Monday, April 26, 2010

Porrits & Spencer: Form over Substance Reaffirmed

We have extensively discussed issues around tax avoidance previously; and one of the questions in this regard is the exact relationship between the 5-Judge Bench decision in McDowell and the subsequent 2-Judge Bench decision Azadi. To briefly recapitulate, in McDowell, Justice Chinappa Reddy took a strong stance against tax avoidance and effectively equated avoidance with evasion. Under Justice Chinappa Reddy’s reading, tax avoidance was also illegal. In Azadi, the Bench held that Justice Chinappa Reddy’s opinion was a “far cry” from the view of the majority; and cited some paragraphs from McDowells’s majority opinion (per Justice Ranganath Mishra) to support this view. What creates some confusion is that the majority however also states that on the issue of transactions planned because of a tax-saving motive, “one of us, Chinnappa Reddy, J., has proposed a separate and detailed opinion with which we agree.” This opens the door for the Revenue to try to circumvent Azadi. I have discussed these issues previously here. (What is also noteworthy is that a petition for review of the judgment in Azadi has been dismissed, and a curative petition against that dismissal has also been rejected by a 5-Judge Bench. The order dismissing the curative petition can be found here.)

Some subsequent decisions – including Akshay Textiles of the Bombay High Court and E*Trade Mauritius of the AAR (discussed here) – suggest that the Revenue’s argument of following McDowell over Azadi is incorrect. The clearest and most recent indication of this comes in a recent decision of the Punjab & Haryana High Court in Porrits & Spencer v. CIT.

The assessee had purchased certain units of ‘US64’ of the Unit Trust of India at the market rate from ANZ Grindlays Bank in May 1990. In June, dividend was declared on those units, and the assessee claimed deduction on the dividend under the then-existing Section 80-M of the Income Tax Act, 1961. The assessee sold the units back to ANZ Grindlays Bank in July. In the course of this transaction, the assessee incurred a loss of Rs. 51,61,875. This sum of loss represented the difference between the purchase price and the sale price plus transaction costs.

The Tribunal had held that these transactions (on which losses had been incurred) would have to be ignored, as they were entered into only because of a tax-saving motive. The Tribunal found that the assessee had planned to purchase the shares in May and then sell them after 60 days in July. Furthermore, a finding was made that the reason why the assessee took such a step was that the assessee was well aware that dividend was to be declared in the month of June. As noted above, this dividend was indeed declared, and the assessee claimed deduction under Section 80-M of the Income-tax Act. Furthermore, the Tribunal also found that “the assessee (knew) that there will be a loss on account of sale in the month of July and there was a loss of Rs. 51 lakh and odd, which it claimed against its business income. In this way, the assessee claimed deduction u/s 80-M and then he claimed deduction on account of loss against business income also.” Taking a negative view of this series of transactions, the Tribunal concluded, This planning, in our considered view, cannot be approved, as the same was clear cut planning to reduce the tax effect, which is not permissible in the eyes of law…

This holding was reversed on appeal to the High Court. After considering both McDowell and Azadi, the Court observed, “The argument of the learned counsel for the revenue-respondent based on the judgment rendered in the case of McDowell & Co. Ltd. (supra) cannot be accepted because the judgment rendered by Hon’ble Mr. Justice O. Chinnappa Reddy in McDowell’s case has been explained in detail by the later judgment of Hon’ble the Supreme Court in the case of Azadi Bachao Andolan (supra). It is well settled that if a smaller Bench of Hon’ble the Supreme Court has later on explained its earlier larger Bench then the later judgment is binding on the High Court. In that regard reliance may be placed on a Full Bench judgment of this Court rendered in the case of State of Punjab v. Teja Singh, (1971) 78 PLR 433… once the transaction is genuine merely because it has been entered into with a motive to avoid tax, it would not become a colourable devise and consequently earn any disqualification…

The decision strongly reaffirms the form-over-substance approach of the judiciary towards tax planning; and it appears that arguments based purely on McDowell will not persuade Courts easily.

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