Arrangement to lack commercial substance [ Section 97(1)(b) ] - Income Tax - Ready Reckoner - Income Tax

Arrangement to lack commercial substance [ Section 97(1)(b) ] Another alternate condition of an impermissible avoidance arrangement is that the arrangement lacks commercial or is deemed to lack commercial substances in whole or in part. An arrangement shall be deemed to lack commercial substance, if- (b) it involves or includes - (1) Item (i) of clause (b) of section 97(1) deems an arrangement, which includes round tripping of funds, to lack commercial substance. The phrase round trip financing has been further defined as under section 97(2) For the purposes of section 97(1), round trip financing includes any arrangement in which, through a series of transactions- (a) funds are transferred among the parties to the arrangement; and (b) such transactions do not have any substantial commercial purpose other than obtaining the tax benefit (but for the provisions of this Chapter), without having any regard to- (A) whether or not the funds involved in the round trip financing can be traced to any funds transferred to, or received by, any party in connection with the arrangement; (B) the time, or sequence, in which the funds involved in the round trip financing are transferred or received; or (C) the means by, or manner in, or mode through, which funds involved in the round trip financing are transferred or received. Example Indco incorporates a Subco in a NTJ with equity of US$100. Subco gives a loan of US$100 to another Indian company (X Ltd.) at the rate of 10% p.a. X Ltd. claims deduction of interest payable to Subco from the profit of business. There is no other activity in Subco. Can GAAR be invoked in such a case? Interpretation - The arrangement appears to be to avoid payment of tax on interest income by Indco in the case loan is directly provided by Indco to X Ltd. The arrangement involves round tripping of funds even though the funds emanating from Indco are not traced back to Indco in this case. Hence, the arrangement may be deemed to lack commercial substance. Consequently, in the case of Indco, Subco may be disregarded and the interest income may be taxed in the hands of Indco. (2) Item (ii) of clause (b) of section 97(1) deems an arrangement which includes an accommodating party to lack commercial substance, The phrase accommodating party has been further defined as under section 97(3) For the purposes of this Chapter , a party to an arrangement shall be an accommodating party, if the main purpose of the direct or indirect participation of that party in the arrangement, in whole or in part, is to obtain, directly or indirectly, a tax benefit (but for the provisions of this Chapter) for the assessee whether or not the party is a connected person in relation to any party to the arrangement. It means that where a party is included in an arrangement mainly for obtaining tax benefit to the taxpayer, then such party may be treated as an accommodating party and consequently the arrangement shall be deemed to lack commercial substance. Also, it is not necessary that such party should be connected to the taxpayer. (3) Item (iii) of clause (b) pf section 97(1), deems an arrangement, which includes elements that have effect of offsetting or cancelling each other to lack commercial substance . (4) Item (iv) of clause (b) of Section 97(1), deems an arrangement, which disguises value, source or location etc. of funds, to lack commercial substance. In other words, such arrangements have an element of deceit as regards funds. A transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction; or [ Section 97(1)(b)(iv) ] Example Indco has raised funds from a company (X Ltd.) incorporated in a low tax jurisdiction outside India (LTJ) through borrowings, (i) X Ltd. is a banking institution in LTJ; (ii) there is a closely held company Subco in LTJ which is a wholly owned subsidiary of another closely held Indian company Indco; (iii) Subco has reserves and, if it provides a loan to Indco, it may be treated as deemed dividend under section 2(22)(e) of the Act. (iv) Subco makes a term deposit with X Ltd. bank and X Ltd. bank based on this security provides a back to back loan to Indco. Say, India-LTJ tax treaty provides that interest payment to a LTJ banking company is not taxable in India. Can this be examined under GAAR? Interpretation - This is an arrangement whose main purpose is to bring money out of reserves in Subco to India without payment of due taxes. The tax benefit is saving of taxes on income to be received from Subco by way of dividend or deemed dividend. The arrangement disguises the source of funds by routing it through X Ltd. bank. X Ltd. bank may also be treated as an accommodating party. Hence the arrangement shall be deemed to lack commercial substance. Consequently, in the case of Indco, the loan amount would be treated as dividend income received from Subco to the extent reserves are available in Subco; and no expense by way of interest would be allowed. In the case of bank X Ltd, exemption from tax on interest under the DTAA may not be allowed as X Ltd is not a beneficial owner of the interest, provided the DTAA has anti-avoidance rule of beneficial ownership. If such anti-avoidance rule is absent in DTAA, then GAAR may be invoked to deny treaty benefit as arrangement will be perceived as an attempt to hide the source of funds of Subco.