CA Ahmad Faraz*
General Anti Avoidance Rules (GAAR)
Subordination of legality to transactional reality
1. Introduction:
Tax payers want to reduce their tax liability through various means available to them. It may take the form of tax planning, aggressive tax planning or tax avoidance. There has always been a tussle between taxing authorities and tax payers when there is aggressive tax planning or tax avoidance. Over the years, the legislature has introduced several Specific Anti Avoidance Rules (SAAR) to plug known tax avoidance techniques.
- Section 40A(2) was introduced to stop claim of inflated expenditures by means of payment to relatives.
- Section 2(22)(e) was introduced to tax payments disguised in the form of loans or advances by a specified company to related entities.
- Chapter of Transfer Pricing was introduced to prevent shifting of taxable profits between associated entities from one tax jurisdiction to another.
- Section 94B was introduced in line with BEPS Action Plan 4 to limit interest deduction between associated enterprises.
- Section 56(2)(x) was introduced to tax transfer of specified assets between unrelated entities without adequate consideration.
- Section 94(8) was introduced to curb the technique of bonus stripping for reducing capital gains.
However, tax payers are proficient enough in planning their financial affair by devising new techniques to reduce tax liability, which are though legal, but hard to accept for the tax department. Thus, where SAAR fails to curb known tax avoidance techniques, GAAR would step in to tax such arrangements.
2. Need for GAAR:
2.1 Basic Terms:
The need for a legislation like GAAR can be best understood once the following terms are examined:
1. Tax Planning – Tax planning is arrangement of financial affairs in a way that all incentives available under a taxing statute are taken advantage of. The incentive may be in the form of exemption, deduction, assistance, allowance, rebate etc. Tax planning gives equal consideration to legality and substance of a transaction. Tax planning is legal and allowed by the tax authorities.
Example: A business is being set up. The proposed business is for manufacturing of information technology hardware. The Promoters decided to set it up in the State of Arunachal Pradesh to take the benefit of section 80-IE which gives 100% deduction for 10 consecutive years.
2. Tax Avoidance – Tax avoidance is arrangement of transactions in such a way that it defeats the legislative intent without contravening any law. Here, country is deprived of its due share in tax. Tax avoidance is perfectly legal. Even though the transaction may appear in a particular way, the document trail is prepared to have a lower/no tax liability. The substance of a transaction is not in synchronisation with its legal reality under a taxing statute.
Example: A business is being set up. The proposed business is for manufacturing of information technology hardware. The Promoters undertake the following modus operandi:
i. Promoters set up a company ‘A’ in Country ‘X’ where the income tax rate is zero.
ii. Promoters set up a company ‘B’ in India.
iii.Company ‘A’ enters into an agreement to provide the technical knowhow to Company ‘B’ for manufacturing information technology hardware. Company ‘B’ will pay royalty to Company ‘A’ as consideration.
iv. India’s tax treaty with Country ‘X’ states that the right to tax Royalty accruing in India to a Resident of Country ‘X’ lies with Country ‘X’.
v. Now Company ‘B’ pays heavy Royalty to Company ‘A’ to reduce its taxable income. It is also able to bypass transfer pricing rules due to subjective calculative methods and lack of comparables in public domain.
Here Company A and Company B are able to shift profits to a tax haven, thereby reducing the effective global tax rate. India is deprived of its due share in tax.
3. Tax Evasion – Tax evasion is an illegal arrangement of financial affairs to evade tax liability. It is flagrant violation of the provisions of a taxing Act. It is to be noted that there is a very thin line between tax evasion and tax avoidance. Tax avoidance becomes tax evasion if a penal provision exists in statute for a particular arrangement of transaction.
Example: Mr. A earns Rs. 1 crore as profit during the year. However, he offers only Rs. 10 lakhs to tax. This is illegal and a penalty u/s 270A exists for mis-reporting particulars of income.
