The Hindu Business Line : Neutralising taxable gains with pre-arranged loss

A Karnataka High Court case where the transaction was so designed as to pass on the depreciation claim from a non-taxable entity to a taxable entity without the latter having to pay the price for it.

T. C. A. Ramanujam

Tax planning is an honourable term. It also goes by different names, such as tax mitigation and tax avoidance. Courts in both India and the UK have considered the matter at length and laid down parameters for acceptability of various devices for reducing tax liabilities. Debate goes on about the intricacies of the Supreme Court judgment in the McDowell (154 ITR 148) and Azadi Bachao Andolan (2003 263 ITR 706) cases. Litigation continue s to grow as companies adopt ingenious devices to circumvent the law. One of the latest in line is one from Karnataka.

The ICDS case

In this case (ICDS Ltd vs CIT — 2007 161 Taxmann 293 Karnataka), the company entered into several “leasing” transactions involving movables with Kasturiba Medical College, Manipal Institute of Technology and other educational institutions and trusts. Identical contracts were entered into. The company purchased assets and leased the same to the various institutions. It received refundable security deposits which were equivalent to the purchase value of the assets. Interest was payable on such deposits. Such interest was equal to the lease rental payable by the lessee. Depreciation was claimed by the lessor company in respect of assets leased out.

The assessing officer (AO) found that both the company and the institutions were controlled by common members. The security deposit was used to purchase the asset leased out. The company was able to adjust the lease rentals against interest payable on the deposit. It took the view that this was a “self-cancelling transactions”.

The educational institutions were not liable to pay income-tax and, therefore, could not claim depreciation on the assets. The net result was that the transaction enabled ICDS to claim depreciation on an asset which was actually purchased with the funds of a non-taxable entity. The AO disallowed the claim for depreciation amounting to Rs 44,22,955. The question was whether this action of the income-tax (I-T) department was justified in law.

Clever documentation

The case was fought in the Karnataka High Court. The Revenue pointed out that interest payable on deposits was equal to the lease rent.

The total quantum of investment in the assets was received back from the lessee by way of deposits. It was an uncanny coincidence that the lessees were educational institutions exempt from paying tax. The company was claiming depreciation in respect of those assets without actually investing any of its funds. The documentations were cleverly done. Lease agreements were generally renewed and lessees were not getting back the security deposits.

The scheme of the transaction was designed to pass on the depreciation claim from a non-taxable entity to a taxable entity without the taxable entity having to pay the price for it.

The Karnataka High Court held that the transaction was blatantly geared to avoid tax liability. It would be extremely naïve to accept the transaction as commercially acceptable. It cannot be considered as being a tidy management affair in accordance with the law. The company had devised a mechanism to enable a non-taxpaying entity to acquire an asset and also to claim depreciation on it. “It does not require a vivid imagination to discern the obvious in these transactions; there is no warrant to give chase to a will-o’-the-wisp”.

Self-cancelling transactions

The court concluded: “The finding that the assessee is not entitled to claim depreciation on the assets is not on the basis of the underlying motive but the direct result of the manner these transactions are engineered.”

In quite a number of cases, the House of Lords dealt with schemes involving a series of interconnected transactions which were self-cancelling, the taxable gains were artificially neutralised by a pre-arranged loss, the loss being a mirror image of the gain. The loss was not real but manufactured, created or produced. Several transactions were commercially inert, only intended to be fiscally active on the assumption that a make-believe schemes is sufficient to produce a tax effect.

(The author is a former Chief Commissioner of Income-Tax.)

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