Sunday, September 12, 2010

Manipulative Tax Avoidance is not tax planning

Manipulative Tax Avoidance is not tax planning

T.N. Pandey, Ex-chairman, CBDT

The author, in this article, with the instance of an advertisement appearing in an Economic Daily has amply demonstrated how the income-tax benefits intended for broader public goodwill can be used by the advertiser for individual benefits under calibrated tax avoidance techniques. According to him, such benefits need to be denied to persons who resort to such tactics even if the same could be said to be within the framework of law!

In the Economic Times, dated June 25, 2010, at page 3, an advertisement has appeared prominently which reads as under:


Wanted hotel companies with assessed carried forward losses/unabsorbed depreciation of Rs. 5 crores and above for immediate takeover. Please email full details to

Advertisement made for mere tax avoidance!

1. Prima facie, the solicitation of offers is motivated by a desire to deprive the exchequer of its rightful income tax dues by someone having generated substantial profits to wipe off the same by purchasing undertakings with losses and unabsorbed depreciation who are having no future prospects so that the profits could be set off against the losses of bought out companies not making bona fide use of the income-tax provisions permitting set off and carry forward provisions in cases of mergers/amalgamations under the Income-tax Act, 1961(Act). No other purpose could be there behind such an unusual advertisement for taking over losing undertakings!

Word `takeover' loosely used!

2. Apparently, the words `immediate takeover' have been used in a loose sense (for merger/amalgamation) as no advertisement is needed for takeover activities. In common parlance, takeover is generally understood to imply the acquisition of shares carrying voting rights in a company in a direct or indirect manner with a view to gaining control over the management of the company. Takeovers (also referred to as acquisitions) are generally affected by purchase of assets of a target company or by means of schemes of arrangement following the procedure laid down under the Companies Act, 1956 – Sections 391 to 396A. These are of two types, namely, (a) friendly or negotiated takeovers and (b) hostile takeovers. First category of takeovers are generally in the forms of mergers or amalgamations.

It is apparently in the first sense that the word `takeover' has been used in the advertisement as there cannot be an immediate takeover in the 2nd category as in this type of takeovers, no offers are made for acquisition of a company or companies, but the acquirer unilaterally, generally secretively pursues efforts to get controlling interest in the other company or companies against the wishes of the target company. Such acts of acquirer are referred to as `raids' or `takeover raids' in the corporate world. These raids, when organized in systematic ways, are called `takeover bids'. A takeover is hostile where it is in the form of `raid'. Obviously, such attempts may or may not require merger or amalgamation.

Although, the term `takeover' has not been defined under the SEBI Takeover Regulations, the term basically envisages the concept of an acquirer (as defined under regulation 2(b) of the Regulations) taking over the control (as defined under regulation 2(c) of the Regulations) or management of the target company (as defined under regulation 2(o) of the Regulations). When an acquirer acquires substantial quantity of shares or voting rights of the target company, it results in the substantial acquisition of shares. Thus, takeover can be by reorganization or reconstruction of the existing company also and this does not require any advertisement of the nature published in the Economic Times reproduced earlier. The SEBI Takeover Regulations, 1997 contain provision for making public announcement mandatory bid, in cases of takeovers vide regulations 10 and 12 in the manner prescribed. A bid besides being mandatory could also be partial or competitive. Though no advertisement of the nature as reproduced earlier is necessary in the case of takeovers, a public announcement is to be given in the newspapers (see Regulation 21(1) of the SEBI Takeover Regulations) by the acquirer, primarily to disclose his intention to acquire the voting capital of the target company from the existing shareholders by means of an open offer.

Elaborate compliance is required to various regulations in cases of such takeovers. No special tax benefits in regard to loss or depreciation (unabsorbed) have been mentioned for takeover cases as, by and large the company/companies takeover remain the same.

