TRC necessary but not sufficient - Is Budget seeking to prevent treaty shopping ?

Background
 
The Finance Bill 2012 proposes a slew of measures as an immediate response to certain observations of Supreme Court in the Vodafone case, highlighting the need for “Tax Clarity”. “Lack of clarity and absence of appropriate provisions in the statute and/or in the treaty regarding the circumstances in which judicial anti-avoidance rules would apply has generated litigation in India.”  “Tax policy certainty is crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner. Legal doctrines like ‘Limitation of Benefits’ and ‘look through’ are matters of policy.  It is for the Government of the day to have them incorporated in the Treaties and in the laws so as to avoid conflicting views.  Investors should know where they stand.  It also helps the tax administration in enforcing the provisions of the taxing laws”.  As a matter of fact, a senior official of the Finance Ministry clarified on the budget day that foreign investors are not seeking certainty of no tax in India but looking for certainty of taxing provisions.  In view of the that matter, the proposed amendment of Tax Residence Certificate (TRC) in terms of amendment of Sections 90 and 90A basically emanates from the overall background of judicial pronouncement asserting that there is no conflict between Azadi Bachao Andolan and McDowell and the practical difficulties experienced in collecting information from certain jurisdictions on offshore investments/deals/bank accounts, etc., particularly, as confronted in the course of investigation in the 2G case.
 
Amendment of TRC for claiming relief under DTAA
 
In the Memorandum Explaining the Provisions in the Finance Bill 2012, a reference is made that in many instances, the tax payers who are not tax resident of a contracting country, do claim benefits under DTAA entered into by the Government with that country.  Thereby, even third party residents claim unintended Treaty benefits.  Therefore, it is proposed to amend Sections 90 and 90A of the Act, to make submission of TRC containing prescribed particulars, as a necessary but not sufficient condition for availing benefits of the agreement referred to in these Sections.  The actual language employed in Section 90 of the Act to convey the said intent is not in harmony with the avowed purpose.  To quote the amendment –
‘An assessee, not being a resident, to whom an agreement referred to in sub-section (1) applies, shall not be entitled to claim any relief under such agreement unless a certificate, containing such particulars as may be prescribed, of his being a resident in any country outside India, as the case may be, is obtained by him from the Government of that country or specified territory.’
 
Basically, the amendment as above, on a plain reading of the language, seeks to suggest that a TRC with prescribed particulars from any country outside India or specified territory outside India would be a precondition for claiming relief under the agreement.  This is not what the explanatory memorandum implies in as such as it seeks to regulate Treaty Shopping, so that third party residents cannot claim unintended Treaty benefits.  Also, in terms of the stated objectives, TRC though a necessary condition, would not be sufficient condition for availing the benefits of the agreement.  Obviously, there appears to be a disconnect.  As per clarifications appearing in certain financial dailies, it is seen that the proposed amendment would not affect the TRC with Mauritius for claiming benefit as it stands today.  Also, one understands that the proposed amendment is in respect of such countries/jurisdictions, where no TRC is issued or available.  At the same time, it is seen that many countries do not issue TRC as of now, and the proposed amendment would mandate it for claiming the Treaty benefit.  However, it is quite likely that an additional information regarding the tax incidence in respect of the subject transaction in the host country may be called for in addition to other material details, which may be relevant from the aspect of due diligence.  However, these are matters of speculation and one can be certain of the same only when the rules are notified after the bill is enacted.  Till then, the whole issue will be smothered in a welter of confusing and misleading signals.  But the basic disconnect remains, namely, whether the amendment is for checking the unintended Treaty benefit to third party residents or not.  Such unintended Treaty benefits normally go by the nomenclature of “Treaty Shopping” and if the intention is as spelt out in the explanatory memorandum, the corresponding provision in the amendment has to be read harmoniously with it to apply the language of the amendment to Treaty Shopping as well.  But, definitely, the explanatory memorandum seeks to address ‘Treaty Shopping” which will also have a material bearing on Indo-Mauritius Treaty.
 
Treaty Shopping in the context of Indo-Mauritius Treaty
 
The Indo-Mauritius Treaty was executed on 1-4-83 and notified on 16-12-83.  Article 13 of the Treaty deals with taxability of capital gains.  Article 13(4) covers taxability of capital gains arising from the sale and/or transfer of shares and stipulates that such gain of a resident of contracting state should be taxable only in that state, which in the case of Mauritius, happens to be nil.  CBDT issued circular no. 682 dated 30-3-1994, clarifying that capital gains derived by resident of Mauritius by alienation of shares of an Indian company shall be taxable only in Mauritius according to Mauritian tax law.  However, in the year 2000, the Revenue authorities sought to deny the Treaty benefits to some resident Mauritian companies, pointing out that beneficial ownership in those companies was outside Mauritius.  Thus, the foremost purpose of investing in Mauritius was found to be tax avoidance.  In that view, the authorities sought to deny the Treaty benefits despite the absence of limitation of benefit clause in the Treaty.  In the wake of the same, CBDT issued circular no: 789 dated 13-4-2000 stating that the Mauritian TRC issued by a Mauritian tax office was sufficient evidence of residence of the company in Mauritius and that such companies were entitled to claim Treaty benefits. TRC will be proof of residence as well as beneficial interest.  The legal challenge to the said circular culminated in the famous judgment in the case of AzadiBachao Andolan as reported in the 263 ITR.  The Supreme Court upheld the validity of the circular as within the meaning of Section 90 of the Act.  The circular shall prevail even if inconsistent with the provisions of the Act.  The Mauritian resident is eligible to the benefits of the Mauritius Treaty.  In the said judgment, the Supreme Court also made the following observations relating to Treaty Shopping.
 

1. DTAAs of countries not supporting Treaty Shopping incorporates a ‘Limitation of Benefits’ (LOB) clause (eg. DTAA between India and USA)
2. In the absence of a LOB clause in the DTAA between India and Mauritius there are no disabling or disentitling conditions prohibiting the residents of a third nation deriving benefits there under
3. Also ‘Treaty Shopping’ should ideally be looked at by the Government and not by the courts as it involves various political considerations.  Many developed countries tolerate ‘Treaty Shopping’ for other non-tax reasons unless this leads to significant loss of tax revenues.
4. Many developing countries also allow ‘Treaty Shopping’ to attract scarce foreign capital and technology, which they need.

 
The chequered case history of failed efforts in the wake of judicial pronouncements from time to time is, in parts attributable to the absence of LOB clause in the Indo-Mauritius Treaty and the beneficial circular no. 789 of 13-4-2000.  Accordingly, it stands to reason that the present move of tweaking the TRC may be to bring it in alignment with what was sought to be achieved earlier, but without success.  It is also not very clear whether such a move with altered ground rules without structural changes, can neutralise the absence of limitation of beneficial clauses in the Indo-Mauritian Treaty without actually amending the Treaty of equally inescapable question would be whether the proposed amendment would provide for a limited Treaty override without actually tinkering with it.  Presently, there is no clarity on these issues excepting to state that a harmonious interpretation of the proposed amendment with the explanatory memorandum carries the runes to the effect that the Treaty Shopping is sought to be regulated in some way or the other, so that third party residents do not claim unintended Treaty benefits and to that extent, the TRC is going to impose some more de rigueur conditions than mere proof of presence in Mauritius.
 
On a conspectus of various proposals in the Finance Bill 2012 to introduce GAAR, tweaking of the TRC and other anti-avoidance measures to tax off-shore share transfers, one is inclined to think that there is a design in the same as a combination to effectively plug the loopholes in the cross border transactions.  In the event of TRC being used to collect information about the non-resident entity, such information like tax liability of the transaction in the off-shore jurisdictions, residential status, the beneficial ownership etc., can be of use in evaluating and appraising whether GAAR is applicable to such arrangements.  As a matter of fact, one of the presumptions in GAAR is that obtaining of tax benefit is the main purpose of an arrangement, unless otherwise proved by the tax payer.  In the event of the arrangement being held to be an impermissible avoidance arrangement, then the consequences of arrangement in relation to tax or benefit under tax Treaty will be determined.  It is quite likely that TRC tweaks may directly or indirectly lead to a situation in appropriate cases for limited Treaty override through GAAR route.
 
In concluding, it is emphasized that there appears a disconnect between the intent as per explanatory memorandum and the actual language employed in the amendment provisions.  However, as per the cardinal principle of interpretation, both have to be read harmoniously, which would imply that there can be a check on Treaty Shopping with concomitant Treaty override in appropriate cases either on the strength of amended TRC or GAAR.

GAAR legislates Ramsay principle, is an urgent requirement of modern tax system

The news that the Indian government is planning to introduce a general anti-avoidance provision and measures to tackle tax haven abuse are both extraordinarily welcome. Many budgets, the world over, are forgotten a day or so after they have been delivered. For India this one is likely to go down in the annals of tax history.
 
The history of general anti-avoidance rules is chequered. Some, and here I think mainly of Australia and South Africa, have worked. Less noticed, but perhaps most effectively of all, has been the curious dependence of some tax havens, such as Jersey, on such provisions to ensure they offer what looks like a simple tax code that they can, none the less, impose upon their resident populations, many of whom are taxable on their world wide incomes but are aware of multitudinous ways to hide that income from view! In other cases, and Canada is the most often referred to, experience of general anti-avoidance provisions has been poor. It is therefore good to note that India has noted some of such issues that have caused GAARs to fail whilst clearly having a focus on what it needs from a GAAR.
 
Let's be clear what a general anti-avoidance rule should do. It should say, as clearly as possible, that if a step is added into a transaction or series of transactions without apparent primary motive bar the avoidance of tax then that step should be ignored for the purposes of computing the tax liability arising on the transaction in question. The behaviour  that is being challenged is the desire to subvert the apparently legal, but none the less abusive, actions of those in the tax profession who make it their business to scour legislation and regulation, nationally and internationally, and both within the tax code and in other connected areas, such as accounting regulation, to exploit legal loopholes on behalf of their clients knowing that the combined construction that they put upon the law and regulation was never the intent of the domestic parliament whose tax revenue is threatened as a result. This can, of course, in very many ways be said to be the legislative embodiment of the Ramsey principle, much discussed in tax litigation in common law countries around the world, and not least in India of late.
 
