Substance and Form

in Indian Tax Laws

Pramod Kumar
International Taxation Conference FIT, India December 6,2012
Pramod Kumar

International Taxation Conference, Mumbai December 6, 2012.

Disclaimer
This presentation seeks to present the factual and legal
elements relating to various points of view about the
concept of substance over form in Indian Tax laws. This
presentation is only a compilation of such points of view
and does not canvass or support any particular point of
view. The views expressed herein, therefore, do not
necessarily reflect the views or the understanding of
the author or his employer i.e. the Income Tax Appellate
Tribunal, Government of India.
This presentation deals only with the judicial doctrine of
substance over form, and does not deal with GAAR, on
which a separate presentation is being made later, as
also on statutory provisions dealing with substance
over form.

Doctrine of substance over form

Doctrine of substance over form is a judicial creation. It is

invoked in cases in which taxpayer has conducted a
scheme of transactional relationships in documents and has
a view on tax advantages that flow from tax reporting
based on such transactional relationships, rather than on
the substance of arrangement. The economic reality is thus
hidden and transaction exists in form only.

This doctrine allows tax authorities to ignore the legal form

of an arrangement and to look at its actual substance, so as
to prevent artificial structures from being used for tax
avoidance purposes.

Doctrine of substance over form judicial

approach

In its pure form, when, on the basis of evaluation of

evidence and analysis of facts, judicial authorities find
that tax motivation outweighs business purpose or
profit objective, it is held that the taxpayers efforts of
form does not reflect the substance of economic
transactions, and intended tax benefits are declined.

Recent Indian decisions, however, can be viewed as

proceeding on the basis that substance prevails over
form only when the form has no commercial
justification whatsoever and is completely tax driven.

Do we really need the doctrine of

substance over form in tax laws ?

It is extremely difficult, if not altogether impossible, for

legislation to keep pace with dynamism of, and innovations
in, business and commerce, and therefore, normative
systems, which legal provisions inherently are, cannot
effectively handle the aggressive tax positions taken by the
businesses.

This doctrine provides flexibility to judges to deal with the

cases not visualized by the legislature and, as a judicial
doctrine, it is inherently more flexible than a statutory rule,
it can develop gradually and it cannot be undermined by
microscopic examination in search of loopholes.

Application of substance over form

Substance over form is one of the fundamental tax issues

debated right from the initial days of tax laws in India, but
initial controversies about characterization of income and
expenditure, and nomenclature assigned to the same by the
taxpayers. Relatively simple matters and no major issues arose
on application of this doctrine.

The focus is now due to revenues challenge to investment and

transaction structures on the basis that use of intermediate
companies is for dominant purpose of obtaining tax benefits
through treaty or otherwise. Relatively complex issues but
doctrine of substance over form applied mainly when the
structure is completely tax driven and devoid of any
commercial justification whatsoever.

Doctrine of substance over form role of

judges

Judiciary
cannot be a silent spectator when facts and
circumstances clearly warrant the inference that there has
been a dubious, though seemingly legal, method adopted with
the sole motive of avoiding taxes.

The role played by judges while handling tax cases is a tight

rope walk. On the one hand, they should be entirely neutral
towards the parties, even if not value neutral, and, on the
other hand, their judgments should be objective, fair,
reasonable and unaffected by their ideologies. Indian judicial
doctrine on the substance over form, by and large, reflect this
position.

Doctrine of substance over form- role of

judges

Not everyone in the judiciary is, or can be, really

confident in meeting the challenge of looking through
the complex maze of contrived transactions, and
understanding the core economic and business realities
of such transactions. Is that the reason, as many believe,
judiciary prefers to go by the form and prone to err on
the side of excessive caution at the cost of the
exchequer ?

Should the judiciary be content with foundationalist

approach to interpretation of tax statutes by
implementing its plain meaning, intent or purpose, or
has the time come that judges should approach the tax
statutes by exploring for most sensible policy option. Will
latter will essentially lead to more emphasis on
substance over form ?

Doctrine of substance over form

controversy in judicial approach

It is a controversial issue as to whether doctrine of

substance over form can be invoked only when the form of
transaction is completely tax driven or whether it can also
be invoked when tax motivation clearly outweighs the
business purpose or profit objective. Judicial precedents
seem to be in favour of the former approach as on now, but
there is little conceptual justification in its support.

