Tax Avoidance and Tax Evasion: How the judiciary understands the difference

Tax is a mandatory charge paid by a citizen of a country to the government to funds for undertaking public projects incurring expenditures. A default in payment of taxes may amount to tax avoidance or evasion. Understanding the difference between tax evasion and tax avoidance is essential as one of them is punishable by law and the other one is not. However, this line of distinction is a thin one and judicial pronouncements in India have also not been the most consistent. This article discusses three important landmark judgements of the Supreme Court which discussed the distinction between tax avoidance and tax evasion in order to determine which one is lawfully permissible.

M/s McDowell and Company Limited v. Commercial Tax Officer[1]

As per the Andhra Excise Act of 1968, a manufacturer was liable to pay excise tax before he could remove any liquor from the distillery. McDowell was a manufacturer or liquor who in order to reduce their tax liability, made their purchasers pay the excise duty amount so that liquor could be removed from the distillery. The result being that the sale invoice prepared by McDowell only reflected the amount received for the sale of the liquor but not the amount paid as excise duty. The sales tax authorities objected to the non-inclusion of the excise duty in McDowell’s turnover. The Supreme Court in 1976 held that the purchasers also legally obligated to pay excise duty collected by the excise dept. and that the excise duty amount did not form a part of the common till of the manufacturer or the assesse and was not a part of its circulating capital. Therefore, since the purchasers directly paid the excise duty, the tax authorities cannot include that amount as a part of the assessee’s turnover.

Thereinafter, the Excise rules were amended in 1981 stating that no liquor was to be removed unless excise duty had been paid by the manufacturer who is a holder of D-2 license. Thereby obliging only the manufacturer to pay the excise duty. Based on the revised rule, McDowell was sent a notice again demanding the inclusion of excise duty amount as a part of its turnover amount. The matter was presented again in the SC for consideration. The SC majority judgement held that the amended rules should be read as it is, making the manufacturer’s total turnover to include the excise duty which the rules indicate that it should be paid by him. The argument that the purchaser already paid the excise duty on behalf of the manufacturer should only be considered as a fulfillment of the agreement between them and nothing more. On the issue of tax avoidance and tax evasion, the court held that tax avoidance within legal contours is very much legal and permissible as long as there is no use of any colorable devices is over to avoid tax payment. In Justice Chinappa Reddy’s ‘concurring’ opinion, he stated that courts must look at nature of the transaction to ascertain whether it was for dishonest purposes carried out with the intention of avoiding payment of taxes. No one can get away with tax avoidance merely because statutorily, there is nothing illegal about it.

Union of India v. Azadi Bachao Andolan[2]

In the present case, the court was tasked with the interpretation of a Double Tax Avoidance Agreement between India and Mauritius. According to the agreement, Capital Gains accrued by a Mauritian resident is liable to be taxed in Mauritius and not in India. On the basis of this, many Mauritius residents invested in India so as to not incur tax liabilities in India. Thereby income tax authorities sent out notices to these companies alleging them to them shell companies which were operated by non-Mauritian residents with the intention to take advantage of the India-Mauritius agreement.

The court observed that the agreement did not include any provision of a ‘term of limitation’ prohibiting nationals of a third state from using the advantage of the India-Mauritius tax agreement ignoring them specifically. Thereby giving the impression that the legislature was fine with such ‘non-residents’ from using the advantage granted by the agreement. In absence of such express wording of the agreement, the court cannot assume the intention of the legislature. Ultimately granting the judgement in favour of the assesses. The court was also of the opinion Justice Reddy’s views on there being no distinction between tax evasion and tax avoidance and any attempt at lessening tax burden as being unlawful was an extreme view and could not be considered to be a good decision.

Vodafone International Holdings Ltd. v. UOI[3]

In this case, the court was to consider the validity of the allegation of the tax authorities that a transaction carried outside India was to be taxed in India as it involved the transfer of effective management of an Indian subsidiary company. The SC again held that intention of the parties in question was not necessary to take into account. The only factor which must be ascertained is whether the legislature allows the transaction or not. Court must not interpret legislative intent to include instances which the legislature did not want to be included.

In conclusion

The Supreme Court has made it absolutely clear the use of colourable devices, in an attempt to avoid paying taxes is unlawful and amounts to tax evasion. The problem seems to arise on the question of who decides what constitutes as a colourable device- the judiciary or the legislature. Legislature is the obvious answer. It is my opinion that Justice Reddy in his McDowell opinion, wanted the court to take proactive stance in ascertaining whether a particular transaction is unlawful should not be considered good law. This will amount to judicial overreach. Some have sided with Justice Reddy’s opinion based on the argument that India being a welfare state which depends largely on public generated revenue for its financial needs requires judiciary to take a proactive stance to clamp down on individuals looking for ways to reduce their tax liability. But I believe being a welfare state also entails protecting economic interests of its individuals. It would be unfair for the legislature to encourage tax planning, give tax reduction incentives so that more people invest in getting health insurances, buy houses etc. on one hand and then say that looking for ways of reducing tax is unlawful and amounts to tax evasion. It does not make sense. This does not mean that judicial scrutiny becomes meaningless. Ascertaining the true nature of a transaction is important in order to see whether colourable devices were used but if the statue remains silent or does not invalidate the outcome of such transactions, the courts should not overreach their power to deem them as unlawful. The three landmark cases do not seem to be the end of discussion on this topic and we may expect more light to be shed on this question in future decisions.

[1] McDowell v. CTO (1985) 154 ITR 148 (SC)

[2] Union of India and anr v. Azadi Bachao Andolan (2003) 263 ITR 706 (SC)

[3] Vodafone International Holdings Ltd. v. UOI [2012] 1 SCR 573

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