GAAR in Simple Words

We’ve been hearing about General Anti – Avoidance Rule or GAAR since the day of the budget, and this story has evolved a lot since the first time it was written about.

GAAR is a new chapter introduced in the Finance Bill 2012, and can be found in Clause 40, Chapter X-A of the Finance Bill 2012 if you are interested in reading it raw.

I’ve read about GAAR in the last few days, but I’ve read the document itself only now, and I can now understand why FIIs are so concerned about this.

Broadly speaking, GAAR provisions will disallow a tax benefit if it is proved that you entered into an arrangement with the intent of avoiding tax.

First, some raw text from the Finance Bill (emphasis mine):

95. Notwithstanding anything contained in the Act, an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement and the consequence in relation to tax arising therefrom may be determined subject to the provisions of this Chapter.

Explanation.—For the removal of doubts, it is hereby declared that the provisions of this Chapter may be applied to any step in, or a part of, the arrangement as they are applicable to the arrangement.

96. (1) An impermissible avoidance arrangement means an arrangement, the main purpose or one of the main purposes of which is to obtain a tax benefit and it—….

If you look at the highlighted text, there are several things that fall under this category. As pointed out in this ET article on GAAR if you buy Section 54EC bonds then it can be said that your primary intent is to save taxes and then that can fall under this purview and you can be disallowed the benefit.

This becomes worse because the onus is on you to prove that you are entering into an agreement solely to save tax, which sounds like they are saying you are guilty unless proven innocent.

Here is the relevant text:

(2) An arrangement which results in any tax benefit (but for the provisions of this Chapter) shall be presumed to have been entered into, or carried out, for the main purpose of obtaining a tax benefit unless the person obtaining the tax benefit proves that obtaining the tax benefit was not the main purpose of the arrangement.

This sounds harsh and in fact the standing committee on DTC has suggested that it should be the responsibility of the tax department to prove that there is tax avoidance and that may well get accepted.

Reading these things makes me wonder if GAAR will be used on residents, but at least so far the focus has been on FIIs and let’s look at why FIIs in particular are jittery about this.

Before this issue came into limelight it wasn’t very well known (I certainly didn’t know) that FIIs registered in Mauritius have a tax advantage when compared with ordinary retail investors in India. While no one pays long term capital gains – residents have to pay 15% short term capital gains. However, FIIs registered in Mauritius don’t have to pay those short term capital gains because they enjoy tax benefits under the DTAA (Double Taxation Avoidance Agreement) India has with Mauritius.

Now, if the tax department says that a FII has registered in Mauritius solely to benefit from this DTAA and the FII is unable to prove otherwise – they will be liable to pay short term capital gains on their investments as well.

Here is the relevant text:

97. (1) An arrangement shall be deemed to lack commercial substance if—…..

(a) the substance or effect of the arrangement as a whole, is inconsistent with, or differs significantly from, the form of its individual steps or a part; or

(b) it involves or includes—

(i) round trip financing;

(ii) an accommodating party;

(iii) elements that have effect of offsetting or cancelling each other; or

(iv) a transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction; or

(c) it involves the location of an asset or of a transaction or of the place of residence of any party which would not have been so located for any substantial commercial purpose other than obtaining a tax benefit (but for the provisions of this Chapter) for a party.

If you see the two highlighted parts above – the first deals with Participatory Notes – which are derivative products that FIIs transact into and are anonymous in nature and the second part deals with the location of the asset. So, if you were an American hedge fund that registered an office in Mauritius to buy Indian equities then that looks like it will fall under the purview of this.

Now, this was how the situation looked like when this first came out and obviously there was a lot of confusion about this because of the way this has been worded and because of the powers it gives to the tax department. Since then numerous conciliatory noises have been made by the government and it is not clear how much of this will be retained in the final form. In fact, last week the Finance Minister specifically exempted P-Notes from GAAR provisions and drew flak from editorials in both Business Standard (Not taxing P-Notes is Policy Absurdity) and Financial Express (What’s so special about P-Notes? ).

This is a very complex issue and I won’t pretend that I understand it enough to have a strong opinion on it but I do think as this thing stands today it is fairly harsh and this is hardly the time to pass such laws when the economic situation has deteriorated so much in the last few years.

This post was from the Suggest a Topic page.


4 thoughts on “GAAR in Simple Words”

  1. Good Article Manish.

    Government is seems on the back foot as it is trying to add revenue by taxing different avenues.Already Vodafone case is there and then GAAR. The intention may be right but surely the measures are not appreciable.

  2. I was always curious about Participatory Notes and heard a lot of times that firms save a lot of taxes through these.

    This whole tax evading scam is also known as “Mauritius Route” and it is estimated that about $ 55 billion of foreign direct investment flows into India is through Mauritius route. How much is Indian government losing? Just curious.

    and what possible logical argument there could be behind such an agreement (DTAA) ??

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