FORENSIC ACCOUNTING

AVOIDANCE VERSUS EVASION

The Substance v. Form Debate

The Vodafone judgment re-ignited commentary on the matter of
whether the tax authorities and the Courts can disregard the
form (legal structure) of a transaction and determine
chargeability to tax on the basis of the substance (economic
reality) of the transaction. Counsel for Vodafone continuously
argued that the business arrangement did not result in a sham
transaction and was perfectly legal in form. Counsel for the
Revenue contended that the structure put into place by Vodafone
was calculated to avoid tax liability. This debate is important
because it could have far-reaching ramifications on tax planning.

Substance over form in England

Discussion on the substance vs. form debate normally begins by
analyzing the judgment of Inland Revenue Commissioners v Duke
of Westminster. Lord Russell observed that given that a
document or transaction is genuine, the court cannot go behind it
to some underlying substance. Later, in Commissioners of Inland
Revenue v Wesleyan and General Assurance Society, Viscount
Simon laid down two propositions: First, the name given to a
transaction by the parties concerned does not necessarily decide
the nature of the transaction and second, a transaction, which on
its true construction is of a kind that would escape tax, is not
taxable on the ground that the same result could be brought
about by a transaction in another form that would attract tax.
These cases adopt the form over substance principle.
The winds of change began to blow in W. T. Ramsay v Inland
Revenue Commissioners. The Ramsay  case while accepting the
principle laid down inDuke of Westminster as cardinal was
cautious to state that the principle must not be overextended.
Further the Court held that if it can be seen that a document or
transaction was intended to have effect as part of a nexus or
series of transactions, there is nothing in the doctrine to prevent
it from being so regarded. It was not until Inland Revenue
Commissioners v Burmah Oil Co. Ltd  that the full significance of
the judgment of Ramsay was realized. Lord Scarman observed
that the Ramsay case marked a significant change in the
approach by the House of Lords in its judicial role towards tax
avoidance schemes and that it was now crucial when
considering such schemes to take the analysis far enough to
determine where the profit, gain or loss is really to be found.
Further inFurniss v Dawson, Lord Brightman observed that the
fact that the Court accepted that contention that even where
each step in a transaction was a genuine step producing its
intended legal results, the Court was not confined to considering
each step in isolation for the purpose of assessing the fiscal
results. These cases suggest that the principle of substance over
form came to be adopted in the English courts.
However, there was further churning of the legal position.
In Macniven v Westmoreland Investments Limited, the House of
Lords, stating that Ramsaydid not lay down a new legal principle,
held that the need to consider a document or transaction in its
proper context and the need to adopt a purposive approach while
construing tax legislation are principles of general application
which depend on the particular set of facts and the particular
statute. Further in the case of Astall & Anr v Revenue and
Customs, Arden, LJ while discussing the
Ramsay, Burmah  and Furniss held that the proposition suggested
by these cases that in the application of any taxing statute,
transactions or elements of transaction which had no
commercial purpose were to be disregarded was going too far.
Thus the English law evolved to a position wherein the principle
of applying a substance over form approach or vice versa would
depend on the particular facts and the particular statute in
question.

The Indian Position

The position in India regarding the substance over form principle
has been steeped in controversy relating to interpretation.
In Commissioner of Income-Tax v A. Raman & Company, a Full
Bench of the Supreme Court rejected the Revenue’s
characterization of income which could have been earned by the
assessee but was not earned as a subterfuge of contrivance and
held that avoidance of tax liability by arranging commercial
affairs in a manner such that charge of tax is distributed is not
prohibited.
Following this was the highly controversial judgment of the
Constitution Bench of the Supreme Court in McDowell and Co.
Ltd. v Commercial Tax Officer.  All five judges were unanimous in
dismissing McDowell’s appeal but Chinnappa Reddy, J delivered a
separate judgment from Ranganath Mishra, J who was speaking
for the other four judges. As per Ranganath Mishra, J, tax
planning may be legitimate provided it is within the framework of
the law. Colourable devices cannot be a part of the law and it is
wrong to encourage or entertain the belief that it is honourable to
avoid payment of tax by resorting to dubious devices.
Chinnnappa Reddy, J in his separate judgment emphasized the
need to depart from the principle laid down in Duke of
Westminster and held that the proper way to construe a taxing
statute while considering a device to avoid tax is not to ask
whether a transaction is not unreal or not prohibited by the
statute but whether the transaction is a device to avoid tax and
whether the judicial process will accord its approval to it. The
difference in the approaches of the two Judges is clear. The rule
laid down by Chinnappa Reddy, J is much wider and seeks to
prohibit all devices to avoid tax, including those that fall within
the legal framework. The confusion with respect to interpreting
the judgment arises due to a sentence in which Ranganath
Mishra, J after asserting that tax planning within the legal
framework is not prohibited, states that Chinnappa Reddy, J has
proposed a separate opinion with which the remaining judges
agree.
The next stage of development in the position of law came in the
decision of a Division Bench of the Supreme Court in Union of
India & Anr. v Azadi Bachao Andolan and Anr. The Division Bench
observed that Chinnappa Reddy, J proceeded on the assumption
that the principle in Duke of Westminster had been departed from
by the House of Lords in Ramsay. The Bench then went on to
recount inter alia the case of Craven v White where it was held
that it is not a part of the judicial function to treat as nugatory
any step whatever which a taxpayer may take with a view to the
avoidance or mitigation of tax. Ultimately, the Division Bench
held that it was unable to agree with the view that the principle
in Duke of Westminster is dead and that the observations of
Shah, J inCIT v Raman  are very relevant today. Further, the
Bench also mentioned the decision of the Madras High Court
in M. V. Vallipapan & Ors v ITO where it was explicitly held that
the decision in McDowell cannot be read as laying down that
every attempt at tax planning is illegitimate and must be ignored.
However, an interesting controversy surfaced regarding the
observation of the Division Bench in Azadi Bachao Andolan.
Critics questioned how the Division Bench could detract from the
observations of the Constitutional Bench of the Supreme Court
in McDowell given that Ranganath Mishra, J in the latter case
explicitly stated that the judges whom he was speaking for
agreed with the separate judgment of Chinnappa Reddy, J on tax
avoidance. They argued thatAzadi Bachao Andolan was
decided per incuriam since the Constitutional Bench’s decision
was binding on the Division Bench. It appears however, that a
recent decision of the Bombay High Court prevents this anomaly
from being exploited. The Court held that the ratio
of McDowell as understood by the Supreme Court in Azadi
Bachao – Andolan  is the law, considering that this was the
manner in which the Supreme Court understood the ratio
decidendi of the judgment in McDowell.
Some commentators are of the opinion that the Supreme Court
in Azadi Bachao Andolan did not move away from the substance
over form principle laid down inMcDowell. They argue that the
Supreme Court even in the case of Azadi Bachao Andolan held
that substance in the transaction is the key for tax purposes.
However, the Court was quick to declare a transaction which
was otherwise in accordance with the law would receive the
blessings from the perspective of tax laws even if the
transactions was designed exclusively for tax saving purposes.
Accordingly, the Revenue was precluded from questioning the
commercial necessity or justification of a transaction provided
that such transactions was not colourable or prohibited by law.