THE controversies surrounding the various tax-avoidance schemes that exploded in the public domain in the last couple of years in the UK and elsewhere reignites the seemingly eternal debate relating to the difference between tax planning and tax avoidance. In this context, it may be worthwhile to retrace the steps and look at the origin and development of the concept.

While it is easy to define tax evasion, it is not so easy in case of tax avoidance. Tax evasion is as simple as breaking the law, which is committed by the hoi polloi of the tax fraternity, the lowly pick-pockets, thieves, et al of the day to day tax world, while tax avoidance belongs to the sophisticated realm of the elites of the tax world. In fact, the doyens of tax world would take objection to the use of the term ‘avoidance' and would like to call it intelligent planning of tax while remaining strictly within the letters of the law.

It is in fact the importance given to the strict meanings of the letters of the law by the judiciary that gave birth to the above practice. An over simplified example illustrates the point. Let us assume for the sake of argument that Indian Penal Code defined ‘murder' as killing someone with a sharp object. Now if I battered someone to death with a blunt wooden pole, will it amount to murder? I think everyone in the society will be aghast that such a naive query can be raised and will unanimously condemn me as a murderer, but the question is whether the judiciary will also feel the same way and consider itself competent to interpret the act as that of murder or will it call upon the Legislature to change the law.?

In the beginning :

The answer will be mostly in the negative in the tax world. It is because, as early as in 1926 in the case of Fisher's Executors (1926 AC 395, 412), and in a large number of subsequent decisions to this effect, the House of Lords observed: “The highest authorities have always recognized that the subject is entitled so to arrange his affairs as not to attract taxes imposed by the Crown, so far as he can do so within the law, and that he may legitimately claim the advantage of any expressed terms or any omissions that he can find in his favour in taxing Acts. In so doing, he neither comes under liability nor incurs blame.” This was subsequently followed in the famous case of Duke of Westminster v. Commissioners of Inland Revenue (19 TC 490) wherein in the year 1936, Lord Tomlin observed : “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 …”

Indian courts at that time closely followed the decisions of the British courts and the above principle was quoted with approval by Privy Council in 1940 in the case of Bank of Chettinad Ltd (8 ITR 522). In 1953, Justice Chagla reiterated the same view in the case of Provident Investment Co. Ltd (24 ITR 33,40) (Bom): “A citizen is perfectly entitled to exercise his ingenuity so to arrange his affairs as may make it possible for him legally and lawfully not to pay tax, and if his ingenuity succeeds, however reluctant the Court may be to acknowledge the cleverness of the taxpayer the Court may give effect to the letter of the taxation law rather than strain that letter against the taxpayer. In other words, there was no compulsion to pay taxes; it was only a legal liability which could be avoided with ingenuity”.

Discordant views:

However, a discordant note also started being voiced by a certain members of the judiciary. The murmurs against tax avoidance became louder as the tax avoidance practices became more and more sophisticated. As early as in 1940, it was observed by Viscount Simon, Lord Chancellor, House of Lords in the case of Latilla (25 TC 107,117) – “Of recent years much ingenuity has been expended in certain quarters in attempting to devise methods of disposition of income by which those who were prepared to adopt them might enjoy the benefits of residence in this country while receiving the equivalent of such income, without sharing in the appropriate burden of British taxation. Judicial dicta may be cited which point out that, however elaborate and artificial such methods may be, those who adopt them, are ‘entitled' to do so. There is, of course, no doubt that they are within their legal rights, but that is no reason why their efforts, or those of the professional gentlemen who assist them in the matter, should be regarded as commendable exercise of ingenuity or as a discharge of the duties of good citizenship. On the contrary, one result of such methods, if they succeed, is of course, to increase pro tanto the load of tax on the shoulders of the great body of good citizens, who do not desire, or do not know how, to adopt these manoeuvres. Another consequence is that the Legislature has to make amendments to our Income-tax Code, which aims at nullifying the effectiveness of such schemes.”

In In re Westem's Settlements a British Court further observed: “There must be some limit to the devices which this Court ought to countenance in order to defeat the fiscal intentions of the legislature. In my judgement, these proposals overstep that limit. I am not persuaded that this application represents more than a cheap exercise in tax avoidance which I ought not to sanction, as distinct from a legitimate avoidance of liability to taxation.”

In the case of Campbell v. IRC (1967 Ch. 651), it was observed - “It smells a little of the lamp. It is a splendid scheme. It is almost too good to be true; in law, quite too good to be true. It won't do.”

Justice Krishna Iyer made a somewhat prophetic remark by way of obiter, while allowing the assessee's claim in the case of T.N.Aravinda Reddy (120 ITR 46, 49), -“… a passing reference to avoidance and evasion of tax was made at the bar, a dubious refinement of a dated 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. ”

Corporate veil:

Long back in the year 1897 in the case of Salomon v. Salomon & Co. (1897 AC 22), a British Court held that a corporation is an independent juristic entity separate from its members capable of holding properties and performing duties and accepting liabilities. This simple principle has been used and is still being used for framing various tax avoidance schemes using corporations and their subsidiaries. Such schemes came to judicial notice and Courts occasionally did not hesitate to lift the corporate veil to unravel the true legal relationship or the legal nature of the transaction.