Is the legislation on GAAR intended to fill in this gap

created by, what tax administration may perceive as,
judicial inertia and inconsistency in applying judicial
doctrine of substance over form ?

Legal substance over form

vs. economic substance over form
Legal substance :
Legal substance generally prevails over form. When despite
the legal steps, intended legal results not obtained, the court
could be justified in ignoring the intermediate steps.
Economic substance :
Economic substance applies over form, it is often argued,
only when it is completely tax driven, devoid of any other
consideration and revenue authorities are able to
demonstrate that position.

Legal substance over form

vs economic substance over form

If the Court finds that notwithstanding a series of

legal steps taken by an assessee, the intended legal
results have not been achieved, the Court might be
justified in overlooking the intermediate steps, but it
would not be possible for the Court to treat the intervening
steps as non est based on some hypothetical assessment of
real motive of the assessee. In our view, the Court must
deal with what is tangible in an objective manner and
cannot afford to chase a will-o'-the-wisp

Union of India Vs Azadi Bachao Andolan

(263 ITR 706 Supreme Court)

Ignoring the corporate entity used for tax

evasion

It is well established that in a matter of this

description the Income- tax authorities are entitled to
pierce the veil of corporate entity and to look at the reality
of the transaction. 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 cases the Court is entitled to lift the veil
of corporate entity and to pay regard to the economic
realities behind the legal facade. For example, the Court
has power to disregard the corporate entity if it is used for
tax evasion or to circumvent tax obligation.

CIT Vs Meenakshi Mills Ltd (63 ITR 609)

Apparent need not always be treated as real

It is true that apparent must be considered real unless it is

shown that there are reasons to believe that apparent is
not real. If all that an assessee, who wants to evade tax, is
to have some recital made in documents either executed
by him or executed in his favour, then the door will be left
wide open to evade tax. .The taxing authorities were
not required to put on blinkers while looking at the
documents produced before them. They were entitled to
look into surrounding circumstances to find out reality of
recitals made in those documents.
CIT Vs Durga Prasad More
82 ITR 540 - Supreme Court

Use of colourable devices

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 the belief that it is
honourable to avoid tax by resorting to subterfuges. It is the
obligation of every citizen to pay the taxes honestly without
resorting to subterfuges

On this aspect (i.e. tax evasion through use of colorable

devices and by using dubious methods and subterfuges*), one
of us, Chainappa Reddy J, has proposed a separate opinion with
which agree.

McDowell & Co Ltd Vs CTO (154 ITR 148)

Justice Ranganath Mishra (speaking for the majority )
* See Justice Kapadias observations in Vodafone case

Justice Reddys observations in McDowells

case

.in the very country of its birth, the principle of

Westminster has been given a decent burial and in that
very country where the phrase 'tax avoidance' originated
the judicial attitude towards tax avoidance has changed
and the smile, cynical or even affectionate though it might
have been at one time, has now frozen into a deep frown.
The Courts are now concerning themselves not merely with
the genuineness of a transaction, but with the intended
effect of it for fiscal purposes. No one can now get away
with a tax avoidance project with the mere statement that
there is nothing illegal about it.

Justice Reddys observations in McDowells

case

It is neither fair not desirable to expect the legislature to

intervene and take care of every device and scheme to
avoid taxation. It is up to the Court to take stock to
determine the nature of the new and sophisticated legal
devices to avoid tax and consider whether the situation
created by the devices could be related to the existing
legislation with the aid of 'emerging' techniques of
interpretation was done in Ramsay (1982 AC 300), Burma
Oil (1982 STC 30) and Dawson (1984-1 All ER 530), to
expose the devices for what they really are and to refuse to
give judicial benediction.

