RENEWED FOCUS ON ‘SUBSTANCE OVER FORM’ IN THE WORLD OF INTERNATIONAL TAX

At first instance,
the term ‘Double Irish Dutch Sandwich’ would appear to be an appetising snack.
However, in the world of international tax this has become an unappetising
proposition for multinational corporations (MNCs). This is because ‘Double
Irish Dutch Sandwich’ refers to the use of a combination of Irish and Dutch
companies by MNCs to shift profits to low or no tax jurisdictions.

This and other
similar aggressive tax strategies not only help MNCs reduce their effective tax
outgo, but also highlight the shift in mind-set of tax being a cost against
profit, rather than a duty towards society. Many countries have started
frowning upon such investment and operating ‘structures’ and are implementing
various measures both nationally and internationally to address the issue. The
general consensus amongst them is that MNCs should pay their fair share of
taxes in the countries where they actually operate and earn income. In this
context, the two important aspects identified by the world at large are that

(a) certain countries provide aggressive and preferential tax regimes to
MNCs to enable them to adopt aggressive tax strategies (including access to
favourable tax treaties); and (b) the operations of
MNCs in such countries do not have adequate economic or commercial substance to
justify the income allocated to them.

At the heart of
this fairly recent initiative is an age-old concept in tax laws, ‘substance
over form’ – whether the substance of the transaction is in fact different from
what its form is legally made out to be. This article aims to touch upon some
of the recent updates in the world of international tax which have a renewed
focus on ‘substance over form’ and the impact of some of the common structures
involving India.

(I)     Meaning of the terms ‘substance’ and ‘form’

‘Substance is
enduring, form is ephemeral’. These are the words
of Mr. Dee Hock (founder of VISA) which imply that while ‘substance’ is
long-lasting, ‘form’ is transitory. The term ‘substance over form’ is a
well-known,
age-old concept under accounting and tax laws not only in India but even
globally. In essence, the concept requires looking at the real purpose /
intention of the transaction rather than simply relying on the way the
transaction is presented legally and on paper (e.g. accounting entries, legal
agreements, etc.). Black’s Law Dictionary defines the terms ‘substance’ and
‘form’ as under:

(i)    Substance: ‘The essence of
something; the essential quality of something as opposed to its mere form’;

(ii)    Form: ‘The outer shape or structure
of something, as distinguished from its substance or matter’.

(II)   Landmark
judgements on substance over form

One of the earliest
landmark judgements in the world in the context of ‘substance over form’ is the
English Court judgement in the case of IRC vs. Duke of Westminster (1936)
AC 1 (HL). This judgement laid down certain important observations
which have subsequently been applied even by Indian courts. In this case, based
on professional advice, the Duke of Westminster paid his gardener an annuity
instead of wages and the same was claimed as tax-deductible expenditure. The argument
of the tax authorities was that the substance of the annuity payment was to in
fact pay wages, which were household expenses and not tax-deductible. The said
argument was, however, rejected by the House of Lords and Lord Tomlin observed
as under:

‘Every man is
entitled if he can to order his affairs so that the tax attaching under the
appropriate Acts is less than it otherwise would be. If he succeeds in ordering
them so as to secure this result, then, however unappreciative the
Commissioners of Inland Revenue or his fellow taxpayers may be of his
ingenuity, he cannot be compelled to pay an increased tax. This so-called
doctrine of “the substance” seems to me to be nothing more than an attempt to
make a man pay notwithstanding that he has so ordered his affairs that the
amount of tax sought from him is not legally claimable.’

The concept of ‘substance over form’ has also been discussed in Indian
judicial precedents since many years – for instance, the Supreme Court
judgement in the case of Mugneeram Bangur & Co.¹  on facts of the case held that the sale of
the business of land development as a whole concern was a slump sale not liable
to tax, even though the Tribunal had factually held that the goodwill component
in the sale was the excess value / profit from stock in trade transferred with
the other assets. In a way, the Supreme Court had upheld the principle of form
over substance.

