Pramod KumarInternational Taxation Conference – FIT, India December 6,2012

Pramod KumarInternational Taxation Conference, Mumbai December 6, 2012.

This presentation seeks to present the factual and legalelements relating to various points of view about theconcept of substance over form in Indian Tax laws. Thispresentation is only a compilation of such points of viewand does not canvass or support any particular point ofview. The views expressed herein, therefore, do notnecessarily reflect the views or the understanding of theauthor or his employer i.e. the Income Tax AppellateTribunal, Government of India.

This presentation deals only with the judicial doctrine ofsubstance over form, and does not deal with GAAR, onwhich a separate presentation is being made later, as alsoon statutory provisions dealing with substance over form.

Doctrine of substance over form is a judicial creation. It isinvoked in cases in which taxpayer has conducted a schemeof transactional relationships in documents and has a view ontax advantages that flow from tax reporting based on suchtransactional relationships, rather than on the substance ofarrangement. The economic reality is thus hidden andtransaction exists in form only.

This doctrine allows tax authorities to ignore the legal formof an arrangement and to look at its actual substance, so asto prevent artificial structures from being used for taxavoidance purposes.

In its pure form, when, on the basis of evaluation ofevidence and analysis of facts, judicial authorities findthat tax motivation outweighs business purpose orprofit objective, it is held that the taxpayer‟s efforts ofform does not reflect the substance of economictransactions, and intended tax benefits are declined.

Recent Indian decisions, however, can be viewed asproceeding on the basis that substance prevails overform only when the form has no commercialjustification whatsoever and is completely tax driven.

It is extremely difficult, if not altogether impossible, forlegislation to keep pace with dynamism of, and innovationsin, business and commerce, and therefore, normativesystems, which legal provisions inherently are, cannoteffectively handle the aggressive tax positions taken by thebusinesses.

This doctrine provides flexibility to judges to deal with thecases not visualized by the legislature and, as a judicialdoctrine, it is inherently more flexible than a statutory rule, itcan develop gradually and it cannot be undermined bymicroscopic examination in search of loopholes.

Substance over form is one of the fundamental tax issuesdebated right from the initial days of tax laws in India, but initialcontroversies about characterization of income and expenditure,and nomenclature assigned to the same by the taxpayers.Relatively simple matters and no major issues arose onapplication of this doctrine.

The focus is now due to revenue‟s challenge to investment andtransaction structures on the basis that use of intermediatecompanies is for dominant purpose of obtaining tax benefits –through treaty or otherwise. Relatively complex issues butdoctrine of substance over form applied mainly when thestructure is completely tax driven and devoid of any commercialjustification whatsoever.

Judiciary cannot be a silent spectator when facts andcircumstances clearly warrant the inference that there has been adubious, though seemingly legal, method adopted with the solemotive of avoiding taxes.

The role played by judges while handling tax cases is a tightrope walk. On the one hand, they should be entirely neutraltowards the parties, even if not value neutral, and, on the otherhand, their judgments should be objective, fair, reasonable andunaffected by their ideologies. Indian judicial doctrine on thesubstance over form, by and large, reflect this position.

Not everyone in the judiciary is, or can be, really confidentin meeting the challenge of looking through the complexmaze of contrived transactions, and understanding thecore economic and business realities of such transactions.Is that the reason, as many believe, judiciary prefers to goby the form and prone to err on the side of excessivecaution at the cost of the exchequer ?

Should the judiciary be content with foundationalistapproach to interpretation of tax statutes by implementingits plain meaning, intent or purpose, or has the time comethat judges should approach the tax statutes by exploringfor most sensible policy option. Will latter will essentiallylead to more emphasis on substance over form ?

It is a controversial issue as to whether doctrine of substanceover form can be invoked only when the form of transactionis completely tax driven or whether it can also be invokedwhen tax motivation clearly outweighs the business purposeor profit objective. Judicial precedents seem to be in favour ofthe former approach as on now, but there is little conceptualjustification in its support.

