GAAR and Its Implications-05!10!2012

7/29/2019 GAAR and Its Implications-05!10!2012

1/6

1

GAAR and its Implications

Background

Mauritius has been used as a holding company jurisdiction for making investments in India, with the

investors in the holding companies being tax residents of other countries. The Mauritius route is an

interesting facet of the Indian tax system which involves the arrangement relating to the residence rule of

taxation. This is applicable to Article 13 of the Indo-Mauritian tax treaty, which provides for attribution of

taxation rights among the two countries for capital gains. Article 13 (4) provides that gains derived by a

resident of a contracting State shall be taxable only in that State. While this is present in mo st of Indias

other Double Tax Avoidance Agreements (DTAAs), the Mauritius treaty assumes significance because

Mauritius has no domestic level tax on capital gains, thus making it exempt. This has made Mauritius an

attractive route for the purpose of investment in India.

The Indian law taxes gains derived from the sale of shares irrespective of whether the shareholder is a

resident or nonresident. Under India's tax treaty with Mauritius, gains derived by a resident of Mauritius

from the sale of shares in an Indian company are taxable only in Mauritius and as it does not tax capital

gains, the transaction escapes tax in both countries. Foreign investors have been using the Mauritius

holding company structure to make investments in India right from the early 1990s. Following the

liberalization of the Indian economy, the Indo-Mauritius DTAA, was "discovered" as an effective

mechanism to avoid capital gains tax on sale of shares in Indian companies.

A Foreign enterprise can set up a subsidiary in Mauritius, and use it to derive capital gains from acquisition

and sale of shares. Although India follows the source rule for taxation of non-residents, which makes this

transaction taxable under the Income Tax Act, 1961, Article 13(4) of the DTAA gives Mauritius the right to

tax this transaction. Since such gains are exempt from tax in Mauritius, the transaction becomes

completely tax exempt, resulting in double non-taxation. As a result, much of the Mauritian investmentinto India is actually round tripping by Indian companies setting up a Mauritian entity to avoid capital

gains tax in India.

Economics

May10,

2012


2/6

Economics

GAAR and its Implications 2

Why was it permitted?

While this channel was frowned upon, it did promote foreign investment as more investors came in. Most other

countries have been plugging these loop holes through their tax codes with anti-avoidance provisions. Hence, it

was only a matter of time that the stance of the Indian tax authorities would stiffen.

While India has tried renegotiating such agreements, so as to include a limitation on benefits clause or making

capital gains taxable in the source state, Mauritius has been reluctant as its economy functions through the

import of capital.

The proposed DTC Bill was to activate a set of specific anti-avoidance rules within its ambit. Most of these anti-

avoidance rules are very broad in their construction and can effectively strike down most of these types of

arrangements, as they will override the treaties.

Has there been a precedent to addressing this issue?

The Indian revenue officials in 2003 did launch a drive against some FIIs. Following investigations into the

investment pattern of these FIIs, the Bombay High Court ruled that the Mauritius entities floated by them were

mere "shell" companies without any commercial or economic substance and, therefore, did not qualify for capital

gains tax benefits under the Mauritius DTAA. The ruling, however, created great uncertainty among FIIs in

particular and foreign investors in general, leading to a free fall in the Indian capital markets. The Central Board of

Direct Taxes subsequently issued clarifications saying Mauritius entities would be eligible for benefits under the

DTAA if they obtained a bona fide Tax Residency Certificate.

How are other DTAA treaties structured?

In case of Singapore, the tax treaty clearly says only those companies which are listed on recognized stock

exchanges of Singapore, or whose total annual expenditure on operations is equal to or more than Singapore

$200,000 in the 24 months immediately before the date its capital gains arise, would be accepted as genuine

Singapore companies. Others would be treated as shell companies set up simply to avoid taxes.

The clauses added to the India-UAE Treaty were even broader and applied to all benefits under the double

taxation avoidance treaty. It clearly stated that tax benefits would not be given to a firm if the main purpose or

one of the main purposes of the creation of such entity was to obtain the benefits of the tax treaty.


3/6

Economics


What about other countries?

More than 30 countries have introduced GAAR provisions in their respective tax codes to check evasion. Further,

more specifically GAAR has been in force in Australia (1981), Canada (1988), Singapore (1988), South Africa (2006)

and China (2008) according to a study compiled by Deloitte. UK is considering it in 2013 while USA is also working

towards it.

What did the Budget FY13 say?

The Budget sought to make an amendment to section 90 and Section 90A of the income tax law, a clause which

says that just by submission of a tax Residency Certificate containing prescribed particulars a firm or an

individual which carries on some real business in a tax haven cannot claim the benefits of a tax avoidance treaty

signed with that country. Introduced as part of the 2012 Finance Bill, the GAAR provisions objective is to insistupon the principal of substance over form, meaning the real intention of the parties involved and the purpose

of establishing an arrangement are taken into account for determining the tax consequences, irrespective of the

legal structure of the transaction or arrangement.

GAAR hence allows tax authorities to call a business arrangement or a transaction 'impermissible avoidance

arrangement' if they feel it has been primarily entered into to avoid taxes. Once an arrangement is ruled

'impermissible' then the tax authorities can deny tax benefits. Most aggressive tax avoidance arrangements would

be under the risk of being termed impermissible. The rule can apply on domestic as well as overseas transactions.

Impact of this announcement

It was felt that these provisions would give unbridled powers to tax officers, allowing them to question any tax

saving deal. Foreign institutional investors in particular were worried that their investments routed through

Mauritius could be denied tax benefits enjoyed by them under the Indo-Mauritius tax treaty.

