Month: December

6. The Hon’ble Finance Minister in his Budget speech 2006
stated the intention to move towards comprehensive goods and service tax (GST)
by April, 2010. The scope of the Empowered Committee of State Finance Ministers
(ECFM) has been expanded to deal with issues relating to GST. The institution of
Empowered Committee of State Finance Ministers is one of the most successful
innovations in fiscal federalism. GST is considered to be the single largest tax
reform of the country in the domestic taxation. Adoption of Value Added Tax
(VAT) at the Central level and also by all the States for taxation of goods and
services has given enough confidence to all the stake-holders to move towards
GST at the national level.

7. Major problem afflicting taxation of goods and services
today is the tax cascading arising on account of the partial nature of the taxes
and also of multiple and overlapping taxes. Current tax structure results into
varying degree of taxes on goods and services depending upon the nature of
inputs used. No credit is allowed on CST paid on interstate sales. Even if the
statutory rate is the same, effective tax rate varies from product to product,
depending upon the quantum of hidden taxes paid on inputs and the structure of
production and distribution chain.

8. Indirect taxation in India, therefore, provides
opportunities for planning and arbitration. Simplified system of taxation
reduces the cost of compliance and cost of collection considerably and would
enable the business to plan its activities. GST reduces the scope for ad hoc
decisions and political compromises apart from reducing the compliance cost.

9. The core objective of GST is to remove barriers for trade
by creating a common national-level domestic market. A major reform of such
magnitude does require change of ideas, attitudes and mind-sets. This may cause
discomfort mainly on account of fear of the unknown. If one appreciates the
economic advantage of GST and appreciates its necessity in the context of the
global economic competition, then apprehensions and misgivings may not have any
place.

10. Consumption tax on goods and services on the basis of
value addition known as VAT or GST has been emerging as the tax of the future.
The global experiences support that VAT is the most effective mechanism to raise
revenue efficiently. The fact that more than 145 countries in the world across
the ideological spectrum adopted VAT to tax domestic consumption of goods and
services substantiates the view that VAT has now become a main feature of
indirect revenue system.

11. GST or VAT is a broad-based tax levied on multiple stages of production and distribution with the taxes on inputs credited against taxes on output. Revenue is secured by being collected throughout the process of economic transactions, but without distorting production decisions. It is collected at each stage of the transaction and the amount of tax is calculated on the prices of the goods and services at the rate applicable after deduction of the amount of VAT borne directly on various inputs used for providing output goods or services. Taxes collected at intermediate stages are only pass-through transactions. Collection of tax being at each stage of the transactions with input credit scheme, VAT has inherent incentive for tax compliance. Being a consumption tax imposed on goods and services, the tax burden is to be borne by ultimate consumers.

12. VAT is the single largest source of revenue in some countries and one of the most important sources in many more. Increase in VAT collection is not at the expense of income tax. VAT and income tax are in fact complementary to each other and one is not a substitute for other. VATis a simple way of collecting sales tax. No fiscal innovation is ever spread so widely in such a wide variety of countries.

13. GST designed with the objective of economic efficiency and neutrality requires:

14. The relevant questions to be responded while designing GST are, –

Equity and distributional effects of GST are matters of concern and academic debate. It is difficult to design VAT to meet the needs of vertical equity. However, experiences all over the world show that at present VATis the best form of general consump-tion tax available.

15. One of the critical areas in designing single GST is sub-national jurisdiction in levying of VAT. GST design in a federal country needs to take into account:

16. Considering the revenue needs of provinces to meet their developmental objectives, provinces do expect sufficient fiscal space to mobilise revenue. The Constitution of India clearly demarcates the taxation power between the Centre and the States. GST model needs to strike a balance between harmonisation which is critical for economic efficiency and creation of common domestic market and fiscal autonomy of the Centre and the States required to discharge their obligations.

17. Though the desirable objective is broader base with lower rate, preferably single rate, the need to protect and ensure the interest of the economically weaker sections by way of exemptions, reduced rates or zero rates for basic services like food, medicines cannot be totally ignored especially in a developing or transitional economy. Equity aspects of VATare a matter of concern. It may be inevitable to introduce some degree of explicit progressivity within the VATsystem itself. In such cases, reduced rate is generally considered as the preferred choice. Minimising distortion and at the same time accommodating the different economic and social objectives is the real challenge for designing the GST system. However, experiences show that introducing specific measures inevitably creates complexities and resultant cost and goes contrary to the demand for simplification. It is also a challenge to balance the procedural requirements to eliminate the possibility of non-compliance and fraud and at the same time ensuring that the level of compliance cost does not affect the ability to compete. Ideal model may not be politically acceptable and administratively feasible.

18. Different forms of eST exist in different countries. What is important is designing an appropriate GST to suit the specific needs and environment and then running it efficiently. Differences among various GST systems indicate the objective reality of history and politics of member countries. European Union’s VAT is the much talked about VAT. However, there is a strong view that the Sixth VAT Directives of EU need major revision to cope with the realities of the expanded, more integrated and more developed EU of today.