Those who oppose general anti-avoidance rules, and who opposed Ramsey, argue that the form of contracts must be honoured in tax law. It is a curious argument to an accountant like me. I am well aware that the form of a multinational corporation, or indeed the form that the affairs of many a wealthy family takes, is far removed from its substance. It is this substance versus form argument that is at the core of the GAAR debate. Those, like me, who argue for GAARs, suggest that it is the substance of the issue that matters. If, then, it is possible for a multinational corporation to so structure its affairs in almost any contractual style that it so wishes to minimize its tax bill but the substance is that any such structuring is simply an artifice because the whole structure is under common control and the outcome of the supposed contractual arrangements is pre-ordained to achieve a particular result (and this is, almost invariably true) then the contractual structure is but an artifice too because the arrangements are not between independent parties but are instead designed with but one aim. The fact that some of the parties may appear independent, whether as trustees, orphan entities or even as genuine third parties who have however contracted to lend their name to the pre-agreed purpose in exchange for a fee does not change this fact: the contractual arrangement to act in pre-agreed fashion is what is critical. The substance if such arrangements is ultimately not commercial; it is tax driven. It is proving this substance that is key to any assessment of a case to apply a GAAR to: if it cannot be shown that there was a pre-agreed agreement as to the nature of the transaction that was designed to achieve the tax goal, or unless it can be shown in the case of repetitive arrangements (and here I have derivative arrangements in mind, which are now for many multinational companies the favoured mechanism of choice for transferring profits offshore) that such is the pattern of events that there was no commercial substance to the arrangements because a predictability of outcome appears sufficiently prevalent in the events, then it is unlikely that a GAAR accusation will succeed.
 
All this takes effort. That is why the suggestion that there be a de minimis anticipated tax loss before the GAAR can be applied seems sensible in India. That also prevents the GAAR being used to attack routine transactions which should be addressed by legislation in their right. Such a situation might, for example, relate to the simple decision to incorporate. If this gives a tax advantage (and candidly, that is often the intent, limited liability frequently being a secondary consideration) it would be perverse to apply a GAAR for that reason alone. The law encourages incorporation and therefore the GAAR should not apply. It is for the same reason that the recommended use of a panel who must be convinced of the relevance of applying the GAAR is also appropriate. Current proposals in the UK also have this requirement, although when (as I was) I was consulted on this issue by Graham Aaranson QC on this matter during the preparation of his recommendations I suggested the three person panel should comprise a tax official, an informed lay member and be chaired by a person with judicial status. He did not include that suggestion, but I will repeat it none the less for India as I think the role of a person who can clearly be seen to be independent is important in this process.
 
That though does bring me to the other issue that I think vital if any GAAR is to succeed. This is the essential requirement that the GAAR include very clear instruction to judges on the basis of interpretation they must use when applying the legislation. It is precisely because Canadian judges appear to have ignored the fact that applying a GAAR requires purposeful interpretation of the statute under consideration that basically undermined the GAAR in that country. In that case it is essential that the GAAR gives such direction to judges that they will always seek to endeavor to interpret the spirit of the law or laws that have been transgressed when making their judgements and it may also be appropriate, in the absence if purposefully written legislation, to specify what they make not consideration when determining what they think that purpose might be. This could include ministerial statements at the time the legislation was introduced, press releases, consultations and of course parliamentary proceedings. Whatever is decided, without this the risk that a GAAR simply becomes another rule of judicial interpretation and is neutered as a consequence in the way Lord Hoffman neutered Ramsey in the Westmoreland case is all too likely.
 
There is no doubt in my mind that a comprehensive GAAR that includes sensible protections, reasonable but not excessively onerous burdens of obligation on a tax authority to prove its case and protection against it being used in trifling matters or to tackle issues where new primary legislation is really required is an essential part of any modern tax system where a government wishes to prevent abuse of its territorial domain, its right to collect tax from its residents and where it wishes to stop the persistent abuse of the form of legislation (a form that is, ultimately inevitable) by those who will construct transactions whose substance is to simply undermine the right of the state to tax in a modern democracy. India is taking an important step forward in this respect, and all who believe in that right of India to tax in the name of its democracy and people should also welcome this move.

Measures for prevention of generation and circulation of un-accounted money

It is often loosely mentioned in discussions that the parallel economy in India is larger than the official economy. This is unproved and unsubstantiated. However, when one reads a about the large sums of money involved in various scams, one is not surprised at the unproved allegation.
 
Unaccounted money gets generated due to various reasons. One of the biggest sources of unaccounted money is corruption. The receiver of a bribe, obviously, would not account for that money. But, in most cases, the payer of the bribe too would try to camouflage the payment in his books of account through one way or another. This, in turn, leads to a cascading effect on the generation and circulation of money. The multiplier effect only ensures that the parallel economy feeds itself and grows by leaps and bounds.
 
My personal view is that the main generators of unaccounted money are as under:
a)      Politicians in power
b)      Bureaucrats who are in charge of various licences and approvals
c)       Gold and bullion sellers & buyers
d)      Construction industry
e)      Small traders/manufacturers/professionals who prefer to indulge in cash transactions
f)       Unscrupulous people who act as accommodating parties by giving fictitious invoices in return for a small fee.
 
Let us see how the latest Budget seeks to address some of these issues. The other side of this problem is whether the existing provisions of the law are adequate to detect the generation of unaccounted money or whether we need to amend our laws.
 
My personal view is that our laws do have enough number of provisions that empower our tax department to unearth black money and punish the guilty. What is lacking is the will to do this seriously. We have the search and seizure provisions. We have the survey powers. We have 40A(3) and 269SS/269T etc. We also have 271(1)(c ) and other penalty sections. We also have certain other sections which compel people to use non cash modes of payments. These are only illustrations. But the moot question is “Are these provisions being used effectively?” To me, the answer is a clear and resounding “NO”. It is common knowledge as to what actually transpires during a search operation. Do we all not know that a majority of the search operations end up with large sums of cash being exchanged? Do we all not know how many appeals are ultimately “settled” amicably? Who is responsible for all these?
 
Today, if one were to objectively analyse the situation, one would concur that:
 
a)      There are several deterrent provisions in the Income-tax Act that would stop a normal tax payer from indulging in wrong practices as far as taxes are concerned
 
b)      There are several penal provisions in the Income-tax Act which would make a habitual defaulter also think twice before attempting to evade taxes
 
c)       The real problem is that the law is not implemented properly and there is enough discretion given to the Govt officers to permit them to use this discretion to their own advantage. The various press reports telling us the extent of unaccounted money that many Govt servants have amassed clearly point towards this fact.
 
d)      Another chronic problem that the Govt departments are facing since past few years is that of staff shortage. A short visit to the tax department and a brief discussion with any randomly selected tax officer will reveal that almost every officer is under staffed and over worked. The number of cases selected for scrutiny being huge and consequently, the resultant litigation, appeals, rectifications etc arising on account of the scrutinies are simply too heavy to be handled efficiently by the current staff strength. To compound this problem, the CBDT chairman has apparently issued a letter to the Commissioners of Income-tax on 7^th February to the effect that their career prospects would depend on their success in meeting targets for tax collection, emphasising the government's desperation to raise revenues to plug the rising fiscal deficit. The Chairman of CBDT has told 100 top officials that tax revenue targets are 'nonnegotiable'. The letter further goes on to state that "Among the parameters of performance in your area, achievement of revenue collection target will obviously be given the highest weightage while writing your APAR and (it) will also be a major factor while considering placements during AGT 2012." APAR is the annual performance appraisal report and AGT is annual general transfer. 
 
In light of this kind of a situation, it is common sense that the tax officers would be pressurised to make high pitched assessments and raise huge demands. A logical fall out of this would be that tax payers will be forced to pay under the table to prevent such harassment. This only gives rise to more unaccounted money.
 
e)      The construction industry is one of the biggest generators of unaccounted money. It is common knowledge that almost every transaction relating to an immovable property involves the give and take of huge sums of cash. Has any Govt worth its salt taken any steps to put an end to this menace? The latest Budget proposes to levy a 1% TDS on certain transactions. But here too, there are certain gaping deficiencies. Firstly, transactions involving agricultural land are excluded from this provision. It is common knowledge that agricultural land sale also involves huge sums of cash. Therefore, there is no effort to detect, prevent and punish the guilty from engaging in transactions of purchase and sale of agricultural land with unaccounted money. Secondly, the 1% rate of TDS is far too low to bring to tax the income from such transactions. For example, if a flat is sold for say, Rs. 2 crores and the profit margin is 20%, then the seller makes a profit of Rs. 40 lakhs. Presuming a tax rate of 30%, the tax payable is Rs. 12 lakhs. Against this, the buyer is now expected to deduct TDS of Rs. 2 lakhs only. Finally, there is the issue of giving credit for the TDS to the seller. While this does not, per-se, have a direct nexus with generation of unaccounted money, the fact remains that even with a detailed system of OLTAS and elaborate TDS statements, a large number of tax payers do not get credit for huge sums of TDS. This happens even though TAN, PAN etc are duly filled in at various places. Now, in the newly proposed section, there is a move to do away with the requirement of quoting the TAN and also filing of TDS statement by the deductor. I am very sceptical about the seller getting credit for the TDS in such cases. If this is an apprehension that is shared by the builders and/or sellers of property, it would only result in the selling prices of property being inflated to the extent of the TDS. In all probability, this amount would exchange hands in cash. The result, ironically, would be that the very proposal that is brought in to curb black money will only increase the generation of more black money.
 
f)       In the Budget, the Finance Minister has specifically referred to “the following legislative measures for strengthening anti corruption framework”:

• Prevention of Money Laundering (Amendment) Bill, 2011 introduced in Parliament with a view to bring certain provisions of the Act in line with global standards;
• Benami Transactions (Prohibition) Bill, 2011 is currently being examined by the Standing Committee on Finance. It would replace the `Benami Transactions (Prohibition) Act, 1988’

 
Now, with due respect to the Government’s stated objective of bringing the PMLA in line with global standards and the referral of the other Bill to the Standing Committee, I would like to question the outcome of both initiatives. We are all aware of the fact that the Standing Committee on Finance to whom the DTC was referred had come down strongly on the various GAAR related provisions in the DTC. Despite this, the Govt has thought it fit to introduce even more harsh GAAR provisions into the IT Act. Therefore, the sanctity of the Standing Committee itself is in question here. That being the case, the common man is entitled to a genuine belief that the reference to the Standing Committee is only an eye wash. So also, the stated objective of bringing certain provisions of the PMLA is in line with global standards. If this were actually the case, then some of the draconian provisions that have been proposed in the DTC would certainly not have seen the light of the day. I wonder which country has a long standing tradition of bringing retrospective amendments to its tax laws.
 
g)      On the issue of black money, the budget says that “The Government has taken a number of proactive steps to implement this strategy”. The strategy referred to here is the strategy outlined in the earlier Budget. The proactive steps mentioned here include the finalisation of 82 DTAAs and 17 TIEAs. It is claimed that “information regarding bank accounts and assets held by Indians abroad has started flowing in. In some cases, prosecution will be initiated”. Coupled with this, there is a move to make it mandatory for any tax resident holding assets abroad to file a return of income in India even if he/she does not have any income in India. A question that arises here is “Can the Govt first act on the small list of bank accounts held in HSBC by about 700 Indians”? In this connection, a press report is reproduced below:
 
MUMBAI: The Income-Tax Department in Mumbai has secured at least 17 'voluntary disclosures' out of 700 Indians having secret accounts with HSBC Bank, Switzerland.
 
