GAAR Analysis

by CA. Arinjay Kumar Jain

Tax Mitigation Setting up an Undertaking in an underdeveloped Area Exemption on Goods manufactured therein - Example 1 & 2 (1/2)
Facts Business entity, sets up an undertaking through substantial investment in an underdeveloped Area, to carry out manufacturing activities and claims a tax deduction on sale of production and manufacturing from such undertaking Issue Whether setting up of an undertaking can be classified as an arrangement , one of whose purpose is to obtain a tax benefit ? Interpretation by Committee

Business Entity

Undertaking in under developed Area

Setting up production facilities in an under developed area to claim tax deduction on sale of such production is a case of Tax mitigation, wherein a tax payer is availing the benefit provided by Statute, subject to the specified condition, and hence GAAR cannot be invoked in such a case.

Tax Mitigation Setting up an Undertaking in an underdeveloped Area Exemption on Goods only Packaged therein - Example 1 & 2 (2/2)
Facts Business entity, sets up an undertaking through substantial investment in an underdeveloped Area, to carry out manufacturing activities and claims a tax deduction on sale of production and manufacturing from such undertaking

Business Entity

Such business also packages (without manufacturing) and Sells goods purchased from other undertaking to Customer

1 Developed Area (Unit I)

Transfer of unpackaged Goods

Under developed Area (Unit

II)

Packages Goods

Issue Whether profit earned by underdeveloped Area undertaking on sale of goods which are merely packaged, is entitled to obtain a tax benefit ? Interpretation by Committee

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Sale to Customer

Customer

Profits relating to goods which are not produced at that location is a case of transaction, which lacks commercial substance, and tries to misuse tax provisions and hence should be covered with GAAR.

Inbound Investment - Foreign Shareholder Company with substance Example 3 Foreign Investor

Doing Business and has commercial substance

Facts Foreign Investor has invested in India through a holding company situated in a low tax jurisdiction X Investment Co. has commercial substance, including the following : Board of Directors meets in Country X Company carries out business with adequate manpower, capital and infrastructure of its own Issue Can GAAR be invoked or would the arrangement be permissible ? Interpretation by Committee
India

Investment Co.
Low tax jurisdiction - X

Indian Co.

In view of the factual substantive commercial substance of

the arrangement, Revenue would not invoke the GAAR provisions

Inbound Investment - Foreign Shareholder Company without substance Example 18 A

Facts Foreign Investor A has invested in India through Investment Co. B situated in a low tax jurisdiction R Investment Co. does not have commercial substance
Does not has commercial substance

Issue Can GAAR be invoked or would the arrangement be permissible ? Interpretation by Committee

B
Low tax jurisdiction - R

India

India Co.

If A invests directly in India, it does not get benefit of treaty and has to pay capital gains tax in India. Routing funds through B in country R results in avoiding payment of capital gains tax It is an impermissible avoidance arrangement and revenue would invoke GAAR with regard to this arrangement.

Dividend declared by Foreign operating subsidiary retained in Overseas and not repatriated to India - Example 4
Facts Indian company has invested in overseas operating subsidiary C, through a Investment company in favorable jurisdiction Dividend declared by C are not repatriated back to India as this would result in taxation of such dividend in India Issue Would the deemed dividend be treated as income using GAAR ? Interpretation by Committee

Indian Holding Company

India

Overseas Investment Co.

Favorable tax jurisdiction - X

Declaration/repatriation of dividend is a business choice of

C Operating Subsidiary
Operating subsidiary Jurisdiction

the companies and GAAR provisions would not apply. Specific provision of CFC (when introduced) would also exclude application of GAAR to dividends retained in low tax jurisdiction by Indian companies investing overseas.

Merger of Loss making company into Profit making entity - Example 5

Facts Loss making entity A is merged into another profit making entity B Losses of A would be offset against profit of B resulting in overall lower net profit and lower tax liability for the merged company. Issue Would the losses be disallowed under GAAR I Interpretation by Committee

Shareholders

Share issue

Loss making entity - A

Profit making entity - B

Wherever Specific Anti Avoidance provision (SAAR) are

available for particular transaction, GAAR would not be applied. Since there are specific provisions restricting set off of losses in case of merger and amalgamation, GAAR would not be invoked.

Merger of Loss making entity into Profit making entity

Lease Vs Purchase of Asset Example 6

?
Option to company which has to acquire Asset
Where the company leases an Asset and claims lease rental deduction, which is higher than depreciation, that would have been allowed on owned Asset , can lease rental s be Disallowed ?

Interpretation
GAAR provisions, would not, prima facie, apply to a decision of leasing (as against purchase of an asset), unless its a case of Circular leasing, wherein an asset purchased by taxpayer, is taken back through various sub-leases to take tax benefit without an economic substance.

Lease Asset, and claim deduction for lease rental

Purchase Asset, and claim depreciation

Borrowing Vs Equity Thin capitalisation -Example 7

?
Option to raise Funds
Where the company borrows funds from unconnected party, while it could have raised equity, whether interest deduction can be denied ?

