The Income Tax authorities may still deny tax treaty benefits to offshore private equity (PE) and venture capital (VC) firms if it’s found that any transaction made in India was done solely to avail tax benefits, a senior government official told Moneycontrol.
The recent amendments to the Income Tax rules (applicable from March 31), which grandfathered pre-2017 “investments” from retrospective scrutiny of the General Anti-Avoidance Rule (GAAR), still allow authorities to inspect “arrangements” and test them according to anti-abuse provisions.
GAAR is a regulatory framework that allows tax authorities to deny tax benefits (that is, impose additional tax on capital gains) for “impermissible avoidance arrangements.” It targets complex structures created by foreign firms (that is, private equity, venture capital, etc.) primarily for tax-savings purposes rather than for commercial substance.
The rules empower officials to ensure foreign entities pay their fair share of taxes for income earned on their investments in India.
“The March 31 amendments were brought in to provide confidence to investors that their erstwhile transactions won’t be questioned, but if the arrangement is found to be built solely for availing tax benefits, the transaction may be challenged,” the official said.
What is an arrangement?
Under Indian tax law, the term ‘arrangement’ is broadly defined. It includes any step or part of a transaction, scheme, agreement or understanding. While ‘investment’ is not separately defined, it would typically fall within this ambit.
For example, routing an investment into India through a Mauritius SPV to obtain India-Mauritius treaty benefits would constitute an ‘arrangement’ for GAAR purposes. The investment itself is one component of that wider arrangement.
In this sense, an investment is a subset of an arrangement and can be tested under GAAR as part of the overall structure.
What is a commercial substance?
The tax laws don’t lay down a codified test for ‘substance’. It is therefore assessed on a case-by-case basis, on the facts of each arrangement. Generally, the substance can be established through demonstrable commercial presence and decision-making.
This typically includes having a functioning board in the relevant jurisdiction, local management and employees, operational infrastructure such as office and banking arrangements, adequate capitalisation, and clear evidence that the entity is the beneficial owner of the India-sourced income. The overall enquiry is whether the economic reality of the structure aligns with its legal form.
‘Treaty benefits can be denied’
A second official told Moneycontrol that “authorities still have the power to examine cases (including pre-FY18) where there is significant tax avoidance or lack of substance. If the structure is primarily tax-driven or lacks substance, it can still be challenged.”
“It is not like the tax department has no power. We can make a case, but ultimately, it will have to convince the courts. The government clarified through a circular that GAAR should not be invoked on ‘investments’ made before 2017. However, this does not mean there is blanket protection. There are many other anti-avoidance provisions, that still apply, ” the second official said.
The official explained that apart from GAAR, there are judicial anti-avoidance principles where courts can examine whether the structure is genuine. “Based on that, they can decide whether treaty benefits should be granted or denied.”
“Earlier, there was a view that a Tax Residency Certificate was sufficient, but that position has now been diluted, the person added.
A Tax Residency Certificate (TRC) is an official document issued by the tax authorities of a country that certifies a person or company as a tax resident of that nation. With a TRC, the company based out of Mauritius will attain a lower tax on capital gains in India, which otherwise would be subject to a 20 percent tax.
“The amended rules confirm that investments made prior to April 1 2017 are grandfathered and remain outside the scope of GAAR. At the same time, this does not displace the broader jurisprudence (including the Tiger Global ruling) that a Tax Residency Certificate is necessary but not sufficient to claim treaty benefits. Access to treaty benefits under the India-Mauritius and India-Singapore DTAAs still depends on the presence of genuine commercial substance, not merely on formal residency or documentation,” an tax expert explained.
The government officials said that there could be some hesitation among PE and VC funds because there is still no complete clarity, even after the circular. “While there is some comfort, the risk has not been fully eliminated.”
