General Anti-Avoidance Rules

Specific anti-avoidance rules close specific loopholes, one at a time, always a step behind the people who design them. GAAR is the general answer: a power to look at an arrangement as a whole, decide it exists mainly to produce a tax benefit and has no real commercial substance, and simply refuse the benefit.

The provisions sit in Chapter X-A of the Income-tax Act and apply to income accruing or arising on or after 1 April 2017. Many countries have introduced such rules; the common aim the workbook states is to give the tax authority power to deny the tax benefit of transactions or arrangements that have no commercial substance and whose main purpose is to achieve tax benefits.

For an AIF this is not abstract. Fund structuring routinely runs through holding jurisdictions, feeder vehicles and treaty routes, and GAAR is the rule that asks whether the structure does anything other than reduce tax.

The test. A transaction can be declared an impermissible avoidance arrangement if the main purpose of the arrangement is to obtain a tax benefit and it satisfies at least one of four specified tests:

1. the arrangement creates rights or obligations not ordinarily created between persons dealing at arm's length;
2. it directly or indirectly results in the misuse or abuse of the provisions of the Income-tax Act;
3. it lacks commercial substance, or is deemed to lack commercial substance, in whole or in part; or
4. it is entered into, or carried out, by means or in a manner not ordinarily employed for bona fide purposes.

Main purpose plus any one of the four. Both limbs are needed.

The consequence. The authorities may reallocate the income, or re-characterise or disregard the arrangement. The illustrative powers are wide:

• disregarding, combining or re-characterising any step of the arrangement or any party to it;
• ignoring the arrangement for the purposes of the taxation law;
• treating an accommodating party and another party as one and the same person;
• deeming connected persons to be one and the same person for determining tax treatment of any amount;
• relocating the place of residence of a party, the location of a transaction, or the situs of an asset;
• looking through the arrangement by disregarding any corporate structure; or
• re-characterising equity into debt, capital into revenue, and so on.

The treaty point, and it is the one that matters most for offshore fund structures: the GAAR provisions override the provisions of a tax treaty in cases where GAAR is invoked. A taxpayer may normally choose whichever of the Act or the DTAA is more beneficial — but that choice is subject to GAAR.

An offshore feeder for an Indian Category II AIF is incorporated in a treaty jurisdiction. The holding entity has no employees, no office of its own, no board meetings held locally, and its only asset is the participation in the Indian fund. On exit it claims treaty relief on a capital gain of Rs 340 crore.

The revenue applies the two-limb test:

Both limbs are met, so the arrangement can be declared an impermissible avoidance arrangement. Using the power to look through the arrangement by disregarding the corporate structure, the authorities treat the ultimate investors as having realised the gain directly, and the treaty route that would otherwise have applied is overridden.

At an Indian long-term capital gains rate of, say, 12.5%, the difference between treaty relief and no relief on Rs 340 crore is Rs 42.5 crore of tax — which is why fund structuring memoranda spend so much space on substance.

Change one fact — the same entity has its own investment team, takes its decisions locally, and holds participations in eleven funds across four countries — and the commercial-substance limb is much harder for the revenue to establish.

Chapter 12 (Taxation — India specific) sets out GAAR at 12.6, and Chapter 5 (Alternative Investment Fund Structuring) refers to it when explaining why structures are tested for substance. The examinable points are the effective date of 1 April 2017, Chapter X-A as the location, the main purpose plus at least one of four tests structure, the illustrative re-characterisation powers, and the rule that GAAR overrides a tax treaty where it is invoked.

• Both limbs are required. Main purpose of obtaining a tax benefit and at least one of the four tests. An arrangement that lacks commercial substance but was not mainly for tax is not caught by this formulation.
• "At least one" of the four, not all four. Questions sometimes list all four and ask how many must be satisfied.
• GAAR applies to income accruing or arising on or after 1 April 2017 — the date is examinable, and it is not the date the arrangement was entered into.
• GAAR overrides the DTAA. The general rule that a taxpayer may take whichever of the Act or the treaty is more beneficial does not survive GAAR being invoked — and a Tax Residency Certificate does not make an arrangement GAAR-proof.
• Tax avoidance and tax evasion are not the same thing. GAAR is aimed at arrangements that are legally effective but commercially empty; evasion is already an offence.
• The powers are re-characterisation powers, not just denial. Re-characterising equity into debt or capital into revenue changes the rate and the head of income, not merely the exemption.