Section 98 of ITA, 1961 : Section 98: Consequences Of Impermissible Avoidance Arrangement

Explanation using Example

Example Application of Section 98 of The Income-tax Act, 1961

Consider a scenario where Company A, based in India, sets up a subsidiary, Company B, in a country with a lower tax rate. Company A then sells its intellectual property (IP) to Company B at a low price, allowing Company B to license the IP back to Company A at a much higher price. This arrangement is designed to shift profits to the lower-tax jurisdiction, thus reducing Company A's tax liability in India.

The Indian tax authorities investigate this arrangement and determine that it is primarily aimed at tax avoidance and lacks substantial commercial purpose, thus declaring it an impermissible avoidance arrangement under Section 98 of The Income-tax Act, 1961.

As a result, the tax authorities may:

• Recharacterise the sale of IP as not being genuine and combine the income of both companies for taxation in India.
• Disregard Company B entirely, treating the licensing fees paid as if the transaction never occurred, and tax Company A on the profits as if the IP was never sold.
• Treat Company A and Company B as one entity for tax purposes, negating the benefit of the lower tax rate in the other country.
• Reallocate the income and expenses between the two companies in a manner that reflects a fair market value transaction, thereby increasing Company A's taxable income in India.

This example demonstrates how tax authorities can use Section 98 to counteract tax avoidance schemes and ensure that taxes are levied based on the substance of the transactions rather than the form.