"Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be."
Introduction
Though the terms tax evasion, avoidance and planning might appear interlinked, they have different connotations jurisprudentially. In general parlance, tax planning is a legitimate means of arranging taxes in a manner that reduces the overall tax liability. Tax avoidance has been defined by the Organization for Economic Co-operation & Development ('OECD') as the "arrangement of a taxpayer's affairsthat is intended to reduce his liability and that although the arrangement could be strictly legal is usually in contradiction with the intent of the law it purports to follow." On the other hand, tax evasion refers to the unlawful escaping of tax liabilities.
Given the above interpretation of these terms, though tax planning is a legitimate means of reducing tax liability, not all tax planning can be termed legitimate, and a distinction must be drawn between schemes/devices and legitimate avoidance of tax liability.
The obligation to pay taxes is a constitutional and statutory mandate in India. While tax planning within the bounds of the law is deemed legitimate, the employment of colourable devices is impermissible and must be discouraged. The courts in contemporary times are concerned with the genuineness of transactions and their intended effect for fiscal purposes.1 This article seeks to understand the distinction between these topics, which has been established through the catena of judicial pronouncements.
Tax Planning
Tax planning entails the organisation of one's financial affairs in a manner that fully complies with legal provisions. It involves the strategic utilisation of all available tax exemptions, deductions, concessions, rebates, allowances, and other reliefs or benefits sanctioned under tax legislation, thereby minimising the tax burden to the greatest extent possible. This ensures that the post-tax financial position remains as favourable as feasible. In essence, tax planning involves structuring one's economic activities, particularly those related to income generation, in a manner that adheres strictly to the legal framework while simultaneously reducing tax liability to the minimum permissible level.
Tax Avoidance
As mentioned above, tax avoidance is developing a mechanism around the 'grey area' of the taxation laws to maximise the benefit of a reduction in tax liability. The distinction between tax avoidance and tax evasion is that the former is legal and may be subject to ethical conundrum, and the latter is illegal and a crime. The crux is that tax avoidance strategies exploit the inconsistencies and gaps within tax regulations by employing various tax arbitrage methodologies.
The following are the most popular techniques used by the taxpayers for avoidance of tax liability:-
i. Deferred Payment of tax liability.
ii. Re-characterising an item, income, or expense to tax at a lower or nil rate.
iii. Permanent elimination of tax liability
iv. Shifting of income from a high-taxed to a low-taxed person.
In the earliest decision, the Supreme Court ('SC') in CIT v. A. Raman & Co.2, while elucidating upon tax avoidance, held that the avoidance of tax liability by arranging the commercial affairs so the charge of tax is distributed is not prohibited as such. A taxpayer may resort to a device to divert the income before it accrues to him. The effectiveness of the device does not depend upon morality but on the operation of the Income-tax Act, 1961('Act'). While the violation of law is prohibited and subject to penalty, its circumvention is within the legal means and is permissible.
The Gujrat High Court ('GHC'), while elucidating upon tax avoidance in the case of CIT v. Sakarlal Balabhai3, held that the assessee in receipt of an amount which, in fact, is liable to taxation but on which he avoids the tax liability by some artifice or device, may not be subject to legal consequences.
Tax Evasion
Tax Evasion, in simple terms, means violation of statutory provisions to evade payment of tax liabilities by the taxpayer. The taxpayers usually deploy certain artificial devices for the purpose of evasion, such as circular and fictitious transactions, fake invoicing, deployment of artificial loans and advances, etc.
Duke of Westminster Principle
The House of Lords in IRC v Duke of Westminster4 has categorically held that the taxpayer is entitled to arrange his affairs in a manner such that the liability to pay tax is lower than it would have been under the relevant law. Further, in W.T. Ramsay v. CIR5, the House of Lords cautioned about transactions intended only to reduce tax liability and have no commercial purpose.
McDowell Saga
In the case ofMcDowell & Co. Ltd v Commercial Tax Officer6, the SC held that tax planning would be considered legitimate if it is within the confines of the law. What has been frowned upon is 'colourable devices,' 'dubious methods and subterfuges' under the guise of tax planning.
There has been much debate about whether this decision disapproves of tax avoidance methods adopted by taxpayers to reduce their liability within the confines of law. It was further argued that the decision treats tax avoidance schemes at par with tax evasion schemes.
