Understanding The GAAR Effect

It has now been more than two months after the elections got over. And while the voting mark of the same is about to vanish from the voters’ hands, the expectations from the government have already gone askew. A month after the election process commenced there came the Union Budget which lacked the much-needed reforms which could have revived the economy and brought growth back on track. The policy-paralysed government gave nothing to cheer about in the budget and merely pushed the scenario in an even more chaotic state. Meanwhile, an announcement about the General Anti-Avoidance Agreement (GAAR) in the Union Budget 2012 led to panic among investors.

GAAR has been hitting the headlines with regular frequency in recent times. However, investors still lack basic informative knowledge about the same. We usually hear or read that GAAR implementation will have a negative impact on the market but do we know how? In this article we have tried to explain the impact of GAAR in simple terms for our readers.

GAAR is a simple rule which allows the Indian tax authorities to levy tax if the arrangement or transactions done are ‘impermissible avoidance arrangements’. The term ‘impermissible avoidance arrangements’ comprises two tests: the first one is the main purpose test and the second is the specified condition test. The main purpose test is to obtain tax benefit. And in addition to the first condition, there is a specified condition test which must satisfy any one or more of the following four conditions:

1. There has been misuse or abuse of the provisions or
2. The transaction or agreement is non-arms length or
3. The transaction or agreement is not bonafide or
4. The transaction or agreement lacks commercial substance.

In simple terms, the above points mean that one should not get into any agreement for which the main purpose is to obtain tax benefit. For example, many of the companies are now getting converting into limited liability partnership (LLP) where there are tax benefits like lower tax rate, absence of dividend distribution tax and minimum alternative tax (MAT), etc. Hence, companies that have converted into LLP might face adverse consequences if the arrangement is not for bonafide (true faith, authentic) commercial purpose. Therefore the burden of proof would lie on the tax payer.

The Finance Bill has provided very little guidance as to what the misuse and abuse of the provisions mean. For example, it could be considered as cross-border mergers wherein foreign companies take over Indian companies for tax benefits or vice versa. This may be considered as an exposure to GAAR. Hence, proper business rationale and proof should be documented to avoid any such situation.

A transaction or agreement is known as arm’s length when buyers and sellers trade considering their own self interest. Both should be an independent entity and should have no relation with each other. For example, if a parent company has made any transaction with its subsidiary firm resulting into avoidance of tax, this would be considered exposure to GAAR risk.

Further, under the provisions of GAAR no clear definition of commercial substance has been provided which further gives unrestricted powers to the tax authorities to interpret the term, resulting into a losing situation for the tax payers. The proposed GAAR provisions in the budget are not clear about whether the structured set-ups before March 31, 2012 are exempt from the provisions.

The provisions made under GAAR still do not have much clarity but may impact many companies. This has led to creating negative sentiments in the environment. Foreign institutional investors, which were the net buyers in the initial months of 2012, are now being the sellers as there is still high uncertainty about their investments. There is also news in the market that the investments made through the Mauritius route might also come under the eyes of the GAAR.

Every new and better provision or clause must work towards benefitting the economy. But the government should also keep in mind that to tax almost each and every thing to bulge its own pockets is not the right approach. Readers must note that this is just an initial study of GAAR and an endeavour to help the investor community understand the more complex and intricate details that could affect the markets. As time goes by, we shall attempt to further simplify such complex laws and rules and present it to our readers in a simple-to-understand format.

(Source: KPMG and Nishith Desai Associates)