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

Arrangement to lack commercial substance [ Section 97(1)(c) (d) ] 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- (c) it involves the location of an asset or of a transaction or of the place of residence of any party which is without any substantial commercial purpose other than obtaining a tax benefit (but for the provisions of this Chapter) for a party; or [ Section 97(1)(c) ] Clause (c) of section 97(1) Deems an arrangement to lack commercial substance where it involves the location of an asset or of a transaction or of the place of residence of any party and such location is without any substantial commercial purpose. It means if a particular location is selected for an asset or transaction or residence, and such selection has no substantial commercial purpose, then such arrangement shall be deemed to lack commercial substance. 1. 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 Subco Debt NTJ X Ltd. INDIA Indco 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. Example (i) Y Ltd. is a company incorporated in country C1. It is a non-resident in India. (ii) Z Ltd. is a company resident in India. (iii) A Ltd. is a company incorporated in country F1 and it is a 100% subsidiary of Y Ltd. (iv) A Ltd. and Z Ltd. form a joint venture company X Ltd. in India after the date of commencement of GAAR provisions. There is no other activity in A Ltd. (v) The India-F1 tax treaty provides for non-taxation of capital gains in the source country and country F1 charges no capital gains tax in its domestic law. (vi) A Ltd. is also designated as a permitted transferee of Y Ltd. Permitted transferee means that though shares are held by A Ltd, all rights of voting, management, right to sell etc., are vested in Y Ltd. (vii) As per the joint venture agreement, 49% of X Ltd s equity is allotted to A Ltd. and 51% is allotted to Z Ltd.. (viii) Thereafter, the shares of X Ltd. held by A Ltd. are sold to C Ltd., a company connected to the Z Ltd. group. As per the tax treaty with country F1, capital gains arising to A Ltd. are not taxable in India. Can GAAR be invoked to deny the treaty benefit? Interpretation - The arrangement of routing investment through country F1 results into a tax benefit. Since there is no business purpose in incorporating company A Ltd. Country F1 LTJ Y Ltd. 100% Country C1 A Ltd. 49% Debt Z Ltd. 51% X Ltd. INDIA 71 in country F1 which is a LTJ, it can be said that the main purpose of the arrangement is to obtain a tax benefit. The alternate course available in this case is direct investment in X Ltd. joint venture by Y Ltd. The tax benefit would be the difference in tax liabilities between the two available courses. The next question is, does the arrangement have any tainted element? It is evident that there is no commercial substance in incorporating A Ltd. as it does not have any effect on the business risk of Y Ltd. or cash flow of Y Ltd. As the twin conditions of main purpose being tax benefit and existence of a tainted element are satisfied, GAAR may be invoked. Additionally, as all rights of shareholders of X Ltd. are being exercised by Y Ltd instead of A Ltd, it again shows that A Ltd lacks commercial substance. Hence, unless it is a case where Circular 789 relating Tax Residence Certificate in the case of Mauritius, or Limitation of Benefits clause in India Singapore treaty is applicable, GAAR can be invoked. 3. Example A Ltd. is incorporated in country F1 as a wholly owned subsidiary of company Y Ltd. which is not a resident of F1 or of India. The India-F1 tax treaty provides for non-taxation of capital gains in India (the source country) and country F1 charges no capital gains tax in its domestic law. Some shares of X Ltd., an Indian company, are acquired by A Ltd in the year after date of coming into force of GAAR provisions. The entire funding for investment by A Ltd. in X Ltd. was done by Y Ltd. These shares are subsequently disposed of by A Ltd after 5 years. This results in capital gains which A Ltd. claims as not being taxable in India by virtue of the India-F1 tax treaty. A Ltd. has not made any other transaction during this period. Can GAAR be invoked? Interpretation - This is an arrangement which has been created with the main purpose of avoiding capital gains tax in India by routing investments through a favourable jurisdiction. There is neither a commercial purpose nor commercial substance in terms of business risks or cash flow to Y Ltd in setting up A Ltd. It should be immaterial here whether A Ltd has office, employee etc. in country F1. Both the purpose test and tainted element tests are satisfied for the purpose of invoking GAAR. Unless it is a case where Circular 789 relating Tax Residence Certificate in the case of Mauritius, or Limitation of Benefits clause in India-Singapore treaty is applicable, the Revenue may invoke GAAR and consequently deny treaty benefit.