From the foregoing account, it is apparent that though in the advertisement the word `takeover' has been used, the intention seems to have merger/amalgamation of the companies having substantial unabsorbed losses/depreciation with the advertiser undertaking(s) to benefit under the Income-tax Act from carried forward unabsorbed losses/depreciation. Hence, the impact of the effort for takeover as mentioned in the advertisement is being examined to see whether tax benefits should be permissible in cases of such takeovers.

Income-tax benefits

3. Though under the Income-tax law certain benefits have been provided for in cases of losses related to amalgamating companies, in the case of amalgamated companies, the revenue foregone is with some objectives – not to offer a route for private gains to save tax without any benefits to the economy/society or the country. In other words, the benefits are permissible from broad perspectives and not to give a tax escape route.

Business Restructuring

4. Mergers/amalgamations/takeovers/reconstruction/reorganization of undertakings are the ways for business restructuring. These have become imperative because of globalization of trade, commerce/business activities. Business restructuring is done with a view to fully utilize potentialities of the existing businesses, redirection or changes in them to achieve better results, managing more finances, deployment of funds usefully in expanded areas of work consequent to reorganization, contribute to growth of the blended organization(s), utilizing interdependence in a better way to increase business and profits, development of core-competencies, risk reduction, better management and many other such benefits. In short corporate restructuring is intended to improve the competitiveness of individual businesses maximizing best utilization of resources, sustained growth and exploiting each others strengths to the maximum benefit of the reorganized/restructured unit and ultimately for the benefit of the country. Obviously, these objectives cannot be achieved in a short run by amalgamation or merger of already loss making units or who have the enormous burden of carried forward losses without any scheme for improving their functioning and merely with an idea of using their losses!

The basic objective of exercises of the nature proposed to be carried out through the medium of the advertisement reproduced earlier is to give set back to the revenue in its efforts to maximize collections. The issue proposed to be examined in later paragraphs is whether the same would come in the category of legitimate/legally permissible tax planning or the schemes are merely in the nature of subterfuges to save tax.

Observation of Chinappa Reddy J. in McDowell & Co. Ltd.'s case

5. On reading such an advertisement, one is reminded of the observations made by learned J. Chinappa Reddy in the case of McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148/22 Taxman 11 (SC) where he has remarked regarding tax avoidance as under:

(a) Substantial loss of much needed public revenue, particularly in a welfare State like India.

(b) Serious disturbance caused to the economy of the country by piling up of mountains of black money directly causing inflation.

(c) Large hidden loss to the community by some of the best brains in the country being involved in the perpetual war waged between tax avoider and his expert team of advisers, lawyers and accountants on one side, and the Tax Officer and his perhaps not so skilful advisers on the other side.

(d) Sense of injustice and inequality which tax avoidance arouses in the breasts of those who are unwilling or unable to profit by it.

(e) Ethics (or lack of it) of transferring the burden of tax liability to the shoulders of the guideless, good citizens from those of artful dodgers.

As to the ethics of taxations, the learned Judge observed:

"We now live in a welfare State whose financial needs, if backed by the law, have to be respected and met. We must recognize that there is behind taxation laws as much moral sanction as behind any other welfare legislation and it is a pretence to say that avoidance of taxation is not unethical and that it stands on no loss moral plane than honest payment of taxation."

The learned Judge further said that the proper way to construe a taxing statute while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is such that the judicial process may accord its due approval to it.

However, there have not been many takers of the views expressed by Reddy J. Even in McDowell & Co. Ltd.'s case (supra) itself Rangnath Mishra J. made the following observations regarding the situation when tax avoidance devices could be said to be permissible. He said –

"Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay taxes honestly without resorting to subterfuges."

Whether taking advantage of setting off losses/depreciation by purchasing these from others could be considered legitimate tax planning?

6. Before examining this proposition, it would be appropriate to consider the Income-tax provisions permitting set off of carried forward losses.

6.1 Carry forward and set off of depreciation/accumulated depreciation – Present position. Section 32 of the Act contains provisions relating to depreciation on plant, machinery, building, etc. Appendix 1 to rule 5 in the Income-tax Rules, 1962 provides for rates of depreciation.

