Piercing the Veil in Taxation Matters Essay Example
Piercing the Veil in Taxation Matters Essay Example

Piercing the Veil in Taxation Matters Essay Example

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  • Pages: 15 (7607 words)
  • Published: April 29, 2017
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Piercing the veil is one of the most discussed and litigated doctrines in all of corporate law. A company has a corporate personality distinct from its members. From the juristic point of view, it is a legal person distinct from its members. This is the principal laid down in Salomon v. Salomon & co. ltd. , (1897). The courts did this to in relation to a one person member company. The principal is commonly referred as “veil of incorporation” The courts were bound by these principals but they realised exceptions to the rule.

This happened due to human inventiveness which started using the veil of corporate personality deliberately for fraud and improper conduct. The courts started to lift the fictional veil between the company and its members. Professor of Law, S. Ottolenghi in his article "From Peeping Behind the Corporate Veil, to ignoring it Completely" says "the concept of 'piercing the veil' in the United States is much more developed than in the UK.

A company is “A new legal entity, a person in the eye of the law. Perhaps it were better in some cases to say a legal persona, for the Latin word in one of its senses means a mask: Eriptur persona, manet res. ” The separate legal entity principle has continued unexpurgated from Anglo-Australian corporate law for more than one hundred years. When a company acts it does so in its own right and not just as an alias for its controllers.

Similarly, shareholders are not liable for the company’s debts beyond their initial capital investment, and have no proprietary interest in the property


of the company. The Saloman principal led to limited liability companies,which means that members can be held liable only to a fixed extent of the debts of the company. The creditor can sue the company but not the members of the company. There are two exceptions why a company cannot be treated as a separate entity. It clearly cannot be treated as an independent person.

For example, a corporation is not capable of committing a tort or a crime requiring proof of mensrea unless courts disregard the separate entity and determine the intention held by the directors and/or shareholders of the corporation. 16 Secondly, strict recognition of the principle may lead to an unjust or misleading outcome if interested parties can "hide" behind the shield of limited liability. At the same time, courts have acknowledged that the corporate veil of a company may be pierced to deny shareholders the protection that limited liability normally provides. Piercing the corporate veil” refers to the judicially imposed exception to the separate legal entity principle, whereby courts disregard the separateness of the corporation and hold a shareholder responsible for the actions of the corporation as if it were the actions of the shareholder. A court may also pierce the corporate veil where requested to do so by the company itself or shareholders in the company, in order to afford a remedy that would otherwise be denied, create an enforceable right, or lessen a penalty.

Since Salomon, the courts in the United States, England and Australia, have found exceptions to the general

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principle stated in Salomon and have pierced the corporate veil to reveal those who control the company. It is impossible to establish when the courts would lift the veil. The matter is largely in the prudence of the courts and will depend upon “the underlying social, economic and moral factors as they operate in and through the corporation. ” It can be said “that adherence to the Salomon principle will not be resolutely followed where this would cause an unjust result”.

As the laws have evolved, the judges have given grounds under which the corporate veil can be pierced. An eminent judge noted ““[T]he separate legal personality of a company is to be disregarded only if the court can see that there is, in fact or in law, a partnership between companies in a group, or that there is a mere sham or facade in which that company is playing a role, or that the creation or use of the company was designed to enable a legal or fiduciary obligation to be evaded or a fraud to be perpetrated. A number of other discrete factors recognised by international courts for piercing the corporate veil includes

(a) agency;

(b) fraud;

(c) sham or facade;

(d) group enterprises;

(e) unfairness/justice.

These categories are probably not exhaustive. Under Indian Law,The Companies Act 1956 itself provides provisions for the lifting of corporate veil. These generally are exceptions for the companies to be regarded as a separate legal entity. The concept of limited liability ceases to exist and the individual members/directors will be made liable for certain transactions.

The statutory provisions are as follows: 1. Reduction of membership below statutory minimum (Section 45): This section provides that if the number of member of a company is reduced below 7 in the case of public company or below 2 in the case of private company and the company continues to carry on the business for more than 6 months, while the number is so reduced, every person who knows this fact and is a member of the company is severally liable for the debts of the company contracted during that time. Improper use of name (Section 147): Under sub-section of this section, an officer of a company who signs any bill of exchange, hundi, promissory note, cheque wherein the name of the company is not mentioned in the prescribed manner, such officer can be held personally liable to the holder of the bill of exchange, hundi etc. unless it is duly paid by the company.

