December 2, 2008

Avoidance and evasion are different birds

The 4,000-odd amendments to the Income-Tax Act in the past 42 years are evidence to the unending tussle between taxpayers and tax-collectors - the former forever trying to reduce or negate their tax liability and the latter constantly attempting to plug the lacunae in the law.
Taxmen cannot collect tax except with the authority of law. The taxpayer, within the framework of the same law, is entitled to reduce his/her tax liability.
If the exchequer attempts tax collection without legal basis, it is unconstitutional. Likewise, when an assessee escapes tax payment beyond law, he is an evader liable for prosecution.
Avoidance vs evasion
Tax avoidance is reducing or negating tax liability in legally permissible ways. It has legal sanction.
For instance, a person may change his residential status, adopt different accounting methods for different sources of income or invest in tax saving securities or other tax-planning schemes - all these may reduce/negate tax liability, but within the provisions of statute, respecting and taking full advantage of the law.
Reducing or negating tax dues beyond what is permitted by law is outright concealment, and amounts to evasion.
While tax evasion is to be condemned, tax avoidance is an assessee's entitlement.
Courts have consistently given tax avoidance a favourable treatment. Nearly 75 years ago, the British courts recognised taxpayers' rights in the legal method of avoidance. The Duke of Westminster case (see chart 1) is a landmark judicial pronouncement on this fundamental concept.
The English precedents were relied on repeatedly by Indian courts as well. Tax avoidance was thus seen as a permanent right of assessees. Then came the turbulence, temporary though.
The Supreme Court, in the McDowell & Co Ltd vs CTO (1985 154 ITR 148 SC) case, said that time has come to depart from the old thinking. It said even tax avoidance is bad and deserves condemnation. The apex court's justification for this being, the House of Lords, the highest judicial forum of English, has given a go-by to the principle laid down by the British courts (in Duke of Westminster case).
Since tax avoidance as a legal route was rejected by the very country of origin, it does not merit any better treatment in India, the Supreme Court held.
The adverse legal consequences of this judgment for taxpayers were enormous. First, it came from the highest court of the land and, therefore, binding on all lower courts and Tribunals.
Two, the McDowell case blurred the distinction between avoidance and evasion. The Department, of course, welcomed the ruling. It repeatedly tried applying this case, as only the Supreme Court can undo the McDowell case, if at all. And fortunately the apex court did reverse the findings in the McDowell case in Union of India vs Azadi Bachao Andolan (2003 132 Taxmann 373 SC).
It was argued before the Supreme Court that the McDowell case had changed the face of fiscal jurisprudence in the country. Therefore, for any tax planning, the court must strike down what is intended to and results in avoidance.
Rejecting this argument, the apex court upheld the legitimate rights of taxpayer in tax avoidance. In the process, it found that the McDowell ruling was nothing exceptional but only an exception to the well-settled law.
The court did an excellent analysis of a number of cases, both in the UK and India, and brought to surface the legal misinterpretation by which the same court earlier came to the sensational conclusion.
Legal misinterpretation
On two counts the apparent tenor of the McDowell case was legally incorrect.
First, even in the McDowell case, Justice Ranganath Mishra confirmed that tax planning might be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods.
The rest of the judges, other than Justice Chinnappa Reddy, did not contribute to the radical thinking that tax avoidance itself is bad.
Second, the decision was flawed on the court's assumption that the British courts have disassociated themselves from the Westminster principle, as evidenced by three cases: W.T. Ramsay Ltd vs IRC (1982 AC 300); IRC vs Burman Oil Co Ltd (1982 STC 30); and Furmiss vs Dawson (1984 1 ALL ER 530).
Contrary to this, the House of Lords had occasion to analyse the very same trilogy of cases, three years after the McDowell ruling was pronounced and clearly affirmed its support to tax avoidance and the principle lay down in the Westminster case still valid. This position was vindicated even as recently as 2001.
Factual error
Each case spins around its own facts. The three decisions of the House of Lords (which were heavily relied on in the McDowell case) were rendered in the context of facts entirely dissimilar to those before the Supreme Court in the McDowell case.
In this case, the question under the Andhra Pradesh Sales tax law was whether excise duty voluntarily paid directly to the State by the buyer should be included in the turnover of the manufacturer, who contended that sale tax was payable only on the contractual sale price, which did not include excise.
The House of Lords cases, admired by the court in the McDowell case dealt with sham cases; these were readymade schemes (usually purchased off the shell), which involved a series of inter-connected transactions, which were `self-cancelling".
These make-believe schemes were commercially inert, only intended to be fiscally active to produce a desired tax effect.
The settled legal position
Indian courts, in spite of McDowell decision, have been carefully allowing legitimate tax avoidance measures.
The apex court, in Union of India vs Azadi Bachao Andolan, summarised the legal position with regard to tax avoidance as follows:
Before the Constitution came into being, the principle laid down in the Duke of Westminster case was fully approved and followed in the Bank of Chettinad Ltd vs CIT (1940 8 ITR 522 PC) case. This Privy Council judgment was the law when the Constitution came into force.
This legal position continued in terms of Article 372 - by which, all the law in force in the territory of India immediately before the commencement of the Constitution shall continue in force until altered or repealed or amended by a competent Legislature or other competent authority.
This principle also acquired the judicial blessings from the Constitution Bench of the Supreme Court of India.
The legal principle will continue to hold good unless reversed by a clear verdict of the Supreme Court or by an Act of Parliament.
Thus tax avoidance was, is and will be permissible. It is settled law that tax avoidance is always allowed.
McDowell was a freak decision, which temporarily attempted unsettling this clear legal entitlement. The only ways in which tax avoidance can be threatened are another Supreme Court decision overruling the latest one.
This does not seem possible in the near-term owing to the extensive research, clinical analysis of series of literature on the subject for the past eight decades in the Azadi Bachao Andolan case.
The other option is that Parliament can legislatively suppress the decision by specifically incorporating anti-tax-avoidance measures.
It can condemn tax avoidance on moral and ideological grounds, but not before looking at the following observations of Justice Sabyasachi Mukharji in the Arvind Narotam case:
"One would wish, as noted by Justice Chinnappa Reddy, that one would get the enthusiasm of Justice Holmes that taxes are the price of civilisation and one would like to pay that price to buy civilisation.
"But the question, which many ordinary taxpayers very often in a country of shortages with ostentation consumption and deprivation for the large masses ask, is does he with taxes buy civilisation or does he facilitate the waste and ostentation of the law.
"Unless waste and ostentation in government spending are avoided or eschewed, no amount of moral sermons would change people's attitude to tax avoidance."

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