Sec.54F of the Income Tax Act,1961:
54F. (1) Proviso specifies that nothing contained in this sub-section shall apply where the assessee,—
i. owns more than one residential house, other than the new asset, on the date of transfer of the original asset; or
ii. purchases any residential house, other than the new asset, within a period of one year after the date of transfer of the original asset; or
iii. constructs any residential house, other than the new asset, within a period of three years after the date of transfer of the original asset; and
the income from such residential house, other than the one residential house owned on the date of transfer of the original asset, is chargeable under the head “Income from house property”.
Background
Section 54F of the Income Tax Act,1961 stipulates conditions for claiming exemption under capital gain.
This issue was agitated in the Rachit Shah case, specially relating to the question of exemption under Sec. 54F of the Income Tax Act, 1961 on the grounds of non-fulfillment of conditions specified under that section.
Non fulfillment of conditions specified u/s 54F can reflect in many numbers of ways. There are certain cases where the transaction in its entirety starting from the sale of the original asset till the purchase or construction of the new assets is called into question as a colourable transaction done with the sole purpose of evasion of capital gain tax. For example, the following are the illustrations of such colourable transactions
1. Assessee owns more than 2 residential houses, and transfers the additional houses to his family members by way of Gift or settlement deed to his family members , so as to present a valid exemption under Section 54F.
2. Assessee owns more than 2 residential houses in joint names as the word own is subject to interpretation.[1]
3. Assessee claiming multiple residential flats as a single unit, in particular multi storeyed buildings of a residential complex.[2]
4. Assessee claiming the other asset as commercial property on the date of transfer of original asset.[3]
Out of the above, the first scenario is point of contention in the discussed case, which we will be discussing in this article. The key questions which arise from this case include
1. Whether the assessee’s transactions amounted to a colorable device for the sole purpose of avoiding taxes?
2. Whether a series of legal transactions to claim exemption u/s 54F can be construed as colourable transaction when viewed together in its entirety?
3. Whether the provisions under Sec.54F should be construed beneficially in favour of the assessee or should it be construed in favour of the larger public good?
4. Whether taxation law be construed to strictly look only int the legal effect or should it look into the purpose and intention behind the transaction?
What is colorable device ?
Colourable device are transactions that fall under one or more of the following categories
1. Substance over form transactions, where the substance of the transaction is different from the form of the transaction. In such cases, the Revenue can lift the veil and look into the substance and adopt the same for calculating tax liability, as in the case of Commissioner v. Court Holding Co. (1945)[4], in the US Courts.
2. Transactions in its entirety, where separated steps of a transaction can be considered as a single one in its entirety, as in the case of Wood Polymer case, where the steps involved in amalgamation being valid intermediate steps, but the transaction in its entirety revealed a transfer of a capital asset from one company to another.
3. Camouflaging transactions such as transferring shares in subsidiaries instead of transfer of substantial interest in land held as asset by the said subsidiary cos as in M/s. Unitech Limited vs. DCIT, Cir.27(1), New Delhi ITA No. 6181/DEL/2015
4. Any transaction is a sham arrangement or transaction, if courts prove that the transaction does not exist or occurs in a different way than declared; or if it does not have economic substance or business purpose.
5. Economic substance is a test that can be applied on any transaction to see if there is any practical commercial substance in the transaction in combination with a business purpose, or was done only to obtain a tax benefit, such as amalgamation of two shell companies with no known source of revenue or evidences of valid operations as in the Wood Polymer Limited case. The tests for economic substance checks if a transaction had some economic meaning, like improvement in profits, reduction in costs, or if this transaction had as a purpose only to reduce the tax liability of the taxpayer.[5]
Where tax avoidance is not tax evasion:
An assessee who seeks refuge under the above mechanism mentioned above, can either call his actions as tax planning whereas in Mc Dowells case, the Judiciary calls it “colorable device”. While tax statutes have always been subject to strict interpretation, it has been argued by Revenue that the assessee had intentionally used such provisions with the avowed object of defeating tax. On the contrary, it is argued that if a statute permits a thing to be done, doing of it in the manner provided as per law could never be against or contrary to public interest. It is said that in a tax law, morality has no place and it is a strict rule of fiscal law that has to prevail.[6] Every person is entitled so to arrange his affairs as to avoid taxation but the arrangement must be real and genuine and not a sham or make-believe.[7]
Any tax planning can be viewed under the lens of tax avoidance or as a colorable device under tax evasion. It has always been a subject of controversy as to what is the thin line between tax avoidance and tax evasion. In the M/s McDowell and Company Limited v. Commercial Tax officer[8], Justice Ranganath Mishra’s words may be recollected
“Tax planning may be legitimate provided lt is within the framework of law, Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuge”
In the In Re: Wood Polymer Limited[9], the Court had held that a merger or amalgamation was a colorable device to avoid capital gains tax, ruling in the specific context of granting approval to merger transactions which may result in a tax benefit, and distinguished Wood Polymer from the instant case on the basis that Wood Polymer there was a clear use of company law provisions in a sole attempt to avoid tax.
