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FinXpress : Special Edition 2.0

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FinXpress

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December 2012

INSTITUTE OF MANAGEMENT TECHNOLOGY, GHAZIABAD


General Anti Avoidance Rules (GAAR) Definition GAAR is a concept which generally empowers the Revenue Authorities in a country to deny the tax benefits of transactions or arrangements which do not have any commercial substance or consideration other than achieving the tax benefit. Whenever revenue authorities question such transactions, there is a conflict with the tax payers. Thus, different countries started making rules so that tax cannot be avoided by such transactions. Australia introduced such rules way back in 1981. Later on countries like Germany, France, Canada, New Zealand, South Africa etc too opted for GAAR. However, countries like USA and UK have adopted a cautious approach and have not been aggressive in this regard. Thus, in nutshell we can say that GAAR usually consists of a set of broad rules which are based on general principles to check the potential avoidance of the tax in general, in a form which cannot be predicted and thus cannot be provided at the time when it is legislated.

Difference between GAAR and SAAR Anti Avoidance Rules are broadly divided into two categories namely "General" and "Specific".

Thus,

legislation dealing with ‘General’ rules is termed as GAAR, whereas legislation dealing with ‘Specific’ avoidance is termed as SAAR. In India till recently SAAR was in vogue i.e. laws were amended to plug specific loopholes as and when they were noticed or were misused en-masse. However, now Indian tax authorities wants to move towards GAAR but are facing severe opposition as tax payers fear that these will be misused by tax authorities by giving arbitrary and wide interpretations. We can say that SAAR being more specific provides certainty to taxpayers where as GAAR being general in nature can be misused and is subject to arbitrary interpretation by tax authorities.

GAAR in India In India, the real discussions on GAAR came to light with the release of draft Direct Taxes Code Bill (popularly known as DTC 2009) on 12th August 2009. It contained the provisions for GAAR. Later on the revised Discussion Paper was released in June 2010, followed by tabling in the Parliament on 30th August, 2010, a formal Bill to enact the law known as the Direct Taxes Code 2010. The same was to be made applicable wef 1st April, 2012. However, owing to negative pressures from various groups, GAAR was postponed to at least 2013, and was likely to be introduced along with the DTC from 1st April 2013. Moreover, an Expert Committee has been set by Prime Minister Manmohan Singh in July 2012 to vet and rework the GAAR guidelines issued in June 2012. The latest reports (September 2012) indicates, it may not be implemented even for 3 years i.e. this will be postponed for 3 years (2016-17).

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Implications It empowers officials to deny the tax benefits on transactions or arrangements which do not have any commercial substance or consideration other than achieving tax benefit. It contains a provision allowing the government to retroactively tax overseas deals involving local assets (like Vodafone).

Will P-Notes be targeted? Investments into Indian stock markets through participatory notes might slow after the introduction of GAAR. According to data from market regulator SEBI, P-notes issuance reached Rs. 1.83 trillion at the end of February, about 16.4% of total assets under the foreign investor inflow scheme. P-Notes are instruments used by investors or hedge funds that are not registered with the SEBI to invest in Indian securities and they offer the buyer anonymity. The tax would be imposed on the registered financial firm buying the security on behalf of the client, meaning the brokerage would then pass on the taxes to the end investor. To avoid tax altogether under GAAR, an investor may now have to prove the P-note was not set up specifically to avoid paying taxes or to prove that the deal has commercial substance.

What happens to the Mauritius route? GAAR could give powers to the tax department to deny double taxation treaty benefits to foreign funds based out of tax-havens like Mauritius. India has a Double Taxation Avoidance Agreement with Mauritius. Overseas portfolio investors, routing their investments via countries like Mauritius, currently do not pay any tax on short-term capital gains. If GAAR is implemented, FIIs domiciled in such treaty locations may have to prove that they have created this structure for genuine business purposes and not just for avoidance of tax.

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Recent developments regarding GAAR (a) 16th March, 2012: Finance Minister, Pranab Mukherjee takes a tough stand and announces that the government will crack down on tax avoidance effective from fiscal year 2012-13. (b) 7th May, 2012: Finance Minister, Pranab Mukherjee forced to eat his words and agreed to defer GAAR by a year as his announcements spooked overseas investors. (c) 28th June, 2012: Finance Ministry releases first draft on GAAR; there is wide criticism of the provisions. (d) 14th July, 2012: PM, Manmohan Singh, forms review committee under Parthasarathi Shome, for preparing a second draft by 31st August and final guidelines by 30th September, 2012. (e) 1st September, 2012: Shome Committee recommends deferring GAAR by three years.

It also

recommends some more investor friendly measures. (f) 1st October 2012: Finance Ministry says the final guidelines for GAAR to be issued by October 2012 end. (g) 17th November 2012: Finance Ministry says the final amendments to GAAR has been finalised.

What is the Basic Criticism of GAAR? Why GAAR is dreaded? Many provisions of GAAR have been criticised by various people. However, the basic criticism of GAAR provisions is that it is considered to be too sweeping in nature and there was a fear (considering poor record of IT authorities in India) that Assessing Officers will apply these provisions in a routine manner (or read misuse) and harass the general honest tax payer too. There is only a fine distinction between Tax Avoidance and Tax Mitigation, as any arrangement to obtain a tax benefit can be considered as an impermissible avoidance arrangement by the assessing officer.