The list of Indians having unreported accounts with the bank was handed over to India by the French government a few months ago.
 
According to sources in the tax office, the amount disclosed ranges from Rs 50 crore to Rs 300 crore. Many in the list have opted to file 'revised return' — a procedure allowed under the Income-Tax Act for taxpayers who think they made a mistake while filing the original return.
 
Revised returns are usually filed within a year of filing the original. The I-T department has chosen to summon the alleged evaders and ask them to declare their undisclosed offshore deposits rather than initiate prosecution proceedings. This is on account of two reasons.
 
Firstly, the tax department does not have the manpower to go after all the 700. It has, instead, prepared a shortlist based on the quantum of deposits in the HSBC accounts.
 
No strong action
 
The tax department is also not in a position to verify the list with HSBC Switzerland, as the information was stolen. It is these factors that have prevented it from taking stringent action against the alleged tax evaders.
 
The list is part of the stolen data that French authorities obtained from a former HSBC employee. Such a list has to be certified by Swiss authorities before it can be used as evidence in any court of law. Both the tax office and taxpayers are in a tricky situation.
 
I-T officials know prosecuting those in the HSBC list may be a long and difficult process while the taxpayers have sensed that fighting the department, which has come to know about the accounts, can be painful and expensive. Under the circumstances, the I-T department is taking a carrot and stick approach.
 
"If someone agrees to pay tax, there will be very little action against him. Otherwise, the department may not only use its powers, but also involve the Enforcement Directorate. Then, the party may face charges relating to violation of foreign exchange regulations and money laundering," said a person familiar with the situation. The Enforcement Directorate administers the Foreign Exchange Management Act and Prevention of Money Laundering Act.
 
It is clear to me that the Govt lacks the will to go after such tax evaders. The fact that regular tax payers are hounded day in and day out for the smallest of defaults including small TDS defaults while the big fish with several hundred crores in foreign bank accounts are not pursued vigorously because it “may be a long and difficult process” only highlights the fact that something is wrong somewhere. What is it that prevents the CBDT chairman from picking up 20 of his top CITs and their entire team and taking away all the regular scrutinies handled by them and instead handing over to them the work of going hammer and tongs after the 700 people listed in the HSBC list? The only reason that I can think of is that it is simpler for the tax department to punish honest people who are already tax payers than to go after the tax evaders.
 
h)      Another important aspect that is constantly neglected by the Finance Minister is about brining in accountability into the system. Today, we are all aware of the manner in which tax department is administering the law. The Govt has brought out the “Citizen’s Charter” for the Income-tax Department which is a “declaration of its Vision, Mission and Standards of Delivery.” In this Charter, one of the Mission Statements of the tax department is “to enforce tax laws with fairness”. This is a cruel joke that is being perpetrated on the tax paying community by the Govt. It seems very unlikely to a tax payer (who does not get his refunds in time, who is constantly served with notices informing him of arrears of demands for years dating back into history) that his ITO has ever read this Citizen’s Charter. In any case, if there is no deterring section or rule in the tax law of the country which will make an officer think twice before taking any action, how can one expect any officer to act responsibly and in a just and fair manner?
 
i)        Finally, based on the discussions that I have had with a broad spectrum of tax payers and the feedback that I get from the audiences where I have addressed meetings, I am of the opinion that the credibility of the Govt is at a new low. The common man learns about new scams and new corruption charges every day. He also reads news reports that the accused get bail and are out of jail very soon after they are caught. Therefore, the common man is very sceptical and cynical about the Govt’s intentions on unearthing black money. Till such time as these doubts, cynicism and scepticism remain, it is unlikely that people will stop generating and circulating black money simply because they would rather not pay tax because they are not sure how their hard earned money is spent by the Govt when it is recovered from him by way of taxes.

Budget 2012, Software, and Irony!

The Software Industry has been having a torrid time due to haziness in taxation laws around Software.  The myriad of litigation is proof enough.  Many of my colleagues watched Budget 2012 with great expectation as they were expecting some relief from the Finance Minister.  However, post the budget most of them came back and said that there was nothing much for the Industry and it was status quo.  Time was to suggest that all of us had missed the ‘detail’ and the devil was indeed there.  Post the budget we have now heard many experts talk about the various retrospective amendments, clarifications that have been made in the Income-Tax Act, the manner in which service tax has now moved to a ‘negative list’ based of taxation etc.  I thought of highlighting a few changes which will affect the Software Industry especially those companies which ‘trade in software’ i.e. buy and sell ‘shrink wrapped software products’ in India.
 
Companies who traded in shrink wrapped software products have for long been either importing from outside India or buying these products locally in India and then selling them to their customers in India.  These trading companies in the case of imports, imported shrink wrapped boxes through customs and paid appropriate custom duties thereon and when sourced locally they paid taxes local taxes such as Sales Tax, VAT etc. as charged by the supplier.  Subsequently, when selling the products to its customers these trading companies charged appropriate taxes such as Sales Tax, Octroi, or VAT as the case may be.  As you will notice, the entire industry was clearly under the belief and understanding the they were buying and selling ‘goods’ as defined under law.
 
The Income-Tax officials at some point in early 2001 woke up and made demands on these companies on the pretext that the payments made by them to their suppliers of shrink wrapped products was in the form ‘Royalty’ as defined under the Indian-Income Tax Act and so was duty bound to have deducted tax on these payments.  They pursued the line of argument that this was not in the nature of purchase of goods and the understanding of the Industry was wrong.  This was clearly a case of the department waking up after the ‘proverbial horse had bolted’.  The companies had already made payments for their purchase and there was no way they could now go back and ‘deduct taxes on their payments in the past’.  The liability for missed deduction was thus for the companies to bear.  The trading companies picked up the debate with the department it became a raging dispute.  To ensure that the liability did not continue to build up, most of the companies started deducting taxes on payments commencing 2002.  As regards cases for the previous years, multiple decisions of the Tribunals and High Courts held in favor of the companies and said that payments for purchase of shrink wrapped software was not in the nature of royalty whereas a couple of decisions held against that view as well.  The question is now finally pending before the Honorable Supreme Court.
 
Now, in the Budget 2012 the Government has inserted certain clarifications to Section 9 of the Income-Tax Act stating that right from 1976 they have believed that payment for import of shrink wrapped software was ‘Royalty’.  Effectively they answered the question pending before the Supreme Court in their own favor and with retrospective effect.
 
The same Ministry of Finance which made the above amendment through its Tax Research Unit has issued a circular covering amendments made it in Budget 2012 to the Service Tax Act covering the taxation of shrink wrapped software.  Reproduction of Clause 5.4.4 from the aforementioned circular reads as:
 
“It is a settled position of law that prepackaged software or canned software or shrink wrapped software is goods. (Supreme Court judgment in case of Tata Consultancy Services vs. State of Andhra Pradesh [2002(178) ELT 22(SC) refers]. To determine whether providing license to use a software is a service or sale of goods it would need to be seen whether the license to use packaged software tantamount to ‘transfer of right to use goods’. ‘Transfer of right to use goods’ is deemed to be a sale under Article 366(29A) of the Constitution of India…..”
 
In simple terms, the Tax Research Unit has clarified that sale of ‘shrink wrapped software’ is sale of ‘goods’ as ruled by the Supreme Court and hence no ‘Service Tax’ is applicable from a date to be notified.
 
The irony cannot be more glaring.  The Finance Ministry believes with retrospective effect from 1976 that ‘payment for shrink wrapped software is ‘Royalty’ under the Income-Tax Act even while the question is pending before the Honorable Supreme Court and the same Finance Ministry supported by its Tax Research Unit holds that Shrink Wrapped Software is ‘goods’ and takes guidance from a ruling of the Honorable Supreme Court to support its view!
 
When the Law makers, the Ministry and the Government are so confused think of the plight of the tax -payer.  When a debate starts between the tax-payer and the Government it clearly looks like that the latter has an undue advantage, and this is not a debate between equals.  I think the need of the hour is certainty, clarity and clarifications which are prospective and not retrospective.
 
In the next part I will cover an amendment which is positive in nature and sets right a draconian provision in the Income-Tax Act.
 

GAAR - Impact on tax planning

A Sovereign state which has the power to enact laws, should enact appropriate laws to safeguard its own interest and in the better interests of its people. Effective and express legislation enforces clarity and certainty to an investor upfront on what a country holds for him/her at the threshold. For an express legislation to be effective, yardstick is how the legislators and subordinate authorities implement and enforce the same. The express legislation which is effectively implemented leaves no room for surprises and distress, letting an investor to take an informed decision before making a foothold in any country.
 
True, the above is for a country like India which has been a lucrative destination for doing business for various business houses. India must offer certainty and repose the confidence in one and every who views India as a stop to set-up business operations.
 
With the introduction of GAAR in the present Act, anticipation and apprehension around its codification in the Indian Income Tax history which was surmounting day by day has come to rest. The Supreme Court of India has advocated bringing in codified legislation to counter aggressive tax avoidance and subscribed to the fact that the codified law advances certainty to an investor.
 
Having said this, let us do an encore.
 

• Is the timing right for India to legislate a code like that of GAAR?
• Is India ready or to put it differently, have we analysed the tangible impact of bringing in GAAR?
• Will India’s viability as lucrative jurisdiction for business operations be getting lost?
• What are India Inc’s apprehensions? And
• What all ironing GAAR needs for it to be express and effective legislation for India?

 
These questions and many more are making rounds in everyones’ mind. Furore which was created merely with the proposal of GAAR in DTC two years back has now become reality and more furore can be expected from both sides i.e. tax payers and the tax department.
 
GAAR remains an enigma till it is tested in Indian waters. Though the powers of an assessing officer seems to go through two-layered filtration process – one at CIT level and other at level of Approving Panel, yet the current dispute standards set by the tax department does not let investor to not get worried of his/her legitimate actions as well.
 
Gargantuan exercise to apply GAAR and complete the process is to be watched out for. But it appears that legitimate tax planning has to be more than legitimate to escape being struck in the web of GAAR. Documentation to be put in place to secure a safe position away from the trigger point of GAAR.  How one achieves the sanity, one may ponder over.
 
