This year's budget was disappointing, even unpleasant, for many industries, but no tax rule has caused as much disquiet as the General Anti-Avoidance Rules (GAAR). As the term suggests, GAAR is aimed at curbing tax avoidance by say, structuring a business or effecting a transaction so as to minimise the liability.
A shining example would be the creation of a shell-holding company in a tax-friendly country like Mauritius to invest in India. GAAR empowers tax authorities to separate transactions aimed at avoiding tax from the ones driven by commercial consideration.
For its part, the government says the move is not aimed at maximising tax revenues but plugging tax leakages. It intends to have in place a "substance over form" doctrine to determine mischief.
The Need :
Truth be told, efforts to lower tax liability are rampant. An often quoted example is investment in windmills. Investors in windmills can claim 100% deduction as depreciation in the first year. The intent was to promote clean energy. But the real motive has become lowering of the tax outgo.
Similarly, many multinational companies operating in India have routed their investment through Mauritius. While there is no wrong in having a holding company there, it often turns out to be a shell company. The arrangement exploits the loopholes in the double tax avoidance treaty that India has with Mauritius. The government believes GAAR will end all this.
The Fear : General
Though the opposition to GAAR is muted, the wording of the law is giving taxpayers and professionals nightmares. For one, the scope of the law is very wide. Sudhir Kapadia, national tax leader, Ernst & Young, says the problem is that "we don't know the instances under which GAAR would be invoked".
Equally worrying is the sweeping powers bestowed on tax officers. They can question any transaction, even legitimate deductions, say experts. The powers are omnibus, says NC Hegde, partner at Deloitte, Haskins & Sells. For instance, the tax department can accuse companies of setting up shop in underdeveloped areas solely to claim a tax deduction. Never mind that tax is counted as one of the costs of doing business.
The Fear in Foreign Companies :
Foreign investors with a holding company in a tax-friendly country are concerned how the Indian tax department will define commercial presence. Normally, if the holding company is doing business in the country of incorporation, has a board of directors that meets in that country and has a predefined threshold turnover, it would satisfy conditions of commercial presence. Mauritius has in recent years become more transparent. It remains to be seen if that is enough to satisfy Indian authorities.
The Fear in Indian MNCs:
Indian companies expanding overseas too have reasons to be worried. Most set up a holding company outside India and will have many offshoots. A holding company overseas may also enable easier access to cheap overseas borrowings. Subsidiary operating companies may pay dividends to the holding company, which it may not transfer to the Indian parent, as that money could be ploughed into other overseas activities. Under GAAR, tax authorities could rule that the Indian parent did not bring the dividend to India to avoid paying taxes.
The Fear in Domestic Companies:
GAAR can prove tricky for domestic companies too, and many of their transactions, done in the normal course of business, can be questioned and tax benefit disallowed.
Take for instance the merger of a loss-making company into a profit-making one. On merger, losses would offset profits and the lower net profit, if any, would mean substantially lower tax liability for the company. The merger may have been driven by pure commercial considerations, better integration of operations or to ensure the loss-making company does not shut down, but tax department can claim it was a tactic to avoid taxes.
In another situation, a company can choose between leasing an asset and purchasing the same. On a leased asset, it can claim deduction on lease rental while on an asset that was bought, it can claim depreciation. Disputes can arise on leasing versus buying.
Likewise, a company can be asked why it raised funds through borrowing when it could have issued equity. On borrowings, a company can claim deduction on interest paid. Both decisions depend on what is more beneficial for the company.
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