In Commissioner of Income-tax v. A. Raman & Co.[10] it was observed as under :
“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. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in taking statues may not except on peril of penalty, be violated, but it may lawfully be circumvented.”
In Commissioner of Income-tax v. Sakarlal Balabhai[11] it was observed that where the transfer is legitimate, the income arising out of the asset is also parted with, there was is no argument to favour tax evasion.
“If the assessee parts with his income producing asset, so that the right to receive income arising from the asset is transferred to and vested in some other person, there is no avoidance of tax liability : no part of the income from the asset goes into the hands of the assessee in the share of income or under any guise.”
In the book, Law and Practice of Income Tax by Palkhivala, 7th edition, it is argued that avoidance of tax is not tax evasion and it carries no ignominy with it, for it is sound law and, certainly, not bad morality for anybody to so arrange his affair in such a way as to minimize tax liability.
“it is open for the assessees to arrange its affairs in such a manner that it would not attract the tax-liabilities, so far, it can be managed within in the permissible limits of law. The assessees can very well manage its tax affairs so that the tax attracted in the transaction is less and would not fall outside the four corners of the law applicable at the relevant time. The tax-management is permissible, if the law authorises so”[12]
Where Tax avoidance is tax evasion
It is to be noted that in the Wood Polymers case, the Court has held that the Amalgamation was a colorable device used only for the purpose of defeating tax, and hence the Court did not approve the amalgamation. When the amalgamation falls apart, the transfer of the underlying assets also fall apart. So, in the Wood Polymer case, the Court did not rule on the validity of the exemption under Section 54F citing that the amalgamation was colored, but ruled on the validity of the amalgamation itself, as provided under second proviso to Sec.394(1) of the Companies Act,1956 thereby nullifying the transfer of the original asset, and making the application of Section 54F irrelevant. Since the Court has not applied the tests of colorable device mentioned above to the facts in the Wood Polymer case it cannot act as a judicial precedent for denial of exemption under Section 54F.
At no point in the Wood Polymer case has the Court rejected the exemption sought under Section 54F by creating a fictional nexus between the prior fact (the amalgamation of two shell companies) and the application of Section 54F.
However, where the facts suggest that the assessee has devised a transaction in such a way as to avoid payment of income tax, the Court can step in three ways
1. Invalidate the prior transaction which is the colorable device or
2. Reject the exemption sought by lifting the veil and identifying transactions that are not bonafide
3. Look at the transaction as a whole, to see if the transaction had a commercial substance and not merely a device to avoid taxes.
So, the judicial scrutiny, by far seems to suggest that, if a statute or a procedure as per law permits the invalidation of the prior transaction and the facts suggest that the assesse has devised a mechanism solely for the purpose of tax evasion, then the Court may invalidate the prior transaction.
Analysis of Rachit V Shah Vs ITO-7(3), ITAT, Hyderabad
| Case No | ITA. No. 420/Hyd/2022 |
| Assessment Year | 2015-16 |
| Appellant | Rachit V Shah, Hyderabad |
| Respondent | ITO-7(3), Hyderabad |
| Date of hearing | 23.02.2023 |
| Date of pronouncement | 15.03.2023 |
| Accountant Member | Shri Rama Kanta Panda |
| Judicial Member | Shri Laliet Kumar |
Facts of the case :
Assessee owns two house properties – one house (H1) in Hyderabad, a second apartment ( H2) in Secunderabad, and a land (L1) at Hyderabad, and a another land (L2) in Rangareddy District, Andhra Pradesh. The assessee transferred H2 to his father by way of gift settlement deed executed on 27-10-2014. After a gap of 7 days, assessee sold the land L2, jointly owned with his mother for a total consideration of Rs 4,41,98,880 /-, on 03-11-2014 through an Agreement to Sell cum General Power of Attorney, out of which the share of the assessee was Rs 2,28,38,880/-. The Agreement to Sell also recorded a receipt of Rs 2,18,880/- in cash prior to the signing of the Agreement to Sell. The assessee used the sales proceeds of the land L2, in purchasing a new residential property. Assessee claimed exemption under Section 54F on the entire amount of capital gains arising from the sale proceeds of the land L2.