19. The single-rate structure usually considered as an ideal and recommended by experts is followed only by Denmark among the EU countries. Most EU countries have a standard rate with two reduced rates. The average effective VAT rate as compared with the standard rate among EU member states varies widely and the percentage of variation is in the range of 8% to 32% of the standard rate. In EU, about  one-third  of the tax base is subject to non-standard  rates including  zero rate. Exemptions also vary  widely  from country  to country.  VAT in EU differs on many important  aspects. Variations are in relation  to the tax base, treatment  of foreign trade-origin or destination,  and the method  of collection.

20. GST model followed by New Zealand, Singapore and Australia with broad base and single rate is no doubt a clean model. But it may be difficult to replicate such model in a federal structure with strong identity of units and also in developing or transitional economies.

21. Despite differences, almost all the VAT models in the world follow the principle to tax consumption on destination basis and is applied on a transaction basis using the invoice – credit (output tax minus input tax) method basis. Origin-based income type VAT exists in Italy, Japan and some American states. China already initiated the process to have eST by the year 2013. Countries that do not have VATare US, Iraq, Iran, Cuba, some oil-rich countries and large number of small island countries basically in the Caribbean and Pacific.

22. Selectivity and discretion erode tax base and tend to create powerful special interest groups apart from introducing complexity in the system. Single national-level eST does avoid issues relating to interstate transactions. However in a democratic polity with federal structure and assignment of tax powers, it may be difficult to achieve, if not impossible, the ideal comprehensive value added consumption tax at the national level. The other model is taxing consumption at uniform rates across goods and services. This will avoid tax-induced distortions, bring simplicity and minimise the pressures for favourable treatment for some goods or services over others. However, fiscal autonomy warrants power to decide the tax rates to meet the revenue needs notwithstanding harmonisation of law and procedure.

23. Independent VAT applied simultaneously on the same tax base by two different and overlapping jurisdictions leads to high administrative and compliance cost. The only way in which sub-national units can effectively levy VAT is on origin basis. In such cases, if the rates are not uniform, results would be highly distortionary.

24. Destination-based consumption VAT through invoice-credit method requires physical border controls. In the absence of border controls, the alternative approach is to put through some form of clearing house mechanism to deal with the state transactions. Considering the magnitude of transactions, this approach requires a sound and extensive IT infrastructure.

25. One of the most critical VAT design issues is consideration of local conditions including support the level of the threshold limit above which firms . from trade and industry. Good GST design makes must register. One view is to set the threshold limit good VAT administration easier and bad design too high rather than too low. Dealing with a large makes good administration almost impossible. number of very small taxpayers inevitably results in
some loss in administrative efficiency. It is preferable to include all firms above a fairly high threshold in the tax base. The other view is that high threshold limit reduces the tax base and encourages growth of informal sector. A balanced and a pragmatic view needs to be taken. There are also challenges to make GST work in a system, which relies on self-assessment.

26. Desirable features of VATdesign such as single rate, zero rating instead of exemptions, refund of input tax credit, that cannot be adjusted against taxes due on outputs may not necessarily be feasible in the context of the economic realities. Features like more than one rate, few exemptions, and too high or too low thresholds may be inevitable at a particular point of time for successful adoption in the first place. However, experiences show that it is extremely difficult to remove such features at a later stage.

27. The clean system is critical in lowering compliance cost for business and administration cost for Government. The fundamental choice is between concessions to some with high rates or no concessions with low tax rates. This needs to be explained and communicated well so as to evolve a consensus.

28. VAT provides a competitive advantage to the country that implements it. It removes hidden taxes on exports. Many goods and services that bore no taxes are in fact have hidden taxes paid on most of their inputs. The resulting pattern of effective rates on products and industry vary widely and bear little relation to the Jegislativ,e intent. In India, the study shows that the tax incidence on different commodity groups varies widely. Elimination of exemptions and concessions reduces administrative cost as well as the influence of special interest groups on tax policy. Self-imposing nature of GST leads to increase in revenue productivity. VAT also strengthens the information base of the tax administration, resulting in improved compliance not only of VAT,but also of other taxes.

29. Critical factors for successful implementation of GST are political commitment, adequate and advance preparation, investment in tax administration, extensive public education programme and consideration of local conditions including support from trade and industry. Good GST design makes good VAT administration easier and bad design makes good administration almost impossible.

30. “Tax Administration is Tax Policy” says Milka Casanegra. The real tax system is that which is administered, not that which appears in the formal law. VATcan certainly be designed to fit into the tax administration of the country.

31. The most basic lesson learnt from international experiences in implementing GST is that doing it right is in most respects a matter more of art than of science. It is extremely critical to keep the administrative dimensions at the Centre rather than at the periphery while designing the GST system. Poor administrative system creates a wedge between theory and practice and thus encourages the spread of informal economy. A good policy is only as good as it is administered. It is important to keep in mind the administrative realities. Reform of the tax system is not a one-time affair. It is a dynamic process in which the responses are to be calibrated continuously.

32. Successful implementation of GST requires an effective consultative and communication process. Consultative process helps to improve the quality of decision-making. It may not be possible to have consensus with many interest groups and the public on all issues. As long as the decisions are fair and reasonable, and consistent with the stated core objectives, consensus develops after the decisions deliver satisfactory results. It is equally important to appropriately package the proposal.

