Much ado about GAAR

There has been a huge hue and cry in the country over the decision of the ministry of finance to enforce a General Anti-Avoidance Rule (GAAR) aimed at curbing both, the avoidance as well as the evasion of taxes by foreign investors. Many foreign investors route their investments to India through tax havens like Mauritius and Singapore, countries that either do not levy certain taxes, such as capital gains tax (or a tax on profits earned by transacting in financial instruments like shares), or levy very low rates of income tax.

On account of the controversy generated, the government buckled under pressure from influential lobbies to postpone the implementation of the GAAR till the coming financial year i.e. April 1, 2013 onwards. There is a big debate currently raging about the fine print of the GAAR which is unlikely to conclude in a hurry. The UPA government headed by Prime Minister Manmohan Singh, who is also the finance minister at present, appears rather keen to placate foreign investors at a time when the double-dip recession is playing havoc with economies across the world. But by postponing the enforcement of the GAAR, the government is merely delaying the inevitable. But first, the GAAR needs to be demystified.

The proposal to introduce GAAR was mentioned in the Direct Taxes Code (DTC) presented in Parliament on August 30, 2010. The backdrop to the rule was that foreign institutional investors (or FIIs who invest in stocks and shares) as well as corporate entities who bring in foreign direct investment (FDI) used tax havens to route their investments into the country, thereby depriving the Indian exchequer of its share of taxes.

The finance ministry’s “white paper on black money” tabled in Parliament on May 21, 2012, observed that Mauritius and Singapore together accounted for over half the cumulative inflows of foreign investments in the country over the last decade or so. “Mauritius and Singapore, with their small economies, cannot be the sources of such huge investments and it is apparent that the investments are routed through these jurisdictions for avoidance of taxes and/or for concealing the identi- ties from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, through a process known as round tripping,” the finance ministry’s paper noted.

India is hardly unique in wanting to enforce GAAR. For some time now and especially in the wake of the ongoing worldwide recession, there has been a major debate across the world on the fine distinction that is often sought to be drawn by smart lawyers and accountants between tax “avoidance” and tax “evasion”. Over the years, the term “tax avoidance” has come to signify the arranging of affairs with the main motive of obtaining a tax advantage while prima facie fully intending to comply with the law. The phrase prime facie (or, at first glance) is important, for “tax avoidance” is used to describe every attempt by legal means to prevent or reduce tax liability, which would be otherwise incurred, by taking advantage of some provision or lack of provision in extant laws.

Here is what the DTC stated: “Tax avoidance like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner.”

During recent G20 meetings, there has been considerable consternation about the way tax havens operate. India’s Prime Minister has been party to these discussions. Yet his government has done little or nothing to check the inflow of funds through tax havens. What is worse, the finance ministry has stubbornly refused to curb the use of participatory notes (PNs) — offshore financial instruments that conceal the source of funds invested by FIIs in stock exchanges — heightening suspicion that these derivative instruments have been and continue to be widely misused to launder illegal money and bring slush funds into the country.

FIIs issue PNs against underlying shares and securities that can be traded by individuals or firms who are not legally entitled to buy or sell shares in Indian stock markets. The crux of the problem lies in identifying the “real” and “final” beneficiaries of transactions using PNs. Company A could be controlled by Company B which, in turn, could be controlled by Company C in a country over which the Indian government has no jurisdiction. The problem arises when Company C is controlled by the infamous D Company!

Technically, the Securities and Exchange Board of India (Sebi) is supposed to regulate such transactions and establish an “audit trail” of beneficiaries, but it rarely does so. The real beneficiaries of these transactions have engaged smart corporate lawyers who are adept at “slicing” and “splicing” these financial instruments in complex ways to conceal their identities.

The day before the proposal to introduce GAAR as part of the Finance Bill was passed by Parliament, on May 7, the then finance minister Pranab Mukherjee succumbed to pressure and postponed the implementation of the rule to the next fiscal year and, importantly, removed the onus of proving tax avoidance from the taxpayer to the revenue authorities. He set up a committee to provide “greater clarity and certainty” on the GAAR. A discussion note on the GAAR has now been made public on which comments have been invited. The final rule should hopefully clarify the language now considered by some to be ambiguous.

On the retrospective “clarificatory” amendment to the Income Tax Act in the context of the Vodafone case, Mr Mukherjee said the changes proposed will not override the provisions of different double-tax avoidance treaties that India has signed with 82 countries and will also not be used to reopen cases where assessment orders have already been finalised.

So where’s the problem? The government, it seems, is neither keen on tightening rules governing investments through tax havens nor in curbing the use of opaque offshore financial instruments like participatory notes that are misused for money-laundering. The draft guidelines of the GAAR state that non-resident investors of FIIs will be exempt from the rule and that those FIIs not opting for treaty benefits and who are ready to pay taxes will not come under the GAAR.

The hullabaloo over the GAAR seems to be an instance of much ado about little. The writer is an educator

and commentator