GAAR and its Impact - Important analysis The Finance Bill, 2012 (Finance Bill) proposes tointroduce a far-reaching

GAAR in the Income-Tax Act,1961 (the Act). Though largely modeled on GAARproposed in the Direct Taxes Code Bill, 2010 (DTC),GAAR provisions in the Finance Bill are in some wayswider in scope and application. The wide reach of thisRule, coupled with its largely subjective nature couldmake tax planning, implementation and litigationextremely challenging. Virtually all transactions thatmay give rise to tax benefits will have to be evaluatedunder GAAR provisions.It may be appreciated that while the Finance Bill willundergo some changes and safeguards as suggestedby various forums including the Standing Committeeon Finance are likely to be provided, mainly through theformulation of the statutory guidelines, we thought itwas important to analyse the current GAAR proposalsand bring out some of the likely impacts on a largenumber of domestic and foreign corporations. Thishopefully prepares you to carry out a review exercisewithin your organisation to identify potential issuesunder GAAR. Needless to say, the success of anyorganisations long term strategy will depend to a largeextent on how well it is able to adapt and meet thechallenges posed under GAAR regime

Background

In the

Duke of Westminster v. IRC 1 , and in several subsequent tax cases including Ramsay v. IRC 2 , Furniss v. Dawson 3 , Craven v. White 4

and others, English Courts haveconsistently affirmed the cardinal principle that if a document or a transaction is genuine,Courts cannot go behind it to some supposed underlying substance. This principle hasbeen applied in India too in several cases, the more recent among them being the Azadi Bachao Andolan 5 case and the

Vodafone 6 case. The Supreme Court in the McDowell case frowned only upon the use of colourable devices and resort to dubious methodsand subterfuges, and, as clarified by the Supreme Court in the Vodafone case, not on alltax planning in general.However, this long standing principle is set to face legislative reversal with theintroduction of GAAR in the Finance Bill largely modeled on South African GAAR, whichseeks to incorporate the substance over form doctrine in Indian tax law. Broadlyspeaking, GAAR will be applicable to arrangements/transactions which are regardedas impermissible avoidance arrangements and will enable tax authorities, among otherthings, to re-characterise such arrangements/transactions so as to deny tax benefits Brief overview of the mechanics of GAAR The mechanics of GAAR are captured in the diagram below:In a nutshell, the whole scheme of GAAR revolves around the question of whether anarrangement qualifies as what is termed an impermissible avoidance arrangement .This term in turn comprises of two distinct components - the main purpose test andthe specified conditions test. If upon application of the above tests, an arrangementqualifies as an impermissible avoidance arrangement , the Finance Bill proposes toempower the tax authorities with wide ranging powers to determine its consequences,including one or more of the six specified consequences appearing in the above chart. Source: KPMG in India analysis 04 2012 KPMG, an Indian Registered Partnership and a member rm o the KPMG network o independent member rms a liated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.

First condition: Main purpose is to obtain tax benefit First condition for the application of GAAR is that the mainpurpose or one of the main purposes of the arrangement is toobtain a tax benefit . The term tax beneft is de ned in s. 102 (11) as:a. a reduction or avoidance or de erral o tax or other amountpayable under this Act; orb. an increase in a re und o tax or other amount under thisAct; orc. a reduction or avoidance or de erral o tax or other amountthat would be payable under this Act, as a result o a taxtreaty; ord. an increase in a re und o tax or other amount under this Actas a result o a tax

treaty; ore. a reduction in total income including increase in loss,in the relevant previous year or any other previous year.In this context, the ollowing points are relevant: Main purpose or one o the main purposes: The mainpurpose test depends not on the actual accrual o a taxbene t, but only on the purpose behind entering into anarrangement. Hence, a transaction may be caught withinGAAR even i it has not yet resulted in a tax bene t so longas it has been entered into or the main purpose (or one o the main purposes) o obtaining a tax bene t, at any time.Thus, the Finance Bill has widened the scope o GAAR ascompared to that under the DTC wherein the criterionwas main purpose is to obtain tax bene t. Even the SouthA rican GAAR applies the sole or main purpose test andnot one o the main purpose as the key test. Burden o proo : Where any arrangement results in anytax bene t, it shall be presumed to have been entered into or the main purpose o obtaining a tax bene t, unless itis proved that obtaining the tax bene t was not the mainpurpose o the arrangement. There ore, the burden o proo would lie on the tax payer. Part o an arrangement: In any arrangement i the mainpurpose o a step in, or a part o , the

arrangement is to obtaina tax bene t, the arrangement will be presumed to have beenentered into to obtain tax bene t, in spite o the act that themain purpose o the whole arrangement is not to obtain a taxbene t. Determining tax bene t: For determining the tax bene t:I. the connected parties may be treated as one and thesame person;II. any accommodating party may be disregarded;III. such accommodating party and any other party may betreated as one and the same person;IV. the arrangement may be considered or looked through bydisregarding any corporate structure.