6.1.1 Unabsorbed depreciation - If the whole amount of current depreciation allowance is not deductible on account of the insufficiency of income (under various heads of income), the remaining unabsorbed amount is called `Unabsorbed Depreciation'.

6.1.2 Set off and Carry forward of Depreciation (i.e. unabsorbed deprecia-tion)

(1) If on account of the insufficiency of profits full amount of allowable depreciation cannot be deducted from the profits of the business in that year, the balance of unabsorbed depreciation shall first be set off against the profits of any other business or profession carried on by the assessee.

(2) If still some part of unabsorbed depreciation is left unabsorbed, the amount left unabsorbed can be set off against income under any other head for that assessment year.

(3) If unabsorbed depreciation cannot be wholly set off, the amount of depreciation not set off shall be carried forward to the following assessment year.

(4) The unabsorbed depreciation shall be added to the depreciation allowance for the following P.Y. or for the succeeding previous years till such time, it is fully deducted. In other words, the unabsorbed depreciation shall be treated as part of the current year's depreciation.

Carry forward and set off of losses

7. If for any assessment year the net result under the head `Profit and gains of business or profession' is a loss to the assessee (not being a loss of speculation business), and such loss cannot be wholly set-off against his income under any other head, so much of the loss as has not been so set off shall be carried forward to the following assessment year and it shall be set off against the income under the head `Profit and gains of business or profession'. If the loss cannot be wholly set off in the following year, it shall be carried forward for a maximum period of eight assessment years immediately succeeding the assessment year for which the loss was first computed.

Preference in setting off of unabsorbed losses and unabsorbed depreciation

8. If there is brought forward business loss along with unabsorbed depreciation, the order of set off shall be as under:


Business profits before depreciation for current year

Less: Current year's depreciation


Less: B/fd business loss


Less: B/fd unabsorbed depreciation


Still if there is any unabsorbed depreciation left, it can be set off against income under any other head.

Treatment of unabsorbed losses/depreciation in situations of mergers/amalgamations/takeover

9. The term `amalgamation/merger' generally convey the same meaning. Amalgamation has been defined in section 2(1B) of the Act to mean either merger of one or more companies with another company or the merger of two or more companies to form one company.

For merger to qualify as amalgamation for the purposes of the Income-tax Act, the following conditions have to be satisfied:

(i) All the properties of the amalgamating company immediately before the amalgamation should become the properties of the amalgamated company by virtue of the amalgamation.

(ii) All liabilities of the amalgamating company immediately before the amalgamation should become the liabilities of the amalgamated company by virtue of the amalgamation.

(iii) Shareholders holding not less than three-fourths (in value) of the shares in the amalgamating company (other than shares already held by the amalgamated company or by its nominee) should become shareholders of the amalgamated company by virtue of the amalgamation.

Tax benefits in regard to carried forward losses/depreciation of amalgamating company/companies in the hands of the amalgamated company/companies – Section 72A of the Income-tax Act

10. If the following conditions are satisfied, then the accumulated loss and the unabsorbed depreciation of the amalgamating company shall be deemed to be loss/depreciation of the amalgamated company for the previous year in which the amalgamation is effected—

(i) There is an amalgamation of a company owning industrial undertaking, ship or a hotel with another company; or a banking company with a SBI or any subsidiary of SBI. From the assessment year 2008-09, section 72A is also applicable in the case of an amalgamation of a public sector airlines with another public sector airlines.

(ii) The amalgamating company has been engaged in the business in which the accumulated loss occurred or depreciation remains unabsorbed, for 3 or more years.

(iii) The amalgamating company has held continuously as on the date of the amalgamation at least three-fourths of the book value of fixed assets held by it two years prior to the date of amalgamation.

