What was all that exuberance about in the markets on Friday? If it was over hopes of a benign regulatory regime on GAAR (General Anti-Avoidance Rules) then the markets had better think again because the draft guidelines notified by the Finance Ministry don’t support that view.
Yes, of course, there are two major points in the guidelines that favour tax payers but the overall thrust of stubbing out tax avoiding strategies using GAAR remains unchanged from the original intent revealed in the Budget.
Onus on taxman
The most significant gain for tax payers is that the onus of proving tax avoidance has been shifted to the taxman which is as it should be. The original Budget provision required the tax payer to prove that a particular transaction or structure was not designed to avoid tax. The government has obviously seen merit in the argument that nowhere in the world is such unfair onus laid on the tax payer.
The second gain is that GAAR provisions will apply only to transactions/arrangements where the tax benefit is over a certain threshold. This is to avoid indiscriminate application of GAAR and ensure that small tax payers are not harassed.
The guidelines, however, don’t specify the threshold limit; the sincerity of this relaxation will be apparent only when the limit is notified. Take these two concessions away, and the face of GAAR is as stern as it was in the Budget. Interestingly, the third major demand from the industry for a neutral member, preferably not from the government, on the approving panel has not been conceded. As it stands, the GAAR panel will have three members, two of whom will be from the Income Tax Department, and the third a Joint Secretary or higher level officer from the Law Ministry.
Where the guidelines retain and reinforce the intent of the Budget proposals are in relation to tax avoidance measures used in cross-border capital flows, especially FII (foreign institutional investment). The guidelines make it clear that where an FII exploits a tax treaty to avoid payment of tax, GAAR will kick in. In other words, all those investments funnelled into the stock market through Mauritius will now be GAARed.
This particular guideline could militate against the terms of Circular 789 issued by the Central Board of Direct Taxes in April 2000, which clarified that a Certificate of Residence from Mauritius tax authorities is enough to grant even investors with a post-box address in Mauritius benefits under the Double Taxation Avoidance Agreement. Will the latest guidelines override this Circular, as it ought to if FIIs are to be brought under the tax net? We need to see what the Prime Minister, who also holds the Finance portfolio, does when he reviews the guidelines.
P-notes in focus
Non-resident investors in FIIs, also known as Participatory Note- holders, will be exempt from GAAR. P-Notes are issued by FIIs to clients abroad who may want to invest in the Indian market but are not registered with the regulator here. This route has been abused earlier by Indian companies/individuals who want to rig up the prices of their shares in India.
While the draft GAAR guidelines appear to let off P-note investors, the reality is that they will be subject to tax in indirect fashion. The FII which invests on their behalf will be liable to pay tax, and it is but natural that it will recover the tax from the P-note holder. FIIs that don’t avail themselves of treaty benefits and subject themselves to tax in India will obviously be out of GAAR’s gaze.
The draft guidelines provide an indicative list of deals/transactions/arrangement where GAAR will be invoked. The illustrative cases in the list cover all methods of tax avoidance that may have been employed till now by investors and these are all liable to attract GAAR. While tax mitigation using available provisions in the law are allowed, it is tax avoidance that GAAR will seek to crush.
There are already voices of protest against the draft guidelines from tax consultants, especially some of the multi-national audit and consulting firms such as PriceWaterhouse and Ernst & Young.
These firms made an industry out of tax planning and creating intelligent tax avoidance structures. This will now come unstuck if the guidelines are implemented without change.
All eyes will now be on Dr Manmohan Singh. A relaxation in the draft might help boost capital inflows in the immediate context, and this might be a tempting option too given the rising current account deficit.
Yet, it should also be pointed out that every mature economy, whether Canada, Australia, South Africa or China, has GAAR enshrined in its tax statute. India is not out of line with this trend. Having taken the bold step to initiate this in the tax laws and also taking the worst flak for it in the last two months, the government can ill afford to backtrack now without losing its face.