[Varun Kannan is a 4thyear student at NUJS, Kolkata].
In a recent post on this Blog, Prof. Umakanth Varottil has elaborately examined the NCLT decision rejecting the proposed scheme of merger of Gabs Investments Private Limited into Ajanta Pharma Limited. In this post, I shall specifically analyze the applicability of the General Anti-Avoidance Rules (“GAAR”) against a proposed scheme of arrangement or amalgamation. After explaining the nature and purpose of GAAR, I shall argue that GAAR was incorrectly applied by the Income Tax (“IT”) Department in the present case. I shall also elaborate on the principles and conditions that must be complied with in the future before invoking GAAR against a scheme of arrangement.
Introduction and Brief Background
In its decision, the NCLT had rejected the proposed scheme of merger on grounds of (i) accrual of benefits solely to the promoters, without any corresponding public interest and (ii) objections with respect to possible tax avoidance raised by the IT Department.
Both Gabs Investments and Ajanta Pharma had common promoters and, as a result of the merger, the promoter shareholders of Gabs Investments (who were also the promoters of Ajanta Pharma) would be allotted shares of Ajanta Pharma. The main objective of the scheme (as stated before the NCLT) was to grant the promoters more direct shareholding in Ajanta Pharma.
The IT Department’s objection was that if the shares of Ajanta (as held by Gabs Investments) were to be transferred to the promoter shareholders directly through a share transfer, then that would attract an approximate tax liability of INR 421.66 crores. The Department contended that the transaction of share transfer to the promoters was being undertaken through a scheme of merger solely to avoid tax liability. In this regard, the Department also contended that the proposed scheme would be classified as an ‘impermissible avoidance arrangement’ under the GAAR, as it was a deliberate measure to avoid tax liability. It was also contended that this transaction was nothing but round-trip financing, which involved transfer of funds among the parties through a series of transactions.
While the NCLT did not specifically analyze whether GAAR can be invoked in this scenario, the NCLT rejected the scheme on grounds of possible tax avoidance raised by the IT Department.
The Nature of GAAR and Meaning of an ‘Impermissible Avoidance Arrangement’
The provisions of GAAR are laid down in Chapter X-A (sections 95-102) of the Income Tax Act, 1961 (“IT Act”). According to section 95, notwithstanding anything contained in the statute, an arrangement (such as a scheme for merger) entered into by an assessee can be declared as an ‘impermissible avoidance arrangement’, and consequences relating to tax liability shall be determined subject to Chapter X-A. Hence, for GAAR to be invoked, the IT Department shall first have to declare an arrangement as an ‘impermissible avoidance arrangement’ under Chapter X-A.
According to section 96, an ‘impermissible avoidance arrangement’ means an arrangement – (i) whose main purpose is to obtain a tax benefit; and (ii) which also satisfies any of the following conditions:
(a) creates rights/obligations not ordinarily created between persons dealing at arm’s length.
(b) results in abuse of the provisions of the statute.
(c) lacks commercial substance (e.g. involves round-trip financing, under Section 97).
(d) is executed in a manner not ordinarily employed for bona fide purposes.
Hence, under section 96, an arrangement can be classified as an ‘impermissible avoidance arrangement’ if its main purpose is to obtain a tax benefit and, secondly, if it satisfies one or more conditions from (a) to (d) above.
Under section 97, an arrangement shall be deemed to lack commercial substance if, inter alia– (a) the substance or effect of the arrangement differs significantly from its form and (b) it involves or includes round-trip financing – which means transfer of funds among the parties through a series of transactions which do not have any substantial commercial purpose other than obtaining a tax benefit.Under section 102(10), the term ‘tax benefit’ has been defined in an inclusive manner, and includes a “reduction, avoidance or deferral of tax payable under the statute”.
For understanding the scope and applicability of GAAR, it is instructive to refer to a clarificatory circular on the applicability of GAAR, which was issued by the Central Board of Direct Taxes (Circular No. 7/2017, January 27, 2017). In this clarificatory circular, it was stated that GAAR shall not interfere with the right of the taxpayer to select or choose a method of implementing a transaction. This essentially implies that a taxpayer’s choice of using a more tax efficient method of implementing a transaction (when multiple methods are available) shall not attract GAAR.
