Tax planning and tax avoidance have been discussed between tax authorities and taxpayers for decades. Tax authorities always try to ignore transactions and label them as planned for tax avoidance / evasion under the guise of tax planning.
On the other hand, taxpayers always claim that transactions or structures are legal for legitimate tax planning. The House of Lords England had raised the issue of tax planning in its orders, in the Fisher’s Executors and Duke Westminster cases, that “a taxpayer is entitled to regulate his affairs under the law in order to pay minimum taxes”. This is commonly known as the Westminster Principle.
The first landmark ruling on the difference between “tax planning” and “tax avoidance” was passed in India in 1985 when the Supreme Court ruled legitimate in its CTO vs. McDowell and Co. Ltd ruling, provided that it is within the law.
Dyeable devices cannot be a part of tax planning, and it is wrong to promote or to believe that it is honorable to evade paying taxes by dubious methods. It is the duty of every citizen to pay taxes honestly without resorting to deception. “
Although the case had borrowed the principles of Westminster, it had created some confusion about what should be considered a “dyeable device” and what is and what is not allowed.
The issue was raised again by the Apex Court in the Union of India Vs Azadi Bachao Andolan case, which stated, “The principle in the Duke of Westminster is not only alive in England, but it also appears to have received legal blessings from the Constitutional Bank in India, regardless of the temporary turmoil that arose in the wake of the McDowell & Co case. ”
Reference was also made to the judgment of the Madras High Court in MV Valliappan Vs CIT, which correctly concluded that the McDowell & Co decision cannot be understood as meaning that any attempt at tax planning is unlawful and must be ignored, or that any legally permissible transactions or agreements that have a tax-reducing effect on the part of the agent are to be rejected.
In the case of Vodafone International Holdings BV VsUOI, the Supreme Court reiterated that every taxpayer is entitled to organize their affairs in such a way that their taxes are as low as possible and are not obliged to choose the pattern that the treasury will regain replenishes.
Recently, a similar dispute came up in the Income Tax Appellate Tribunal in Mumbai where the tax authorities rejected the taxpayer’s claim to offset taxpayer’s capital losses from the sale of near-worthless shares in an Indian company against the taxpayer’s capital gains of residential houses.
Such was the case of Michael E. Desa, a non-resident Indian now resident in the United States – futures income from the sale of real estate.
The Assessing Officer (“AO”) alleged that the loss claimed by the Assesse was fictitious and deliberate in order to avoid tax liability on property sales. The AO stated that the transaction was not real, just a fake story claiming that the net worth of the company; whose shares were sold has been completely eroded. The acquirer did not acquire the shares with the intention of actually continuing the business, although the method of share valuation assumes that the company will continue to operate.
In addition, the AO had stated that the buyer of the shares was not only known to the Assesse, but was also a director of the company. Therefore, the AO took the view that the transaction was preconceived, predetermined and fabricated for commercial reasons.
The Mumbai ITAT contradicted the AO’s allegations in reviewing the facts of the case. The court found that even if the company’s net assets were worthless, it actually had to be examined whether the transaction was actually and legally effective. It was not for the AO to take a call about how the Assesse should organize his tax affairs.
Based on the judgment of the Apex Court in McDowell & Co and Vodafone International Holdings BV, it was decided that the time at which the damage was booked is not relevant in the present case. As long as the Assesse could prove that the sale has actually taken place, the consideration has been received by the buyer and the shares have actually been transferred in the name of the buyer, the AO can make the commercial decision of the transaction and its timing.
The ITAT concluded that minimizing tax liability, as long as it is done through legitimate tax planning and without the use of a dyeable device, is not illegal. In addition, it is not even immoral as everyone has a duty to properly manage their affairs within the framework.
The legitimacy of tax planning was confirmed by Mumbai-ITAT through this ruling with the aim of giving this classic old debate a new look. It is important to note, however, that the conclusion in each case and the applicability of these principles depends on the facts in each case, and small actual differences can change the balance in either the taxpayer’s or the tax department’s favor.
(The authors are partners or managers at Nangia Andersen, a law firm)