Consentia on Multidisciplinary Research

A CRITICAL ANALYSIS OF TAX PLANNING, TAX EVASION AND TAX AVOIDANCE

Introduction

The recent verdict by Supreme Court on Vodafone case generates fresh debates on whether India needs to review its existing legal provisions particularly with respect to offshore tax laws. In this context, formal treatment and clear demarcations between tax evasion, tax avoidance and tax planning practices are imperative. The Standing Committee on Finance in its 49th Report on Direct Taxes Code bill, 2010 (submitted to Parliament on 9th march, 2012) recommended Controlled Foreign Corporations (CFC) rules, Advance Pricing Agreement (APA) along with General Anti Avoidance Rule (GAAR) provision to replace the Income Tax Act, 1961 as per the International Taxation Standard and also in line with the recent Chinese Corporate Income Tax (CIT) Law introduced in 2008 to deal with offshore transactions via holding companies. Whereas introduction of GAAR is essential given the limited applications of a specific or targeted anti avoidance rule, the Committee also acknowledges the need for an appropriate Dispute Resolution Panel (DRP) as GAAR might result in a disproportionate discretionary power for the Income tax authority. The appropriate application of GAAR provision assumes a crucial role, in particular with countries lacking any Limitations of Benefit (LOB) clause (e.g. Mauritius) with India. Before entering into litigation, it might be beneficial to settle tax disputes through a bilateral negotiation in the form of Mutual Agreement Procedure (MAP), where tax authorities of the respective countries negotiate to settle disputes in a cordial manner.

 Vodafone Case and Tax Laws Debate

The recent verdict by Supreme Court on Vodafone case generates fresh debates on whether India needs a review of its existing legal provisions particularly with respect to offshore tax laws. Regarding this, serious discussions are essential for a clear distinction between tax evasion, tax avoidance and tax planning. Tax evasion is the illegal practice where individuals/firms escape paying taxes to the government through deliberate concealment or misrepresentation of their tax liability. On the other hand, when a taxpayer escapes his/her tax liability by exploiting legal ambiguities or in other words resort to non-compliance of tax payments being entirely within the framework of the law, it amounts to tax avoidance (Sandmo 2004). Another way to make a distinction between tax evasion and avoidance is that while in case of evasion, transactions are mostly unreported due to the natural tendency of avoiding punitive actions, in tax avoidance details are not hidden by tax payer i.e. transactions are usually on record.[1] For instance, the Australian Ralph Review of Business Taxation has described tax avoidance as misuse of the law that is often driven by structural loopholes in the law (Garg and Mukerjee 2012).

However, it is often difficult to distinguish between the two as both practices are harmful to society as they cause a drain on the exchequer through loss of public revenue. Both tax avoidance and evasion are forms of tax noncompliance describing a range of activities that are unfavourable to a nation’s tax system. For instance, though tax avoidance is a legal practice, it is often very hostile as companies/individuals seek to pay less than their tax liabilities. Such aggressive tax avoidance causes substantial public revenue loss. Hence, most literature on tax evasion discusses both tax evasion and avoidance as a collective way of escaping taxes (using terms like ‘tax noncompliance’ or ‘tax dodging’). For instance to quote Michael Wenzel, a social psychologist and researcher in the Centre for Tax System Integrity:

Tax evasion refers to such deliberate criminal non-fulfillment of tax liabilities. In contrast, tax avoidance refers to deliberate acts of reducing one’s taxes by legal means. However, the distinction is not always clear because tax laws are not always precise. Moreover, when taxpayers try to find loopholes with the intention to pay less tax, even if technically legal, their actions may be against the spirit of the law and in this sense considered noncompliant. The present research will deal with both evasion and avoidance and, based on the premise that either is unfavorable to the tax-system and uncooperative towards the collective, subsume both under the concept of tax noncompliance. Its primary form is of course tax evasion (Wenzel 2002).

