ANTI TAX AVOIDANCE MEASURES

Westminister’s Law

“Avoidance of tax is not evasion and carries no ignominy” has been held in famous English decision IRC Vs. Duke of Westminister and famously known as Westminister’s law. It further said “Every citizen has legal right to dispose of his capital and income so as to attract upon himself the least amount of tax……. Given a document of transaction is genuine the court can not go beyond it to some underlying substance”

Analysis of Mcdowell’s Case

However the Mcdowell’s case upheld by Supreme Cout in 1985 did not find favour with tax planning resulting tax avoidance.Justice Ranganatha Mishra however in this case stated tax planning is legitimate provided it is with in framework of law, colourable devices can not be part of tax planning and it is wrong to promote avoidance of tax by resorting to dubious methods” In this judgement certain facts were misstaed by Justice Chinnappa Reddy like it was said that westminister principle is not applicable now even in England.

However just three years later English law upheld the validity of westminister principle in 1988 in “Craven v. White” and then again in 2001 in Mac Niven v. West Morland Investments Ltd.

Azadi Bachao Andolan

                        There after much sought after respite was provided by honourable Supreme Court in Union of India v. Azadi bachao Andolan where in the arguments put forth in Mc dowell’s case were outrightly rejected . Supreme Court held that Mc dowell judgement was nothing exceptional but exception to well settled law. Court held that Wetminster principle was applicable law when the constitution was formed. By virtue of Art 372 “all laws in force in territory of India before commencement of constitution shall continue in force unless altered or repealed by competent legislature or other competent authority” Court held that we are unable to under stand that an act other wise lawful can be held non est merely on basis of some underlying motive supposedly resulting detriment to revenue…….”

                        Review petition filed against Azadi bachao Andolan  in Shiv kant Jha Vs. UOI has also been dismissed.

Punjab & Haryana High Court in Porrits ans Spencer

This position has been confirmed by the Punjab and Haryana High Court in Porrits and Spencer V. CIT. The relevant observations are as follows:

“The argument of the learned counsel for the revenue-respondent based on the judgment rendered in the case ofMcDowell & Co. Ltd. (supra) cannot be accepted because the judgment rendered by Hon’ble Mr. Justice O. Chinnappa Eddy in McDowell’s case has been explained in detail by the later judgment of Hon’ble the Supreme Court in the case of Azadi Bachao Andolan (supra). It is well settled that if a smaller Bench of Hon’ble the Supreme Court has lateron explained its earlier larger Bench then the later judgment is binding on the High Court. In that regard reliance may be placed on a Full Bench judgment of this Court rendered in the case of State of Punjab v. Teja Singh, (1971) 78 PLR 433. Speaking for the Bench, Hon’ble Mr. Justice S.S. Sandhawalia observed as under:- “Now it is trite learning to say that when an earlier judgment of the Supreme Court is analysed and considered by a latter Bench of that Court then the view taken by the latter as to the true ratio of the earlier case is authoritative. In any case latter view is binding on the High Courts.”

The following conclusions can be drawn from this discussion:

a) Tax planning is an entitlement of the assessee within the contours of law.

b) Any genuine attempt to plan the financial and economic affairs should not be discouraged merely by taking shelter under McDowell’s judgment.

c) Tax incentives availed of by an assessee should be within the ambit of legitimate tax planning.

d) Tax planning should not involve use of colourable devices for reducing tax liability

Vodaphone Case

In  Vo d a f o n e   I n t e r n a t i o n a l  Ho l d i n g s   B V v.   Un i o n   o f   I n d i a , Hutchinson International (non-resident company) held 100% shares of CGP Investments Holdings Ltd. (non-resident company) which in turn held 67% shares in the Indian company Hutchinson-Essar. Hutchinson-Essar was a joint venture between Hutchinson International and Essar.  Vodafone International Holdings BV (non-resident company) acquired the entire share capital of CGP Investments Holdings Ltd. from Hutchison International. This resulted in an indirect transfer of 67% shareholding in Hutchinson-Essar to Vodafone.

The question which arose was, whether the income accruing to Hutchinson as a result of the transaction could be deemed to accrue or arise

in India by virtue of S. 9 of the Income Tax Act. The Income Tax Department issued Vodafone a show cause notice asking why action should not be taken against it for failing to deduct tax at source under S. 195 of the ITAct while making payment of the consideration to Hutch. The validity of the show-cause notice was challenged by Vodafone in a writ petition before the Bombay High Court. The High Court held that the writ petition challenging the show-cause notice was premature as an alternative remedy was available to the petitioner.  Vodafone appealed in the Supreme Court. The petition was dismissed with a direction to reagitate the jurisdictional issue before the assessing officer.

                                    In Vodafone, the High Court answered all issues against Vodafone.

In Vodafone, the High Court tried to lift the veil over the intermediary foreign company, holding that the transfer of shares of the intermediary company in fact amounted to the transfer of controlling interest in Hutchinson-Essar which is an Indian company. Interestingly, in response to a specific query from the High Court, the learned Additional Solicitor General categorically asserted that it was not the case of the respondents that the transaction entered into by Hutchinson and Vodafone was a colourable attempt to evade tax. It was also not contended that the corporate entity was abused for unjust and inequitable purposes. The Court lifted the corporate veil without any discussion on the fulfillment of these conditions, ignoring the principle that lifting the corporate veil is an exception and not a rule by itself.

