India’s controversial tax proposals

January 18, 2013

Indian tax policy has witnessed unprecedented action, particularly on the international taxation front, since the presentation of the Union Budget in March 2012.

This article was first published in the Ernst & Young Global Tax Policy and Controversy Briefing, Issue 11, December 2012 (pdf, 4.25 MB)

The Finance Act 2012 introduced a number of far-reaching amendments to Indian tax law, the most controversial being the introduction of a general anti-avoidance rule (GAAR) and the taxation of indirect transfers of assets (at the holding company level), the latter with a 50-year retroactive effect, putting many global multinationals into a situation where they were unwittingly taxed on transactions that would not formerly have attracted tax.

In a series of recent events, the Indian government has demonstrated a real willingness to engage with and listen to business, with the signs showing that a more balanced approach is likely to be taken on both accounts. The provisions created a serious negative impact on the investors and the business community, raising doubts about India as a stable tax jurisdiction.

The immediate month following the announcement of these provisions saw a sharp decline in Foreign Direct Investment (FDI) and investments by the Foreign Institutional Investors (FIIs) into India. This significant disquiet from the investor community triggered a serious review of the new provisions by the Indian government.

GAAR rising

The Finance Bill was amended in May 2012 to defer the applicability of the GAAR provisions by one year to 1 April 2013, and some added degree of comfort was offered to taxpayers by removing the onus of proof from them and putting it onto the Revenue Department as well as the introduction of an independent member in the GAAR approving panel to ensure objectivity and transparency.

Advance rulings for GAAR were also proposed, and a committee was constituted under the Chairmanship of the Director General of Income Tax (DGIT) (International Taxation) to recommend guidelines for implementation of the GAAR and to suggest safeguards against the indiscriminate use of GAAR provisions.

The DGIT Committee published the Draft GAAR Guidelines for public comments on 28 June 2012. Though the DGIT Committee made some good recommendations, they did not provide the necessary comfort and clarity to taxpayers about the circumstances in which GAAR could be invoked. In July 2012, the Prime Minister (who himself took interim charge of the Finance Ministry on the then Finance Minister’s appointment as the President of India), announced the formation of two important committees.

An Expert Committee on GAAR was set up under the Chairmanship of Dr. Parthasarthi Shome to undertake stakeholder consultations and finalize the guidelines for GAAR. The Expert Committee’s mandate was later expanded to include making a series of recommendations regarding the issue of the taxation of indirect transfer of assets where the underlying asset is in India and bring clarity on the tax liability of portfolio investors and FIIs.

Transfer pricing also a bone of contention

India has the dubious distinction of having perhaps the greatest number of transfer pricing (TP) controversy cases compared to other jurisdictions, with TP cases under litigation numbering around 3,500 to 4,000 a year.

To address the concerns about the rising number of disputes in transfer pricing, especially in the IT and IT-enabled services (ITeS) sector, the Prime Minister constituted another committee, under the Chairmanship of Mr. N. Rangachary, former Chairman of the Central Board of Direct Taxes, to finalize the safe harbor provisions sector-by-sector and suggest the approach to taxation of development centers in India.

The safe harbor provisions were announced in the Budget 2010, but have been pending implementation since that time. A significant aspect about both Committees was that they were headed by independent persons outside the Revenue Department.

Given the urgent need to restore investors’ confidence, the Committees were given short deadlines to submit their recommendations. That the government is serious in its intent to reconsider the contentious international tax provisions announced earlier and reduce the anxiety of both inbound and domestic investors was made more evident by the following statement made by the new Finance Minister, Mr. P. Chidambaram, shortly after assuming office:

“The key to restarting the growth engine is to attract more investment, both from domestic investors and foreign investors. We intend to fine tune policies and procedures that will facilitate capital flows into India. Clarity in tax laws, a stable tax regime, a non-adversarial tax administration, a fair mechanism for dispute resolution and an independent judiciary will provide great assurance to the investors. We will take corrective measures where necessary.”