4. Aggressive Tax Planning – Aggressive tax planning is a relatively new term and refers to tax planning wherein an entity takes advantage of the technicalities of a taxing statute or of mismatches between two or more tax jurisdictions. It includes rearranging transactions to avoid taxes on repatriation, relocating substantial taxable income to a lower tax jurisdiction, taking benefit of double deduction or double non-taxation etc. In aggressive tax planning, tax decisions take precedence over all other business decisions.
| Type of Arrangement | Pre GAAR Scenario | Post GAAR Scenario |
| Tax Planning | Legal | Legal |
| Aggressive Tax Planning | Legal | Illegal, if GAAR applicable |
| Tax Avoidance | Legal | Illegal, if GAAR applicable |
| Tax Evasion | Illegal | Illegal |
2.2 Response of Indian Judiciary to Tax Avoidance and Aggressive Tax Planning:
Nothing is illegal unless the law says so
A fiscal statute imposing tax must be interpreted in strict legal sense. No tax can be levied and collected except with the permission of law. In a Taxing Act, one has to look at merely what is clearly said. Though some High Courts and Appellate Bodies have held tax avoidance and aggressive tax planning as illegal by going beyond the language of the statute, Hon’ble Supreme Court has been very clear in adopting a literal approach while interpreting tax provisions.
In CIT vs. A. Raman & Co. (1968) 67 ITR 11, Hon’ble Supreme Court upheld literal interpretation and said that it is not prohibited to avoid taxes by arranging commercial decisions in a manner that charge of tax is distributed.
In Dayal Singh vs. Union of India (AIR 2003 SC 1140), Hon’ble Supreme Court held that where the language of the statute is clear and unambiguous, nothing can be read into it by implication and the intention of the legislature is to be gathered from the clear language used.
In State of W. Bengal vs. Kesoram Industries Ltd. (2004) 266 ITR 721, Hon’ble Supreme Court held that taxing statutes cannot be interpreted on presumptions or assumptions. A taxing statute has to be interpreted in light of what is clearly expressed; it cannot imply anything which is not expressed; it cannot import provisions in the statute.
In Union of India vs. Azadi Bachao Andolan (2003) 263 ITR 706, Hon’ble Supreme Court held treaty shopping legally tenable. Further, it made following observation in para 146 of its order – We are unable to agree with the submission that an act which is otherwise valid in law can be treated as non-est merely on the basis of some underlying motive supposedly resulting in some economic detriment or prejudice to the national interests, as perceived by the respondents.
In Vodafone International Holding BV vs. UOI (2012) 17 taxmann.com 202 (SC), Hon’ble Supreme Court refused to look beyond what was clearly stated in section 9(1) of Income Tax Act, 1961. Justice S.H. Kapadia in para 71 of his order held – A legal fiction cannot be expanded by giving purposive interpretation particularly if the result of such interpretation is to transform the concept of chargeability which is also there in Section 9(1) (i), particularly when one reads Section 9(1)(i) with Section 5(2) (b) of the Act. What is contended on behalf of the Revenue is that under Section 9(1)(i) it can “look through” the transfer of shares of a foreign company holding shares in an Indian company and treat the transfer of shares of the foreign company as equivalent to the transfer of the shares of the Indian company on the premise that Section 9(1)(i) covers direct and indirect transfers of capital assets. For the above reasons, Section 9(1)(i) cannot by a process of interpretation be extended to cover indirect transfers of capital assets/property situate in India. To do so, would amount to changing the content and ambit of Section 9(1)(i). We cannot re-write Section 9(1)(i). The legislature has not used the words indirect transfer in Section 9(1)(i).