It would be good governance on the part of the tax department if GAAR is invoked in actual tax evasion transaction only. Looking at the present form of GAAR, all transaction even if having a miniscule tax benefit may attract GAAR. Investors will welcome these provisions in spirit if the Government reflects that no undue hardship being caused to a rational businessman and makes sure that implementation is in more mature & neutral hands. It would not be less than ideal if certain industry experts are nominated for the Approving Panel so that long-term approach can be culled out in a transaction much above than one-time tax benefit i.e. rational analysis of the problem on hand. Business purpose should continue to resonate and be appreciated by the tax department.
 
Today, when world economies are changing constantly and businesses are looking at inorganic growth, business reorganizations are natural more than common. These reorganizations not only aim at achieving economies of scale or synergies but also channelize capital to core competencies. With GAAR coming in, these advantages may be outperformed by tax challenge in the form of GAAR. Clarity on imperative tax aspects of GAAR will redefine frontiers for India and growth trajectory, India is on.
 
Though the Indian legislators have casted GAAR in lines with the internationally accepted standards of anti-avoidance measures, even since the concept of GAAR made a debut in the DTC, India Inc has been making several representations and efforts to ensure that GAAR does not end up putting extraneous burden or arouse anxiety among the taxpayers to the extent that they don’t take up sound commercial decisions under the fear of GAAR.
 
GAAR provisions, as proposed, would apply to a taxpayer irrespective of the fact that the treaty provisions are more beneficial. It may be noted that a unilateral enactment of a new domestic tax law which is contrary to an existing treaty, without an amendment in treaty could possibly be regarded as violation of international law and is generally known as ‘treaty override’. How international community will perceive the same that is for the times ahead to tell.
 
Some of the important recommendations of the Parliamentary Standard Committee on Finance (as mentioned below) are yet to be incorporated in GAAR as proposed under the Finance Bill, 2012:
 

• Suitable grandfathering provisions may be made to protect the interest of the tax- payers who have entered into structures / arrangements under the existing law
• Uncertainties with regard to applicability of tax treaty provisions to be removed so that India’s credibility as a reliable treaty partner is not affected
• Proposals should not lead to any fiscal uncertainty or ambiguity;
• It should be ensured that any of the proposals do not pave the way for increased and avoidable litigation.

 
To conclude, it is important to have adequate built –in safeguards to ensure it does not unleash unnecessary litigation. It is understood that GAAR is best implemented in a climate of trust…in an environment in which there is faith in the transparency, fair play and reasonableness of the administration.

Reassessment for 16 years - will it impact cases other than black money?

In the current Budget 2012, the Hon’ble Finance Minister has initiated various measures to unearth black money. In order to curb tax avoidance and enforce the concept of substance over form, the Indian revenue policy makers have proposed various tax reforms. Amendment in the provisions of Section 9 of the Income-tax Act, 1961 (Act), introduction of General Anti- Avoidance Rules (GAAR) and et care the steps to curb the tax avoidance practices. Amongst the other measures to unearth the black money the Hon’ble Finance Minister has also proposed an amendment in provisions of section 147 and section 149 of the Act.
 
Presently the provisions of section 149 are as under:
 
S. 149. (1) No notice under section 148 shall be issued for the relevant assessment year,—
(a) if four years have elapsed from the end of the relevant assessment year, unless the case falls under clause (b);
(b) if four years, but not more than six years, have elapsed from the end of the relevant assessment year unless the income chargeable to tax which has escaped assessment amounts to or is likely to amount to one lakh rupees or more for that year.
Explanation — In determining income chargeable to tax which has escaped assessment for the purposes of this sub-section, the provisions of Explanation 2 of section 147 shall apply as they apply for the purposes of that section.
(2) The provisions of sub-section (1) as to the issue of notice shall be subject to the provisions of section 151.
(3) If the person on whom a notice under section 148 is to be served is a person treated as the agent of a non-resident under section 163 and the assessment, reassessment or recomputation to be made in pursuance of the notice is to be made on him as the agent of such non-resident, the notice shall not be issued after the expiry of a period of two years from the end of the relevant assessment year.
 
Section 148 specifies the time limit for the issue of notice where income has escaped assessment. Thus under the existing provisions of the Act, the time limit for issue of notice for reopening an assessment towards income escaping assessment is six years.
 
Proposed Amendment
 
In the present Finance Bill 2012, it is proposed to amend the provisions of section 149 of the Act so as to increase the time limit for issue of notice for reopening an assessment to 16 years, where the income in relation to any asset (including financial interest in any entity) located outside India, chargeable to tax, has escaped assessment.
 
Following proviso is proposed to be inserted in section 147 of the Act:
“provided further that nothing contained in the first proviso shall apply in a case where any income in relation to any asset including financial interest in any entity located outside India chargeable to tax, has escaped  assessment for any assessment year”
 
Section 149 shall be amended to include as under:
“ if four years , but not more than sixteen years , have elapsed from the end of the relevant assessment year unless the income in relation to any asset ( including financial interest in any entity) located outside India, chargeable to tax has escaped assessment’
 
It is proposed to amend the provision of section 149 of the Act so as to increase the time limit for issue of notice for reopening an assessment to sixteen years, where the income in relation to any asset (including financial interest in any entity) located outside India, chargeable to tax, has escaped assessment. It is stated in the explanatory memorandum that the time limit of 6 years is not sufficient in cases where assets are located outside India because gathering information regarding such assets takes much more time on account of additional procedures and laws of foreign jurisdiction. Thus, the prime intention of the amendment as envisaged in the explanatory memorandum to section 149 is to unearth the black money parked in foreign jurisdiction in various forms and to charge to tax income in relation to any asset (including financial interest in any entity) located outside India.
 
It seems that the Finance minister had been focusing too much in the present budget to overcome the recent Supreme Court Ruling in the case of Vodafone International Holding BV. v. Union Of India [2012] 204 Taxman 408 and in doing so he has ignored the other implication of the proposed amendment to section 149 of the Act.
 
The proposed amendment to section 149 will have far reaching implications and may not be restricted only to the purpose for which the section is proposed to be enacted. The amended section states that the provisions of section 149 of the Act would be invoked ‘…to charge any income in relation to any asset (including financial interest in any entity) located outside India”. The provisions of section 149 of the Act would be invoked to tax any income from any asset located outside India. Thus in a scenario wherein a non-resident owns shares in a company registered in a foreign country provisions of section 149 ought to be invoked as owning of shares in a company registered in a foreign country will be treated as financial interest and thus subject to provisions of section 149 of the Act. The words ‘financial interest’ is neither defined in the Explanation to section 149 or under section 2 of the Act and therefore the litigation on the interpretation of section 149 would increase with the passage of time
 
The provisions of the section would be invoked in respect of any asset located outside India and therefore the officer may go beyond territorial jurisdiction to form reason for reopening the assessment. The information is purported to be gathered from other jurisdictions and therefore more likely than not the government of other jurisdiction would play a major role in gathering the information. In a scenario wherein the reason recorded for reopening is challenged by the taxpayer and presuming that the case is adjudicated in favour of the taxpayer, the entire judicial system would be doubted, the world over.
 
The time limit for reopening of assessment in the specified scenarios is proposed to be extended to sixteen years. The implication of the said amendment would be the taxpayer ought to maintain the books of account for sixteen years henceforth. The necessity to maintain the books of account would be substantiated with the fact that there are many judicial pronouncements in favour and against the taxpayer on the proposition of whether the assessing officer can redo the entire assessment?  Thus by virtue of introduction of the new amendment, if taxpayers are required to maintain their books for a period of 16 years, it could prove to be cumbersome and unreasonable exercise. Further, while the taxpayer may start maintaining books of account henceforth , but due to retrospective amendment, in case the Revenue authorities re-opens the assessment for any year prior to the last 7 years, it would be difficult for the taxpayer to furnish books of account to substantiate its claim.
 
Thus the amendment in section 147 to section 149 in respect of reopening of assessment would have a far reaching effect and would not be restricted to unearth black money. Amendment to the reassessment provisions might cause hardship to genuine taxpayers and burden taxpayer to maintain books of accounts for 16 years!!!

Rajendra Nayak - Partner, International Tax Services, SR Batliboi & Co.
Unintended consequences of amending Sec 9!

Tax policy has in the recent years been a key lever, globally, to revive, resuscitate and re-set economies on a much-needed growth trajectory. In the Indian context, this couldn’t have been more relevant, in the wake of a slowdown in the economy in the past year, which was mainly due to an uncertain global economic environment and domestic challenges on certain macroeconomic factors. However, the road-map for providing for a better fiscal consolidation, as seen in some of the 2012 budget proposals, has been done at the cost of cataclysmically unsettling established tax positions, and which could (in)advertently vex the investment climate for multinationals.
 
“clarifying” the meaning of “through”
 
Perhaps bitter over the Vodafone defeat^[1], and aware that the provisions for taxation of offshore indirect transfers of an underlying Indian asset in India as present in the Direct Taxes Code would not get promulgated soon, the Government has proposed to introduce and tax such transactions in the current Indian Tax Law (ITL), albeit retrospectively (i.e., from April 1962). However, in doing so, the Government has probably widened the scope of not just indirect transfer of a capital asset situated in India, but also of other source rule taxation of income, deemed to accrue or arise in India.
 
In this context, the source rule in the ITL under section 9(1)(i), provides certain streams of income, which are deemed to accrue or arise India. It is a legal fiction created to tax income, which may or may not arise in India and would not have been taxable but for the deeming provisions created under this section. The section provides source-based taxation of all income accruing or arising, whether directly or indirectly, through: (i) or from any business connection in India; (ii) or from any property in India; (iv) or from any asset or source of income in India; (v) the transfer of a capital asset situate in India. The Finance Bill 2012, has now “clarified” that in the source rule, the expression “through”, shall mean to include “by means of” or “in consequence of” or “by direct reason of”.
 
While the intent, as evident from the memorandum explaining the provision, is to only capture offshore indirect share deals which have substantial Indian underlying assets, there could be some unintended tax consequences. It may be noted that in the Vodafone ruling, the Supreme Court had held that the source rule provisions under the ITL needs to be strictly construed and in the absence of a “look through” provision, an indirect transfer would not be taxable in India. Now however, juxtaposing the proposed meaning of “through” with other limbs in the source rule (above), it would seem that the expanded meaning qualifies all the other streams of income, and may have far reaching consequences beyond the fact pattern in Vodafone-like cases. These cases may result more particularly in the context of a nonresident having any “property” or “asset or source of income” in India, rather than through a “business connection” as the same is restricted in the section itself to only operations carried out in India.
 
