DTC: Concern for FIIs

In the economic times there is an interesting article carrying the title DTC: Cause of Worry for FIIs. Some aspects relating to the taxability of FIIs has been a matter of previous discussions on this blog. Here are some of the excerpts of the article in the economic times:

"The Bill provides that the income earned by FIIs will be deemed as capital gains. This would not have much impact on the FIIs as most FIIs at present offer their income to tax as capital gains. The deemed characterisation under the Bill implies that income from derivative transactions, which are currently treated as business income, will now be taxed as capital gains. Considering that most derivative contracts have a maturity period of between 30-90 days, the income from the derivative transactions will be subject to tax at 15%. "

"For FIIs investing from favourable treaty jurisdictions, all capital gains will be tax exempt. Though, structures without much commercial substance are likely to face challenges with the advent of general anti-avoidance rule ('GAAR'). As per the proposed GAAR, if the structure has been set up to obtain an unintended 'tax benefit' or involves treaty shopping, the Indian tax authorities will have the ability to lift the corporate veil or deny the treaty benefits. While the detailed rules and safe harbours are still to be announced, it is apprehended that holding structures set up in tax favourable jurisdictions such as Mauritius and Cyprus will be presumed to be set up for tax avoidance and the onus to prove otherwise will be on the taxpayers. This uncertainty might tilt the balance in favour of certain well established jurisdictions such as Singapore, which already have an objective substance test built into their tax treaty with India. For those FIIs who have traders based in jurisdictions from where they invest, it may be easier to meet the commercial substance test."


"The significant impact on the FIIs will be as regards the taxation of their investors. The Bill deviates from the current law and has sought to tax offshore transfer of shares in companies which hold at least 50% or more investment in the form of Indian assets. As a consequence, non-residents investing in an open-ended offshore fund set up as a company may be subject to Indian tax upon redemption of offshore shares. This might create unintended cascading tax burden on the investors in the offshore funds set up as collective investment vehicles, and which have more than 50% asset allocation to India."



I shall explore some of the points in detail at a latter point.

Changes Proposed to be Brought by The Direct Tax Code Bill, 2010

The Direct Tax Code is proposed to be brought in to consolidate and amend the regime relating to Direct Taxes in India so as to establish an economically efficient, effective and equitable direct tax system which will facilitate voluntary compliance and help increase the tax-GDP ratio. Also the secondary purpose of the Code is to reduce disputes and minimize litigation. The Code proposes to bring all forms of Direct Taxes under a single code. A Discussion Paper was released in August 2009; subsequently a revised discussion paper was brought out in June 2010 which incorporated certain suggestion made with regard to the Discussion Paper. Finally, the Bill was tabled in the Parliament on 30th August, 2010. The post highlights certain changes which are to be brought by the Direct Tax Code Bill, 2010.

• Tax Rates

The tax slabs have been widened (First Schedule Paragraph A). The lowest tax rate of 10% is applicable to salary income of Rs2-5 lakh, 20% on income of Rs5-10 lakh and 30% on income above Rs10 lakh.

• Residential Status of Individuals

Residential Status of Individual under the Direct Tax Code has undergone a significant change. The requirement of being present in India for 730 days in the preceding seven years, essential for qualifying as an ordinary resident and the categorization of Resident but not ordinary Resident has been done away with (Clause 4).

• Residence of Companies

Under the Direct Tax Code a company would be treated as a Resident if it is an Indian Company or if its place of ”effective management” at any time of the year is in India (Clause 4) in contrast to the requirement of being “wholly” situated in India under the Income Tax Act. 'Place of effective management' under Clause 314(192) is defined as either the place where the Board/Executive directors of a company make their decisions or, in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company or the place where such executive directors or officers of the company perform their functions. This has been done to enlarge the scope of taxability of companies by bringing in more number or Companies under the banner or Resident Companies.

• Income from Salary

The broad head of Income from Salary under the Income Tax Act has been renamed to “Income from Employment” under the Direct Tax Code. Clause 23 (e) has removed the cap of 1 lakh towards the Employer’s contribution towards approved Superannuation fund.

