Arrangement to lack commercial substance

180(1)

An arrangement shall be deemed to lack commercial substance, if––

• (a) the substance or effect of the arrangement as a whole, is inconsistent with, or differs significantly from, the form of its individual steps or a part; or
• (b) it involves or includes— (i) round trip financing; or (ii) an accommodating party; or (iii) elements that have effect of offsetting or cancelling each other; or (iv) a transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction; or
• (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
• (d) it does not have a significant effect upon 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 this Chapter).

180(2)

In sub-section (1), round trip financing includes any arrangement in which, through a series of transactions

• (a) funds are transferred among the parties to the arrangement; and
• (b) such transactions do not have any substantial commercial purpose other than obtaining the tax benefit (but for the provisions of this Chapter), without having any regard to— (A) whether or not the funds involved in the round trip financing can be traced to any funds transferred to, or received by, any party in connection with the arrangement; (B) the time, or sequence, in which the funds involved in the round trip financing are transferred or received; or (C) the means by, or manner in, or mode through, which funds involved in the round trip financing are transferred or received.

180(3)

The following may be relevant but shall not be sufficient for determining whether an arrangement lacks commercial substance or not:—

• (a) the period of time for which the arrangement (including operations therein) exists;
• (b) the fact of payment of taxes, directly or indirectly, under the arrangement;
• (c) the fact that an exit route (including transfer of any activity or business or operations) is provided by the arrangement.

Explanation

Section Summary:

Section 180 of the new income tax law in India focuses on identifying and addressing arrangements that lack commercial substance. The purpose of this section is to prevent taxpayers from engaging in transactions or structures that are primarily designed to obtain tax benefits without any real economic or business purpose. This is part of the broader anti-avoidance framework aimed at curbing tax evasion and ensuring that transactions reflect genuine commercial intent.

Key Changes:

1. Introduction of "Commercial Substance" Test: This section introduces a formal test to determine whether an arrangement lacks commercial substance. Previously, such assessments were based on judicial interpretations or general anti-avoidance rules (GAAR).
2. Specific Indicators of Lack of Commercial Substance: The law now explicitly lists scenarios that indicate a lack of commercial substance, such as round-trip financing, accommodating parties, or transactions designed to disguise the true nature of funds.
3. Expanded Scope: The section covers not only transactions but also the location of assets, residency of parties, and the overall effect on business risks or cash flows.

Practical Implications:

1. For Taxpayers: Taxpayers must ensure that their transactions have a genuine commercial purpose and are not solely aimed at obtaining tax benefits. Structures that lack economic substance may be disregarded, leading to disallowance of tax benefits.
2. For Businesses: Companies engaging in cross-border transactions, intra-group financing, or complex structures must carefully evaluate whether their arrangements meet the commercial substance test.
3. For Compliance: Tax authorities will scrutinize transactions more closely, especially those involving round-trip financing, accommodating parties, or offsetting elements. Taxpayers may need to provide detailed documentation to prove the commercial rationale behind their arrangements.

Critical Concepts:

1. Commercial Substance: Refers to whether an arrangement has a genuine business or economic purpose beyond just obtaining a tax benefit.
2. Round-Trip Financing: A series of transactions where funds are transferred among parties without any real commercial purpose, often to create the appearance of legitimate activity.
3. Accommodating Party: A party involved in a transaction solely to facilitate a tax benefit, without any real economic interest.
4. Tax Benefit: Any reduction, avoidance, or deferral of tax liability resulting from an arrangement.

Compliance Steps:

1. Evaluate Transactions: Assess whether your transactions or arrangements have a genuine commercial purpose and are not solely aimed at obtaining tax benefits.
2. Document Commercial Rationale: Maintain detailed records and documentation that demonstrate the economic or business purpose of the arrangement.
3. Avoid Red Flags: Be cautious of structures involving round-trip financing, accommodating parties, or offsetting elements, as these are likely to attract scrutiny.
4. Review Existing Structures: Reassess existing arrangements to ensure they comply with the commercial substance requirements under the new law.

Examples:

1. Round-Trip Financing: Company A lends ₹10 crore to Company B, which then lends the same amount back to Company A. The funds circulate without any real economic activity, and the sole purpose is to claim interest deductions. Under Section 180, this arrangement would lack commercial substance, and the tax benefit (interest deduction) may be disallowed.
2. Accommodating Party: Company X sets up a subsidiary in a tax-friendly jurisdiction solely to route profits and reduce its tax liability. The subsidiary has no real business operations or employees. This arrangement would likely be deemed to lack commercial substance under Section 180.
3. Disguised Transactions: A company transfers funds through multiple entities in different countries to obscure the source and ownership of the funds. If the primary purpose is to obtain a tax benefit, the arrangement would fail the commercial substance test.

By focusing on the economic reality of transactions, Section 180 aims to ensure that tax benefits are only available for arrangements with genuine commercial substance.