India’s Finance Minister announced on January 14, 2013 that the Government of India would adopt a majority of the recommendations of the committee constituted to review India’s pending income tax anti-avoidance rule. The committee’s recommendations, summarized in a previous Jones Day Commentary, “ Recommendations of the Expert Committee on the Indian General Anti-Avoidance Rule: A Welcome Step,” dated September 2012, are likely to be included in the forthcoming 2013 Budget, which will be debated in Parliament in late February 2013.

Background

India’s Finance Act, 2012 (the “Act”) inserted into the Indian Income Tax Act a general anti-avoidance rule (the “GAAR”) permitting the Indian Revenue Service to disregard, in assessing a taxpayer’s liability, any agreement, structure, or device (referred to in the Act as an “arrangement”) employed not for bona fide commercial reasons but rather “to obtain, directly or indirectly, a tax benefit.”1 The GAAR was intended to be effective from April 1, 2014.

The GAAR attracted strong opposition from Indian businesses, foreign investors, and even select foreign governments, such as the Government of Mauritius, which argued that the GAAR would violate benefits secured under that country’s tax treaty with India. Consequently, Prime Minister Manmohan Singh constituted an Expert Committee under the leadership of Dr. Parthasarathi Shome (the “Shome Committee”) to review the GAAR and make recommendations for its modification and application.

The resulting draft report was first released for comment on August 31, 2012,2 and was received favorably by investors. After considering feedback from investors and others, the Shome Committee submitted its final report to the Government on September 30, 2012 (the “Shome Committee Report”), which was released to the public on January 14, 2013.

The Finance Minister’s Statement

Speaking on behalf of the Cabinet as a whole, the Finance Minister announced on January 14 that the Government “accepted the major recommendations of the Expert Committee.”3 Some of the key reforms are as follows:

1. Implementation of GAAR: The effective date for implementation of the GAAR will be pushed back by two years to April 1, 2016.

2. Primary Purpose Test: Only arrangements, “the main purpose of which is to obtain a tax benefit,” will be subject to the GAAR. The Act had provided that it would suffice for a tax benefit to be “one of the main purposes” of a targeted arrangement.

3. Grandfathering of Investments: Investments made before August 30, 2010 will be exempt from the GAAR. This reflects only partial acceptance of the Shome Committee’s recommendation that all investments predating the implementation of the GAAR be grandfathered.

4. Non-Application of GAAR: The GAAR will not apply in a range of specified situations, such as:

  • Where the tax benefit resulting from an arrangement is less than INR 30 million (approximately US$550,000);
  • To a foreign institutional investor, where such investor elects not to claim benefits under a dual tax avoidance treaty, and to nonresident investors in such foreign institutional investor; and
  • Where a specific anti-avoidance rule applies and the application of the GAAR would result in a duplicative penalty (e.g., in cases involving divided stripping or bonus stripping).

5. Procedural Protections Under GAAR: The Act provides that taxpayers subject to the GAAR would be provided with (i) notice and (ii) an opportunity to prove, first before the Commissioner and then before a reviewing Approving Panel, that the challenged arrangement had a bona fide purpose unrelated to the resulting tax benefit. The Government has committed that a majority of the Approving Panel will be independent of the Indian Revenue Service. While one of the Approving Panel’s three members will be a Chief Commissioner of Income Tax, the remaining two will be a retired judge and an “academic or scholar,” respectively.

6. Indicia of Purpose for Applicability of GAAR: The Act provides that three factors “shall not be taken into account” in determining whether an arrangement violates the GAAR: (i) the period for which the arrangement existed; (ii) that taxes were paid under the arrangement; and (iii) that the arrangement contains an exit mechanism. The Government will amend the act to allow the Approving Panel to “have regard to” the foregoing factors, but these factors will not be “sufficient to determine whether an arrangement is an impermissible avoidance arrangement.” Because the burden of proof in challenging a GAAR determination is on the taxpayer, it may be on balance preferable to the taxpayer that the Approving Panel consider as much evidence on the nature of the challenged arrangement as possible.

The Finance Minister’s statement also set out certain principles that will be incorporated in future regulations. Notably, (i) the GAAR will apply only to the “the tax consequence of that part” of an arrangement targeted at avoiding taxes, and not the arrangement as a whole, and (ii) the Indian Revenue Service will be obliged to “ensure that the same income is not taxed twice in the hands of the same taxpayer,” whether in a single year or across multiple tax years. It goes without saying that the value of those very general commitments will be proved only in the details of their implementation.

Open Issues

While the Finance Minister indicated that the Government had accepted the Shome Committee’s “major recommendations,” the specifics of his statement omitted to mention several significant issues raised in the Shome Committee Report. Among these are the report’s recommendations that the short-term capital gains tax be abolished and that certain arrangements contemplated by other legislation be expressly excluded from the GAAR, regardless of the motive for their use. Such exempt arrangements would have included: a company’s choice between paying dividends and buying back its shares; a company’s choice of a debt or equity-weighted capital structure; and a company’s decision to lease rather than purchase a capital asset. The Finance Minister also failed to address the continuing validity of Direct Taxes Circular No. 789,4 which provides that the Indian Revenue Service will not challenge the veracity of a validly issued Mauritian tax residency certificate.5 It is not yet clear whether these unaddressed recommendations have been rejected by the Government or whether the Government is still considering their adoption in the 2013 Budget or through future legislation.

Conclusion

While the Finance Minister’s statement was not an unconditional embrace of the Shome Committee Report, it does indicate that the Government will significantly leaven the application of the GAAR as contemplated in the Act. Moreover, the Finance Minister’s announcement comes as part of a series of announced measures, including reforms of the banking and insurance sectors, aimed at accomplishing the “immediate priority of the Government … to keep the investment cycle going.”6 Investors should be cautiously optimistic that, at a minimum, the announced reforms to the GAAR will soon be passed into law.

Footnotes

1 Finance Act, 2012, Section 41. See “ Impact of the Indian Finance Bill 2012 on Foreign Investment in India,” Jones Day Commentary, May 2012.

2 Final Report of the Expert Committee on General Anti-Avoidance Rules (GAAR) in the Income Tax Act, 1961 (2012), available h ere. See “Recommendations of the Expert Committee on the Indian General Anti-Avoidance Rule: A Welcome Step,” Jones Day Commentary, September 2012.

3 Press Information Bureau of the Government of India, “Major Recommendations of Expert Committee on GAAR Accepted,” January 14, 2013, available here.

4 Central Board of Direct Taxes, Circular No. 789 (April 13, 2000).

5 According to Indian Government statistics, close to 40 percent of foreign direct investment in India between 2000 and 2011 was routed through Mauritius, the result of a favorable tax treaty between the two countries. See Department of Industrial Policy & Promotion, “Fact Sheet on Foreign Direct Investment,” December 2011, available here.

6 Press Information Bureau of the Government of India, “Immediate Priority of the Government is to Keep the Investment Cycle Going: Foreign Minister,” January 7, 2013, available here.