DR. RAM MANOHAR LOHIYA NATIONAL LAW UNIVERSITY LUCKNOW
SEMESTER V (2015-16) INTERPRETA INTER PRETATION TION OF STATUTES STATUTES
PROJECT PROJ ECT ON ON
FROM MCDOWEL MC DOWELL L TO VODAFONE: THE FINE FIN E LINE ETWEEN ETWE EN TA! EVASIO EVASION N AND TA! PLANN PL ANNIN" IN"
SUMITTED Y # #
S UMITTED TO
"ARIMA P ARAKH HUSSAIN
M RS . S AMREEN
.A.LL (HON ) S EMESTER IV (L AW) R OLL
NO .
5$
A SST . P ROFESSOR
ACKNOWLED"EMENT
I would like to extend my sincere thanks to My teacher and my mentor Mrs. Samreen Hussain for giving me this wonderful opportunity to work on this project and for his able guidance and advice, ice !hancellor, "r. #urdeep Singh Sir and "ean $%cademics&, 'rofessor !.M. (ariwala for their encouragement and )nthusiasm* My seniors for sharing their valuable tips* %nd my classmates for their constant support.
TALE OF CONTENTS
+. I-/"0!-I/111111111111111111111111111....+ 2. -%3 '4%I# %" )%SI/1111111111111111111112 5+.+6 -ax avoidance by large corporations1111111111111111111..2 5+.26 ules for interpretation of taxing statutes7 8hen tax avoidance becomes evasion111111111111111111111111111111111.9 :. M!"/8)44 . !/MM -%3 /;;I!)7 !%S) %%4rief facts and judgment of the case1111111111111111111...= 52.26 "ecision in %?adi >achao %ndolan case an d the conflict11111111111.@ 9. /"%;/) I-)%-I/%4 H/4"I#S 4-" . 0/I7 !%S) %%4rief facts and judgment of the case1111111111111111111..A 5:.26 "etailed analysis of tax evasion with respect to income tax provisions111111B 5:.:6 )xtension of Mc"owellCs principle of purposive construction111111111+D E. !/!40SI/11111111111111111111111111...11++
INTRODUCTION
-he rue in McDowell & Co. Ltd. v. Commercial Tax Officer 1 has been the source of significant controversy in the area of tax governance. 8hile on one hand it may seem to have changed the face of tax jurisprudence, some detractors and writers are of a different opinion that it is a mere judicial aberration in the otherwise clear and reasonable exposition of fiscal principles by the Supreme !ourt. (udicial pronouncements after McDowell have only increased the confusion as to what is permissible in the determination of tax liability through the transactions entered into by the assessee. -herefore, the fundamental Fuestion is where to draw the line between legitimate tax planning and tax avoidance within the framework of the law, and whether what the court sought to accomplish and what it actually did. -he contention raised by McDowell in the case was that it is open to everyone to arrange hisGher affairs in a legitimate manner so as to reduce the tax burden to a minimum and does not constitute tax evasion. -he court held that tax planning may be legitimate as long as it is within the framework of the law. However, it also held that the legal effect of a transaction cannot hide the substance of that transaction, and colourable devices cannot be part of tax planning. It further observed that every citi?en has an obligation to pay taxes without resorting to subterfuges. In other words, the court accorded a purposive interpretation to the unambiguous law, which maybe argued to be in contravention of the literal rule principle that when the law is clear and unambiguous the meaning that is most apparent from its reading is to be given effect even though it may lead to misfortune and injustice. -his conflict was sought to be resolved in the case o f Vodafone International Holdings v. Union of India. %lthough the facts and issues in the case are completely different from McDowell , the issue that is of concern here is that of interpretation of taxing statutes. 8hen the argument was raised before the Supreme !ourt with regard to the reading of the McDowell decision in the case of Union of India v. !"adi #ac$ao !ndolan% the court observed that it cannot be read as leading to a conclusion that all tax planning is illegal, illegitimate or impermissible and there is no conflict between the Supreme !ourtCs decisions in the McDowel l and the !"adi #ac$ao !ndolan case. -he substance over formC test should be applied only once it