33. There are no disagreements between the Centre and the States and trade and industry on the issue of common tax base, rates and laws and procedures. The issues are more on details and the mechanism required to achieve the stated objectives. Considering the consensus and the enthusiasm of the stakeholders and the appreciation of the necessity and economic benefits of GST, there is every reason to believe that the country is on the right path and will reach its destination.

However, more and more countries have come to the realisation
that taxpayers were choosing forms for their transactions that led them to a
beneficial tax treatment. This may and does in practice, lead to undesired
behaviour. Especially in cases where the form of the transaction has no or
little connection with its actual substance and such form is chosen merely to
get a better tax result, the ability to look beyond the form may be justified.
An example could be where a parent company provides funding to its 100 percent
loss-making subsidiary company, without a repayment obligation, and without
charging interest. Calling such funding a loan, and not (quasi) equity, would
not do justice to the substance of the transaction.

What should be avoided, however, would be a requalification
of any transaction to a form that puts the taxpayer in the worst position.
Striking the balance is not easy.

The approach of a few countries towards the issue of
substance over form has been reflected below, to provide a better framework for
understanding the issue.

The US has included several rules in its legislation to
codify the substance-over-form concept. Illustrations include : The rule on
conduit financing and on domestic reversed hybrid entities.

The Internal Revenue Service (IRS) is permitted to re-characterise
cross-border conduit financing transactions, including back-to-back loans which
are undertaken for tax avoidance purposes. Specifically, the IRS is authorised
to disregard an intermediate company in a multiparty financing arrangement if
the company is used as part of a tax avoidance plan, for example, if the company
is put in place to take advantage of reduced withholding under a US tax treaty.
In that case, the overall transaction will be analysed without recognition being
given to the conduit entity and the US domestic withholding rate or that of
another tax treaty will be applied.

The Domestic Reversed Hybrid rules, finalised in 2002,
provide a check on certain abusive double-dip financing arrangements between
related parties. If a payment from a domestic entity to a related Domestic
Reversed Hybrid entity is treated as a dividend under either US or foreign law,
and if the Domestic Reversed Hybrid entity makes a payment to a related foreign
interest holder which is deductible in the US and entitled to a reduced treaty
rate, then the payment by the Domestic Reversed Hybrid entity is treated as a
dividend. Thus, there will be no deduction and the treaty withholding rate will
be governed by the Article relating to dividends.

The IRS in the US and the US courts have consistently taken
the view that transactions are to be taxed according to their economic substance
rather than their legal form (Goldstein v. Commissioner, 364 F.2d 734 (2d
Cir. 1966).

In the matter of Burger King v. State Tax Comm’n, (416
NE2d 1024) (NY Ct. Apps. 1980), the Tax Commission assessed a restaurant sales
tax on purchases of packaging material. The assessment was based on the fact
that the restaurant did not charge its customers a line item on the receipt for
packaging. Based on this, the state argued, the packaging was not being ‘resold’
as required for exemption from sales tax. In ruling for the restaurant, the
court overlooked the form of the transaction (i.e., the absence of a line
item for packaging on the customer receipt) and looked to the substance to
determine if a resale had occurred.

The Supreme Court, in F. & R. Lazarus & Co., (308 US 252)
(1939), summarised the doctrine as follows : In the field of taxation,
administrators of the laws and the courts are concerned with substance and
realities, and formal written documents are not rigidly binding.

The tax authorities introduced general anti-avoidance rules
effective from January 1, 2008. The Chinese tax authorities are authorised to
make adjustments to arrangements that can result in a reduction of tax payable
and which are made without any justifiable commercial or business reason.
According to the draft administrative regulations on special tax adjustments,
the following may result in the involved enterprise becoming a target of an
investigation : abuse of tax incentives; treaty shopping; abuse of form of
organisation; frequent trading with companies located in a tax haven; and any
other business arrangements without bona fide commercial purposes.

The form and substance of an arrangement will be reviewed.
The tax authority may redefine the arrangement based on the business substance,
cancel an enterprise’s tax benefits, and re-identify or reallocate revenue,
costs, income, losses and tax deductions between the involved parties. An
anti-avoidance case must be reported to the State Administration of Taxation
(SAT) for its approval.

Under the German law (S. 42 of the AO – Tax Procedure Act) substance over form is applied if an in-appropriate legal structure is chosen that leads to a tax advantage for which the taxpayer cannot provide significant non-tax reasons.

A legal structure is considered inappropriate if the taxpayer or a third party generates a tax benefit that is not intended by the law. The amended Section also includes a clear hierarchy, i.e., specific anti-abuse rules according to applicable tax laws have to be applied on a step-by-step basis, after which the general anti-abuse provision can become applicable.

As the legal definition of ‘abuse of form’ is some-what vague, the German tax courts had established a long-term practice based on numerous cases regarding ‘base companies’ which are placed in a low-tax jurisdiction and have no or only insignificant substance.