On the other hand, ‘tax planning’ may be justified where individuals/institutions or firms plan to minimise their tax payments through financial planning.[2]

A disturbing fact is that while tax evasion is an outright illegal way of non-payment of taxes (breaching the law) and from legal point of view is quite unambiguous, the distinction between tax avoidance and tax planning is often difficult to make. The ambiguity arises since both the tax planning and tax avoidance is related with the activity of non-payment of tax liability being within the framework of the law. For instance, a person may adopt different accounting methods for different sources of income/ invest in tax saving securities/other tax-planning schemes- all these may reduce/negate tax liability and do not violate laws. However, some strategies for tax avoidance (for instance transfer mispricing) are often intended for the sole purpose of non-payment of taxes and hence controversial. Therefore, tax avoidance is controversial and often treated as bizarre whereas tax planning is not. But the distinction between the two in practice is extremely difficult since both are legal. Therefore if a person/company is accused of tax avoidance in its negative sense, that person/company may claim that the intention is only ‘tax planning’ and not ‘tax avoidance’. The debate then ultimately boils down towards identifying what transactions should be treated as legal. Given the proliferation of sophisticated devices used by companies for non-compliance of legitimate tax payments fine-tuning the existing legal provisions has also become essential.

Nobody would like to pay tax since it reduces disposable income. However, the approach towards non-compliance is crucial. For instance, an economic entity in India may engage in a ‘tax planning’ by investing in a judicious portfolio of tax saving instruments (e.g. National Savings Certificates, Equity Linked Savings Schemes etc.) to minimise her overall annual tax payments. On the other hand, a practice of routing back same amount of money via a number of tax haven countries (or the so called ‘round tripping’) to the origin country, or parking higher profits in lower tax jurisdictions and lower profits in higher tax jurisdictions via ‘transfer mis-pricing’[3] may be ‘tax avoidance’. Another way of looking into the difference between tax planning and tax avoidance is that while an economic entity tries to minimise the overall tax burden by utilising the available options in case of tax planning (and does not try to escape from tax payments), in case of tax avoidance an entity try to escape from tax burden by creating sophisticated methods for non-compliance of legitimate tax payments. However, it is difficult to treat the latter practice in a legal manner as it is done within the framework of the law, even in cases where the sole purpose is noncompliance of taxes and nothing else.[4]

Certain transfer pricing policies have been challenged on legal ground in some countries. For instance, global pharmaceutical company GlaxoSmithKline was accused of charging a transfer price for its marketing services to its US-based subsidiaries at rates much lower than the normal market price, which undermined Glaxo’s US income. By understating its income, the company escaped around USD 5.2 billion in US taxes. Glaxo had to pay a penalty of USD 3.4 billion to the Internal Revenue Service (IRS) of the United States after a prolonged litigation. This case is remarkable in the sense that GSK’s USD 3.4 billion payment to the IRS is the largest single payment made to the US tax authority to resolve a tax dispute.[5] Again, Russia’s biggest privatised energy company, Yukos, has allegedly been engaged in stripping of enormous amount of assets and of transfer pricing.[6] The Russian government filed a case against Yukos and a number of shell companies[7] helping the transfer pricing process by acting as legitimate financial institutions. The Russian government claimed that a subsidiary of Yukos sold crude oil at a price much below the market rate to some shell companies to escape its tax liability. The shell companies are unregistered companies and therefore not liable to pay tax to the Russian government.

These companies are accused of reselling the crude oil at much higher prices than the transfer prices charged by Yukos to domestic and foreign buyers, and the revenues following the resale has in effect been appropriated by Yukos. Yukos has been able to escape the tax by officially reporting a much lower transfer price (below the taxable limit) while indirectly appropriating the revenue proceeds from the resale at the market price (not declared, as these prices were charged by shell companies not officially registered with the Russian government as being liable to pay tax).[8]

The Supreme Court Verdict on Vodafone

In this context, the recent Supreme Court (SC) verdict regarding the Vodafone case is not only important for the Income Tax Department (IT Department) of India but for the country as a whole given the aspect of shrinking fiscal policy space with respect to resource mobilisation. It is crucial to understand the reasons for which SC gave the decision against Income tax Department of India, whereas the verdict of Bombay High Court was the opposite.