To illustrate, a nonresident provides a guarantee for a loan taken by another nonresident from a bank. As a guarantor, the nonresident, who has no business or profession in India, may provide a Indian shares as a collateral to the bank. The issue that may arise now is whether the guarantee fee that the non-resident guarantor earns arises directly or indirectly “through” or from an asset or property situated in India.
 
As a measure of clarification, explanation 5 provides that share or interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India if the share or interest derives, directly or indirectly, its value substantially from the assets located in India. Once the asset is deemed to be in India, income from such asset is also deemed to accrue or arise in India. This could imply that any dividends distributed by the foreign company whose shares are deemed to be situated in India could also be regarded as accruing or arising India.


Royalty blues for taxpayers
 
The Government has also amended the source rule on taxation of royalty related transactions, provided under section 9(1)(vi) of the ITL. The royalty source rule provides that any income payable by way of royalty in respect of any right, property or information is deemed to accrue or arise in India. The term “royalty” has been defined to mean consideration received or receivable for transfer of all or any right in respect of certain rights, property or information. There have been a catena of judicial decisions, which have interpreted this definition in a manner which has raised doubts as to whether consideration for use of computer software is royalty or not; whether the right, property or information has to be used directly by the payer or is to be located in India or control or possession of it has to be with the payer. Similarly, doubts have been raised regarding the meaning of the term “process”.
 
The debate principally has focused on characterizing transactions as generating either “royalty” or “sales” income. The characterization of income as “royalty” or “sales” income can have obvious consequences, particularly in light of the fact that under the ITL as well as under many Double Taxation Avoidance Agreements (DTAAs), income characterized as “royalty” attracts withholding tax, whereas any income characterized as “sales” income or “business profits” would not be subject to tax in India in the absence of a permanent establishment (PE) or other taxable presence of the nonresident in India.
 
The Indian tax authority has generally taken a position that income arising from such transactions should be characterized as “royalty”, irrespective of the nature of rights acquired by the end-user or re-seller. The Taxpayer's position on the other hand generally has been that characterization as royalty or business profits, especially under an applicable DTAA, should be based on the nature and extent of rights granted to the end user. Depending upon the nature and extent of rights granted, a distinction needs to be made between a "copyright” transaction (generally giving rise to royalty) and "copyrighted article" transaction (generally giving rise to sales income). Further, supply of “shrink wrapped” computer program should be regarded as a "copyrighted article" transaction.
 
The overall tenor of judicial thinking on this issue, as evident in the Delhi High Court (HC) ruling in the case of Ericsson [246 CTR 422], has recognized the distinction between copyright right and copyrighted article. However, a different approach has been taken by the Karnataka HC in the case of Samsung Electronics [245 CTR 481], wherein it was held that payment for shrink-wrapped software is taxable as royalty. On the issue of whether payments for using segment capacity in a transponder for up-linking/ down-linking data is taxable under the ITL, the Delhi HC in the case of Asia Satellite [332 ITR 340], ruled that such payments do not constitute royalty under the ITL as the Taxpayer does not grant the customer a right to use the “process” of transmitting signals/data under the arrangement.
 
Appearing to clear and clarify  the conflict on various court decisions, as stated in the memorandum explaining the provisions, the Government proposes to amend retrospectively (i.e., June 1976) the definition of royalty in favor of the Tax Authority, to enlarge its scope whereby: 

• The consideration for the transfer of all or any right would include right for use or right to use a computer software (including the granting of a license) to be taxable as royalty regardless of the medium through which the right is transferred;
• ‘royalty’ would also include consideration paid for right, property or information, regardless of such right, property or information being: in the possession of the payer; used directly by the payer; located in India.
• the expression ‘process’ includes transmission by satellite (including up-linking, amplification, conversion for down-linking of any signal), cable, optic fibre or by any other similar technology regardless of whether such process being secret or not

 
While the above amendments do not directly impact the interpretation of the term “royalty” under an applicable tax treaty, it is likely that the tax authority could now seek to argue that the clarification in domestic tax law is an expression of the intention that also existed when the tax treaty was negotiated and should be considered for interpreting the terms “right to use copyright”, “process” that are used in the in the royalty definition of the tax treaty; but not defined. The Government could also seek to notify the meaning of these terms for purpose the tax treaty.
 
What is perhaps significant in the section 9 source-rule proposals is its retroactive operation and whether they are constitutionally valid. This aspect, may be challenged legally as it may be argued that, the proposals not really “clarify”, but purport to make substantive amendments to the source-rule, and accordingly infringe on the rights of the taxpayers. The proposals, if passed, would have far reaching impact on past assessments and for the tax deductors, including representatives for non residents.
 
Rapid technological evolution in the space and communications industries has taken place over the last decade, which has resulted in changes in business practices and business models. The emerging convergence in communications, technology, media and outer space activities raises a number of tax issues such as our ability to apply our traditional principles of source and residence for taxing these activities, applying the conventional concept of fixed place of business or permanent establishment as a threshold for taxing cross-border activities, challenges in classifying income arising from these activities as royalty or technical service fees. It might be expected that many countries could react by protecting and expanding their own taxing jurisdiction over income arising from cyberspace, outerspace and ocean activity, creating double taxation issues. The proposed amendments in the Finance Bill, 2012 reflects India’s reaction to these technology developments.
 
As India moves towards a more open economy and emerges as a key stakeholder in global trade and commerce, cross-border transactions will continue to grow manifold. However, lack of a clear and certain tax environment, as reflected in the Government’s belligerence in pushing through vexatious tax proposals, is likely to exacerbate the ambiguity that currently prevails on these matters and exasperate interested investors. While the future may be fraught with uncertainty, careful and comprehensive tax and risk management would go a long way in avoiding possible pitfalls for multinationals.
 

[1] Vodafone International Holdings B.V. vs UOI and Anr. (341 ITR 1)

Are GAAR provisions unconstitutional?

GAAR is introduced in Finance Bill 2012 to address aggressive tax planning and codify the doctrine of “substance over the form”. However, such introduction when a Report of the Standing Committee has provided significant comments thereon (which Report is being discussed in the Finance Ministry) is certainly not the best thing. As per legal circles, the provisions of GAAR can perhaps be challenged as violative of the constitutional right to practice any profession, or to carry on any occupation, trade or business. This will also nullify an established position that a tax payer is legally entitled to arrange his affairs so as to pay minimal tax and is not expected to choose a way which entails payment of maximum tax.
 
Surprisingly, in the present form of GAAR the burden is on the assessee to prove that there is no “tax benefit” and the transaction is not an “avoidance transaction”. Even under criminal law, the Constitution provides that no person accused of any offence shall be compelled to be a witness against himself. The provisions of GAAR by casting a presumption of tax avoidance where any tax benefit results from an arrangement or even part thereof (unless the assessee proves otherwise) amounts to casting an onerous burden on a tax payer.
 
In Canada, the burden is on the revenue to prove that there is “abusive” tax avoidance and GAAR is applied only if transaction results in misuse or abuse of the provisions of the Act/ Regulations/Rules/Tax Treaties.
 
A perusal of the finance bill provides following situations for invoking GAAR:

• Creates  rights / obligations that are not normal between arms’ length parties;
• Results directly or indirectly in misuse or abuse of the provisions of the Act;
• Lacks commercial substance;
• Means or manner employed not ordinary for bona fide purposes.

 
Current provisions are inspired from the GAAR provisions in the South Africa. Being non-obstinate provisions, GAAR overrides all the other provisions of the Act. Further, the terms used and defined in the GAAR provisions are wide enough to include even legitimate transactions for which a deduction/ benefit is within the GAAR net. Treaty override provisions leave no recourse to assessee to whom GAAR provisions are made applicable.
 
In Australia, the treaties override the rest of the domestic income tax legislation except GAAR. This position prevails since 1981. However, in respect of treaties signed prior to 1981, the treaties will override even the GAAR. Will this be true for Indian DTAA signed prior to Finance Act 2012?  This is the least that needs to be provided.  Also a public debate/consultation is needed to test the GAAR proposals against commercial transactions to ensure that they would not get unnecessarily caught as UK is contemplating to do. The provisions can in the present form undermine tax certainty and can perhaps lead to making India less attractive in Global Business world.
 
In UK, a report on feasibility of GAAR was submitted to the UK Government. This report had concluded that GAAR would not be beneficial for the UK tax System as it would carry “a real risk of undermining the ability of the business to carry out sensible and responsible tax planning”. However, it was suggested to introduce a moderate rule which does not apply to reasonable tax planning, and instead target only abusive arrangements as that would be better from a country perspective. Further, even this should not be done without public consultation. We need to have this kind of approach to be incorporated in our legislation.
 
Certain tests which are to be considered before implementation of GAAR in UK are:
-       whether it simplifies the overall tax code,
-       whether it will promote growth in UK,
-       whether it will improve the UK’s competitive position and increase the perception of fairness in tax system, etc.
 
Similar considerations and tests should be considered by India before embarking on this journey.
Also it’s not clear as to whether GAAR is applicable in cases where the Legislature itself has provided a “tax benefit”? For example - Investment in bonds approved under section 54EC, Setting up of units in backward areas under section 80IC, Amalgamation of loss making companies into profit making companies, utilization of losses in compliance with Section 72A, etc. Even if the provisions stand the test of constitutional validity, the provisions of the proposed GAAR would have to be read down to exclude such “tax benefits” provided under the statute to ensure that these benefits already forming part of current tax statute are not diluted/denied.

Battle of Copyright vs. Copyrighted Article not yet over under Treaty ...