The recent German anti-treaty-shopping rule (5. SOd EStG) increases the substance requirements for non-German companies to benefit from withholding tax relief, in particular with respect to dividends or royalties provided for by the double tax treaties (DTT) or EU directive. A foreign company is in general entitled to neither full nor partial tax relief if:

United Kingdom (UK):

In Furniss (H.M. Inspector of Taxes) v. Dawson, House of Lords, (55 TC 324) (1984) (AC 474), the case involved a disposition of shares by family members, who disposed of shares in two family companies to an investment company incorporated in the Isle of Man. The shares were subsequently sold to another company. The reason for interposing the Isle of Man company was to provide capital gains tax relief. On the question whether the two transactions were in substance a single transaction, it was held that: In ascertaining the substance of a transaction, the courts must look at the entirety of a composite trans-action if it appears that it was designed and intended to be carried through as a whole. The court is not bound to take each step in isolation in order to ascertain the legal rights and liabilities of the tax-payer at the beginning and end of each step. The court can and should have regard to the result which the transaction as a whole was designed to achieve. Further, the court may disregard a transaction and treat it as fiscally a nullity even though there is a change in the legal position of the parties before and after the scheme is carried through, if that change can be regarded as a mere change of form with no enduring legal consequences.

In  Commissioners    of Inland    Revenue    v. Duke    of Westminster (19 TC 490, 520,524) (1936) (AC 1), it was held, as is commonly used as supporting comment in various commentaries on substance-over form matters, that: Every man is entitled if he can to order his affairs so that the tax incidence 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.

In WT Ramsay Ltd. v. Commissioners of Inland Revenue, (54 TC 101) (1982) (AC 300), it was held that: If it can be seen that a document or transaction was intended to have effect as part of a nexus or series of transactions, or as an ingredient of a wider transaction intended as a whole, there is nothing in the doctrine to prevent it being so regarded. It is the task of the court to ascertain the legal nature of any transaction to which it is sought to attach a tax or a tax consequence, and if that emerges from a series or combination of transactions intended to operate as such, it is that series or combination which may be regarded.

The above ruling provides a logical summary of addressing the legal nature of each transaction in a series of transactions.

First, it established that there is nothing in the Westminster principle which compels a consideration of individual transactions separately from a preconceived chain or series of transactions of which they form merely a part.

Secondly, it established that where one finds a series of preconceived transactions which are entered upon solely for fiscal purposes and are clearly interconnected and mutually dependent upon one another, one should look at the overall transaction to ascertain what has been and what was intended to be achieved.

Thirdly, it established that if what one finds on such a consideration is that nothing whatsoever has been achieved because the individual steps taken cancel one another out, one is entitled then to ignore the fiscal consequences which might otherwise have resulted from each of those individual steps considered in isolation. That represents the substance of the general principle deducible from the decision.

In conclusion, the fact that transactions may be circulating or are merely paper transactions is further not conclusive. Thus, where no commercial purpose in relation to the transactions is evident apart from tax avoidance which in the absence of the transactions would have been payable, the series of transactions should be looked at as a whole in relation to intention and motivation.

Netherlands:

It is generally accepted that artificial or simulated transactions may be ignored by the tax administration and the Courts of Appeals through a determination of the facts rather than the form (substance over form).

In addition, there are two specific provisions to combat tax avoidance or evasion (i.e., transactions the main purpose of which is avoidance or evasion of tax) :

The just levying provision (richtige heffing), under which the legal act in dispute may be ignored for tax purposes. This procedure is subject to prior approval by the Ministry of Finance and involves a lot of administrative work. Therefore, this procedure is not commonly used.

The abuse of law doctrine (jraus legis), which is not laid down in tax law but is an interpretation method developed in case law. Under this provision, the spirit of the law is decisive, rather than the exact wording. The transaction in dispute may be converted to the closest equivalent which does not give rise to an abuse of law. The abuse of law procedure can be used only as a last resort.

In general, the results of both  procedures are the same for the taxpayer.

In the recent Supreme Court decision (HR 17-10-2008,42954), the merger exemption for capital duty payment was denied, as it was held that interposing an English company for a short period of time, and based on a pre-determined step plan, lacks a real function.

From a series of Supreme Court decisions it can be deduced that abuse of law is present when the chosen structure is predominantly or exclusively motivated by tax savings and also is in contradiction with the meaning of the law. If the motivation is exclusively to save tax, and no commercial justification for the chosen structure exists, abuse of law can be present as well. However, if the legislature has recognised a tax-saving route, but deliberately did not close this route, the courts are not inclined to apply the abuse of law doctrine.

India:

The most important Indian case addressing the substance-over-form question is without doubt McDowell and Co. Ltd. v. Commercial Tax Officer, (154 ITR 148) (SC). The case was about a mitigation of sales tax by having the buyers separately pay the excise duty, whereby such excise duty would not be included in the taxable basis for sales tax.

The Commercial Tax Officer was of the view that the excise duty paid directly to the Excise authorities or deposited directly in the State Exchequer in respect of Indian liquor by the buyers before removing the same from the distillery could be said to form part of the taxable turnover of the appellant distillery for the purpose of the Sales Tax Act.

