“Tax avoidance” means arranging affairs where the main object or purpose or one of the main object or purposes of the arrangements are to obtain tax advantages, although the arrangement, even though it could be strictly legal, is usually in contradiction with the intent of the law it purports to follows.
Thus, one can identify the following characteristics in case of a Tax avoidance:
- Obtaining tax advantages is the main or one of the main object’s of how the Taxpayer’s affairs are arranged
- Such arrangement could still be strictly legal ;
- The arrangement are usually in contradiction with the intent of the law, which it shows its following.
TECHNIQUES OF TAX AVOIDANCE
METHODS OF USING THE TAX AVOIDANCE TECHNIQUES
Anti-Avoidance measures are either a part of the tax statute by specific incorporation therein or developed by the judiciary over a period of time.
A. JUDICIAL ANTI-AVOIDANCE DOCTRINES
B. BUSINESS PURPOSE RULE (MOTIVE TEST)
Under the “business purpose rule” , the taxpayer is required to justify the following : –
- What are the business reasons of entering a particular transaction, and
- Why such transactions can be said to be not entered into , only for tax avoidance.
In the case of GREGORY V. HELVE RING , it was held that where the sole purposes of entering into a corporate organization , was to qualify for certain tax benefits, taxpayer was not entitled to such benefits, even when such reorganization was permitted under the law.
C. SUBSTANCE OVER FORM RULE
The principle of “substance over form”, requires that the economic, or social reality (that is substance), should prevail over the literal wording of legal provisions to determine the tax consequences of a transaction. The application of this doctrine produces tax result that are different from the tax result that the form of transaction would present.
Where a taxpayer has created certain documents , wherein a scheme of certain transactional relationships is made to obtain certain tax advantages, although in reality, there is no such economic linkage, as it appears from the documents, substance of the transaction, and not the form presented in documents should get precedence to decide the tax outcomes.
For example a non-resident seller of goods , has an Indian agent who sells goods on behalf of non resident and who may be an agency PE of the non-resident in India. To avoid PE exposure , the non resident shows the agency relationship as that of Principal to Principal through an agreement, and shows sale of goods outside India. The agent’s commission is equivalent to the margin left by the non-resident seller with the Indian party. In such a case, the substance of the transaction, and not the form presented in documents should get precedence to decide the tax outcomes
FACES OF SUBSTANCE OVER FORM RULE
Following are the faces of the substance over form rule : –
i. LEGAL V. ECONOMIC SUBSTANCE
Under several provisions related to taxation of income, a non-resident is entitled to the benefits of the tax treaty, only when he is both the legal, as well as the beneficial owner of income. Where the recipient to receive anything on behalf of another person, who is not a resident of the state , the benefit under the Treaty are denied.
In such cases of legal vs economic substance, the legal form of the transaction is presented in a manner, that the legal owner (taxpayer) has real economic power over taxable income, so that there is no tax liability. In such cases it is important to distinguish between the legal ownership and economic ownership. The Treaties benefit should generally be given to the economic owner of income rather than the legal owner
For Example, a US company which intends to invest into an Indian company, floats a Mauritius Entity to invest into an Indian entity. While the US company would still have complete ownership of Indian entity, capital gains arising on transfer of Indian entity would not be taxable as an exemption from Capital gains would be available under the India Mauritius Treaty.
ii. SHAM TRANSACTIONS
Sham transaction doctrine, seeks to deny tax benefit treatment to transactions which are entered into only for the sake of avoiding tax.
A sham transaction is the one where the ‘tax avoiders’, give effect to a transaction, which they : –
- Do not carry out ; or
- Do not intend to carry out; or
- Are cover ups for another transaction or relationship, and such transaction or relationship, if they would not have been covered up would have resulted in an adverse tax implications.
For example, X Ltd. bought a share for Rs. 1,000 on which a dividend of Rs. 200 was declared, but not paid on the date of purchase. It receives dividend income of Rs. 200 and claims it exempt from tax. Later on it sells the share for Rs. 600 and claims capital loss of Rs. 200.
iii. DOCTRINE OF THE LABEL (“WRONG CHARACTERIZATION”)
Parties use incorrect labels to classify or characterize a transaction or relationship for tax purposes.
While the transactions in such cases are real and not artificial or fraudulent, and also create legal rights and liabilities, the true legal rights and obligations differ from the characterization by the taxpayer.
For example, a transaction may be defined as a loan when it is actually an equity, to enable parties to claim tax deductions or lower rate of taxation under Treaties.
iv. STEP-TRANSACTION DOCTRINE
In these cases, the taxpayers break a single transaction into distinct steps, which result in its acceptance for tax purpose and results in favorable taxation.
Certain countries (like USA, UK, Japan and Canada) regard a series of connected transactions as a single transaction under the “substance v. form” principle.
In India, with the introduction of GAAR regulations, such transactions can be clubbed to determine the tax consequences.
v. PIERCING THE CORPORATE VEIL
Under corporate laws, a company has a separate and distinct existence, vis a vis its shareholder.
Lifting of corporate veil refers to disregarding such separate and independence status of a company, and to directly tax the shareholders of such company
For example in case of a Mauritius company (owned by US shareholders), which has been used as an intermediary to invest in Indian company, and claim capital gains exemption under India-Mauritius Treaty, lifting of corporate veil refers to disregarding status of Mauritius company, and to directly tax the US shareholders of such company on capital gains arising on sale of shares of Indian investee company.