Article
Introduction :
Laws and regulations are the intentions of legislators
captured in words. The challenge is to choose a formulation that captures such
intentions in a way that it is clear and covering exactly those situations that
are desired to be covered. The subjects to the law should be able to understand
the rules, and also to trust that once the rules are interpreted in the
appropriate way, it is clear which situation is covered by the rules and which
one is not. Thus, the subjects can accordingly structure their behaviour or in
other words : Choose the right form for their actions.
To ensure non-discriminatory enforcement of laws and
regulations, choosing a formal approach is very logical. It rules out
arbitrariness or at least mitigates the same. In other words, the form of a
situation — a transaction, determines the legal consequences. For long, most
countries have used the formal approach.
However, more and more countries have come to the realisation
that taxpayers were choosing forms for their transactions that led them to a
beneficial tax treatment. This may and does in practice, lead to undesired
behaviour. Especially in cases where the form of the transaction has no or
little connection with its actual substance and such form is chosen merely to
get a better tax result, the ability to look beyond the form may be justified.
An example could be where a parent company provides funding to its 100 percent
loss-making subsidiary company, without a repayment obligation, and without
charging interest. Calling such funding a loan, and not (quasi) equity, would
not do justice to the substance of the transaction.
What should be avoided, however, would be a requalification
of any transaction to a form that puts the taxpayer in the worst position.
Striking the balance is not easy.
The approach of a few countries towards the issue of
substance over form has been reflected below, to provide a better framework for
understanding the issue.
Country overview :
United States of America (US) :
The US has included several rules in its legislation to
codify the substance-over-form concept. Illustrations include : The rule on
conduit financing and on domestic reversed hybrid entities.
The Internal Revenue Service (IRS) is permitted to re-characterise
cross-border conduit financing transactions, including back-to-back loans which
are undertaken for tax avoidance purposes. Specifically, the IRS is authorised
to disregard an intermediate company in a multiparty financing arrangement if
the company is used as part of a tax avoidance plan, for example, if the company
is put in place to take advantage of reduced withholding under a US tax treaty.
In that case, the overall transaction will be analysed without recognition being
given to the conduit entity and the US domestic withholding rate or that of
another tax treaty will be applied.
The Domestic Reversed Hybrid rules, finalised in 2002,
provide a check on certain abusive double-dip financing arrangements between
related parties. If a payment from a domestic entity to a related Domestic
Reversed Hybrid entity is treated as a dividend under either US or foreign law,
and if the Domestic Reversed Hybrid entity makes a payment to a related foreign
interest holder which is deductible in the US and entitled to a reduced treaty
rate, then the payment by the Domestic Reversed Hybrid entity is treated as a
dividend. Thus, there will be no deduction and the treaty withholding rate will
be governed by the Article relating to dividends.
The IRS in the US and the US courts have consistently taken
the view that transactions are to be taxed according to their economic substance
rather than their legal form (Goldstein v. Commissioner, 364 F.2d 734 (2d
Cir. 1966).
In the matter of Burger King v. State Tax Comm’n, (416
NE2d 1024) (NY Ct. Apps. 1980), the Tax Commission assessed a restaurant sales
tax on purchases of packaging material. The assessment was based on the fact
that the restaurant did not charge its customers a line item on the receipt for
packaging. Based on this, the state argued, the packaging was not being ‘resold’
as required for exemption from sales tax. In ruling for the restaurant, the
court overlooked the form of the transaction (i.e., the absence of a line
item for packaging on the customer receipt) and looked to the substance to
determine if a resale had occurred.
The Supreme Court, in F. & R. Lazarus & Co., (308 US 252)
(1939), summarised the doctrine as follows : In the field of taxation,
administrators of the laws and the courts are concerned with substance and
realities, and formal written documents are not rigidly binding.
China :
The tax authorities introduced general anti-avoidance rules
effective from January 1, 2008. The Chinese tax authorities are authorised to
make adjustments to arrangements that can result in a reduction of tax payable
and which are made without any justifiable commercial or business reason.