The Court, however, came to the conclusion that excise duty did not go into the common till of McDowell and did not become a part of the circulating capital. Therefore, the Sales Tax authorities were not competent to include in the turnover of the appellant the excise duty which was not charged by it but was paid directly to the excise authorities by the buyers of the liquor.

The Supreme Court took the view that tax planning was legitimate so long as it was strictly within the four corners of the law and any ‘colourable’ device or dubious methods to minimise tax incidence were not legally permissible.

The Court reaffirmed the view of English cases while examining a legally valid transaction, and held that the Revenue should proceed objectively and not hypothetically attribute ‘motives’ behind the taxpayer’s action.

In the case of the Commissioner of Income-tax v. A. Raman and Co, (67 ITR 11,17) (SC), it was stated that: The law does not oblige a trader to make the maximum profit that he can get out of his trading transactions. Income which accrues to a trader is taxable in his hands. Income which he could have, but has not earned, is not made taxable as income accrued to him. Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in tax statutes may not, except on peril of penalty, be violated, but may lawfully be circumvented.

In the case Bank of Chettinad Ltd. v. Commissioner of Income-tax, (8 ITR 522), it was stated that: The tax authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it is open to the tax authorities to unravel the device and to determine the true character of the relationship. But the legal effect of a transaction cannot be displaced by probing into the ‘substance of the transaction’.

In Simon in Latilla v. I.R.C. (11 ITR Suppl. 78, 79) (HL), it was stated that: Tax planning may be legitimate, provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay their taxes honestly without resorting to subterfuges.

In CIT v. Abhayananda Rath Family Benefit Trust, (255 ITR 436) (Orissa HC), the assessee set up a trust for his minor son’s benefit. The income of the minor child from the trust was to be accumulated during his minority. In other words the income of the minor child from the transferred assets was not includible in the total income of the assessee. However, the contention of the Revenue that the trust has been created by the assessee for the purpose of avoidance of tax was rejected by the Court, as ‘Evading payment of tax’ is quite different from ‘tax planning’.

According to the Orissa High Court, a person may plan his finances in such a manner, strictly within the four corners of the tax statute that his tax liability is minimised or made nil. If this is done and observed strictly in accordance with and taking advantage of the provisions contained in the Act, by no stretch of imagination can it be said that payment of tax has been evaded.

In the context of payment of tax, ‘evasion’ necessarily means, ‘to try illegally to avoid paying tax’. But, as in the instant case, a trust has been created in accordance with law and creation of such a trust is not hit by any of the provisions contained in the Act.

Analysis:

It appears from the above, that there is no single approach towards the issue of substance over form. A clear tendency exists for tax authorities to try and counter any kind of undesired outcome (in their eyes) of a certain piece of legislation by applying the substance-over-form doctrine. This puts, more than in many other situations, a strong responsibility on the shoulders of the judicial system to protect the rights of the taxpayer.

The following common denominator can, however, be found in most countries: If a taxpayer has multiple avenues available to structure his transaction, he is free to choose the most tax-efficient avenue, provided a certain level of commercial justification for the choice exists, and tax considerations are not the only reason.

The OECD leaves it to the individual countries to introduce anti-abuse legislation, legislation that can be applied without interference by the OECD model convention (and vice versa). The OECD does subscribe to the concept of (economic) substance over (legal) form.

Looking at the current situation in India, the Indian tax authorities are clearly exploring the limits to the substance-over-form concept with their secondary line of argumentation in the Vodafone case, which involves an attempt to lift the corporate veil of the companies that were interposed between the Hong Kong ultimate parent and the Indian operating company. This seems to indicate that the tax authorities want to go beyond the earlier decision in the Union of India v. Azadi Bachao Andolan, (263 ITR 706) (SC), where the existence, and beneficial ownership for claiming benefits under the treaty between India and Mauritius, of a Mauritian group company were respected based on a valid certificate of residence of that company issued by the appropriate Mauritius authorities. From Mukundrary K. Shah v. Commissioner of Income tax, (143 Taxman 743) (Calcutta HC)t and Deputy Commissioner of Income tax v. GVS Investment (p) Ltd, (92 TTJ 706)( Delhi ITAT) a principle emerges that the corporate veil can be lifted only where the transaction is found to be sham, bogus or contrived. The corporate veil can be lifted so as to expose any person to liability, who has committed a fraud upon the public from their sheltered position. In addition, from Mafatlal Holdings Ltd v. Additional Commissioner of Income-tax, (85 TTJ 82) (Mumbai ITAT)1 and Additional Commissioner of Income-tax v. Nestle India, (94 ITJ 53) (Delhi ITAT), it is clear that the onus is on the tax authorities to prove that a transaction is sham or bogus, before resorting to lifting the corporate veil.

Conclusion:

The substance-over-form doctrine is used most often in an anti-abuse context by the tax authorities. This implies that it should be applied with care. It should also be applied in a consistent way. A requalification of only certain elements of a transaction, to come to the maximum tax cost for the tax-payer, will not do. The substance of the total trans-action structure should be reviewed. Only when the chosen form is illegal or legal, but lacking commercial reality and just aimed at receiving a beneficial tax treatment, a challenge based on the substance-over-form doctrine should succeed. And, also the tax authorities are required to stay within the four corners of the law.