Liability for fraudulent conduct of business (Section 542): If in the course of the winding up of a company, it appears that any business of the company has been carried on with intent to defraud the creditors of the company or any other person or for any fraudulent purpose, the persons who were knowingly parties to the carrying on of the business, in the manner aforesaid, shall be personally responsible, without any limitation of liability for all or any of the debts or other liabilities of the company, as the court may direct. This paper indicates how corporate veil is pierced in taxation matters.

In a democratic society , the economic

stability of a country would depend on the correct interpretation of provisions of taxation laws by the apex courts. Article 256 of our constitution states that taxes cannot be levied without the authority of law . As Justice Holmes quoted “taxes are what we pay for civilized society”. Law recognises tax planning within the framework or its contours. That is known as tax avoidance. The broad definition of tax avoidance would be using the tax rules of the state for one’s own benefit by reducing the amount of tax to be paid within the framework of law.

This principle is recognised in law. Way back in 1936,the House of Lords in IRC v Duke of Westminster stated that “Every man is entitled if he can to arrange his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure that 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” (IRC v Duke of Westminster [ 1936 ] AC1 (HL)) .

This means that every person has a right to reduce his tax liability provided it is within the structure of law. Established 45 years later after this judgement which limited tax avoidance was the Ramsay principle, which has significant repercussions for tax planning. This Ramsay principle is the short hand name given to the decisions of House Of Lords in two most important cases of UK tax i. e. Ramsay v. IRC and IRC v. Burmah Oil Co. Ltd.

The core of the Ramsay Principle is to be found in the Burmah Oil case in this remark by Lord Diplock: It would be disingenuous to suggest, and dangerous on the part of those who advise on elaborate tax-avoidance schemes to assume, that Ramsay's case did not mark a significant change in the approach adopted by this House in its judicial role to a pre-ordained series of transaction (whether or not they include the achievement of a legitimate commercial end) into which there are inserted steps that have no commercial purpose apart from the avoidance of a liability to tax that, in the absence of those particular steps, would have been payable.

Before Ramsay, it was an axiom of tax planning that in the absence of express statutory provision to the contrary, unenforceable arrangements were not relevant and the tax implications of any stage in a transaction fell to be analysed by reference only upto what had been agreed upto that stage as distinct from what steps were expected thereafter. This has been called as the “step by step” approach. In extreme cases, the taxpayers relied on this approach to manufacture capital losses the technique being to put money into a chargeable asset and take the money out by way of non-chargeable assets.

Although in a commercial sense,the loss on a chargeable asset was matched by a gain on non- chargeable asset, for tax purposes only the loss fell to be taken into account. The decision in Ramsay was itself a decision

on the scheme of this kind: after setting out the separate stages by which the loss arose, Lord Wilberforce concluded that there was no loss nor a gain. Initially it was thought that, notwithstanding some wider dicta, that the Ramsay doctrine was confined to self-cancelling transactions, that is in case of transactions where the parties had not changed their position or produced any commercial sense.

After the Ramsay case, the courts started taking a less kinder view to the tax payers who engaged in elaborate steps to avoid tax. The case which extended the Ramsay principal was Furniss v Dawson and its citation is [1984] A. C. 474, or alternatively [1984] 2 W. L. R. 226. In this case it was concluded that the House of Lords had indicated that a scheme would not be effective for tax avoidance purposes if there was a pre-ordained series of transactions and if steps had been inserted which had no commercial purpose apart from the avoidance of a liability to tax.

The implication of that in the light of the above cases, the present law could be restated under five heads:

  1. a subject could arrange his affairs so as to avoid tax; the fact that the motive for a transaction was the avoidance of tax did not invalidate the transaction;
  2. if a transaction were genuine the court was obliged to have regard to the true legal effects of the transaction and could not go behind it to some supposed underlying substance;
  3. owever, if there was 'a scheme' involving more than one transaction regard had to be paid to the overall legal effect of the scheme as a whole to see if there was a pre-ordained series of transactions, and if steps had been inserted with no commercial purpose apart from the avoidance of a tax liability;
  4. if it was found under the above principles that successive transfers of property by A to B and B to C amounted to a transfer by A to C, then consideration provided by C to B might be treated as provided to A.
  5. had to be borne in mind that the House of Lords had emphasised that the law in this area was in an early stage of development.

