Treaty Won't Shield FIIs from General Anti-Avoidance Regulations

Foreign institutional investors (FIIs) that benefit from tax treaties, including the contentious India-Mauritius tax treaty, will fall under the ambit of General Anti-Avoidance Regulations (GAAR). On the other hand, the rules, notified by the Central Board of Direct Taxes (CBDT) on Thursday, have spared the participatory notes (P-Notes), through which many foreign investors invest in India. The new rules come into effect from the financial year 2015-16.


Finance minister P Chidambaram had in the 2013-14 Budget deferred introduction of GAAR. Consequently, on enactment of the Finance Bill, chapter XA relating to GAAR was inserted in the Income Tax Act but was effective from the financial year 2015-16. Accordingly, the newly notified rules will be applicable from this year onwards. The rules also notify that GAAR shall not apply where the tax benefit arising to all parties to an arrangement (any investment transaction or even business transactions like lease) does not exceed Rs 3 crore in a financial year. Grandfathering or protection of past transactions from the application of GAAR is also provided by the rules. Only FIIs that have not taken the benefit of any tax treaty entered into by India and who have invested in listed or unlisted securities with the prior permission of the relevant authorities - Sebi or other regulatory guidelines - shall not be covered by GAAR. 

"The GAAR rules provide amnesty only for FIIs not claiming treaty benefits. This is practically meaningless as it would not settle any controversy around the India-Mauritius tax treaty," says Shefali Goradia, partner, BMR Advisors. 

Sudhir Kapadia, tax leader, EY, adds: "The rules clarify that foreign investors investing in an FII via an offshore derivate investment shall not be covered by GAAR. This is a welcome step. However, as regards FIIs, in order to provide certainty all FIIs, including those seeking tax treaty benefits, should have been excluded from GAAR." 

Under the provisions of the Income Tax Act, GAAR applies to an impermissible avoidance arrangement. If the main purpose of an arrangement is to obtain a tax benefit and it also satisfies certain other tests, such as the transaction lacks commercial substance, it is regarded as an impermissible avoidance arrangement. The tax benefits or benefits arising out of tax treaties applicable to such transactions can be denied by the tax authorities. As the tax implications of a transaction falling within the GAAR ambit are onerous, the rules may unsettle the FII community. For instance, if the arrangement of investing into India via a favourable country is treated as a transaction where the main aim was to obtain a tax benefit and if the transaction was considered as lacking commercial substance, or was treated as resulting in abuse of the Income tax Act provisions, the tax treaty benefits could be denied. Tax officials, speaking on condition of anonymity, said that genuine investors are unlikely to come within the GAAR ambit and there is no cause for panic. 

According to RBI statistics, Mauritius continued to be the top-most jurisdiction for investments into India during 2012-13 with $8.1-billion inflows during the period. Under the India-Mauritius tax treaty, sale of investments in India by a resident of Mauritius can be subject to tax only in Mauritius, which does not levy any capital gains tax. India does not tax long-term capital gains arising on sale of listed securities (which are held for more than a year). However, short-term capital gains, where shares are held for less than a year, are taxed. Sale of unlisted securities is also subject to tax. 

Times of India, 27-09-2013, New Delhi