At the same time, management fees can be one of the more
important and legitimate tax planning tools for effectively lowering taxable
income in a particular tax jurisdiction, if it is structured in a proper manner.
Hence it is obvious that tax authorities look at this mechanism as a profit
extraction technique and adopt a strict posture while investigating the
inter-company affairs. Further it is imperative that the Multinational
Enterprise (MNE) group which is formulating an intra-group management fee
policy, must consider the tax implications in both the jurisdictions. It is also
equally important to consider other aspects such as withholding tax, indirect
tax levies, international tax and regulatory issues while formulating an
intra-group management fee policy.

This article (in two parts) seeks to outline certain key
aspects that need to be considered while formulating a management fee policy and
also the broad approach to be followed in this regard. The analysis here is
mainly from an Indian perspective (i.e., mainly with reference to a
foreign MNE proposing to charge management fees to its Indian group company to
which support services are rendered, and also with reference to an Indian MNE
proposing to charge management fees to its overseas group companies). At various
places, the article also highlights the practical approach currently being
followed by the Indian tax authorities and issues encountered by taxpayers based
on transfer pricing assessments recently completed.

3.0 Broad parameters for designing a policy for charging for intra-group
services :

Considering the importance of charging arm’s-length management fees from the perspective of both the service provider and the service recipient, the basic principles involved in designing a management fee policy are discussed here. Broadly speaking, the OECD Guidelines” outline two main issues that should be addressed when evaluating intra-group services in the context of transfer pricing, namely:

3.1 Determining whether intra-group services have been rendered:

The OECD Guidelines provide a basis to determine whether a service has been rendered. The OECD Guidelines broadly state that when one group member performs an activity for one or more group members, it will be regarded as a service rendered if and only if the activity provides the respective group member with economic or commercial value that might conceivably enhance the recipient’s commercial position.’ It also provides another simple way to ensure that a legitimate service is being rendered by considering whether an independent enterprise in similar circumstances would be willing to pay for the same service conducted by another independent entity or whether it would perform that service in-house. In other words, the OECD Guidelines are based on the principle of willingness to pay for an activity from an independent enterprise vis-a-vis performing it in-house. Simply stated, if the activity is not one for which the independent enterprise would have been willing to payor perform for itself, the activity ordinarily should not be regarded as a chargeable intra-group service under the arm’s-length principle.

The US regulations u/ s.482 of the Internal Revenue Code (US regulations) are also based on the same lines. Similarly, the position of the Australian Tax Office (ATO) with regard to head office activities is that services are chargeable only when the activity has conferred a benefit to an assessee. The ATO also takes the view that where a benefit is provided to an entity by way of a service and there is a real connection between the entity’s operations and the associate, the entity would be expected to pay for the services.

This test involving a willingness to payor existence of a benefit (benefit rule), as enunciated above is, by far, the most important factor that determines whether a related-party service recipient would pay for an intra-group service and, therefore, in turn, whether the service provider can justify a charge for the provision of the intra-group services. The objec-tive of the benefit rule is not only to determine the quantum of benefit, but also the relative proximity of the benefit derived to the intra-group services rendered. Therefore, one should determine how direct or remote the benefits derived are in relation to the activity performed under the guise of intra-group services. A direct or perceived benefit from the service rendered must be identified. Conse-quently, allocations are not to be made if the prob-able benefit to other members is so indirect or re-mote that unrelated parties would not have ‘charged for similar  services.

Further, such management fee charge is to be consistent and commensurate with the relevant benefits intended for the services, based on the facts known when the services were rendered, and not based on benefits realised later on. In other words, the use of hindsight is to be avoided.

Consequently at a practical level, with a view to determining whether intra-group services have been rendered, each service must be evaluated on the basis of whether it provides a group member with economic or commercial value that enhances its commercial position in the market where it operates.

This is also relevant because certain services are not chargeable at all. The OECD Guidelines identify certain services or activities that are deemed to be non-beneficial for the recipient. As a result, those activities cannot be regarded as chargeable intra-group services. The main categories of non-beneficial services identified in the OECD Guidelines are:

The same are briefly  discussed hereunder:

3.1.1  Shareholder services/Custodial activities:

Shareholder activities are regarded as activities that a group member performs solely because of its ownership interest in one or more of the group members (in its capacity as a shareholder). Such an activity may be performed by one group member for related group members, even though those members do not need the activity and would not be willing to pay for it if it were performed by an independent enterprise. Consequently, under the OECD Guidelines, this type of shareholder activity would not justify a charge to the recipient company.

On reading of OECD Guidelines, the Canadian Regulations, and the US Regulations, an illustrative list of services/ costs that are regarded as share-holder activities are mentioned below :

However, merely because an activity has been per-formed for the benefit of the owner does not, per se, mean that it is a shareholder activity for which an allocation is not warranted. This is because there may be activities performed for the interest of the owner, which conform to the shareholder activity definition provided in the OECD Guidelines, but which could nevertheless be regarded as chargeable based on surrounding facts and circumstances of the case. In such cases, the OECD Guidelines advise that whether the activities fall within the definition of shareholder activities as defined in the OECD Guidelines is to be determined based on whether under comparable facts and circumstances, the activity is one that an independent enterprise would have been willing to pay for or to perform for itself.

