The general anti-avoidance rule, or GAAR, was introduced into India’s domestic tax legislation in 2012 and came into effect in 2017. This was viewed as an essential milestone in increasing transparency in the Indian tax authorities’ approach to targeting tax avoidance, as it introduced procedural safeguards against their unchecked use of the GAAR.

The rule provided the tax authorities with the power to deny tax treaty benefits and disregard arrangements and transactions primarily undertaken to obtain tax benefits, notwithstanding their compliance with statutory requirements.

The introduction of the GAAR marked the codification into Indian law of the theory of substance over form.

The Indian tax authorities have rarely invoked the codified GAAR to challenge tax treaty benefits. Denial of tax treaty benefits has continued to be based on judicial GAAR, developed through precedent and case law before the GAAR provisions were enacted.

The continued use of judicial GAAR raises interesting questions. Could the tax authorities deny treaty benefits to a nonresident taxpayer without explicitly invoking codified GAAR, instead relying on the judicial GAAR with its lower threshold and safeguards? Is the judicial GAAR easier to use for the authorities to challenge transactions and treaty benefits than the codified GAAR?

In this context, the arguments advanced by the taxpayer and the tribunal’s observations in the case Leapfrog Financial Inclusion India (II) Ltd. v. ACIT are significant, because they could shape the approach to the future applicability of the GAAR.

Leapfrog Case

The taxpayer, a company based in Mauritius, sold shares of an Indian company, the capital gains from which were claimed as exempt under the India–Mauritius tax treaty on account of the shares being subject to a legacy exemption. While examining the taxpayer’s claim of exemption under Article 13 of the tax treaty, the tax authorities called for details relating to the taxpayer’s structure, directors, activities, funds, financial status, etc.

After examining the details, the tax authorities took the view that the taxpayer company lacked commercial substance: It didn’t have any principal business activity, all decisions relating to investment activities and other management decisions were taken outside Mauritius, funds for investments were generated from outside Mauritius, and the benefit arising from such investments was also transferred to the real investors on back to back basis.

Based on these observations, the Indian tax authorities applied the substance over form doctrine. They held that the entire scheme was a tax avoidance arrangement and denied the benefit of the capital gains tax exemption to the taxpayer under the India–Mauritius tax treaty.

The taxpayer appealed to the tax tribunal.

Tribunal Ruling

The tribunal reinforced the legal position that if a nonresident has a valid tax residency certificate, that should be sufficient evidence as to the residency of the nonresident for the application of the relevant tax treaty and the benefits under the treaty.

However, apart from reiterating the tax residency certificate position, the Leapfrog ruling is significant because of the tribunal’s interesting observations regarding codified GAAR. To deny treaty benefits, the tribunal seems to suggest that tax authorities should invoke the codified GAAR, under which benefits can be refused to a nonresident taxpayer if obtaining them is one of the primary purposes of the arrangement.

This ruling thus provides an insight into some fundamental considerations going forward regarding any denial of tax treaty benefits by the tax authorities.

Treaty Override and GAAR

Indian tax law provides that the provisions of a tax treaty will override domestic tax provisions; this means that if treaty provisions are more beneficial to a taxpayer, they would apply, as opposed to the domestic tax law rules.

However, with the codification of the GAAR into Indian law, that position was modified to provide that only such codified GAAR can override the provisions of a tax treaty and be used or invoked by the Indian tax authorities to deny treaty benefits.

It’s also important to note that there are rules in the Indian income tax law that provide mechanisms and safeguards to ensure that the GAAR isn’t used indiscriminately or arbitrarily by the tax authorities. The rules also exempt certain taxpayers and investments made before April 2017 from the GAAR’s applicability.

The Indian tax authorities are expected to follow the prescribed legal process to invoke codified GAAR, which provides adequate protection to taxpayers and respects the specific exemptions provided under the rules. In this context, continued reliance on judicial GAAR developed through case law can be viewed as a way to bypass the exemptions and safeguards provided under codified GAAR.

Because the codified GAAR overrides tax treaties, whenever the tax authorities want to challenge treaty benefits, they should follow the procedure prescribed under law for invoking codified GAAR. They shouldn’t rely on judicial GAAR, which may amount to circumventing the codified exemptions and safeguards against giving the tax authorities unfettered powers to deny treaty benefits.

The position that treaty benefits can only be denied by invoking codified GAAR also balances the sovereign power of a country concerning taxation with the government’s obligation to respect the negotiated positions under various tax treaties.

The case is Leapfrog Financial Inclusion India (II) Ltd. v. ACIT, ITA Nos. 365/Del/2023 and 366/Del/2023.