• House Property

No taxation on deemed income basis. The concept of fair market value (S.23) for calculation of income from house property has been done away with primarily because computation of notional rent has been a predominant cause of litigation. Income from the letting of house property will be computed on the basis of contractual rent (Clause 26), i.e. the amount of rent received or receivable, directly or indirectly for the financial year less specified deductions (Clause 27). Standard deduction on account of repairs and maintenance has been reduced from 30% to 20% [Clause 27 (1) (b)].

• Branch Profit Tax

The Direct Tax Code introduces a Branch Profit Tax (BPT) on branch profits of foreign companies in addition to the income tax on income attributable to a Permanent Establishment (PE) or an immovable property in India, as reduced by the income tax payable on such attributable income. The Rate of Tax as proposed in the Second Schedule Para D (4) is 15%.

• DTAA

The Direct Tax Code in Clause 291(8) lays down that between the Code and a DTAA the provisions of the Code will apply to the extent that the provisions of the Code are more favorable to the assessee.

• Wealth Tax

The existing exemption limit (30 lakh) for the chargeability of Wealth Tax under the Act has been increased to 1 Crore. (Second Schedule Para E).

• Minimum Alternate Tax

The Direct Tax Code has brought in the concept of Minimum Alternate Tax so as to overcome the problem of excessive tax incentives. Where the normal income-tax payable for a financial year by a company is less than the tax on book profit, the book profit shall be deemed to be the total income of the company for such financial year and it shall be liable to income-tax on such total income (Clause 104 Direct Tax Code).

Introduction of the Controlled Foreign Corporations Regime in India: Necessity and Limitations

In an expedition to enlarge the scope of taxation of Residents, the revised discussion paper on the Direct Tax Code has yet again instituted a platform for debate with the introduction of taxation for Controlled Foreign Corporations( hereinafter CFC ). On an ongoing debate the legal fraternity has been divided amongst those who opine that India does not still require such a change as they believe in the existence of two different and distinct legal entities; those incorporated within and those incorporated outside the country. On the flipside others propagate that the Revenue is suffering losses as the recent trend shows an increase in outward investment, thereby making it necessary to introduce such laws for taxation. In my opinion there is a necessity to examine the proposal as laid down under the DTC, secondly to put forward the shortcomings of the proposal and finally to determine whether India has adhered to the principles recognised by most developed jurisdictions for taxation of the CFC’s.

In the Indian context, Controlled Foreign Corporations are understood as Companies which have been incorporated abroad, in countries with low tax jurisdictions, controlled directly or indirectly by Residents in an attempt to accumulate income without having to pay tax in India. It can therefore be concluded that such a structure is an added method for legally avoiding the payment of taxes in India.

The present proposal can be seen as yet another attempt by the Revenue to overcome the recognition given to the principle of Tax Avoidance in Azadi. It has sought to tax the Resident controlling such a Foreign Corporation on the passive income earned by the same. Furthermore in order to check the deferral of taxes from dividend earned by the CFC’s which are not distributed in India to the shareholders, the DTC(Chapter 8) proposes to tax such dividends as deemed dividend from the Foreign Corporation. The effective test laid down under the DTC is the ‘place of effective management’ of the corporation which is an internationally recognised principle for determining the residence of the Corporation. The DTC defines the term ‘place’ as being the country in which the ‘ key management’ and ‘commercial decisions’ are made for the ‘entity as a whole’. Therefore in substance it widens the ambit of residence of a Foreign Company if it is managed wholly or partially in India unlike the present law which limits a Foreign Corporation liable to tax only if the management and control are wholly in India (s.9 Income Tax Act, 1961). Further the DTC lays down a two-fold test for determining the Place of effective management under Schedule 10 of the code-

(i) The place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or

(ii) in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.”