3.1.2  Duplicative Services:

Duplicative services or stewardship services are those that a group member offers to any other member, which can be considered duplicate in the sense that the service is already performed by the recipient or by a third, unrelated party on its behalf. In that case, no intra-group services should be considered to be rendered by the group member.

Such stewardship or duplicative expenses are illustrated in the US Regulations in the context of a financial analysis for a subsidiary’s borrowing needs. When the subsidiary does not have personnel qualified to make the analysis, and does not make the analysis, the cost of the financial analysis done by the parent is required to be allocated to the subsidiary. If, however, the subsidiary has qualified financial staff that makes the analysis, the review of the analysis by the parent’s financial staff is duplicative and an allocation of such costs is not to be made to the subsidiary in such cases.

However, at the same time, it is also recognised that there may be some exceptions, i.e., a temporary circumstance or an opportunity to eliminate critical business risk. The instances of elimination of critical business risk would come into play, for example, while taking a second legal opinion or performing an external audit to avoid a risky or wrong business decision. In other words, when a valid business reason exists, those duplicate services may be considered intra-group services eligible for a management fee payment.

3.1.3  Services that provide incidental benefits:

The OECD Guidelines highlight another set of services which do not warrant an allocation – namely, services that result in an ‘incidental benefit’. This refers to services performed by one group member, such as a shareholder or coordinating centre, for a particular group member or a set of group members, such that it also incidentally provides a benefit to other group members.

To illustrate, a situation of reorganisation decision or acquisition/ disinvestment deal being carried out by a parent or a sister company results in economies of scale or some other benefit for some other group member not directly involved in the process/deal. In this case, though there is a service element, the same cannot be charged for since it only provides indirect benefit.

3.1.4 Passive association benefit:

This is another category of activities that does not justify an allocation under the benefit test. A mere ‘status as a member of a controlled group’ in case of a taxpayer generally will not be considered as adequate to justify provision of a benefit to the tax-payer for which an arm’s-length charge or allocation will be required.. ,

For example, an enterprise deriving incidental benefits simply because of its affiliation with the parent or the group per se; like in the form of a higher credit rating cannot be said to be receiving a service and does not warrant a management fee payment. However, if the higher credit rating is due to a guarantee provided by a group member, then an intra-group service charge would be required”.

3.1.4  On-call services:

The OECD Guidelines refer to another category of services in the context of intra-group services, i.e., services provided ‘on-call”. The availability of those services generally requires the existence of a support group of some sort and an understanding between the group members about the nature of the assistance being provided in any field of operation whenever required and on an on-call basis. For example, a parent company or a group service centre may be on-hand (always ready/prepared) to provide assistance in matters of legal, finance, technicalor tax issues at any time.

The aspect that merits consideration here is whether the ‘availability’ of that service in itself is considered as a separate service (for chargeability) over and above the service fee compensation for the actual service rendered. The justification provided in the OECD Guidelines for considering such availability as a separate service rendered is that it is common knowledge that independent enterprises incur so-called ‘stand-by charges’ to ensure availability of those services when the need for them arises. An example of that service is the appointment of any legal, technical or financial service provider on a ‘retainer basis’.

These services are not necessarily a regular requirement and may vary in terms of frequency and importance from year to year. Therefore, one must ascertain the potential need of the stand-by service option for the recipient of the service. In cases in which the service requirement is remote or could be easily procured from other sources without an ‘on-call’ service option, the availability of that option is redundant and, hence, unjustified. Therefore, to evaluate whether an ‘on-call’ service is rendered, one must consider the benefit that the’ on-call’ arrangement offers to the group over a period of several years (given the sporadic nature of the occurrence of those service needs), rather than only for the year of taxation under consideration).

In sum, it would be necessary to justify intra-group services from the point of view of an independent enterprise and whether that enterprise would be willing to pay for the service in question or perform the same service in-house.

Also, special attention and close scrutiny should be paid to certain non-chargeable categories of services such as the shareholder activities, duplicative services, services providing incidental benefits, passive association benefits and on-call services as the OECD Guidelines (and perhaps even the laws of the overseas countries of the subsidiaries of Indian MNE) regard above-referred services as non-beneficial activities for the recipient entity, for which a charge is not justified.

Having discussed the nature of services for which the charge is required, the second aspect that is equally important is how to determine an arm’s-length consideration for such services (in accordance with the benefit received). This aspect would be discussed in detail in the second part of this article.

4.0 Documentation to justify that the services are rendered and benefits accrue to the service recipient:

The documentation process for intra-group services is vitally important to establish before the tax authorities the legitimacy of any intra-group service charges, including management fees. Even though the Indian regulation has prescribed detailed transfer pricing documentation requirements in general, no specific guidance has been given in the context of intra-group services. However, it would not be correct to assume that a taxpayer does not have to prepare the necessary documentation to substantiate any and all intra-group charges within an MNE. Further, it is pertinent to note that under the Indian regulations, the primary onus to prove that the international transactions are at arm’s length is on the taxpayer and the tax authorities have powers to make appropriate adjustments where such onus is not adequately discharged by the taxpayer.

