Tax avoidance gets a boost

Out Of Court

Tax planning has become a challenging task because of the emerging concepts of "fiscal residence" of a company doing global business, "treaty shopping" to avoid double taxation by two or more countries and the good old method of arranging affairs in such a way as to avoid tax altogether.

The Supreme Court found these ingenious methods lawful, though perhaps not morally sound, in Union of India vs Azadi Bachao Andolan, delivered last week.

It upheld the notification of the Central government which granted certain benefits in capital gains tax to foreign investors operating through the well-known Mauritius route.

It has become important to find out the fiscal residence of a corporation to fix its liability to pay tax in a particular country. The majority of the countries have accepted the principle of worldwide taxation.

Fiscal residence is the place where a corporation is subject to unlimited fiscal liability and subjected to taxation for worldwide profit. The state of residence is the one entitled to levy tax on the corporation's worldwide profit.

However, this exercise is riddled with difficulties. A company may be incorporated in one state. But it may carry on business in several places. It may have administrative activities, directors or managers who reside and meet to take decisions in one or more places on the globe.

Since these elements are scattered in different countries, each country would want to tax the activity in that country. Laws have not come out with a uniform standard to deal with this problem, nor have the courts in different countries settled the knotty issues.

The Indo-Mauritius Double Taxation Avoidance Convention, 1983 has been helpful in this case, as it clearly defined the term "residence" in a contracting state. Therefore, for the moment, the question has been answered.

Another interesting discussion in the judgement centred around the legality of "treaty shopping".

The term is used to describe the act of a resident entity of a third country taking advantage of a fiscal treaty between two contracting states, as in the Indo-Mauritius treaty.

This treaty does not limit the benefits to the corporations of a third state, unlike the Indo-US treaty on double taxation.

The government argued that "there are no disabling or disentitling conditions under the Indo-Mauritius treaty prohibiting the resident of a third nation from deriving benefits under it." This view was accepted by the Supreme Court.

This led to the argument that motives with which the residents have been incorporated in Mauritius are wholly irrelevant and could not in any way affect the legality of the transaction.

The Supreme Court agreed with this view. It cited a 1926 judgement of the English Court of Appeals which had stated that a person is "entitled so to arrange his affairs as not to attract taxes so far as he can do so within the law."

This was further confirmed by a later English judgement which asserted that if such a person succeeds in his effort, "However unappreciative the tax-gatherers may be of his ingenuity, he cannot be compelled to pay an increased tax."

In 1985, a dissenting judge in the constitution bench that decided the McDowell & Co case had doubted this proposition and observed that the time had come to depart from that principle.

He wrote that the proper way to construe a taxing law while considering a device to avoid tax is to ask "whether the transaction is a device to avoid tax and whether the transaction is such that the judicial process may accord its approval to it."

He wanted veils to be torn to see the real intention. However, the Supreme Court, in the latest judgement, did not give much credence to this view as it was not only a minority opinion but also because later judgements of the constitution benches had taken the contrary stand.

Thus, the present judgement has left it all to the resourcefulness of the tax wizards to go treaty-shopping and arrange the fiscal affairs in such a way as to bestow maximum benefits to their clients.