The developments and the efforts made by the government are clearly indicative of the positive turnaround in the government’s thinking. They are a signal to the investors that the government is committed to providing better tax policies that are openly debated, well-considered and provide higher levels of certainty to taxpayer and tax authority alike.

Key issues surrounding GAAR

It is useful to understand the key issues under debate that guided the recommendations of the Committees constituted by the government on GAAR. Though the GAAR provisions were thoroughly discussed as a part of the Direct Taxes Code Bill 2010 (DTC), the form in which they were introduced in the recent Budget generated much controversy.

The GAAR provisions proposed in the Finance Bill 2012 gave wide discretionary powers to the tax authorities to invoke GAAR and to declare an arrangement to be an “impermissible tax avoidance arrangement.” The main concern of the industry was that the provisions as they were worded were so open ended that even those transactions that are globally considered legitimate tax planning and are thus permissible, now became vulnerable to being treated as impermissible by the authorities.

Moreover, in the absence of any guidelines or rules to bring clarity in respect of the application of GAAR, business was concerned about the positions that may be taken by the tax authorities on various transactions. The most fundamental issue raised was: “Is India ready for GAAR at the current juncture?”

  1. By its very nature, GAAR involves the use of discretion by the tax authorities and holds a strong danger of being misused or used indiscriminately. Other countries have put safeguards in place such that GAAR is invoked selectively in prima facie contrived or artificial transactions, and not against the “center ground” of tax planning. However, in a jurisdiction like India, where the tax administration has still to gain the requisite maturity and may arguably lack complete accountability, the degree of discretion that GAAR offers can be hazardous.
  2. Secondly, if GAAR is introduced, under which circumstances should it be invoked? Given the complexity of transactions, there is a very thin line dividing tax mitigation and tax avoidance. If invoked inconsiderately, GAAR may affect even the transactions that are genuine and constitute legitimate tax planning.
  3. The third aspect was the use of specific anti avoidance rules (SAAR) instead of GAAR. Having SAARs provide greater clarity and certainty in law as they communicate the clear intent of the government to not accept certain transactions. Thus, the avoidance transactions should be first checked through the use of SAARs and only the residual cases that are clearly abusive and contrived in nature should attract the attention of GAAR. GAAR should not be a substitute for SAAR. It should be invoked only as a residual, to fortify the SAARs, and only in the case of abusive transactions.

DGIT Committee’s recommendations

With the above key issues under debate, the DGIT Committee, constituted under the directive of the former Finance Minister, Mr. Pranab Mukherjee, issued draft guidelines on GAAR in order to obtain wider feedback. The guidelines reiterated the government’s assurances on many points:

  • The GAAR provisions will apply to the income accruing or arising to the taxpayers on or after 1 April 2013.
  • That the onus to prove an arrangement impermissible would be on the revenue authority.
  • The unequivocal recognition that GAAR is a codification of the ‘substance over form’ doctrine.
  • The assurance to taxpayers that GAAR would not be averse to tax mitigation.
  • That where only a part of the arrangement is impermissible, the tax consequences would be limited to only that part of the arrangement.
  • Treaty benefit could be availed by an investor who had adequate substance in the holding jurisdiction.
  • Taxpayers were given a business choice of raising funds by mode of equity or capital.
  • The guidelines also stated that in normal circumstances, SAAR would prevail over GAAR.

Finally, the guidelines included 21 examples of situations where GAAR could and could not be applicable.

Steps in the right direction

The guidelines did not provide, however, the desired clarity around the application of the GAAR provisions or the comfort about their judicious use. For instance, some of the illustrative examples contained conclusions concerning denial of tax benefits, including treaty benefit, even where the fact pattern did not suggest abuse or artifice.

Interestingly, soon after the DGIT Committee gave its recommendations, the Prime Minister’s Office issued a statement that the guidelines had not been studied by the Prime Minister and that these were only draft guidelines for public comments.