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has been established through the facts that the impugned transaction is a sham and a front for the illegal purpose of tax evasion. )very strategic foreign investment coming into India should be looked at in a holistic manner. Merely because at the time of exit, capital gains tax becomes not payable would not make the entire share saleJ $investment& a sham or a tax avoidant. -he decision in !"adi #ac$ao case was incongruent with both McDowell and Vodafone in as much as it categorically restored the right of the taxKpayer to mitigate taxes by all legitimate means. >ut this matter was absolutely settled in Vodafone Holdings that !"adi #ac$ao is not in conflict with McDowell . In delivering the judgment, the Supreme !ourt after reviewing various judgments of the House of 4ords in )ngland, has reiterated that the 8estminster principle $will also be discussed in the final draft of the project& is the cornerstone of law and every taxKpayer is entitled to arrange his affairs so as to reduce the tax liability. -he fact that the motive for a transaction is to avoid taxes does not invalidate it unless a particular enactment so provides. In all the above cases the !ourt was referring to the appropriate line of analysis to be adopted while determining the legality of a transaction. -his project aims at analy?ing the same and ascertaining whether there exists scope for further debate. TA! PLANNIN" AND EVASION
-he word tax planningC connotes the exercise carried out by the taxpayer to meet his tax obligations in a proper, systematic and orderly manner, availing all permissible exemptions, deductions and reliefs available under the statute as may be applicable to hisGher case. 'lanning does not necessarily mean reduction in tax liability but is also aimed at avoiding controversies and conseFuential litigations. )very taxpayer is expected to voluntarily make disclosures of his incomes and tax liabilities through legal compliance. 8hen a tax payer deliberately or consciously does not furnish material particulars or furnishes inaccurate or false information to defraud the State, it violates legal provisions and is termed as tax evasionC. In other words, tax evasion means illegally hiding income or concealing the particulars of income or concealing the particular source or sources of income or in manipulating the accounts so as to inflate the expenditure and other outgoings with a view to illegally reduce the burden of taxation. It is not only illegal, but also unethical and immoral. %1.1& T' '*+,'/ '34/ *3*3'+*7
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In the case of McDowell Co. Ltd. v. CTO the Supreme !ourt observed L Tax 'lanning ma( )e legitimate *rovided it is wit$in t$e framewor+ of law. Colo,ra)le devises cannot )e *art of tax *lanning and it is wrong to enco,rage or entertain t$e )elief t$at it is $onora)le to avoid t$e *a(ment of tax )( resorting to d,)io,s met$ods. It is t$e o)ligation of ever( citi"en to *a( t$e taxes $onestl( wit$o,t resorting to s,)terf,ges.J It is a well established principle that if a person sought to be taxed comes within the letter of the law, he must be taxed, however great the hardship may appear to the judicial mind to be. In a taxing statute, there is no place for intention, presumption or eFuity, and there is nothing to be read in through implication* the words are clear enough.E However, a way can be found around any law with diligence, given the time. !orporations and enterprises exploit the loop holes in taxation statutes to legally evade tax and such actions cannot be termed to be violative of the law *rima facie since it does not expressly identify it as such. 4iterality, here, becomes the bane for enforcement authorities since such exigency was not foreseen. 4egitimate tax avoidance has been accepted by the Supreme !ourt such that taxpayers have a right to arrange their affairs in such a manner so as to pay the least tax possible. However, tax authorities internationally consider aggressive tax planning schemes by taxpayers to erode the tax base unnaturally, particularly when effective rates of tax diminish significantly. -he most common method of tax evasion is changing the jurisdiction. >usiness clusters develop in those countries where the tax regime is liberal, which serves a twoKfold purpose L one, they save huge amounts on tax and two, business clusters can usually provide the necessary expertise reFuired to operate.= ;or instance, Swit?erland is the centre of the world coffee trading business due to the fact that it charges a lowly rate of +2 on trading profits. It therefore comes as no surprise that Starbucks sources its 0N coffee from its wholesale trading subsidiary in Swit?erland. 8hat makes matters even more difficult to resolve is the competition among such tax jurisdictions to attract multinationals L the lower and more liberal the
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6 4aurence Nnight, !orporate -ax %voidance7 How do companies do itOC ##C ews $9 "ecember 2D+2& Phttp7GGwww.bbc.comGnewsGbusinessK2DEADE9E Q accessed 2: September 2D+E.
