Wednesday, February 3, 2010

Corporate Restructuring and the Business Purpose Rule

In 1935, the House of Lords famously observed that “every man is entitled to order his affairs” in order to minimise his liability to tax (IRC v. Duke of Westminster, [1936] AC 1). This is the dictum that is often cited as the source of the rule that while tax avoidance is legal, tax evasion is not. The distinction between the two, while not always clear, is regarded by some as especially thin after the growth of the corporation as the preferred vehicle of investment, and defining the use of the corporation as a tax planning device is one of the greatest challenges that corporate and taxation law face today.

India has seen its fair share of controversy in this area. Traditionally, it followed the Westminister rule that tax avoidance is legal, and that a citizen is entitled to the benefit of the letter of the law, even if the result is manifestly contrary to its spirit. This seem rather well-established, until Justice Chinnappa Reddy’s “concurring” opinion in McDowell v. CTO, where he observed that the “ghost” of the Duke of Westminster must be “exorcised” and that any device intended to avoid tax liability is illegal. It is difficult to conclude that the majority endorsed this reasoning, although some dicta in the case suggest that it did. In 2003, however the Supreme Court rejected Justice Reddy’s view in Azadi Bachao Andolan, and the law continues to be the position expressed in Andolan.

In this connection, the recent decision by the Authority for Advance Rulings in Star TV v. Director of International Taxation, Mumbai is a welcome one. A copy of the decision is available on the AAR website. In this case, three Star TV companies incorporated in the British Virgin Islands decided to amalgamate with the Star TV Indian entity, known as Star India Pvt. Ltd. [“STPL”]. The reason offered was that it was to the commercial advantage of Star TV to consolidate its holdings in one company. Before the AAR, the Revenue argued that approving this merger would have adverse consequences on the Revenue, and more importantly that the AAR should itself decline to answer the question since the transaction was designed to avoid tax. The power of the AAR to answer a reference is circumscribed by s. 245R of the ITA, which provides that the “Authority shall not allow the application” where the question raised in the application relates to a “transaction which is designed prima facie for the avoidance of income tax”. Consequently, the AAR considered tax avoidance not in the context of chargeability, but as a jurisdictional question. Indeed, even if the AAR had concluded that the transaction in question was designed primarily to avoid tax, it would not have followed that it is chargeable to income tax merely for that reason.

In any case, an analysis of the opinion reveals support for the Westminster principle. The Revenue argued that the object of the arrangement was to avoid the payment of existing tax dues. This, it is clear, could not have been the case, since, as the AAR held, an amalgamating company transfers its liabilities to the entity into which it amalgamates. As to the argument that this reduces the capital gains tax payable in the future, the AAR noted the developments in India leading upto to Andolan, and that the Westminster principle continues to be applicable. Consequently, the AAR construed “designed for the avoidance of tax narrowly”. The following observations are apposite:

A design to avoid the tax within the meaning of clause (iii) of the proviso to Section 245 R(2) apparently covers such of the transactions which are sham or nominal or which would lead to the inescapable inference of a contrived device solely with a view to avoid the tax. The corollary thereto is that there is no real and genuine business purpose other than tax avoidance behind such transaction.”

The “business purpose” test, according to the AAR, only requires that the arrangement afford some commercial benefit. In this case, the test was satisfied by the business purpose of consolidating various entities into one entity, which achieves “synergies of operation and enhanced operational flexibility.”

In sum, this decision is another indication that India’s tax avoidance jurisprudence is continuing to recede from Justice Reddy’s observations in McDowell, and accepts any device short of a sham. There continues to be some doubt, however, over whether a transfer arising out of an amalgamation is a "transfer" in the first place, for the purposes of s. 2(47) of the ITA. This has interesting implications for the taxability of share transfers in a scheme of amalgamation.

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