The stream of reasoning in the Vodafone judgment lacks logic and coherence which are the essential ingredients of legal reasoning. The judgment completely disregarded the principles laid down in McDowell and Azadi Bachao Andolan judgments. It was not proved that the arrangement/transaction was a colourable device to bring down tax liability. This sets in a dangerous precedent which may jettison any tax planning  involving a corporate entity.

E Trade Maritius Ltd.

Advance Ruling Authority (hereinafter AAR) ruling in E*Trade Mauritius Ltd. is As under:

The applicant, a resident of Mauritius, was a subsidiary of a USA company. It received capital contribution and loans from the USA parent

which were used to purchase shares in ILFS, an Indian company. On the sale of shares, the applicant earned capital gains which were taxable under the ITAct. However, under Article 13 (4) of the India-Mauritius tax treaty, such gains were not taxable in India. The applicant filed an application for advance ruling on the question whether in view of Article 13 (4), the gains were chargeable to tax in India. The department resisted the application on the ground that though the legal ownership ostensibly vested with the applicant, the real and beneficial owner of the capital gains was the US Company which controlled the applicant. The applicant was merely a façade of the US holding Company to avoid capital gains tax in India. Rejecting the contention of the department and relying on Azadi Bachao Andolan judgment, it was held that there was no “legal taboo” against ‘treaty shopping’.

It was held that the underlying objective of tax avoidance/mitigation cannot be equated to a colourable device. If a resident of a third country, in order to take advantage of a tax treaty sets up a conduit entity; the legal transactions entered into by that conduit entity cannot be declared invalid. The motive behind setting up such conduit companies is not material to judge the legality or validity of the transactions. However, a colourable device adopted through dishonest methods deserves perusal from the tax angle. Tax avoidance is not objectionable, if it is within the framework of law and not prohibited by law. However, a transaction which is ‘sham’ in the sense that ‘the documents are not bona fide in order to intend to be acted upon but are only used as a cloak to conceal a different transaction’ stands on a different footing. An act is a ‘sham’ if the parties have a common intention not to create legal rights and obligations which they appear to create.

As all legal formalities for the purchase of the shares and their subsequent transfer had been completed, the assumption that the capital gain had not arisen in the hands of the applicant but had arisen in the hands of the USA parent did not hold ground. The fact that the holding company exercised control over its subsidiary did not, in the absence of compelling reasons, dilute the separate legal identity of the subsidiary. Thus, it was held that the India Mauritius treaty benefits could not be denied on the ground that assessee was a subsidiary of US corporation.

Voda Phone Vs. E- Trade Mauritius

On the other hand, in Vodafone, as mentioned earlier, the department did not even contend that the transaction was a ‘sham’ or a colourable attempt to avoid tax. Nor was there any attempt to characterize the transaction as an ambiguous transaction. For these reasons, the High Court should not have ignored the form of the transaction viz. selling shares of a company, by another company to a third company. The High Court, ignoring the legal form, held that the petitioner had  prima facie acquired, apart from controlling interest, other interests and intangible rights from the transaction.  The judgment, if it becomes final, can frustrate any tax planning involving a corporate entity as the corporate veil can be lifted at will in all impugned transactions.

Introduction of  ANTI TAX AVOIDANCE MEASURES in DTC

It is in this back drop that need for anti tax avoidance measures was  felt while drafting Direct Tax Code. Discussion paper echoes the objective in these words: “Tax avoidance, like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner.…Therefore, there is a strong general presumption in the literature on tax policy that all tax avoidance, like tax evasion, is economically undesirable and inequitable. On considerations of economic efficiency and fiscal justice, a taxpayer should not be allowed to use legal constructions or transactions to violate horizontal equity

Hence following measure are being pondered over to defeat tax planning

a)      General Anti Tax Avoidance measures under section 123 of DTC

b)      Change in definition of residence for companies u/s 4(3) of DTC

c)      Controlled Foreign Corporation Provision under sch 20 of DTC

d)      Overriding DTAA through s. 291(9) of DTC

A.General Anti Tax Avoidance measures under section 123 of DTC

Under section 123 od DTC Commissioner can declare any arrangement an impermissible avoidance arrangement (IAA).

IAA as per S.124(15) means , an arrangement, whose main purpose is to obtain a tax benefit and it:

i       creates rights, or obligations, which would not normally be created between persons dealing at arm’s length;

ii      results, directly or indirectly, in the misuse, or abuse, of the provisions of the DTC;

iii    lacks commercial substance, in whole or in part; or

iv   is entered into, or carried out, by means, or in a manner, which would not normally be employed for bona fide purposes.

                        These definitions of “arrangement” and “impermissible avoidance arrangement” are broad enough to include even bona fide commercial transactions which are permissible in the light of McDowell and  Azadi Bachao Andolan judgments. GAAR would apply to those transactions which the Commissioner presumes to be motivated by tax avoidance. The concerned commercial transaction shall be deemed to be for the main purpose of obtaining tax benefit. It has been left to the taxpayer to demonstrate otherwise. The Commissioner has the powers to disregard, re-characterise or combine transactions at his will.