According to the draft administrative regulations on special tax adjustments,
the following may result in the involved enterprise becoming a target of an
investigation : abuse of tax incentives; treaty shopping; abuse of form of
organisation; frequent trading with companies located in a tax haven; and any
other business arrangements without bona fide commercial purposes.
The form and substance of an arrangement will be reviewed.
The tax authority may redefine the arrangement based on the business substance,
cancel an enterprise’s tax benefits, and re-identify or reallocate revenue,
costs, income, losses and tax deductions between the involved parties. An
anti-avoidance case must be reported to the State Administration of Taxation
(SAT) for its approval.
Germany :
Under the German law (S. 42 of the AO – Tax Procedure Act) substance over form is applied if an in-appropriate legal structure is chosen that leads to a tax advantage for which the taxpayer cannot provide significant non-tax reasons.
A legal structure is considered inappropriate if the taxpayer or a third party generates a tax benefit that is not intended by the law. The amended Section also includes a clear hierarchy, i.e., specific anti-abuse rules according to applicable tax laws have to be applied on a step-by-step basis, after which the general anti-abuse provision can become applicable.
As the legal definition of ‘abuse of form’ is some-what vague, the German tax courts had established a long-term practice based on numerous cases regarding ‘base companies’ which are placed in a low-tax jurisdiction and have no or only insignificant substance.
The recent German anti-treaty-shopping rule (5. SOd EStG) increases the substance requirements for non-German companies to benefit from withholding tax relief, in particular with respect to dividends or royalties provided for by the double tax treaties (DTT) or EU directive. A foreign company is in general entitled to neither full nor partial tax relief if:
- there are no economic or other relevant reasons for its interposition,
- not more than 10% of its aggregate gross revenue for the relevant financial year is generated from the company’s own economic activities, or
- it fails to participate in the open market place with business operations that are adequately equipped for the business purpose pursued by the company.
United Kingdom (UK):
In Furniss (H.M. Inspector of Taxes) v. Dawson, House of Lords, (55 TC 324) (1984) (AC 474), the case involved a disposition of shares by family members, who disposed of shares in two family companies to an investment company incorporated in the Isle of Man. The shares were subsequently sold to another company. The reason for interposing the Isle of Man company was to provide capital gains tax relief. On the question whether the two transactions were in substance a single transaction, it was held that: In ascertaining the substance of a transaction, the courts must look at the entirety of a composite trans-action if it appears that it was designed and intended to be carried through as a whole. The court is not bound to take each step in isolation in order to ascertain the legal rights and liabilities of the tax-payer at the beginning and end of each step. The court can and should have regard to the result which the transaction as a whole was designed to achieve. Further, the court may disregard a transaction and treat it as fiscally a nullity even though there is a change in the legal position of the parties before and after the scheme is carried through, if that change can be regarded as a mere change of form with no enduring legal consequences.
In Commissioners of Inland Revenue v. Duke of Westminster (19 TC 490, 520,524) (1936) (AC 1), it was held, as is commonly used as supporting comment in various commentaries on substance-over form matters, that: Every man is entitled if he can to order his affairs so that the tax incidence under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.
In WT Ramsay Ltd. v. Commissioners of Inland Revenue, (54 TC 101) (1982) (AC 300), it was held that: If it can be seen that a document or transaction was intended to have effect as part of a nexus or series of transactions, or as an ingredient of a wider transaction intended as a whole, there is nothing in the doctrine to prevent it being so regarded. It is the task of the court to ascertain the legal nature of any transaction to which it is sought to attach a tax or a tax consequence, and if that emerges from a series or combination of transactions intended to operate as such, it is that series or combination which may be regarded.
The above ruling provides a logical summary of addressing the legal nature of each transaction in a series of transactions.
First, it established that there is nothing in the Westminster principle which compels a consideration of individual transactions separately from a preconceived chain or series of transactions of which they form merely a part.
Secondly, it established that where one finds a series of preconceived transactions which are entered upon solely for fiscal purposes and are clearly interconnected and mutually dependent upon one another, one should look at the overall transaction to ascertain what has been and what was intended to be achieved.