The Supreme Court verdict on Vodafone case:

The Supreme Court verdict regarding the Vodafone issue is extremely important with respect to the current Income tax laws, potential revenue impact of the Government of India, future approach regarding offshore transactions as well as socio-economic implications for the common people. Among others the following issues required further discussions:

  • The suggested ‘look at’ approach (or a holistic approach) instead of a ‘look through’ approach (or a dissected approach) provides scope for further debates and discussions. While, the need for a holistic approach can be recognized from the perspective of the distinction between ‘genuine’ and ‘sham’ transactions, it appears also that the treatment of taxes might be case sensitive and not a uniform approach. In the present Income Tax Act Section 9 (1) (i) it is mentioned that the following incomes shall be deemed to accrue or arise in India “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.”[9]

Therefore the income that deemed to accrue in India is income generated through either from-

  • a business connection in India;
  • a property in India
  • any asset or source in India; and
  • transfer of a capital asset in India.

It is difficult to believe that no income has generated through any of the four categories in this transaction. Vodafone has a business connection in India through CGP Holding and in turn Hutchison. Even if we consider that there is only a share sale and not an asset sale, it is clear there is a share sale which generated an amount of income from India. The important question is whether this is taxable, and if so who should pay the tax? Is it Hutchison or Vodafone? Since this is an acquisition (the purchase or obtaining of a controlling interest in a firm, usually via a tender offer for the target shares) by Vodafone (the acquirer or bidder) of Hutchison (the target company), it appears the proceedings from such acquisition or takeover should be included in the asset side of Vodafone in its balance sheet. However, if we accept the definition of capital gains as ‘The gain on sale of a capital asset is called capital gain’ (Standing Committee on Finance 2012) then capital gains tax can be implemented only on capital assets. Hence, the issue is whether capital gains tax is applicable on income generated through purchase or sale of shares and whether shares can be treated as capital assets. As per the Income Tax Act Department, India:

The incidence of tax on Capital Gains depends upon the length for which the capital asset transferred was held before the transfer. Ordinarily a capital asset held for 36 months or less is called a ‘short-term capital asset’ and the capital asset held for more than 36 months is called ‘long term capital asset’. However, shares of a Company, the units of Unit Trust of India or any specified Mutual Fund or any security listed in any recognised Stock Exchange are to be considered as short term capital assets if held for twelve months or less and long term capital assets if held for more than twelve months.[10]

In the 49th Parliamentary Standing Committee report, equity or preference shares, securities like debentures, listed government securities, units of mutual funds and UTI, zero Coupon bonds are defined as long term capital assets (Standing Committee on Finance 2012).

Another crucial issue is to determine the benchmark of permissible amount of ‘income transfer’ (whether in form of assets or shares) or ‘upper limit’ of such transfer.[11]

However, Supreme Court stated that:

This problem has arisen also because of the reason that this case deals with share sale and not asset sale. This case does not involve sale of assets on itemized basis…The High Court has failed to appreciate that the payment of $11.08 was for purchase of the entire investment made by HTIL in India…..Thus, it was not open to revenue to split the payment and consider a part of such payments for each of the above items.[12]

In this context it can be mentioned that the practice of seeking non-compliance of tax can be contrary to the spirit of the law whilst attempting to comply with the letter of the law. To quote:

Aggressive tax avoidance is the practice of seeking to minimise a tax bill whilst attempting to comply with the letter of the law while avoiding its purpose or spirit. It usually entails setting up artificial transactions or entities to re-characterise the nature, recipient or timing of payments. Where the entity is located or the transaction routed through another country, it is international avoidance. Special, complex schemes are often created purely for this purpose. Since avoidance often entails concealment of information and it is hard to prove intention or deliberate deception, the dividing line between avoidance and evasion is often unclear, and depends on the standards of responsibility of the professionals and specialist tax advisers.[13]

It has been argued also that the CGP Holding has not been created at the last moment and existed since 1998. A disturbing fact is that there are a number of such tax havens corporations already in place which may be used to avoid paying taxes by a number of companies like Vodafone. This is a fully external factor and beyond the scope of Income Tax Authorities. Unless global pressure is created on ‘tax haven’ countries to amend their tax laws to impose certain taxes on offshore transactions and broaden tax bases on such transactions, it is difficult to tackle such tax avoidance practices. Though OECD has taken an initiative in this regard[14], still the tax rates and tax structure in a number of tax haven countries are highly and unnecessarily beneficial for business purposes. In this regard, the Standing Committee Finance recommendation on Controlled Foreign Corporation (CFC) rule is crucial which would be applicable to Companies located in low tax jurisdictions.