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1   [1965] 57 ITR 299 (SC)

2        [2012] 341 ITR 1 (SC)

However, in the
context of cross-border / international tax issues arising from ‘structures’,
the concept of ‘substance over form’ has recently gained more significance from
the judgement of the Supreme Court in the case of Vodafone International
Holdings B.V.²  The
judgement underlined the difference between adopting a ‘look-through’ approach
(substance) at the transaction, versus adopting a ‘look-at’ approach (form).
The Supreme Court observed that the following principles emerged from the
Westminster judgement:

1. A legislation is
to receive a strict or literal interpretation;

2. An arrangement
is to be looked at not by its economic or commercial substance but by its legal
form; and

3. An arrangement
is effective for tax purposes even if it has no business purpose and has been
entered into to avoid tax.

However, the
Supreme Court also noted that during the 1980s, the House of Lords began to
attach a ‘purposive interpretation approach’ and gradually began to place
emphasis on ‘economic substance doctrine’ as a question of statutory
interpretation. For example, in Inland Revenue Commissioner vs.
McCruckian (1997) BTC 346 the House of Lords held that the substance of
a transaction may be considered if it is a tax avoidance scheme. Lord Steyn
observed as follows:

‘While Lord
Tomlin’s observations in the Duke of Westminster
case [1936] A.C. 1 still point to a material
consideration, namely, the general liberty of the citizen to arrange his
financial affairs as he thinks fit, they have ceased to be canonical as to the
consequence of a tax avoidance scheme.’

In the light of
various judgements, the Supreme Court laid down the following rationale in the
context of substance over form:

(i)    The principle of the Westminster judgement is
that if a document or transaction is genuine, the court cannot go behind it to
some supposed underlying substance. Subsequent judgements of the English Court
have termed this as ‘the cardinal principle’.

(ii)    Courts have evolved doctrines like ‘substance
over form’ to enable taxation of underlying assets in cases of fraud, sham,
etc. However, genuine strategic tax planning is not ruled out.

(iii)   Tax authorities can invoke the ‘substance over
form’ principle (or ‘piercing the corporate veil’ test) only after establishing
on the basis of facts and circumstances that the transaction is a sham or tax
avoidant.

(iv)   For instance, in a case where the tax
authorities find that in an investment holding structure, an entity which has
no commercial / business substance has been interposed only to avoid tax, then
applying the test of fiscal nullity it would be open to the tax authorities to
discard such inter-positioning of that entity.

It is well-known
that the Supreme Court judgement in the Vodafone case was
significantly overridden through retrospective amendments made in the Indian
tax law in 2012. However, the retrospective amendments did not alter the
rationale that, unless there is conclusive evidence to suggest otherwise, once
a non-resident furnishes a tax residency certificate (TRC) from its home
country, benefits under the applicable tax treaty with India should not be
denied³ .

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3   This was also in line with an earlier Supreme
Court judgement in the case of Azadi Bachao Andolan and Another [2003] 263 ITR
706 (SC)

To address the
issue of ‘substance over form’, the General Anti-Avoidance Rule (GAAR) was
introduced in 2012 itself, although it became effective in India only from 1^st
April, 2017. Subject to conditions, GAAR now permits tax authorities to deny
tax treaty benefit in India if the main purpose of undertaking the transaction
was to obtain a tax benefit under an impermissible avoidance arrangement in
India. GAAR also permits disregarding or re-characterising any step in the
impressible avoidance arrangement, including deeming connected persons to be
one person, relocating the situs of any asset or place of residence,
disregarding corporate structure or treating equity as debt or revenue item as
capital or vice versa, as deemed fit. Accordingly, the concept of
‘substance over form’ has now been codified under the Indian law with effect
from 1^st April, 2017 through GAAR.

Further, with India
adopting the Place of Effective Management (PoEM) criteria from 1^st
April, 2016 for determination of tax residency of foreign companies in India,
it can be said that Indian tax laws now have greater focus on the concept of
‘substance over form’. This is also the case under the Income Computation and
Disclosure Standard I relating to accounting policies which categorically
states that the treatment and presentation of transactions and events shall be
governed by their substance and not merely by the legal form.

(III)  Renewed international focus on substance over
form, i.e., tax planning vs. tax avoidance

In the past few
years, certain large MNCs were found to implement aggressive business /
investment structures (such as the ‘Double Irish Dutch Sandwich’) which shifted
profits to jurisdictions with low / NIL taxes. At times, while the structures
were legally valid, it was found that the economic activities in the
jurisdictions with lower / NIL taxes were not commensurate with the profits
allocated to such jurisdictions. With courts upholding the legal validity of
the structures in light of tax treaties and international tax law principles,
countries realised that tax treaties along with aggressive tax regimes in
certain countries were in fact the thin line that separated fair tax planning
from aggressive tax mitigation / planning.