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tax regulations, the larger the number of large corporations who flock there. %n Indian !ompany, with the idea of tax evasion can also incorporate a company offKshore, say in a -ax Haven, and then create a 8/S in Mauritius and after obtaining a -! may inv est in India. 4arge amounts, therefore, can be routed back to India using -! as a defence, but once it is established that such an investment is black money or capital that is hidden, it is nothing but circular movement of capital known as ound -ripping* then -! can be ignored, since the transaction is fraudulent and against national interest. %nother issue with regard to tax evasion is overpricing through transfer pricing to shift larger share of profits to low tax jurisdictions, thereby circumventing the place of establishmentC rule @. -here have been allegations against #oogle, %pple, %ma?on, odafone Holdings etc, recently, of indulging in blatant tax evasion. 8hile determining whether a particular transaction constitutes as tax management, tax avoidance or tax evasion, interpretation of the statutes by way of case laws is of considerable importance. %1.2& R8/7 9*3 +/33/'+* *9 '+4 7'8/7: W/ ' '*+,'/ /*;/7 /'7+*
It is well established that penal and taxing statutes are not to be extended by analogy to cover acts and situations not within the words of the statute or any doctrine of substance of the matter. >ut this principle has no application where what is done is actually the thing prohibited, under the cloak or colour of a different transaction not prohibited by the statute. A #rove (. in !. /. v. o(es0 and 4ord Hobhouse in -imms v. egistrar of 'ro)ates12 evasionC has been considered to hold two meanings L one, which suggests an underKhand dealing to avoid that to which the %ct applies and two, a mere intentional avoidance of something to which the %ct does not apply. % transaction which by the acts done is of the nature of a trading transaction and is genuine and not sham, does not cease in the
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absence of a statutory provision providing otherwise to be an adventure or concern in the nature of tradeC, merely because those taking part in it have their eyes fixed on the fiscal advantage of avoiding income tax.++ >ut a wholly artificial scheme remote from the trade planned with the purpose of tax avoidance, even if real and not a sham cannot be regarded as a concern in the nature of trade.+2 -he principle laid down in the case of IC v. D,+e of 3estminster 1% that one has to see only the legal nature of the transaction and not the substance of the matter, will be inapplicable in case of a series of transactions or a composite transaction completed for the purpose of tax avoidance. -he new approach laid down in 3. T. amsa( Ltd v. IC 1 has been adopted by the Indian jurisdiction through the case of McDowell & Co. Ltd v. CTO14 where it was observed that L 3e m,st recogni"e t$at t$ere is )e$ind taxation laws as m,c$ moral sanction as )e$ind an( ot$er welfare legislation and it is a *retence to sa( t$at avoidance of taxation is not ,net$ical and t$at it stands on no less moral *lane t$an $onest *a(ment of taxation. In o,r view5 t$e *ro*er wa( to constr,e a taxing stat,te5 w$ile considering a device to avoid tax5 is not to as+ w$et$er t$e *rovisions s$o,ld )e constr,ed literall( or li)erall(5 nor w$et$er t$e transaction is not ,nreal and not *ro$i)ited )( law5 ),t w$et$er t$e transaction is a device to avoid tax.J -he conditions for application of this new approach were laid down in 6,rniss v. Dawson17 . -hese are L +. -here must be a preordained series of transactions or a composite transaction
11 /riffit$s v 8 ' Harrisan Ltd $+B=2& + %ll ) BDB $H4&.
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2. -here must be steps inserted which have no commercial purpose except for avoidanceGdeferment of tax liability. -hough the 8estminster principle is not dead and can still be applied, it is rendered inapplicable in cases where the amsay principle or the new approach has application. -he conditions laid down in 6,rniss v. Dawson19 were further explicitly delineated in Craven v. 3$ite1: ; +. -he preKordained series of transactions must have been done so when the tax saving transaction was entered into. 2. -he transaction should have had no other purpose except tax avoidance. :. -he tax saving transaction had no independent life since there was no likelihood of the series of transactions not taking place as planned. 9. -he preordained transactions took place. In other words, first, the relevant enactment must be construed to ascertain its meaning* then the series of transactions in Fuestion should be analysed, regarded as a whole to ascertain its true legal effect* and finally the enactment as construed must be applied to the true legal effect of such transactions, to determine whether the enactment will cover the said transaction or not. !onsidering the entire series of transactions as a whole is the most important part of the process since the true effect of the transaction can be gleaned from this.