The issue came up before Supreme Court in the case of Meenakshi Mills Ltd (63 ITR 609). In this case, the taxpayer company was engaged in the production and sale of cotton yarn in British India and had a branch in a native State. The taxpayer company and its promoters were the major shareholders of a bank, which also had its registered office in British India and a branch in the same native State. The branch office of the taxpayer company had deposited its sales turnover with the branch of the bank as fixed deposits on interest. The branch had transmitted the funds to its head office in British India. The taxpayer company had taken loan from the head office on the security of the fixed deposits. The Court held that the entire transactions formed part of a basic arrangement or scheme between the taxpayer company and the bank that the moneys deposited by the taxpayer company in the native State should be brought into British India after they were taken by the bank outside the taxable territories. The interest on fixed deposits made by the taxpayer with the branch of the bank outside British India was held to be taxable in British India. The Court observed: “It is true that from the juristic point of view, the company is a legal personality entirely distinct from its members and the company is capable of enjoying rights and being subjected to duties which are not the same as those enjoyed or borne by its members. But in certain exceptional circumstances the Court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal façade. For example, the Court has power to disregard the corporate entity if it is used for tax evasion or to circumvent tax obligation.” (page 616)

The Court had referred to two decisions of the British Court. The first one was in the case of Apthorpe v. Peter Schoenhofen Brewing Co. (4 TC 41), wherein the income-tax commissioners had found as a fact that all the property of the New York company, except its land, had been transferred to an English company, and that the New York company had only been kept in being to hold the land, since aliens were not allowed to do so under the New York law. All but three of the New York company shares were held by the English company, and as the commissioners also found, if the business was technically that of the New York Company, the latter was merely the agent of the English company. In the light of these findings the Court held that the New York business was that of the English company, which was liable for English income-tax accordingly.

In the second case (Firestone Tyre & Rubber Co 33 ITR 741), an American company had a wholly owned subsidiary in England, which manufactured goods for it. The parent company had an arrangement with its distributors in the continent of Europe, whereby the distributors obtained their supplies from the subsidiary in England. The subsidiary credited the parent company with the sale proceeds after deducting the costs plus five per cent. The Court held that these sales were a means whereby the American company carried on its European business and the substance of the arrangement was that the American company traded in England through the agency of its subsidiary.

Lord Denning of House of Lords, U.K. was one of the foremost judges in U.K., who always tried to look at the real essence of a transaction and ignore devices. In a case of dividend stripping, i.e., acquisition of shares pregnant with dividend at a higher price and its subsequent sale, after declaration of dividend, at a much lower price to generate a tax loss, while the dividend income is tax exempt, (Griffith v. Harrison (Watford) Ltd 1963 AC 1) he held that the whole transaction has to be looked at commercially. From the commercial point of view, it was a composite transaction and the tax payer will not be taken to have made a loss if the dividend income is equal to or more than the shortfall in the sale price of shares compared to purchase price. He held that no claim of loss can be allowed in computation of income, unless it is a loss in the real and commercial sense.

In the case of Littlewoods Mail Order Stores (75 ITR 327), the assessee company was in possession of a premises as lessee for a lease period of 99 years, for an annual lease rent much less than the market rent. The assessee surrendered the lease to the lessor and obtained a new lease for 22 years for a nominal lease rent. The new lease was assigned to the wholly owned subsidiary of the assessee company, which in turn gave an under lease to the assessee for a much higher lease rent than the assessee was originally paying. The subsidiary then assigned the under lease to the lessor and in turn acquired reversionary rights in the freehold property, after expiry of the lease term of 22 years. The net result of the transactions was that the assessee surrendered the lease of 99 years with a lesser annual rent, for a shorter lease of 22 years for a higher annual rent with the condition that its wholly owned subsidiary would become the owner of the property after 22 years. Lord Denning observed - “I decline to treat the (subsidiary) as a separate and independent entity. The doctrine laid down in Salomon v. Salomon & Co. has to be watched very carefully. It has often been supposed to cast a veil over the personality of a limited company through which the Courts cannot see. But that is not true. The Courts can and often do draw aside the veil. They can, and often do, pull off the mask. They look to see what really lies behind…….. I think that we should look at the subsidiary and see it as it really is - the wholly owned subsidiary of the assessee company. It is the creature, the puppet of the assessee, in point of fact: and it should be so regarded in point of law. The basic fact here is that the assessee through its wholly owned subsidiary has acquired a capital asset by paying extra lease rent over a period.” (page 346).

The Supreme Court reiterated this view in the case of JuggilalKamlapat (73 ITR 702,710) : “In a matter of this description it is well established that the income-tax authorities are entitled to pierce the veil of corporate entity and look at the reality of the transaction. It is true that from juristic point of view the company is a legal personality entirely distinct from its members and the company is capable of enjoying rights and being subject to duties which are not the same as those enjoyed or borne by its members. But in certain exceptional circumstances the Court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal façade.”

In this case, the assessee firm was appointed as the managing agent of a sister concern, a company in which the partners of the assessee firm and their wives held majority shares. The managed company claimed to be in need of additional funds for repaying loans and for working capital. It asked the assessee firm for a loan, who expressed inability. The managed company decided to terminate the managing agency and pay a substantial compensation to the assessee firm. It appointed another sister concern as managing agent. The partners of the assessee firm and their wives held majority shares in this concern also. The Court held that the whole series of transactions were collusive, aiming to make a tax-free payment to the assessee firm.

(To be concluded)