GAAR test

The General Anti-Avoidance Rules let the Indian revenue authorities look through a structure that is legal in form but built for tax. Effective from 1 April 2017, GAAR does not ask whether each step complies with the statute; it asks what the arrangement was for.

The test has two limbs and both must be satisfied. First, the main purpose of the arrangement must be to obtain a tax benefit. Second, the arrangement must satisfy at least one of four tainted elements.

A structure that has a genuine commercial purpose fails the first limb and GAAR does not bite, however tax-efficient it happens to be. A structure with no commercial substance but no tax benefit fails the second. It takes both.

The four tainted elements, any one of which is enough:

1. The arrangement creates rights or obligations not ordinarily created between parties dealing at arm's length.
2. It results in the direct or indirect misuse or abuse of the ITA.
3. It lacks commercial substance, or is deemed to lack commercial substance, in whole or in part.
4. It is entered into or carried out in a manner not normally employed for bona fide purposes.

Where GAAR is invoked, the authorities may reallocate the income, or re-characterise or disregard the arrangement altogether. The illustrative powers are wide: disregarding, combining or re-characterising any step or party; ignoring the arrangement for tax purposes; relocating the place of residence of a party, the location of a transaction or the situs of an asset; looking through a corporate structure; re-characterising equity into debt, or capital into revenue; and treating connected persons or an accommodating party as one and the same person.

The CBDT's clarifications of 27 January 2017 narrow the field in three ways that matter to a fund structurer:

• Where tax avoidance is sufficiently addressed by a Limitation of Benefit clause in a tax treaty, GAAR shall not be invoked.
• GAAR shall not be invoked merely because an entity is located in a tax-efficient jurisdiction.
• The INR 30 million limit cannot be read in respect of a single taxpayer only.

Related but separate is the treaty-shopping machinery: section 159 of the ITA requires double taxation agreements to be entered into without creating opportunities for non-taxation or reduced taxation through evasion or avoidance, including treaty shopping arrangements aimed at obtaining reliefs for the indirect benefit of residents of another country — the limb through which the Multilateral Instrument, notified under section 159 with effect from 1 October 2019, operates.

A Category II AIF is being structured with an offshore feeder for non-resident investors.

Structure A. The feeder is incorporated in a treaty jurisdiction. It has its own board that meets there, three employees, its own bank accounts, and it makes and documents its own investment decisions. Non-resident investors from six countries pool into it because a single feeder is administratively simpler than six direct routes. It claims treaty relief on capital gains of Rs 84 crore.

The main purpose limb is arguable at best — there is a real commercial reason for pooling — and the tainted elements are hard to make out: the arrangement has substance, the terms are arm's length, and the manner is ordinary. The CBDT clarification adds that mere location in a tax-efficient jurisdiction is not enough. GAAR is a poor fit.

Structure B. A company is incorporated in the same jurisdiction three weeks before the exit, has no employees, no office and no decision-making of its own, holds the shares for 19 days, and exists so that a gain of Rs 84 crore arising to an Indian resident group is routed through a treaty. Its only funding is a back-to-back loan from the ultimate owner, repaid the day after the exit.

Here the main purpose is plainly the tax benefit, and at least three tainted elements are present — no commercial substance, rights not ordinarily created at arm's length, and a manner not normally employed for bona fide purposes. The authorities may disregard the company entirely, tax the Rs 84 crore in the hands of the group that really owned the asset, and treat the two entities as one and the same person.

The tax saving sought was identical in both. What differed was substance.

Chapter 13 (Taxation), section 13.3 (General Anti-Avoidance Rules), with the CBDT clarifications; section 13.4 carries the MLI and section 159 treaty-shopping material. Expect a question asking how many tainted elements must be satisfied — one — and a recall question on the CBDT clarifications, especially that location in a tax-efficient jurisdiction alone does not invoke GAAR.

• Main purpose AND one tainted element. Both limbs. A question offering "all four tainted elements" is wrong.
• A tax-efficient jurisdiction is not, by itself, GAAR. The CBDT said so in terms.
• A Limitation of Benefit clause can displace GAAR where it sufficiently addresses the avoidance.
• The INR 30 million threshold is not per taxpayer — the clarification exists precisely to stop that reading.
• GAAR has applied from 1 April 2017. It is not a proposal.
• The powers include relocating residence, situs and the location of a transaction, and re-characterising equity as debt or capital as revenue. It is not limited to denying a deduction.