Sections 97 and 98 of Income Tax Act: Lack of Commercial Substance and GAAR Consequences

Sections 97 and 98 of the Income Tax Act, 1961 formed part of India's General Anti-Avoidance Rule, commonly called GAAR. Section 97 explained when an arrangement is treated as lacking commercial substance, while Section 98 prescribed the possible tax consequences after an arrangement is declared an impermissible avoidance arrangement.

What does "lack of commercial substance" mean under GAAR?

In broad terms, GAAR looks beyond the legal form of an arrangement to its real commercial effect. An arrangement may lack commercial substance where its structure, financing, parties, location or economic effect does not reflect a substantial commercial purpose and the arrangement is materially driven by a tax benefit.

This does not mean that every transaction producing a tax benefit is automatically impermissible. The GAAR framework requires the statutory conditions for an impermissible avoidance arrangement to be satisfied. Sections 97 and 98 of the 1961 Act should therefore be read with Sections 95 and 96 dealing with applicability of GAAR and impermissible avoidance arrangements.

Section 97 of the Income Tax Act, 1961: Arrangement to lack commercial substance

The principal indicators under Section 97(1) were:

• the substance or effect of the arrangement as a whole was inconsistent with, or significantly different from, the form of its individual steps or any part;
• the arrangement involved round trip financing, an accommodating party, offsetting or cancelling elements, or a transaction that disguised the value, location, source, ownership or control of funds;
• the location of an asset, transaction or residence of a party lacked a substantial commercial purpose apart from obtaining a tax benefit; or
• the arrangement did not significantly affect the business risks or net cash flows of a party apart from the effect attributable to the tax benefit.

Round trip financing

Section 97 treated a series of transfers among parties as round trip financing where the transactions lacked a substantial commercial purpose other than obtaining the tax benefit. The provision directed that tracing of the same funds, timing or sequence of transfers, and the particular mode of transfer were not decisive.

Accommodating party

Under the 1961 Act, an accommodating party was a party whose direct or indirect participation had, wholly or partly, the main purpose of obtaining a tax benefit for the assessee. The party did not have to be a connected person for this concept to apply.

Factors that were relevant but not sufficient by themselves

Section 97 also clarified that the duration of an arrangement, payment of taxes under it, and the existence of an exit route could be relevant, but those facts alone were not sufficient to decide whether the arrangement lacked commercial substance.

Section 98 of the Income Tax Act, 1961: Consequences of an impermissible avoidance arrangement

Section 98 operated after an arrangement was declared to be an impermissible avoidance arrangement. It authorised the tax consequences to be determined in the manner considered appropriate in the circumstances, including denial of a tax benefit or a benefit under a tax treaty.

The statutory consequences could include:

• disregarding, combining or recharacterising a step, part or the whole arrangement;
• treating the arrangement as though it had not been entered into or carried out;
• disregarding an accommodating party or treating parties as the same person;
• treating connected persons as one person for determining the tax treatment of an amount;
• reallocating capital or revenue receipts, expenditure, deductions, relief or rebates among the parties;
• altering the tax treatment of residence or the situs of an asset or transaction; and
• looking through an arrangement by disregarding a corporate structure.

Section 98 also permitted recharacterisation of equity as debt or debt as equity, capital receipts as revenue receipts or vice versa, and expenditure, deductions, relief or rebates where the statutory GAAR consequences justified that treatment.

Current law: Sections 180 and 181 of the Income-tax Act, 2025

For tax years beginning on or after 1 April 2026, the current provisions are Sections 180 and 181 of the Income-tax Act, 2025. Their substantive GAAR concepts broadly carry forward the earlier rules. Section 181 continues to permit denial of a tax benefit or treaty benefit and permits steps or structures to be disregarded, combined or recharacterised where an arrangement has been declared impermissible.

The Income-tax Rules, 2026 also contain the procedural and consequential rules relevant to GAAR. In particular, the current rules address determination of consequences where only part of an arrangement is declared impermissible.

Practical reading of Sections 97 and 98

A useful way to understand the provisions is to separate the analysis into stages. First, identify the arrangement and the claimed tax benefit. Second, examine the statutory conditions for an impermissible avoidance arrangement. Third, consider whether the arrangement lacks commercial substance by looking at its real economic effect, financing, parties, location, risks and cash flows. Only after an arrangement is declared impermissible do the consequential powers corresponding to old Section 98 and current Section 181 become relevant.

For example, the mere use of a company, financing vehicle or treaty jurisdiction does not by itself establish that GAAR applies. The statutory tests, facts, commercial purpose, economic substance and prescribed procedure must be considered together.

Official Income Tax resources

For the law currently in force and transition from the 1961 Act, use the official Income Tax Department resources:

• Income Tax Act 2025 - official Income Tax Department portal
• Objective and scope of the new Act - official FAQs
• Income-tax Rules, 2026 - official notification

This article explains the statutory framework for general information. Application of GAAR is fact-specific and may depend on the relevant tax year, transaction documents, treaty provisions and prescribed procedure.