Impermissible avoidance arrangements


The legitimacy of tax planning or tax mitigation has been called into question ever since the Supreme Court frowned on the same in the McDowell case. The Azadi case revived the controversy laying down that there is nothing wrong in legitimate tax planning. The raging controversy has been given a quietus by the Direct Taxes Code (DTC) Bill.


A General Anti-Avoidance Rule (GAAR) has been promulgated in Section 123, which empowers the Government to declare any arrangement entered into by a person as an impermissible avoidance arrangement. Such an arrangement will be disregarded in framing the assessment and all consequences will follow under the Act. Detailed provisions have been made to invoke the anti-avoidance rule. Section 123(15) exhaustively defines what an impermissible avoidance arrangement means. The main purpose of such an arrangement is to obtain a tax benefit. Rights or obligations are created which will not normally be created between persons dealing at arm's length. It results in the misuse or abuse of the DTC (Direct Tax Code) provisions. It is entered into in a manner which would not normally be employed for bona fide purposes. Finally, it lacks commercial substance, in whole or in part.

Commercial Substance

The phrase “lacking in commercial substance” is a new innovation in tax law. It calls for detailed analysis of the intention behind the arrangement. Section 123(19) explains the phrase. A step, in or a part or whole of an arrangement, shall be deemed to be lacking commercial substance if it does not have a significant effect on the business risks or net cash flows, of any party to the arrangement apart from any effect attributable to the tax benefit that would be obtained but for the provisions of the Section 123. It visualises a contingency in which the legal substance, or effect, of the arrangement as a whole is inconsistent with, or defers significantly from, the legal form of its individual steps. It includes or involves round-trip financing. It also involves a party who is indifferent to the tax arrangement. It includes any element that can have the effect of offsetting or cancelling each other or a transaction which is conducted through one or more persons and disguises the nature, location, source, ownership or control of the fund. Round-trip financing includes financing in which funds are transferred among the parties to the arrangement and the transfer of the funds would result in a tax benefit but for the provisions of Section 123. Such a financing would significantly reduce, offset or eliminate any business risks incurred by any party to the arrangement. Section 125 lays down a rule of presumption. An arrangement shall be presumed to have been entered into for the main purpose of obtaining a tax benefit unless the person obtaining the tax benefit proves that getting such benefit was not the main purpose of the arrangement. The provisions of Chapter XI of the DTC Bill are widely worded. Critics have found fault with these provisions on the ground that these provisions would severely constrain business decision-making and lead to unavoidable delay in critical cases. It had been pleaded that these provisions should be applied selectively, in cases where there is a clear attempt to avoid tax without any commercial motive. Even at the introductory stage, the framers of the DTC declared that they will be following the best international practices.

The American Model

A few months back, the US codified the Economic Substance Doctrine which was itself created by the court. A transaction has economic substance only if it changes in a meaningful way the taxpayer's economic position and the taxpayer has a substantial business purpose. The American law imposes a substantial penalty if the transaction lacks economic substance. The penalty can go up to 40 per cent if the taxpayer does not disclose the relevant facts on its tax return.

The British Code

Realising that banks are participating in large scale tax avoidance schemes using a series of complex transactions and financial instruments, the British Chancellor George Osborne has brought in a tax conduct code which will have to be signed by banks. Banks will have to adhere to the spirit rather than just the letter of the law when advising their clients regarding tax avoidance schemes. Countries are increasing the disclosure requirements for structured finance transactions. The American Tax Shelter Rules and the Australian promoter penalty provisions are worthy of emulation in India. European courts deny tax benefits based on the Doctrine of the Abuse of Law. Norway and Germany have toughened the existing legislation in this regard. The American Doctrine of Economic Substance is similar to the concept of ‘lacking commercial substance' in Section 123 of the DTC. Before the DTC provisions are enacted into law, it is necessary to look into the way the Rule is implemented in Europe and the US. –