2.3 Judiciary’s call for General Anti Avoidance Rules:
It can be seen from the above-mentioned judicial precedents that Tax Avoidance and Aggressive Tax Planning went untaxed in India. In the Vodafone judgement (discussed before), Justice K.S. Radhakrishnan said in para 54 and 55 of the order that the impugned transaction could have been taxed in India if GAAR provisions of Direct Tax Code 2009 were in place. He further went on to say that necessity to take effective legislative measures has been felt in this country, but we always lag behind because our priorities are different. This Judgement was the point of inflection for the Government and among the various retrospective amendments introduced by Finance Act 2012, GAAR which found mentions in Direct Tax Code 2009, got a place in Income Tax Act, 1961. For various reasons, including aligning of GAAR with BEPS Action Plans, the provisions got deferred and became effective from 1st April 2017 i.e. AY 18-19.
3. About GAAR:
3.1 Applicable Sections, Rules and Circular (as on 28-01-2019)
| Section | Title |
| 95 | Applicability of General Anti-Avoidance Rule |
| 96 | Impermissible Avoidance Arrangement |
| 97 | Arrangement to Lack Commercial Substance |
| 98 | Consequences of Impermissible Avoidance Arrangement |
| 99 | Treatment of Connected Person and Accommodating Party |
| 100 | Application of this Chapter |
| 101 | Framing of Guidelines |
| 102 | Definitions |
| 144BA | Reference to Principal Commissioner or Commissioner in certain cases |
–
| Rule | Title |
| 10U | Application of General Anti Avoidance Rule |
| 10UA | Determination of Consequences of Impermissible Avoidance Arrangement |
| 10UB | Notice, Forms & Reference under section 144BA |
| 10UC | Time Limits |
–
| Circular | Description |
| Circular No. 7 of 2017, dated 27-01-2017 | FAQ on GAAR |
3.2 Overview of Provisions
Section 95 begins with a non-obstante clause overriding the entire Income Tax Act. It gives an indirect overriding power to Chapter X-A. A careful reading of the section reveals that for invoking section 95, following conditions are to be fulfilled:
i. There must be an ‘arrangement’.
Section 102(1) defines an arrangement as any step in, or a part or whole of, any transaction, operation, scheme, agreement or understanding, whether enforceable or not, and includes the alienation of any property in such transaction, operation, scheme, agreement or understanding.
ii. The arrangement must be entered into by the assessee.
Mere planning of an arrangement cannot be a basis for invoking section 95. It must have an economic existence. Assessee must be a party to the arrangement.
iii. The arrangement must satisfy the two tests laid down u/s 96 to be an “Impermissible Avoidance Arrangement”.
Tests down under section 96 for an arrangement to be an impermissible avoidance agreement has been discussed later.
iv. The arrangement must be declared as “Impermissible Avoidance Arrangement”.
The procedure for declaring an arrangement as an impermissible one is stated u/s 144BA which is discussed later.
3.2.1 What an Impermissible Avoidance Arrangement actually is:
Section 96 (1) is reproduced below –
“An impermissible avoidance arrangement means an arrangement, the main purpose of which is to obtain a tax benefit, and it—
(a) creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
(b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act;
(c) lacks commercial substance or is deemed to lack commercial substance under section 97, in whole or in part; or
(d) is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.”
Section 96 gives a restrictive meaning to the phrase by using the word means.
An arrangement can be treated as impermissible if the main purpose of the arrangement is to obtain tax benefit (referred to as Main Purpose Test) and either of the conditions specified under clause ‘a’, ‘b’, ‘c’ or ‘d’ to section 96(1) is fulfilled (referred to as Tainted Element Test).
Thus, an arrangement must pass Main Purpose Test as well as Tainted Element Test to be classified as Impermissible under the Act.
Analysis of the Two Tests:
Main Purpose Test:
The main purpose of an arrangement must be to obtain tax benefit. Section 102(10) gives an inclusive definition of “Tax Benefit” to be:
a. a reduction or avoidance or deferral of tax or other amount payable under this Act; or
b. an increase in a refund of tax or other amount under this Act; or
c. a reduction or avoidance or deferral of tax or other amount that would be payable under this Act, as a result of a tax treaty; or
d. an increase in a refund of tax or other amount under this Act as a result of a tax treaty; or
e. a reduction in total income;
f. an increase in loss, in the relevant previous year or any other previous year.