The English precedents were relied on repeatedly by Indian courts as well. Tax avoidance was thus seen as a permanent right of assessees. Then came the turbulence, temporary thought. The Supreme Court, in the McDowell ; Co Ltd vs CTO (1985 154 ITR 148 SC) case, said that time has come to depart from the old thinking. It said even tax avoidance is bad and deserves condemnation. The apex court's justification for this being, the House of Lords, the highest judicial forum of English, has given a go-by to the principle laid down by the British courts (in Duke of Westminster case). Since tax avoidance as a legal route was rejected by the very country of origin, it does not merit any better treatment in India, the Supreme Court held. The adverse legal consequences of this judgment for taxpayers were enormous. First, it came from the highest court of the land

and, therefore, binding on all lower courts and Tribunals. Two, the McDowell case blurred the distinction between avoidance and evasion.

On two counts the apparent tenor of the McDowell case was legally incorrect. First, even in the McDowell case, Justice Ranganath Mishra confirmed that tax planning might 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. The rest of the judges, other than Justice Chinnappa Reddy, did not contribute to the radical thinking that tax avoidance itself is bad.

Second, the decision was flawed on the court's assumption that the British courts have disassociated themselves from the Westminster principle, as evidenced by three cases: W. T. Ramsay Ltd vs IRC (1982 AC 300); IRC vs Burman Oil Co Ltd (1982 STC 30); and Furmiss vs Dawson (1984 1 ALL ER 530). Contrary to this, the House of Lords had occasion to analyse the very same trilogy of cases, three years after the McDowell ruling was pronounced and clearly affirmed its support to tax avoidance and the principle lay down in the Westminster case still valid. This position was vindicated even as recently as 2001.

The eminent jurist Mr. N. A. Palkhivala in one of his books “we the nation, the lost decades” in an illuminating article have analysed the judgment of Supreme Court in McDowell vs. CTO 154 ITR 148 and considered the validity of ruling of the Supreme Court blurring the distinction between tax avoidance which is legitimate and tax evasion. By an indepth analysing the said judgment in McDowell’s case, Mr. Palkhivala observed that the Courts’ pronouncement obliterating such distinction is patently incorrect and proceeds on a total misreading of three decisions of the House of Lords.

The said article of Mr. Palkhivala is published at page 130 in his famous book “we the nation, the lost decades”. In this article the whole object is that in a taxing statute the courts have little scope to find out the underlying intention of the legislature beyond what is stated in the plain language of the statute The Supreme Court in CIT Madras v Meenakshi Mills Ltd(1967) stated that “In certain exceptional cases the Court is entitled to lift the veil of corporate entity and pay regard to the economic realities behind the legal facade.

For example, the Court has power to disregard the corporate entity if it is used for tax evasion or to circumvent tax obligation. [941 E] Devid Payne ; Co. Ltd. in re, Young v. David Payne ; Co. , Ltd. [1904] 2 Ch. D. 608. Distinguished” In Barbara Greene Americas Inc v Commissioner of Internal revenue, it was stated A corporate entity otherwise qualified should not be disregarded as a sham or facade merely because it was created and operated to gain tax benefits. Thus the form in which the transaction is entered into cannot be disregarded.

India has always respected form over substance. Yet to pierce corporate veil, the substance of the transaction should be perused.

The real intention behind the transactions should be considered. In matters of taxation, the real intention could be tax evasion and whether these transactions border on illegality. In a recent case Madras High Court has ruled that the consideration paid by a company for purchase of business of an ongoing profitable firm is in the nature of goodwill as against technical knowhow and non-compete fee claimed by the tax payer and in case of any attempt made to evade tax.

Facts and Issue involved in the case M/s Indo Tech Electric Co (“taxpayer”), a partnership firm comprising father and son and engaged in the business of manufacture of transformers, sold its entire business as a going concern to “Indo Tech Transformers Limited” (“the company”), with the partners of the firm becoming the directors of the company. The company paid the taxpayer Rs 1. 25 crores towards technical know-how, Rs 36 lakhs towards non-compete compensation for pending orders and Rs 33 lakhs towards non-compete compensation for future orders.

