India’s GAAR and the Multilateral Instrument: A Consideration for Foreign Portfolio Investors

[Aditi Khemani is a 4th Year student at Jindal Global Law School]


Since the Union Budget of 2018-19, the India-Netherlands Double Taxation Avoidance Treaty (DTAA) has garnered attention. A major renegotiation of India’s treaties with Mauritius, Cyprus and Singapore last year saw a shift from the “residence rule” to the “source rule” of capital gains taxation. This eliminated the longstanding pattern of double non-taxation that fostered Mauritius’ popularity with foreign portfolio investors. Now, with the Government’s introduction of a 10% long-term capital gains (LTCG) tax by way of the 2018 Union Budget, the Netherlands has further been pushed into the spotlight, as it holds the unique status of being the only major investing country into India where shareholders in Indian companies are not subject to tax on disposal of shares.

In June 2017, India signed the Multilateral Instrument (MLI), a consent-driven text incorporating the Base Erosion and Profit Shifting Project recommendations. It deals with pertinent issues of international tax, including hybrid mismatches, treaty abuse, avoidance of permanent establishment (PE) status and improved arbitration. India and Netherlands have both notified their DTAA, indicating that it shall bear the greatest consequences upon ratification of the instrument next year.

The Principle Purpose Test

Articles 6 and 7 of the MLI read together ensure that covered tax agreements are definitively geared towards remedying treaty abuse. The former lays down new preamble language that shall supersede, or at least add to, existing preambles. It encapsulates an unequivocal intention to curb reduced taxation through evasion or avoidance “including through treaty shopping arrangements aimed at obtaining reliefs” (Article 6 of the MLI). Meanwhile, Article 7 requires parties to introduce an anti-abuse rule into its tax treaties in one of three ways: (i) a principal purpose test (PPT); (ii) a PPT plus simplified limitations of benefits (LOB) clause, or; (iii) a detailed LOB clause. Although India has opted for both, most of its treaty partners have chosen to disallow application of the simplified LOB. Thus, Indian treaties will be impacted by the PPT alone.   

The PPT provides that treaty benefits shall be denied in instances where it is reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit (Article 7(1) of the MLI). It also supersedes existing general anti-abuse provisions of a treaty. This will entail replacing narrow definitions of both what constitutes a benefit as well as conceptions of the intent that anti-abuse rules seek to redress.

Inconsistencies Between the Principle Purpose Test and GAAR

India’s Income Tax Act, 1961 (ITA) incorporates a General Anti-Avoidance Rule (GAAR) that came into effect starting April 1, 2017 (Chapter 10, ITA). A similar arrangement aimed at preventing treaty abuse, the GAAR is triggered only if the “main purpose” of an arrangement is to obtain a tax benefit. Secondly, other elements must be satisfied, such as the “creation of rights or obligations that not at arm’s length, abuse of ITA lack of commercial substances or lack of bona fides”. Thus, whereas the threshold to deny a person treaty benefits under the GARR is relatively high, doing so under the PPT would require merely that obtaining a benefit be one amongst a number of principal purposes. Being far broader and more subjective in its application, the PPT will vest in Indian tax authorities more discretion in tackling treaty abuse in instances cases that they might otherwise have had their hands tied.

Conflict between the two rules is likely to arise once the instrument is ratified. While the common preconception amidst investors is that the PPT is the “lesser of two evils”, it is also problematic in its degree of subjectivity coupled with the fact that disputes relating to it are to be resolved by a Mutual Agreement Procedure. Currently, resorting to GAAR involves certain procedural safeguards laid down by the ITA such as approval from a panel chaired by an existing or former High Court judge (and accompanied by a revenue official and scholar). It has been argued that application of the PPT ought to be regulated within a similar framework, considering the broad power it currently bestows on tax authorities. Then again, numerous sets of domestic guidelines by various countries are likely to result in discord in the interpretation of rules and resolution of disputes.

Aditi Khemani

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