Recharacterising Offshore Transactions: Economic Substance, BEPS and India’s Evolving Approach under Sections 9 and 195 of the Income-tax Act

Introduction

India’s international tax regime has entered a decisive phase. With increasing inbound and outbound investments, layered holding structures, and complex offshore arrangements, tax authorities are scrutinising whether cross-border transactions reflect genuine commercial purpose or merely facilitate base erosion and profit shifting.

The doctrine of economic substance widely recognised in comparative tax jurisprudence requires that tax consequences follow the real commercial character of a transaction rather than its legal form. Where an arrangement lacks commercial rationale, business purpose, or operational substance, revenue authorities may recharacterise it for tax purposes.

In India, although the economic substance doctrine is not codified in identical terms as in certain Western jurisdictions, courts have progressively embedded substance-over-form reasoning within statutory interpretation for recharacterising offshore transactions particularly under Sections 9 and 195 of the Income-tax Act, 1961.¹

The Global Context: BEPS and Anti-Treaty Abuse

The international tax landscape was fundamentally reshaped by the Organisation for Economic Co-operation and Development (OECD) through its Base Erosion and Profit Shifting (BEPS) Project launched in 2013. BEPS Action 6, in particular, targets treaty abuse and treaty shopping.

Under the BEPS framework:

• Tax treaty benefits must correspond to genuine economic activity.
• Shell or conduit entities lacking operational substance are denied preferential treatment.
• Jurisdictions are encouraged to adopt Principal Purpose Tests (PPT) and Limitation of Benefits (LOB) clauses.

India, as an active participant in the Inclusive Framework, has incorporated BEPS-driven standards into treaty renegotiations and domestic interpretation. The focus has shifted from mechanical treaty entitlement to examining:

• Beneficial ownership
• Commercial substance
• Actual functions, assets and risks
• Business purpose

This marks a clear departure from formalistic treaty reliance.

Judicial Evolution in India: Substance Over Form

Indian courts have consistently warned against structures designed solely for tax advantage. The jurisprudence reflects an increasing willingness to:

• Lift the corporate veil
• Examine beneficial ownership
• Evaluate commercial rationale
• Disregard artificial or circular arrangements

The Vodafone Precedent²

In Vodafone International Holdings BV v. Union of India, the Supreme Court examined whether an offshore share transfer triggered tax liability in India. While the Court ruled in favour of the taxpayer on facts, it clarified critical principles:

• Each case must be evaluated holistically.
• The “look at” test must assess the transaction in its entirety.
• Genuine commercial transactions cannot be disregarded merely because they are tax-efficient.

Importantly, the decision did not reject substance review but refined the standard for invoking it.

Post-Vodafone Developments

Subsequent judicial trends show greater scrutiny of:

• Conduit companies without employees or operations
• Back-to-back arrangements
• Circular financing structures
• Treaty shopping vehicles

Indian courts now examine whether an entity has real operational capacity in the jurisdiction where it claims residence. The presence of board meetings, staff, decision-making authority, and financial autonomy is increasingly decisive.

Sections 9 and 195: Source Rule and Withholding Obligations

Section 9: Income Deemed to Accrue or Arise in India

Section 9 expands India’s source-based taxation by deeming certain income to accrue in India even if received offshore. Courts now interpret Section 9 in light of:

• Real nexus with India
• Economic connection
• Value creation within Indian territory

This is especially relevant in indirect transfer cases, royalty characterisation disputes, and digital income assessments.

Section 195: Withholding Tax on Payments to Non-Residents

Section 195 obligates withholding on payments to non-residents if the sum is chargeable to tax in India. Judicial interpretation confirms:

• Withholding obligation depends on underlying taxability.
• Payers must assess real nature of payment not merely contractual labels.
• Substance prevails over nomenclature (e.g., service fee vs royalty vs FTS).

Failure to correctly assess substance may expose payers to disallowance, interest, and penalty exposure.

Digital Economy and the Expanding Substance Inquiry

Traditional source rules are under stress in the digital economy. Businesses may generate significant Indian revenue without physical presence.

Global reform efforts particularly the OECD’s Pillar One and Pillar Two proposals seek to:

• Reallocate taxing rights to market jurisdictions
• Impose a global minimum tax

As one of the largest market economies, India stands to benefit from reallocation models but must align domestic incentive regimes with global minimum tax standards.

Substance analysis in the digital era increasingly examines:

• User base value creation
• Data exploitation
• Significant economic presence
• Digital infrastructure nexus

Comparative Lessons: UK and Singapore

Jurisdictions such as the United Kingdom and Singapore provide instructive models:

• The UK’s General Anti-Abuse Rule (GAAR) codifies anti-avoidance principles.
• Singapore provides clearer statutory definitions of beneficial ownership and substance tests.

India has introduced GAAR provisions domestically, but greater administrative clarity particularly around Sections 9 and 195 would reduce interpretive friction.

Enforcement, Transparency and Information Exchange

India’s participation in global information-sharing mechanisms such as the Common Reporting Standard (CRS) strengthens detection of:

• Round-tripping
• Offshore profit shifting
• Undisclosed foreign holdings

Enhanced transparency tools enable authorities to move beyond formal documentation and trace actual economic flows.

Tax Certainty vs Aggressive Enforcement

A mature tax system must balance revenue protection with investor confidence. Overly expansive recharacterisation risks unpredictability; excessive formalism invites avoidance.

Reform priorities should include:

• Streamlined advance ruling mechanisms
• Clarificatory circulars on Sections 9 and 195
• Faster dispute resolution
• Reduced withholding ambiguities in cross-border service payments

Tax certainty is a competitive advantage in attracting foreign direct investment.

Emerging Technologies: Cryptocurrency and Decentralised Finance

The rise of blockchain-based transactions, decentralised finance (DeFi), and cryptocurrency complicates source attribution and enforcement.

Challenges include:

• Anonymity of counterparties
• Automated smart contracts
• Cross-border decentralised platforms

Substance evaluation in such cases must consider:

• Control mechanisms
• Economic benefit location
• Platform governance structures

International cooperation will be indispensable in standard-setting.

Conclusion: Toward a Principled Substance Framework

In sum, India’s approach to offshore taxation is steadily moving toward a substance-driven framework where real commercial activity, not merely legal structuring, determines tax consequences. As courts refine the interpretation of Sections 9 and 195 in line with global BEPS standards, greater clarity, administrative consistency, and alignment with international norms will be essential to balance revenue protection with tax certainty for genuine cross-border investors.

1. CA Mohammed S Chokhawala, Section 195 of Income Tax Act – TDS Applicability for NRI (Aug. 26, 2025), https://cleartax.in/s/section-195.is. ↩︎
2. Deloitte, Base Erosion and Profit Shifting (BEPS) Actions (June 12, 2023), https://www.deloitte.com/global/en/services/tax/analysis/beps-actions.html. ↩︎