The taxpayer claimed the entire amount of Rs 1. 94 crores as a non-taxable capital receipt in the return of income filed for assessment year 1995-96. The assessing officer (“AO”) assessed the entire sum as consideration for transfer of “goodwill” under section 55 of the Income Tax Act, 1961(“Act”) holding that an attempt had been made by the taxpayer to evade the payment of tax. The first appellate authority upheld the taxpayer’s stand with regard to the technical knowhow ; non-compete compensation for ending orders while rejecting the contention regarding non-compete compensation for future orders. On cross appeals, the Chennai Bench of Income Tax Appellate Tribunal rejected the taxpayer’s contentions and upheld the stand of the AO that the entire amount was assessable as “goodwill”. The taxpayer carried the matter to the High Court by way of further appeal. Ruling of the High Court l. The taxpayer was not involved in the sale of technical know-how.

Accordingly, the receipts for technical know-how and the compensation for non-compete fees were a part of composite receipt to diminish the value of the assets of the taxpayer and the taxpayer had attempted to prevent the consideration being taxed as goodwill under the provisions of the Act considering the good performance of the taxpayer over past years.

Taxpayer could not produce any material to establish the cost of the alleged technical know-how or to quantify the consideration received for its transfer.

The taxpayer was taken over as a going concern in its entirety. The partners of the taxpayer were the directors of the company and the consideration was paid to the taxpayer and not to the partners. Accordingly, there was no competition between the taxpayer and the company

It is a well settled principle of law that what is permissible is avoidance but not evasion. When an attempt is made by a company to evade tax it is the bounden duty of the authorities to lift the corporate veil and find out the real intention behind the same.

The Karnataka High Court in a recent judgment has indicated that tax authorities can lift the corporate veil to determine the facts of a transaction with

a view to ascertain whether there is any avoidance of tax. From the facts available, Richter Holdings Limited (RHL) a Cypriot company and West Globe Limited (WGL) a Mauritian company purchased all shares of Finsider International Company Limited (FICL) a UK company from Early Guard Limited (EGL) another UK company. FICL held 51% shares of Sesa Goa Limited (SGL), an Indian Company.

The Indian tax department issued a notice to RHL calling upon RHL to show cause as to why this transaction will not trigger withholding tax obligation. RHL filed a writ petition in Karnataka High Court challenging the said notice. In the current case RHL argued that the transfer of shares did not amount to acquisition of immovable property or controlling the management of the Indian company and it was only an incident to owning the shares of a company which flows out of the holding of shares.

The tax department on the other hand was of the view that the transfer of shares constituted transfer of capital asset and hence a withholding tax obligation had arisen in the hands of RHL. The Karnataka High Court disposed the writ petition and held that since the agreement produced in the Court did not throw any significant light on the transaction, the tax authorities should do a further fact finding exercise, for which the corporate veil can also be lifted.

This is an another judgement passed by the High Court , dismissing the writ petition, which was filed against the show-cause notice issued by the tax department, asking a non-resident buyer, that why it cannot be considered as an “assessee in default” for not withholding tax under section 195, while acquiring the controlling interest in an Indian company in the course of purchasing the shares of a non-resident company from another non-resident.

The High Court has also allowed the tax department to lift the corporate veil to look into the real nature of transaction to ascertain vital facts and to ascertain whether the buyer, as a majority share holder, enjoys the power by way of interest and capital gains in the assets of the company and whether transfer of shares in the case on hand includes indirect transfer of assets and interest in the company.

The vital controversy of the issue is revolving around the applicability of section 9(1)(i) of the Income tax Act to the indirect transfer of shareholding in India and whether transaction of transfer of shares of a non-resident company, which has indirect control in the Indian company, between two non-residents can be brought within the ambit of capital gains taxation in India.

Section 9(1)(i) of the Income tax Act states that The following incomes shall be deemed to accrue or arise in India :-  (i) All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India; Explanation : For the purposes of this clause - (a) In the case of a business of which all the operations

are not carried out in India, the ncome of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India Further, whether change in controlling interest is incidental to the transfer of shares or it is a separate capital asset other than holding of shares. The jurisprudence so far evolved in India, is that capital gains are deemed to accrue or arise in the country where the situs of shares is situated.

In this case, the India-UK tax treaty (if at all applicable on such indirect transfer of controlling interest in the Indian company) would come into play and accordingly, as per the treaty the capital gains would be taxable as per the domestic tax laws. However, the moot point would be whether under the treaty the capital gains that accrue to the UK resident would be governed only by the provisions of section 45 of the Act or also, the deeming fiction of section 9 would come into play.