Thirdly, it established that if what one finds on such a consideration is that nothing whatsoever has been achieved because the individual steps taken cancel one another out, one is entitled then to ignore the fiscal consequences which might otherwise have resulted from each of those individual steps considered in isolation. That represents the substance of the general principle deducible from the decision.
In conclusion, the fact that transactions may be circulating or are merely paper transactions is further not conclusive. Thus, where no commercial purpose in relation to the transactions is evident apart from tax avoidance which in the absence of the transactions would have been payable, the series of transactions should be looked at as a whole in relation to intention and motivation.
Netherlands:
It is generally accepted that artificial or simulated transactions may be ignored by the tax administration and the Courts of Appeals through a determination of the facts rather than the form (substance over form).
In addition, there are two specific provisions to combat tax avoidance or evasion (i.e., transactions the main purpose of which is avoidance or evasion of tax) :
The just levying provision (richtige heffing), under which the legal act in dispute may be ignored for tax purposes. This procedure is subject to prior approval by the Ministry of Finance and involves a lot of administrative work. Therefore, this procedure is not commonly used.
The abuse of law doctrine (jraus legis), which is not laid down in tax law but is an interpretation method developed in case law. Under this provision, the spirit of the law is decisive, rather than the exact wording. The transaction in dispute may be converted to the closest equivalent which does not give rise to an abuse of law. The abuse of law procedure can be used only as a last resort.
In general, the results of both procedures are the same for the taxpayer.
In the recent Supreme Court decision (HR 17-10-2008,42954), the merger exemption for capital duty payment was denied, as it was held that interposing an English company for a short period of time, and based on a pre-determined step plan, lacks a real function.
From a series of Supreme Court decisions it can be deduced that abuse of law is present when the chosen structure is predominantly or exclusively motivated by tax savings and also is in contradiction with the meaning of the law. If the motivation is exclusively to save tax, and no commercial justification for the chosen structure exists, abuse of law can be present as well. However, if the legislature has recognised a tax-saving route, but deliberately did not close this route, the courts are not inclined to apply the abuse of law doctrine.
India:
The most important Indian case addressing the substance-over-form question is without doubt McDowell and Co. Ltd. v. Commercial Tax Officer, (154 ITR 148) (SC). The case was about a mitigation of sales tax by having the buyers separately pay the excise duty, whereby such excise duty would not be included in the taxable basis for sales tax.
The Commercial Tax Officer was of the view that the excise duty paid directly to the Excise authorities or deposited directly in the State Exchequer in respect of Indian liquor by the buyers before removing the same from the distillery could be said to form part of the taxable turnover of the appellant distillery for the purpose of the Sales Tax Act.
The Court, however, came to the conclusion that excise duty did not go into the common till of McDowell and did not become a part of the circulating capital. Therefore, the Sales Tax authorities were not competent to include in the turnover of the appellant the excise duty which was not charged by it but was paid directly to the excise authorities by the buyers of the liquor.
The Supreme Court took the view that tax planning was legitimate so long as it was strictly within the four corners of the law and any ‘colourable’ device or dubious methods to minimise tax incidence were not legally permissible.
The Court reaffirmed the view of English cases while examining a legally valid transaction, and held that the Revenue should proceed objectively and not hypothetically attribute ‘motives’ behind the taxpayer’s action.
In the case of the Commissioner of Income-tax v. A. Raman and Co, (67 ITR 11,17) (SC), it was stated that: The law does not oblige a trader to make the maximum profit that he can get out of his trading transactions. Income which accrues to a trader is taxable in his hands. Income which he could have, but has not earned, is not made taxable as income accrued to him. Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in tax statutes may not, except on peril of penalty, be violated, but may lawfully be circumvented.
In the case Bank of Chettinad Ltd. v. Commissioner of Income-tax, (8 ITR 522), it was stated that: The tax authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it is open to the tax authorities to unravel the device and to determine the true character of the relationship. But the legal effect of a transaction cannot be displaced by probing into the ‘substance of the transaction’.