1. The growth of technology in the last few decades and the fast-paced globalisation has deeply influenced the conduct of business transactions. Computers and software are words which have become synonymous with modern business. With the surge in e-commerce and information technology based transactions, the taxation of computer software has attracted the attention of the revenue authorities. In the recent years, the taxability of payments made towards software has been a hotly debated topic in the tax courts. The million dollar question is – “Whether the payments for use of computer software are ‘royalty’ under Section 9(1)(vi) or the Article of the relevant tax treaty?”
This controversy has been further fuelled by the Budget Proposals vide the Finance Bill 2012 which seeks to retrospectively tax payments towards software payments as ‘royalty’ through insertion of new explanations to Section 9(1)(vi), which are as under:
1.1 Explanation 4 to Section 9(1)(vi) clarifies that the consideration for use or right to use of computer software is royalty by clarifying that transfer of all or any rights in respect of any right, property or information as mentioned in Explanation 2, includes and has always included transfer of all or any right for use or right to use a computer software (including granting of a license) irrespective of the medium through which such right is transferred.
1.2 Explanation 5 to Section 9(1)(vi) clarifies that royalty includes and has always included consideration in respect of any right, property or information, whether or not
(a) the possession or control of such right, property or  information is with the payer;
(b) such right, property or information is used directly by the payer;
(c) the location of such right, property or information is in India.
These amendments will take effect retrospectively from 1^st June, 1976 and will accordingly apply in relation to the assessment year 1977-78 and subsequent assessment years.
2. Before we embark upon the analysis of the impact of these explanations on the current status of taxability of payments for software and impact of proposed Explanation 4 & 5, it would be useful to get an insight into the types of software and the standard structure/model of software transactions:
2.1 Types of Software:
2.1.1 Off-the-shelf or shrink-wrapped software:
Computer software which is ready to use is known as ‘off-the-shelf’ software or ‘shrink wrapped’ software. Such type of software is not customised for any particular person. Examples of this type of software are commonly used software like Microsoft Office range of products and Tally.
The end user of such software cannot make any modifications or customizations to the software. Typically, the purchase of such software entails a license agreement to be entered into between the end user and the software developer (mostly electronically) which governs the terms of usage of software and lays down the purposes for which the software may be used.
2.1.2 Customised software:
Computer software which is developed based on specific requirement of its user is known as ‘Customised software’. It is not generic or standard software which can be used by anyone as it is designed to meet the objectives of the specific user. Examples of this type of software are the special accounting and ERP software packages designed for corporate users.
However, there are some customised software packages which are not specific to the needs of a particular user but are designed for a particular industry. Such computer software would be categorized as off-the-shelf software and not as customised software.
2.2 Standard structure/model of software transactions: There are typically the following parties involved in the transaction involving software - 
2.2.1 Software Developer: The software developer is the party which programs and develops the software and has all the rights in relation to the software and the source code of the same.
2.2.2 Distributor: The distributor is the party which obtains the rights from the software developer to copy and distribute/only distribute the software to the end users. The functions of the distributor may differ depending upon the rights held by him in relation to the software.
2.2.3 End user: The end user of the off-the-shelf or the customised software is the party who pays a consideration (either to the software developer/distributor) to use such software.
3. Controversies surrounding the taxability of sale of software
Before dealing with the implications of the proposed Explanation 4 and Explanation 5 to section 9(1)(vi), we are dealing with these issues extensively discussed and debated by the courts till date. The controversy of copyright vs. copyrighted article was largely dependent on the views given by the courts on the following issues. Therefore we have summarized the views of the courts on the following issues:
3.1 Whether the term “transfer of all or any rights” encompasses the term “use or right to use software”?
3.2 Whether the term “right” used in “transfer of all or any rights” refers to rights in respect of a copyright, as defined in the Copyright Act, 1957?
3.3 Whether any right is transferred in case of sale of computer software?
3.4 Whether the sale of computer software amounts to transfer of right in respect of copyright or process, invention or a literary work or all of this?
3.5 What are the implications of the rights of software manufacturer to sue the end user of the software over infringement of the copyright, rights of end user of the software to copy the software for back up purposes or for internal use?
3.1 Issue in relation to use or right to use
The term “use or right to use” does not find place in the definition of royalty provided under the Act[1]. However, this term has been used in the Article for royalty in all most all the tax treaties signed by the India and, while giving its view on the taxability of the sale of software from tax treaty perspective, the term has been extensively discussed by the courts.
While interpreting the Article 12 of the DTAA between India and USA, The Karnataka High Court in the case of Samsung[2] has opined that since the end user is authorised to make use of the copyright software contained in the software, which is purchased off the shelf or imported as shrink wrapped software, the same amounts to transfer of part of the copyright and transfer of right to use the copyright.  Further, the Delhi Tribunal[3] in the case of Gracemac Corporation and AAR in the case of Millennium IT Software[4] has given similar views the issue.
However, Mumbai Tribunal in the case of TII Team[5] has ruled that the connotation “use of copyright” is different from “use of a copyrighted article” and the meaning of “use of copyright” cannot be treated as extending to “use of a copyrighted article”. The AAR in the case of Dassault Systems KK has also opined that “use of copyright” is different from “use of a copyrighted article”. It is interesting to note that the Delhi HC, while holding that the sale of computer software cannot be classified as royalty, in the case of Ericsson A.B[6] has not given its findings on this aspect.
The arguments advanced by the Revenue:

• The revenue contends that the user acquires the computer software to obtain right to use the programme and right to copy the same. The user is permitted to copy the software onto the computer only because he has been permitted by the copyright owner under the concerned license granted to him.
• The Copyright Act, 1957 does not envisage that the reproduction can be said to have happened only in cases of mass copies or only if the software is copied for resell or commercial exploitation.

Conclusion:
The Courts have given divergent views on the interpretation on the term “use or right to use” in the context of sale of software.
3.2 Whether the term right used in “transfer of all or any rights” refers to rights in respect of a copyright?
While interpreting the term right used in “transfer of all or any rights”, almost all the courts have referred to the provisions of the Copyright Act 1957. Hence, it may be said that there is a judicial consensus that the term right needs to be understood as defined in the Copyright Act, 1957.
3.3 Whether any right is transferred in case of sale of computer software?
The courts have again taken divergent views while deciding the issue whether any right is transferred in case of sale of computer software. The Delhi HC (Ericsson), AAR (Dassault) and Mumbai ITAT (TII Team) has held that no right is transferred in the case of sale of software. However, Karnataka HC, Del Tribunal and AAR (Millennium) has held otherwise.
3.4 Whether the sale of computer software amounts to transfer of right in respect of copyright or process, invention or a literary work or all of this?
The Revenue has sought to tax the sale of computer software as royalty interpreting the same as copyright, patent, process, invention and literary work. The Revenue has contended that the software can be protected by its owner under copyright laws or patent laws. Further, the Revenue has also argued that computer software also amounts to process and literary work.
Though, the courts have agreed that the computer software is a literary work, there are divergent views on the issue whether the same amounts to patent / process as well[7].
3.5 What are the implications of the rights of software manufacturer to sue the user of the software over infringement of the copyright, rights of user of the software to copy the software for back up purposes or for internal use?
The rights of software manufacturer to sue the user of the software over infringement of the copyright or the rights of user of the software to copy the software for back up purposes or for internal use have been considered as the deciding factors while concluding whether the sale of software amounts to transfer or any copyright under the Copyright Act, 1957[8].
4. Analysis of Budget proposals – Explanation 4 & 5
The Finance Bill 2012 has proposed to insert Explanation 4 and Explanation 5 to the section 9(1)(vi) w.r.e.f 1^st June 1976. The definition of the royalty prescribed in Explanation 2 is apparently sought to be expanded by these two explanations. Explanation 4 clarifies that the transfer of all or any rights in respect of any right, property or information includes transfer of all or any right for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred. Further, Explanation 5 clarifies that royalty includes consideration in respect of any right, property or information whether or not the payer has the possession or control of it, the payer is using it directly or such right etc are located outside India.
4.1 Implications of Explanation 4:
Explanation 2 to the section 9(1)(vi) defines “royalty” exhaustively. The Explanation 4 seeks to cover “use or right to use a computer software” within the ambit of royalty. Further, it has been held in various judicial pronouncements that the definition of royalty contained in the Act is wider than the definition of royalty under the most of the tax treaties. Though the term “use or right to use” is found in most of the tax treaties India has signed, the term is succeeded with the word “copyright” in the tax treaties. However, the term “use or right to use” is succeeded with words “a computer software” in place of “copyright” in Explanation 4 to Section 9(1)(vi).
While deciding the taxability of the sale of software under the tax treaty, in some cases, the courts have opined that the term “use or right to use a copyright” does not include royalty.
While it remains to be seen how courts interpret the Explanation 4, the important questions which arise are

1. Can it be argued that the scope of the definition of royalty prescribed under Explanation 2 has been sought to be expanded by proposed Explanation 4 and considering that the ratio laid down in various judicial pronouncements that an explanation would only clarify a position of law and is not generally substantive in nature, Explanation 4 is liable to be struck down?; or
2. Can it be argued by the Revenue that irrespective of whether sale of software is covered under the definition of royalty under Explanation 2, the Explanation 4 would cover sale of software in its ambit as royalty? (if this be the case, the authors believe that the Explanation 4 has effect of transforming the meaning of royalty given in the Explanation 2); and
3. Can the interpretation given to the term “use or right to use copyright” while interpreting the tax treaty language be relied while interpreting the term “use or right to use a software”?

4.2 Implications of Explanation 5:
Explanation 5 seeks to clarify that once a right, property or information is deemed to be covered under Explanation 2 read with Explanation 4 to the Section 9(1)(vi), the interpretation would continue to remain so irrespective of possession or control of the right, property or information, direct or indirect use of the right, property or information or location of the right, property or information.
While it remains to be seen how Explanation 5 is interpreted by the courts, it would not be correct to state that on fulfilment of the situations laid down in Explanation 5, the taxability of sale of software is, per se, attracted. It would be pertinent to note that the Delhi HC in case of Ericsson[9], in the context of interpretation of Explanation to Section 9(1), has held that it would not be necessary to interpret Explanation to section 9(1) in respect of clauses (v),(vi), and (vii) of sub-Section (1) of Section 9, once it is held that payment in question is not royalty within the clause (vi) of Section 9 and accordingly the Explanation will have no application.
Accordingly, it may be possible for tax payers to argue that, on principles, the sale of computer software does not amount to royalty under Explanation 2 and hence conditions specified in Explanation 5 would not alter the taxability of the transaction.
Further, it is interesting to note that the Explanation 4 and Explanation 5 refers to transfer of all or any rights in respect of right, property or information or consideration in respect of any right, property or information. Ostensibly, the explanation does not refer to terms such as patent, process, invention etc. found in definition of royalty under Explanation 2 to Section 9(1)(vi). Accordingly, it remains to be seen whether this would mean that taxability of sale of software need not be looked into from the perspective of patent, process, invention etc.
5. Language used in the tax treaties
Definition of the term royalty varies under the tax treaties entered into by India. Under Article 12 of the India-UK tax treaty, the term royalty has been defined as payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic or scientific work, including cinematography films or work on films, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. The language employed in the other tax treaties is on similar lines.
The implications under the tax treaty, for payments made for purchase of an article, which contains copyright/intellectual property in it, can be no different if the proposition that a copyright is different from a copyrighted article is upheld.
The case laws delivering judgement in favour of the assessee have relied on the language used in the relevant tax treaties and have concluded that the sale of software does not amount to royalty. Conversely, the case laws delivering judgement against the assessee have equally relied on the language used in the relevant tax treaties and have concluded that the sale of software does amount to royalty.
6. Conclusion
To conclude, while the debate of taxability of sale of software will not alter, pre and post amendment under section 9(1)(vi), under the tax treaty situations, the battle of copyright vs. copyrighted article is far from over under the domestic provisions of the Act.
 