Under the proposed DTC regime, it has General Anti avoidance rules(GAAR) which is the based on the principle of lifting corporate veil. GAAR is a broad set of provisions which can invalidate an arrangement that has been entered into by a taxpayer with the objective of obtaining a tax benefit. In addition to that DTC incorporates certain specific anti-avoidance rules(SAARS) to supplement GAAR for dealing with circumstances such as international transactions such as armlength transactions. Armlength transactions are related party transactions such as between holding and subsidiary companies.

The whole purpose of incorporating GAAR vide sec 112 of DTC is tax avoidance. It perceives all forms of tax avoidance as inequitable and undesirable. It can be applied to any arrangement which can be perceived as impermissible avoidance arrangement. An impermissible avoidance arrangement has the following characteristics: 1. creates rights and obligations which would not normally be created between persons dealing at arm length results in an abuse of the provisions of DTC lacks commercial substance in whole or in part . is entered into, or carried out by means or in a manner which would not normally be employed for bonafide purpose Using the provisions of GAAR,the taxmen can lift the veil and see the substance of the transaction. The distinction between tax evasion and tax avoidance has become very narrow. In Azadi Bacho Andolan case well accepted tax concepts emerged. They were form over substance, no lifting of corporate veil ,Mauritius tax residency certificate being sufficient evidence for beneficial ownership.

Views expressed by the smaller bench of the Supreme Court are binding on the High Court. The Authority of Advance Rulings has issued its ruling in the matter of ETrade Mauritus; and the Ruling essentially follows the decision of the Supreme Court in  Azadi Bacho Andolan. The facts before the Authority were that the Applicant was a company incorporated in the Mauritius, and had been issued a Tax Residency Certificate by the Mauritius income tax authorities. The Applicant was a subsidiary of a company incorporated in the United States of America.

The Applicant held shares in an Indian company, 

Investsmart Ltd. It transferred its shares in the Indian company to another Mauritius company. Under domestic law, the gains from this transfer (gains arising through the transfer of a capital asset situate in India) would be chargeable under Section 9 of the Income Tax Act. Having a tax residency certificate in Mauritius, the applicant claimed the benefit of Article 13(4) of the Indo-Mauritius DTAA.

Under Azadi Bachao, the applicant would clearly be entitled to the benefit of the DTAA; and the gains would be taxable only in the residence country, Mauritius. The Revenue however contended before the AAR, that “there is scope and sufficient reason to infer that the capital gain from the transaction arises in the hands of the US entity which holds the applicant company. In other words, the beneficial ownership vests with the US company which according to the department has played a crucial role in the entire transaction.

Though the legal ownership ostensibly resides with the applicant, the real and beneficial owner of the capital gains is the US Company which controls the applicant and the applicant company is merely a facade made use of by the US holding Company to avoid capital gains tax in India. ” According to the Revenue, considering that the ‘real’ beneficiary was the US parent of the Mauritius applicant, the gains must be held to accrue to the US company. Under the relevant provision of the Indo-US treaty, the gains would be taxable in India.

Contrary to this argument, the applicant contended that beneficial ownership is irrelevant in the context of Article 13 of the Indo-Mauritius treaty. Strong reliance was placed on Azadi Bachao. The AAR analysed the decision in Azadi Bachao, and ruled, “
the Supreme Court found no legal taboo against ‘treaty shopping’ 
 if a resident of a third country, in order to take advantage of the tax reliefs and economic benefits arising from the operation of a Treaty between other countries through a conduit entity set up by it, the legal transactions entered into by that conduit entity cannot be declared invalid.

The motive behind setting up such conduit companies and doing business through them in a country having beneficial tax treaty provisions was held to be not material to judge the legality or validity of the transactions. ” The Revenue contended that where the incorporation of a Mauritius entity is merely a device or a sham, the ratio of Azadi cannot be applied. Again, the AAR clarified, once again on the basis of Azadi, that “
 the word ‘device’ cannot be used ‘in any sinister sense’ and the design of tax avoidance by itself is not objectionable if it is within the framework of law and not prohibited by law.

However, a transaction which is ‘sham’ in the sense that “the documents are not bona fide in order to intend to be acted upon but are only used as a cloak to conceal a different transaction” (per Lord Tomlin in Duke of West Minister) would stand on a different footing 
. ” Now the judgement of the above case would be very different under the proposed DTC. Presently the Income Tax u/s 90(16) and 91(17) contains provisions for agreements of double taxation.

