The expression ‘colourable device’ means any sham arrangement or transaction, camouflaged as a real transaction, lacking in commercial substance, and done only to obtain a tax benefit.
Consider this. A person pays rent of ₹7 lakhs in a year, to his own parents in respect of a house property and claims the same as House Rent Allowance (HRA) deduction u/s 10(13A). The parents show the said rent as their income in their return of income, but claim a rebate of Rs. 25,000 u/s 87A, in the new personal tax regime.
In International arena, the arrangements such as creation of the parent entity holding the intellectual property rights in tax heaven jurisdictions like Ireland, UAE, Cayman Islands, Bahamas, and making of the royalty expenditure payments by the profit-making subsidiary entities to such parent entity, in order to minimize their tax outflows, have always remain a subject matter of litigation between the revenue authorities and the taxpayers.
The revenue authorities look down upon such arrangements as a colourable device, whereas the taxpayers defend these as tax planning arrangements done within the permissible four corners of law.
The thin dividing line between ‘legitimate tax planning and ‘illegitimate tax evasion through colourable device’, has been distinguished by the hon’ble Supreme Court in the landmark judgements of McDowell, Azadi Bachao Andolan and Vodafone International Holdings B.V.
In these judgements, the Apex Court has observed with subtle clarity that though tax evasion through the use of colourable devices and by resorting to dubious methods and subterfuges is not permissible, but it cannot be said that all tax planning is impermissible.
With these landmark judgments, a well settled legal position regarding the legal sanctity of the ‘legitimate tax planning’ as against the ‘use of colourable devices for illegitimate tax evasion’, had emerged.
But then came ‘General Anti Avoidance Rules’ (more popularly referred to as ‘GAAR’).
A new Chapter X-A, containing GAAR provisions in sections 95 to 102, has been incorporated, in the Income Tax Act and has been made applicable w.e.f. 1.04.2017.
Under the GAAR regime, any arrangement, the main purpose of which is to obtain a tax benefit and which lacks commercial substance, would be considered as an impermissible avoidance arrangement.
A new section 144BA has also been inserted in the Income Tax Act, empowering the assessing officer, at any stage of the assessment or reassessment proceedings, to make a reference to the Principal Commissioner, to declare any arrangement or transaction of the taxpayer, as an impermissible avoidance arrangement/colourable device, so as to deny the tax benefit arising out of such arrangement or transaction. However, if the taxpayer objects to such declaration, then the matter has to be referred to the GAAR Approving panel.
GAAR Secretariat has been set up at Delhi and the GAAR Approving Panel has been constituted.
The legislative intent behind the introduction of these GAAR provisions, has been to curb the use of colourable devices facilitating tax evasion. The denial of tax benefit in a colourable arrangement aimed at tax evasion, is completely justifiable. However, a lot of subjectivity has been somehow, allowed to be crept in, especially, in the manner in which the text of sections 95 to 102, had been drafted. The most significant and crucial aspect, i.e., what would constitute an impermissible avoidance arrangement, has been left to subjective whims and fancies of the Assessing Authorities.
Very wide and unfettered powers have been given to the Assessing Authorities, to completely disregard the legal form of any arrangement/transaction, and to look into the subjective substance of the transaction, to pierce the corporate veil, to treat capital receipts as revenue receipts, to disallow any treaty benefits, by altering the residence, source, location and taxability of any international transaction, by treating any arrangement as an impermissible avoidance agreement, assuming it to be lacking commercial substance.
In order to put a suitable check on the blatant & adhoc application of the GAAR provisions, which might be widely used, to make exorbitant additions in assessments, suitable amendments must be incorporated in the Legislature, so as to provide a standard and objective set of determining factors and parameters for bringing any arrangement under the purview of GAAR. Then only, in true spirit and form, the Governments’ objective of ensuring “Ease of Doing Business” will be accomplished.
Taxpayers are advised to enjoy their Holi, with lots of vibrant Colours, but at the same time to avoid ‘colourable devices’ in their tax affairs.
Mayank Mohanka is the founder of TaxAaram India, and a partner at S M Mohanka & Associates