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Tuesday, May 1, 2012

Why FIIs are not going ga-ga over GAAR

What is GAAR, and why are FIIs so concerned about it? The General Anti-avoidance Rules (GAAR) are being introduced as part of the proposed Direct Tax Code 2010 (DTC 2010). Introduction of DTC 2010 is part of the tax reforms process that is expected to level the playing field for different categories of tax payers, and plug some of the loopholes through which tax revenues are vanishing.

There is a fine line between avoiding taxes and evading taxes. Proper tax planning using permitted provisions in the tax laws can lead to legal avoidance of taxes. Holding equity shares of companies for more than a year before selling them for a profit to avoid paying capital gains tax, or selling a piece of land and investing the proceeds in Capital Gains tax bonds are examples of legal tax avoidance. GAAR provisions will not apply to such transactions.

Blatant tax evasion - by hiding income from tax authorities or not paying adequate amount of excise duty by bribing excise inspectors or mis-labelling finished products as manufacturing waste - is punishable under current laws. GAAR provisions are not meant for such instances either.

GAAR is likely to prevent ‘aggressive’ tax avoidance measures that entail transactions which can not be classified as ‘normal business transactions’. In other words, if a transaction is entered into solely for the purpose of gaining a tax benefit and that transaction would not normally occur as part of the day-to-day business activities, then the Commissioner of Income Taxes (CIT) may invoke GAAR.

That seems to be a perfectly rational step in tax reforms. There is too much avoidance and too little compliance – as can be observed from the amount of taxes (not) paid by many entrepreneurs and well-known business houses. Also, several countries already have GAAR. So, why are FIIs so concerned about GAAR in India?

It is mainly because of the ambiguity in the provisions that may allow tax authorities to treat all tax planning efforts as something devious and slap penalties by attributing motives where none may exist. The onus is on the tax payer to first pay and then prove his innocence. Even after proving his innocence, he has to pay a bribe to get a refund. A murderer or rapist is considered innocent unless he is proven guilty!

More than the CIT’s power in invoking GAAR, FIIs are concerned about the retrospective application of GAAR. Tax cases that have already been decided in a tax payer’s favour or have become time-barred under present tax laws, can become subject to GAAR.

Last, but not the least, is the concern that transactions routed through Mauritius, with whom India has a Double Taxation Avoidance treaty, can become taxable under GAAR. Country to country treaties are covered under the Vienna Convention worldwide, and application of GAAR may violate the treaty. The treaty may need to be amended before application of GAAR.

The Finance Ministry have met a few times with different FIIs to explain that only ‘Post Office Box Number’ type Mauritius entities will be affected, and not genuine FIIs with a real business presence in that island country. But without any clear cut written law, FIIs are unsure whether they will be called upon to pay huge amounts of back taxes. This is one of the main reasons that FIIs had turned net sellers in April.

Hopefully, in the forthcoming session in Parliament the GAAR provisions will become law with the FII concerns clearly addressed. That would be a positive trigger for the stock markets.

(Note: I’m not a tax expert. The views are based on my understanding of the current situation.)

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