Double taxation agreement(DTA) is an agreement by which a resident of a country can avoid paying taxes

for the income earned in another country. Many nations make the double taxation treaty with each other. The first aspect of it is country where the gain arises deducts taxation at source ("withholding tax") and the taxpayer receives a compensating foreign tax credit in the country of residence to reflect the fact that tax has already been paid. To do this, the taxpayer must declare himself (in the foreign country) to be non-resident there.

So the second aspect of the agreement is that the two taxation authorities exchange information about such declarations, and so may investigate any anomalies that might indicate tax evasion Now in the E*TRADE Mauritius case,the DTA was between India and Mauritius. The third party i. e. USA took advantage of this treaty. With the provisions of GAAR, under DTC the taxmen can lift the veil and investigate the substance of the transaction. The third parties cannot take advantage of DTA between two countries. The DTC strictly condemns tax avoidance on moral and economic grounds.

In a recent contradiction to these cases,The Bombay High Court believes otherwise. A two judge Bench of Justices Devdhar ; Sayed have bowled a googly that promises to run out the Mauritius tax advantage. In 2007, the Birla and Tata Group- both shareholders in Idea- exercised a Right of First Refusal (ROFR) to buyout AT;T stake in the Indian telecom company. Aditya Birla Nuvo agreed to purchase Idea shares from AT;T Mauritius and thereafter Tata Industries agreed to purchase AT;T Mauritius itself.

As AT;T Mauritius had a tax residency certificate, Nuvo obtained a new withholding order from the Indian Tax Department. Tata Industry believed since theirs was an offshore transaction, there would be no tax liability. But, in 2008, the tax department issued orders against Nuvo, Tata Industries as well as AT;T. The matter went to the Bombay High Court and revenue won. The court determined that AT;T Mauritius was only a ‘permitted transferee’. The beneficial owner was USA and hence the transactions were not eligible for Mauritius treaty benefits.

It has allowed the tax department to now initiate assessment proceedings. The implications of this case are far reaching. The important point here is the difference between legal and beneficial ownership. Here the court has lifted the corporate veil to find out the beneficial owner. A legal owner only has the title to the legal asset. However he can hold it in a trust as a nominee basis. This nominee is considered the beneficial owner to whom all the profits accrue. Lifting the corporate veil is important to find out the economic reality of the transaction.

One more aspect to avoid tax can be when companies are incorporated outside India and claim to be non-residents so they are taxed only on “global income”. The tax residence of companies (that is, where companies are established or carry on business) is usually based on either place of incorporation (legal seat), location of management (real seat) or a combination of the two. The DTC provides that a company incorporated in India will always be treated as resident in India. However, a company incorporated abroad (foreign company) can either be resident

or non-resident in India.

It has been proposed in the DTC that a foreign company will be treated as resident in India if, at any time in the financial year, the control and management of its affairs is situated „wholly or partly? in India (it need not be wholly situated in India, as at present).

It has been pointed out that under the new test for determining residence in the DTC, a foreign company whose control and management is partly in India will be treated as a resident of India and thus liable for taxation in India on its global income. The word „partly? used in the DTC sets a very low threshold for regarding a foreign company as a resident in India.

Apprehensions have been expressed that it could lead to a foreign multi-national company being held as resident in India on the ground that some activity like a single meeting of the Board of Directors is held in India. Also, a foreign company owned by residents in India could be held to be resident in India as part of the control of such company may be in India. It has been represented that this will result in uncertainty in taxation and will impact foreign direct investment into India. Modification of the phrase „wholly or partly? has therefore been suggested.

Generally, the test of residence for foreign companies is the „place of effective management? or „place of central control and management?  At the same time, it is noted that the existing definition of residence of a company in the Income Tax Act, 1961 based on the control and management of its affairs being situated wholly in India is too high a threshold.

„Place of effective management? is an internationally recognized concept for determination of residence of a company incorporated in a foreign jurisdiction. Most of our tax treaties recognize the concept of „place of effective management? or determination of residence of a company as a tie-breaker rule for avoidance of double taxation. It is an internationally accepted principle that the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity? s business as a whole, are, in substance, made. In case of a company incorporated outside India, the current domestic law is too narrow compared to our tax treaties as the test of residence of a foreign company is based on "whole of control and management" lying in India.

However a test of residence based on control and management of the foreign company being situated "wholly or partly" in India as proposed in the DTC is much wider.