Is the legislation on GAAR intended to fill in this gap createdby, what tax administration may perceive as, judicial inertiaand inconsistency in applying judicial doctrine of substanceover form ?

Legal substance :

Legal substance generally prevails over form. When despite the legal steps, intended legal results not obtained, the court could be justified in ignoring the intermediate steps.

Economic substance :

Economic substance applies over form, it is often argued, onlywhen it is completely tax driven, devoid of any otherconsideration and revenue authorities are able to demonstratethat position.

If the Court finds that notwithstanding a series of legal stepstaken by an assessee, the intended legal results have notbeen achieved, the Court might be justified in overlooking theintermediate steps, but it would not be possible for the Courtto treat the intervening steps as non est based on somehypothetical assessment of real motive of the assessee. In ourview, the Court must deal with what is tangible in an objectivemanner and cannot afford to chase a will-o'-the-wisp

Union of India Vs Azadi Bachao Andolan(263 ITR 706 – Supreme Court)

“………It is well established that in a matter of this descriptionthe Income- tax authorities are entitled to pierce the veil ofcorporate entity and to look at the reality of the transaction. Itis true that from the juristic point of view the company is alegal personality entirely distinct from its members and thecompany is capable of enjoying rights and being subjected toduties which are not the same as those enjoyed or borne byits members. But in certain exceptional cases the Court isentitled to lift the veil of corporate entity and to pay regard tothe economic realities behind the legal facade. For example,the Court has power to disregard the corporate entity if it isused for tax evasion or to circumvent tax obligation.”

CIT Vs Meenakshi Mills Ltd (63 ITR 609)

“It is true that apparent must be considered real unless it isshown that there are reasons to believe that apparent is notreal. If all that an assessee, who wants to evade tax, is to havesome recital made in documents either executed by him orexecuted in his favour, then the door will be left wide open toevade tax. …….The taxing authorities were not required toput on blinkers while looking at the documents producedbefore them. They were entitled to look into surroundingcircumstances to find out reality of recitals made in thosedocuments….”

CIT Vs Durga Prasad More

82 ITR 540 - Supreme Court

“Tax planning may be legitimate provided it is withinthe framework of law. Colourable devices cannot bepart of tax planning and it is wrong to encourage thebelief that it is honourable to avoid tax by resorting tosubterfuges. It is the obligation of every citizen to paythe taxes honestly without resorting to subterfuges

“On this aspect (i.e. tax evasion through use ofcolorable devices and by using dubious methods andsubterfuges*), one of us, Chainappa Reddy J, hasproposed a separate opinion with which agree.”

McDowell & Co Ltd Vs CTO (154 ITR 148)Justice Ranganath Mishra (speaking for the majority )

* See Justice Kapadia‟s observations in Vodafone case

“……….in the very country of its birth, the principle ofWestminster has been given a decent burial and in that verycountry where the phrase 'tax avoidance' originated thejudicial attitude towards tax avoidance has changed and thesmile, cynical or even affectionate though it might have beenat one time, has now frozen into a deep frown. The Courtsare now concerning themselves not merely with thegenuineness of a transaction, but with the intended effect ofit for fiscal purposes. No one can now get away with a taxavoidance project with the mere statement that there isnothing illegal about it.”

“ It is neither fair not desirable to expect the legislature tointervene and take care of every device and scheme to avoidtaxation. It is up to the Court to take stock to determine thenature of the new and sophisticated legal devices to avoid taxand consider whether the situation created by the devicescould be related to the existing legislation with the aid of'emerging' techniques of interpretation was done in Ramsay(1982 AC 300), Burma Oil (1982 STC 30) and Dawson (1984-1 All ER 530), to expose the devices for what they really areand to refuse to give judicial benediction.”

