment istypically made through debt instruments like CCDs and loans which allow a regular interestpayout. Considering this typical form of investment, investors which hold their investment through

jurisdictions like Cyprus (refer Figure 4) for onward investment in project SPVs in India with theintention of reducing the withholding tax rate on interest, will now need to pass the GAAR test.

On application of GAAR, the IRA could re-characterise the debt into equity (especially in the caseof CCDs since these are considered equity from an exchange control perspective) and re-characterise the interest on them as dividend. By doing this, the IRA could – (i) take away thelower rate of tax available under the tax treaty with jurisdictions like Cyprus, (ii) levy DDT on theincome flows, and (iii) disallow the tax deduction on interest payment claimed by the Indian SPVs.It would be useful if thin capitalisation ratio is prescribed in the GAAR rules.

On the other hand, if the surplus is not repatriated by the SPVs to Hold Co and is instead re-invested in new projects, then the IRA can potentially argue that the SPV is deferring taxes inIndia, calling for application of GAAR.

Conclusion

While the Indian Government has not provided any (much) clarity on GAAR yet, one aspect whichnevertheless is crucial would be documentation . It is at the back of the documentation that thereal intent behind a transaction would be examined, and it would be the documentation that wouldassist in making assertions for defence during a tax audit. In addition to this, it would becomepertinent to strengthen substance in the intermediate jurisdiction, measured amongst others, interms of expenditure incurred by the holding company in the intermediate jurisdiction,employment of local Directors with appropriate skills and experience, etc.

GAAR is therefore undoubtedly set to overhaul the conventional ways of doing business not onlyin India but globally. With countries asserting their taxing rights more strongly than before, extra

efforts to rationalise your own tax outgo seems to be the need of the hour. A change, requiringexisting investors to appropriately improvise their current structures before the implementation of GAAR and the new investors to approach with caution seems inevitable to avoid tax litigation inIndia.

This article has been written by Shefali Goradia, Partner with BMR Advisors, who specialises in Direct Taxes. Shefali has been supported by Parul Jain, Director with BMR Legal, and Esha Vatsa, Senior Associate with BMR Advisors, in compiling this article.

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