A matter of substance

The Finance Act 2012 has introduced provisions clarifying the intention of the legislation. Among other issues, this has revived the discussion around ‘form versus substance’, and how far does the taxman go, or indeed, should go?

Given that every nation seeks to maximise its tax revenues, the trend to legislate every conceivable interpretation and intention, albeit on a delayed basis, has become a habit in our country. That this is a cause for concern would be an understatement.

Do we have far too many laws and rules in the tax code? Yes. And here is a request for some more.

Tax avoidance

The intention of a legislation assumes great significance. On the one hand, various incentives are provided to the business community to maximise profits and minimise tax liabilities; on the other, they form the basis of revenue generation to the Government by levy of taxes on these profits. It is widely accepted that while tax planning is legitimate, tax evasion is not.

Litigation and the need for representation arise when stakeholders differ in their understanding of tax avoidance.

‘Tax avoidance’is a term used to describe an arrangement of a tax payer’s affairs that is intended to reduce his liability, and that although the arrangement could be strictly legal, it is usually in contradiction with the intent of the law it purports to follow.

Generally, the courts have accepted the form of a transaction, and not looked at the ‘substance’ as long as the legal requirements were complied with. On a few occasions, while assessing the commercial nature of the transaction, the principle of ‘lifting of the corporate veil’ or what is commonly called the doctrine of substance over form has been adopted.

Given the unanimity that while tax planning is permitted within the framework of the law, it is only colourable devices that cannot be a part of the law, the courts have held that it is wrong to encourage or entertain the belief that it is honourable to avoid payment of tax by resorting to dubious devices. This principle was to be applied only to exceptional cases – and not as a matter of routine.

Overwhelmingly, the appellate authorities have accepted the form of a transaction, frustrating the tax authorities in their attempts to tax certain transactions, which in their view are impermissible.

Tax treaties have anti-abuse provisions and limitation of benefits spelled out. This begets the question of what substance is, and how much is necessary for availing benefits under a treaty or the domestic tax code.

The key issue

The Indian tax code does not have an exhaustive list of what constitutes substance in the eyes of the tax authorities. Common sense, judicial pronouncements and tax treaties have contributed to some understanding.

Most tax payers know that a substance check would involve place of actual business operations, balance sheet size, place of decision making, maintenance of statutory records, place of executive, board meetings, and a tax residency certificate (TRC). While this constitutes a reasonable list, is that all?

Given that stability and certainty for tax payers is critical, can we not have legislation and rules on what the tax man would like to see?

For example, a TRC containing prescribed particulars usually considered adequate is now a necessary, but not sufficient condition for availing benefits under tax treaties.

For a taxpayer who wishes to abide by the rules, any surprises in a tax audit is undesirable. And with evolving tax positions and introduction of the General Anti-Avoidance Rules (GAAR), some specific requirements and rule-making would be desirable. The demand for stability, certainty and less litigation would be met.

These provisions, deferred to next year, empower the revenue authorities to deny tax benefitsfor transactions that lack commercial substance. A concept of impermissible transactions is being introduced that – if coupled with lack of commercial substance – would be liable to tax in India.

Given the extent of powers revenue authorities have to counteract transactions that are purported to avoid tax, it is important for tax payers to be given guidance for proving commercial substance in a transaction that would otherwise be tax-neutral.

The recent amendments and tone of the Government suggest an evangelical confidence in legislating with a righteous use of the substance-over-form argument. The impact of these actions will most certainly be measurable in the coming years.

The need for tax revenue is clear – and the case against evasion, even more so. To enable collection of taxes in ‘substance’, and not only in the ‘form’ of paper demands, one would look for legislative guidance rather than interpretation and judicial intervention.

K. Venkatachalam is Executive Director, Tax and Regulatory Services, PwC India.

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