…. opinion of the majority is a far cry from the view ofChinnappa Reddy,J (in McDowells‟s case): "In our view theproper way to construe a taxing statute, while considering adevice to avoid tax, is not to ask whether a provision shouldbe construed liberally or principally, nor whether thetransaction is not unreal and not prohibited by the statute,but whether the transaction is a device to avoid tax, andwhether the transaction is such that the judicial process mayaccord its approval to it." We are afraid that we are unable toread or comprehend the majority judgment in McDowell ashaving endorsed this extreme view of Chinnappa Reddy,J,which, in our considered opinion, actually militates againstthe observations of the majority of the Judges…

We may also refer to the judgment of Gujarat High Court inBanyan and Berry v. Commissioner of Income-Tax wherereferring to McDowell , the Court observed: "The courtnowhere said that every action or inaction on the part of thetaxpayer which results in reduction of tax liability to which hemay be subjected in future, is to be viewed with suspicionand be treated as a device for avoidance of tax irrespective oflegitimacy or genuineness of the act…. The ratio of anydecision has to be understood in the context it has beenmade. ………….

…………The facts and circumstances which lead toMcDowell's decision leave us in no doubt that the principleenunciated in the above case has not affected the freedom ofthe citizen to act in a manner according to his requirements,his wishes in the manner of doing any trade, activity orplanning his affairs with circumspection, within theframework of law, unless the same fall in the category ofcolourable device which may properly be called a device or adubious method or a subterfuge clothed with apparentdignity.

This accords with our own view of the matter.”

“ In our view, although Justice Chainappa Reddy makes a number ofobservations regarding the need to depart from the „Westminster‟and tax avoidance – these are clearly in the context of artificial andcolourable devices. Reading McDowell, in the manner indicatedhereinabove, in cases of treaty shopping and/ or tax avoidance,there is no conflict between Mc Dowell and Azadi Bachao…”

(Justice Kapadia)

“..a clear cut distinction between tax avoidance and tax evasion isstill to emerge in England and in the absence of any legislativeguidelines, there is bound to be uncertainty ...................... ............….emphasized that the Ramsay approach as a principle of statutoryinterpretation rather than an over-arching anti avoidance doctrineimposed upon tax laws. (Justice Radhakrishna)

“When it comes to taxation of a holding structure, the burdenis on the Revenue to allege and establish tax abuse, in thesense of tax avoidance in the creation and/ or use of suchstructure(s).”

“In the application of a judicial anti avoidance rule, theRevenue may invoke the “substance over form” principle or“piercing the corporate veil” test only after it is able toestablish, on the basis of facts and circumstancessurrounding the transaction that the impugned transaction isa sham or tax avoidant.”

“To give an example, if a structure is used for circulartrading or round tripping or to pay bribes then suchtransactions, though having a legal form, should bediscarded by applying the test of fiscal nullity. Similarly, ina case where the Revenue finds that in a Holding Structurean entity which has no commercial/business substance hasbeen interposed only to avoid tax then in such casesapplying the test of fiscal nullity it would be open to theRevenue to discard such interpositioning of that entity.However, this has to be done at the threshold.”

“It is the task of the Revenue/Court to ascertain the legalnature of the transaction and while doing so it has to lookat the entire transaction as a whole and not to adopt adissecting approach.”

“...we are of the view that every strategic foreign directinvestment coming to India, as an investment destination,should be seen in a holistic manner. While doing so, theRevenue/Courts should keep in mind the following factors:the concept of participation in investment, the duration oftime during which the Holding Structure exists; the period ofbusiness operations in India; the generation of taxablerevenues in India; the timing of the exit; the continuity ofbusiness on such exit. In short, the onus will be on theRevenue to identify the scheme and its dominant purpose.”

Although there is a mention of „dominant purpose‟ of thescheme here, earlier observations refer to discarding thestructure when it has “no commercial/ business substance”.

The doctrine of substance over form well entrenched in Indiantax laws, even as its application may not be as uniform andconsistent as aggressively pursued by the revenue authorities.

It is only in extreme cases where form of a transaction is not atall defensible on commercial basis (other than for tax planning)that the doctrine of substance over form is invoked. As long asthere is some commercial justification for the form of atransaction, judiciary generally refrains from invoking it

Schemes and transactions where economic substance issignificantly different from the legal form, or where an entitywithout economic substance is used in a transaction, are at risk.

Thank you !

pramod.kumar@itat.nic.in