In order to understand the true nature of the applicability of laws governing CFC’s, it is necessary to analyse the limitations of the provisions relating to its induction within the tax structure. Pursuant to the above definition of place of effective management, there should essentially be a bracket which categorises the term ‘ routinely’( clause ii) in such a manner that no further room for interpretation is left. This would check a series of litigation which may arise subsequently. Furthermore the code should specify the ambit of passive income such that there is no ambiguity to the jurisdiction in which such an income arises. There should also exist provisions which specifically limit the applicability to only passive income and does not affect active income. Another issue which arises is in the definition of a Controlled Foreign Income. The DTC should encompass within the meaning of a CFC, structured requisites for determining what would constitute a CFC. By doing so it would thus prevent persons from interpreting the term to their advantage and avoiding tax. Since the concept of CFC’s is not yet developed in India and since this is the first composite legislation governing the same, it lays a higher burden on the drafters to fully analyse the benefits and the limitations, thereby structuring the legislation by according well defined definitions, explanations, exceptions and its effect on the DTA Agreements which India shares with several foreign jurisdictions.

Over the years the developed countries have extensively advanced several principles relating to the taxation of CFC’s as a result of which there has come to exist a set of uniform global principles which have been adopted. A glance at some of the provisions under foreign jurisdictions and the proposal under the DTC makes it evident that India needs to make its law more comprehensive. Illustrating further, most jurisdictions have adopted the principle of determining ‘control’ under the control/ ownership test where a definite percentage is specified which determines if such a corporation could be subject as a Controlled Foreign Corporation. Secondly most of these jurisdictions follow the 50% Shareholder test according to which a Corporation is taxed as a CFC only if 50% of its shareholders are residents of India or have voting power comprising 50%. Such a threshold ensures that there are no two ways in interpreting the provision. Most countries which have adopted this regime do not impose these provisions on Corporations which have their residence in countries with a high tax rate. Therefore it can be inferred that as long as there is bona fide intention for not evading tax, the Corporation will not be taxed. Further, certain exemptions are also granted in favour of these corporations such as the application of the De minimis rule which is prevalent in the UK and the U.S. whereby an exemption is granted only when no part of the gross income of the corporation exceeds a specific limit under the governing laws. In the case of the United States the limit is specified as 1 million dollars.

It is pertinent to take into account that the Indian law still needs to develop a lot further before it has a fully functional system to tax CFC’s. First and foremost the Government should take into consideration the necessity for such legislation. The justification given by the Government for instituting such a provision is that there is a trend for outbound investments which is causing the Revenue to incur losses as it is not being able to tax these entities. However it is vital to understand that a fundamental difference exists between being an economy which has advanced to making outbound investments on a large scale and an economy which is progressively increasing its outbound investments. India today largely depends on inward flow of funds; therefore such legislation would be highly premature. Some considerations are needed to be taken by the Government which largely consists in determining the functioning of the Indian market. Rather than inducting a premature legislation the Government should study the market pattern for a few years such that it is in a position to frame proper laws applicable to the Indian markets than making regular amendments to such provisions. This would be highly ineffective and would lead to a series of unnecessary litigations. A consequent effect of such law would prevent Corporations having Holding Companies in India which would largely affect Mergers and Acquisitions made by Indian Residents.

Concluding, the Government needs to prioritise the needs of the Indian market which would enable the advancement of the Indian economy. Arguendo, the Government should not enact a legislation justifying it as precautionary if there exists no proper framework for its governance. This would entail hardship on a number of Companies which are trying to develop and expand. Therefore a thorough understanding is necessary not only at the domestic level but also the impact on an International platform. Only then can a proper legislation can be brought into effect.

Canada Trust Co.: GAAR and Canada

The supreme court of Canada had the opportunity to interpret the GAAR provisions in 2005 in two companion cases namely, Mathew v. Canada [2005] SCC 55 and The Queen v. Canada Trustco Mortgage Company [2005] SCC 54. In this post I shall discuss the Trustco case and in a subsequent post I shall discuss the recent ruling of the Canadian Supreme Court in Lipson v. Canada [2009] SCC 1 which interprets Trustco.


In Trustco the court laid down a three step test for invoking the GAAR provisons embodied u/s 245 of the Canadian Income Tax Act. These three steps can be simply put as under:

1. Whether there is a “tax benefit” arising from a “transaction” u/s 245(1) and 245(2)?

2. Whether the “transaction” is an “avoidance transaction” as under s. 245(3) i.e. the transaction is not being arranged primarily for bona fide purpose other than to obtain tax benefit?

