The Telangana High Court has ruled against a taxpayer - whom the revenue department had invoked General Anti-Avoidance Rules (GAAR) for using bonus stripping to set off a loss of ₹462 crore against long-term gains.

This is the first judgement on the anti-avoidance provisions, which came into effect on April 1, 2017 and could pave the way for tax authorities to liberally invoke GAAR in tax avoidance cases, said experts.

“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,” the HC observed in an order dated June 7.

According to Ashish Sodhani, Co-founder and Partner, Parakram Legal, the ruling underscores the importance of having a commercial rationale to any transaction. “The taxpayer was not able to put forth any commercial justification for carrying out the transaction. The judgement 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 these shares to another firm Advisory Services (ADR), at the reduced price, resulting in a short-term capital loss of ₹462 crore.

The taxpayer set off this loss against long-term gains made on another transaction of sale of shares in Ramky Enviro Engineers.

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

Court’s stand

The Court ruled that the arrangement was primarily designed to sidestep tax obligations, was devoid of commercial substance and should be perceived as a deliberate misuse of ITA provisions.

“The Court held that SAAR was not applicable since bonus stripping with respect to shares was not covered in the year of dispute. 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.

The Telangana High Court’s decision in a similar case (EKGE Retail LLP) would be keenly awaited to see if it rules on similar lines or distinguishes the Ayodhya Rami Reddy Alla decision on facts.

Pointers for readers

GAAR can be used to deny tax benefit on transactions that do not have any commercial substance and whose only purpose is to avoid tax

Bonus stripping involves buying shares of a company before it issues bonus shares and selling the original shares immediately after to incur a short-term capital loss.

Colourable devices refer to sham transactions that lack commercial substance