USE OF ‘SUBSTANCE OVER FORM’ IN TAXATION

[Dr. Sanjiv Agarwal]

The substance of the activity needs to be looked into and would form the basis for arriving at conclusion about the nature of the activity. 

In the case  of Super Poly  Fabriks Ltd,  the Hon'ble Supreme Court has specifically laid down the ratio as under: 

• §"8. There cannot be any doubt whatsoever  at a document has to be read as a whole. The purport and object with which the parties thereto entered into a contract ought to be ascertained only from the terms and conditions thereof: Neither the nomenclature of the documents nor any particular activity undertaken by the parties to the contract would be decisive. " 

It is well settled that an agreement has to be read as a whole and the intention of the parties is to be gathered from it. Moreover, if the terms used in the agreements are not conclusive and one has to look at the substance rather than the form. In addition, it is equally well settled that a name given to a transaction by the parties does not necessarily decide the nature of the transaction. Thus, it is the substance of the contract that has to be regarded. (Nilkantha Narayan Singh v. CIT 20 ITR 8 at page 14)  In the instant case even though  the term “operating agreement”  has been used in substance, IHCL  have provided services in relation to management and business consultancy.  In this regard reliance is also placed on the following judgments. 

Bhopal Sugar Industries Limited V S.T.O. (1977) 3 SCC 147 wherein the court held as follows: 

“It is well settled that while interpreting the terms of the agreement, the Court has to look to the substance rather than the form of it. The mere fact that the word “agent” or “agency” is used or the words “buyer” and “seller” are used to describe the status of the parties concerned is not sufficient to lead to the irresistible inference that the parties did in fact intend that the said status would be conferred. Thus the mere formal description of a person as an agent or buyer is not conclusive, unless the context shows that the parties clearly intended to treat a buyer as a buyer and not as an agent” 

Moped India Ltd. V Assistant Collector Central Excise 1985 -TMI - 41634 – (SUPREME COURT OF INDIA) wherein the Hon’ble Supreme Court held that while interpreting the terms of an agreement, court has to look to the substance rather than the form and observed as follows: 

“Now it is true that this amount allowed to the dealers has been referred to in the agreement as commission but the label given by the parties cannot be determinative because it is, for the court to decide whether the amount is trade discount or not, whatever be the name given to it.” 

According to Accounting Standard- 1 issued by the Institute of Chartered Accountants of India and Central Government, the primary consideration in presentation of financial statements and selection of accounting policies by a business enterprise is that it should represent a true and fair view of the state of affairs and profit and loss account of the enterprise. The major considerations governing the selection and application are prudence, substance over form and materiality. 

Accordingly, the accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form. Thus, substance should take precedence over its legal form. In any commercial transaction, substance must be recognized rather than its form. 

It is a settled rule that in the determination of liability to taxation under a taxing Act, the court has regard to the substance rather than the form of the transaction sought to be taxed, that is to say, in the case of an instrument that the court is not bound by its apparent tenor but will decide according to the real nature of the transaction. It is not the name of the tax but its real nature which must determine into what category it falls, at the same time it is not proper to take the motives of the assessee, in bringing about a particular arrangement, into consideration, and a subject is entitled, if he can, in any legal manner, to circumvent the incidence of a particular taxing or financing Act. It is open to parties to conduct  them selves of any camouflage that the law allows and does not forbid especially in the case of an enactment for revenue purposes, such as Court Fees Act. It is not open to a court in such circumstances to neglect the actual form of the instrument and determine the question of court-fees having regard to what may be said to be the substance of the claim. Lord Summer in Levene v Inland Revenue Commissioners, observed as follows: 

"It is trite law that his Majesty's subjects are free, if they can, to make their own arrangements so that their cases may falls outside the scope of the taxing Acts. They incur no legal penalties and, strictly speaking, no moral censure if, having considered the lines drawn by the legislature for the imposition of taxes, they make it their business to walk outside them." [Based on Joint CTO v. Youngmen's Indian Association AIR 1970 SC 1212; CIT, Madras v. Ibrahimsa AIR 1928 Madras 543; Organon (India) Ltd. v. Collector of Excise (1977) MP LJ 119 etc.] 

The decision of State of Andhra Pradesh v. Kone Elevators India Ltd. (2005) 181 ELT 156 (Supreme Court) can also be relied upon where apex court held that the substance of the contract is determinative and not its form. Thus, the essence of the contract is crucial and to be seen, keeping in mind the intention of the parties. 

In Sundaram Finance Ltd. v State of Kerala AIR 1966 SC 1178 the Supreme Court has held that the true effect of transaction must be determined from the terms of the agreement considered in the light of surrounding circumstance. In each case, the court can, unless prohibited by statute, go behind the documents and determine the nature of transaction whatever may be form of documents.

To ensure non-discriminatory enforcement of laws and regulation, choosing a formal approach is very logical. In other words, the form of a situation-- a transaction, determines the legal consequences. In tax law particularly, choosing a form to suit a particular tax benefit is not warranted but it is the actual substance that courts.

In India, the most important case addressing the substance-over-form question is without doubt McDowell and Co. Ltd. v. Commercial Tax Officer, 1985 -TMI - 40038 – (SUPREME Court). The case was about a mitigation of sales tax by having the buyers separately pay the excise duty, whereby such excise duty would not be included in the taxable basis for sales tax. The Commercial Tax Officer was of the view that the excise duty paid directly to the Excise authorities or deposited directly in the State Exchequer in respect of Indian liquor by the buyers before removing the same from the distillery could be said to form part of the taxable turnover of the appellant distillery for the purpose of the Sales Tax Act. The Court, however, came to the conclusion that excise duty did not go into the common till of McDowell and did not become a part of the circulating capital. Therefore, the sales tax authorities were not competent to include in the turnover of the appellant the excise duty which was not charged by it but was paid directly to the excise authorities by  the buyers of the liquor. The Supreme Court took the view that tax planning was legitimate so long as it was strictly within the  four corners of the law and any 'colourable' device or dubious methods to minimise tax incidence were not legally permissible. The Court reaffirmed the view of English cases while examining a legally valid transaction, and held that the Revenue should proceed objectively and not hypothetically attribute 'motives' behind the taxpayer’s action.    

Before determining the nature of the taxes which can attract in the context of the Agreements, it is essential to determine the intention of the contracting parties and the true nature of the transaction as per the law declared by the Hon’ble Supreme Court in various judgment including the judgment in the case of Bharat Sanchar Nigam Ltd v Union of India reported in 2006 -TMI - 309 – (Supreme court)  

In the case of Kultar Singh v Mukhtiar Singh (1964) 7 SCR 790 and Jagannath Deb Roy  v. Byomkesh Roy AIR 1973 Cal 397, the Hon’ble High Court of Calcutta has held as follows:

“..One of the well established rule of construction is that the document must be read as a whole. A piecemeal reading of the document either of recital or operative portion or the covenants cannot bring about a fair and proper construction of a document…” 

In addition, it is submitted that it is an established principle of law that commercial documents must be construed in a manner as are understood in commercial parlance. These are business agreements and must be read as a business men would read them (Refer to W T Suren & Co. (P.) v. CIT 80 ITR 602 at page 616).

 

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