Supreme Court in Azadi Bachao Andolans

case

. opinion of the majority is a far cry from the view of

Chinnappa Reddy,J (in McDowellss case): "In our view the
proper way to construe a taxing statute, while considering
a device to avoid tax, is not to ask whether a provision
should be construed liberally or principally, nor whether the
transaction is not unreal and not prohibited by the statute,
but whether the transaction is a device to avoid tax, and
whether the transaction is such that the judicial process
may accord its approval to it." We are afraid that we are
unable to read or comprehend the majority judgment in
McDowell as having endorsed this extreme view of
Chinnappa Reddy,J, which, in our considered opinion,
actually militates against the observations of the majority
of the Judges

Supreme Court in Azadi Bachao Andolans

case

We may also refer to the judgment of Gujarat High Court in

Banyan and Berry v. Commissioner of Income-Tax where
referring to McDowell , the Court observed: "The court
nowhere said that every action or inaction on the part of
the taxpayer which results in reduction of tax liability to
which he may be subjected in future, is to be viewed with
suspicion and be treated as a device for avoidance of tax
irrespective of legitimacy or genuineness of the act. The
ratio of any decision has to be understood in the context it
has been made. .

Supreme Court in Azadi Bachao Andolans

case

The facts and circumstances which lead to

McDowell's decision leave us in no doubt that the principle
enunciated in the above case has not affected the freedom
of the citizen to act in a manner according to his
requirements, his wishes in the manner of doing any trade,
activity or planning his affairs with circumspection, within
the framework of law, unless the same fall in the category
of colourable device which may properly be called a device
or a dubious method or a subterfuge clothed with apparent
dignity.

This accords with our own view of the matter.

Vodafone decision on Mc Dowell and ABA

conflict
In our view, although Justice Chainappa Reddy makes a number
of observations regarding the need to depart from the
Westminster and tax avoidance these are clearly in the
context of artificial and colourable devices. Reading McDowell, in
the manner indicated hereinabove, in cases of treaty shopping
and/ or tax avoidance, there is no conflict between Mc Dowell
and Azadi Bachao
(Justice Kapadia)

..a clear cut distinction between tax avoidance and tax evasion
is still to emerge in England and in the absence of any legislative
guidelines,
there
is
bound
to
be
uncertainty
......................
............
.emphasized
that
theRamsayapproach
as
a
principle
of
statutory
interpretationrather than an over-arching anti avoidance
doctrine imposed upon tax laws.
(Justice
Radhakrishna)

Supreme Court decision in Vodafones case

When it comes to taxation of a holding structure, the

burden is on the Revenue to allege and establish tax abuse,
in the sense of tax avoidance in the creation and/ or use of
such structure(s).

In the application of a judicial anti avoidance rule, the

Revenue may invoke the substance over form principle or
piercing the corporate veil test only after it is able to
establish, on the basis of facts and circumstances
surrounding the transaction that the impugned transaction
is a sham or tax avoidant.

Supreme Court decision in Vodafones case

To give an example, if a structure is used for circular

trading or round tripping or to pay bribes then such
transactions, though having a legal form, should be
discarded by applying the test of fiscal nullity. Similarly,
in a case where the Revenue finds that in a Holding
Structure an entity which has no commercial/business
substance has been interposed only to avoid tax then in
such cases applying the test of fiscal nullity it would be
open to the Revenue to discard such interpositioning of
that entity. However, this has to be done at the
threshold.

It is the task of the Revenue/Court to ascertain the legal

nature of the transaction and while doing so it has to
look at the entire transaction as a whole and not to
adopt a dissecting approach.

Supreme Court in Vodafones case

...we are of the view that every strategic foreign direct

investment coming to India, as an investment destination,
should be seen in a holistic manner. While doing so, the
Revenue/Courts should keep in mind the following factors:
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 will be on the
Revenue to identify the scheme and its dominant purpose.

Although there is a mention of dominant purpose of the

scheme here, earlier observations refer to discarding the
structure when it has no commercial/ business substance.

Summing up

The doctrine of substance over form well entrenched in Indian

tax laws, even as its application may not be as uniform and
consistent as aggressively pursued by the revenue
authorities.
It is only in extreme cases where form of a transaction is not
at all defensible on commercial basis (other than for tax
planning) that the doctrine of substance over form is invoked.
As long as there is some commercial justification for the form
of a transaction, judiciary generally refrains from invoking it
Schemes and transactions where economic substance is
significantly different from the legal form, or where an entity
without economic substance is used in a transaction, are at
risk.

Thank you !