Interaction between GAAR and tax treaties

Caucasian businessman using digital tablet in cafeMany countries are unilaterally applying anti-avoidance measures to their existing treaties, thereby creating further uncertainty among multinationals. Even where treaties provide for specific anti-avoidance measures, the anti-avoidance rules seek to override these. Has India considered this aspect adequately? Are the other countries doing so? What is the emerging landscape for treaties in this backdrop?

The debate surrounding the interplay between a country’s General Anti-Avoidance Rules (GAAR) and its treaties has been long standing. There is a mixed trend internationally on the matter. In countries where there is a domestic GAAR law, some use it to disallow treaty benefits1, while in others the possibility to override treaty benefits is being debated2. Some countries seek to include specific provisions in their treaties to ensure their domestic GAAR law may apply3. Some countries4 have introduced strict documentation requirements as a prerequisite for the application of treaty benefits.

India’s current position on this matter5 seems clear that benefit of treaty can be availed only subject to overcoming its domestic GAAR law. This appears to be along the lines of Australian rules. However, in the context of Australia, this provision was inserted in 1981 and most treaties of Australia were signed after 1981. In case of a few treaties of Australia, which are signed prior to 1981, a doubt has been raised whether the other contracting state can be regarded as having knowledge about GAAR.

India’s tax treaties contain specific anti-avoidance rules (SAARs), such as place of effective management for deciding the residence of non-individuals in article 4, the restricted force of attraction rule as per article 7(1), article 9 dealing with associated enterprises, articles 10, 11, and 12 dealing with dividends, interest and royalties with respect to beneficial ownership6 for concessional tax treatment, the special relationship rule with respect to interest and royalties in articles 11 and 12, alienation of shares of real estate entities in article 13 (4), and artistes/sportsmen companies in article 17(2). Recently, in some treaties7 there is a general limitation on benefits (LOB) article patterned along the lines of a mini GAAR while in some treaties8 there is subjective and objective LOB criterion prescribed. It is thus evident that the India’s tax treaties are subject to numerous SAARs and there is a growing body of evidence that new/re-negotiated tax treaties will have more elaborate LOB and specific anti-abuse insertions. It therefore, behoves consideration whether in the context of tax treaties the domestic GAAR provisions should have a role.

The Standing Committee on Finance9 has cautioned that uncertainties with regard to applicability of tax treaty provisions (vis-à-vis GAAR) should be removed so that India’s credibility as a reliable treaty partner is not affected. Particularly with respect to interplay of GAAR in the domestic law with specific anti-abuse provisions in the treaty (i.e., Limitation of Benefits/Entitlement of Benefits clause), remains a matter of doubt and uncertainty. The Shome Committee10 recommendations11 on this conflict are that where the treaty itself has anti-avoidance provisions in the form of limitation of benefit (as in the India-Singapore treaty), such provisions should not be substituted by GAAR under the treaty override provisions, as well as where a SAAR is applicable to a particular aspect/element, then GAAR should not be invoked to look into that aspect/element. After considering the report of the Shome Committee, the Finance Minister, in a statement12, mentioned decisions taken by the Government including inter alia that where GAAR and SAAR are both in force, only one of them will apply to a given case. While the Committee recommended for a preference of SAAR over a GAAR, the statement of the Finance Minister does not go as far. On the contrary, the law provides that GAAR will apply in addition to or in lieu of any other basis of taxation13. These recommendations still have to see the force of law.

Under OECD’s BEPS Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, this debate is actively engaging the minds of policy makers and business. The recommendations in a recently released discussion draft (the Draft)14 on the subject has proposed incorporating, in tax treaties, both LOB rules similar to those found in US tax treaties and broad anti-abuse rules similar to the “main purpose” tests found in UK tax treaties. The Draft includes the proposed language for a LOB rule and further states that detailed commentary will explain the main features of the rule. On the general anti-abuse rule (GAAbR) that is based on the “main purpose test,” treaty benefits will be denied when one of the main purposes of arrangements or transactions is to secure a benefit under a tax treaty and obtaining such benefit in these circumstances will be contrary to the object and purpose of the relevant provisions of the tax treaty. It is intended that the “main purpose test” should supplement the LOB rule, i.e., a benefit denied under the LOB rule will not then be subject to analysis under the main purpose test and, conversely, a benefit allowed under the LOB rule will be denied if the main purpose test is not satisfied. The Draft, in several places also references the use of domestic law GAAR to override treaties.

LOB provisions, structured as a series of alternative mechanical tests that are objective in nature, are welcome provided they are expansive in coverage to include a wide range of circumstances. Such LOB provisions should be further supplemented with a discretionary benefits provision, which should operate effectively in practice, to redress situations that befit treaty application but fail the mechanical tests of LOB. As compared to LOB provisions, a GAAR/GAAbR styled on the “main purpose” test is likely to create significant uncertainty regarding applicability of the treaty benefits. The main purpose test is substantially broad for the intended purpose of backstopping the recommended LOB provision. A much more narrowly targeted rule is best suited to this objective. Under the India-Singapore treaty, the subjective LOB provision styled as a GAAbR can conflict with the objective criteria and can make the application of treaty benefits uncertain and complex. Furthermore, absence of an effectively operating discretionary resolution mechanism can only make matters worse.

The domestic law GAAR should have no place in treaty matters, particularly where the treaties have specific LOB and/or general “main purpose” based anti-abuse rules. The anti-abuse rules with respect to tax treaty benefits must be included in the treaty itself.

It is no doubt true that tax treaties operate to facilitate cross border trade and investment. The imposition of domestic law GAAR on tax treaties would breed uncertainty; serve as a drain on time and resources of both the taxpayer and tax administrators. It is important that when considering anti abuse rules for treaty situations, priority should be given to such rules embedded within the treaty and, even there, the preference should be for more targeted and objective anti abuse rules as opposed to more subjective rules. Any legislation has to strike an appropriate balance between achieving the intended result and avoiding collateral damage. India should tread the path cautiously; probably targeting truly abusive and egregious cross border transactions through treaty-based targeted/specific anti-abuse rules. Excessive legislation is likely to prevent abuse but in the process will also stifle genuine transactions/investments. India’s development agenda will ill-afford such a consequence.

References:

  1. 1Belgium, Italy, Finland, Norway, Spain, Vietnam
  2. 2China, Germany, South Africa
  3. 3Germany, UK
  4. 4Mexico, India, Hong Kong, Vietnam
  5. 5Section 90(2A) and 90A(2A) of the Income Tax Act, 1961
  6. 62014 Update to The OECD Model Tax Convention including the beneficial ownership changes reflected revised discussion draft on that topic
  7. 7UAE, Kuwait, Iceland, Luxembourg
  8. 8Singapore
  9. 9Report of the Standing Committee on Finance on The Direct Taxes Code Bill 2010, March 2012(ref page 308)
  10. 10Final Report on General Anti Avoidance Rules (GAAR) in Income-tax Act, 1961 – Expert Committee headed by Dr Parthasarthi Shome
  11. 11Para 3.16/ 3.19 page 44/ 49 of the Final Report on GAAR (supra)
  12. 12January 14, 2013
  13. 13Section 100
  14. 14Released on March 14, 2014

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