Law should be able to clearly reflect precisely: Whether Income Tax authorities are entitled to charge capital gains tax where mergers and acquisitions take place outside Indian Territory by foreign companies containing any relation to Indian assets Or whether companies (foreign/domestic) have to pay a capital gains tax to Indian tax authority in case of a M&A held outside Indian jurisdictions containing any relation to Indian assets (and under what conditions).Laws should be clear and mostly inclusive to reflect how to tax direct and indirect offshore transactions arising from sale of assets. Moreover, what should be treated as assets for tax purposes and the related classification of such assets is crucial.

It can be mentioned in this context that the proposed Direct Tax Code (DTC) in India suggested that income from transactions in all investment assets will be computed under the head ‘Capital gains.’ However, more clarity is required whether capital gains tax would be generated on both assets and income since a major controversial area is whether the income generated from capital market transactions should be treated as business income or as capital gains. There is also a need of clear separation of different corporations/companies (for instance, ‘offshore companies’) to specifically categorise which types of taxes would be applicable on which types of companies and under what circumstances. For instance, in the revised discussion paper of DTC an explicit mention is provided whether capital gains tax would be applicable for Foreign Institutional Investors (FIIs) as “The capital gains arising to FIIs shall not be subjected to TDS and they will be required to pay tax by way of advance tax on such gains”( CBDT 2010).

  • The General-Anti Avoidance Rules (GAAR) in the proposed Direct tax Code in India has the potential to empower the Income Tax Department of India regarding taxing offshore transactions. Countries like UK, US, Mexico and Denmark have specific anti abuse rules pertain to taxation instead of a statutory GAAR[15], for instance, Controlled Foreign Corporation (CFC) regime[16] to tax income parked in low tax jurisdictions, thin capitalisation rules[17] to rule out tax rebates for inflated and unjustified interest deduction etc. The positive side of such anti-abuse rules is that these are very clear-cut laws reducing possibilities for litigations. The Standing Committee on Finance has recommended GAAR should not override the Limitations of Benefit (LOB) Clauses already made with contracting countries (Standing Committee on Finance 2012). While this is important to avoid disputes, appropriate application of GAAR is crucial in case any tax disputes arises with countries lacking LOB clauses (e.g. Mauritius). India has included LOB with some countries, for instance with Singapore. The norm of ‘residential status’ is stricter in Double Tax Avoidance Agreement (DTAA) treaty with some other countries compared to Mauritius. For instance, there is a ‘conduit/shell’ test of Singapore- based companies selling Indian shares, whereas the company should either be a listed company on a recognised Singapore stock exchange or it must expend more than Singapore USD 200,000(Indian Rs.5 million) on its operations in Singapore. Again, the Double Tax Avoidance Agreements or DTAA with United Arab Emirates (UAE) provides the definition of a resident company as:

A company is deemed to be a UAE resident if it is incorporated, managed and controlled wholly in the UAE. A strict interpretation of the word “wholly” by the Indian tax authorities might result in a UAE entity being denied the benefits of the treaty if even a small degree of control of the entity is exercised outside the UAE. By contrast, a Mauritius entity carrying out the same activities would not be liable to any tax on capital gains under the Mauritius-India DTAA, nor would it is subject to any ‘primary purpose’ test or such rigid controls regarding the management of its affairs (Xavier 2009).