This was followed by another statement about the formation of the Shome Committee to study the guidelines, including having a more transparent and open debate with stakeholders before finalizing the guidelines.

After a month-long consultation, the Shome Committee submitted its first Report in August 2012 for public comments. The Committee made some path-breaking and positive suggestions.

Duly understanding business concerns and the immense challenges that the GAAR provisions in their current form could create, the Shome Committee recommended a three-year deferral of GAAR’s implementation. Cautioning against the use of GAAR as a revenue-generating tool, it suggested significant pruning of its scope by restricting its application only to abusive, contrived and artificial transactions.

In the words of the Shome Committee itself, “GAAR is an extremely advanced instrument of tax administration — one of deterrence, rather than for revenue generation – for which intensive training of tax officers, who would specialize in the finer aspects of international taxation, is needed.”

As a further safeguard, it recommended the invocation of GAAR to be subject to an approval by an independent Advisory Panel. An important suggestion by the Shome Committee was an exemption from GAAR for mutual funds and other pooling vehicles making investments through low-tax treaty jurisdictions such as Mauritius and Singapore, and the grandfathering of investments made prior to its implementation.

One of the boldest suggestions made by the Shome Committee was to abolish the tax on short-term gains (long-term gains are already exempted), whether by way of capital gains or business income, from transfer of listed shares. Any revenue loss from such exemption could be offset, the panel recommended, by an increase in the rate of securities transaction tax (STT). The exemption would apply to both residents and non-residents of India.

The main benefit for the investments coming through Mauritius and Singapore is the exemption from capital gains. The Shome Committee seems to be of the view that the government of India should extend this benefit to all investments irrespective of the country from which they pertain, thus neutralizing the advantage under the treaty for the FIIs investing in India.

Set out briefly below are the key recommendations of the Report.

Key recommendations of Shome Committee

  • The implementation of GAAR should be deferred by a further three years to financial year 2016–17.
  • The tax on the transfer of listed securities for non-residents and residents should be abolished.
  • Only arrangements having the main purpose of obtaining tax benefits should be covered by GAAR as compared to arrangements having one of the main purposes being sufficient to trigger GAAR. In this vein, GAAR should be applicable only in cases of abusive, contrived and artificial arrangements.
  • An approving panel committee should comprise five members headed by a retired High Court Judge.
  • A monetary threshold of INR 30 million (approximately USD 5.5 million) is recommended for invoking GAAR.
  • GAAR should be made subject to the overarching principle that tax mitigation is distinguished from tax avoidance; specify negative list where GAAR is not applicable (for e.g., payment of dividend versus buyback, funding through debt or equity, court-approved amalgamations and demergers).
  • GAAR is not to be invoked in revenue- neutral intra-group transactions.
  • All investments (not arrangements) made prior to the effective date of GAAR (1 April 2016) should be grandfathered.
  • The period of time of existence of arrangement, payment of taxes, and the availability of exit route are relevant though not sufficient to prove commercial substance. These factors are to be considered, however, in determining whether an arrangement lacks commercial substance.
  • SAAR in Indian DTL / limitation recast as sentence on benefits clauses in treaties to override GAAR.
  • Where part of the arrangement is impermissible, GAAR consequences will be limited to that portion of the arrangement.
  • Allow corresponding adjustment to taxpayers where GAAR is invoked recast as sentence. However, no such relief available to any other taxpayer.
  • GAAR is not applicable to determine genuineness of residency of a Mauritius entity, where the administrative circular (Circular 789) providing for tax residency certificate as being sufficient evidence for residency continues to be applicable. It is also recommended to retain this circular (Circular 789) until the tax on listed securities is abolished.
  • While applying for tax withholding certificate, GAAR may not be applicable on providing satisfactory undertaking to discharge any tax and interest liability in case GAAR was found to be applicable at audit stage.
  • The Shome Committee Report acknowledges GAAR as an extremely advanced instrument of tax administration and one of deterrence rather than revenue generation. Towards this, it recommends training of tax officers to specialize in international taxation.

