The General Anti-Avoidance Rule (GAAR) under the Direct Tax Code (DTC) 2025 represents one of the most significant challenges for AIF structuring in India. With GAAR applicable from 1st April 2026, fund sponsors, managers, and investors must carefully evaluate whether their fund structures could be characterised as "impermissible avoidance arrangements" lacking "genuine commercial substance."
The GAAR Framework Under the DTC
Section 178 — Applicability of GAAR
Section 178(1) provides that "an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement and the consequence in relation to tax arising from it may be determined subject to the provisions of this Chapter". Section 178(2) further clarifies that GAAR "may be applied to any step in, or a part of, the arrangement as they are applicable to the arrangement."
Section 179 — What is an Impermissible Avoidance Arrangement?
An arrangement qualifies as an impermissible avoidance arrangement where the main purpose is to obtain a tax benefit, and it:
- Creates rights or obligations not ordinarily created between persons dealing at arm's length
- Results in misuse or abuse of the provisions of the Act
- Lacks commercial substance or is deemed to lack commercial substance under Section 180
- Is entered into by means not ordinarily employed for bona fide purposes
Section 180 — The Commercial Substance Test
Section 180(1) deems an arrangement 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
- (b) It involves or includes:
- Round trip financing
- An accommodating party
- Elements that have the effect of offsetting or cancelling each other
- A transaction conducted through one or more persons disguising value, location, source, ownership or control of funds
- (c) It involves the location of an asset, transaction, or place of residence without substantial commercial purpose other than obtaining a tax benefit
- (d) It does not have a significant effect upon business risks or net cash flows apart from the tax benefit
Section 180(2) defines round trip financing as any arrangement where funds are transferred among parties without substantial commercial purpose other than obtaining the tax benefit.
Section 180(3) clarifies that the following factors shall not be sufficient for determining whether an arrangement lacks commercial substance:
- The period or time for which the arrangement exists
- The fact of payment of taxes under the arrangement
- The fact that an exit route is provided by the arrangement
What Makes an AIF Structure "Genuine Commercial Substance"?
1. Commercial Rationale Beyond Tax
The structure must have a genuine business purpose beyond tax optimisation. For an AIF, this includes:
- Investment strategy alignment: The structure must be driven by the fund's investment strategy, not tax considerations
- Investor requirements: Structures driven by investor domicile, regulatory, or commercial preferences
- Operational efficiency: Structures that enable efficient fund management and administration
2. Substance Over Form
The economic substance of the arrangement must match its legal form. For AIFs, this means:
- The fund must actually carry on investment activities in the jurisdiction of its domicile
- The manager must perform genuine management functions
- The structure must not be a "shell" or "conduit" for channelling funds
3. Arm's Length Conduct
Transactions between related parties must be conducted as between independent parties. This includes:
- Management fees at arm's length
- Service arrangements with commercial substance
- No artificial pricing or cost-sharing arrangements
4. No Round Trip Financing
Fund structures must not involve circular flows of funds designed to create artificial tax benefits. This is particularly relevant for:
- Structures where funds flow from India to an offshore jurisdiction and back
- Structures involving multiple layers of intermediaries
5. No Accommodating Parties
All parties to the structure must have a genuine commercial purpose for participation. An "accommodating party" is one whose main purpose is to obtain a tax benefit for the assessee.
Red Flags for AIF Structures
Jurisdictional Arbitrage
Locating the fund or investment vehicle in a low-tax jurisdiction with no substantial commercial purpose other than tax benefit is a significant red flag. The "substance" requirements for such jurisdictions are critical.
Complex Layering
Multiple layers of entities with no clear commercial rationale beyond tax optimisation may trigger GAAR scrutiny.
Round Trip Structures
Structures involving funds flowing out of India and back through related entities may be challenged as round trip financing.
Artificial Losses
Structures designed to create artificial losses through related-party transactions may be challenged.
Misuse of Tax Treaties
Structures designed to obtain treaty benefits not intended by the treaty may be challenged.
The "Main Purpose" Test and Presumption
Section 179(2) creates a presumption that an arrangement has been entered into for the main purpose of obtaining a tax benefit if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit. This is irrespective of whether the main purpose of the whole arrangement is not to obtain a tax benefit.
For AIF structures, this means even a single step in the structure — such as the choice of domicile, the interposition of an intermediary, or the allocation of carried interest — if driven primarily by tax considerations, could taint the entire arrangement.
Defensible AIF Structuring Under GAAR
1. Document the Commercial Rationale
Maintain comprehensive documentation of the commercial rationale for each element of the structure. This should include:
- Investment strategy and objectives
- Investor requirements
- Regulatory considerations
- Operational efficiency considerations
2. Ensure Substantial Activities
The fund and its manager should have genuine substance in their jurisdictions of operation. This includes:
- Physical presence (office, employees)
- Decision-making in the jurisdiction
- Board meetings in the jurisdiction
- Regulatory compliance in the jurisdiction
3. Arm's Length Pricing
All related-party transactions, including management fees, service fees, and cost-sharing arrangements, must be at arm's length.
4. Avoid Artificial Steps
The structure should not include steps that serve no commercial purpose other than tax optimisation.
5. Consider the Economic Substance Doctrine
Fund structures should be evaluated against the economic substance doctrine, which requires that a structure has real economic effects beyond tax consequences.
Consequences of GAAR Invocation
If an arrangement is declared to be an impermissible avoidance arrangement, Section 181 empowers the tax authorities to:
- Disregard, combine, or recharacterise any step in the arrangement
- Treat the arrangement as if it had not been entered into or carried out
- Disregard any accommodating party
- Reallocate income, expenditure, deduction, relief, or rebate among parties
- Treat equity as debt or vice versa
- Treat capital receipts as revenue receipts or vice versa
Expert Legal Guidance
Anuj Desai & Associates provides comprehensive legal advisory services on GAAR compliance for AIF structures. Our direct tax experts help fund sponsors and managers evaluate structures for GAAR risk, document commercial rationale, and navigate the regulatory framework. We assist in structuring defensible fund vehicles, preparing documentation, and representing clients before income-tax authorities.
Disclaimer: This article provides general information and does not constitute legal advice. For specific guidance on GAAR compliance or any other direct tax matter, please consult qualified legal professionals.
Need Expert Legal Guidance?
Navigating the complex GAAR framework for AIF structuring requires experienced legal counsel. At Anuj Desai & Associates, we provide comprehensive direct tax advisory services, including:
- Structure Review: GAAR risk assessment for fund structures
- Documentation: Assistance with commercial rationale documentation
- Representation: Representation before income-tax authorities
- Advisory: Guidance on defensible structuring strategies
Contact us for expert legal guidance on your AIF structuring matters.