3. Whether the avoidance transaction is abusive as u/s 245(4)

The court noted that all the three ingredients as stated above needs to be fulfilled before invoking the GAAR provisions. However, the question arises as to what is a tax benefit? What qualifies as an avoidance transaction? When is an avoidance transaction abusive? These questions are critical in understanding the scope and ambit of the GAAR provisions u/s 245.

Tax Benefit

A plain reading of S. 245(1) suggests that a “tax benefit” is one which leads to a “reduction, avoidance or deferral of tax” or “an increase in a refund of tax or other amount” paid under the Act. It seems fairly clear that the amount of “tax benefit” is inconsequential for the purposes of s. 245(1). In Trustco the court noted that inorder to determine whether there arises a “tax benefit” in a given transaction, the “alternative arrangement approach” can also be adopted. Simply put, suppose to achieve a desired business purpose, an enterprise has the option to adopt two distinct models say A and B. Now assume the enterprise adopts model B. Subsequently on a closer scrutiny it is found that if the enterprise had adopted model A instead of model B its tax incidence would have been higher. In such a case the enterprise can be said to have obtained a “tax benefit” as per the “alternative arrangement approach” test.

Avoidance Transaction

In my earlier post I had discussed avoidance transaction u/s 245(3) and stated that GAAR provisions are not attracted in a case where the transaction “may reasonably be considered to have been made for bona fide purposes”. The investigation u/s 245(3) proceeds on the assumption that a transaction can have both tax and non tax purpose. In trustco the court held that a transaction is deemed to be an “avoidance transaction” if its “primary purpose” is to obtain tax benefit (this is contrary to the “only purpose” approach as asserted in my previous post). It would be safe to conclude that this is the correct interpretation of S. 245(3).The ruling of the court also suggests that S. 245(3) is similar to “main purpose” test under the Indian Direct Tax Code.

Abusive Tax Avoidance

The scheme of the GAAR provisions suggests that an avoidance transaction can only be disregarded if it is abusive. In trustco the court stated that what amounts to an abusive tax avoidance is a mixed question of law and fact. In essence the court stated that if a transaction defeats the object and spirit of any of the provisions of the Income Tax Act read as a whole then it would qualify as an “abusive tax avoidance” transaction.

Burden of Proof

S. 114 of the Indian Direct Tax Code presumes that a transaction is undertaken for the “main purposes” of obtaining a tax benefit i.e. the burden of proof lies with the taxpayer to show otherwise. However, the case is slightly different under the Canadian GAAR provisions. In trustco the court noted that for test (1) and (2) the burden lies on the taxpayer whereas for test (3) the burden lies on the department/minister. Simply put, the taxpayer has to show that (a) there is no tax benefit obtained and (b) the transaction was not contemplated primarily for tax purposes. Whereas the department has to prove that the transaction was an abusive tax avoidance transaction i.e. if the existence of abusive tax avoidance is unclear the benefit of the doubt goes to the taxpayer. The Canadian GAAR provisions seems to be fairly well balanced in terms of the burden of both the parties unlike the DTC.


An overall reading of Trustco suggests that:

1. The objective of the GAAR provisions is to draw a line between legitimate tax minimization and abusive tax avoidance and to this extent the principles enunciated in Westminister are not wholly dead.

2. The GAAR provisions under the DTC are far wider than its Canadian counter part, in the sense that the DTC does not require an inquiry as to whether a tax avoidance is abusive or not. Once it is shown under the DTC that the “main purpose” of the transaction is to obtain a tax benefit, the transaction can be disregarded.

3. The GAAR provisions under the DTC are tilted in favour of the department as opposed to the Canadian provisions, which is fairly well balanced.

GAAR and Canada

In an earlier post I had discussed the GAAR provisions under the Direct tax code 2009. In this post I shall look into the GAAR provisions of Canada which is incorporated under S. 245 of the Canadian Income Tax Act (“Act). S. 245 of the Act was introduced with effect from 13 Sep 1988 as a response to the decision of the Canadian Supreme Court in Stubart Investments Limited v. The Queen ( [1984] CTC 294). In Stubart although the court rejected the traditional “strict interpretation” approach to the interpretation of tax statutes, it re affirmed the traditional approach adopted in C.I.R. v. Duke of Westminster ( [1936] AC 1 (HC)) that tax consequences should be based on the legal character of transactions and relationship regardless of their economic or commercial substance.

