Tax Planning And The Doctrine Of Substance Over Form

1. Introduction

The phrases “tax avoidance”, “tax planning”, “tax evasion”, and "substance over form" have been interchangeably used to defend suitable positions since the past immemorial. Quite akin to the adage, beauty lies in the eyes of the beholder. This dispute which continues today will indeed remain an issue for the future as well.

Tax Evasion

To put this article in perspective, tax evasion in my view is clearly il- legal as it consists of wilful violation or circumvention of the tax laws to minimize tax liability. The taxpayer breaches the relevant law knowing very well that his conduct is contumacious and is in actual knowledge of this proposed wrongdoing. This could happen when an assessee deliberately fails to report an item in the income-tax return or knowingly claims a deduction to which he is indeed aware that he is not entitled to or consciously omits to supply information even where there lies a devout duty to furnish. It could also apply to a situation where an assessee fails to clarify an issue, which the tax department requires him to do so. In these cases, there is an element of wilfulness, dishonesty or contemptuous conduct, or even absence of honest belief. In essence, if a taxpayer cannot display that he had an honest belief that he was not liable to tax or liable to lower tax, then prima-facie would fall within the realm of tax evasion. This doctrine was well expounded by

“Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. The effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. The legislative injunction in taxing statutes may not, except on peril of penalty, be violated, but it may lawfully be circumvented.” the Hon’ble Delhi High Court in the case of Shiv Raj Gupta [2015] 372 ITR 337.

Tax Planning

The essence of the doctrine of tax planning dates it way back in time to the famous quote of Lord Tomlin in the case of Inland Revenue Commissioners Vs Duke of Westminister [1936] AC 1, which states as follows:

“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. If he succeeds in ordering them so as to secure this result, then, however, unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax”.

In essence, the above-mentioned principle meant that a taxpayer managing his affairs that would reduce the tax burden is legitimate tax avoidance/ tax planning and is entirely different and distinct from what could be reckoned as deliberate tax evasion. In substance, one would need to review the transaction from its legal form. The said doctrine was also enunciated in IRC Vs Fishers Executors [1926] AC 412.

In contradistinction to the above, emerged the doctrine of substance over form which allows the tax authorities to ignore the legal form of an arrangement and tread into the actual substance in order to pre- vent artificial structures from being used for tax avoidance purposes. This doctrine is on the bedrock that a transaction must have both a substantial purpose aside from the reduction of tax liability and an economic effect aside from the tax effect in order to be considered valid.

History would commend that the doctrine of substance over form first in the context of corporate taxation emerged in the landmark judgment in the case of Commissioner Vs Court Holding Co (1945) 324 US 351. However, one could trace the doctrine of substance over form to judgments in the United Kingdom, in IRC Vs WT Ramsay [1981] 1 All ER 865, IRC Vs Burmah O9l Co Limited [1981] 54 TC 200, Furniss V.

Tax planning as the word signifies the with

Dawson [1984] 2 WLR 226, Craven V White [1989] AC 398.

2. Tax planning - An Indian context

Tax planning as the word signifies the objective of planning with the objective of saving taxes. It could be defined as an exercise by which a taxpayer determines his tax obligations in an orderly, systematic, disciplined, and scientific manner. One of the early judgments in this context was the judgment of the Hon’ble Supreme Court in BM Kharwar [1969] 72 ITR 603, where it was held that the legal effect of a transaction cannot be displaced by probing into the substance of the transaction. The Court also held that the tax authorities are also entitled to and are indeed bound to determine the true legal relations resulting from the transaction. It would be profitable to extract a pertinent observation from the judgment:

“It is now well-settled that taxing authorities are not entitled to ignore the legal character of the transaction which is the source of the receipt and to proceed on what they regard as the substance of the matter.”

This doctrine of tax planning came up for further consideration before the Hon’ble Supreme Court in the landmark judgment in the case of Mc Dowell & Co Limited [1985] 154 ITR 148 where the Hon’ble Court held that tax planning would be “legitimate” if it is within the framework of the law. However, “colourable devices” cannot be regarded as “tax planning”, as it is the obligation of every citizen to pay taxes honestly without resorting to subterfuges. This was also emphasized by Justice Sabyasachi Mukherjee in Playworld Electronics (P) Limited [1990] 184 ITR 308.