The Shome Committee was given the mandate of giving its final recommendations by 30 September 2012 and has duly submitted its final recommendations on GAAR (see box on left). Although the Finance Minister has indicated that the GAAR was to be finalized by the end of October 2012, we await the verdict of the government on which of the Shome Committee recommendations will be implemented.

The finalization of the GAAR is likely to be followed by an amendment in the Income-tax Act, though the time frame for the legislative amendment is not known at the point in time at which this article was drafted.

India’s position on the indirect transfer of assets

Of course, GAAR was not the only source of distress to business earlier this year. Another significant legislative amendment was the taxation of all offshore indirect transfer of assets in India to capital gains tax, negating the well settled and time-tested interpretation of the relevant provisions of law.

The law as it existed at the time did not apply to taxation of indirect transfer of capital assets in India as was clearly brought out by the Honorable Supreme Court in its recent judgment in the Vodafone case. The amendment, expanding the source rule to activities that could have a limited nexus with India, was made with 50 year’s retrospectivity (i.e., affecting transactions back as far as 1962).

Equally concerning was the validation clause in the Finance Bill, 2012 that provided for validation of demands raised under the Income-tax Act in certain cases and would operate “notwithstanding anything contained in any judgment, decree or order of the Court or tribunal or any authority.” The validation clause meant that irrespective of any Court judgment, the government could assert the right to collect tax demanded.

As in the case of GAAR, a severe backlash from business and the negative impact on the investor community spurred the government into reviewing these contentious provisions. The Shome Committee was therefore given the additional mandate of examining the issue of retrospective amendments and the taxation of indirect transfers.

The fundamental issue under debate has been whether income should be taxed on the basis of residence principle or the source principle. The difficulty in applying the source principle to capital gains is that the source of the share capital gains is very difficult to establish.

The concerned corporate entity could be from any jurisdiction, and the change in the valuation of its shares will depend on an amalgam of factors. The valuation of shares may also reflect the contribution of the management, which may be located in the head office of the company, and not just the quantum of physical assets in a particular jurisdiction.

For this reason, the taxation of capital gains is limited to a narrow class of shares, representing interest in real property where is there is much greater correspondence between the valuation of shares and valuation of property. Another key issue under discussion is whether the share capital gains should be taxable at all.

Mr. Pranab Mukherjee had argued that the taxation of the Hutchison-Vodafone transaction was justified, as such income was not taxed anywhere and should therefore be taxed in India as it was derived from the assets located in India.

The fact is, however, that capital gains on shares represent income that has been taxed previously in the country where the corporate assets are located. Capital gains tax is essentially a third tier tax over and above corporate income tax and a tax on dividends.

Interestingly, the Shome Committee used the same argument as Mr. Mukherjee, but to reach an opposite conclusion in its Report on GAAR where it has recommended that the any gains on the transfer of shares should not be taxed. The Shome Committee’s recommendation on doing away with taxation of capital gains was not expected, but it was consistent with the view expressed by Ernst & Young on the subject.

Business has been clear in its view that, should the government decide to retain the provisions on taxation of indirect transfers, they should apply with prospective effect only. Further, as the law seeks to create a tax charge in case “substantial value” of the assets is located in India, an objective definition of “substantial value” (e.g., total value of assets exceeding 50%) should be provided.

It has been suggested that taxation should be limited to only the proportion of gains that relates to Indian assets and only where there is a change in “controlling interest” within a stipulated period (say, 12 months). To avoid economic double taxation, the cost basis of the underlying assets should be permitted to be stepped up to the sales price at which the upper tier companies’ shares have been sold.

Exemption has been sought for intra-group reorganizations, transfer of shares on stock exchanges, portfolio and institutional investments under SEBI- approved rules and transfer made under an initial public offering. Clarification to the effect that dividends distributed by the foreign company would not be taxable in India, and exemption to a non-resident payer from withholding tax obligation in relation to such transactions, have been sought by business.