Subsection 2 to section 96 states that unless proven otherwise by the assessee, it will be deemed that the main purpose of an arrangement is to obtain tax benefit, if the main purpose of any step in, or a part of the arrangement is to obtain tax benefit.
Thus, where any part of an arrangement results in tax benefit, no matter how unintended it might be, the onus to prove to the court that the main purpose of an arrangement is not to obtain tax benefit lies upon the assessee. These provisions being contentious are likely to provide fertile field of litigation.
Note: The onus to prove an arrangement as impermissible still lies upon the tax authority. According to Rule 10UB of Income Tax Rules, 1962, it is incumbent upon the AO to serve a notice to the assessee before invoking GAAR provisions, stating:
(i) details of the arrangement to which the provisions of Chapter X-A are proposed to be applied.
(ii) the tax benefit arising under the arrangement.
(iii) the basis and reason for considering that the main purpose of the identified arrangement is to obtain tax benefit.
(iv) the basis and the reasons why the arrangement satisfies the condition provided in clause (a), (b), (c) or (d) of sub-section (1) of section 96
(v) the list of documents and evidence relied upon in respect of (iii) and (iv) above.
For determining whether tax benefit exists:
i. the parties who are connected persons in relation to each other may be treated as one and the same person;
ii. accommodating party may be disregarded;
iii. the accommodating party and any other party may be treated as one and the same person;
iv. the arrangement may be considered or looked through by disregarding any corporate structure
Tainted Element Test:
The phrase “Tainted Element Test” has not been used anywhere in the Act. It is picked up from Explanatory Notes to section 80A of South African Revenue Law Amendment Bill 2006 which is pari materia to section 96(1) of Indian Income Tax Act. The phrase has since then been used by leading authors, tax practitioners and GAAR Committee.
For an arrangement to pass Tainted Element Test, it must fall under either of the following clauses of section 96(1) –
A. Creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length.
It is similar to the transfer pricing regulations which checks whether a transaction between two enterprise is at arm’s length. However, this clause covers a wider range of transactions since there is no requirement for a transaction to be an international transaction (as defined u/s 92B) or to be between associated enterprises (as defined u/s 92A).
B. Results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act.
Misuse or abuse has not been defined anywhere in the Act. It is again for the courts to interpret what amounts to misuse or abuse. In common parlance, it would mean going against the spirit/intention of a provision.
C. lacks commercial substance or is deemed to lack commercial substance under section 97, in whole or in part.
Under section 97, an arrangement is deemed to lack commercial substance if –
i. The overall effect of arrangement is significantly different from the form of individual steps or part of the arrangement. This mainly establishes the authority of income tax department and gives legal sanctity to the doctrine of substance over form to go beyond what an arrangement is made to look like and lift the corporate veil.
ii. It involves round trip financing including wherein funds are transferred among parties to the arrangement without any substantial commercial purpose other than obtaining tax benefit. An example of round-trip financing is given below:
Example: Company X Ltd of India has a wholly owned subsidiary S Ltd. in Cyprus. Subsidiary S Ltd. has reserves of 500 crore which Company X Ltd. wants to bring back to India. If S Ltd. gives it back in the form of dividend, such dividend would be taxable in the hands of Company X Ltd. @ 15% u/s 115BBD. If S Ltd. gives it back in the form of loan, such loan would be taxable in the hands of Company X Ltd. as deemed dividend u/s 2(22)(e). So Subsidiary S Ltd. undertakes the following modus-operandi:
1. It makes a term deposit with a Bank of Cyprus. This Bank extends a loan to Company X Ltd. keeping the term deposit as security against loan.