In Simon in Latilla v. I.R.C. (11 ITR Suppl. 78, 79) (HL), it was stated that: Tax planning may be legitimate, provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay their taxes honestly without resorting to subterfuges.
In CIT v. Abhayananda Rath Family Benefit Trust, (255 ITR 436) (Orissa HC), the assessee set up a trust for his minor son’s benefit. The income of the minor child from the trust was to be accumulated during his minority. In other words the income of the minor child from the transferred assets was not includible in the total income of the assessee. However, the contention of the Revenue that the trust has been created by the assessee for the purpose of avoidance of tax was rejected by the Court, as ‘Evading payment of tax’ is quite different from ‘tax planning’.
According to the Orissa High Court, a person may plan his finances in such a manner, strictly within the four corners of the tax statute that his tax liability is minimised or made nil. If this is done and observed strictly in accordance with and taking advantage of the provisions contained in the Act, by no stretch of imagination can it be said that payment of tax has been evaded.
In the context of payment of tax, ‘evasion’ necessarily means, ‘to try illegally to avoid paying tax’. But, as in the instant case, a trust has been created in accordance with law and creation of such a trust is not hit by any of the provisions contained in the Act.
Analysis:
It appears from the above, that there is no single approach towards the issue of substance over form. A clear tendency exists for tax authorities to try and counter any kind of undesired outcome (in their eyes) of a certain piece of legislation by applying the substance-over-form doctrine. This puts, more than in many other situations, a strong responsibility on the shoulders of the judicial system to protect the rights of the taxpayer.
The following common denominator can, however, be found in most countries: If a taxpayer has multiple avenues available to structure his transaction, he is free to choose the most tax-efficient avenue, provided a certain level of commercial justification for the choice exists, and tax considerations are not the only reason.
The OECD leaves it to the individual countries to introduce anti-abuse legislation, legislation that can be applied without interference by the OECD model convention (and vice versa). The OECD does subscribe to the concept of (economic) substance over (legal) form.
Looking at the current situation in India, the Indian tax authorities are clearly exploring the limits to the substance-over-form concept with their secondary line of argumentation in the Vodafone case, which involves an attempt to lift the corporate veil of the companies that were interposed between the Hong Kong ultimate parent and the Indian operating company. This seems to indicate that the tax authorities want to go beyond the earlier decision in the Union of India v. Azadi Bachao Andolan, (263 ITR 706) (SC), where the existence, and beneficial ownership for claiming benefits under the treaty between India and Mauritius, of a Mauritian group company were respected based on a valid certificate of residence of that company issued by the appropriate Mauritius authorities. From Mukundrary K. Shah v. Commissioner of Income tax, (143 Taxman 743) (Calcutta HC)t and Deputy Commissioner of Income tax v. GVS Investment (p) Ltd, (92 TTJ 706)( Delhi ITAT) a principle emerges that the corporate veil can be lifted only where the transaction is found to be sham, bogus or contrived. The corporate veil can be lifted so as to expose any person to liability, who has committed a fraud upon the public from their sheltered position. In addition, from Mafatlal Holdings Ltd v. Additional Commissioner of Income-tax, (85 TTJ 82) (Mumbai ITAT)1 and Additional Commissioner of Income-tax v. Nestle India, (94 ITJ 53) (Delhi ITAT), it is clear that the onus is on the tax authorities to prove that a transaction is sham or bogus, before resorting to lifting the corporate veil.
Conclusion:
The substance-over-form doctrine is used most often in an anti-abuse context by the tax authorities. This implies that it should be applied with care. It should also be applied in a consistent way. A requalification of only certain elements of a transaction, to come to the maximum tax cost for the tax-payer, will not do. The substance of the total trans-action structure should be reviewed. Only when the chosen form is illegal or legal, but lacking commercial reality and just aimed at receiving a beneficial tax treatment, a challenge based on the substance-over-form doctrine should succeed. And, also the tax authorities are required to stay within the four corners of the law.