It is therefore proposed that a company incorporated outside India will be treated as resident in India if its „place of effective management? is situated in India. The term will have the same meaning as currently laid down in the Tenth Schedule to the Code as under: „place of effective management of the company ? means- i) the place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or (ii) in a case where the

board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions. " This again is “piercing the corporate veil” to decide the status of the resident of the company to avoid evasions of tax. So the DTC rules are stringent with regard to the norms of a company being a “resident”.

Its provisions allow the courts to choose substance over form. They have a wider implications as far as DTAA (i. e. Double taxation agreements) concerned. Now just having the company as a resident of a country does not escape its liability of tax in another country with DTA if it was deliberately obtained to gain an advantage of tax benefit. The revenue can pierce the corporate veil and use the above provisions to determine the residence of the company. The DTC is far reaching. It charters into territories which have been unclear yet its whole ideology is too idealistic.

India being a developing country needs Foreign Direct Flows(FDIs). The DTC strictly condemns tax avoidance. This would clearly discourage these FIIs. With the above provision, the Indo-Mauritius treaty just became a lot more complicated. Companies have long preferred Mauritius for indirect share transfers setting up elaborate steps to avoid capital gains. The Companies involved in these transactions have always obtained a certificate of residence from Mauritius to show that as the proof for them not to pay capital gains.

The Indian Courts and the Revenue can pierce the corporate veil with the above provisions and contravene the fact of the Companies being “non-residents”. DTC has proposed for Controlled Foreign Corporations(CFC) provisions which will again lift the corporate veil to avoid tax. CFC is a corporate entity which conducts business in one jurisdiction but is owned or controlled primarily by the resident taxpayers of another jurisdiction. CFC’s deliberately route their investments through tax havens to avoid payment of taxes on income at home.

As income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer,the mechanism enables the shareholders to defer the payment of taxes. According to DTC, passive income generated by a foreign company controlled directly or indirectly by Indian tax residents and where such income has not been distributed for tax deferral reasons, shall be deemed to have been distributed, thus making the distribution taxable as a dividend distribution in the hands of the Indian tax resident.

The effective test laid down under the DTC is the ‘place of effective management’ of the corporation which is an internationally recognised principle for determining the residence of the Corporation. The DTC defines the term ‘place’ as being the country in which the ‘ key management’ and ‘commercial decisions’ are made for the ‘entity as a whole’. Therefore in substance it widens the ambit of residence of a Foreign Company if it is managed wholly or partially in India unlike the present law which limits a Foreign Corporation liable to tax only if the management and control are wholly in India

(s. Income Tax Act, 1961).

Further the DTC lays down a two-fold test for determining the Place of effective management under Schedule 10 of the code- (i) The place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or (ii) in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions. In order to understand the true nature of the applicability of laws governing CFC’s, it is necessary to analyse the limitations of the provisions relating to its induction within the tax structure. Pursuant to the above definition of place of effective management, there should essentially be a bracket which categorises the term ‘ routinely’( clause ii) in such a manner that no further room for interpretation is left. Yet some ambiguity may remain as to the nature of income under passive income.

So effectively the provision of CFCs have been incorporated to deny the principle of tax avoidance as seen by the Azadi Bacho Andolan. Yet again the corporate veil would be pierced to see the beneficiaries availing tax benfits. The tax avoidance issue with the DTC just got a whole lot more contentious. In the current scenario , the most awaited judgement would be of the Supreme Court in the Vodafone case. This judgement would set a precedent and actually give rise to new interpretations of tax laws. The facts of the Vodafone case are On 12 January 1998 CGP Investments (Holdings) Ltd.  (CGP) was incorporated in Cayman Islands by the Hutchison Group. 1. HTL Hong Kong was the sole shareholder of CGP and in September 2004, it came to be transferred to/acquired by HTI BVI.

On 11 February 2007, a Sale Purchase Agreement (SPA) was entered into between the Petitioner and HTIL under which HTIL agreed to procure and transfer to the Petitioner the entire  issued share capital of CGP, by HTI BVI free from all encumbrances together with all rights attaching or accruing, and together with assignment of loan interests.

This resulted in an indirect transfer of 67 percent shareholding in Hutchinson-Essar to Vodafone. Main argument of Vodafone for not being  responsible for TDS on payments to Hutchison  and that Income Tax Department has no jurisdiction on the issue of buying shares of Cayman Island companies are as under 1. It  had no presence in India at the time of transfer of share; 2. The transaction was consummated outside India; 3.