The Shome Expert Committee on 09 October 2012 issued its second report. The Shome Expert Committee recommends that retrospective application of tax laws should occur only in exceptional or rarest of rare cases and with particular objectives, namely, first to correct apparent mistakes or anomalies in the statute, second to remove technical procedural defects which have vitiated the substantive laws and third to protect the tax base from highly abusive tax avoidance schemes.

However, retrospective application of tax laws should never be used to expand the tax base as is the case in respect of taxation of indirect transfers.

The Shome Expert Committee has noted the objective of maintaining certainty, predictability and stability of tax laws in India so as to remove uncertainty in the minds of investors about shifting interpretations of the Indian Revenue seriously impacting the perception of safety of investing in India.

The Shome Expert Committee has further proceeded to consider the possibility of government retaining the retrospective amendments and even here has made some specific suggestions vis-a-vis both the purchaser of the foreign shares as also the seller thereof.

Shome Expert Committee has recommended that the purchaser should never be treated as a taxpayer in default in relation to retrospective amendments as this would amount to imposition of burden of impossibility of performance. In other words, government could apply the retrospective provisions only on the taxpayers who earns capital gains from indirect transfers.

Moreover, even for the seller, who earns capital gains, there should be no levy of interest and penalties on such back taxes.

The Shome Committee has also fully incorporated the recommendations made by the Parliamentary Standing Committee on Finance to clarify substantial value as 50% or more value derived from assets located in India and carve out exceptions for internal reorganizations.

The recommendations are truly salutary, and they align with the norms of certainty, predictability and stability of tax laws. A full analysis of the recommendations can be accessed at www.ey.com/shome_indirecttransfers.

India’s initiatives to reduce transfer pricing disputes

In India, transfer pricing (TP) disputes have emerged as a significant challenge faced by multinational enterprises, which significantly add uncertainty, compliance burden and costs to their businesses. As per the government’s own estimates, during 2011–12 more than 50% of the TP audit cases completed faced an adjustment, and the amount of adjustment during the period was as high as almost INR45,000 crores (over US$8.7 billion).

Existing dispute resolution mechanisms have not proved to be very successful. For instance, the mutual agreement procedures (MAP), being essentially negotiated settlements between the authorities of the countries involved, are time consuming and expensive.

Dispute resolution panels (DRPs) were constituted by the government in 2009 with the objective of providing speedy resolution of disputes. Though the DRPs have the potential to be an effective mechanism to deal with transfer pricing controversy, significant implementation gaps have made their functioning ineffective.

Responding to the need to provide alternative channels for dispute resolution, the government has recently taken two significant steps in the right direction – the creation of an advance pricing agreement (APA) scheme and the constitution of a committee by the Prime Minister to review the taxation of development centers and the IT sector and to finalize the Safe Harbor provisions announced in Budget 2010, on a sector-by-sector basis.

APAs are expected to provide more certainty and predictability to the transfer pricing landscape by proactively avoiding controversy before it arises and offering a solution to the difficult and complex TP issues through discussions at the right level. In the Indian context, though the APAs are likely to take some years to gain maturity, their introduction is a step in the right direction and offers a window of opportunity for controversy management.

Safe harbor rules

Further evidence of the government’s intent to provide comfort to investors can be found in their response to the longstanding demand from the IT industry to address the anomalies in the taxation of both the IT sector and development centers in other industries.

A Committee was constituted by the Prime Minister under the chairmanship of Mr. N. Rangachary to address these issues, as well as the tax treatment of “onsite services” of domestic software firms and finalize the safe harbor rules individually, sector-by-sector, by December 2012.

Recognizing that the safe harbor provisions have the advantage of being a good risk mitigation measure that could provide additional certainty to taxpayers, the government had announced the safe harbor provisions in its Budget 2010 but the rules for their implementation have been pending since then.  With the Indian IT sector suffering from fallout from the global financial crisis, clarity in taxation is important if India wants to remain an attractive destination for investment.

