Income Tax Department Can Probe Treaty Benefit Arrangements Despite Grandfathering

Tax Authorities May Deny Benefits to Offshore PE and VC Firms Despite New Rules

The Income Tax authorities in India may still deny tax treaty benefits to offshore private equity (PE) and venture capital (VC) firms even after the recent amendments to the Income Tax rules. According to a senior government official, the authorities can still inspect "arrangements" and test them according to anti-abuse provisions, which can lead to the denial of tax benefits if the transaction is found to be solely for tax savings purposes.

The amendments to the Income Tax rules, which came into effect on March 31, grandfathered pre-2017 "investments" from retrospective scrutiny of the General Anti-Avoidance Rule (GAAR). However, authorities can still inspect "arrangements" and test them according to anti-abuse provisions. GAAR is a regulatory framework that allows tax authorities to deny tax benefits for "impermissible avoidance arrangements" that are created primarily for tax-savings purposes rather than for commercial substance.

Understanding Arrangements and Commercial Substance

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Under Indian tax law, the term "arrangement" is broadly defined and includes any step or part of a transaction, scheme, agreement, or understanding. An "investment" is a subset of an arrangement and can be tested under GAAR as part of the overall structure. 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 tax laws do not lay down a codified test for "commercial substance," which is assessed on a case-by-case basis. Generally, the substance can be established through demonstrable commercial presence and decision-making, such as having a functioning board, local management and employees, operational infrastructure, adequate capitalization, and clear evidence that the entity is the beneficial owner of the India-sourced income.

Denial of Treaty Benefits

A second official confirmed that authorities still have the power to examine cases 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. Apart from GAAR, there are judicial anti-avoidance principles where courts can examine whether the structure is genuine.

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The amended rules confirm that investments made prior to April 1, 2017, are grandfathered and remain outside the scope of GAAR. However, this does not displace the broader jurisprudence 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.

According to Rahul Charkha, Partner, Economic Laws Practice, "While there is some comfort, the risk has not been fully eliminated." The government officials said that there could be some hesitation among PE and VC funds due to the lack of complete clarity, even after the circular.