While dealing with the tax avoidance schemes, it has been observed that at times there is thin line between 'Tax Planning', Tax Avoidance' and Tax Evasion'. While 'tax Planning' is considered legitimate and 'Tax Evasion' is forbidden, it is the 'Tax avoidance' largely where there has been prolonged litigation. The Courts have dealt with these aspects not only under the domestic tax law but also under the international tax laws. This, at times, has resulted into long-drawn litigation on determination of whether a transaction/arrangement is a colourable device or a sham transaction.

The controversy in the last six decades [since the inception of the Income-tax Act, 1961(the Act)] with respect to tax avoidance has not receded. A recent decision of the Mumbai Tribunal in the case of Swiss Reinsurance Co. Ltd v. Dy. CIT [IT Appeal No. 6531 (Mum.) of 2021, dated 20-7-2021] dealt with the issue of eligibility of set off or carry forward of long term capital loss under the provisions of the Act, resulting from a sale of shares of an Indian company by a foreign company. The Mumbai Tribunal held that sale of shares of an Indian company by a foreign company is not a sham transaction and therefore long-term capital loss on such transaction is eligible for carry forward and set off against future capital gains. 

The taxpayer, in the instant case, being a Switzerland based entity and a global re-insurer, provided re-insurance services to various insurance companies, including, Indian insurance companies through its branches across the globe. The taxpayer had acquired shares constituting about 26 per cent of the total shares of an Indian company in tranches under the Foreign Direct Investment route. During the relevant Assessment Year, the taxpayer sold all its shares to an Indian company at mutually agreed terms. In the process, the taxpayer incurred long term capital loss of INR 499.24 million and carry forward of such loss was claimed in the return of income.

The price at which the shares were purchased by the taxpayer was the primary bone of contention in the instant case and it was alleged that it is a sham transaction using colourable device to create artificial loss by selling the shares below par value. The Tribunal observed that the decision of investing in shares at a high premium is a commercial decision of the taxpayer and is not in violation of any rules or regulations including Foreign Exchange Management Act (FEMA) regulations. Thus, when the purchase and sale of shares of the targeted entity by the taxpayer are within the legal framework, there was no justification on the part of the tax authorities in alleging that the transaction was arranged to create an artificial loss. 

Some landmark judicial precedents dealing with tax avoidance

There have been instances where the Courts have relied on the substance of the transaction and held that the said transaction/scheme/arrangement etc. have not been entered into with a contrived objective. The Supreme Court in the case of CIT v. A Raman Co.[1968] 67 ITR 11 observed that avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. 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 Act. 

The Supreme Court, in a landmark decision in the case of McDowell & Co. Ltd. v. CIT[1985] 22 Taxman 11/154 ITR 148 while dealing with the case of tax avoidance observed that the tax planning may be legitimate provided it 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 subterfuges. 

Thereafter, in 2012, the Supreme Court delivered a landmark decision in the case of Vodafone International Holdings BV v. Union of India [2012] 17 taxmann.com 202/204 Taxman 408/341 ITR 1, which dealt with the taxability of capital gains arising on transfer of shares between two non-residents where the shares were deriving value from its subsidiaries from India. The Supreme Court, on the facts of the case, observed that one should keep in mind the following factors such as: the concept of participation in investment, the duration of time during which the Holding Structure exists; the period of business operations in India; the generation of taxable revenues in India; the timing of the exit; the continuity of business on such exit. In short, the onus is on the Revenue to identify the scheme and its dominant purpose. Thus, a corporate business purpose must exist to evidence the fact that the impugned transaction is not undertaken as a colourable or artificial device.

Various Courts/benches of the Tribunal have applied such observations to determine whether the transaction is sham or not.

The Madras High Court in the case of CIT v. High Energy Batteries (India) Ltd. [2012] 22 taxmann.com 242/208 Taxman 213/348 ITR 574 held that sale and lease back transaction is not a sham transaction. The High Court relied on the decision of the Supreme Court in Vodafone International Holdings B.V. (supra) where the Supreme Court had observed that to ascertain the legal nature of the transaction, the Courts have to "look at" the entire transaction as a whole and not to adopt a dissecting approach.

