Tax Avoidance vs Evasion: A Harmonious reading of landmark Judgements of Indian Supreme Court (SC)

Facts of M/s McDowell and Company Limited v. Commercial Tax officer

McDowell and Company Limited (Manufacturer), a distillery established in the state of Andhra Pradesh, runs a business of ‘manufacture and sale’ of Indian liquor. An arrangement was entered between manufacturer and purchaser that required the ‘buyer to pay excise duty to get distillery passes required for release of liquor’. The manufacturer prepared accounts of sale/invoices that excluded payment of excise duty. This meant that the excise duty paid by the buyer did not contain in annual turnover of Co. The Co. adopted this method to lessen their tax liability under Rule 76 & 79 of Andhra Pradesh Distillery rules. These rules provide for a payment of excise duty by manufacturer and to include the same in annual turnover as defined u/s 2(s) of A.P. General Sales Tax. However, the company, in order to reduce its liability resorted to this action so as to create an impression that the excise duty was not a part of their accrued income. This ultimately resulted in reduction of sales tax payable by the manufacturer.

The immediate issue before 5 judge bench of Supreme Court, was, ‘whether excise duty payable by the manufacturer, but instead have been paid by wholesale buyer, actually a part of turnover and therefore liable to be included to determine sales tax’.

Tax Avoidance vs Evasion

Judgement

Justice Ranganath Mishra writing a majority judgement (on behalf of three other judges), after examining the provisions of law, had clearly ruled that, ‘duty to pay excise duty was on manufacturer’. He further goes on to say that it was the ‘exclusive duty’ of a manufacturer to pay the excise duty. Even if payment had been made by the buyer in reference to an arrangement, it does not lose its character as an excise duty because it was nothing more than meeting the obligation of manufacturer. Therefore the excise duty was to be added to the revenue of the manufacturer in determining his sales tax liability.

The manufacturer, by way of an arrangement, masking the true nature of the transaction while enjoying the use of such income, was nothing more than a ‘colourable device’ adopted by the manufacturer to avoid the sales tax/ to lessen the liability of sales tax.

Tax planning is permissible provided it is within the four corners of law but colourable devices are not part of tax planning and such a transaction should be disregarded without giving benefits of such transaction to the assesse. It is wrong to honour the dubious methods of tax avoidance as every person is bound to pay tax without taking recourse to subterfuges.’

However, J. Chinanpa Reddy, in his separate ‘concurring’ judgement, held that,

‘Instead of going into the question of whether transaction is real or not, the real question to be asked is whether transaction is such to avoid tax and if it is such, whether judiciary can accord its approval to such a transaction. The transaction shall have to be looked into as a whole in order to determine its purpose.’

He further went on to say that it was not desirable for the legislature to take care of each and every dubious method of tax avoidance. Therefore it is for the judiciary to determine the nature of each device adopted. It should refuse approval to such transactions if they were done solely for the purpose of tax avoidance.

Analysis

1. Whether principle laid out in McDowell case holds good law

I believe that this judgement and specifically the opinion of J. Chainnapa Reddy, who traces out the entire western jurisprudence on ‘tax avoidance’ to finally rule that ‘tax avoidance is something which should not be honoured’, holds good in law. While holding this particular proposition, Reddy refers to the ‘Ramsay case’ and pronounces that the following principles were buried deep down:-

1. The Westminster principle which held ‘each person is entitled to manage his affairs so as to lessen  he tax liability attached under the appropriate act,’

2. The cardinal principle that ‘if a transaction is genuine the court cannot go beyond its substance’

He held that the “legal substance and nature of transaction assumes prominence over the literal and formal approach. Further, J. Chinnapa Reddy was correct in saying that the Westminster principle was buried down in in its very place of origin where the judiciary has changed its attitude towards tax evasion. The courts there are no-longer concerned only with the genuineness of a transaction but also consider the intended effect of such transaction.

The author, further agree with the J. Chinnapa Reddy’s concurring judgement because it was clear from the W.T. Ramsay v. IRC Case that even the British courts were moving away from the Westminster principle. Therefore, it is not feasible for a country like India, which is a welfare state, to follow the principle laid out in Westminster case because of its manifold consequences. Evil effects of honouring tax avoidance are as follows [1] Substantial loss to the economy, especially in welfare state like ours that demands substantial public revenue to accommodate financial needs a large population [2] Non-Payment of taxes will pile up/aggregate an amount of black-money which will eventually disturb the economy by causing inflation [3]”Perpetual war” between some smart brains of country together with their expert team of lawyers on one side and tax authorities with less skilful advisers on the other which eventually would mean ‘large hidden loss to the community at large.’ [4] Sense of injustice & inequality among sections of the society that are unable to profit from such transactions. Most importantly there would be a problem of increasing tax liability on good-citizens of country. This all brings me to the words of J. Oliver Wendell Holmes that “Taxes are what we pay for civilised society, I like to pay taxes and with them I buy civilization.” Therefore, I agree with the opinion of Chinnapa Reddy and the author believe that judgement rendered by this court holds good in law.