Interpreting McDowell
However, the GHC in Banyan and Berry v. CIT7 has lucidly summed up the manner in which the McDowell (supra) should be dealt with. The GHC has held that nowhere in this decision does it suggest that every action or inaction on the part of the taxpayer that results in a reduction of tax liability is to be viewed with suspicion and treated as a device for the avoidance of tax irrespective of the legitimacy or genuineness of the act.
In this case, the SC relied upon the observation of the Madras High Court in M.V. Valliappan v CIT,8 wherein it was held that the McDowell (supra) decision could not be read as laying down that every attempt at tax planning is illegitimate and must be ignored or that every transaction or arrangement which is permissible which has the effect of reducing the tax burden of the assessee must be looked upon with disfavour.
Azadi Bachao Andolan
The SC further crystallises the position in UOI v. Azadi Bachao Andolan9, while interpreting the McDowell case (supra), dismissed the observation of Chinappa Reddy. J, in the said judgment, held that the same does not appear to be the opinion of the rest of the judges of the Constitutional Bench. The SC further held that the principle laid down in IRC v. Duke of Westminister10 is alive and seems to have acquired judicial benediction of the Constitutional Bench, notwithstanding the temporary turbulence created in light of the McDowell Case (supra). The SC held that the argument that an act that is otherwise valid in law can be treated as non-est merely on the basis of some underlying motive supposedly resulting in economic detriment or prejudice to national interest could not be accepted.
McDowell v. Azadi Bachao: Conflict Resolved in Vodafone
In Vodafone International Holdings B.V. v. Union of India11, the SC overturned the decision of the Bombay High Court, holding that Revenue Authorities in India did not have the territorial jurisdiction to tax offshore transactions. Therefore, Vodafone was not liable to withhold India Tax. The SC reiterated the 'look at' principle enunciated in the case of W.T. Ramsay Ltd. v. Inland Revenue Commissioners12, which has held that revenue must look at the transaction. The SC, in this case, has held that revenue must look at the legal nature of the transaction, and while doing so, it has to look at the entire transaction as a whole and not adopt a dissecting approach. Additionally, the SC held that if a structure has existed for a significant period and the transaction meets all criteria for 'participation in investment,' then the SC does not need to delve into issues such as de facto control versus legal control or legal rights versus practical rights when determining taxability.
In the Vodafone case (supra), the SC inter-alia dealt with the challenge to the Azadi Bachao case (supra) on the grounds that the principles enshrined in the case were contrary to the McDowell case (supra). While interpreting Azadi Bachao Andolan (supra) in the context of McDowell (supra), the SC referred to the Westminister Principle, which enshrines that "given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance." The SC held that the majority in McDowell(supra) held that "tax planning may be legitimate provided it is within the framework of law." Thus, reading the cases in the manner indicated hereinabove, in cases of treaty shopping and/or tax avoidance, there is no conflict between McDowell (supra) and Azadi Bachao (supra).
The SC in Vodafone Case (Supra), while interpreting jurisprudence of tax avoidance and tax evasion, held that "Revenue cannot start with the question as to whether the impugned transaction is a tax deferment/saving device but that it should apply the 'look at' test to ascertain its true legal nature." In short, the onus will be on the Revenue to identify the scheme and its dominant purpose.
In light of the above, the distinction between tax evasion and tax avoidance is clearly established. Tax avoidance, which is legally permissible, is only tax mitigation and cannot be treated as impermissible under every situation where the underlying transaction is genuine. However, tax evasion stands in derogation of law and is subject to penalty. In other words, schemes or devices of reduction in tax liability that are impermissible and contravene the provisions of law fall within the ambit of Tax Evasion.
A more reasonable distinction can be drawn from the perspective with which the transaction or steps undertaken to reduce the liability. A transaction with no reasonable commercial purpose would fall within the ambit of tax evasion and vice versa. The SC in the Vodafone Case (supra) has upheld the right of the taxpayer to arrange his or her affairs tax efficiently without using colourable devices.
Based on the above, it can be concluded that the judicial dicta have always favoured legitimate tax planning and promoted tax planning to reduce tax liability within the confines of law.
Reaffirming the Above Principles
The ITAT Mumbai in Swiss Reinsurance Co. Ltd. v. Dy. CIT13 has held that the income tax officer cannot disregard a transaction merely because it results in a tax advantage to the taxpayer. In this case, the Tribunal has relied on judicial decisions, including McDowell (supra), to hold that tax planning may be legitimate, provided it is within the framework of law.