The Parthasarathi Shome Committee Report
To understand the applicability and purpose of GAAR, we may also refer to Final Report of the Expert Committee on GAAR, headed by Parthasarathi Shome. The Shome Committee highlighted the distinction between tax avoidance and tax mitigation. According to the Committee, tax avoidance involves an arrangement or mechanism executed solely for obtaining a tax benefit, without any other commercial motive. On the other hand, tax mitigation refers to the taxpayer using a fiscal incentive available to it under the tax statute. The Committee noted that the purpose of GAAR was to prevent tax avoidance, and not tax mitigation, which is an intended consequence of the statute.
To this end, the Committee went on to provide a non-exhaustive list of transactions that would fall within the ambit of ‘tax mitigation’, against which GAAR should not be applicable. One such transaction in this list was amalgamations and demergers as approved by the High Court. The Committee also went on to give an illustrative example on how GAAR shall not be applicable if the amalgamation is exempted from payment of capital gains tax under Section 47 of the IT Act.
In this illustrative example, a foreign holding company (which had accumulated dividend) merges into the Indian company through a cross-border merger. The Committee noted that GAAR cannot be invoked on the ground that if the dividend was distributed to the Indian company prior to the merger, then such declaration of dividend would have been taxable in India. This was because parties were entitled to use the exemption conferred by section 47 – which exempts payment of capital gains tax in case of a cross border merger of a foreign company into an Indian company. Moreover, according to the Committee, the timing or sequencing of an activity is the taxpayer’s choice and does not attract GAAR. This example is based on the premise that if parties claim the benefit of an exemption conferred by the statute (such as section 47) then that shall fall within the ambit of ‘tax mitigation’, against which GAAR cannot be invoked.
In another example given in the Report, a loss-making company merges into a profit-making company, which results in losses setting off profits, and consequentially a lower net profit and a lower tax liability. Even in this scenario, GAAR cannot be invoked as Section 72A contains specific anti-avoidance safeguards for setting off losses in certain cases of amalgamation. Hence, according to the Committee, when a specific anti-avoidance rule is applicable, then GAAR should not be invoked.
Can GAAR be Validly Invoked in the Gabs/Ajanta Pharma Merger?
Based on the applicable principles discussed above, let us examine whether GAAR can be validly invoked against the proposed scheme of merger of Gabs investments into Ajanta Pharma. Here, the IT Department classified the scheme as an ‘impermissible avoidance arrangement’ on the ground that the shares of Ajanta (as held by Gabs Investments) were transferred to the common promoters through a scheme of merger solely for obtaining a tax benefit. If the shares were transferred through a share transfer, then a tax liability to the tune of INR 421.66 crores would have been incurred. The Department also contended that the scheme of merger was nothing but round-trip financing, as it involved transfer of funds among the parties through a series of transactions.
The classification of the scheme of merger as an ‘impermissible avoidance arrangement’ is, in my view, incorrect for the following reasons. Firstly, undertaking the transaction of transferring shares to the promoters through a scheme of merger or through a share transfer is a choice available to the parties. Under section 47(vii) of the IT Act, no capital gains tax shall be payable by a shareholder when shares of an amalgamating company are transferred as consideration for receiving shares of the amalgamated company. Hence, if the transfer of shares to the promoters was undertaken through a scheme of merger, the promoter shareholders would not have to pay any capital gains tax on the shares of the amalgamated company received by them. The parties are hence entitled to mitigate tax liability and take benefit of the exemption conferred by section 47(vii), while giving the promoters more direct shareholding in Ajanta Pharma. As clarified in the CBDT circular referred to above, GAAR shall not interplay with the taxpayer’s right to select or choose a method of implementing a transaction. This is hence a perfect example of tax mitigation, where the parties are merely taking benefit of the exemption conferred by section 47(vii) of the IT Act.
