Lakshmi Kumaran & Sridharan AttorneysAn ISO 9001 / 27001 certified law firm

GAAR – Can expansive definition provide certainty?

By R. Subhashree

“Certainty is integral to rule of law. Certainty and stability form the basic foundation of any fiscal system. Tax policy certainty is crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner...”    

The Supreme Court of India’s observation in the Vodafone case emphasises certainty. A much sought after ideal by taxpayer and taxman but perhaps necessarily elusive. As is the practice, it is expected that the government will arm itself with enough legislation to prevent a repeat of this scenario. However, the question remains if a truly abuse-proof legislation can be drafted. It is believed that India will usher in General Anti-Avoidance Rules (GAAR) enabling the Revenue to look into any activity it perceives to be undertaken solely for a tax benefit. Even prior to the Vodafone judgement reports suggested that GAAR also covering Controlled Foreign Corporations (CFC) and thinly capitalised companies will be part of Budget 2012 proposals.    

The Direct Taxes Code (DTC) Bill (2010) envisages General Anti-Avoidance Rules rather than Specific Anti-Avoidance Rules or Targeted Anti-Avoidance Rules though it does talk of Controlled Foreign Corporation and empowers Revenue to characterise equity as debt (thin capitalisation rules). This represents a legislative approach rather than using judicial doctrine to determine abuse of provisions to secure a tax benefit. The Revenue obviously wants to be able to question a transaction, classify it as avoidance and plug leakages rather than be told after a lengthy legal battle that the assessee was all along within his rights. The doctrine of ‘choice’ where a person can choose from options available to him to carry out a transaction has helped tax-payers. A person need not necessarily choose a transaction with most tax outgo. Also the difficulty of proving fraus legis – where a person may defeat the purpose of law while remaining within its boundaries has come to the defence of the tax payer. For instance, in Bowater Property Developments Ltd v Inland Revenue Commissioners (UK)  a company split property into 5 shares and sold them individually to 5 sister concerns who sold them to another company thus escaping land development tax. However, it was held that since each transaction was legal and the company was within its rights to split and sell land, there was no abuse of rights.    

The experience of Australia which witnessed a string of victories for tax payers in FCT v Williams (1972) or Steinberg v FCT (1975) where the courts rested on a literal interpretation of law and upheld the right of a taxpayer to arrange his affairs so as to pay lesser tax paved way for successive changes in GAAR making it more broad based. It now covers any ‘scheme’ - any agreement, arrangement, understanding, promise or undertaking by which a tax payer has obtained or seeks to obtain a tax benefit.  The definition is wide and despite an 8-step test provided in the relevant Section 177D as regards manner of scheme, form and substance, time and length of period for which the scheme was in operation, the Australian Revenue authorities have been able to invoke the provisions against assessees. For instance in Commissioner of Taxation v Spotless Services (1996), the assessee invested in a tax haven which offered lesser rate of interest on deposits but the overall return after taxes was higher than what would have been earned in Australia. Though rational commercial elements were involved, the High Court upheld application of GAAR.  In Federal Commissioner of Taxation v Hart (2004) 55 ATR 712 the assessee pleaded that the dominant purpose of a transaction was to secure a loan. The loan was so structured that it ‘optimised wealth’ by splitting it into investment and residential property loan and the assessee benefited from differential tax treatment of the interest on two loans.  The High Court ruled in favour of Revenue.      

New Zealand has GAAR provisions (similar to Australia) where a transaction is held as void against the Commissioner if an agreement, contract, plan, or understanding (whether enforceable or unenforceable), including all steps and transactions by which it is carried into effect results in avoidance. In Peterson v CIR (2005) 22 NZTC 19,098, the assessee invested in a film which was never made and part finance raised by way of loan made its way back to the assessee by means of a circular arrangement. However, the majority view was that ‘arrangement’ did not require a meeting of minds and as investors were unaware of the circular flow of funds, the arrangement did not call for invoking GAAR.    

The Indian DTC provisions (2010) largely mirror the South Africa GAAR provisions which came into effect in 2006. South Africa also provides that the Commissioner has to give notice to the assessee of his intention to apply GAAR, along with reasons for the same. The DTC’s definition of ‘tax benefit’ is much broader than the South African one and covers a reduction, avoidance or deferral of tax, an increase in a refund of tax or other amount, reduction, avoidance or deferral of tax or other amount that would be payable but for a tax treaty, an increase in a refund of tax or other amount as a result of a tax treaty or a reduction in tax bases including increase in loss, in the relevant financial year or any other financial year.    

As per the DTC (2010) ‘arrangement” means any step in, or a part or whole of, any transaction, operation, scheme, agreement or understanding, whether enforceable or not, and includes any of the above involving alienation of property.     It can be seen that this definition is very broad and grants the Income Tax authorities wide powers to apply the GAAR even to agreements which may not be ‘legally enforceable’. Even if the main purpose of a step, though not of the entire transaction, can be shown to result in a tax benefit, GAAR is attracted as per DTC Clause 125.  The guideline to the South African GAAR records that such a provision was incorporated to overcome limitation in CIR v Conhage (Pty) Ltd [61 SATC 391] where a sale and lease back transaction was held to have an overriding objective of funding and could not be bifurcated into two agreements with one of them being tax driven and hence subject to GAAR.    

The industry in India has requested for a threshold limit for application of GAAR and greater clarity in meaning of terms like ‘commercial substance’ or ‘dominant purpose’. It remains to be seen if GAAR rules will be quite so straight-laced. UK for instance, has long toyed with idea of legislation to end uncertainty over anti-abuse proceedings but relies on judicial doctrine and targeted measures like CFC rules. It is not possible to visualise every type of transaction which will be undertaken by a taxpayer and provide against avoidance in a legislation. An argument that tax benefits are in themselves part of commercial considerations while undertaking a transaction had been advanced in the Spotless case. The more broad-based the legislation greater is the uncertainty.

[The author is Manager, Lakshmikumaran & Sridharan, New Delhi]
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