Thus, there was a hue and cry to put

checks and balances in place to avoid arbitrary application of the provisions by the assessing authorities. It was felt that there is a need for further legislative and administrative safeguards and at least a minimum threshold limit for invoking GAAR should be introduced so that small time tax payers are not harassed.

Examples to Understand GAAR provisions Example 1: Fact: A business sets up an undertaking in an under developed area by putting in substantial investment of capital, carries out manufacturing activities therein and claims a tax deduction on sale of such production/manufacturing. Is GAAR applicable in such a case? Interpretation: There is an arrangement and one of the main purposes is a tax benefit. However, this is a case of tax mitigation where the tax payer is taking advantage of a fiscal incentive offered to him by submitting to the conditions and economic consequences of the provisions in the legislation e.g., setting up the business only in the under developed area. Revenue would not invoke GAAR as regards this arrangement.

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Example 2: Fact: A business sets up a factory for manufacturing in an under developed tax exempt area. It then diverts its production from other connected manufacturing units and shows the same as manufactured in the tax exempt unit (while doing only process of packaging there). Is GAAR applicable in such a case? Interpretation: There is an arrangement and there is a tax benefit. The transaction lacks commercial substance and there is misuse of the tax provisions. Revenue would invoke GAAR as regards this arrangement.

Shome Committee: Deferment of GAAR by 3 years and more investor friendly measures By recommending that it should apply only to cases where tax benefit is the main objective of an arrangement or transaction and not one of the main objectives, the Committee has taken the sting out of GAAR as originally envisaged. Rarely, if ever, can tax authorities prove conclusively that obtaining tax benefit was the main objective of an arrangement or transaction. The Committee’s report should also warm the hearts of foreign investors routing funds into India through sham companies based in Mauritius — it has explicitly stated that “GAAR provisions shall not apply to examine the genuineness of the residency of an entity set up in Mauritius”. In other words, a Tax Residency Certificate from Mauritius is enough to override GAAR provisions. This kills one of the most laudable objectives of the rules as envisaged in the Budget — that of plugging a loophole which foreign institutional investors exploited to avoid paying capital gains tax in India.

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Fiscal Cliff

“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron's, over 1,000 government programs - including the defence budget and Medicare are in line for "deep, automatic cuts."

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In dealing with the fiscal cliff, U.S. lawmakers have a choice among three options, none of which are particularly attractive:

They can let the current policy scheduled for the beginning of 2013 – which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession – go into effect. The plus side: the deficit, as a percentage of GDP, would be cut in half.

They can cancel some or all of the scheduled tax increases and spending cuts, which would add to the deficit and increase the odds that the United States could face a crisis similar to that which is occurring in Europe. The flip side of this, of course, is that the United States' debt will continue to grow.

They could take a middle course, opting for an approach that would address the budget issues to a limited extent, but that would have a more modest impact on growth.

Can a Compromise be reached? The oncoming fiscal cliff is a concern for investors since the highly partisan nature of the current political environment could make a compromise difficult to reach. This problem isn’t new, after all: lawmakers have had three years to address this issue, but Congress – mired in political gridlock – has largely put off the search for a solution rather than seeking to solve the problem directly. Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve and there's a strong possibility that Congress won't act until the eleventh hour. Another potential obstacle is that the next Congress won't be sworn in until January 3. The most likely result is another set of stop-gap measures that would delay a more permanent policy change until 2013 or later. Nevertheless, the non-partisan Congressional Budget Office (CBO) estimates that if Congress takes the middle ground – extending the Bush-era tax cuts but cancelling the automatic spending cuts – the result, in the short term, would be modest growth but no major economic hit.

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What's in House Speaker John Boehner's New Fiscal Cliff Proposal? House Republicans, rejecting President Barack Obama’s demand for higher tax rates, countered with a $2.2 trillion deficit-cutting plan that would trim Medicare and Social Security and cap tax deductions for top earners.

The proposal, in a letter on Tuesday to Obama from House Speaker John Boehner and other Republican leaders, seeks $800 billion in tax revenue in the next decade and would slow the growth in Social Security cost-of-living payments. It would reduce entitlement program costs by at least $900 billion, including raising the Medicare eligibility age, and cut $300 billion in discretionary spending. The talks reached a stalemate late last week when Republicans rejected Obama’s proposal to raise $1.6 trillion in taxes, including by raising tax rates on the top 2 percent of earners.

It's important to keep in mind that while the term “cliff” indicates an immediate disaster at the beginning of 2013, the impact of the changes - while destructive over a full year - will be gradual at first. What's more, Congress can act to change laws retroactively after the deadline. As a result, the fiscal cliff won't necessarily be an impediment to growth even if Congress doesn't address the issue until after 2013 has already begun.

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FinXpress Special Edition 2.0  

General Anti Avoidance Rules & Fiscal Cliff

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