To tackle this
issue, the OECD and G20 countries adopted a 15-point action plan in September,
2013 to address Base Erosion and Profit Shifting (BEPS). The BEPS Action Plan
identified 15 actions on the basis of three key pillars:

(a)   introducing coherence in the domestic rules
that affect cross-border activities;

(b)   reinforcing substance requirements in the
existing international standards; and

(c)   improving transparency as well as certainty.

While the concept
of ‘substance’ is one of the three key pillars of the overall BEPS project, it
is discussed in detail in BEPS Action 5: Countering Harmful
Tax Practices More Effectively, Taking into Account Transparency and Substance.
Further, the concept of ‘substance over form’ has been specifically discussed
in BEPS Action 6: Preventing the Granting of Treaty Benefits
in Inappropriate Circumstances.

The above-mentioned
15 actions have culminated in the formalisation and signing of the Multilateral
Instrument (MLI) which is a landmark development in the context of tax treaties
across the globe. The MLI seeks to modify thousands of existing bilateral tax
treaties through one instrument. It does not replace these bilateral tax
treaties but acts as an extended text to be read along with the covered
bilateral tax treaties for implementing specific BEPS measures.

India has deposited
the ratified MLI with the OECD on 25^th June, 2019 and notified the
date of entry into force of the same as 1^st October, 2019.
Accordingly, covered Indian tax treaties will be impacted from 1^st
April, 2020 onwards. Hence, going forward it is imperative that any Indian
inbound or outbound cross-border structuring of investment / business
operations will have to factor BEPS and MLI aspects, if the structuring
involves availing tax treaty benefits.

(IV) Concept of ‘substance over from’ embedded in MLI

Part III of the
MLI, which deals with Treaty Abuse, includes two minimum standards / articles
which are sought to be introduced in the covered bilateral tax treaties. These
articles in essence require testing the substance of a transaction /
arrangement before granting tax treaty benefit. A summary of these articles is
as under:

1.    Article 6: Purpose of a Covered Tax
Agreement: This article seeks to act as a preamble to the covered bilateral
tax treaty and clarify that while the purpose of such treaty is to eliminate
double taxation of income, the same should not be used for creating
opportunities for non-taxation or reduced taxation through tax evasion or
avoidance. Specifically, it clarifies that cases of treaty-shopping for the
indirect benefit of residents of third jurisdictions would not be eligible for
tax treaty benefits.

2.    Article 7: Prevention of Treaty Abuse: This
article seeks to introduce the Principal Purpose Test (PPT) as a minimum
standard in the covered bilateral tax treaty. There is an option to supplement
the PPT with a Simplified Limitation of Benefits (SLOB) clause⁴.
Further, the PPT can be replaced altogether with a Detailed Limitation of
Benefits (DLOB) clause, if the same incorporates requisite BEPS standards. The
PPT mainly states that tax treaty benefit shall not be granted if it is
reasonable to conclude, having regard to all relevant facts and circumstances,
that obtaining that benefit was one of the principal purposes of any
arrangement or transaction that resulted directly or indirectly in that
benefit. The benefit would, however, be granted if the same is in accordance
with the object and purpose of the relevant provisions of the tax treaty.

From the above
articles it can be observed that wherever applicable, a transaction or
structure will need to have adequate economic substance in order to pass the
test laid down by the preamble or PPT article of the MLI.

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4   India has adopted PPT along with SLOB with an
option to adopt an LOB in addition or replacement of PPT through bilateral
negotiation. However, various important tax treaty partners have only adopted
PPT which means that SLOB will not apply to those tax treaties

(V)    OECD’s focus on substance to tackle cases of
tax treaty abuse

BEPS Action 6 recognises that courts of some countries have developed various
interpretative tools such as economic substance, substance over form, etc.,
that effectively address various forms of domestic law and treaty abuses. There
is, however, an agreement that member countries should carefully observe the
specific obligations enshrined in the tax treaties to relieve double taxation
in the absence of clear evidence that the tax treaties are being abused.

BEPS Action 5 explains that the Forum on Harmful Tax Practices (FHTP) was
committed to improving transparency and requiring substantial activity for any
preferential tax regime in any country. FHTP was to take a holistic approach to
evaluate preferential tax regimes in the BEPS context and engage with non-OECD
members for modification to the existing framework, if required.