(iv) The amalgamated company continues to hold at least three-fourths in the book value of fixed assets of the amalgamating company which is acquired as a result of amalgamation for five years from the effective date of amalgamation.

(v) The amalgamated company continues the business of the amalgamating company for a minimum period of 5 years from the date of amalgamation.

(vi) The amalgamated company, which has acquired an industrial undertaking of the amalgamating company by way of amalgamation, shall achieve the level of production of at least 50 per cent of the installed capacity of the said undertaking before the end of 4 years from the date of amalgamation and continue to maintain the said minimum level of production till the end of 5 years from the date of amalgamation. However, the Central Government, on an application made by the amalgamated company may relax this condition.

(vii) The amalgamated company shall furnish to the Assessing Officer a certificate in Form No. 62, duly verified by an accountant, with reference to the books of account and other documents showing particulars of production, along with the return of income for the assessment year relevant to the previous year during which the prescribed level of production is achieved and for subsequent assessment years relevant to the previous years falling within 5 years from the date of amalgamation.

Consequences when the above conditions are satisfied - If the above conditions are satisfied, then accumulated business loss and unabsorbed depreciation of the amalgamating company shall be deemed to be loss and depreciation of the amalgamated company for the previous year in which amalgamation is effected.

Consequences when the above conditions are not satisfied after adjusting loss/depreciation - In case the above specified conditions are not fulfilled, then that part of brought forward of loss and unabsorbed depreciation which has been set off by the amalgamated company shall be treated as the income of the amalgamated company for the year in which the failure to fulfil the conditions occurs.

Whether the type of arrangement proposed by the advertiser could be considered as a `subterfuge'?

11. Prima facie, the objective of the advertiser seems to be to acquire the loss making hotels at cheap prices, retain these for reaping the benefit of accumulated loss/depreciation and then dispose of the same thus not adding in any way to the growth of the industry but deriving benefit for self of the losses/depreciation of taken over undertakings.

Transactions of the nature which prima facie seem to be unnatural, but are geared mainly at tax avoidance as in the case of advertiser proposing to purchase companies with unabsorbed loss/depreciation, cannot be considered as coming in the category of legal tax avoidance or legitimate tax planning of the nature mentioned by Mishra J. in McDowell & Co. Ltd.'s case (supra). The Karnataka High Court in the case of ICDS Ltd. v. CIT [2007] 291 ITR 18/161 Taxman 293 has not approved manipulative tax planning. In this case the assessee was acquiring assets in its name and leasing the same to various educational institutions. The lessees made interest bearing deposits with the assessee equal to cost of leased assets. The lease rental was equal to interest on deposits which was adjusted by both the parties. Lessor and lessees were having common management. As owner of the assets, the assessee claimed depreciation. All the lower authorities denied the claim of assessee holding transaction blatantly geared to evade tax liability. It was held that transactions entered into by the assessee were a mechanism devised to enable a non-tax paying entity to acquire an asset and also to claim depreciation as the lessees being educational entity are exempt from tax. The finding that the assessee was not entitled to claim depreciation on the assets was not on the basis of the underlying motive but the direct result of the manner in which these transactions were engineered. In the case of the advertiser, the basic objective is not in any way for overall benefit of loss making units but is for self-interest to save income-tax. Where the sole aim behind carrying out the series of transactions in a particular scheme is outright tax avoidance, the court is competent to take judicial notice of it and reject the scheme altogether.

Concluding comments

12. In the case of an advertisement appearing in an Economic daily the author has opined that the true nature of transaction has to be seen – not merely its being coming within the framework of law. The only immediate gain to the advertiser could be to get the income-tax liability reduced in a manner which does not confer any public benefit nor, prima facie, benefits to the undertakings to be taken over, except to the advertiser! That can never be the objective of a tax give away even in terms of the yardstick prescribed by Mishra J. in the McDowell & Co. Ltd.'s case (supra). Hence, the advertiser cannot be said to be eligible for the income-tax benefits available in the cases of mergers/amalgamations.


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