The relevant provisions of S. 245 of the Act read as under:


(2) [General anti-avoidance provision] Where a transaction is an

avoidance transaction, the tax consequences to a person shall be

determined as is reasonable in the circumstances in order to deny a tax

benefit that, but for this section, would result, directly or indirectly, from

that transaction or from a series of transactions that includes that

transaction.


(3) [Avoidance transaction] An avoidance transaction means any

transaction


(a) that, but for this section, would result, directly or indirectly, in a

tax benefit, unless the transaction may reasonably be considered to

have been undertaken or arranged primarily for bona fide purposes

other than to obtain the tax benefit; or


(b) that is part of a series of transactions, which series, but for this

section, would result, directly or indirectly, in a tax benefit, unless

the transaction may reasonably be considered to have been

undertaken or arranged primarily for bona fide purposes other than to

obtain the tax benefit.


(4) [Where s. (2) does not apply] For greater certainty, subsection (2)

does not apply to a transaction where it may reasonably be considered that

the transaction would not result directly or indirectly in a misuse of the

provisions of this Act or an abuse having regard to the provisions of this

Act, other than this section, read as a whole.


S. 245(3) stipulates the transactions which are deemed to be avoidance transactions for which consequences would follow as u/s S. 254(2) read with 245(5) [ S. 245(5) is not quoted above]. A Conjunctive reading of 245(3)(a) and 245(3)(b) suggests that an anti- avoidance transaction is one which is made “only” to obtain a tax benefit. More importantly, a literal interpretation of S. 245(4) would suggest that the other provisions of the Act have to be looked into before the GAAR provisions are invoked. In contrast S. 113(14), DTC, 2009 categorizes any transaction whose ‘main purpose’ is to obtain tax benefit as impermissible avoidance arrangement. Evidently, in this regard the GAAR provisions under the DTC are of wider import than S. 245 of the Canadian Income Tax Act. Further, S. 113 (14) (c) of the DTC stipulates that a transaction which “lacks commercial substance” in any manner may be deemed as impermissible avoidance arrangement. If one peruses S. 113 (17) of the DTC which defines the term “lacks Commercial substance” it would leave no iota of doubt that GAAR provisions under the DTC are far more wider than its Canadian counterpart. It is also worth noticing that the Canadian IT Act does not presume any transaction to be for the “main purpose” of obtaining a tax benefit unlike S. 114(1) in the DTC. However, all these points will need consideration at the backdrop of some leading cases.

In my next post I shall discuss some leading Canadian cases on this point and examine the practical application of S. 245 of the Canadian IT Act.

Review on taxation of Non-Profit Organisations under certain provisions of the Direct Tax Code

Through the years, Institutions and Trusts have received special privileges by the Indian Government in the form of deductions and exemptions. However with the advent of the Direct Tax Code, the Government seeks to decrease its leniency towards these Non-Profit Organisations. The first proposal under the Direct tax Code has been examined and revised to accommodate some of the concerns arising under them.
On the reading of the DTC, the clarity of the inclusive definition under ' charitable purposes' is hard to miss as they substantially alter the wider definitions under the existing Income Tax Act, 1961. The IT Act 1961, allowed a wider import to the terms used under the definition of charitable purpose. However the DTC on one hand seeks to restrict 'charitable purposes' to include relief to the poor, advancement of education, provisions for medical relief and on the other hand enhances the definition by including preservation of the environment, monuments; or places or objects of artistic or historical interest and advancement of any other object of general public utility. The implication of such a provision is that it will restrict the nature of NPO’s for specific purposes. In consonance with the wider definition under the prevailing law several NPO’s have been established for the general activities within the ambit of charitable purposes. Since the DTC specifies the scope of activities within the ambit of charitable purposes, several NGO’s will have to alter their nature. Such a specific inclusive definition will result in unnecessary hardship for several NPO’s and may result in confusion and trivial litigation on the interpretation of such restrictive terms. It is pertinent to note that unlike the Direct Tax Code, under the present Act, 'general public utility' includes any institution set up for promoting trade and commerce which is encompassed within the ambit of 'charitable purposes' as it is believed that such an activity promotes common good through enhancement of business. Such a restriction under the DTC will jeopardise the position of several such trusts and institutions as it seeks to completely prohibit “any activity in nature of trade, commerce or business or any activity of rendering any service in relation to any trade, commerce or business…irrespective of the nature of use, application or retention of the income from such activity”. In consonance with the strict application of the taxing structure, the DTC has laid the burden on these institutions to prove that all such charitable purposes are‘actually’carried out and that the beneficiaries are the general public. One of the effects of such an exacting liability will prevent any such trust or institution from avoiding tax and carrying out activities for its own profits and interests. However the other possible effect could be that under the existing law the NPO’s which are allowed to carry on incidental business will be liable to be taxed as gross receipts under the DTC even though the entire income may be used for charitable purposes. This proposition by the code would clearly invalidate the judgment of the Apex Court in CIT v. Thanthi Trust which recognises income from incidental business under section 11.

