The rise of general anti-avoidance rules in taxation
December 2017 | SPECIAL REPORT: GLOBAL TAX
Financier Worldwide Magazine
December 2017 Issue
Fighting tax avoidance and the closing of tax loopholes are high on the agenda of many countries, as well as multilateral organisations such as the European Union or the Organisation for Economic Co-operation and Development (OECD). While tax avoidance, defined as the use of arrangements available in tax laws to reduce one’s tax liability, is considered legal, it has the undesired effect that it unduly reduces the amount of tax that would ordinarily be payable in a given situation. Laws known as general anti-avoidance rules try to tackle such behaviour on a broad scale by disregarding arrangements which are considered as having been primarily put in place for tax mitigation purposes.
General anti-avoidance rules have a long tradition in some countries and have proven to be a flexible instrument to provide a balance between the freedom of the taxpayer to structure transactions the way they see fit, and the legitimate right of tax authorities to ensure that taxation rules are not circumvented by taxpayers. To a certain extent, trying to mitigate the tax liability of a transaction is a natural and intrinsic outflow of economic behaviour, and no one can be expected to structure a transaction in a way that is particularly burdensome for the taxes it triggers.
Putting in place arrangements, however, whose sole or principal purpose is to reduce or avoid tax that would otherwise be due cannot be expected to find protection, as it would be using the law against its proper objectives.
‘General’ versus ‘specific’ anti-avoidance rules
Rules to tackle aggressive tax planning can either be designed to cover a specific fact pattern (referred to as specific anti-avoidance rules or SAARs). An example of this would be a rule that denies an instrument to be treated as equity when the counterparty can deduct an interest expense in relation to that instrument. Or they can be broad and principle-based, so as to counteract any kind of perceived tax avoidance (referred to as general anti-avoidance rules or GAARs).
While specific rules are often more predictable in their application, and therefore provide more legal certainty, they are also easier to circumvent by taxpayers. When a new arrangement is designed by a taxpayer that is not yet in the scope of a SAAR, the taxpayer can benefit from this arrangement for a certain period of time until it is clamped down by a new SAAR adopted by the lawmakers.
GAARs, on the other hand, are more flexible and give tax authorities an instrument which allows them to react fast to any new perceived tax avoidance scheme by disregarding arrangements that have been put in place mainly to obtain a tax benefit. However, as their critics rightly invoke, GAARs also confer great power and responsibility upon the tax adjudicators.
Their broad scope of application requires a significant amount of judgement, which often makes it difficult to predict upfront whether an arrangement will eventually be caught by a GAAR or not, thus creating uncertainty for taxpayers. Also, unfair outcomes between different taxpayers can result from selective application of a GAAR. This is because GAARs apply to each case separately, and its elements (including the question whether an arrangement pursues solely or predominantly a tax purpose) are assessed for each case individually. Similar arrangements may therefore be treated differently in respect of a GAAR. Despite these concerns, GAARs are widely considered to be an effective tool to protect the integrity of tax laws.
In light of the imperfections attributed to GAARs, tax authorities and courts are bound to apply GAARs with care to mitigate potential adverse effects that may result from their use. In this respect, many countries are offering pre-filing mechanisms or tax rulings to give taxpayers the opportunity to assess the potential application of a GAAR before entering into a transaction. The certainty gained from such mechanisms allows taxpayers to better estimate the return from an investment or transaction, which makes capital allocation in an economy more efficient.
Certain countries have also established GAAR panels with a mixed composition including industry and tax administration representatives as well as independent tax professionals to provide oversight over the application of the GAAR.
Common elements of a GAAR
GAARs appear in different forms and shapes. Nevertheless, they usually have three common features. Firstly, there must be some sort of arrangement, scheme or undertaking carried out by the taxpayer. An entire transaction, or only one or more elements thereof, may be identified as a relevant ‘arrangement’.
Secondly, the arrangement must result in a tax benefit that would not have been obtained if the arrangement was not put in place. This tax benefit can be a tax exemption, or a reduction in tax liability. It can also be a reimbursement of a tax, a postponement or deferral of a tax, or a reclassification of a type of income so as to match existing losses or deductions which would not be matched under a different classification.
Lastly, for the arrangement to be caught by the GAAR it must be shown that the taxpayer’s sole or principal purpose was to obtain the identified tax benefit. While this could be understood to look at the subjective reasons of the taxpayers to put the scheme in place, it is in fact to be applied objectively. The purpose test tries to find out from an independent and objective viewpoint whether the arrangement makes commercial sense for other reasons than the perceived tax benefit.
Drawing the line between arrangements that are, and that are not, made for the sole or principal purpose of obtaining a tax benefit can prove to be tricky. A taxpayer cannot be required to always opt for the course of action which results in the highest level of taxation. Therefore, the mere fact that a transaction provides a tax benefit does not justify the application of the GAAR. However, there may be situations where a transaction generally makes sense commercially, but in the context of which a single step may be identified that in itself can be considered as an ‘arrangement’ and that can be explained only by a tax benefit being obtained, without otherwise having a genuine commercial foundation. In this case, the GAAR can be applied to that step only, without affecting the transaction as a whole. Countries hereby take different approaches as to who bears the burden of proof for applying the GAAR. It can lie with either the tax authorities, the taxpayer, or be shared between the two.
Substitution of a hypothetical fact pattern
When an arrangement is caught by a GAAR and is finally disregarded, this does not mean that tax is automatically recouped. Tax is only recovered when a hypothetical or recharacterised fact pattern is substituted for the arrangement put in place by the taxpayer. Taxes are then assessed on this hypothetical fact pattern, which often means that the envisaged tax benefit, or a part thereof, is denied to the taxpayer. This hypothetical fact pattern can go as far as to disregard an arrangement or transaction entirely, if it is revealed that the taxpayer would not have entered into that transaction if it were not for the perceived tax benefit. When substituting a hypothetical transaction for the one that took place in legal form, tax authorities are generally bound to apply the most appropriate alternative transaction.
Recent developments and conclusion
GAARs have a long tradition in many countries. They were first introduced as early as 1915 in Australia and 1925 in the Netherlands. In most countries, GAARs are enacted in the form of substantive law, although there are some countries such as Switzerland where it emerged as a judicial doctrine. In recent years, a number of countries that had not historically had a GAAR have adopted one, among them China (2008), the UK (2013), Poland (2016) and India (2017). Others, like Belgium (2012), have revised and reinforced existing regimes. Today, out of 46 countries in the OECD and G20 combined, 35 have a GAAR.
Typically, as in the case of the UK, the GAAR complements pre-existing anti-avoidance measures, such as the more specific SAARs. In other cases, they reinforce or replace certain judicial anti-abuse or substance-over-form doctrines. Countries implementing a GAAR expect it to be a significant aid in counteracting aggressive tax avoidance which cannot be caught by the existing mechanisms. It can be expected that the rise of GAARs will continue across the globe, as these rules have proven to be effective in targeting tax avoidance schemes, in particular in an environment where tax rules become ever more complex and financial instruments more sophisticated, and where specific anti-avoidance measures can no longer keep pace with the ongoing developments.
Christoph Suter is a partner at Bär & Karrer. He can be contacted on +41 (58) 261 57 25 or by email: email@example.com.
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