[1] Income-tax Act, 1961

[2] Commissioner of Income-tax, International Taxation v. Samsung Electronics Co. Ltd - [2011] 16 taxmann.com 141 (Kar.)

[3] Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[4] Millennium IT Software Ltd – [62 DTR 1]

[5] TII Team Telecom International Private Limited [TS-490-ITAT-2011-(MUM)]

[6] Director of Income-tax v. Ericsson A.B., New Delhi [2011] 16 taxmann.com 371 (Delhi)

[7] Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[8] Millennium IT Software Ltd – [62 DTR 1], Commissioner of Income-tax, International Taxation v. Samsung Electronics Co. Ltd - [2011] 16 taxmann.com 141 (Kar.) and Gracemac Corporation v. Assistant Director of Income-tax, International Tax Division, Circle 2(1), New Delhi – [42 SOT 550]

[9] Director of Income-tax v. Ericsson A.B., New Delhi [2011] 16 taxmann.com 371 (Delhi)

P - Notes: A story far from over

April 3rd, 2012
Participatory Notes (“P-Notes”) are a form of Offshore Derivative Instruments (“ODIs”) that are issued by Foreign Institutional Investors (“FIIs”) to entities that do not directly invest in the Indian public markets by registering themselves under the FII Regulations. The past few days have seen a frantic scramble by FIIs to understand the implications of the recent budget proposals on the P-Note business as there was an initial perception that income stream from ODIs could be doubly taxed - first in the hands of the ODI holders on account of the indirect transfer (taxation of transfer of interests of a foreign entity having underlying Indian assets) and second if anti-avoidance measures are invoked, denial of treaty benefits to issuer FII who would then pass on the liability to the ODI holder.
Though the Finance Minister has clarified to allay some concerns, a consensus view can only emerge once the budget proposals are formalized. In this hotline, we have set out the issues and implications the issues that FIIs / ODI holders could be potentially faced with under the budget proposals.
 
What would constitute a P-Note?
ODIs have been defined in Regulation 15A of the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995 (the “FII Regulations”), as “any instrument, by whatever name called, which is issued overseas by a FII against securities held by it that are listed or proposed to be listed on any recognized stock exchange in India, as its underlying.”
Therefore, to be perceived/ classified as reportable ODIs, the concerned offshore contracts would need to refer to an Indian underlying security and also be hedged onshore to whatever extent by the issuer FII. Accordingly, unless so hedged, an ODI remains a contract note, that offers its holder a return linked to the performance of a particular underlying security but need not be reported under the disclosure norms set out under the FII Regulations.
It is the issuing FII that engages in the actual purchase of the underlying Indian security as part of its underlying hedge to minimize its risks on the ODI issued. The position of the ODI holder is usually that of an unsecured counterparty to the FII (with inherent counterparty risks amongst others) and under the ODI (the contractual arrangement with the issuing FII) the holder of a P-Note is only entitled to the returns on the underlying security with no other rights in relation to the securities in respect of which the ODI has been issued. 
 
Position of tax on P-Notes
The basis of charge of Indian income-tax depends upon the residential status of the taxpayer during a tax year, as well as the nature of the income earned. Notwithstanding the aforesaid, what needs to be crucially determined is whether the concerned transaction is subject to tax in India. Capital gains from the transfer or sale of shares or other securities of an Indian company held as capital assets would ordinarily be subject to tax in India (unless specifically exempted). Section 9(1)(i) of the Income Tax Act, 1961 (“Act”), deems all income accruing or arising through the transfer of a capital asset situated in India, as taxable.
In case of ODIs, the contractual arrangement between an ODI holder and the FII is typically such that it is not mandatory for the FII to actually hedge its underlying position (i.e. actually ‘hold’ the position in Indian securities). Further, even when the ODI holder redeems the ODI, there is no requirement that the FII also sell the underlying securities. Given that ODIs typically are ‘unsecured’ contractual obligations, even in case of any liquidation of the FII, the ODI holder is subject to counterparty risk and cannot rightfully receive the underlying shares. Therefore, considering that the ownership of the underlying securities vests with the FII,  the ODI holder should generally not be taxable in India.
The 2012 Budget proposals (“Budget”) seek to alter some of the critical understandings on how transactions are to be taxed in India. To begin with, the Budget proposes to amend the definition of “capital asset” to mean “an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share of the interest derives, directly or indirectly, its value substantially from the assets located in India”. In case of an ODI Holder, while the value of the ODI is linked to the value of an asset located in India, the ODI is not in the nature of a ‘share’ or an ‘interest’ in any foreign entity since it is merely a contractual arrangement. This is one of the requirements that need to be satisfied for the transfer of a foreign asset being deemed to be regarded as the transfer of a capital asset in India.
The second proposal under the Budget is to determine the substance of a transaction by overlooking the form of the transaction on the ground that it represents an ‘impermissible avoidance arrangement’ by way of applying the General Anti-Avoidance Rule (GAAR). The concerns under the GAAR provisions for an ODI holder arise since (a) it derives its value from an underlying Indian security, and (b) hedge is (may be) carried out by the counterparty FII residing in a jurisdiction with a favorable tax treaty with India. The concern is further deepened considering that the Budget also introduces an explanation to clarify that the withholding tax obligations under Section 195 of the Act (liability to deduct tax in respect of payments made for purchase of capital asset) apply to all non-residents, irrespective of whether they have any presence whatsoever in India. This could technically come into play as and when an ODI holder redeems an ODI (the obligation in which case lies on the issuer FII) or sells the ODI to another non-resident (on the purchaser non-resident in this case). In case of the FII issuing the ODI, the main concern that arises is whether the GAAR provisions can be used to deny treaty benefits to the FII in respect of the underlying hedge on purchase / disposition of Indian securities.
 
How real are the risks of Indian taxes being imposed on P- Notes?
The Budget proposals are still in a draft form and up for consideration by the Indian legislature. However given the recent turmoil on the Indian secondary markets due to the nature of the proposals, the Finance Minster clarified that “… entities investing in stock markets through P-Notes (participatory notes) would not be required to pay taxes in India”. While it is merely a clarification on a proposed law, it still is comforting. 
However, what still stymies the comfort is his adding “the Income-tax Department would examine the tax liability of the FIIs”. Which means that while ODI holder may not be taxed, there could be some burden imposed on the counterparty FII. The formal language of the law however remains to be seen which is expected to be confirmed by the month of May, effective however from April 1, 2012.
 
Impact on the industry 
If the possible outcome is that ODI structures could come under tax scanner, irrespective of whether it would be the ODI holder or the issuer FII that is taxed, this could lead to several disruptive issues that could potentially sound the death knell for the industry.
The first issue would be whether GAAR would be applied in respect of such structures and the manner of such application. Whether it be applied to ‘look through’ the FII structure and therefore seeks to tax the ODI holder directly or will it ‘look at’ the FII structure to deny treaty benefits to the issuer FII. The tax consequences and issues that arise can be materially different in respect of the two scenarios.
Under the ‘look through’ scenario, the tax authority can perceive the ODI holder as the actual owner of the hedged underlying securities and seek to tax on that basis.  In such case, it could be expected that all income, expenses, tax credits, rebates, gains and losses from the ODI transaction should be passed on to the ODI holder concerned. Some of the key questions / issues that can arise in a case where the ODI holder is being taxed directly are - would the ODI holder (a) be entitled to offset loss transactions against profit transactions; (b) be entitled to a credit in the home jurisdiction or vice versa under given the conventional source rules as applicable on international transactions; (c) what would be the characterization of income in the hands of the ODI holder and what should be the applicable tax rate on such transactions. On the issuer FII side, issues may arise on account of (a) how to treat and account for the losses that may be sitting in its books of the FII entity which actually relate to ODI trades made in the past and (b) will the FII be required to withhold taxes in relation to the ODI trades when redeeming the ODI.
On the other hand, in the ‘look at’ scenario, the tax authorities can seek to deny treaty benefits to the FII and tax the FII on the income made on sale of the underlying hedge (Indian securities). The first issue that could arise is what would the nature of the income sought to be taxed. In case of ‘business income’ the same would be taxable in India only if the FII has a permanent establishment (“PE”) and only that component of income, which is attributable to the Indian PE. In case the treatment of the income is that of ‘capital gains’, the same may not be taxable in India if the FII is resident of a tax favorable jurisdiction. Further the risk of GAAR being applied to deny treaty benefits to the FII could make it difficult to obtain a certificate pursuant to Section 195 of the Act that such income (or a proportion thereof) is not income chargeable to tax.
Determination of the position on the aforesaid issues is critical as there are vast differences between the rates of taxation on the possible characterizations of the income stream. The capital gains tax will vary depending on the nature of the security and whether the gain recognized on the sale qualifies as a short-term or a long-term gain. The variation in such cases could be from 0% to 40%. Alternatively, if any of the income streams arising from the ODI structure is characterized as business income (subject to tax in India to the extent that it is attributable to a permanent establishment in India) the same is taxable at the rate of 40% on a net income basis.
Other issues that arise is how do the FIIs pass on the tax risk to the ODI holder considering there will be a mismatch between the ODI holder’s income and the FII income on a trade. Further issues arise as to whether indemnities in the ODI contract note can resolve the problem and how it can actually be applied. Possible issues in case of indemnities include credit issued for the ODI holder and issues relating to interest / penalties. Another issue to be resolved is that if the FII does not ‘true hedge’ the ODI, how the withholding would and indemnity obligations work.
Some FIIs are actively considering moving their current Mauritius holdings to a Singapore structure. The move has merits for groups that have ability to demonstrate substance (both in entity and in Singapore as a jurisdiction). However, key concerns arise on whether the initial transition itself to Singapore could attract GAAR and consequently, be taxable in India. Further, the eligibility criteria for claiming capital gains tax exemption under the tax treaties with India should also be carefully studied as the same may (as in case of Singapore) require some substantive conditions to be established in the jurisdiction.
 