Under s.11 of the existing Act, NPO’s are allowed to maintain their surplus income and carry it forward to the succeeding years without limitations. The law also allows them to accumulate or set aside an income for a specific purpose. With a view of restraining such an accumulation over a determined period of time, the DTC proposes to allow either 15% of the surplus or 10% or gross receipts, whichever is higher, to be utilised within three years from the end of the relevant financial year. Such a provision can be viewed in two ways. Firstly it can be presumed that such a provision would enhance the functioning of the NPO’s so that they make use of the funds so received within a definite period of time thereby preventing the mischief under the existing law. On the flipside such a provision may prohibit certain NPO’s on utilising their funds for specific savings. Illustrating further, if an NPO which accumulates or sets aside a part of their surplus for future benefits would have to pay a tax of 15% on the same if such is not utilised within the period prescribed by the code. This would in effect limit the capability of the NPO in the advancement of its chosen sphere of charitable purpose. Certain savings made by NPO’s would also be in jeopardy as it would become liable to tax after a period of three years. The DTC has also clearly demarcated a prohibited form of investment for NPO’s, however without specifying the nature of such assets. For instance the code fails to specify the nature and scope of financial assets. Further it becomes pertinent to analyse whether the segregation of deductions available to donors under section 72 benefits the NPO’s more than the existing provision under s.35AC which provides for a 100% deduction. Segregation in deductions would create a difference in the capabilities of different NPO’s to provide deductions thereby preventing the capitalisation of funds at an equal footing.

It is necessary to understand that NPO's play a significant role in the aiding the society. Therefore it creates an even higher burden on the Government to implement changes which would create incentives for NPO's.Pursuant to the above observations it is necessary to determine which provisions would benefit the NPO’s and to what extent they would provide a better structure over the existing Act. In my opinion it is necessary to review the applicability of the proposed provisions by consulting existing NGO's so that it creates a balance between the tax code and its subsequent effect on these institutions and trusts.
For the benefit of comparative review, both the first proposal of the Direct Tax Code and the subsequent revised code has been attached.

Revised DTC and GAAR

The revised discussion paper on the Direct Tax Code proposes the following safeguards for invoking GAAR provisions:

i) The Central Board of Direct Taxes will issue guidelines to provide for the circumstances under which GAAR may be invoked.

ii) GAAR provisions will be invoked only in respect of an arrangement where tax avoidance is beyond a specified threshold limit.

iii) The forum of Dispute Resolution Panel (DRP) would be available where GAAR provisions are invoked.
 
I had earlier discussed GAAR provisions under the DTC here.

Revised DTC and FIIs

The Revised discussion paper on the Direct Tax Code is available here. The discussion paper proposes to characterize the income of FIIs arising from the sale and purchase of shares as "capital gains" (para 3.5). The rationale is based on the reasoning in Fidelity Northstar Fund. I have discussed fidelity here. I shall discuss the other aspects of the Revised Discussion paper in some later posts.

News Update: FIIs and Tax

Early reports on the second Direct Tax Code draft suggests that the income of Foreign Institutional Investors from sale and purchase of shares would be charged under the head "capital gains" (Courtsey: CNBC). In an earlier post on this blog I had discussed the issue of taxability of FIIs. I shall post my views on this issue once the draft code is available.