The distinction between “tax planning” and “tax avoidance” was in my opinion judicially first recognized in India, in the case of Jityajeerao Cotton Mills [1958] 34 ITR 888 before the Hon’ble Supreme Court. In this case, the Court while recognizing the right of an individual to arrange his affairs so as to avoid taxation provided the tool is real and genuine and not a sham or makebelieve. This was further expounded by the legal luminary, Late Justice Krishna Iyer in TN Aravinda Reddy [1979] 120 ITR 46, whose words I intend to borrow:

“A passing reference to avoidance and evasion of tax was made at the bar. A dubious refinement of an outdated legal culture sanctified, though by judicial dicta. The Court is not the mint of virtue and one day in our welfare State geared to social justice, this clever concept of 'avoidance' against evasion may have to be exposed. Enough unto the day is the evil thereof.”

Another leading judgment on the issue is the judgment in the case of Azadi Bachao Andolan (2003) 132 Taxman 373, which reiterated the principles in the case of Inland Revenue Commissioners Vs Duke of Westminister [1936] AC 1, which held that its ghosts have been exorcised. The Court further expounded the judgment in the case of Mc Dowell & Co Limited [1985] 154 ITR 148 to mean that the said judgment did not imply that tax planning is illegitimate or that every transaction or arrangement which is perfectly permissible under law, which has the effect of reducing the tax burden of the assessee, must be looked upon with disfavour. A key extract of the judgment is reproduced below for better understanding:

“Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. The effectiveness of the device depends not upon considerations of morality, but on the operation of the Income- tax Act. The legislative injunction in taxing statutes may not, except on peril of penalty, be violated, but it may lawfully be circumvented.”

The issues raised again came up for consideration before Justice Kapadia in the case of Vodafone International Holdings BV Vs Union of India (2012) 6 SCC 613 which is now indeed a locus classicus. In the said judgment, the Hon’ble Supreme Court had to deal with an issue concerning the taxability of capital gains arising on the transfer of shares between two non-residents of shares of a company that was not resident in India but in essence derived its value from subsidiaries in India. In this judgment, the Court emphasized the doctrine of “look at” and the “look through” approach.

3. Substance over form –

An Indian context

The concept of substance over form has been in a dynamic state in India. One would note that at times substance prevails over form and in certain situations form has prevailed over substance. In tax cases, in India, though the substance of the matter could be considered, the form of the relationship whether contractual or otherwise cannot be ignored, which has been well explained by the Hon’ble Bombay High Court in Provident Investment Co Limited [1953] 24 ITR 33.

In continuation of the discussion in Para 2 above, one would note that the views as stated above by the Hon’ble Supreme Court have ruled the field to hold that form must prevail till such form is regarded as “colourable”. In other words, till the form is regarded as deceitful, artificial, and devious, the need to review the “substance of the transaction” would not arise. Further, only where there is an extenuating or extraordinary circumstance, should the Court “look through” the form of the transaction to examine its purpose and decide that its substance was to avoid taxes. The change in thinking to review the substance over form came up pursuant to the judgment of the Constitution Bench of the Hon’ble Supreme Court in Mc Dowell Vs ITO [1985] 154 ITR 148. In my view, the vagaries of the judgment in the case of Mc Dowell were well articulated by the Hon'ble Gujarat High Court in the case of Banyan & Berry V CIT [1996] 222 ITR 831 which held that one cannot interpret the judgment in Mc Dowell to mean that any act of an assessee which results in reduction of his tax liability or expectation of a tax benefit in future would amount to a colourable device, a dubious method or subterfuge. An interesting from the judgment is extracted below:

“While the planning adopted as a device to avoid tax had been deprecated, the principle cannot be read as laying down the law that a person is to arrange his affairs so as to attract the maximum tax liability, and every act which results in tax reduction, exemption of tax or not attracting tax authorised by law is to be treated as a device of tax avoidance”

It would be pertinent to note that the judgment of the Gujarat High Court in the case of Banyan & Berry V CIT [1996] 222 ITR 831 was subsequently approved by the Hon’ble Supreme Court in the case of Azadi Bachao Andolan [2003] 132 Taxman 373.