In the case of Consolidated Finvest & Holdings Ltd. v. Asstt. CIT[2014] 51 taxmann.com 187/[2015] 152 ITD 792, the Delhi Tribunal examined a series of transactions between two related entities which resulted in a capital loss in the hands of one entity and determined that there was no tax avoidance. The Tribunal observed that the AO was not able to provide any reasoning or evidence for holding it to be a sham except the fact that the transaction resulted in long term capital loss.

GAAR

While introducing the statutory General Anti-Avoidance Rules (GAAR), the Memorandum to the Finance Bill, 2012 stated that the question of substance over form has consistently arisen in the implementation of taxation laws. In the Indian context, anti-avoidance principles are based on various judicial pronouncements where judicial decisions have varied. While some courts in certain circumstances had held that legal form of transactions can be dispensed with and the real substance of transaction can be considered while applying the taxation laws, others have held that the form is to be given sanctity.

The Memorandum further stated that keeping in view the aggressive tax planning with the use of sophisticated structures, there is a need for statutory provisions so as to codify the doctrine of "substance over form". The real intention of the parties and effect of transactions and purpose of an arrangement is to be taken into account for determining the tax consequences, irrespective of the legal structure that has been superimposed to camouflage the real intent and purpose.

After having deferred the GAAR provisions on more than one occasion, the said provisions have come into effect from Assessment Year 2018-19 (Financial Year 2017-18). GAAR provisions are applicable if the transaction is an impermissible avoidance arrangement. The term 'impermissible avoidance arrangement' has been defined in these provisions. Under the provisions of GAAR, it is important to prove that the main purpose of transaction is to obtain the tax benefit. Further one of the additional conditions is to justify that the transaction lacks commercial substance or is deemed to lack commercial substance.

Since then the action on the anti-avoidance front (domestic or international) has been only snowballing. Though GAAR is a domestic anti-avoidance measure, it is provided in Section 90(2A) of the Act that provisions of GAAR shall apply to the taxpayer even if such provisions are not beneficial to him. In other words, once the provisions of GAAR are invoked, it will have an overriding effect on the beneficial tax treaties. 

International anti-avoidance measures

Further, to tackle the tax avoidance transactions, in last few years, India has introduced 'limitation of benefit' (LOB) clause in several Indian tax treaties. It provides for the granting of tax treaty benefits upon satisfaction of certain prescribed conditions to entities/transactions. India has also ratified the Multilateral Instrument (MLI) [in pursuance to the Base Erosion and Profit Shifting (BEPS) Action Plan 15 of the OECD] and included all of its tax treaties as Covered Tax Agreement (CTA). Thus, Principal Purpose Test (PPT) which is a minimum standard will apply to all CTAs of India provided the other country has also included India in the list of the agreement deposited with OECD. Under the PPT, benefits emanating from tax treaties can be negated if the main or even one of the principal purposes is to obtain a tax benefit. Additionally, India has also adopted the Simplified Limitation of Benefits (SLOB) clause in respect of its CTA's. SLOB provides for the tax treaty benefits to be made available to qualified persons. Apart from the PPT, India also intends to adopt some other measures through the BEPS Action Plan 15 viz MLI or bilateral tax treaty negotiation to combat tax avoidance strategies.

Way forward

With all the anti-avoidance measures in place, the moot point that holds ground is that the substance of the transaction may have to be examined in most cases to ascertain the existence of a tax avoidance strategy. Having said that the Courts have also recognised that a transaction undertaken by a taxpayer is required to be seen from the prism of commerciality. Merely because a particular transaction results into a tax benefit cannot be a yardstick to frame that the transaction is a colourable device for tax avoidance. Not all transactions are sham, and that business consideration do outweigh tax considerations in many cases. Therefore, each case is to be examined based on the facts and circumstances of the case and applying the important principles laid down by the Courts.