One of the key issues under discussion has been the identification of the legal and economic ownership of the IP of the work product of the development centers, and to determine who bears the cost and risks, and undertakes the critical functions in the entire process. The industry is of the view that given the “contract R&D” and “work for hire” arrangement between the IT development center and principal R&D company, the intangible-related returns belong to service recipients and not service providers.

Most captive development entities are compensated on a cost-plus-mark-up basis wherein they are reimbursed for all of their costs (including costs of rework, hiring costs), and there is no real risk borne by these captive centers. The development centers have also been facing aggressive audits for their transfer pricing, with the tax authority determining arm’s length markups in a much higher range.

Indian companies forming part of a multinational corporation and rendering IT services and ITES to their related parties overseas generally earn a markup on total costs (“margin”) in the range of 12–18 % 6 for rendering these services. However, the indicative markup on total cost determined by tax authorities in various transfer pricing assessments has been as high as 25–35%.

Such issues faced by the industry underscore the need for early implementation of the safe harbor provisions in order to bring greater certainty. The Committee has been sympathetic to the industry concerns and has submitted its report to the Finance Minister but the recommendations have not yet been made public.

Where to next?

Returning to the Shome Committee recommendations on indirect asset transfers, the question now seems to be whether the Indian government has enough room on the expenditure side to allow itself the luxury of sacrificing income by way of tax revenues. Of course, they will be balancing this side of the equation with the possibility of damaging FDI flows if that choice is not taken.

The government may be tempted to adopt a balancing approach suggested by the Shome Committee, which centers on retaining the retrospective amendment but provide for waiver of interest and penalties. The dilemma for the government here would be that it might weaken its legal stance before the courts where it is already facing a challenge to the retrospective amendment in two cases.

The fact of the matter is that these amendments are so complex in nature and so exhaustive in their reach that to justify them as mere clarificatory was by itself an unreasonable move by the government.

With its new found boldness and conviction, the government might spring a pleasant surprise and roll back the retrospective amendment in Parliament with a reasonably achievable assumption of attracting far greater investments in the remaining months to 2014 whereby both the fiscal deficit and political capital can be protected. The recommendations are truly salutary and they align with the norms of certainty, predictability and stability of tax laws.

GAAR

If past international experience is any guide, the task of introduction of GAAR provisions through a consultative process and the formulation of guidelines for its implementation have always been a challenge, given the need to strike a fine balance between the desire to protect the tax base on one hand and tackling artificial and contrived schemes on the other, all while putting a check on the discretionary exercise of power so as not to create an environment of long-term uncertainty.

This is a delicate exercise because conferment of certain levels of discretion is always inherent in a GAAR. The ability to categorize tax arrangements as either permissible or impermissible in an objective, transparent and clear manner is yet another challenge.

In the midst of these challenges, the report by the Shome Committee nonetheless represents a positive step towards allaying the fears of investors and providing a policy direction to government and tax administration. The proposal to defer the introduction of GAAR to allow for change in the mindset of the taxpaying community and to prepare the tax administration is highly salutary.

Likewise, the insertion of overarching principles as a precondition to GAAR applicability is reflective of the true intent of GAAR. Proposals to grandfather existing investments, to protect the tax efficiency of fund pooling vehicles, to respect double taxation avoidance agreements containing specific anti-avoidance rules and to uphold the validity of Circular No. 789 (which states that a tax residency certificate issued by Mauritius constitutes sufficient evidence) should allow go some way to starting the process of rehabilitating investor confidence in India.

The creation of a minimum threshold level of tax benefit for GAAR trigger is also likely, if enacted, to keep a large volume of taxpayers outside GAAR scrutiny, and the creation of an independent approving panel should have most bona fide GAAR cases happy with the proposals.

But, as with any challenging change, some items remain open. For the business community, the comprehensive final report due on 30 September 2013 should provide more clarity.

Note. Events continue to develop in India. Parts of this article may be surpassed by the time this article is read and, readers are advised to secure timely and up to date professional advice.

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