Legitimate versus illegitimate tax planning – Delhi High Court dissects Vodafone

Globally, the sphere of taxation has witnessed a constant tussle between its primary players – while governments continually strive to maximise revenue and widen the tax base through successive amendments to tax laws and streamlining tax administration, taxpayers seek to arrange their affairs in a manner so that the incidence of tax is minimised.

India is no exception to this phenomenon. The backdrop to this tussle is also formed by the dichotomy in the government’s attitude to taxation. While the imperatives of being a welfare state demand that the Indian government seek revenue maximisation to finance its public responsibilities, it also employs tax incentives as an economic tool to spur the growth of priority sectors. It is in this context that one needs to delineate the boundaries of legitimate tax planning by taxpayers and answer the question as to what constitutes illegitimate tax planning or, in other words, tax avoidance.

The Delhi High Court ruling

Throughout the development of the jurisprudence and principles governing tax planning, the courts have always held that every taxpayer is entitled to arrange his affairs so that his taxes shall be as low as legally possible and that he is not bound to choose that pattern which would add to the coffers of the government treasury.

The question which then arises is: how does one determine the boundaries of legitimate tax planning? One approach, which is adopted in the US, is the application of the test of ‘business purpose’ or ‘economic substance’. Under this test, the tax authorities are empowered to examine the substance of a commercial transaction to determine if it is devoid of any business purpose or lacks economic substance and the only objective of entering into the transaction is to gain any tax advantage. The other approach, known as the Westminster principle, states that: “Given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance” and is also referred to as the form over substance approach.

In a recent ruling delivered in India in the case of CIT v Shiv Raj Gupta, the Delhi High Court (HC) has analysed the principles laid down by the Supreme Court of India (SC) on legitimate versus illegitimate tax planning in the landmark case of Vodafone International Holdings BV ([2012] 341 ITR 1 SC). The ruling was rendered in the context of taxability of non-compete fees received by an individual in connection with the sale of shares and controlling interest in a company. The HC held that the share sale consideration had been artificially bifurcated into non-compete fees and sale consideration so as to avoid taxation; and that such bifurcation was a “colourable device” which resulted in abusive tax avoidance.

In the above ruling, the HC elaborates that the Vodafone ruling rejects the economic substance and business purpose tests and holds that a transaction entered into by a taxpayer would amount to tax avoidance, that is, illegitimate tax planning, when the taxpayer adopts a colourable device, dubiousness and otherwise indulges in a sham arrangement or transaction. The HC observed that the dividing line between legitimate and illegitimate tax planning as per the Vodafone ruling is therefore ethically principled and moralistic and illegitimate tax planning involves some subterfuge or artifice on the part of the taxpayer.

The HC made the following important observation: “pre-ordained, circular or self-cancelling transaction with a step or steps having no commercial purpose or lack of economic or business purpose could in a given case be, though not necessarily, a relevant fact, yet they are not the touchstone, yardstick or the final test. These could be circumstances or facts to infer and discern whether the taxable event selected was a colourable device, sham or deceit and not the tax event intended by the parties. Right to choice to select the most beneficial legal way and manner to execute a transaction is unquestionable and perennial. A fact is not the test; rather the corrupt and mendacious conduct, i.e. colourable device, sham or deceit, is the specified bright line, dividing acceptable tax avoidance from abusive tax avoidance.”

Reigniting the form versus substance debate

The HC reiterates the ‘look at’ approach expounded in the Ramsay ruling and adopted by the SC in Vodafone case which requires the tax authorities and courts to look at the document or transaction in the context to which it properly belonged, that is, to understand the real nature of a transaction, one has to look at the entire transaction as a whole and not adopt a dissecting approach. The ‘look at’ test is to ascertain the true legal nature of the transaction in an holistic manner.

However, the HC also holds that the true nature of the transaction or terms of the agreement may be determined from the surrounding circumstances and in each case, the court (unless prohibited by the statute), has the power to go behind the document and determine the nature of the transaction whatever be the form of the document. With this observation, the HC seems to be deviating from the ‘look at’ approach adopted in the Vodafone ruling and leaning towards the ‘look-through’ approach. Admittedly, the distinction between these approaches is not clear-cut. Nonetheless, this aspect of the HC ruling has the potential to perhaps add fuel to the fire of the debate on substance versus form in the context of tax planning.

Thin line of distinction

With the General Anti-Avoidance Rules (GAAR) looming on the Indian tax law horizon, aspects of tax planning and what constitutes tax avoidance have assumed increased importance. The GAAR rules themselves employ concepts such as commercial substance and ‘impermissible avoidance arrangement’ which have a necessary element of subjectivity in them. There is a thin line of distinction between legitimate tax planning and tax avoidance and it is a very fact-specific enquiry depending upon a close examination of the actual conduct of the taxpayer and all relevant facts. Therefore the significance of establishing clear boundaries of what constitutes legitimate tax planning cannot be overstated.

It is also advisable for taxpayers to ensure that the documents effecting transactions entered into by them are properly drafted such that they bring out their actual intentions and place the surrounding circumstances on record, thereby avoiding unnecessary litigation.