New anti-avoidance measures

By Pranay Bhatia and Vidushi Maheshwari, Economic Laws Practice
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The union budget for 2011 proposes to introduce anti-avoidance measures that will come into effect on 1 June. Accordingly, India Inc will need to be cautious in their dealings with entities located in notified jurisdictional areas (NJAs) as transactions entered into with such entities will trigger the following:

1) The need to comply with transfer pricing (TP) regulations; 2) disallowance of expenses in certain circumstances; and 3) higher withholding taxes.

The Finance Bill, 2011, proposes the introduction of section 94A in the Income Tax Act, 1961, so as to discourage transactions by Indian tax resident with persons located in any country or jurisdiction that does not effectively exchange information with India.

Pranay Bhatia Partner Economic Laws Practice
Pranay Bhatia
Partner
Economic Laws
Practice

Not easy to implement

While the impact of section 94A will ultimately be borne by the Indian tax payer, it will be a challenge to implement as there are no guidelines on what constitutes a NJA – besides lack of effective exchange of information. Clarity is also required as to which countries will be included in the list of NJAs, especially as India has already entered various tax information exchange agreements and tax treaties, which provide for exchange of information.

In addition, no guidelines or methodology has been prescribed to ascertain how parties to the transaction would be deemed to be associated enterprises (AE). For instance, as it stands even a solitary transaction with a person situated in a NJA would be deemed to be an AE, which would need to comply with TP regulations. Further, the tax payer is not only disallowed the deduction of expenses, but is also required to explain the source of its receipts in the hands of the entity situated in the NJA. Whether this explanation is accepted is entirely at the tax officer’s discretion.

Consequences

As a result of section 94A, a transaction entered into by an Indian entity with a person located in a NJA would be deemed to be an international transaction. However, the TP regulations in India shall be equally applicable to such a transaction.

In addition, the section seeks to disallow the deduction of the following:

• Payments made to financial institutions situated in a NJA.

• Any expenditures or allowance (including depreciation), unless the assessee maintains and furnishes the prescribed documents.

Section 94A also provides that any money received by an assessee from a source situated in a NJA shall be treated as the assessee’s income, unless he can provide the income tax officer with a convincing explanation about the source of such receipts in the hands of the person or entity situated in the NJA.

If the payment to any person located in a NJA is “chargeable to tax” in India, then such payment would be subject to withholding tax at 30% or more.

International efforts

In general countries that adopt anti-avoidance measures do so through a mix of:

• Tax haven black lists; and/or

• Legislative anti-avoidance policies.

Vidushi Maheshwari Associate Economic Laws Practice
Vidushi Maheshwari
Associate
Economic Laws
Practice

If a country uses a tax haven black list, it adopts a policy of penalizing citizens who enter into transactions with persons or entities located in such black listed countries. Countries that use this type of anti-avoidance measures include Mexico, Italy, Venezuela and Spain. NJAs proposed under section 94A are a kind of tax haven black lists.

Legislative anti-avoidance policies focus on effectively preventing the use of tax efficient structures wherever they are established. Countries that have adopted such measures include the US, the UK, South Africa and Sweden and the legislation introduced under this scheme include general anti-avoidance rules (GAAR), special anti-avoidance rules, controlled foreign companies (CFC) rules, etc.

Both tax haven black lists and legislative anti-avoidance policies, need not be mutually exclusive of each other. Many jurisdictions, including the US and the UK, have issued tax havens black lists and also introduced certain legislative barriers as anti-avoidance measures.

Looking ahead

India intends to adopt both these mechanisms. While at the initial stage it has proposed provisions to specify any country as a NJA, it will introduce legislative anti-avoidance policies like GAAR and CFC under the direct taxes code, which is proposed to take effect from 1 April 2012.

The introduction of section 94A will see India moving towards a tightening of its anti-avoidance provisions involving transactions with countries that are non-cooperating.

In doing so, India is definitely abiding by its commitment to ensure transparency in international transactions. However, challenges remain regarding its implementation and that will require immediate attention as the provisions are to be effective from 1 June.

Pranay Bhatia is an associate partner at Economic Laws Practice where Vidushi Maheshwari is an associate. Economic Laws Practice is a full service law firm headquartered in Mumbai and has offices in New Delhi, Pune and Ahmedabad.

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