2. How subsequent judgements looked at the McDowell case

In UOI V. Azadi Bachao Andolan the matter involved a Double Tax Avoidance agreement entered into between India and Mauritius (DTAA). By way of Circular No. dated 30/03/1994, issued by CBDT, it clarified that capital gain accrued to ‘resident’ of Mauritius by way of an alienation of shares of Indian company was liable to be taxed in accordance with Mauritius laws and not to be taxed under Indian laws. On the basis of this circular, many residents of Mauritius (FII’s) started investing in Indian companies so that they can alienate their shares of Indian companies without incurring any tax liability. However, Income tax authorities issued a show cause notice to the some FIIs who were alleged to be sham companies/shell companies incorporated in Mauritius, controlled by non-residents of Mauritius, with the sole objective of investing in Indian companies.

The division Bench of SC, held that if it was intended by the DTAA to preclude the nationals of third state, they should have mentioned it specifically. McDowell had already held as follows:-

it is neither fair nor reasonable to expect the legislature to anticipate every dubious methods of tax avoidance to tackle it.” Therefore, it is for the judiciary to deal with such transaction and to decide on its legitimacy.’

The question that arose on applying the McDowell case then was whether legislature had in fact contemplated the type of transaction involved in Azadi Andolan Case and whether such transaction was specifically excluded from being taxed. For this the US-India Double Tax Avoidance Convention was referred to. The said convention incorporated ‘a term of limitation’ to explicitly prohibit nationals of a third state from deriving benefits of that convention. This was cited to show that transactions of such kind were indeed contemplated by the legislature. The ‘India-Mauritius (DTAA)’, instead of excluding such transactions specifically, ignored them specifically. This provided an impression that the legislature was fine with non-residents using the agreement to their advantage. Therefore, what was excluded by the legislature could not be included by the Court. Hence orders were passed in favour of assesses.

While pronouncing this judgement, ‘it went one step ahead and declared that the law held by ‘McDowell did not change the fiscal jurisprudence’. They further held that Justice Chinnappa Reddy’s opinion, far from being correct, was not the ‘ratio decidendi’ of the case but merely orbiter dicta. The author disagrees with the said observation for the following reasons:-

1. It misread’ the McDowell case as two different parts. [1] Majority opinion by J. Ranganath Mishra [2] Concurring judgement by J. Chinnapa Reddy. Further, it wrongly held that ‘the majority Judgement by Ranganth Mishra did not agree with the opinion of Chinnapa Reddy and that they were at loggerheads’.This was blatantly incorrect because concurring opinion by J. Chinnapa Reddy supplemented the legitimacy of the judgement rendered by J. Ranganath Mishra on behalf of three other judges. Above all, ‘it was very much clear from the para no.46 of judgement where J. Ranganath Mishra, on behalf of three other judges, clearly agreed with the opinion given by the J. Reddy. Therefore, it would act as a precedent for following cases.’ Hence the Division Bench of the Supreme Court was wrong to the extent it declared Justice Reddy’s opinion as bad law and in arguendo, even if there was some sort of confusion w.r.t. McDowell case, the correct way of resolving it was to refer the matter to a larger bench instead of misreading the judgment. Therefore, to this extent the Azadi case was wrong.

Then comes the Vodafone International Holdings Ltd v. Union of India & Ors, where SC reiterated the principle of McDowell by holding that ‘Tax planning is legitimate provided it is within the four corners of the law and  that the intention to avoid tax does not, by itself, invalidate the transaction unless a statute prohibits the same.’ While delivering the judgement the court was of the opinion that ‘what was not provided by the statute could not be supplemented by the court as it would amount to violation of separation of powers’.

Conclusion

In McDowell it was held that if a transaction was carried with an intention to avoid taxes it was up to the judiciary to decide whether the same ought to be regarded. In other words, the duty to decide the validity of the transaction was left to the court. In Vodafone, it was held that even if a transaction was carried with an intention to avoid taxes, it did not, on its own, become illegal unless a statute prohibited the same. It is the submission of the author that these cases ought to be read together. While McDowell holds that it is up to the judiciary to decide on the effect of a transaction, the judiciary, at the end of the day, has to decide based on the dictates of the legislature (as held by the Vodafone case).

Azadi Bachao Andolan was correct to the extent it held that the legislature was not clear. However, it overstepped when it misinterpreted the McDowell case.

Author- Banoth Sundarshyam | 4th Year law student | NALSAR UNIVERSITY OF LAW | HYDERABAD

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Banoth Sundarshyam | 4th Year law student | Nalsar University of Law | Hyderabad View Full Profile

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