The problem with tax: Planning, avoidance or evasion? Sankhanath Bandyopadhyay1
The recent verdict by Supreme Court on Vodafone case generates fresh debates on whether India needs to review her 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.
The recent verdict by Supreme Court on Vodafone case generates fresh debates on whether India needs a review of her 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 (i.e. not violating any laws), 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(s) i.e. transactions are usually on record.i 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.ii
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 mis- pricing) 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 mispricing’iii 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 non- compliance of taxes and nothing else.iv
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.v Again, Russia’s biggest privatised energy company, Yukos, has allegedly been engaged in stripping of enormous amount of assets and of transfer pricing.vi The Russian government filed a case against Yukos and a number of shell companiesvii 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).viii
2 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 (I-T 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. Let us explore the following:
- The background of the case and Issues
- Reasons for rejecting the case in favor of Vodafone
- Some Concerns
2.1. The background of the case and Issues
The entire transaction and subsequent acquisition of shares of CGP(a Holding Company incorporated in Cayman Islands) by Vodafone is a complex process. Put simply, the claim by the Indian Tax Department is that Vodafone purchased USD 11.2 billion worth of assets (67 percent stake) of a Hong Kong-based company called Hutchison Whampoa Limited in 2007 indirectly through the purchase of shares( or being entered into a Share Purchase Agreement called SPA) of CGP Holding private Limited. This deal by Vodafone is subject to a capital gains tax of USD 2.5 billion, as most of the assets acquired by it from Hutchison were based in India and under Indian law. These assets had been generated and held initially by Hutchison while doing its mobile business in India. The rule of violation arises since the transaction involves a transfer of Indian assets (initially held by Hutchison, which Vodafone acquired in 2007 without deducting tax at source on them through the purchase of shares of CGP Holdings Limited; a company incorporated in Cayman Islands) which were supposed to generate public revenue in India. The defense argument by Vodafone is that Indian tax laws do not apply in this case since it is a Dutch company registered in the Netherlands, whereas CGP( through which the Hutchison shares had been acquired by Vodafone) is located in the Cayman Islands and the agreements were signed abroad (outside the Indian geographical territory) between two non-Indian entities. On the other hand, the acquisition of shares by Vodafone of Hutchison is on income/revenue generated in India acquired initially by Hutchison via their mobile business in India. Therefore, the revenue is subject to Indian capital gains tax laws. The Income Tax Department of India sought to tax the capital gains arising from the sale of the share capital of CGP on the basis that CGP though not a tax resident in India, holds the underlying Indian assets which acted as an intermediary between Vodafone Group and Hutchison. The crux of the dispute had been whether or not the Indian Income Tax Department has jurisdiction over the transaction. Vodafone had maintained from the outset that it is not liable to pay tax in India, and even if tax were somehow payable, then it should be Hutchison to bear the tax liability which I-T Department is supposed to collect during Hutchison’s business in India. The relevant Sections of the Income Tax Act (for instance Section 9), henceforth is not applicable for Vodafone as the contract had taken place in a different (offshore) jurisdiction.
Bombay High Court, in September 2010, dismissing the writ petition filed by Vodafone, held that share transfer had a significant nexus with India and the proceedings which have been initiated by the Income Tax Authorities cannot be held to lack jurisdiction. Accordingly, Bombay High Court has held that the share transfer by Cayman entity (CGP) is liable to tax in India.
1 Sankhanath Bandyopadhyay is a Delhi based researcher Electronic copy available at: http://ssrn.com/abstract=2102282
i 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’.
ii 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 minimisation 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.
iii Transfer price is the price at which goods and services between related companies are transacted. The main branch of a company is called the parent company and a number of associated units spread in different jurisdictions/ countries are called its subsidiaries. Often, associated companies and main company manipulate prices at which goods & services are transacted among them to reduce overall tax liabilities. Hence, higher profits are shown at countries/region where tax rates are low, and lower profits are shown at countries/regions where tax rates are high by adopting suitable transfer prices (transaction prices).Though this is not an illegal practice, and a cost minimisation strategy of multinational companies, often transfer prices are manipulated( manipulated transfer pricing practices are sometimes referred to as ‘transfer mispricing’ to indicate the abusive nature of such transactions) to avoid substantial tax payments. 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.
iv 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.
v 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
vi 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
vii “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.
viii 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.