The transaction related to transfer of a share  outside India, contracted to be delivered outside India and the transfer of which was registered outside India; 4. The governing law of the contract pursuant to which it was transferred was English law; 5. Payment was made from a bank account outside India to a bank account outside India, there is no question of deduction of tax on such payments. Main argument of Income Tax Department  are as under :

  1. The payment  on which TDS was required to be deducted was not merely for CGP,

Cayman shares.

  • The consideration paid by Vodafone to Hutchison was for composite package , as there were  numerous  agreement between them by which Hutchison was required to perform a lot of duties in India for making the agreement successful.
  • The acquisition of the shareholding in CGP ,Cayman did not transfer by  itself all the rights and interests which flow to Vodafone  from the transaction. Though neither the Vodafone nor  HTIL are shareholders in  HEL , still they are able to secure control over the Indian  Corporate entity only by reason of their entering into contractual  obligations  as evidenced from the term sheet agreements between the joint venture partners.
  • Several valueable rights which are property rights and capital assets stand relinquished in favour of the Vodafone by  reason of the agreements which form part of the composite  transaction and not merely by the simple transfer of one CGP share. These rights are property and constitute an asset of a capital nature which is situated in India. But for these agreements, HTIL would not have been able to effectively transfer to the Petitioner, controlling interest in the joint venture to the extent of 66. 9828%.
  • The approval of FIPB would not have been required if the transaction was only the transfer of one CGP share.
  • Under Section 9(1), the deeming fiction is of a wide amplitude and all kinds of income derived by a non resident from  whatever source are brought within the ambit of the provision. Clause (i) of Section 9(1) provides that income is deemed to accrue  or arise in India whether directly or indirectly inter alia through or from (a) a business connection in India; (b) property in India; (c ) any asset in India; (d) any source of income in India; or (e) through the transfer of a capital asset situated in India.
  • HEL is situated in India and its business of  telecommunications was carried out entirely in India with relevant licences and regulatory clearances granted under Indian Laws. There has been a transfer of controlling interest in HEL from one non-resident to another non-resident.
  • The business of HEL is based on property located within India. The gains received by HTIL through the transfer of the CGP share, the value of which was determined on the basis of the enterprise value of HEL being property situated in India and other valuable rights transferred by way of agreement are chargeable to tax in India. The gains are deemed to arise once the subject matter of the transaction constitutes a capital asset and its location is in India. Section 2(14) defines the expression “capital asset” in wide terms to mean property of any kind held by assessee.

    This will include rights and interests which are capable of being owned and transferred. The definition of the word “transfer” in Section 2(47) is wide enough to comprehend any method of transfer. The entire enterprise value attributed to HEL, was only on account of the fruits of the  investment made by HTIL in India, goodwill/brand value generated by HTIL for the Hutch Brand in India, the telecom licences granted in India, customer base in India and the prospect of future development and expansion of business in India. In the above case,

    High Court answered all the issues against Vodafone.

    When the High Court gave its judgment ,it dealt only with the validity of the show-cause notice issued by the department. So a final and concrete conclusion on taxability of the transaction could not be drawn. This judgement is more of an academic benchmark. Now if the DTC had been implemented , the GAAR provisions would have restricted the freedom of the parties in this case Vodafone and Hutichisson Essar to enter into commercial transactions in a tax-efficient manner. The burden of proof would have shifted to the revenue department and not the assesse. The applicability of DTAA is subject to GAAR and CFC provisions.

    By introduction of DTC legislatively, specifically incorporating anti-tax-avoidance measures like GAAR,CFCS, concept of a resident company and a more strict interpretation of DTAA the government hopes to curb tax avoidance. It can condemn tax avoidance on moral and ideological grounds, but not before looking at the following observations of Justice Sabyasachi Mukharji in the Arvind Narotam case: "One would wish, as noted by Justice Chinnappa Reddy, that one would get the enthusiasm of Justice Holmes that taxes are the price of civilisation and one would like to pay that price to buy civilisation. But the question, which many ordinary taxpayers very often in a country of shortages with ostentation consumption and deprivation for the large masses ask, is does he with taxes buy civilisation or does he facilitate the waste and ostentation of the law. "Unless waste and ostentation in government spending are avoided or eschewed, no amount of moral sermons would change people's attitude to tax avoidance. "