The Telangana High Court has ruled against a taxpayer against whom the revenue department had invoked General Anti-avoidance Rule (GAAR).

According to experts, this is the first judgement on GAAR, seven years after it came into effect on April 1, 2017.

GAAR empowers tax authorities to deny tax benefits on transactions or arrangements that have no commercial substance and whose only purpose is to avoid tax.

“Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges,” the court observed in an order dated June 7.

Colourable devices refer to sham transactions that lack commercial substance.

According to Ashish Sodhani, Co-founder and Partner of Parakram Legal, the ruling underscores the importance of having a commercial rationale for any transaction.

“The taxpayer was not able to put forth any commercial justification for carrying out the transaction. The judgment serves as a reminder that GAAR is an all encompassing safety net designed to capture colourable devices,” he said.

The case

The taxpayer, Ayodhya Rami Reddy Alla, had purchased shares of Ramky Estate and Farms (REFL). The company subsequently issued bonus shares in the ratio of 1:5 to Alla. Considering the reduction in price per share, the taxpayer immediately sold the shares to another firm, Advisory Services, or ADR, at the reduced price, resulting in a short-term capital loss of ₹462 crore.

The taxpayer set off the short-term capital loss incurred on the sale of shares of REFL against the long-term gains made on another transaction: the sale of shares in Ramky Enviro Engineers.

The taxpayer argued that since the transactions undertaken fall under chapter X of the Income Tax Act, 1961 (ITA), a specific anti-avoidance provision (SAAR), GAAR cannot be invoked. Since the relevant provision that should be applicable only refers to units and not shares, that section is also not applicable in the present case. Reliance was placed on the Shome Committee, which also recommended that in cases where SAAR is applicable, GAAR should not be invoked.

Court’s stand

The court ruled that the arrangement was primarily designed to sidestep tax obligations, in direct contravention of the ITA principles, devoid of commercial substance, and should be perceived as a deliberate misuse of the ITA’s provisions, going beyond the intended use of the law, and manipulating it to one’s advantage.

“The Court held that the case in hand was not covered by SAAR since bonus stripping with respect to shares was not covered in the year of dispute and so it upheld the application of GAAR. The principle that GAAR can apply when SAAR does not apply has also been clarified by CBDT in its circular dated January 27, 2017,” said Ashish Karundia, Founder, Ashish Karundia & Co.

The applicability of either GAAR or SAAR would be determined on a case-by-case basis, according to the court.