Tainted Element Test of Section 96 - Income Tax - Ready Reckoner - Income Tax

The tainted element test requires that the arrangement should have one or more specified tainted elements mentioned at clauses (a) to (d) of section 96 The first tainted element refers to non-arm s length dealings where an arrangement creates rights and obligations, which are not normally created between parties dealing at arm s length. As there are specific transfer pricing regulations (SAAR) applicable to international transactions and certain specified domestic transactions, this tainted element is to be examined only in those transactions which are not covered by TP regulations and where the main purpose of the arrangement is to obtain tax benefit. As current transfer pricing regulations are applicable to international transactions and some specified domestic transactions, a mechanism needs to be provided for the Assessing Officer (AO) to ascertain whether rights, or obligations, created in an arrangement are the same as ordinarily created between persons dealing at arm's length. He should be able to seek expert opinion in this regard from the Transfer Pricing Officer (TPO). Example Y Tech Ltd. is a company resident of country C1. It enters into an agreement with Z Energy Ltd., an Indian company for setting up a power plant in India. It is a composite contract for an agreed price of US$ 100million. The payment has been split in the following parts as per separate agreements (i) US$ 10 million for design of power plant outside India (payment for which is taxable at 10% on gross basis) (ii) US$ 70 million for offshore supplies of equipment etc (not taxable as no role is played by any PE in India. There are not subject to import duty) (iii) US$ 20 million for local supplies and installation charges (taxable on net income basis) It is found that the fair market value of offshore design is about USD 30 million; therefore it is under invoiced. On the other hand, offshore supplies were over invoiced. The arrangement resulted in significant tax benefit to the taxpayer. Can GAAR be invoked in such a case? Interpretation: The allocation of price to different parts of the contract has been decided in such a manner as to reduce tax liability of the foreign company in India. Both conditions for declaring an arrangement as impermissible are satisfied. (1) The main purpose of this arrangement is to obtain tax benefit; and (2) the transactions are not at arm s length. Consequently, GAAR may be invoked and prices would be reallocated based on arm s length price of each part of the contract determined as per transfer pricing regulations under the Act. However, it is clarified that GAAR provisions in such cases may be invoked only where there is an overall benefit in reallocation of prices to different parts of the overall contract. For instance, where import duty is levied on offshore supplies, it may not result in any net gain on reallocation of prices; or where offshore designs are not taxable as per the relevant DTAA. The second tainted element refers to an arrangement which results in misuse or abuse of the provisions of the tax law. It implies cases where the law is followed in letter or form but not in spirit or substance, or where the arrangement results in consequences which are not intended by the legislation, revealing an intent to misuse or abuse the law. Example Under the provisions of a tax treaty between India and country F4, any capital gains arising from the sale of shares of Indco, an Indian company would be taxable only in F4 if the transferor is a resident of F4 except where the transferor holds more than 10% interest in the capital stock of Indco. A company, A Ltd., being resident in F4, makes an investment in Indco through two wholly owned subsidiaries (K Ltd. and L Ltd.) located in F4. Each subsidiary holds 9.95% shareholding in the Indian Company, the total adding to 19.9% of equity of Indco. The subsidiaries sell the shares of Indco and claim exemption as each is holding less than 10% equity shares in the Indian company. Can GAAR be invoked to deny treaty benefit? Interpretation: The above arrangement of splitting the investment through two subsidiaries appears to be with the intention of obtaining tax benefit under the treaty. Further, there appears to be no commercial substance in creating two subsidiaries as they do not change the economic condition of investor A Ltd. in any manner (i.e on business risks or cash flow), and reveals a tainted element of abuse of tax laws. Hence, the arrangement would be treated as an impermissible avoidance arrangement by invoking GAAR. Consequently, treaty benefit would be denied by ignoring K and L, the two subsidiaries, or by treating K and L as one and the same company for tax computation purposes. The third tainted element refers to an arrangement which lacks commercial substance or is deemed to lack commercial substance. It is discussed in detail in the section 97. (For more detail refer this chapter) The fourth element refers to an arrangement which is carried out in , or by means of, a manner which is normally not employed for a bona fide purpose. In other words, it means an arrangement that possesses abnormal features. This is not a purpose test but a manner test. Concerns have been raised that section 96(2) provides that an arrangement shall be presumed to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit, notwithstanding the fact that the main purpose of the whole arrangement is not to obtain a tax benefit. in view of this provision, where only a part of the arrangement is to obtain a tax benefit even if the whole arrangement is permissible, the whole arrangement may be treated as an impermissible arrangement.