Roneil Prasad: GAAR and the question of ‘commercial substance’
Experience from Australia and New Zealand shows that these rules do not give a tax authority a carte blanche to attack tax arrangements that it does not like
The Narendra Modi administration’s high-octane economic charge will be widely welcomed but, perhaps tax policy discretion will indeed be the better part of valour. One of the major bugbears will be the coming into effect of the General Anti-Avoidance Rules (GAAR) in 2016. India’s nascent GAAR has already created considerable uncertainty, primarily for the somewhat uncertain nature of this legislation. Yet this is merely the tip of the tax iceberg. India is a relative latecomer to the GAAR game. It is about to traverse an even more tumultuous journey that has been well travelled in Australia (since at least 1936) and generate considerable arguments along the way.
A couple of worrying trends have been noted in the Indian media on the interpretation of GAAR. The first one is how GAAR is often confused with tax evasion. Both are conceptually different.
Tax evasion arises where the taxpayer is fully aware that income has been derived but he deliberately conceals this income for tax purposes. Tax avoidance, on the other hand, arises when a taxpayer gets into an arrangement that has the effect of creating a tax advantage that would not exist if the arrangement had not been created.
What is important to note is that the arrangement has artificially created a tax advantage. And that this tax advantage, although legal, nevertheless violates the spirit and purpose of the income tax legislation. Without GAAR, the tax authority can do nothing to counter the tax advantage.
The second area of confusion relates to how tax avoidance is to be determined. Some commentators have suggested that GAAR applies where the intention of the taxpayer is to avoid tax. The test for GAAR is not subjective, so taxpayers’ personal motivations for entering into tax arrangements are irrelevant. Tax avoidance is determined objectively – by reference to the tax effect of the transaction.
More importantly, it is absolutely vital to note that morality has no role in tax avoidance analysis. A morally repugnant tax outcome can nevertheless be outside the clutches of GAAR.
Once these initial teething problems are ironed out, the Indian GAAR is about to undergo a maturing process, in which the courts and taxpayers alike grapple with one fundamental question – where is the line at which legitimate tax mitigation crosses into the clutches of GAAR? This in turn hinges on whether the main purpose of a tax arrangement is to create a tax benefit. One question is especially pertinent – exactly how is the “purpose” to be determined? Along the way, undoubtedly there will be many twists and turns.
Key to this analysis is how terms such as “commercial substance” will be interpreted by Indian courts. The good news is that there are lessons for Indian taxpayers and their advisors from the Australian and New Zealand experience to provide guidance on how GAAR rules are to be interpreted.
Former Chief Justice Barwick of the Australian High Court held a famous reputation for deciding in favour of the taxpayer in the tax cases he sat on, including those involving GAAR issues. His honour said GAAR only applies if an arrangement has already been entered into and that arrangement was subsequently altered to create tax benefits. As such, GAAR could not apply to tax benefits flowing from “new” arrangements. Under this approach, GAAR became the equivalent of a toothless tiger and was seldom invoked since tax advisors would design schemes that were “brand new”. These were golden days for the Australian tax planning community.
GAAR came back to life considerably after Barwick retired. Great emphasis has been placed on the commerciality of transactions and the economic substance of transactions. So, for example, deductions would only be allowed if the taxpayer suffered an economic cost (i.e. actually paid for the deduction one way or the other).
In New Zealand, there has also been a considerable shift in the approach taken by the courts. It has moved from a literalist approach taken in the 1980s, when the courts were hesitant to counter the legal form of an arrangement. It has now moved to a “parliamentary contemplation test” under which the focus is to analyse the intention of the underlying tax legislation that the tax arrangement is trying to abuse (for example, tax on capital gains rules). This approach has considerably expanded the scope of GAAR and has led to the New Zealand tax commissioner using GAAR in relatively minor cases.
The discussion above should show that GAAR does not give a tax authority a carte blanche to attack tax arrangements that it does not like. To succeed, GAAR has many hurdles that the tax authority must cross. In India, much will depend, of course, on the interpretation that the Indian courts will take on key GAAR concepts. In the Vodafone case, the Supreme Court showed a somewhat literalist and “black letter” approach. If this approach is extrapolated into GAAR cases, the scope of GAAR will be limited and will be a source of relief for a lot of taxpayers.
A final point. In New Zealand, too many “outrageous” cases went to court which lead to an overly expanded GAAR. This has now given the tax commissioner considerable ammunition to apply to GAAR to even minor cases. The onus is on the tax advisors of India to ensure this does not happen there.