MCDOWELL V. COMM TA! OFFICER: CASE ANALYSIS
%2.1& 3+/9 9'7 ', <8,4;/ *9 / '7/
17 ibid.
18 $+BAA& : %ll ) 9BE $H4&. 6|Page
'urchasers of Indian liFuors for obtaining distillery passes paid excise duty under )xcise ules. 0nder the governing law it was includible in the turnover of the manufacturer of liFuor. )xcise duty though paid by the purchaser to meet the liability of the manufacturer, is a part of the consideration for the sale and is includible in the turnover of the manufacturer. -he purchaser has paid the tax on behalf of the manufacturer. In terms of the law the manufacturer was liable to pay excise duty on the manufacture of liFuor. -he excise duty paid on his behalf was integral to the consideration for the sale of liFuor. -he strategy was the conjoint product of two facts7 $i& under an agreed strategy the purchasers had to discharge the manufactureCs liability* and $ii& under this system the transactions of such payments were not made to figure in the assesseeCs books of accounts* it was stageKmanaged not to be part of the assesseeCs trade. -he assessee continued to sell liFuor in this manner and paid sales tax under the %.'. Sales -ax %ct on the turnover returned by him which did not, as mentioned, include the amount of the excise duty. -he assessee devised a way not to pay tax on turnover inclusive of duty paid by the liFuor purchasers. However, the %ssessing %uthority took the view and held that the assessee had failed to include in its turnover, the amount of excise duty paid by its buyers to the )xcise "epartment. -he assessee challenged that view but the High !ourt agreed with the %ssessing %uthority. -he assessee appealed to the Supreme !ourt. % "ivision >ench of the Supreme !ourt examined the excise laws as well as the sales tax laws. Held7 -he fact that excise duty does not go into the common till of the manufacturer $assessee& to become a part of the circulating capital, is not the decisive test for determining whether such duty constitutes the sellerCs turnover. -ax planning may be legitimate provided it is within the framework of law. !olourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citi?en to pay the taxes honestly without resorting to subterfuges. -he Supreme !ourt, while making a distinction between tax avoidance and tax planning in this case, famously observed L Tax 'lanning ma( )e legitimate *rovided it is wit$in t$e framewor+ of law. Colora)le devises cannot )e *art of tax *lanning and it is wrong to enco,rage or entertain t$e )elief t$at it is $onora)le to avoid t$e *a(ment of tax )( resorting to d,)io,s met$ods. It is t$e o)ligation of ever( citi"en to *a( t$e taxes $onestl( wit$o,t resorting to s,)terf,ges.J %2.2& D/+7+* + A=',+ ''* A,*' '7/ ', / *9+
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In the McDowel l10 case, the Supreme !ourt held that colourable devices and subterfuges do not constitute legitimate tax planning. In the !"adi #ac$ao !ndolan2 case, the Indian Supreme !ourt held that treaty shopping is a legitimate exercise of tax planning and %IM4 cannot be denied benefits of the Mauritius -reaty in the absence of express treaty provisions limiting such benefits. !onsidering that the shares were held by %IM4 for a considerable period of time and are proposed to be sold at fair market value, the %% did not view the arrangement as a tax avoidance scheme. -herefore, the benefits of the -reaty for residents of Mauritius subject to there being a valid tax residency certificate issue by the Mauritian #overnment were validated. 8hat differentiates !"adi #ac$ao from McDowell is the perception of the ambit and reach of judicial role. -he court in McDowell 1 nowhere said that every action or inaction on the part of the taxpayer which results in reduction of the tax liability to which he may be subjected in future, is to be viewed with suspicion and be treated as a device for avoidance of tax irrespective of legitimacy or genuineness of the act. -he principle enunciated in the above case has not affected the freedom of the citi?en to the act in a manner according to his reFuirements, his wishes in the manner to do any trade, activity or planning his affairs with circumspection, within the framework of law, unless the same falls in the category of colourable device. >ut the interpretation of McDowell in !"adi #aca$o% tends towards the extreme, where it supposes all transactions to be scrutini?ed under the substance over form test, which is clearly not the intention of the judges in the former. Such misinterpretation led to the decision in the latter case that the tax payer has an overriding right to mitigate tax payable, by legitimate means and should not be scrutini?ed.29 %lthough !hinnappa eddy, (. makes a number of observations regarding the need to depart from the 8estminster principle and tax avoidance, these are clearly only in the context of artificial and colourable devices. eading Mc"owell, in the
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21 ibid.
