Has the government bitten off more than it can chew with GAAR?
The introduction of General Anti-Avoidance Rules (GAAR) in budget 2012-13 has set off the proverbial storm in a teacup. Foreign investors, who will be primarily affected by this rule, are up in arms, and are lobbying furiously with the Finance Ministry for its withdrawal. So far the latter has refused to budge on the essentials, though it has promised to soften the rules so that honest investors are not unduly harassed by the tax man.
What is GAAR and why has it perturbed FIIs so much? India has a Double Taxation Avoidance Agreement (DTAA) with countries such as Mauritius and Singapore. A large number (by some estimates, as much as 50 per cent) of FIIs have until now routed their investments via Mauritius in order to avoid paying taxes on their investments in India. This status is now threatened by GAAR.
According to GAAR, you can avail of tax benefit (by investing via a DTAA country) only if you have “substance” in that country. What does “substance” mean? Though this has yet to be spelled out clearly, in all likelihood it means that the foreign investor should have a full-fledged operation in that country. In other words, the corpus for the fund should have been raised in that country, and its analysts and fund managers should reside there. It should not have only, what is being called, a “post-office box” operation in that country, meaning that the corpus is raised elsewhere, the fund managers and analysts reside elsewhere, but the foreign institutional investor (FII) routes its investments into India through that country to avail of tax benefits. The term used to refer to such a set-up is “impermissible arrangement”.
A few concessions granted
After FIIs put forth their point of view, the Finance Ministry (according to news reports) has agreed to soften some of the provisions of GAAR. The budget document had said that the onus for proving innocence would be on the taxpayer (in this case, FIIs). In other words, the taxpayer would be presumed guilty of being in an impermissible arrangement unless he was able to prove his innocence. This would be a rather draconian provision and could lead to undue harassment of foreign investors by the tax authorities. The Finance Ministry has now agreed to shift the onus for proving guilt to the assessing officer from the tax department.
Two, the Finance Ministry has assured FIIs that GAAR will apply only from assessment year 2013-14 and not retrospectively.
Three, even if an impermissible arrangement exists, if the FII pays the capital gains tax that is due, he will not be punished further with a penalty or interest charge.
Moreover, if an assessing officer comes upon, what in his opinion, is an impermissible arrangement, he will have to refer the case to a commissioner. The latter will hear the taxpayer’s viewpoint, and if he finds it unsatisfactory, will refer the case to an approving panel. Normally this panel comprises tax officers of the rank of commissioner and above. To make its composition more broad-based, the finance ministry is reported to be thinking of including a member from the judiciary as well. So a due process will be followed.
The FII response
FIIs argue that if they have to pay a 20 per cent tax on short-term capital gains (India does not tax long-term capital gains), then India will no longer be such an attractive investment destination for them, especially against the backdrop of a depreciating rupee (which erodes FIIs’ returns further).
But every country, at some stage in the evolution of its tax regime, implements GAAR. So after the short-term hue and cry ends, FIIs will either have to accept the new regime or find a way to circumvent it. Many foreign investors are already planning to set up a base in Singapore. If they must have operations on the ground, they would rather have it in a well-developed financial hub. But merely shifting base to Singapore will not do. To avail of the DTAA between Singapore and India and avoid GAAR, they will have to demonstrate that they have had operations on the ground for at least two years in that country, and that they have incurred at least $200,000 per annum in operational expenses in that country for two consecutive years.
Morality versus realpolitik
India is very much within its sovereign rights to tax FIIs on capital gains. There is nothing morally wrong or underhanded about what it has done. After all, if its own citizens pay taxes on short-term capital gains, why shouldn’t foreigners?
In any case, GAAR was part of the Direct Tax Code (DTC) and would have come into force once the latter got implemented. All that the finance minister has done is implement GAAR ahead of the rest of DTC.
The more pertinent question is whether India will be able to get away with its implementation. Nowadays the country has a persistent current account deficit (expected to be in the range of 3 per cent of GDP this year). Foreign inflows act as the life-support fluid that helps the country fund this deficit. The situation is so bad that even if foreign inflows slow down marginally during a month or quarter, the rupee begins to slide. If the implementation of GAAR leads to a slowdown in inflows (and, heaven forbid, causes outflows), the finance minister may well rue his decision to implement this scheme for rustling up more revenues for the government.