It is not understood, why such Limitation of Benefit clause cannot be included between India and Mauritius whereas such clause can be included in the DTAA treaty between India and Singapore.[18] While GAAR may obviate the need for such fresh LOB clauses, appropriate application of GAAR is crucial. Moreover, It may be noted that the applicability of GAAR would be most useful in case of abusive ‘tax avoidance’, i.e. in cases where it is difficult to draw clear legal lines between genuine tax planning and abusive tax planning (or ‘tax avoidance’ in its bizarre interpretation). Inputs may be sought from recent Chinese Corporate Income Tax (CIT) Law introduced in 2008. As per the old income tax system, corporations in China were taxed under two different legal provisions, one for domestic enterprises and one for foreign enterprises. With the introduction of the new CIT Law, these two classifications were merged. Circular 698 focuses on offshore transactions with regard to share transfers and specifically designed to treat abusive tax avoidance practices in cases offshore Special Purpose Vehicles (SPV) have been established for the only purpose to avoid capital gains tax in China. The Chinese tax authorities would have the right to disregard the existence of the offshore holding company (if found to be operative without substantial economic or commercial substance) and levy Corporate Income Tax (CIT) on the indirect equity transfer. Circular number 698 also requires non-resident companies to report their share transfer transactions with supporting documents in case the transfer is done via a holding company in certain circumstances.

  • Before entering into litigation, it might be beneficial to settle tax disputes through a bilateral negotiation in the form of Mutual Agreement Procedure (MAP), where tax authorities of the respective countries negotiate to settle disputes in a cordial manner and/or seeking advice from Supreme Court authorities.[19] In the Vodafone issue, The Netherlands government was reported to have written to the Indian government on behalf of the Vodafone Dutch holding company(CGP) with a view to arranging an out of-court settlement, using mutual agreement procedures provided in the double taxation agreement between the two countries.
  • There is a need for a formal treatment of tax evasion and tax avoidance. There should be clear legal guidelines distinguishing tax evasion, tax avoidance and tax planning and what type of strategies under what circumstances would be taxable or subject to penalty. In the Vodafone case it has been pointed that “Tax avoidance and tax evasion are two expressions which find no definition in the Indian Companies Act, 1956 or the Income Tax Act, 1961.”[20]

Conclusion

As concluding remarks it can be mentioned that in the era of globalisation and liberalisation competition among multinational corporations has increased tremendously. It would be a natural tendency for such companies seeking reduction of their ‘tax costs’ by any affordable means. To prevent certain abusive tax avoidance practices, such practices should be made illegal. The challenge lies in framing appropriate legal provisions to tackle such practices in an unambiguous manner. Apart from this, global pressure should be created on ‘tax haven’ countries to amend their tax laws to impose certain taxes on offshore transactions and broaden tax bases on such transactions.

[1] An example of tax evasion may be cited by referring the practice of money laundering. The major purpose of money laundering is to hide illegally generated money from official records to escape from investigations and punitive actions. Initially, the amount is kept in offshore banks (where secrecy/non-disclosure of the account holder is guaranteed) and then the account holder/launderer brings back the money by mixing that money into the ‘white component’.

[2] Ideally, tax planning refers to the minimisation of total tax liability/burden by firms/individuals through an appropriate ‘planning’ by consulting tax advisors/consultants. It is a cost minimization strategy. However, occasionally this strategy is being criticised (for instance, the transfer pricing strategy of Multinational Companies) as a tendency towards non-compliance of legitimate tax payments and referred to as ‘aggressive tax planning’. For details see the OECD report published in August 2011, titled as “Corporate Loss Utilisation through Aggressive Tax Planning”, ISBN 978- 92-64-11921-5.

[3] The OECD published general guidelines for dealing with transfer pricing for Multinational Enterprises and Tax Administrations that form the basis for the transfer pricing legislation in the UK, which was put in place in 1999.

[4] This aspect is however, noted by the OECD project report on “Harmful Tax Practices”. For details see OECD’s project on Harmful Tax Practices: Update on Progress In Member Countries, 2006, URL: http://www.oecd.org/dataoecd/1/17/37446434.pdf.

[5] See “IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute”( September 11, 2006), URL: http://www.irs.gov/newsroom/article/0,,id=162359,00.html

[6] See “Yukos tax case coming full circle”( February 6, 2007), The New York Times, URL:

http://www.nytimes.com/2007/02/06/business/worldbusiness/06iht-yukos.html

[7] “Shell” companies are often susceptible as fake companies operating just as a mediator/conduit in tax haven countries for abusive tax practices and other illegal activities like money laundering, market manipulation, bankruptcy fraud etc. Though a shell company may act as perfectly legal entity, however in a number of instances certain companies are alleged to engage in tax abusive practices, particularly in States like Delaware, Wyoming, and Nevada based in United States. On the other hand, States like Alaska and Arizona have strict regulations for company formations. For details see, the URL: http://www.fraudauditing.net/ShellCompanies.pdf.