22 ibid.
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manner indicated hereinabove, in cases of treaty shopping andGor tax avoidance, there is no conflict between McDowell and !"adi #ac$ao.2E VODAFONE INTERNATIONAL HOLDIN"S V. UOI: CASE ANALYSIS
-he odafone tax case throws an interesting Fuestion on the taxability of a non resident company acFuiring shares of a resident company through an indirect route. -his is a landmark case, as it is for the first time that the tax departments have sought to tax a company through a mechanism of tracing the source of acFuisition. 8hile we have heard about lifting the corporate veilC, this instance has set a rare example wherein the Indian tax authorities have gone to length to interpret the existing tax laws, to bring a global company like odafone to its tax ambit. %>.1& 3+/9 9'7 ', <8,4;/ *9 / '7/
odafone International Holdings > $IH&, a company resident for tax purposes in the etherlands, acFuired the entire share capital of !#' Investments Holdings 4td $!#'&, a company resident for tax purposes in the !ayman Islands, which held E2 shares in Hindustan )ssar 4td $H)4& as well as options to acFuire a further +E shareholding interest in H)4, subject to relaxation of ;"I orms. -he alleged purpose of this transaction was to acFuire =@ controlling interest in H)4. %nother issue in Fuestion in this case was the validity of %?adi >achao case when contrasting it with Mc"owell case which explains as to how in certain circumstances tax avoidance should be brought within the tax net. Held7 -he Supreme !ourt delivered a judgment in favour of odafone, stating inter alia that no Indian tax was reFuired to be withheld on a transfer of offshore assets between two nonKresidents. % tax free corporate reorgani?ation should not per se co nstitute a colourable device. -he ;inance %ct, 2D+2 introduced )xplanation E to Section B $+& $i& of the IncomeKtax %ct, +B=+ clarifying that an offshore capital asset would be considered to have a situs in India if it
24 %shish Sodhani and Shreya ao, 4andmark International -ax !ases decided by Indian (udiciary K SummaryC $ is$it$ Desai5 = (uly 2D+:& Phttp7GGwww.nishithdesai.comGfileadminGuseruploadGpdfsGesearch 2D%rticlesG4andmark2DInternational2D-ax.pdf Q accessed 2E September 2D+E.
25 Vodafone International Holdings v UOI $2D+2& = S!! =+:. 9|Page
substantially derived its value L directly or indirectly L from assets situated in India. -he amendment is currently retroactively applicable from +B=+. It was argued by the revenue authorities that if transfer of a capital asset situate in India happens in conseFuence ofJ something which has taken place overseas $including transfer of a capital asset&, then all income derived even indirectly from such transfer, even though abroad, becomes taxable in India. However, this argument was rejected by the court as an incorrect reading of S. B of the Income -ax %ct, +B=+. -he income dealt with in each of the subKclauses are to be read separate from each other and the satisfaction of reFuirements of others cannot be sought with respect to one. -he income in Fuestion in this case is transfer of a capital asset situate in IndiaC for which the elements of transfer, existence of a capital asset, and situation of such asset in India must be satisfied to be taxable. 2= -hus, income accruing or arising to a nonKresident outside India on transfer of a capital asset situate in India is fictionally deemed to accrue or arise in India, which income is made liable to be taxed by reason of Section E$2&$b& of the %ct. -his is the main purpose behind enactment of Section B$+&$i& of the %ct. However, a legal fiction has limited scope and cannot be expanded by giving purposive interpretation particularly if the result of such interpretation is to transform the concept of chargeability which is also there in Section B$+& $i&, particularly when one reads Section B$+&$i& with Section E$2& $b& of the %ct. -herefore, indirect transfers cannot be covered under this provision. %>.2& D/'+/, ''7+7 *9 ' /'7+* ?+ 3/7/ * +*;/ ' 3*+7+*7