                        Effectively, the Commissioner can lift the corporate veil to ascertain the “substance” of the transaction as and when desired. Thus the broadly worded GAAR   can allow the department to perceive a subsidiary as an agent or asset of the holding company at its will. This is a clear departure from the existing legal principles which have set a certain threshold for lifting the corporate veil  . This can result in uncheckedscrutiny of any tax planning involving a subsidiary. DTC provides that a transaction would fall outside the rule if it was carried out for commercial and economic reasons. However, considering the extensively worded provision and the discretion conferred upon the department, it is impossible for a corporate to satisfactorily pre-determine its tax liability till the completion of due diligence by revenue authorities.The Revised Discussion Paper (RDP) on Direct Taxes Code which was released on 15 th  July, 2010, attempted to address some of these concerns. According to RDP, GAAR provisions do not envisage treating each and  every arrangement as impermissible avoidance arrangements. The provisions shall be attracted only when the arrangement, besides obtain ing tax benefit for the assessee, satisfies one of the four conditions as laid down in § 113 of DTC. The RDP proposed the following safeguards for invoking GAAR provisions:

a)    issue of guidelines by Central Board of Direct Taxes

b)    invoking  GAAR provisions in respect of an arrangement where tax avoidance

is beyond a specified threshold limit

c)    providing Dispute Resolution Panel for addressing grievances

The proposals such as issue of guidelines and specifying threshold limit for tax avoidance will enable the department to unilaterally draw the contours of GAAR. Thus, contingent upon the language of guidelines and the specified threshold limit, any use of corporate vehicle for tax planning may attract GAAR provisions.  Further, as the composition of Dispute Resolution Panel is unknown,

it remains to be seen whether it will serve as an appropriate forum for adjudicating GAAR disputes.

B. THE CONCEPT OF RESIDENCE  IN CASE OF A COMPANY INCORPORATED OUTSIDE INDIA

Under § 6(3) of the Income  Tax Act, a foreign company shall be considered to be resident in India only if the “whole” of the control and management of its affairs are located in India. The DTC has widened the concept of residence.According to RDP, a company incorporated outside India will be treated as a resident in India and subjected to tax if its “place of effective management” is

situated in India.

 The term shall have the same meaning as currently laid down in the s.314(192), that is:

a)     the place where the Board of Directors (BoD) of the company or its executive directors, as the case may be, make their decisions; or b)  in a case where the BoD routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions. Accordingly, applying situation a) as mentioned above, a company may be treated as a resident even when the BoD takes any routine or ordinary decision from India, and does not necessarily encompass situations  where crucial strategic  decisions are taken. Thus the contours are ambiguous and uncertain. In essence, though RDP attempted to address the concerns raised by DTC and DP on definition of “resident” , it failed to bring in clarity in this regard. Therefore, we suggest that the first condition should be clarified to state that the place of

effective management is the place where  key management and commercial decisions that are necessary for the conduct of the entity’s business are, in substance, made. Else, the test of effective management shall not only broaden the ambit of taxability of companies, but also make the application of the test uncertain and be subject to interpretation by Courts at a subsequent stage, thereby making tax planning more difficult.

C. CONTROLLED FOREIGN CORPORATION PROVISIONS

RDP has proposed for Controlled Foreign Corporations (CFC) provisions in DTC. CFC is a corporate entity which conducts business in one jurisdiction (foreign country) but is owned or controlled(50% or more) primarily by the resident taxpayers of another jurisdiction. CFCs deliberately route their investments through tax havens (i.e. where corporate rate of tax is lower as compared to India) to avoid payment of taxes on income at home. As income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer, the mechanism enable the shareholders to defer the payment of taxes. Passive income earned by a foreign company which is controlled directly or indirectly by a resident in India, and where such income is not distributed to shareholders resulting in deferral of taxes, shall be deemed to have been distributed. Consequently, it would be taxable in India in the hands of resident shareholders as dividend received from the foreign company.

D. DOUBLE TAXATION AVOIDANCE AGREEMENT

Double Taxation Avoidance Agreements (DTAAs) are commonly opted by multinational companies (MNCs) for enjoying tax benefits. It is a common practice among them to establish Special Purpose Vehicles (SPVs) in tax havens such as Mauritius or Cayman Islands for holding shares in downstream Indian companies. According to RDP, an assessee will be free to opt for either DTAA provisions or DTC, whichever is more beneficial. Although RDP attempted to address the concerns raised by DTAA provisions in DTC , uncertainty still remains. DTAA, according to RDP, shall not inter alia enjoy preferential status when the Revenue Department invokes GAAR or CFC provisions. As the DTAA provision is evidently linked to the contours of GAAR and CFC provisions which remain highly ambiguous and unsatisfactory, RDP has not adequately addressed the concerns raised in this regard.

                                                In Nutshell, through introduction of anti tax avoidance measures unbridles powers have been vested with tax authorities.