Also, mere existence of services agreement or invoice would not be sufficient to justify the arm’s-length nature of management fee charge. Neither do the service agreement nor the invoice demonstrate that the services are actually rendered and the recipient has benefited from such services.

The most important and crucial aspect is the documentation of the fact that intra-group services were rendered by the service provider and the benefits were received by the service recipient. Thus, apart from documenting the aspects such as description of the business operations of the group and the tax-payer, detailed analysis of functions performed, assets employed and risk assumed, etc. which are mentioned in S. 92D read with Rule LOf), one must demonstrate that the service recipient benefited from the provision of the intra-group service and the same must be proved beyond reasonable doubt”.

The following documents would be useful in demonstrating that the services were actually rendered and benefits were received by the taxpayer:

In fact, the Indian tax authorities are insisting on some of the above documents during the course of transfer pricing assessment in order to satisfy themselves of the arm’s-length nature of management fee charges. In cases where the taxpayer fails to furnish the requisite documentation, the tax authorities have been disallowing the entire management fee charge by treating the arm’s length value of the said management fee paid as Nil. In contrast, the US and Canadian IRS have adopted an increasingly proactive and more sophisticated approach towards examining transfer pricing policies in respect of intra-group support services.

Concluding remarks:

In the realm of transfer pricing, intra-group service transactions present as many challenges as opportunities to the multinational taxpayer. Needless to say, the management fee policy should be designed with the above background in mind such that it does not result in either overcharging or under-charging of management fees and also considering other tax and regulatory aspects. Any under or overcharging could result in adverse tax implications for the group as a whole. Further, as transfer of services is less obvious than transfer of goods, documentation of service transfer has to be robust. One of the major aspects that enable tax authorities to challenge the management fee charge is the lack of a comprehensive and thorough identification, evaluation, and documentation process that can effectively present the best possible arguments to justify any charges for intra-group services. In the context of an aggressive audit and litigation environment like the one that currently prevails in India, the best defense for a multinational with intra-group service transactions is a thorough evaluation process, with the help of transfer pricing experts that results in adequate documentation to present the most persuasive case to tax authorities.

In the next part of this article, we shall discuss how to determine and justify an arm’s-length consideration for such intra-group services.

Texonomy, the relevant dictionary, has been developed, which
provides a tag with a standardised definition to each data element in the
financials. India is exploring the possibility of assuming jurisdiction to adopt
XBRL to facilitate the listed companies to upload their financial statements
using this language with the stock exchanges to make the global investor to
understand, analyse and compare them in a uniform manner. This would require the
audit function to validate the inputs and certify the outputs. If more and more
nations assume jurisdiction, Indian Professionals may even get outsourcing work
in this field.

Electronic filing of statutory forms and returns is gaining
momentum. Over the next decade the e-filing initiative will be complete in all
the Departments of the Central and State Governments and professional firms
would equip themselves to meet this obligation of their clients.

In view of the growing importance of corporate governance the
role of audit will undergo a change. Financial debacle of many corporations in
the US like Enron, Worldcom and a few others; the not long ago sub-prime crisis
in the US and the present financial crisis of banks leading to bail-out plan by
the US Government by pumping in 700 billion dollars are all leading to closer
evaluation of the risk assessment and management functions in an entity. Similar
financial crisis is engulfing banks in Europe also and G7 nations are pondering
on methodologies to prevent major banks from failing. Regulations like SOX in
the US will emerge in a stringent way in the rest of the world and the role of
audit will transform to a different level involving objective evaluation and
reporting.

Audit findings and reporting can no longer be elusive on
non-detection of collusive frauds at the management level. The stakeholders
would expect more information and assurance on the risks and uncertainties
arising out of the decisions taken by the management. Independent assurance on
the reliability of systems, procedures and controls that generate the
information and the reliability of such information which forms the basis for
business policies and decision-making, would be expected. Corporate Social
Responsibility (CSR) will assume new dimensions and the audit reporting and
monitoring will encompass the various initiatives taken as part of CSR including
sustainability and growth. All these developments would result in more
opportunities as well as risks for the profession which can be ably met by
enhancing the skill sets and equipping itself with modern audit tools.

Yet another development for which the profession should be
prepared is the possibility of more disciplinary proceedings and adverse
developments in the context of professional indemnity. In the US, PCAOB does the
oversight function. In India, till now, we are used to peer-review mechanism to
ensure quality in attestation services. Peer review does not lead to
disciplinary proceedings and even an adverse finding results in refusal of
issuance of peer review certificate. Henceforth the scenario will change.
Quality Review Board (QRB) will replace peer review board and any adverse
finding will lead to disciplinary proceedings. The change in the disciplinary
mechanism will also expedite the disposal time of a case. More claims may lead
to popularisation of insurance policies with reference to professional
indemnity.