Contributed by Karan Anand

The doctrine of substance over form (“doctrine”) is a legal and accounting doctrine, which enables authorities to probe beyond the legal form and analyse the underlying economic substance of a transaction. This paper aims to track the evolution of the doctrine across Indian and foreign jurisprudence, as well as analyse and comment on its present application.

It has been applied in the Indian jurisdiction as early as the 1960’s. A leading case in the application of the doctrine in India has been in Mc Dowell and Co. v. CTO.  The case was important as it introduced the doctrine in issues pertaining to taxation and determined the court’s stance pertaining to tax avoidance vis-a-vis tax evasion. Justice Reddy in his judgement, criticized earlier jurisprudence and opined that an individual’s obligation to pay tax was absolute, and tax planning using “colourable devices” and “dubious methods” was identical to tax avoidance. The court’s decision not only contradicted previous cases like Inland Revenue Commissioners v. Fishers Executorswhich restricted authorities to the form and surface of the transaction, but also begat the solicitation of the doctrine of ‘substance over form’ in India.

Despite the doctrine’s decade-long existence, the court took a departure from this view in the case of Azadi Bachao Andolan. The court, while dealing with the issue of double tax avoidance, completely, and outrightly contradicted the Mc Dowell judgement and regressed to the earlier interpretation of ‘form over substance.’ The court, while referring to cases like Banyan and Berry v. Commissioner of Income-Tax and Bank of Chettinad Ltd. v. CIT, took away the power of revenue authorities to lift the corporate veil for international taxation purposes.

The doctrine has been applied across countless jurisdictions, both nationally and across borders. One of the earliest applications in the US was in the case of Gregory v. Helvering wherein the court held that even if a transaction appeared legal in its form, if it violated the law, it wouldn’t shield it from authorities’ investigation.

The decision paved way for the IRS to prevent tax evasion by probing into the essence of the dealings, rather than being barred by the legal form of the transaction. While both Indian and American jurisprudence have recognized and applied the doctrine of substance over form, the application of the principle differs greatly. India uses the test of substance over form in conjunction with the test of substantial compliance. This test states that the taxpayer while conducting a transaction must comply with the law substantially, even if not completely. Thus, in the Indian context, the nature of the transaction is held to be good in law, as long as its form substantially complies with the statutes governing it.

The case of Vodafone International Holdings v. Union of India (“Vodafone”) provided new perspectives to the doctrine of substance over form by creating new parameters to determine the nature of transactions in cases of indirect taxes, being the principle of “look at.” “The Court emphatically resounded the ‘look at’ doctrine to ascertain the legal nature of a transaction, rather than ‘looking through’ it to determine tax consequences.” The look at principle, differs from substance over form as it states that a transaction must be seen as a whole and not in parts. It does not particularly deal with the nature of the transaction but rather analyses the ‘bigger picture’ in a transaction.

In the current situation, the court has grappled with the application of the doctrine in indirect taxation cases, leading to not only revisions in its own interpretations but also a complete dismissal of the doctrine’s applicability. The legislature, with the dual objectives of firstly, cracking down on tax evasion, masquerading as avoidance, and secondly, to provide clarity and stability to both authorities as well as taxpayers, introduced the GAAR (general anti-avoidance rules) in the Income Tax Act. While the GAAR enabled the tax authorities to invoke the doctrine of substance over form, its application was restricted by a multitude of conditions and prerequisites, thus effectively nullifying its intended effect. The application of the GAAR was only permitted in situations wherein there was there was an elaborate set of procedural regimentation and substantive declaration of safeguards of taxpayer’s rights. This gave rise to the question of the applicability of the Doctrine of Substance Over Form in cases of indirect taxation. However, the same was never codified by the parliament in the form of an addition or amendment, despite making significant revisions in the Income Tax Act as well as the general policy framework. The doctrine of substance over form has continued to be used, albeit partially in matters of indirect taxation to determine the substance and nature of the transaction.

The court has remained inconsistent in its application of the doctrine. In Vodafone International Holdings v. Union of India, the court opined that revenue authorities must, operate based on the ‘look at’ test where a holistic view of the transaction is taken, rather than a ‘look through’ approach which dissects the transaction. The prerequisite for employing a dissecting approach is the blatant abuse of corporate form.

However, the court has often opted for a ‘look through’ approach when adjudicating cases, even in absence of such abuse. This can be seen in the recent Sh. Sumeet Taneja vs Commissioner of Income Tax, wherein the high court equated the sale of equity shares to sale of business and deemed it liable for taxation at a higher rate, as a business income.

“…. the sale- purchase agreement is a transfer of business and not a mere sale of equity shares.”

The court relied on the form of the transaction, and relied on the transfer of elements like transfer of databases and client lists. It declared that such a sale was in the nature of a transfer of business. It dissected the transaction into its smaller components to arrive at such a decision.  The application of the doctrine was also reiterated in the case of Commr. of Customs, Central Excise and Service Tax v. Northern Operating Systems (P) Ltd. which was the source of major controversy in the tax fraternity. The court took the view held in the case of Sh. Sumeet Taneja, reiterated the tax authorities’ powers to disregard the legal form of the transaction in order to determine fraud, specifically pertaining to matters of indirect taxation. Further, it employed the test of substance over from in order to look at the agreement between the parties, wherein it stated,

“The mere payment in the form of remittances or amounts, by whatever manner, either for the duration of the secondment, or per employee seconded, is just one method of reckoning if there is consideration.”

The decision went against the understanding of the rules established by the apex court in various cases, including the Vodafone judgement wherein, revenue authorities cannot adopt a dissecting approach in matters pertaining to the transfer of shares. The court has seemingly gone back on its own application of the principle and has adopted a narrower approach to settle the issue in the case. The court, in the case gave priority to the form of the transaction rather than its underlying substance. The inconsistent application has had a detrimental effect on the taxpayer’s ability to assess and plan for their own tax liability. This outlook resembles that of Justice Reddy, who opined that in a welfare state like India, an individual’s tax liability was absolute and equates smart tax saving with tax evasion. The authorities are going beyond established and conventional means to impose taxes and are using their own discretion in the application of the doctrine.

Such an application may be perceived as a necessary evil, insofar as being imperative to safeguard the State’s taxable interest. However, inconsistent application not only affects taxpayers within the country, who are unable to discern their own taxable interests and plan accordingly, but is also calamitous and detrimental to foreign investment in India. This is because the complicated tax structure discourages companies from investing in the Indian market.

 The courts moving forwards must provide a sense of clarity and stability to the doctrine’s application by adopting a two-pronged solution. Firstly, they must provide formal recognition to the doctrine, given its wide ambit of application, via its inculcation in the statutes like the Income Tax Act, 1961 and Companies Act, 2013. Secondly, the court must also streamline the existing tax structure like the GAAR to avoid confusion and inconsistent application of the doctrine.

They must also lay down specific guideline for its usage by taxing authorities as well as the courts. This will prevent the inconsistent application of the principle and will resolve not only the internal tax struggles between the people but also address the external exigencies pertaining to foreign investment within the Indian market.