2. India-Cyprus tax treaty exempts interest paid to foreign banks from tax in India.
The arrangement is so designed that India loses its share of tax.
iii. It involves accommodating party. This tries to cover cases where dummy companies are floated for the only purpose of obtaining tax benefits. “Accommodating Party” has been defined u/s 97(3) as a party to an arrangement whose main purpose of direct or indirect participation to the arrangement, in whole or in part, is to obtain, directly or indirectly, a tax benefit for the assessee whether or not the party is a connected person in relation to any party to the arrangement.
“Connected person” has further been defined u/s 102(4).
iv. It involves elements that have the effect of offsetting or cancelling each other. It covers cases like setting off artificially fabricated capital loss against capital gain.
v. It includes a transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction. This can be explained with the following example:
Example: Company X Ltd. wants to give loan to Company Y Ltd. (both being residents of India). Now Company X Ltd. undertakes the following modus-operandi:
1. Company X Ltd. sets up a wholly owned subsidiary S Ltd. in Cyprus with a share capital of 500 crore. Cyprus is a low tax jurisdiction.
2. Subsidiary S Ltd. gives a loan to Company Y Ltd. in India at 12% p.a.
3. Under India-Cyprus tax treaty, interest income cannot be taxed at a rate higher that 10%.
4. Had Company X Ltd. directly given loan to Company Y Ltd., interest income would have been charged to tax at 30% + surcharge/cess.
vi. It involves the location of an asset or of a transaction or of the place of residence of any party which is without any substantial commercial purpose other than obtaining a tax benefit for a party. This covers cases where tangible and intangible assets, residence of an entity is located to a low tax jurisdiction so as to reduce effective tax rate of a global enterprise.
vii. It does not have a significant effect upon the business risks or net cash flows of any party to the arrangement, apart from any effect attributable to the tax benefit that would be obtained.
D. Is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes. The following example has been quoted from Final Report of GAAR Committee:
Example: An Indian company A Ltd makes an investment of Rs. 10 crores in shares of a listed company. After a year, the prices go up and fair market value of shares becomes Rs. 20 crores. If A Ltd sells these shares, the long-term capital gains of Rs. 10 crores would be exempt, but it would be liable to tax under MAT. A Ltd. forms a partnership firm with another person with nominal partnership. It transfers shares in the firm at a cost price. No capital gain arises u/s 45 of the Act. After a year, the firm sells these shares and realises the gains of Rs. 10 crore which is exempt from taxation and no MAT is payable. Subsequently, the firm is dissolved and share of A Ltd in the partnership firm is transferred back along with profits, which is exempt from tax under the Act.
3.2.2 Consequences to follow an Impermissible Avoidance Arrangement:
Section 98 outlines draconian consequences for denial of tax benefit under domestic law as well as under tax treaties. It gives a wide range of powers to the tax authorities to impose tax on assessee by –
1. Disregarding, combining or recharacterizing any part or whole of the impermissible avoidance arrangement.
2. Treating the impermissible avoidance arrangement as if it has not been entered into.
3. Disregarding any accommodating party or treating an accommodating party and any other party as single entity.
4. Deeming connected persons as one for the purpose of tax treatment of any amount.
5. Reallocating any accrual, receipt, expenditure, deduction, relief or rebate.
6. Treating the place of residence of any party or the situs of an asset or of a transaction at a place other that its place of residence or situs.
7. Treating any corporate structure as a “look through”.
8. Treating an equity as debt or vice versa.
9. Treating any accrual or receipt of capital nature as revenue or vice versa.
10. Recharacterizing any expenditure, deduction, relief or rebate.
Section 90(2A) clarifies that treaty benefit available under section 90(2) shall be withdrawn if GAAR has been applied to an assessee.
4. Procedure for invoking GAAR provisions (Section 144BA):
The provisions relating to procedure for invoking GAAR is explained with the flowchart
Notes:
1. PCIT/CIT must issue the direction within 1 month from the end of the month in which reference is received from the AO.
2. PCIT/CIT must issue the direction within 1 month from the end of the month in which the period specified in the notice ends.