It is a wellKsettled principle that all corporate entities have separate existence irrespective of them being the parent or the holding company and shall be taxed as per their respective places of residence, notwithstanding the location of the parent company. However, in certain cases where the executive decisionKmaking of the subsidiary company has become fully subordinate to the parent company, so much so that, the executive board of the subsidiary has become a mere puppet in the hands of the parent company, a visible change occurs in the rule of residence stated above. In the instant case, odafone argued that the entire transaction had taken place overseas and India had no jurisdiction to tax the same. 8hether a transaction is used principally as a colourable device for the distribution of earnings, profits and gains is determined by a review of all the facts and circumstances surrounding the transaction. It is in the above cases that the principle of lifting the corporate veil or the doctrine of substance over form or the concept of beneficial ownership or the
26 Income tax %ct +B=+, s B $+& $i&. 10 | P a g e
concept of alter ego arises.2@ -he corporate business purpose of a transaction is evidence of the fact that the impugned transaction is not undertaken as a colourable or artificial device. -he stronger the evidence of a device, the stronger the corporate business purpose must exist to overcome the evidence of a device. %>.>& E/7+* *9 MD*?/@7 3++/ *9 83*7+/ *738+*
In Vodafone Holdings, the court upheld the validity of the judgment in McDowell and rejected the misconstrued reading of the same in !"ai #ac$ao.
Mishra, (. has observed as follows after
referring to a number of )nglish decisions laying down various principles L Tax *lanning ma( )e legitimate *rovided it is wit$in t$e framewor+ of law. Colo,ra)le devices cannot )e *art of tax *lanning and it is wrong to enco,rage or entertain t$e )elief t$at is $ono,ra)le to avoid t$e *a(ment of tax )( resorting to d,)io,s met$ods. It is t$e o)ligation of ever( citi"en to *a( t$e taxes $onestl( wit$o,t resorting to s,)terf,ges.J eddy, (. has opined while agreeing with the judgment of Mishra, (. that L T$e *rinci*le of 3estminster $as )een given a decent ),rial in
27 Vodafone International Holdings v UOI $2D+2& = S!! =+:.
28 $+BBB& A S!! ==@. 11 | P a g e
reopening of the case was rejected. Hence, purposive construction adopted in McDowell still holds good and has been adopted in the present case as well. CONCLUSION
-he principle of purposive construction adopted in McDowell has been repeatedly upheld in subseFuent cases, despite the confusion that arose from the decision in !"adi #ac$ao !ndolan. -he facts of the two cases were Fuite different and dealt with different aspects of tax avoidance and tax evasion due to which such confusion arose. -his was dispelled by the judgment inVodafone. 8hile the 8estminster principle states that L #iven that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substanceJ, amsa( lays down that the principle of statutory interpretation rather than an overKarching antiKavoidance doctrine imposed upon tax laws, and therefore is only a reading of the 8estminster case in proper context by which deviceC which was colourable in nature had to be ignored as fiscal nullity. Similarly, it has been observed in Vodafone that in the application of a judicial antiKavoidance rule, the revenue authorities may invoke the substance over formC principle or piercing the corporate veilC test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant. In other words, if the interposition of a holding company has been proved to have no commercial substance, fiscal nullity can be resorted to the revenue authorities. However, every transaction cannot be looked at from the purpose of tax defermentGevasion and must be presumed to be legitimate and holistic unless proved otherwise. -his is the limitation delineated for the application of substance over form principle and the final holding of this case upheld the form over substance rule. -hough form over substance is the rule where the provision is so clear as to leave no room for ambiguity, the substance over form rule is being preferred by tax authorities who are adopting an aggressive approach towards tax avoidance to safeguard tax collection in the face of weakening world economies and stiff international competition. >ut this new rule is a fresh approach to interpret taxation statutes which usually do not admit a *riori principles of interpretation will make it tougher of illegitimate evasions to subsist. -he Supreme !ourt must lay down guidelines for application of this new approach to prevent arbitrariness from creeping into tax collection mechanisms and protect legitimate transactions from unwarranted scrutiny, which can adversely affect the corporate entities.
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