Secondly, in my view, the scheme of merger cannot be classified as an ‘impermissible avoidance arrangement’ involving round-trip financing for the following reasons. Under section 97(2), ‘round-trip financing’ means an arrangement through which funds are transferred among the parties through a series of transactions, and such transactions do not have any substantial commercial purpose other than obtaining a tax benefit. Here, the commercial rationale behind the merger was to grant the promoters more direct shareholding in Ajanta – which would consequentially remove one unnecessary layer of shareholding and lead to greater shareholding efficiency. Hence, in my view, there was a legitimate commercial purpose behind the proposed scheme for merger, and it would be incorrect to contend that the main purpose was to avoid tax liability.
In this regard, it is instructive to refer to the Bombay High Court decision in Re: AVM Capital Services and Ors [2012 (114) BomLR 2533] which was based on a similar fact scenario. This case involved the merger of five private companies into Unichem Laboratories Ltd. Both the transferor and transferee companies had a common promoter – who owned and controlled the shares of Unichem through the five transferor companies. The objective of the scheme of merger was to enable the common promoter to hold shares directly in the transferee company. The objector to the scheme (a shareholder of the transferee company) contended that the scheme was devised solely to avoid capital gains tax that would have arisen if the five transferor companies had directly transferred their shares to the common promoter.
This contention was rejected by the Bombay High Court, which stated that the scheme had a perfectly legitimate commercial objective – which was to convert indirect shareholding of the promoter to a direct shareholding. It also stated that the transaction was undertaken in a manner that was permissible by law and was not undertaken to evade tax. Although this is a 2012 decision (given under the erstwhile Companies Act, 1956 and prior to the enactment of GAAR), this decision supports the proposition that streamlining the shareholding of the promoters in the transferee company is a legitimate commercial objective. Although this case was brought to the notice of the NCLT, the NCLT refused to analyze this decision, even though it was based on a similar fact scenario.
For these reasons, I would argue that the IT Department incorrectly applied GAAR while objecting to the scheme.
Future Invocation of GAAR: Overarching Principles that must be Followed
From the above analysis, we can note two principles that must be followed prior to invocation of GAAR against a scheme of arrangement.First, GAAR should not be invoked where the parties seek to take benefit of the exemptions conferred to certain categories of mergers and demergers, under section 47 of the IT Act. GAAR should also not be invoked if the scheme of amalgamation or demerger is covered by a specific anti-avoidance provision present in the statute, such as section 72A.
Second, if the parties establish a legitimate commercial purpose or rationale behind undertaking a scheme of amalgamation or demerger, then such a scheme must not be classified as an ‘impermissible avoidance arrangement’ merely because parties have chosen the most tax efficient method of undertaking the transaction. In my view, streamlining the shareholding of a certain class of persons (such as promoters) is a legitimate commercial objective, which must preclude applicability of GAAR.
As mentioned in the CBDT clarificatory circular referred to above, the proposal to declare an arrangement as an ‘impermissible avoidance arrangement’ under GAAR shall at the first stage be vetted by the Principal Commissioner or Commissioner, and at the second stage by an approving panel headed by a High Court judge. The principles referred to above should be kept in mind by the approving authorities, and must act as condition precedents for invocation of GAAR against a proposed scheme of arrangement.
Concluding Remarks: The Role of the NCLT
The same CBDT circular also states that if an arrangement is sanctioned by the NCLT after expressly and adequately considering its tax implication, then GAAR shall not apply to such an arrangement. Also, under section 230(5) of the Companies Act, 2013, it is mandatory to give a notice of the proposed scheme to statutory authorities such as the IT Department, which shall file its representations before the NCLT. However, it is pertinent to note here that the NCLT does not have the jurisdiction and competence to determine issues of tax liability, and is also not the appropriate forum for the same.
In this scenario, the NCLT may adopt two distinct approaches – (a) the NCLT may sanction the scheme in spite of the objections raised by the IT Department, stating that sanctioning the scheme shall not preclude the IT Department from initiating proceedings against the companies for possible tax law violations; and (b) it may sanction the scheme only once issues of tax avoidance and GAAR are settled with the IT Department. In the present decision rejecting the Gabs/Ajanta Pharma merger, the NCLT stated that the scheme cannot be sanctioned till issues of tax avoidance are settled with the IT Department. If the second approach is adopted in future, it becomes even more important for the IT Department to invoke GAAR only after complying with the overarching principles referred to above.