Subsequently, department issued a notice under Sec 142(1), consequent to which assessee filed a revised return showing a total income of Rs 7,80, 890 under Head House Property, Business, Capital Gains and Income from Other sources. The return of income was processed u/s 143(1) of Income Tax Act, 1961 and the case was selected for limited scrutiny under CASS. The assessee produced relevant record and information before the Assessing Authority and the Assessing Authority ultimately passed the impugned assessment order for the said Assessment Year 2015-16 u/s 143(3) dated 29.12.2017 by disallowing exemption u/s 54F of Rs.2,63,67,705/- and assessed the total income at Rs.2,71,48,595/-.
Assessee appealed the decision of the Assessing Officer to the Learned Commissioner of Income Tax (Appeals), National Faceless Appeal Centre, Delhi and pursuant to this appeal, an order was passed on 06.07.2022 by the Learned CIT(A) disallowing exemption u/s. 54F of Income tax Act, 1961 claimed by the assessee amounting to Rs.2,63,67,705/- by stating that the assessee has used a colourable device to claim exemption u/s. 54F of the Income tax Act, 1961. Aggrieved by this order, the Assessee preferred an appeal with the ITAT, Hyderabad Bench.
Reasons cited by the Learned CIT(A) :
The disallowance of the exemption was taken under the following grounds by the Learned CIT(A)
1. That by transferring the original asset by way of gift settlement deed to his father, the Assessee did not truly alienate the property, whereas, the Assessee claimed that the original asset, so transferred to his father was alienated in favour of a third party in 2019-20, which disproves the reason cited by the Learned CIT(A).
2. Further the Learned CIT(A) stated in the order that
“Whereas, if the property is gifted to the father, being a lineal ascendant, the gifted property would come back to the son (assessee) as an inherited property or the father would even gift back the same property to his son during father’s lifetime. Gifting the house property to his father is like throwing a ball tied with rubber band and the ball would come back to the thrower’s hands after lapse of certain time.”
3. The CIT(A) concluded that the gift settlement deed executed by the assessee is a colourable device to evade taxes.
4. The Learned ITAT Bench in its order concluded that the gift deed dt.27.10.2014 was merely a paper gift deed as it was not covered with the transfer of possession and it was not executed on account of love and affection but was executed only for the purpose of taking undue benefit of the provision of law.
5. The Learned ITAT bench relied on circumstantial evidence to strengthen its conclusion that the assessee had used a colorable device to evade taxes
i. The ITAT Bench noted that the Agreement to sell the original asset showed a receipt of Rs 2,18,880 in cash prior to the signing of the Agreement to sell, and whose date of receipt was not proven by the Assessee by adducing evidence. So, the Learned ITAT Bench presumed that such consideration was received prior to the transfer of the property H2 to his father.
ii. The Gift Deed shows that Rs.2,20,000/- towards stamp duty and registration fee had been paid by the assessee dated 12.01.2015 after execution of Agreement of Sale dated 03.11.2014 and just prior to purchase of the new asset on 30.01.2015.
iii. Further, the assessee before and subsequent to gifting the property, continued to live with his father in the same property, which shows that the gift deed executed by the assessee was merely a camouflage.
iv. Though, gift deed, on a standalone basis seems to be a natural act on the part of son to gift home to his father, but when the gift deed is to be examined in the light of the prior and subsequent acts and prevailing circumstances, then it is clear that the real intention of the assessee, was to claim the deduction u/s. 54F of the Act
v. In the present case, per se gift deed was not executed on account of natural love and affection but was executed by the assessee to artificially avail the deduction u/s 54F of the Income Tax Act 1961. So, it falls under the mischief of Sec 23 and 24 of the Indian Contract Act, 1872, in as much as, where any contract is signed to defeat the provisions of any law, the contract is void.
6. On the basis of the above circumstantial evidences and acts, the appeal was dismissed by the Learned ITAT Bench.
Critical Analysis:
1. In Wood Polymer, the Court did not rule on the validity of the exemption under Section 54F citing that the amalgamation was colored, but ruled on the validity of the amalgamation itself.
2. In the Rachit Shah case, the order by the Learned ITAT Bench has called into question, the validity of the gift settlement deed because it contravenes two conditions as per the Indian Contract Act, 1872
i. That the gift was not made on account of natural love and affection, but with the purpose of claiming exemption under Sec 54F of the Income Tax Act, 1961, and so the foundation of Sec 25 of Indian Contract Act, 1872 falls apart.
ii. That the gift deed was made with the object of defeating the provisions of Income tax Act, 1961 and falls into the provisions of Section 23 and Section 24 of Indian Contract Act 1872
3. But, it is to be noted that the Wood Polymer case was a petition to approve the Amalgamation, and so, it was within the powers of the Court to look into the substance of the transaction, and decide whether to approve the amalgamation or to reject it. In the Rachit Shah’s case, it is to be noted that unless the gift settlement deed is declared to be void, there is no legal basis for the Learned ITAT Bench to declare the exemption under Sec 54F as not valid. Since the order does not conclude or declare the contract as void, but only lays the argument on its validity, it cannot be said the gift settlement deed is invalid, and so, the claim of exemption under Section 54F have ceased to exist, which is not the case with the Wood Polymer case. The Rachit Shah’s case is missing an important step in the process of denying the exemption. So, it is not possible to draw a parallel between the Wood Polymer judgement and the Rachit Shah order.
