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GAAR Analysis by CA. Arinjay Kumar Jain

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

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GAAR Analysis by CA. Arinjay Kumar Jain

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  1. GAAR Analysis by CA. Arinjay Kumar Jain

  2. 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 • 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. Business Entity Undertaking in under developed Area 1

  3. 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 • Such business also packages (without manufacturing) and Sells goods purchased from other undertaking to Customer • 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 • 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. Business Entity Packages Goods 1 Transfer of unpackaged Goods Developed Area (Unit I) Under developed Area (Unit II) 2 Sale to Customer Customer 2

  4. Inbound Investment - Foreign Shareholder Company with substance - Example 3 - Foreign Investor • 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 • In view of the factual substantive commercial substance of the arrangement, Revenue would not invoke the GAAR provisions Investment Co. Low tax jurisdiction - X Doing Business and has commercial substance India Indian Co. 3

  5. 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 • Issue • Can GAAR be invoked or would the arrangement be permissible ? • Interpretation by Committee • 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. B Low tax jurisdiction - R Does not has commercial substance India India Co. 4

  6. Dividend declared by Foreign operating subsidiary retained in Overseas and not repatriated to India - Example 4 Indian Holding Company • 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 • Declaration/repatriation of dividend is a business choice of 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. India Favorable tax jurisdiction - X Overseas Investment Co. C – Operating Subsidiary Operating subsidiary Jurisdiction 5

  7. 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 • 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. Shareholders Share issue Loss making entity - A Profit making entity - B Merger of Loss making entity into Profit making entity 6

  8. Lease Vs Purchase of Asset – Example 6 ? 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 it’s 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.

  9. Borrowing Vs Equity – Thin capitalisation -Example 7 ? Where the company borrows funds from unconnected party, while it could have raised equity, whether interest deduction can be denied ? Interpretation • 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.

  10. Mark up on Cost recharge by service company covered under Transfer Pricing provision – Example 8 Service Company • Facts • Service Company, handling non core operations of group, charges group companies at Cost plus mark up • 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. B Cost recharged at Mark up C A 9

  11. Set off of losses in the stock market against gains which is aimed at balancing the portfolio – Example 9 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. 10

  12. 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 Z’s group • Issue • Is sale of shares by A taxable in India ? • Interpretation by Committee • 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. Y Non resident A Country ABC India Z & Group X 49% 51% 11

  13. Inbound Investment through Subsidiary where funds are provided by Parent – Example 11 B • Facts • 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. • 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. Non resident Fund infusion A Country ABC India Share acquisition C 12

  14. 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 • 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 Low tax jurisdiction Other jurisdiction C B D A Buy back shares 13

  15. 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 ? • 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. C E Country ABC India 2. Distributed shares to E and C X 1. Liquidated V 14

  16. Assignment of Loan by Foreign bank to Indian Borrower to its Branch in a favourable third country - Example 14 • Facts • Foreign bank ‘F’s branch in India arranges loan for Indian borrower from branch located in a third country • Loan is later assigned to ‘F’ bank’s 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 ? • 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. F’s branch in XYZ country Assignment of Loan Foreign Lender Bank Arranges loan for Indian Borrower Branch Indian Borrower 15

  17. 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% • 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. Sells shares piecemeal A Country ABC India B 16

  18. 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 ? • Interpretation by Committee • 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 Country T A Country R India B 17

  19. Overseas Trading company set up by Indian company – Control and Management from India - Example 17 Indian Company • 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 • Would trading profits be taxable in India using GAAR ? • 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 India Favorable tax jurisdiction - X Control Overseas Trading Co. Purchase Sale A B 18

  20. Providing Bonus/ Salary due to an employee through issue and Redemption of Preferential shares - Example 19 • 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 employee’s 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 ? • Interpretation by Committee • 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 Company A 2(a) 1 Allotment of Preference shares Redemption by company Employee Connected group company 2(a) Sale to Connected company 19

  21. 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 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. • Issue • Whether GAAR would be attracted ? • Interpretation by Committee • Transfer of Actionable claims, which are disputed, to 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. 3 D C Gift Realizes such amount and claims as capital receipt 2 Transfer of instrument 1 Transfer of instrument at low value Company A B 20

  22. Purchase of shares of Subsidiary at High Price and sold at loss to claim capital gains loss - Example 21 • 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 ? • Interpretation by Committee • It’s a case of creating rights and obligations, which are not created between parties in ordinary course of business, and hence GAAR can be invoked. 1 A B Lends 2 Purchases Shares 3 Transfer back of funds Subsidiaries B’s connected concerns 21

  23. 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. 22

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