GAAR: Why do markets, FIIs & tax evaders care so much?

The markets fell almost 400 points on 26 March 2012, mainly on concerns about the application of the General Anti-Avoidance Regulations (GAAR) that will come into effect from 1 April 2012. And, on Tuesday, after reports from the finance ministry said that GAAR will not target participatory notes (P-notes), the markets climbed up 230 points. P-notes are instruments used by investors abroad to invest in Indian securities indirectly.

So what is this GAAR and why is it so important for the markets?

GAAR is a taxation regulation that will make investors pay tax who otherwise legally avoid it. It must be kept in mind that legal evasion of tax is not the same as avoidance of tax.

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[caption id=“attachment_257358” align=“alignleft” width=“380” caption=“P-notes are instruments used by investors abroad to invest in Indian securities indirectly. Reuters”]  [/caption]

That GAAR will be introduced in India as a part of the Direct Tax Code was mentioned by the finance minister a year back. But this year’s budget made it clear it will be applicable from 1 April. So under GAAR, the revenue authorities will get to tax transactions or arrangements which were conducted or set up just to get tax benefits.

So routing transactions through Mauritius when there is no substantial purpose to route it from there other than achieving the tax benefit will not be allowed.

The issue of P-notes is crucial. P-notes are financial instruments used by investors or hedge funds that are not registered with Sebi to invest in Indian securities. The investor does not have to fulfill KYC (Know Your Client) norms here and gets to invest whatever amount he wants by keeping his own identity hidden.

There is confusion in the market whether the gains from these instruments will also be taxed. Now, with the finance ministry’s statement, there could be temporary relief, but FIIs might not be wholly convinced.

Sections 9 and 95 of the new Finance Bill (under which GAAR was introduced) says clearly that any transfer of shares in India which gives rise to income anywhere else will be taxable here. These sections will clearly have to be amended if cash investments of P-notes routed through tax havens like Mauritius will have to be exempted from tax.

According to an Edelweiss note, P notes will be facing indirect taxes only. Direct taxation is not possible if the note or the contract is carefully worded because shares or voting rights are not transferred through these. The nature of transaction is a contract and does not transfer share or interest, that Section 9 talks about.

Taxes will also be applicable to indirect transfer, which alludes to the recent Vodafone case where the Supreme Court, much to the shock of tax authorities in India, had ruled against levying tax on transactions fully carried out abroad. The main contradiction in Section 9, therefore, lies with the retrospective effect of the tax which might go back even to 50 years (1962 to be precise, when India’s existing tax code got enacted). This would retrospectively tax all cross-border deals the government might fix upon and gives a wrong signal to foreign investors.

In case of companies routing investments through Mauritius, under the new law, the onus lies on the taxpayer to prove that the transaction or the arrangement of any transaction did not have tax benefit as the main purpose. It might be difficult for most Indian corporate entities to prove they have any other sound reasons for having an establishment in Mauritius.

PwC, in a recent note explains, “The scope of the Indian GAAR is very wide as it seeks to cover within its ambit nearly all the arrangements (the term ‘arrangement’ is very widely defined to cover almost every transaction, scheme, understanding, etc.) and therefore could be difficult to favour the taxpayer in any way.”

Once GAAR is invoked, a commissioner of income tax (CIT) has been entrusted with enormous powers to settle the issue and revoke tax benefits which might have gone to the taxpayer.

In such a situation, there are options to move establishments to countries like Singapore, though that also includes additional costs. P-note issuers like CLSA have halted issuing such instruments for now till there is more clarity on the issue. They have made it clear that taxes will be passed on to clients who are ultimate gainers of the transaction. However, they say, there is no need for panic selling if one is fundamentally bullish on India.

But it is definitely easier for companies like CLSA to shift clients from Mauritius to say, Singapore, where they already have a formidable base. But entities who will not be able to justify a base in Mauritius for reasons other than tax planning will be in deep trouble.

There could be immediate volatility in the market mainly in futures and options section, but ultimately investors might just begin to price in a tax cost when they invest in India.