3. PCIT/CIT must issue the direction within 2 months from the end of the month in which the final submission of the Assessee in response to the notice is received.
4. No reference to Approving Panel can be made by PCIT/CIT after expiry of 2 months from the ends of the month in which the final submission of the Assessee in response to the notice is received.
5. The Approving Panel shall issue directions within a period of 6 months from the ends of the month in which reference from PCIT/CIT is received.
5. Other Important Points
5.1 Exclusions from GAAR
Rule 10U of Income Tax Rules highlights the exclusion from GAAR where the following have been kept outside the purview:
1. An arrangement where the tax benefit in the relevant assessment year arising, in aggregate, to all the parties to the arrangement does not exceed a sum of Rs. 3 Crore.
2. An assessee Foreign Institutional who has not taken benefit of an agreement referred to in section 90 or section 90A and who has invested in listed securities, or unlisted securities, with the prior permission of the competent authority, in accordance with the Securities and Exchange Board of India (Foreign Institutional Investor) Regulations.
3. A person, being a non-resident, in relation to investment made by him by way of offshore derivative instruments or otherwise, directly or indirectly, in a Foreign Institutional Investor.
4. Any income accruing or arising to, or deemed to accrue or arise to, or received or deemed to be received by, any person from transfer of investments made before the 1st day of April 2017 by such person
5.2 Constitution of Approving Panel
The Approving Panel shall comprise of the following:
1. A Judge of High Court who shall be the Chairperson.
2. One member from Indian Revenue Service not below the rank of Principal Chief Commissioner or Chief Commissioner of Income-Tax.
3. One member who shall be an academic or scholar having special knowledge of matters, such as direct taxes, business accounts and international trade practices.
The term of Approving Panel shall be for one year which may be extended upto three years.
5.3 Remedy of Appeal
The Income-Tax Act does not provide an appeal against the directions of Approving Panel. In absence of an efficacious alternate remedy, constitutional remedy of writ may be exercised by the Assessee as well as the Department.
In case the Assessee does not want to exercise the option of writ, he must wait for the AO to pass the order of assessment against which an appeal shall lie with Income Tax Appellate Tribunal u/s 253. Here also, the regular channel of appeal through Commissioner of Income Tax (Appeals) has been omitted as in the case of 144C – Reference to Dispute Resolution Panel.
5.4 Miscellaneous Points
1. The Approving Panel has the power to apply the consequences of impermissible avoidance arrangement to any previous year other that the year for which the proceeding is ongoing. The AO may open the assessment proceeding of such other year, subject to limitation of section 153, and no fresh compliance of section 144BA is required for such other year.
2. Where in an order of assessment, there is any tax consequence arising due to application of Chapter of GAAR, the AO is bound to seek approval of Principal Commissioner or Commissioner of Income Tax before passing the order.
3. Where the Principal Commissioner or Commissioner of Income Tax holds an arrangement to be permissible in one year, it cannot be open to them to hold the same arrangement as impermissible in subsequent years on the principle of consistency.
4. Where Authority for Advanced Ruling hold an arrangement to be permissible, the decision is binding on all Income Tax Authorities.
6. Conclusion:
It is yet to be seen how tax authorities use the special power vested with them under GAAR. The way in which the “Main Purpose Test” and Clause C (vi) [section 97(1)(c)] of “Tainted Element Test” have been drafted, global tax planning will take a serious hit. Moreover, the General Anti Avoidance Rules are res integra and judicial interpretation is yet to be seen. Organisations will now have to be very careful before taking tax decisions.
Let’s just hope that these provisions are implemented in the right spirit in field to avoid prolonged litigation as in the case of some other provisions where the authorities are working more like departmental officers causing avoidable litigation.
*CA Ahmad Faraz Jahangir is an associate member of the Institute of Chartered Accountants of India. He is practicing in Mumbai and specialises in Direct Tax consultation and litigation.
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