[8] Some abusive tax avoidance practices are treated under the provision of General Anti Avoidance Rule (GAAR) or Specific Anti Avoidance Rule (SAAR) in some countries. However, treating such practices under GAAR is sometimes highly controversial and entails prolonged litigation.

[9] See the Section No. 9: “Income deemed to accrue or arise in India” in the URL:

http://law.incometaxindia.gov.in/DIT/Income-tax-acts.aspx.

[10] See “How to Compute Your Capital Gains? “Taxpayers Information Series-3, Income Tax Department, URL: http://incometaxindia.gov.in/Archive/How_to_compute_capital_gains_2008-09.pdf P.15.

[11] This discussion is however, has taken place in the Standing Committee of Finance in its 49th report and the proposed Direct Taxes Code Bill, 2010.See p.70.

[12] “Vodafone International Holdings BV vs. UOI (CIVIL APPEAL NO.733 OF 2012 (arising out of S.L.P. (C) No. 26529 of 2010)” dated 20th January 2012, pp.85-87.

[13] “Tax havens Report” Richard Murphy, Tax Research LLP, UK, see the URL: http://www.pcs.org.uk/taxhavens.

[14] The initial objectives were three-fold: (1) Identifying and eliminating harmful features of preferential tax regimes in OECD member countries (2) Identifying “tax havens” and seeking their commitments to the principles of transparency and effective exchange of information and (3) Encouraging other non-OECD economies to associate themselves with this work. Currently, the OECD maintains three lists: (a) A white list of countries implementing an agreed-upon standard (b) A gray list of countries that have committed to such a standard (c) A black list of countries that have not committed. See OECD’s project on Harmful Tax Practices: Update on Progress In Member Countries, 2006, URL: http://www.oecd.org/dataoecd/1/17/37446434.pdf.

[15] See “Ready for GAAR?” by Ajay Kumar and Dheeraj Chaurasia, Business Line (December 5, 2009), URL: http://www.thehindubusinessline.com/todays-paper/tp-opinion/article1070925.ece.

[16] When a person/company invests in a foreign company, the tax base of the investing person/company apparently declines in his/her domestic country as the invested amount that could be taxed in the investor’s residence state is transferred to a foreign company. In order to prevent erosion of the tax base due to residents investing in foreign companies in tax havens or low tax regimes many countries impose Controlled Foreign Company (CFC) rules.

[17] A company is thinly capitalized when the proportion of debt is higher than equity in its capital structure. A potential problem arises when such companies claim higher tax rebates/deductions from tax authorities on interest payments on such debts since there is no deduction of tax on the interest that is paid on the debt, whereas certain amount of income tax is deducted on the dividend that is paid on equity. Interest payments on debt may be inflated artificially or can be manipulated to substantially lessen tax liability.

[18] As per the DTAA treaty between India and Mauritius, capital gains realised from sale of shares are taxable only in the country of residence of the shareholder (the company/entity selling shares). Hence, an offshore company taking a residential status in Mauritius and making capital gains tax by selling Indian shares in India or elsewhere needs to pay capital gains tax only according to the tax laws of Mauritius. However, there is no capital gains tax in Mauritius. Therefore, any company having a residential status of Mauritius effectively need not pay any capital gains tax on transactions of Indian shares as per the DTAA treaty with India and Mauritius.

[19] After the verdict of the Vodafone case, there is a plan of tax authorities seeking advice from Supreme Court regarding taxation of offshore transactions. See, “Vodafone effect: Taxmen to seek Supreme Court advice on foreign bank accounts of Indians” (January 30, 2012) Economic Times, URL: http://articles.economictimes.indiatimes.com/2012-01-30/news/31005843_1_lgt-bank-bankaccounts-tax-havens.

[20] “Vodafone International Holdings BV vs. UOI (CIVIL APPEAL NO.733 OF 2012 (arising out of S.L.P. (C) No. 26529 of 2010)” dated 20th January 2012,p.162.

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