By Aditya Kalra and Nikunj Ohri

NEW DELHI (Reuters) - Indian authorities have ordered British insurer Aviva's local unit to pay $7.5 million in back taxes and penalties after an investigation found it created fake invoices to pay illegal commissions and claimed incorrect tax credits, an order shows.

The tax demand is significant for Aviva's India business, which recorded a profit after tax of only $10 million in the 2023-24 financial year. Aviva also faces stiff competition from rivals in India's insurance market.

To grow its business, Aviva India paid about $26 million between 2017 and 2023 to vendors who purportedly provided marketing services, but they were only a front to give Aviva's agents excess commissions beyond regulatory limits, Indian tax authorities alleged in an August 3 notice Reuters reported last year.

Using the clandestine system of fake invoices and cash payments, Aviva incorrectly claimed tax credits and evaded $5.2 million in taxes, authorities had alleged.

After hearing Aviva's defence, joint tax commissioner Aditya Singh Yadav ruled the company evaded tax of around 326 million rupees ($3.8 million), which it must pay with a 100% penalty, totalling 653 million rupees, or $7.5 million, according to a February 5 order reviewed by Reuters that has not been made public.

"The vendors were just puppets playing their role for Aviva to get them undue benefit of bogus" tax credits, the order said.

"Vendors were selected as face mask to conceal the game of input tax credit," it added.

In a statement to Reuters, Aviva India said it "will contest the latest order through an appeal. The order will have no impact on its operations."

Aviva's India business is run in joint venture with Dabur Invest Corp., a prominent local firm. Aviva owns 74% of the business, after increasing its stake from 49% in 2022.

Dabur did not respond to a request for comment.

Before the tax authority, Aviva denied wrongdoing, saying the allegations were "incorrect and unsustainable" and the vendors were not fake and had indeed provided services to the company, the February 5 order said.

The tax investigation notice from last year included screenshots of emails and messages between Aviva executives and insurance distributors in which they discussed ways to skirt compensation regulations using fake invoices, and details of how the insurer claimed incorrect tax credits on such transactions.

Aviva also hired so-called "agent mentors" to train sales agents, but they merely issued fake invoices to the insurer to facilitate excess commissions to agents, tax officials said.

In December, Reuters reported the Aviva business model that officials said was used to pay agents unlawful commissions from 2017 to 2023 was rolled out internally in 2013 and approved in writing by top India executives.

(Reporting by Aditya Kalra and Nikunj Ohri; Editing by Jamie Freed)