Interpretation
Raise Equity No tax deduction on dividend Raise Borrowings Tax deduction for interest
Evaluation of loan Vs equity should be left to commercial judgment and GAAR would not apply There are no specific thin capitalization rules under IT Act to disallow such interest If payments are made to connected parties, Transfer pricing provision would apply In such a case, depending on Source of their Funds & their location in low tax jurisdiction, GAAR provision may apply.

Mark up on Cost recharge by service company covered under Transfer Pricing provision Example 8
Facts Service Company, handling non core operations of group, charges group companies at Cost plus mark up
Cost recharged at Mark up

Service Company

Issue Can mark up be questioned using GAAR ?

Interpretation by Committee

Since there are specific anti avoidance provisions in form of Transfer Pricing for transactions among related parties, GAAR will not be invoked.

Set off of losses in the stock market against gains which is aimed at balancing the portfolio Example 9

Company

Capital gains

Losses from stock market

Lower Overall Taxes

Sale/purchase through stock market transactions where the buyer and seller are anonymous to each other would not come under GAAR provisions. However, where the parties are related, or are not anonymous, i.e, they are brought together by an intermediary to enable adjustment of losses amongst themselves, GAAR would be applicable.

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Inbound Investment through a Permitted Assignee Example 10

Facts Y a non resident incorporated company A, in Country ABC to invest in Indian JV with Indian partner Z India - ABC Treaty provides for non-taxation of capital gains in India and ABC charges a minimal capital gains tax in its domestic laws All rights of voting, management, right to sell etc., are vested in Y, who is a permitted assignee of A Shares of X held by A are sold to a company connected to Indian partner Zs group Issue Is sale of shares by A taxable in India ? Interpretation by Committee

Y
Non resident

Country ABC India

Z & Group

49%

51% X

Controlling rights of A are with Y A was only interposed with main purpose of taking advantage of India and Country ABC Treaty. Such an arrangement results in misuse or abuse of tax provisions and hence attract GAAR.
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Inbound Investment through Subsidiary where funds are provided by Parent Example 11 Facts

Fund infusion B

Non resident

Share acquisition A

Company A, resident of Country ABC is a wholly owned subsidiary of company B, India-ABC tax treaty provides for non taxation of capital gains in India and ABC charges a minimal capital gains tax in its domestic law. A acquired shares of an Indian Company C wherein entire funding was done by B. A sells the shares and claim these as non taxable by virtue of the India- ABC tax treaty.

Country ABC India

Issue Is sale of shares by A taxable in India applying GAAR ? Interpretation by Committee

GAAR would be invoked in such a case since the beneficial owner of such shares was B , even though legal owner was A, This was an arrangement which has been created with the main purpose of avoiding capital gains tax in India.

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Selective Buy Back Example 12

Facts A is a closely held Indian company held by connected companies B, C and D A after regularly distributing dividends, stopped distributing dividends from 1.4.2003 after Dividend Distribution Tax was introduced Subsequently it made an offer to buyback shares from all shareholders Buyback offer was only accepted by B, which came from country ABC, which provides non taxation of such gains in India and low taxes in ABC. Other shareholders, who are not resident of ABC deny buyback offer Issue Is buyback of shares taxable in India applying GAAR ? Interpretation by Committee Buy back shares

Low tax jurisdiction

Other jurisdiction

C D

Non distribution of Dividend (which would have attracted Dividend distribution tax ) was not for bonafide purpose. Since the company did not perform buy back from other shareholders (as that would have attracted capital gains tax), and passed this as an exempt capital gains tax in the hands of B (and not other shareholders), the arrangement is a colourable device designed to avoid tax in India, and Revenue would invoke GAAR in this case

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Sale of shares of an Indian asset owning company, by a foreign parent, situated in low tax jurisdiction Example 13
Facts X an Indian company held shares of V, an asset owning Indian company X was liquidated and distributed shares of V to E and C, its parent companies, situated in country ABC India - ABC Treaty provides for non-taxation of capital gains in India and ABC charges a minimal capital gains tax in its domestic laws Subsequently E and C sold shares of V to claim capital gains exemption in India Issue Is sale of shares by E and C taxable in India ?
X 1. Liquidated

Country ABC India

2. Distributed shares to E and C

Interpretation by Committee

Facts indicate that liquidation of the Indian company, and resulting transfer of shares of V was an arrangement to misuse or abuse the provision. of tax. Revenue would invoke GAAR as regards this arrangement.

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Assignment of Loan by Foreign bank to Indian Borrower to its Branch in a favourable third country - Example 14
Facts Foreign bank Fs branch in India arranges loan for Indian borrower from branch located in a third country Loan is later assigned to F banks branch in XYZ country, India-XYZ Treaty provides no withholding tax in India on interest to a bank carrying out bona-fide business from XYZ Issue Whether GAAR would be attracted ?
Arranges loan for Indian Borrower

Assignment of Loan

Foreign Lender Bank

Fs branch in XYZ country

Branch

Indian Borrower

Interpretation by Committee

Arrangement of finalizing the loan from one country,

and assignment to another country has been made to avoid withholding tax provisions, which is a misuse of tax treaty, and thus will be treated as an impermissible avoidance arrangement.