Direct Tax Code 2009 and GAAR

Although it is fairly well settled under the Indian tax jurisprudence that tax avoidance is legal but tax evasion is not, the dividing line between the two has always been extremely thin and blurred. In Mcdowell v. Commercial Tax officer [AIR 1986 SC 649], Justice Chinappa Reddy while delivering a minority opinion had further blurred the distinction between tax avoidance and tax evasion. However, a smaller bench of the Supreme court in Azadi Bachao Andolan [(2003) 263 ITR 706] correctly did not endorse the minority view in Mcdowell, holding clearly that a man has every right to structure his business in a manner that would reduce his tax liability. Having said that in my humble view Azadi may be per incuriam as in Mcdowell, interestingly the majority might have concurred with some of the findings of Justice Chinnappa Reddy (para. 26&27 of the Mcdowell Judgement is relevant) making the latter a binding precedent.


It is widely believed that both the decisions would be rendered inconsequential if the provisions relating to the General Anti Avoidance Rules (GAAR) as incorporated in the Direct Tax Code Bill, 2009 are brought into force. In this post I shall discuss some of the provisions relating to GAAR in the Direct Tax Code and in some later posts I shall also look into the provisions of GAAR as it exists in some matured jurisdictions such as Canada, Britain, France etc.

The intent of incorporating the GAAR can be best explained by the relying on the discussion paper released by the department last year. The following remarks from the paper may be relevant:

24.1 Tax avoidance, like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner…………………….there is a strong general presumption in the literature on tax policy that all tax avoidance, like tax evasion, is economically undesirable and inequitable. On considerations of economic efficiency and fiscal justice, a taxpayer should not be allowed to use legal constructions or transactions to violate horizontal equity.



The intent echoes the sentiment of Justice Chinappa Reddy in Mcdowells and is in line with the aggressive tax policy undertaken by the department in recent times [See Generally: Geoffrey T. Loomer, The Vodafone Essar Dispute: Inadequate Tax Principles Create Difficult Choices For India, 21(1) NLSI. Rev. 89 (2009)] . Although the intent may be questionable or noble, the actual provisions relating to GAAR seems to be untenable.



S. 112(1) stipulates that the revenue may declare “any arrangement as an impermissible avoidance arrangement”. At first blush this clause seems to be very wide and gives blatant discretionary powers to the revenue. S. 112 not only empowers the revenue to declare “any” arrangement as impermissible but also gives it the power to disregard the arrangement, treat the parties who are connected to each other as one and the same person, re-characterising any equity into debt or vice versa and so on. Further, S. 113 (14) defines impermissible avoidance arrangement as under:


“impermissible avoidance arrangement means a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit and it,-

(a) creates rights, or obligations, which would not normally be created between persons dealing at arm's length;

(b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Code;

(c) lacks commercial substance, in whole or in part; or

(d) is entered into, or carried out, by means, or in a manner, which would not

normally be employed for bonafide purposes;

Conventional wisdom would suggest that S. 113 (14) imposes a limitation on the word “any” in S. 112 i.e. to say that the GAAR only gets triggered when the ingredients of S. 113 (14) are satisfied in a given case. But the interpretation can also be that S. 113 (14) is not exhaustive and the revenue may treat “any” other transaction as an impermissible avoidance arrangement even though it might not expressly fall within the ambit of S. 113(14). The discussion paper supports the former interpretation i.e. S. 113(14) imposes a restriction on the word “any” in S. 112. This interpretation is however rendered meaningless if one refers to S. 114 (1) which stipulates that an arrangement shall be presumed to have been entered for the main purpose of obtaining a tax benefit unless the contrary is shown by the person obtaining such a benefit. The effect of S. 114 (1) is fairly simple; the revenue might deem “any” arrangement to be for the main purpose of obtaining a tax benefit and if the assesse is unable to prove anything to the contrary the revenue would then be free to undertake the consequences as laid down in S. 112 even if the ingredients of S. 113 (14) are not expressly met.

Readers may also refer to a post written by Mihir here.