The party could end soon for domestic and multinational companies that do tax planning only to avoid paying taxes in India. The government is set to usher in the next stage of reforms in taxation, framing anti-abuse rules that will empower tax authorities to lift the corporate veil and look for what are called avoidance transactions. Other anti-avoidance measures could include controlled foreign corporation (CFC) regulations and norms on thin capitalisation.
Tax benefits will be denied to firms found indulging in tax avoidance through one or a series of transactions. This would cover both cross-border and domestic deals. CFC regulations, on the other hand, will help prevent domestic firms from accumulating profits in low tax jurisdictions. In the US, these rules apply to US investors who own substantial stock in non-US corporations. It accelerates the taxation of passive income in the hands of US investors.
Norms on thin capitalisation will ensure that domestic companies do not over-leverage on debt when they expand to set up operations overseas. If they do so, such firms may not be able to claim a tax deduction on the excess interest. Again in the US, thin capitalisation rules discourage US companies from having a debt-equity ratio higher than 3:1.
These proposals are relevant in the current global environment, where the US and other countries are targeting firms structuring deals in tax havens. In the Budget proposals, anti-abuse rules feature first in the pecking order, followed by CFC regulations and norms on thin capitalisation, said a revenue department official, who wished not to be named.
Cross-border M&A deals were brought under the capital gains tax net last year, after the government woke up to the possibility of a tax revenue goldmine when British mobile giant Vodafone bought a controlling stake in Indias Hutchison Essar for nearly $11 billion. More such deals have followed, and they have strengthened the governments case.
The introduction of anti-abuse rules in the domestic law was first mooted way back in 2003 by a panel on reforms in taxation of non-residents, mainly to curb the misuse of the Indo-Mauritius tax treaty. Under this pact, Mauritius does not tax capital gains arising from sale of shares. Mauritius-based investors do not pay tax on the capital gains from sale of Indian equities.
But there have been allegations of third country entities using the tax treaty provisions to set up conduit companies in Mauritius. These firms are used as vehicles to invest in India to escape paying tax, and the practice is known as treaty shopping. Besides this, some Indian entities also channel (black) money into the country through shell companies in Mauritius.
India is trying to re-negotiate the tax treaty with Mauritius to curb treaty shopping, but has not made much headway so far. The introduction of an general anti-abuse rules in the Income-Tax Act could be similar to those adopted by Canada to curb treaty shopping. The introduction of a General Anti-Avoidance Rule (GAAR) will take our tax reforms to the next orbit.
But this must follow the long overdue administrative and judicial reforms. Aggressive assessments by revenue department by triggering GAAR will add to the huge backlog of pending tax disputes, said Shefali Goradia, partner at BMR Advisors.