One of the recent rulings dealing with the issue of tax planning is the recent judgment of the Hon’ble High Court of Andhra Pradesh in the case of Sanofi Pasteur Holding SA [2013] 354 ITR 316. As a precursor, the Authority of Advance Ruling by the lifting of the corporate veil held that an indirect transfer of shares of an Indian company under the India-France tax treaty was liable to tax in India. In the appeal, the Andhra Pradesh High Court held that the corporate veil of the French holding company cannot be pierced. The High Court held that the French holding company was an independent corporate entity that had commercial substance and business purpose and was not a device for avoiding taxes in India. In the said judgment, the High Court relied heavily on the dictum of the Hon’ble Supreme Court in the case of Vodafone (supra).

At the same time, one should also note that tax authorities are not expected to put on blinders while looking at documents produced before them. This has been upheld in a series of judgments dealing with the lifting of the corporate veil which is evident from CIT Vs Durga Prasad More [1971] 82 ITR 540 (SC), National Finance Limited [1962] 44 ITR 788 (SC).

In the context of sham transactions, the Delhi Tribunal had to decide on the legitimacy of a capital loss caused by a transaction between sister concerns. In the case of Consolidated Finvest & Holdings Limited

[2015] 152 ITD 792, the Tribunal had to consider the question as to whether the entire series of transactions would be reckoned as a sham merely because its sole purpose was to transfer funds from one company to another so as to generate capital loss to enable one company to avoid taxes on capital gains. The Tribunal held that as the earlier steps in the series of transactions were considered as genuine. A contrary ruling on similar facets was pronounced by the Hon’ble Karnataka High Court in the case of Wipro Limited [2014] 227 Taxman 244.

4. Emerging trends

4.1

Base Erosion and Profit Shifting

A new phenomenon in the offing has-been initiatives around Base Erosion and Profit Shifting (“BEPS”). The BEPS initiative shifts the entire focus to treaty shopping and other treaty abuse that in essence undermines the tax sovereignty by claiming benefits that were not intended to be granted. The BEPS Action Plan gives a clarion call for a realignment of taxation based on substance and the disbandment of the use of structures with shell companies that have little or no substance in terms of office space, tangible assets and employees. It would be profitable to recollect the quote of President John F Kennedy, which aptly summarizes the reasons behind BEPS:

“Recently more and more enterprises organized abroad by American firms have arranged their corporate structures aided by artificial arrangements between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights, the shifting of management fees, and similar practices… in order to reduce sharply or eliminate completely their tax liabilities both at home and abroad.”

As apparent, base erosion and profit shifting revolve around tax strategies that exploit gaps and mismatches in tax rules with the result that profits are shifted to jurisdictions where little or no economic activity or substantial activity is undertaken resulting in little or no overall corporate tax being paid.

4.2 General Anti-Avoidance Rules

Another interesting phenomenon has been the introduction of General Anti Avoidance Rules (“GAAR”), which has an overriding effect even over tax treaties through the introduction of Section 90(2A) of the Income-tax Act, 1961. This clearly shows a tectonic shift towards a substance-based system. In essence, once GAAR is invoked, Indian authorities have been bestowed with wide powers and discretion in taxing impermissible avoidance transactions, disregarding entities, reallocating income and even denying tax treaty benefits to a non-resident investor. Consequent to the introduction of GAAR, it now becomes imperative for taxpayers to bring to the fore the real intention and the purpose of the agreement between the parties, irrespective of the legal structure adopted. Further, the concept of impermissible avoidance arrangement contemplates a situation where an arrangement’s main purpose is to obtain a tax benefit and where it lacks commercial substance.

The term “substance" in my opinion does not merely encompass legal substance but also economic substance. In evaluating the economic substance, one would need to evaluate whether the taxpayer has a substantial nontax purpose for entering into the transaction. Meaningful change and substantial purpose would in my opinion embrace both qualitative and quantitative aspects

His Highness His Holiness Manavendravarma