Way forward: Reaction from prime brokers and other issuers of P-Notes 
Most of the FIIs have constricted their ODI issuance. The stance seemed to be taken is that contractually, the risks (including that of any taxes) should lie with the P-Note holder. A combined reading of the Finance Minister’s statements and the proposals under the GAAR lead to a perception (albeit not a consensus view) that that while indirect transfers/ redemptions of P-Notes may not be taxed in India, the GAAR provisions could challenge the FII structure in the ODI mechanism. Under such circumstances till the Budget is approved and clarity is obtained, most FIIs could limit the issuance of ODIs until some resolution is obtained on some of the issues set out.
Beyond doubt, jurisdictions globally are in a fight for attracting capital. Recent reports indicate that FII exposure to stock markets through P-notes stood at over US$ 36 Billion. It is required that the regulators take a pragmatic approach as any move towards taxation of ODIs would likely lead to fatal consequences as the margins for the issuer FIIs and may no longer justify the business and cost risks that would get inherent in the structure. The fundamental question that arises is whether in the hasty move to bring in GAAR, without taking into consideration any of the proposals set out by the Parliamentary Standing Committee, the Finance Minister has actually sounded a death knell for the P-Note business which will only result in a significant slowdown in inflow of foreign capital and adversely impact the capital markets. Neither of these can be afforded at this stage. 
  
This article is written by Richie Sancheti & Rajesh Simhan, Nishith Desai Associates.

Is Realty Sector Blessed by the Union Budget? - Reality vs. Myth

April 3rd, 2012
The year passed by saw a continued slow down in the Global and Indian economy and the Indian real estate was no exception.  Despite the slowdown, the sector still continued to contribute more than 5% to the overall GDP and remained the second largest employment provider next to the agricultural sector.  Besides its contribution to the economy, employment and other economic aspects, the sector also caters to one of the basic needs of human being, the house. 
The sector has been gearing up to the newer challenges and adopting the newer approaches to the business namely corporatisation of businesses, adoption of latest construction technology, innovative products and multi-facet projects, partnering with the Government and involvement of Private Equity players. However, some of the external factors like lack of industry status, pricing pressure, liquidity and shortage of low cost funding, land acquisition related challenges, cost escalations, long drawn and time consuming approval process especially obtaining multiple approvals, unclear and frequent policy changes, etc. have contributed to the sluggishness in the sector.    
Amidst this scenario, the sector represented before the Government to express its concerns and sought relaxations on various matters among other are – 

• Granting of industry status for ‘Real Estate Sector’;
• Introduction of ‘Real Estate Regulatory Authority’ to enhance transparency in the sector and increase investor and customer confidence;
• Development friendly regulations for acquisition of land to facilitate easy availability of land;
• Single-window clearance for real estate development projects to reduce hassles in obtaining multiple and varied nature of project clearances;
• Interest subvention for one more year and also increase the threshold for eligibility limit;
• Introduction of tax sops for developers;
• Allowing ECB for the sector especially for township projects, affordable housing projects;
• Eliminate multiple levy of taxes on the real estate development;  

As usual the Finance Minister (FM) disappointed the fraternity and did not provide much needed fillip for the sector except for some policy measures – 

• Issuance of tax free bonds worth Rs. 60,000 crores, out of which Rs. 10,000 crores would be issued by National Housing Authority of India and Rs. 5000 crores would be issued by National Housing Bank. In other words, Rs. 15,000 crores worth of the investment augmentation for the sector;
• Opening up of External Commercial Borrowings (ECB) route for the low cost affordable housing projects;
• Setting up of Credit Guarantee Trust Fund to ensure better flow of institutional credit for housing loans;
• Increased allocation to the Rural Housing Fund from Rs. 3000 crores to Rs. 4000 crores;
• Extension of 1% interest subvention on housing loan up to Rs. 15 lakhs where cost of the house does not exceed Rs. 25 lakhs by one more year; and
• Opening up of the FDI in retail sector will be considered by the Government 

While the above policy reforms are welcome, among others, the long awaited expectations of sector have not been met with. 
If we talk about tax proposals, the FM did not tweak the corporate tax, surcharge and MAT rates, but silently introduced Alternate Minimum Tax (AMT) on partnership firms and other non corporate entities availing benefits under specific provisions of Chapter VIA and section 10AA of the Act. Further, the FM has proposed several provisions that could have far reaching ramifications for foreign as well as domestic players. Some of them are tax withholding from property transactions, stringent criteria for claiming benefits under tax treaty, introduction of the General Anti Avoidance Rules (GAAR), taxability of excess premium in the hands of private companies, withholding of tax on payments made by one non-resident to another non-resident where the income is subject to Indian tax and more importantly, expanding the coverage of transfer pricing regulations to the domestic transactions between related parties. The provisions giving unfettered powers to the tax authorities to apply GAAR coupled with applicability of transfer pricing provisions to the domestic transactions would severely impact the various business arrangements including intra group transactions especially when the sector is so inter-twined. 
We have analysed some of the important proposals in more detail. 
 
Benefits for Affordable housing – A Reality or a Myth? 
Affordable housing gained prominence in the Budget 2012. Apart from allowing the External Commercial Borrowing ("ECB") for the affordable housing segment, the proposal to lower the withholding tax rate on interest on ECB taken during the specified three year period at a much lower rate of 5% as compared to the normal rate of 20% is a welcome move. Secondly, investment linked deduction for capital expenditure (other than land) incurred for affordable housing segment at the enhanced rate of 150% is perceived to be a beneficial tax proposition. However, if one looks at the real estate business model, the developers have light asset base and most of the capital cost on capital asset is borne by the construction contractors thereby virtually no real and significant benefit of this proposal to the developers. In fact, the benefit is a “myth”. Certainly, service tax exemption for construction services relating to specified infrastructure, residential dwelling, and low-cost mass housing up to an area of 60 square meters will be helpful for the sector.
 
Domestic Transfer Pricing made applicable:
Introduction of transfer pricing regulations and determination of arm’s length price for the specified domestic transactions between two related persons or two units of the same entity having transaction value exceeding INR 50 million, in a year is not being debated much and the impact thereof is not being fully apprehended by the sector. However, these provisions with enhanced coverage of related party transactions will impact the sector adversely. 
The proposal states that all the provisions of transfer pricing regulations (including procedural and penal provisions) would be applicable to such domestic transactions, which will increase the burden for the realty players. Further, these provisions will severely impact real estate transactions as the expenditure such as construction charges, management fees, development fees, marketing and personnel provisioning services, etc. to related parties would be disallowed if it is found be excessive or unreasonable having regard to the arm’s length price. More importantly, the scope of applicability has been widened whereby indirect relationship could also get covered which will bring in many more transactions within the ambit of disallowance. Further, the way the industry is structured, related party transactions are inevitable and applicability of transfer pricing regulations to such transactions will hamper the growth of the sector. 
 
GAAR introduced – A draconian regime? 
Budget 2012 introduced comprehensive GAAR provisions providing wide powers to the tax authorities in treating the transaction as ‘impermissible avoidance arrangement’ and taxing them. These powers are very wide including the power to disregard entities in a structure, , alter the tax residence of such entities reallocate income and expenditure between parties to the arrangement and the legal sites of assets involved, treat debt as equity and lifting of corporate veil. The way the provisions have been crafted, it appears that the tax payer is required to justify its every act and establish that the transaction has not been entered into with the main motive of obtaining tax benefits. The obligation is onerous and cumbersome. Some of the regular business transactions that could be impacted by GAAR are –  

• Structuring of funding through hybrid and debt instruments; 

• Transfer of shares of the company having immovable property rather than transferring the immovable property;

• Genuine transactions of bulk sale of apartments to group companies and many more; 

• Business reorganization like slump sale, mergers and demergers. 

As per the GAAR provisions, if the tax authorities believe that the holding company has been interposed mainly for tax benefits, then the treaty benefits can be denied. Further, in case the debt transaction is re-characterization into equity, it could lead to double taxation and that it would work as “Thin capitalization norms” with open ended powers. Further, there are many Specific Anti Avoidance Rules (SAAR) in the Income-tax Act and a question arises, whether GAAR will override such SAAR provisions having limited scope and coverage? 
The introduction of GAAR in line with some of the developed countries is not a bone of contention, but the real challenge is in it’s implementation and approach of the tax authorities. If these provisions are not implemented rightly, then it could create chaos and significant litigations. The Government should revisit its decision of introducing the GAAR in the same manner as in the Budget and also consider it introducing in a phased manner by diluting the proposed regime.
Be that as it may be, these provisions will become the statute and the industry needs to prepare itself to tackle these provisions. Proactive approach needs to be adopted and proactive measures such as building substance, documenting business decisions, documenting arm’s length arrangement, etc will be critical to defend any allegations of the tax authorities.
 
Tax withholding from immovable property transactions 
These provisions require that the transferee shall withhold tax @1% from sale consideration paid or credited, whichever is earlier, on transfer of immovable property (other than agricultural land) and deposit it with the Government in relation to transactions exceeding specified threshold limited for different areas. Albeit, the compliance provisions are simple and hassle free, the implementation of this provision will create significant practical difficulties and will create a “BIG question mark” on its implementation. It is not possible to fathom how these provisions can be practically implemented in cash less transactions such as transfer of land under JDA arrangement for area sharing, transfer of property without consideration under re-organization, slump sale of business having immovable property, long term land lease transaction, transaction of TDR sale, transactions which are exempt from tax under section 47, etc.
 
Negative list of services 
The “Negative List” approach of levy of service tax has widened the tax net significantly, albeit with some sector specific exemptions from levy of service tax. This has almost made most of the services to be taxable unless specifically excluded from the tax net. Further increase in the rate by 2% has increased the overall construction cost including ability to claim rebate/refund. 
Apart from the above, there are many proposals which could have negative impact on the sector such as taxability of share premium in excess of fair market value, relaxation from DDT in multi-layer structure given the word “paid” used in the section, denial of tax treaty benefits, Tax Residential Certificate (TRC) not being satisfactory evidence to claim treaty benefits, enhancing the time limit for reopening of assessment, plethora of retrospective amendments, etc, 
All this will result in increased cost of housing thereby making housing costlier for the ultimate buyers resulting in rippling effect on the sector. 
Clearly, the Budget 2012 has not met with some of the important expectations of the sector. While, the favorable policy announcements are welcome, but the Budget has not addressed many areas namely, granting of industry status to the sector, infrastructure status to some of the projects like IT Parks and townships, introduction of the Real Estate Regulatory Bill, Land Acquisition Bill and the Land Titling Bill, introduction of a Real Estate Investment Trust (REIT) regime to facilitate liquidity. The expectation gap will always remain and ignoring the unsatisfied demands of the sector for a moment, the authors hope that the policy initiatives, specifically for the affordable housing proposed by the FM are implemented properly and effectively to ensure that they deliver the desired fillip to the sector.  Further, the Government should implement some of the anti-avoidance provisions with the right mind set and approach to achieve the desired result rather than creating a negative impact on the sector.