From McDowell to Vodafone

In recent times, there has been some controversy surrounding the Supreme Court's decision in the Vodafone case, with the Government filing a review petition in the apex court, requesting it to reconsider its verdict.

At the heart of the issue is the question of where to draw the line between legitimate tax planning and tax avoidance within the framework of the law, and intentional evasion of taxes through colourable devices.

The expressions ‘tax avoidance' and ‘tax evasion' require a deep understanding of tax jurisprudence to decipher their meaning. Both find no definition in either the Indian Companies Act, 1956 or in the Income-Tax Act, 1961. As in the past, the apex court, in interpreting the principle on tax avoidance, has again relied extensively on the decisions of the House of Lords in England that span a period of 75 years.

A quick look into the ratio decidendi (legal principle upon which the decision in a case is founded) of English decisions may assist our understanding of the thought process of Indian courts.

One of the decisions that came up before the House of Lords in 1936 was the case of IRC v. His Grace The Duke of Westminster (‘Duke of Westminster'), in which payments were made by the taxpayer to domestic employees in the form of deeds of covenant (which were tax-deductible) instead of regular wages (which were not tax-deductible).

The House of Lords refused to disregard the form of the transaction over the substance and in doing so laid down the cardinal principle that “every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be”.

Complex schemes

In IRC v. WT Ramsay Ltd (1981) , the House of Lords cautioned against a series of transactions which are pre-ordained, inserted into which are steps that have no commercial purpose apart from tax avoidance.

Ramsay was a turning point in the interpretation of tax laws in England and was followed by subsequent House of Lords decisions in IRC v. Burmah Oil Co Ltd (1982) (‘Burmah Oil') and in Furniss v. Dawson (1984) (‘Dawson'). In Craven v. White (1988) (‘Craven'), the House of Lords held that Revenue cannot start with the question as to whether the transaction was a tax deferment/tax-saving device but that Revenue should look at the transaction as a whole to ascertain its true legal nature.

It observed that genuine strategic planning had not been abandoned. Post Craven, the House continued to uphold the Duke of Westminster principle in subsequent rulings.

At the beginning of the 21st century, the House of Lords eliminated the possibility of misinterpretation of its previous judgments and reset the law on tax avoidance by ruling in MacNiven v. Westmoreland Investments Ltd (2001) (‘MacNiven').

The foremost decision in India on the matter was the Supreme Court's decision in the case of CTO v. McDowell and Co. Ltd. (‘McDowell'), rendered in 1985.

In the McDowell case, the majority decision delivered by Justice Mishra held that ‘tax planning may be legitimate, provided it is within the framework of the law'.

However, it also held that ‘colourable devices cannot be a part of tax planning and it is wrong to encourage the belief that it is honourable to avoid payment of tax by resorting to dubious methods'.

Westminster's ghost

McDowell's decision and the matter of tax avoidance was again reconsidered by the Supreme Court in the case of Union of India v. Azadi Bachao Andolan (‘Azadi Bachao') in 2003, in which a three-member bench categorically restored the right of the tax-payer to mitigate taxes by all legitimate means.

In light of the House of Lords' decisions in Craven (1988), the Supreme Court's view was that the Westminster principle is very much ‘alive and kicking' and is relevant even today.

The issue before the Court, then, was the availability of benefits of the India-Mauritius tax treaty on the basis of a valid tax residency certificate in Mauritius.

The Court has comprehensively ruled in Vodafone that there was no conflict between McDowell and Azadi Bachao and there was no need for reconsideration of the Azadi Bachao decision by a larger bench.

In delivering the judgment, the Supreme Court after reviewing various judgments of the House of Lords in England, has reiterated that the Westminster principle is the cornerstone of law and every tax-payer is entitled to arrange his affairs so as to reduce the tax liability.

The fact that the motive for a transaction is to avoid taxes does not invalidate it unless a particular enactment so provides.

The quest to find an answer to this eternal question may reach its conclusion in the regulations which India proposes to legislate in the new tax code. Until then, hopefully, His Grace, the Duke of Westminster will stay ‘alive and kicking'.

(The author is an Executive Director and heads the South India tax practice for PwC.)

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