Sunday, October 19, 2008

The Tax Evasion Debate Revisited

An earlier post here had looked at the interrelation between the ratios of Azadi Bachao Andolan and McDowell on the issue of tax evasion, and concluded that the stricture against tax evasion laid down in McDowell hadn’t been completely laid to rest by Azadi, and that there still was scope for challenging a proposed transaction as being motivated purely by tax avoidance. A recent decision of the Bombay High Court in CIT v. Walfort Share & Stock Brokers Ltd. revisits this debate, partially reading down, and partially expanding the decision in Azadi.

The assessee (respondent), a member of the Bombay Stock Exchange, had entered into a transaction of purchasing dividend bearing units of Chola Freedom Technology Fund and then redeeming them at a loss after receiving the dividend on them. The dividend earned was then sought to be exempted under s. 10(33), Income Tax Act, and the loss was sought to be set off as a business loss against its other income. This loss was disallowed by the Revenue on the ground that there was no business purpose behind the transaction, and that the only motive was to manufacture a ‘loss’ to set off against other income. Thus, it, being a tax avoidance transaction, was challenged by the Revenue.

The Income Tax Act had been amended w.e.f 1-4-2002 to weed out such transactions. However, this transaction having been entered into prior to this amendment, the Revenue’s only grounds of challenge were the reality of the transaction and the motive.

First, it was contended that the loss was an artificial loss, and hence could not be allowed as a valid business loss under the Act. The Court rejected this contention, albeit on slightly dubious reasoning. The Court held that if the loss was to be considered artificial, s. 94(7) would be rendered otiose, since the loss would anyway have been disallowed. The Court went on to say that the only way then s. 94(7) could be given meaning was if it made a heretofore disallowable loss allowable and then didn’t allow it in certain cases. While this reasoning achieved the desired result, it is submitted that a simpler approach would have been to hold that the amendment was prospective (which the Revenue was in agreement with) and that its very introduction meant that the law prior allowed the loss.

Secondly, and more relevant for the purposes for the tax evasion debate, the Revenue placed reliance on McDowell to argue that the transaction of purchase and sale was a composite one for the purposes of creating an artificial loss, and should not be treated as two independent transactions. The assessee, represented by Mr. Dastur, contended that after the decision in Azadi, a transaction which is within the bounds of the law cannot be questioned on grounds of any underlying motive. The Court rejected the Revenue’s contention by restricting McDowell to facts, and following the ratio in Azadi. What is of particular interest here is the caveat retained by the Court, in stating, “in the absence of any allegation that it was a sham transaction”, the assessee would be entitled to set off the loss. As pointed out in the
previous post, the language of Azadi leaves open the door open for lifting the corporate veil in cases of sham transactions, or when the two corporate entities formed a single economic unit. This decision further seems to reaffirm that conclusion, thus narrowing the popular import of Azadi. Ironically, what the Bombay High Court also does is inadvertently widen the scope of Azadi. A second reading of Justice Reddy’s opinion in McDowell showed that he did not impose an absolute bar on tax avoidance measures, but mandated an inquiry into “whether the transaction is such that the judicial process may accord its approval to it”. On the facts of that case, he had concluded that, for several policy reasons, the arrangement should not be approved. However, the facts there did not concern international investment and DTAAs. Given the other policy justifications that do weigh in favour of allowing limited treaty shopping in the case of DTAAs and international investment, those policy reasons may not have as much force in a case similar to that in Azadi. Thus, even within the ambit of permissible tax avoidance as laid down by Justice Reddy, it may be possible to justify the decision in Azadi. Such an interpretation, would whittle down the scope of the decision in Azadi, but would serve to reconcile the two decisions. What the decision in Walfort does is apply the Azadi logic to a case far removed from any DTAA issues. In fact, on the facts of Walfort, the policy imperatives seem to argue against a pro-assessee decision. By so applying Azadi, it has, in a way, widened the scope of Azadi, and possibly completed the departure from McDowell, subject to the sham exception.

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