0 GAAR Analysis by CA. Arinjay Kumar Jain. Tax Mitigation – Setting up an Undertaking in an underdeveloped Area – Exemption on Goods manufactured therein.

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GAAR Analysisby CA. Arinjay Kumar Jain

GAAR Analysisby CA. Arinjay Kumar Jain

Tax Mitigation – Setting up an Undertaking in an underdeveloped Area – Exemption on Goods manufactured therein - Example 1 & 2 – (1/2)

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Business Entity

Undertaking in under

developed Area

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.

Tax Mitigation – Setting up an Undertaking in an underdeveloped Area – Exemption on Goods only Packaged therein - Example 1 & 2 – (2/2)

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Business Entity

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 ?


• 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.

Under developed Area (Unit II)

Developed Area (Unit I)

Transfer of unpackaged Goods

Customer

Sale to Customer

1

2

Packages Goods

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

4

Low tax jurisdiction - X

India

Foreign Investor

Indian Co.

Investment Co.

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 ?


• 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 -

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Low tax jurisdiction - R

India

A

India Co.

B

Does not has commercial substance

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 ?


• 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

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Favorable tax jurisdiction - X

IndiaIndian Holding

Company

C – Operating Subsidiary

Overseas Investment Co.

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 ?


• 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.

Operating subsidiary

Jurisdiction

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

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Shareholders

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


• 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.

Profit making

entity - B

Loss making

entity - A

Merger of Loss making entity into

Profit making entity

Share issue

Lease Vs Purchase of Asset – Example 6

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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 ?

?

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.

Interpretation

Borrowing Vs Equity – Thin capitalisation -Example 7

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

?

• 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.

Interpretation

Mark up on Cost recharge by service company covered under Transfer Pricing provision – Example 8

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Service Company

B

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 ?


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

CA

Cost recharged at Mark up

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

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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.

Inbound Investment through a Permitted Assignee – Example 10

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Non resident

Country ABC

India

Y

X

A

49%

51%

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 ?


• 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.

Inbound Investment through Subsidiary where funds are provided by Parent – Example 11

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Non resident

Country ABC

India

B

C

A

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 ?


• 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.

Fund infusion

Share acquisition

Selective Buy Back – Example 12

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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 ?


• 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

D

B C

A

Low tax jurisdiction

Buy back shares

Other jurisdiction

Sale of shares of an Indian asset owning company, by a foreign parent, situated in low tax jurisdiction – Example 13

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Country ABC

India

X

E

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 ?


• 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

V

1. Liquidated

2. Distributed shares to E and C

Assignment of Loan by Foreign bank to Indian Borrower to its Branch in a favourable third country - Example 14

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Foreign Lender Bank

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 ?


• 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.

Indian Borrower

Branch

Arranges loan for Indian Borrower

F’s branch in XYZ country

Assignment of Loan

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

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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 ?


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.

Country ABC

India

B

A

Sells shares piecemeal

Inbound Investment through Subsidiary where funds are provided by Parent – Example 16

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Country T

Country R

India

X

B

A

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 ?


• 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

Overseas Trading company set up by Indian company – Control and Management from India - Example 17

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Favorable tax jurisdiction - X

India

Indian Company

Overseas Trading Co.

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 ?


• 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

A B

Purchase Sale

Control

Providing Bonus/ Salary due to an employee through issue and Redemption of Preferential shares - Example 19

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Company AFacts 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 ?


• 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

Employee

Allotment of Preference shares

Connected group

company

Sale to Connected company

1

2(a)

Redemption by company

2(a)

Assignment of Actionable claims and realisation – Claim for Capital Receipt - Example 20

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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.



• 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.

BCompany

A

Transfer of instrument at low value

CGift

D

Transfer of instrument

1

3

2

Realizes such amount and claims as capital

receipt

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

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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.



• 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.

B’s connecte

d concerns

Subsidiaries

BLends

A

Transfer back of funds

1

Purchases Shares

2

3

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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 [email protected]

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.

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0 GAAR Analysis by CA. Arinjay Kumar Jain. Tax Mitigation – Setting up an Undertaking in an underdeveloped Area – Exemption on Goods manufactured therein.

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