4. The observations by the Supreme Court in the Commissioner Of Income-Tax, Gujarat vs M/S. B.M. Kharwar (1969 AIR 812) must be recalled
“The taxing authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it Is open to the taking authorities to unravel the device and to determine the true character of relationship. But the legal effect of a transaction cannot be displaced by probing into the “substance of the transaction”.
5. So, one may argue that the transactions that led to the claim of exemption under Section 54F remain valid in the eyes of law. And, so the real question of law to be asked is
“ If Section 54F was supplied with the available facts, will the exemption under Section 54F be available to the assessee or not, irrespective of the opinion that it may be colored ?”
6. In contrast, in Inland Revenue Commissioners v. Burmah Oil Company Ltd. ( 1981 48 STC 37 Ker) where Lord Diplock said,
“It would be disingenuous to suggest, and dangerous on the part of those who advise on elaborate tax- avoidance schemes to assume, that Ramsay’s case did not mark a significant change in the approach adopted by this House in its judicial role to a pre-ordained series of transactions (whether or not they include the achievement of a legitimate commercial end) into which there are inserted steps that have no commercial purpose apart from the avoidance of a liability to tax which in the absence of those particular steps would have been payable.”
7. The above doctrine says that it’s the judiciary’s role to ask the question
“Did the inserted steps in the whole transaction have any commercial purpose other than avoidance of liability to pay tax?”
Conclusion
So, the heart of this judgment goes to the principle behind interpretation of a taxing statute either using the Westminister principle (IRC v Duke of Westminster[1936] AC 1) or the Ramsay Principle (W.T. Ramsay Ltd. v. IRC [1981] 1 All ER 865)
Should the Court restrict itself to the transactions, their legality, and the end outcome of feeding these legal transactions into Section 54F to get a legal effect? ( Westminister principle)
OR
Should the Court concern itself not merely with the genuineness of a transaction, but with the intended effect of it for fiscal purposes. Should an assessee get away with a tax avoidance project with the mere statement that there is nothing illegal about it? (Ramsay Principle)
This dichotomy was played out in the English Courts and has been extensively discussed in the McDowell judgment. In this case, the Learned ITAT Bench has not travelled using the Wood Polymer judgment to invalidate a prior transaction but to prove that the series of transactions had no other commercial purpose other than tax avoidance using the Ramsay principle.
We can end this article with a statement by Lord Wilberforce who stated that
“While the techniques of tax avoidance progress are technically improved, the courts are not obliged to stand still”. So, the Rachit Shah case is a demonstration of the Courts willingness to step into the shoes of a guardian wishing to defend taxation law as a legislation made for the purpose of safeguarding the welfare of the people and public at large.
It is further observed that the recent legislative amendments w.r.t. General Anti Avoidance Rules, there has been shift towards substance-based system which empowers Income Tax Authorities, a full discretion in taxing colorable transactions. The GAAR provisions of Chapter X-A of the Income tax Act provide a suitable doctrine to assess such transactions.
[1] M J Siwani vs CIT (2015) 53 Taxmann.com 318/232 335 (SC)
[2] Navin Jolly vs ITO 2020 117 Taxmann.com 323 KAR
[3] ibid
[4] 324 U.S. 331 (1945)
[5] Ronaldo de Melo Parreira Filho, Ethics of Tax Avoidance, School of Business, George Washington University, Washington, DC, 2014
[6] “Adopt Avoidance and Avoid Evasion” by S. R. Loonekar, 1972, edition
[7] Jiyajeerao Cotton Mills Ltd. v. Commissioner of Income tax and Excise Profits Tax Bombay
[8] 1986 AIR 649, 1985 SCR (3) 791
[9] [1977] 109 ITR 177 (Guj)
[10] [1968] 67 ITR 11, 17 (SC)
[11] [1968] 69 ITR 186, 200, 201, (Guj)
[12] CIT vs. George Williamson (Assam) Ltd. & ors. (2004) 178 Taxation 597 (Gau): (2004) 265 ITR 626 (Gau)
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