06 In order for an arrangement to be classified as an impermissible avoidancearrangement, in addition to meeting with tax benefit test, it must satisfy any one ormore of the following four conditions:

a. It creates rights, or obligations, which are not ordinarily created betweenpersons dealing at arms length;b. It results, directly or indirectly, in the misuse, or abuse, o the provisions o this Act;c. It lacks commercial substance or is deemed to lack commercial substance inwhole or in part; ord. It is entered into, or carried out, by means, or in a manner, which are notordinarily employed or bona de purposes.There is little guidance in the Finance Bill as to what constitutes a misuseor abuse o the Act. However, it may be use ul to re er to the recentdecision o the Supreme Court o Canada in Cophorne Holdings Ltd. v.Canada, 2011 SCC 63 where the Court held that it was not enough that atransaction is a misuse or abuse o tax policy and that the misuse or abusemust be tied to a speci c provision or provisions in the law. According tothe Court, a nding o misuse or abuse will be upheld only:1. where the transaction achieves an outcome which the statutoryprovision was intended to prevent;2. where the transaction de eats the underlying rationale o the provision;or3. where the transaction circumvents the provision in a manner that rustrates or de eats its object, spirit or purpose.These observations, though in the context o the Canadian GAAR, mayhave a bearing on how the Indian judiciary interprets this provision. Some issues in this regard are discussed below: Burden of proof: Unlike in the case of the tax benefit, there is no presumptionin connection with the above conditions. Hence, the burden of proving theexistence of one or more of the above conditions should lie with the Revenue. Misuse or abuse of the provisions of the Act:Cross-border inbound mergers- Whether misuse or abuse of provisions of the Act? The use o cross-border inbound mergers o oreign companies into India as tax e cient cash repatriationor debt pushdown mechanisms may again trigger an exposure to GAAR. It may there ore be necessary toensure that such transactions are not driven purely by tax considerations alone and that there is adequatecommercial/business rationale which has been appropriately documented.

CONSEQUENCES

GAAR provides wide powers to the tax authorities to dealwith impermissible avoidance arrangements. It provides that ifan arrangement is declared to be an impermissible avoidancearrangement, the consequences in relation to tax of thearrangement, including the denial of a tax benefit or a benefitunder a tax treaty, shall be determined in such manner as isdeemed appropriate in the

circumstances of the case, includingby way of but not limited to:a. disregarding, combining or recharacterising any step in, or apart or whole of, the impermissible avoidance arrangement;b. treating the impermissible avoidance arrangement as if it hadnot been entered into or carried out;c. disregarding any accommodating party or treating anyaccommodating party and any other party as one and thesame person;d. deeming persons who are connected persons in relation toeach other to be one and the same person for the purposesof determining tax treatment of any amount;e. re-allocating amongst the parties the arrangement (i) anyaccrual, or receipt, of a capital or re venue nature; or (ii) anyexpenditure, deduction, relief or rebate;f. treating (i) the place of residence of any party to thearrangement; or (ii) the situs of an asset or of a transaction,at a place other than the place of residence, location of theasset or location of the transaction as provided under thearrangement; org. considering or looking through any arrangement bydisregarding any corporate structure.It is also expressly provided that:a. equity may be treated as debt or vice versa.;b. any accrual or receipt of a capital nature may be treated as ofa revenue nature or vice versa;c. any expenditure, deduction, relief or rebate may be recharacterised.

APPLICABILITY he The provisions o The provisions o GAAR begin with a non-obstante clause i.e.they have been made applicable notwithstanding anythingcontained in the Act. The provisions o GAAR are to override provisions o taxtreaties. GAAR are to be made e ective rom 1 April2012. ollowing are the key points in connection with theapplicability o GAAR:

GAAR: Retrospective/Retroactive GAAR is to be e ective only prospectively i.e. rom 1 April2012. Hence, in respect o

arrangements that have beenconcluded prior to that date, the question o applying GAARshould not arise. However, while applying this rule in thecontext o inbound investment structures, it is possible thatinvestments made prior to the enactment o GAAR may behit by it at the time o exit made on or a ter April 1, 2012. Inother words, even though the provisions o GAAR are notintended to be retrospective, they could nonetheless apply topost-1 April 2012 transactions in investment structures set upprior to the enactment o GAAR. This is depicted in the chartbelow:

Some other impact areas Secondary consequences Though not explicitly provided in GAAR, a question may arise as to whether secondaryadjustments could also be made under GAAR. For instance, if additional incomeis deemed to arise in the hands of an Indian company from its overseas parent byapplication of GAAR or where excessive interest on debt is recharacterised as dividend,whether further tax consequences can be determined so as to impute a deemeddistribution of this income to the overseas parent, leading to an additional DDT liabilityin India.A similar question may arise as to whether book profits can be increased on account ofre-characterisation of interest as dividend or revenue expenditure as capital expenditurein cases where the taxpayer is under the MAT regime. Withholding obligations and GAAR A question may also arise as to the applicability of withholding tax provisions in respectof payments made under impermissible avoidance arrangements. For example, ifa payment which is otherwise not subject to the withholding tax provisions is re-characterised under GAAR as being of a nature which is subject to withholding tax, canproceedings under s. 201 of the Act be initiated against the person making paymentfor failure to deduct tax. Further, whether disallowances of such amounts can be madeunder s. 40(a)(i) for failure to withhold such tax.

Way forward The introduction of GAAR is without doubt one of the mostradical changes in the Indian tax regime since its inception.Considering the inherent subjectivity in GAAR coupled with thefact that the taxpayer has to discharge the burden of proving thatthe transaction was not entered into with a view to obtain taxbenefits, it is critical to evaluate and assess the impact of GAARon a taxpayers long term tax strategy, particularly in the contextof transactions that give rise to tax benefits.In particular, structuring of transactions in a post-GAAR world willnecessarily have to be fact specific and tailored based on specificcircumstances of each taxpayer. However, as a general rule, itwill be critical to ensure that transactions are based on a strongcommercial rationale and that such rationale is appropriatelydocumented.The provisions of GAAR are to be applied in accordance withsuch conditions and guidelines to be prescribed. While thesewill undoubtedly play a crucial role in the interpretation andapplication of GAAR to specific arrangements/transactions, itwill be critical for organisations to review concluded, ongoingand proposed transactions to assess the possible impact ofGAAR on them. It should also be assessed whether the currentdocumentation of commercial rationale for such transaction issufficient and robust enough to withstand GAAR scrutiny.

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 2012 KPMG, an Indian Registered Partnership and a member rm o the KPMG network o independent member rms a liated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.