It has been
categorically explained that the work on harmful tax practices is not intended
to promote harmonisation of income taxes or tax structures generally within or
outside the OECD, nor to dictate to any country what should be the appropriate
level of tax rates. The intention mainly is to encourage an environment in
which free and fair tax competition can take place, i.e., a ‘level playing
field’ through agreement of common criteria that promote a co-operative
framework. The broad steps recognised by BEPS Action 5 are:

(i)    Enhanced requirement of having substantial
activity in jurisdictions with preferential tax regimes;

(ii)    Suitably checking the ‘nexus’ of actual
activity in such jurisdictions with the nature of income earned there;

(iii)   Improved transparency and addressing of BEPS
concerns through an agreed framework to exchange information pertaining to tax
provisions and rulings amongst countries;

(iv)   Need for amendments to preferential tax
regimes of countries in line with BEPS;

(v)   Ongoing engagement between FHTP and OECD and
non-OECD members to address BEPS.

The nature of core
income-generating activities, other than for IP activities, specifically
discussed in the BEPS Action 5 in the context of substantial
activity is as follows:

Subsequent to the Action
Report 5, the FHTP published its 2018 report on preferential regimes in
the context of harmful tax practices. An update to the same has been published
on 19^th July, 2019. The report explains in detail the activity-wise
review of tax regimes in various jurisdictions and the FHTP’s view on the same.
Some of the key observations arising from the said report for the purpose of
this article are:

(a)   In the context of the first time review of the
substantial activities factor in ‘no or only nominal tax jurisdictions’, the
status of United Arab Emirates (UAE) was ‘in the process of being amended’,
while the status of others, including Bahrain, Bahamas, Bermuda, BVI, Cayman
Islands, Isle of Man, Jersey, etc., was held to be ‘not harmful’. The report
states that while economic substance requirements were introduced in all these
jurisdictions (in case of UAE from 30^th April, 2019 onwards) and
domestic legal framework meets all aspects of the standard, there was ‘one
technical point’ in UAE that is outstanding. However, the UAE has committed to
addressing this issue as soon as possible. The technical point has, however,
not been discussed in the report.

(b)   Tax regimes in Mauritius such as ‘innovation
box’, ‘Global headquarters administration regime’, ‘Global treasury
activities’, ‘Captive insurance’, ‘investment banking’, ‘shipping regime’ and
the recently introduced ‘partial exemption system’ are all compliant and not
harmful. The report also recognised the abolition of the tax regime for Global
Business License 1 and 2 holders
in Mauritius.

(VI) Steps regarding
economic substance taken by UAE and Mauritius in light of the BEPS Project

It is well known
that UAE and Mauritius have favourable tax regimes (such as non-levy of
income-tax in UAE, non-levy of income-tax on foreign capital gains in
Mauritius, etc.) and tax treaties which allocate right of taxation of certain
income to these countries. This effectively results in double non-taxation.
Accordingly, to address BEPS concerns both UAE and Mauritius have recently
introduced substance norms. A summary of the substance regulations is provided
below:

From the above table it can be observed that entities / businesses based
out of UAE and Mauritius are now required to meet the enhanced criteria of
economic substance in those jurisdictions to be considered as tax resident in
that jurisdiction and benefit from their tax regimes.

(VII)      Impact on
Indian inbound and outbound business / investment structures

In terms of Indian inbound and outbound structures, Mauritius and UAE
have been popular choices for businesses. Some of the common structures are
discussed below along with their impact on account of BEPS.

Structure 1: Indian outbound – use of UAE trading company

Facts: XYZ India has incorporated a
trading company, DUB, in one of the Free Trade Zones (FTZs) of UAE. XYZ India
undertakes import from, and export to, third parties through DUB. DUB maintains
a fairly good margin while dealing with XYZ India.

Tax advantage: Subject to Indian transfer pricing
regulations, profits earned by DUB are not liable to any tax in India provided
DUB is non-resident in India under the PoEM regulations and does not have a PE
in India. Since UAE does not levy tax on income of companies incorporated in
FTZs, the effective tax rate on profits of such UAE companies is NIL, unless
repatriated to India as dividend.

