When an immovable property is transferred, two parties are involved: the seller and the buyer. Transfer of immovable property is transfer of capital asset within the meaning of Section 45 of Income Tax Act. On effecting the transfer, the seller has to pay income tax at 20% on long term capital gains arising from the transfer (assuming that the seller holds the property for more than two years). The buyer has to pay stamp duty to the land registrar at a rate of 5% to 7% of the sale value, depending on the state in which the immovable property is located.

Due to the significant incidence of taxes on both the seller and the buyer, many times the two parties are inclined to collude and structure the transaction so as to avoid paying any tax. One common way of doing this is to form a Special Purpose Vehicle. Typically, the SPV has the legal form of a partnership firm. The seller introduces the immovable property into the partnership firm as her capital contribution. As per Section 45(3) of IT Act, the gains arising from the transfer of a capital asset by a partner to a firm by way of capital contribution is taxable as capital gains. The property is introduced into the partnership firm at the guidance value; the seller calculates capital gains by taking guidance value as the sale consideration (whereas in practical situations, the real value is much higher).

The seller’s share of partnership is 99% (say) while the buyer’s share is 1%. Then the buyer introduces the real sale consideration into the partnership firm as her contribution. This is taken out by the seller as her drawings. Then an amendment to the partnership deed is effected by which seller’s share of partnership becomes 1% and buyer’s becomes 99%. The buyer gets complete control of the firm and its profits. The seller, however, remains in the firm with a nominal share so that there is no impact of stamp duty on reconstitution (as per state stamp acts, stamp duty incidence may arise if the seller completely exits the partnership firm. In Karnataka Stamp Act 1957, for instance, Article 40B(a) of the Schedule to the Act requires the seller to remain a partner, howsoever nominal, or stamp duty liability will arise).

Tax incidence

There are three different values attributed to an immovable property: book value, guidance value, and market value. Book value is the value reflected in books of the owner, and is usually the cost of acquisition. Guidance value is the value ascribed to the property and other properties in the area by the local government. Market value is the real worth at which the property will sell at a point of time. Usually book value is less than guidance value and guidance value is less than market value.

However, for the purpose of income tax, the guidance value is to be taken as the Fair Market Value (FMV) when no clear sale price is available or when sale price is lower than the guidance value. Hence, when the property is introduced into the SPV as a capital contribution, the ‘book value’ should be revalued to the guidance value. The seller has to pay tax on deemed capital gains u/s. 45(3), which is equal to guidance value less indexed cost of acquisition. However, the seller does not pay any tax on the incremental gain from market value (the tax saved is equal to 20% of [actual sale price minus guidance value]). The buyer does not pay any stamp duty, on using this structure.

Note that the seller has to pay tax on capital gains at some point of time. The immovable property is in the control of the partnership firm, but the firm is not the absolute owner of the property. The seller has drawn money from the firm, but the money still lies in his accounts as a drawing. The idea is to square off the transaction and pay tax towards the end of the project. This activity leads to tax deferment, and many benefits arise out of deferment of tax. First, the seller gets working capital free of cost by not paying tax to the exchequer. The exchequer’s revenue gets deferred, and thus treasury has to bear the time value of money. Secondly, the seller can create capital loss from some other structuring scheme in the interim period so that when finally capital gains is recognised, the tax incidence will be low.

Implications under GAAR

GAAR gets activated only if tax implication is more than Rs. 3 Crores.

Section 95 of the Income Tax Act states that notwithstanding anything contained in the Act, ‘an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement and the consequence in relation to tax arising therefrom may be determined subject to the provisions of’ Chapter X-A. The arrangements that are referred to as impermissible avoidance arrangements (detailed in Section 96) are:

A. Main purpose of the arrangement is to obtain a tax benefit; AND

B. Either of the following conditions are satisfied:

a. The arrangement creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length

b. The arrangement results, directly or indirectly, in the misuse, or abuse, of the provisions of the Act

c. The arrangement lacks commercial substance or is deemed to lack commercial substance under section 97, in whole or in part.

d. The arrangement is entered into, or carried out, in a manner which is not ordinarily employed for bona fide purposes.

The structuring discussed in aforementioned paras squarely falls under the purview of GAAR. In bona fide arrangements, the property gets transferred from the seller to the buyer. In this arrangement, the control and rights get transferred but the ownership does not get transferred. Ownership effectively means control and rights. Hence, there is no formal transfer of ownership but there is effective transfer of ownership. Transfer has happened in substance but not in form. The purpose is purely to save on taxes: had there been no tax, the seller would have simply sold to the buyer. Further, creation of the SPV lacks commercial substance; the buyer can simply purchase the immovable property and commercially exploit it.

Interestingly, GAAR will hit both the buyer and the seller. It will hit the seller because the seller has reduced her capital gains tax incidence by entering into this arrangement. It will hit the buyer because the buyer has not deducted TDS (a buyer of immovable property, in a genuine transaction, is supposed to deduct TDS at 1% of the transfer value) and hence is in default.

The writer is author of the book ‘Tangible Guide to Intangibles: Identification, Valuation, Taxation, and Transfer Pricing’ published by WoltersKluwer. Views are personal.