New ‘Indian’ Head-Ache for Offshore Financial Centres.

Mauritius – a popular OFC and intermediary jurisdiction for investments into India is worried that companies set up there to take advantage of the country’s lack of capital gains tax and the significant benefits under its tax treaty with India will come under increasing scrutiny if the ‘form over substance’ doctrine becomes law under new general anti-avoidance rules (GAAR) proposed by the Indian government.

In fact Mauritius is so worried that this could end its reign as the leading offshore financial centre for investment into India that although its authorities have indicated a willingness to renegotiate its tax treaty to include a limitation of benefits clause it is reported that they have also demanded that structures set up before April 1, 2013 be left untouched.

Blurred Lines.

In practice the new GAAR means that the real intention of the parties, the purpose of the arrangement, and the effect of the transactions will be taken into account to determine the tax consequences of the transactions, regardless of the legal structure used by the taxpayer. It will also grant the tax authorities considerable administrative discretion in applying the rules, potentially creating uncertainty about where accepted tax planning ends and abusive tax avoidance begins.

Real Commercial Substance.

It is expected that an arrangement will be deemed to have been created with the main purpose of avoiding capital gains tax in India if the legal ownership ostensibly resides with the intermediary holding company but the beneficial ownership rests with the foreign investor. Such arrangements typically are characterized by all of the funding for the investment in India coming from the foreign investor and simply being routed through the offshore holding company.

The test of substantive commercial substance can however be satisfied if the holding company conducts business in the jurisdiction where it is incorporated, if its board of directors meets in that jurisdiction, and if it carries out business with adequate personnel, capital, and infrastructure of its own.

This presents a real problem for such companies as typical holding companies are set up to ‘hold’ assets and not engage in ‘active’ business.

Who Has the Burden of Proof?

Under existing law the Indian tax authorities have the burden of demonstrating a lack of commercial substance. It was originally proposed that the taxpayer would have the burden of showing commercial substance, but this was changed while the Finance Bill was being debated in Parliament. Under existing rules, a taxpayer can provide a tax residence certificate to obtain benefits under one of India’s tax treaties unless the treaty contains more onerous requirements, such as having to satisfy a limitation on benefits clause. The GAAR will give the Indian tax authorities discretion to determine whether the offshore holding company has substantive commercial substance.

State of Play.

In announcing the budget, former Finance Minister Pranab Mukherjee assured taxpayers that detailed guidance would be issued on the application of the GAAR to allay the concerns of foreign investors and ensure that the provision is not applied indiscriminately. A committee was immediately set up to formulate guidance for implementing the GAAR.

The draft guidelines have now been released for public comment.

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