Ever since the former Finance Minister announced the proposal to introduce the General Anti Avoidance Rule (GAAR), in this year’s Budget, there was a huge uproar against it, as many thought that such a move would drive potential foreign investors away from India.
Taking note of investors’ sentiments, which became emphatic after perusing the Finance Ministry’s draft guidelines in June, Prime Minister Dr Manmohan Singh set up the Parthasarathy Shome committee in July. By September 1, the draft recommendations of the Shome Committee were out. It recommended postponing the introduction of GAAR by at least three years; it also wanted the abolition of tax on capital gains from listed securities, and that traditional investors’ paradises such as Mauritius and Singapore be kept out of the reach of GAAR.
What is GAAR?
The Union Finance Ministry had pushed for the introduction of GAAR in India, which would enable tax officials to probe if a non resident entity, directly or indirectly through a resident Indian, was establishing companies in other countries merely to benefit from their benevolent tax structure. The discretion to deny such tax benefits rests with taxmen, and experts feel that such sweeping powers could find a number of innocent people caught in its net.
When Is Gaar Being
The Finance Ministry wanted the introduction of GAAR from this financial year. However, it was deferred by a year to April 1, 2013. With corporate India unhappy with GAAR in its current form, the Shome Committee was set up. In its draft report, it has suggested that GAAR come into effect from the financial year 2016-17, since a lot of ground work has to be laid in terms of defining what is good business practice and what is not, among others.
Why Do We Need GAAR?
Rarely does the taxman fail to invoke terror in the minds of both the honest tax payer and the ones who try to dodge paying tax on a sizeable portion of their income. Worldwide, a number of organisations and investors try to take advantage of a benevolent regime that invites investments by offering a liberal tax policy in exchange.
A number of countries such as Mauritius, Singapore, many Gulf countries and islands such as the Cayman Islands are investors’ paradises. Many investors also avail of such havens to either under-invoice or over-invoice their expenses, all of which helps in generating black money or rendering black money white. The G-20 group of nations has been pushing all entities towards such a tax regime, and many developed nations have a strict tax regime. However, many in the corporate world are of the view that the Indian economy has not matured to the levels of developed nations, and numerous suggestions have been forthcoming from many sides for months ahead of the draft report of the Shome Committee.
GAAR became a talking point in India only because of the Supreme Court’s verdict in January this year, favouring Vodafone, and not the Income Tax department. The verdict also saw former finance minister and current President Pranab Mukherjee make an announcement in the Budget on the proposal to introduce GAAR in India from this fiscal year.
The Vodafone Case
To fully understand the many dimensions to GAAR and why it is thought to be necessary, we need to revisit the Vodafone case, in which the Income Tax department (I-T) wanted to retrospectively tax Vodafone, a Multi National Corporation (MNC).
It all began when the British telecom giant Vodafone purchased a company located in the Cayman Islands. At that time, the seller had a controlling interest (shares held) in Hutchinson Essar, an Indian company. However, Vodafone’s purchase of this stake in Hutchinson Essar was by default, and not a direct act. The Indian company was not in any way involved in the transaction of the original sale of the Cayman Islands company which was bought by Vodafone. This was in 2007. The British company had also applied to the Foreign Investment Promotion Board for acquiring over 50 per cent stake in Hutchinson Essar.
In October 2010, the I-T department determined that Vodafone had a tax liability from this multi-layered deal, amounting to `11,208 crore, for the purchase it made in 2007 in the Cayman Islands. It passed the order on October 22. However, Vodafone went to court, and the Apex Court quashed the I-T order. The Court also said that the I-T department has to prove that a corporate company had deliberately opted for a complex, multi-layered structure only to avoid taxation. In the case of Vodafone, Hutchinson Essar had been functioning since the 1990s, whereas Vodafone got into a buying deal in the Cayman Islands only in 2007. Hence, it ruled in favour of the telecom player.
After this landmark ruling, the I-T Act was amended with retrospective effect, to bring all such deals under the tax net.
Why Did GAAR Have Such an Effect on FDI?
One of the main reasons for GAAR to be reviewed was the effect it had on Foreign Direct Investments (FDI). There are three main reasons for this.
The first is that the proposals sought to make the law effective with retrospective effect. While it could be argued that such a law would never have come into effect, this provision shattered investor confidence.
The second point was that it sought to override treaties entered into by India with other sovereign nations. This would have been inadmissible in international courts. It had a very detrimental effect on investors abroad.
Third is the standard perception among observers that this act was a reaction to the government is losing its claim against Vodafone, triggering fears that the act may become another instrument of harassment in the hands of the bureaucracy.
The draft recommendations of the Shome Committee address the above concerns substantially. There can be no doubt about the need to put an end to tax evasion. However, that should not be done in a way that would frighten off investors, especially now, when the UPA 2 government has allowed FDI in retail and aviation sectors.