The Hindu Business Line : Eternal debate on tax avoidance

With courts recognising a taxpayer's right to pay as little tax as possible, there has always been debate on whether such arrangement of one's finances constitute (acceptable) tax mitigation or (unacceptable) tax avoidance. But the assessments cannot be made solely on the basis of the figures or arithmetical calculations. Each case has to be decided on its own merit, says H. P. Ranina.

FROM time immemorial, courts have upheld a taxpayer's right to so arrange his affairs as would require him to pay the least amount of tax within the framework of the law. The debate on what constitutes tax avoidance commenced with the decision in the case of McDowell and Co. Ltd. v C.T.O. (154 I.T.R. 148 (SC); [1985] 59 S.T.C. 277 (SC)). This decision of the apex Court relied on the decision of the House of Lords in W. T. Ramsay Ltd. v I.R.C. ([1982] AC 300).

The decision in the case of W. T. Ramsay Ltd. came up for consideration in 2001 before the House of Lords in Macniven v Westmoreland Investments Ltd. (255 I.T.R. 612). In the latter decision, the House of Lords observed that the boundary of the Ramsay principle can be defined by asking whether the taxpayer's actions constituted (acceptable) tax mitigation or (unacceptable) tax avoidance.

In Inland Revenue Comrs v Willoughly ([1997] 1 WLR 1071, 1079), Lord Nolan described the concept of tax avoidance as "elusive". In that case, the House had to grapple with what it meant, or, at any rate, what its "hallmark" was, because the statute expressly provided that certain provisions should not apply if the taxpayer could show that he had not acted with "the purpose of avoiding liability to taxation".

The same question arose on the interpretation of the anti-avoidance provisions to which Lord Cooke of Thorndon referred in Inland Revenue Comrs v McGuckian ([1997] 1 WLR 991, 1005). After considering all the authorities, the House of Lords in the case of Westmoreland Investments Ltd. held that statutory construction involved ascertaining what Parliament had meant by using the language of the statute, and all other principles of construction were no more than guides to assist in that task.

The first step in the process was the identification of the concept to which the statute referred; that if the statutory language was construed as referring to a commercial concept and steps which had no commercial purpose had been artificially inserted for tax purposes into a composite transaction, they would be disregarded for the purposes of applying the relevant concept.

A transaction which came within the statutory language, construed in the correct legal or commercial sense, could not be disregarded merely because it was entered into solely for tax purposes.

Recently, the Special Bench of the Income-tax Appellate Tribunal in Mid East Portfolio Management v C.I.T. (271 I.T.R. (AT) 87) once again dwelt on the controversy initiated in McDowell's case. The facts in this case pertained to a sale and leaseback transaction whereunder the assessee claimed depreciation of Rs 97.50 lakh in respect of air pollution equipment being an electrostatic precipitation system, at 50 per cent of the cost of Rs 1.95 crore because the asset concerned was used in the leasing business for less than 180 days during the relevant accounting year.

The equipment was purchased from the Rajasthan State Electricity Board (RSEB) on March 27, 1995, just four days before the close of the accounting year by a sale deed and was leased back to RSEB on the very same day for ten years. The equipment was lying at Kota in Rajasthan and, before its purchase by the assessee, was being used by the RSEB for the generation and distribution of electricity.

The Assessing Officer was of the prima facie view that the transaction was a colourable device to claim depreciation and was a mere lending of monies by the assessee on the security of the assets belonging to RSEB on the grounds that:

the whole arrangement was put through with the motive of infusing funds into the RSEB and there was no intention to purchase the assets and lease them back;

there was no delivery of the assets by the RSEB;

the exact location of the assets was not mentioned and there was no identification thereof;

the RSEB had not filed any information about the written down value of assets before the sale to the assessee;

the assessee was quite casual in verifying even the existence of the assets;

the assessee never became the real owner of the equipment since it had no rights of ownership as per the sale deed, not even the right to sell the asset; and

the RSEB could not afford to remove the asset which would affect and disrupt the working of its entire plan.

The Assessing Officer invoked the doctrine in McDowell's case (154 I.T.R. 148 (SC)) and disallowed the assessee's claim for depreciation. The Commissioner (Appeals) confirmed the disallowance. The Special Bench, while dealing with the appeal, observed that in a sale and leaseback transaction an asset is sold by A to B and simultaneously B agrees to lease out the assets to A for a consideration which is known as lease rental. There are three types of leases: (i) finance lease; (ii) operating lease; and (iii) hire purchase contract.

A finance lease is stated to be one which transfers substantially all the risks and returns of ownership of an asset to the lessee. Under this arrangement, the lessee is the economic owner. He can and usually does exclude the legal owner from the use of the asset for a period long enough to reduce the value of the property to a point where the legal title is economically insignificant.

An operating lease is a lease other than a finance lease. A hire-purchase agreement is a contract for the hire of an asset which contains a provision giving the hirer an option to acquire legal title to the asset upon the fulfilment of certain conditions stated in the contract.

Finance leasing is basically a method of financing. In a finance lease, the asset is transferred to the lessor first as and by way of security for the finance. This is invariably the case in sale and lease-back transactions where the seller of the asset becomes the lessee subsequently.

In the case of an operational lease, where the owner of the asset effects a simple lease thereof to the lessee for lease rentals, the question of the asset itself being security is satisfied by appropriate safeguards in the lease agreements. Here, the idea is not to finance the lessee, but to enable him to operate the asset and earn profits. In such cases, the asset is not previously owned by the lessee.

However, in the case of a sale and lease-back, which is a species of a finance lease, the asset is first purchased by the assessee and almost simultaneously leased back to the seller, who thereafter holds and uses the same in a different capacity. The erstwhile owner becomes the lessee after the lease. The advantage he gets is the money on sale of the asset to the assessee. The assessee is thus the owner of the asset but at the same time, the asset continues to remain with the seller, who has now become the lessee.

Explanation 4-A to section 43(1) of the Income-tax Act, 1961, inserted with effect from October 1, 1996, by the Finance (No. 2) Act, 1996, is a recognition of the position that all sale and lease-back transactions cannot be held to be motivated only by tax evasion.

The Explanation only seeks to thwart the move to inflate the value of the asset leased out, in order solely to obtain the benefit of 100 per cent depreciation. It applies to an otherwise genuine transaction. If the sale and lease back is not genuine there is no need to invoke the Explanation.

The absence of physical delivery may not be decisive since even in the case of a genuine sale and lease back, there could be no physical or actual delivery. The fact that there was only constructive or symbolic delivery of the asset cannot by itself decide the issue. The decisive issue is whether there was an intention on the part of the parties to really convey and acquire the property in the goods.

The view to be taken on a particular transaction cannot differ, depending on whether the parties have made a profit or have incurred a loss in the same. The assessments cannot be made solely on the basis of the figures or arithmetical calculations. Each case has to be decided on its own merits and on the basis of the peculiar facts obtaining in that case, more so when the question of genuineness is involved.

To conclude, the Special Bench decision is certainly not the final word on the subject. The matter will ultimately be decided by the Supreme Court since a substantial question of law is involved. Needless to add, the debate on the concept of tax avoidance refuses to die and will continue so long as the tax laws are in force.

(The author, a Mumbai-based advocate specialising in tax laws, can be contacted at ranina@bom2.vsnl.net.in)

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