Net FIIs have been illustrating an inflow since December, 2011. Net FII inflows peaked to $7 bn in February, 2012.

However, foreign institutional investments have declined post the announcement of GAAR on 16 th March, 2012.

March saw a net inflow of mere $0.4 bn while April registered an outflow of $8 bn. This clearly indicates that the

adoption of GAAR by India was not found to be favorable by foreign investors.


4/6

Economics


Source: SEBI

The above figure illustrates daily movement of FII flows in India from 16 th March, 2012 when the Finance Minister

announced the implementation of GAAR. It can be observed there has been an outflow of dollars to the effect of

$ 1 bn during this period.

This has also had an impact on the exchange rate which has depreciated from Rs 50.31 on March 16th

, 2012 to Rs

51.16 on March-end and further to Rs 52.51 and Rs 53.72 on April end and May 4 th, 2012 respectively. This was

notwithstanding the fact that forex reserves had remained largely stable, increasing from $ 294.8 bn on March

16th to $ 295.4 bn on April 27th. Clearly the sentiment was affected which drove the rupee down further.

What were the modifications made while passing the Finance Bill?

GAAR will now be applicable from April 1st, 2013. Further this rule would only be invoked when there are specific

complaints and it will not be easy for assessing tax officers to invoke GAAR. The onus to prove that anarrangement is 'impermissible' will lie with the tax department. Also to provide greater clarity and certainty in the

matters relating to GAAR, a Committee has been constituted under the chairmanship of Director General of

Income Tax to give recommendations for formulating the rules and guideline for implementation of GAAR

provision and to suggest safeguards so that the provisions are not applied indiscriminately.
http://economictimes.indiatimes.com/topic/taxhttp://economictimes.indiatimes.com/topic/tax


5/6

Economics


Source: SEBI

The figure above shows the net annual FII flows in India. India has historically been a favored global investment

destination with Indias success story being one of the contributing factors. Cumulatively the inflows have been $

140 bn ever since the market was opened up. The above figure shows that barring 2009, the year of the global

financial crisis, India has witnessed improvement in its global capital flows. Net FII inflows peaked to $32 bn in

2011. However, financial year 2011-12 witnessed a major setback to the Indian economy due to persistently high

inflation (over 9%) and the stance taken by the Central Bank in order to tame inflation which led to rising

borrowing costs that in turn stifled industrial activities and therefore investment in the country.

FII flows would be mainly governed by long term prospects seen for any economy. The present global scenario is

typified by high liquidity overhang which is looking for avenues for investment. With the Euro region expected to

go into a recession and the interest rates to remain low in the developed economies, funds would tend to

gravitate towards the emerging markets. India still holds a relatively healthier growth story of around 7% which

should continue to attract such investment. However, the implementation of GAAR has to be pragmatic or else it

can lead to a degree of hesitancy in investing in the country. India gets around 20% of overall global portfolio

flows and these funds help substantially to support the current account deficit, and are hence important.

The rupee should be driven more by fundamentals of which FII inflows are an integral part. In FY11, FIIs were

around 72% of the current account deficit and 56% of net capital inflows. In the first 9 months of FY12, however,

as the current account deficit widened and the FII flows slowed down, the coverage level was just 11%. Also FIIs

2,5802,091

1,841 648

10,723 9,695 9,3977,274

16,188

-9,950

30,36132,226

18,923

-15,000

-9,000

-3,000

3,000

9,000

15,000

21,000

27,000

33,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

mnUSD

Financial Year

Annual FII inflows


6/6

Economics


contributed to just 12.5% of net capital flows. Therefore, any reduction in these inflows could impact the

fundamentals.

Going ahead

Economic activities are expected to pick up with the Indian economy seen to grow at around 7-7.2% during 2012-

13. Inflation is also believed to moderate and hover around 6% by the end of March 2013. Therefore, it can be

deduced by March 2013 when the GAAR is likely to be re-implemented the investor sentiment and confidence in

the Indian economy would have improved.

Disclaimer

This report is preparedby the Economics Division of CreditAnalysis & Research Limited [CARE]. CARE has taken utmost care to ensure

accuracy and objectivity while developing this report based on information available in public domain. However, neither the accuracy

nor completeness of information contained in this report is guaranteed. CARE is not responsible for any errors or omissions in

analysis/inferences/views or for results obtained from the use of information contained in this report and especially states that CARE

(including all divisions) has no financial liability whatsoever to the user of this report.

Credit Analysis and Research Limited proposes, subject to receipt of requisite approvals, market conditions and other considerations, to

make an initial public offer of its equity shares and has filed a draft red herring prospectus (DRHP) with the Securities and Exchange

Board of India (SEBI). The DRHP is available on the website of SEBI at www.sebi.gov.in as well as on the websites of the Bo ok Running

Lead Managers at www.investmentbank.kotak.com, www.dspml.com, www.edelcap.com, www.icicisecurities.com,

www.idbicapital.com, and www.sbicaps.com. Investors should note that investment in equity shares involves a high degree of risk and

for details relating to the same, see the section titled Risk Factors of the DRHP.

This press release is not for publication or distribution to persons in the United States, and is not an offer for sale within the United

States of any equity shares or any other security of Credit Analysis & Research Ltd. Securities of Credit Analysis & Research Ltd.,including its equity shares, may not be offered or sold in the United States absent registration under U.S. securities laws or unless

exempt from registration under such laws.

Contact:

Madan Sabnavis Samruddha Paradkar

Chief Economist Associate Economist

[email protected] [email protected]

91-022-67543489 91-022-67543407

GAAR and Its Implications-05!10!2012

Documents

Transcript of GAAR and Its Implications-05!10!2012