In Bhoruka Engg. Industries Ltd. Dy. CIT,14 the Karnataka High Court held that the sale of shares of a listed company on a recognised stock exchange resulting in the transfer of underlying immovable property would not be considered a 'colourable device' or 'sham' transaction and thus would be eligible for exemption from income tax relating to capital gain.
The judicial principle on the anti-avoidance principle has been varied. Some pronouncements have given sanctity to the substance of the transaction over the legal form of the transaction, while others have held that form is to be given sanctity.
General Anti Avoidance Rules ('GAAR')
Pursuant to the judgment in the Vodafone Case (Supra), the anti-avoidance rules were codified and introduced as GAAR. The GAAR provisions are applicable from the Assessment Year 2018-19. The provisions are applicable if the transaction is an impermissible avoidance agreement. Under the GAAR, for a transaction to fall within its purview, it is essential to prove that the main purpose of the transaction is to be a benefit. Further, it has to be established that the transaction lacks commercial substance or is deemed to lack commercial substance. S. 90(2A) of the Act enunciates that the provisions of GAAR shall apply to the taxpayer even if such provisions are not beneficial to him. In other words, once the provisions of GAAR are invoked, it will have an overriding effect on the beneficial tax treaties.
The provisions of GAAR reflect the 'substance over form' principle, comprising a set of broad rules based on general principles to counter potential tax avoidance. These provisions could also be applied to deny treaty tax benefits to non-residents who would have otherwise been entitled to them through improper use of treaty provisions. It is important to understand that the provisions of GAAR have an overriding effect over the other provisions of the Act. Further, the GAAR provisions may, under specific situations, be construed to override treaty provisions in cases of treaty abuse.15
GAAR provisions may be invoked when the transaction satisfies any of the following tainted element tests: -
- Arm's Length Test: This test results in the creation of rights and obligations that would not ordinarily have been created between persons dealing with arm's length. This may be done by allocating prices to different parts of the contract to reduce the tax liability of a foreign company in India. Under such a scenario, GAAR may be invoked, and prices would be reallocated based on arm's length prices as per transfer pricing regulations.
- Abuse Test: results, directly or indirectly, in the misuse or abuse of the provisions of the act. While ascertaining if the provisions of the law have been contravened, the intent of the particular provisions will have to be examined.
- Commercial Substance Test: the transaction lacks commercial substance and has been formed merely as a device to reduce the taxation liability.
- Bona fide Test: the transaction that is entered into is not employed in the ordinary course of business or for bona fide purposes.
Our Analysis
Based on the above, it can be concluded that a taxpayer has the option to undertake a transaction in two different ways—one resulting in no taxation or lower taxation and the other resulting in substantial tax liability. The taxpayer is entitled to structure the transaction in a manner that results in no or lower taxation; the only requirement is that the transaction comply with all relevant laws and statutory provisions.
Despite the implementation of numerous anti-avoidance measures, the prevailing issue necessitates the examination of the substance of transactions to determine the presence of tax avoidance strategies. The judiciary has recognised that transactions undertaken by taxpayers must be assessed through the lens of commerciality. The mere fact that a transaction yields a tax benefit does not suffice as a criterion to deem the transaction a colourable device for tax avoidance. Not all transactions are shams, and in many instances, business considerations surpass tax considerations. Consequently, each case must be evaluated based on its specific facts and circumstances in accordance with the salient principles established by the courts.
Footnotes
1 MC Dowell & Co. Ltd v Commercial Tax Officer [1985] 22 Taxmann 11 (SC).
2 [1968]1SCR10,
3 [1968] 69 ITR 186. The decision was affirmed by SC in CIT v. Sakarlal Banalbhai [1972] 86 ITR 2.
4 [1936] AC 1.
5 [1981] 54 TC 101.
6 1985] 22 Taxmann 11 (SC).
7 222 ITR 831.
8 [1988] 170 ITR 238/37 Taxmann 46.
9 263 ITR 706 (SC).
10 [1936] AC 1.
11 [2012] 17 taxmann.com 202 (SC).
12 [1982] AC 300
13 IT Appeal No. 6531 (Mum.) of 2021.
14 [2013] 36 taxmann.com 82 (Kar).
15 CBDT Circular 7/217.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.