Tax motivated transaction IPSO Facto may not be regarded as Sham

In today’s economy, a business entity cannot undermine the impact of taxation on its growth and development trajectory, which is why tax planning is considered to be the most pivotal part of financial planning. While the line between tax planning and tax evasion is very thin, the Supreme Court, on various occasions, has differentiated between the two concepts and has repeatedly held that minimisation of tax liability through legitimate tax planning is not illegal.[1]

Recently, in the Michael E Desa case,[2] the Mumbai Income Tax Appellate Tribunal (“ITAT”) reiterated the legitimacy of tax planning while allowing the set-off of Long Term Capital Loss on sale of shares against Long Term Capital Gain on sale of property..

Decision analysis

In the present case, the taxpayer, a non-resident individual, had reported long-term capital gains from sale of property, along with long-term capital loss arising from the sale of shares of a private company (“Company”). The taxpayer filed the tax return for the relevant year and claimed the set-off of the capital gains against the losses arising to him from the sale of shares of the Company.

The tax officer rejected the claim of set-off of losses on the grounds that the capital loss incurred by the taxpayer was fictitious. The tax officer attributed the lack of bonafide to the near worthlessness of the Company’s shares that were sold to a director of the Company, who was well known to the taxpayer. The tax officer also questioned the timing of the sale of shares and held that the same was undertaken to generate artificial and incorrect long-term capital loss. Thus, the taxpayer’s claim for set-off of losses was rejected. The tax officer’s order was further upheld before the first appellate authority.

When the matter came up before the ITAT, it observed that even the tax authorities accepted the fact the value of the shares of the Company had eroded, with no business prospect. Thus, the ITAT was not only convinced of the taxpayer’s losses, but also held that these losses crystalized in the year in which he sold the shares of the Company. Further, the ITAT held that merely because the timing of the sale of shares was such that the taxpayer was able to set-off losses arising from such sale share, would not render the transaction colorable/ illegal. The ITAT observed that a transaction may be tax-motivated but that would not ispo-facto render the transaction a sham. The ITAT in this regard relied on the locus classicus decisions of the Supreme Court in the case of McDowell & Co Ltd[3] and Vodafone International Holdings BV [4] and reiterated the right of a taxpayer to arrange his/her affairs in a tax efficient manner without deploying any colorable device.

The ITAT also observed that the timing of the share sale was not pertinent in the present factual matrix. Similarly, it was not relevant that the buyer was a director of the Company with whom the taxpayer had other business transactions. The ITAT observed that the only relevant aspect was to determine whether there was an actual sale of shares for a valid consideration and if there was anything to substantiate that the taxpayer continued  as  the economic or beneficial owner of the shares even after their sale. The ITAT noted that not only do the records reflect the buyer and his family as the sole shareholders of the Company pursuant to the sale of shares, , but there had also been a change in the composition of the board of directors, whereby the buyer’s wife was introduced as a director. Thus, the ITAT held that these facts establish that there was an actual sale of shares in the case at hand. Accordingly, the ITAT directed the tax officer to allow the set-off of losses to the taxpayer.

Key takeaways

While this decision by the ITAT comes as a great relief to all the taxpayers who are facing similar issues regarding set-off of losses, it has a greater impact on taxpayers’ sentiments across the country. The ITAT, through this order, has very rightly reminded the tax authorities that the line of demarcation between what is tax planning and what is tax avoidance may be somewhat thin, but that cannot be an excuse for the tax authorities to err on the side of excessive caution.

The legitimacy of tax planning in India has been upheld and ingrained in the Indian jurisprudence through various judgments of the apex court, most famously the McDowell & Co Ltd (supra), Azadi Bachao Andolan[5] and Vodafone International Holdings BV (supra). However, this decision of the ITAT comes as a ray of hope to taxpayers that despite lower tax authorities’ aggressive approach towards disallowing the deduction/exemptions claimed by taxpayer, the legitimate claims/planning of the taxpayer would be upheld at the higher appellate levels. Further, the ITAT has clarified that merely establishing that a transaction was tax motivated may not be sufficient to render it illegal, it would have to be established that a dubious method or a colorable device was utilised.

It would be relevant to note that there has been an increase in the number of cases where the department has sought to disallow the claims of the taxpayer by questioning the substance or the bonafide of a transaction. Very recently, the same ITAT in the case of Leena Power Tech Engineers Pvt. Ltd.,[6] had questioned the share application money received by the taxpayer through a complex web of shell companies. The ITAT taxed such amount as unexplained credit as the taxpayer failed to explain the genuineness of the transaction involving six layered routing of funds.

Given the trend, a taxpayer would avoid such trouble by reviewing every transaction from a tax perspective and ensuring the presence/existence of sufficient material on record to show commercial substance behind the said transaction. Especially, with the introduction of the General Anti-Avoidance Rules and the ‘Principal purpose test’ under the Multilateral Instruments, the need to vet transaction structures from a tax perspective cannot be undermined.

[1] Union of India v. Azadi Bachao Andolan (2004) 10 SCC 1; McDowell and Co Ltd v. CTO (1985) 3 SCC 230; Vodafone International Holdings B.V. v. Union of India [2012] 341 ITR 1 (SC).

[2] [2021] 130 314 (Mumbai ITAT).

[3] McDowell & Co Ltd v. CTO (1985) 154 ITR 148 (SC).

[4] Vodafone International Holdings BV v. Union of India (2012) 341 ITR 1 (SC).

[5] Union of India v. Azadi Bachao Andolan (2004) 10 SCC 1.

[6] Deputy Commissioner of Income Tax Circle 15(1)(2), Mumbai v. Leena Power Tech Engineers Pvt. Ltd., [2021] 130 341 (Mumbai ITAT).