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Sale of shares of an Indian company in installments - Example 15

Facts A hold equity investment into company B; India - ABC Treaty provides that where A sells more than X% interest of B in one lot, it can be taxed in India. A sells shares in installment wherein individual quantum is less than X% for each installment, though total sale is more than X%
Country ABC India

Sells shares piecemeal

Issue Whether GAAR would be attracted to tax such gains ? Interpretation by Committee

Where a foreign company sells the shares at short interval, each of which is less than specified percentage, but cumulatively, are more than prescribed percentage, GAAR can be invoked as such arrangement is an abuse of tax law and lacks commercial substance.

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Inbound Investment through Subsidiary where funds are provided by Parent Example 16
X
Facts Company A, resident of Country R , sells shares of Indian company B, India- R tax treaty provides that shell/conduit company would not be entitled to beneficial capital gains tax treatment Protocol further provides that company shall not be treated as shell company if its annual expenditure on operations is more than Rs. 100,00,000 in preceding 24 months A claims its not a shell company as its incurred 40,00,000 as operating expenses and Rs.80,00,000 as interest payment to X, resident of Country T, total expenses being more than prescribed limit Issue Would A be entitled to the benefit of the Treaty ? Country R India Interpretation by Committee

Country T

Where A claims to have incurred interest payments of Rs. 80,00,000 outside its country of residence, such payment cannot be considered for purpose of computing limit on expenses in country R. This benefit can be denied within Limitation of Benefit clause in Protocol. Further revenue, may also invoke GAAR in such an arrangement

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Overseas Trading company set up by Indian company Control and Management from India - Example 17
Facts Indian company has an overseas export and import company Director of the Indian company finalizes the contracts in India but shows the documentation of the purchase and sale in Country X. Day to day management operations are carried out in India. Goods move from A directly to B. Transactions are recorded in the books of subsidiary in country X, where the profits are tax exempt Issue

Control

Indian Company
India

Favorable tax jurisdiction - X

Would trading profits be taxable in India using GAAR ?

Overseas Trading Co.

Purchase

Sale

Interpretation by Committee Company is camouflaging sale and purchase transactions as X country based transactions. Indian company has obtained tax benefit through this arrangement. Substance of the arrangement as a whole is inconsistent with forms of its individual steps and hence, lacks commercial substance. Revenue would invoke GAAR with regard to this arrangement

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Providing Bonus/ Salary due to an employee through issue and Redemption of Preferential shares - Example 19
Company A 2(a) 1
Allotment of Preference shares

Redemption by company

Facts Employee of Company A is to receive bonus or salary. Employee subscribes for preferential shares of the employer. Preferential shares are purchased by a connected company of A, or are redeemable at a premium that reflects a portion of the employees annual salary or bonus, after a period of one year. In this manner, the employee receives the income as capital gain.

Issue Whether GAAR can be invoked in such a case ?

Connected group company 2(a)
Sale to Connected company

Interpretation by Committee

Employee

Acquisition and transfer of such shares results in recharacterisation of Salary income as Income from capital gains, and is part of the arrangement to avoid income tax which would have been payable on salary. Hence , GAAR can be invoked

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Assignment of Actionable claims and realisation Claim for Capital Receipt - Example 20 Facts
Company A had disputed claim with Z company. Company A transferred its actionable claims for 10% of
3
Gift

amount to a connected concern B by way of a transfer instrument. B transferred such claim to C company C gifted instrument to D company, Upon redemption D showed it as a capital receipt and claimed exemption.

Realizes such amount and claims as capital receipt

2
Transfer of instrument

Issue Whether GAAR would be attracted ? Interpretation by Committee

1
Transfer of instrument at low value

Transfer of Actionable claims, which are disputed, to

B

Company A

group companies at discounted value/gift, wherein the recipient redeems such claims, and treats gains there from as a capital receipt, is a colorable device, and lacks commercial substance. GAAR can be invoked.

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Purchase of shares of Subsidiary at High Price and sold at loss to claim capital gains loss - Example 21
1
Lends

2
Purchases Shares

Facts Company A borrowed money from a Company `B` and used that to buy shares in three 100% subsidiaries above Fair Market Value (FMV) Subsidiary companies transfer amount received to connected companies of B. A sells shares at below purchase price and claims a short-term capital loss, which is proposed to be set off against other long-term capital gains. Issue Whether GAAR would be attracted ?

3 Subsidiaries
Transfer back of funds

Interpretation by Committee
Bs connected concerns

Its a case of creating rights and obligations, which

are not created between parties in ordinary course of business, and hence GAAR can be invoked.

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The Author is an International Tax and M&A Tax consultant with more than 10 years of consulting experience. For any queries, the Author can be reached at arinjayjain@iedubook.com

The Author also runs a Free Video Based Education platform www.iEdubook.com , which provides a growing collection of 1500+ Free videos for Maths, Accounts, Economics, Science and Tax for various levels, starting Class VI XII, CA students and others. Be a part of our efforts to Promote education by spreading a word about www.iEdubook.com.

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