“Coherence”, “transparency” and “substance” – these words have become the focal point of every discussion surrounding transactions today. In India, the glass ceiling on the importance of these terms was broken a few years ago with the advent of GAAR in the Direct Tax Code and retroactive amendments for taxation of indirect transfers. However, the adoption of Base Erosion & Profit Shifting (BEPS) action points will leave it resoundingly shattered.
BEPS refers to tax avoidance strategies resulting in double non-taxation, or less than single taxation, on account of differences in tax rules across jurisdictions. It includes shifting of profits away from jurisdictions where the economic activity takes place by using arrangements that exploit gaps and mismatches in tax rules.
The call to prevent BEPS originated primarily from developed countries that had earlier supported globalization because it offered new markets for their companies. These countries are now realizing that global operations may have been used by multinational companies to reduce their legitimate tax share across geographies. In this context, the Organisation for Economic Co-operation and Development (OECD), at the request of the G20 nations, developed comprehensive action points to address BEPS. The plan identified 15 action points to tackle BEPS.
Some of the key BEPS action points that can impact transactions are –
- Action 2 – Neutralizing effects of Hybrid Mismatch Arrangements (HMA): HMA involves creating an arbitrage opportunity to reduce the overall tax burden. Such an arbitrage opportunity arises on account of differences in the tax treatment of an entity or instrument, under the laws of two or more jurisdictions to produce multiple deductions, or deductions without any symmetric taxation.
An example of HMA could be an inbound investment into India using a hybrid instrument, such that the Indian company is eligible for interest deduction in India, while the interest qualifies for participation exemption in the foreign country. Adoption of the BEPS action point could result in denial of interest deduction in India, or denial of participation exemption in the foreign jurisdiction.
- Action 5 – Countering Harmful Tax Practices (HTP): HTPs owe their existence to the tendency of setting up a mobile tax base in a preferential tax regime (PTR). The regime is considered preferable if it offers tax preference vis-à-vis general principles of taxation in that country. While the intent of PTR was toward supporting growth and innovation, the action point intends to target practices whereby companies are merely shifting profits from the location in which value is created to another location where taxes are lower. Examples of PTR include the UK/Netherlands patent box regime and the headquartered entity regime.
- Action 6 – Prevent treaty abuse: Treaty abuse has become a matter of concern globally, with many corporations obtaining treaty benefits under inappropriate circumstances.
Some of the recommendations in the report to prevent treat abuse are:
- Introduction of “Limitation of Benefit” rule or “Principal Purpose Test” rule
- Alignment of domestic laws and tax treaties such that inappropriate benefits are prevented
In addition to the above, some of the other relevant BEPS action points include addressing the tax challenges of the digital economy, base erosion via interest deductions, avoidance of Permanent Establishment status and other actions related to transfer pricing (TP).
Several international tax developments reflect a trend of increased scrutiny and strengthened enforcement on tax avoidance even before BEPS action points take effect. Notable developments include a robust Dutch decree on substance requirements, and a Chinese tax judgment where the indirect transfer of an overseas intermediary holding company holding shares in a Chinese entity was found to be tax-abusive, and the overseas intermediary was disregarded for such transfer.
Also, recent media reports indicate that India and Mauritius have reached a tentative understanding on a revised tax treaty, which is expected to contain a “Limitation of Benefit” clause. As more details become available, foreign investors investing in India through Mauritius will need to consider the impact of such developments.
India is an active participant in the BEPS project. This is evident in the amendments proposed in the Union Budget 2015, in which GAAR was deferred for two years in order to implement it as part of a comprehensive regime that addresses the BEPS actions points.
Foreign institutional investors and strategic investors need to be prepared for BEPS-related developments in India. Their existing structures are likely to be affected as grandfathering of existing structures does not seem to be intended. They may need to revisit their exit strategies and also factor in the impact of BEPS action points on future transactions. Some of the commonly perceived BEPS practices in India that may be affected include:
- Payments made to foreign affiliates of Indian companies as royalty, management fee, etc.
- Indirect transfer of assets through companies in low-tax jurisdictions
- Aggressive TP practices to allocate risks and profits in low-tax jurisdictions
To sum it up, while the OECD BEPS agenda can be considered an ambitious one with complex issues, a vast scope and aggressive timing, there is a real sense of political imperative behind it. It indicates global, coordinated thinking against tax avoidance arrangements. We can infer that the key mantra for transactions going forward is that of “substance over form.” Therefore, the commercial rationale for selecting jurisdictions and the functionality of companies set up in those jurisdictions would be a fulcrum aspect to be dealt with in each case.
Sriram Krishna, Senior tax professional from EY has also contributed to this article.