Impact of BEPS: As a distribution /
service centre company, under the UAE substance regulations DUB will be
expected to undertake the following activities in UAE:

1. Transporting and
storing goods;

2. Managing the
stocks;

3. Taking orders;

4. Providing
consulting or other administrative services.

Accordingly,
businesses adopting the above structure will now need to factor the substance requirements
in UAE.

Structure 2: Indian inbound – use of Mauritius as holding company

Facts: XYZ USA has incorporated a
company in Mauritius, MAU, as a holding company for investment in XYZ India
(made prior to 1^st April, 2017). Income of MAU is either dividend
from XYZ India or capital gains from sale of shares of XYZ India.

Tax advantage: MAU will not be liable to pay any tax on capital gains earned from
sale of XYZ India since the same are not taxable in Mauritius and are also
grandfathered from taxation in India under the amended India-Mauritius tax
treaty. The dividend income of MAU, which is exempt from tax in India, will be
subject to an effective tax rate of 3%, which is low. Also, Mauritius has
various favourable tax treaties (especially with African countries) making it
an ideal jurisdiction for holding investments.

Impact of BEPS: Mauritius has not notified the tax treaty with India under MLI and
hence, the treaty is not currently impacted by MLI. However, the same is
expected to be bilaterally amended on the lines of BEPS and hence the
requirement of substance in the form of the preamble and PPT (or DLOB) is
expected in the future.

In the context of
inbound investment structures through Mauritius, past litigation with Indian
tax authorities has been mainly on the ground that the structures lack
commercial / economic substance and are artificially interposed to avail tax
treaty benefits in India. Now, under Mauritius law, MAU will be required to
have PoEM in Mauritius to be eligible for TRC. Further, as an investment
holding company, in compliance with circular letter CL1-121018 dated 12^th
October, 2018 issued by the Financial Services Commission (FSC) of Mauritius,
the minimum expenditure to be incurred by MAU is USD 12,000 p.a. (although no
minimum employees are specified). The same will, however, be tested on a
case-to-case basis, as per facts. For instance, BEPS Action 5
states that in addition to undertaking all applicable corporate law filings,
holding companies are expected to have both the people and premises necessary
to ensure that letterbox and brass plate companies do not benefit from
preferable tax regimes. Whether this will impact the substance evaluation in
Mauritius needs to be seen in the future.

It may be noted
that the minimum expenditure in Mauritius will be required even though the
India-Mauritius tax treaty does not provide for any such expenditure under its
LOB clause for availing grandfathering benefit for capital gains.

Structures 3-6: Indian inbound structures involving UAE or Mauritius
(others)

Impact of
BEPS: The above structures seek to obtain tax
treaty benefits in India which may otherwise not be available under India’s tax
treaty with the country of headquarters of the business (say, USA or UK). Any
adverse impact on meeting substance requirements in the UAE or Mauritius could
adversely impact grant of tax treaty benefits in India – especially if TRC is
not granted to entities non-compliant with substance regulations.

Accordingly, businesses adopting the above
structures or any other structures involving use of an entity in a preferential
tax regime, in addition to PPT, should factor in the impact of substance
regulations in that country to ensure that the structure is compliant under
BEPS.

(VIII)     Parting
note

Considering the intention of the BEPS
project to tackle cases of tax avoidance and aggressive tax planning, it is not
surprising that India has been at the forefront of this landmark global
initiative. In addition to GAAR and PoEM, India has actively also incorporated
BEPS Actions into its domestic tax laws such as:

(i)    Country by country reporting (CbCR)

(ii)   Equalisation levy

(iii)
Commissionaire arrangements resulting in taxable presence

(iv) Significant
economic presence (SEP) constituting taxable presence for certain digital
businesses

(v) Limitation on
interest deduction for payments to associated enterprises

In fact, as a sign of things to come, the
recently-concluded protocol to the India-China tax treaty incorporated various
MLI provisions within the text of the tax treaty, including PPT (as a
result, India-China tax treaty is outside the purview of the MLI).

Accordingly, it is expected that BEPS
Actions and MLI will influence the approach of Indian tax authorities in the
future while granting tax treaty benefits in India. One of the key expected
areas of focus is to probe the economic substance of non-resident entities
under BEPS Action 5.

In light of the above, reference may be
made to another set of wise words from Mr. Dee Hock, which may be relevant in
the context of the future of international tax – ‘Preserve substance; modify
form; know the difference’.