Splitting of Composite Contracts as a means to Tax Avoidance in light of Ramsay Principle

[Pratik Raoka]

Introduction

Multinational Enterprises operate in a number of countries. So that the combined tax effect on their income should be minimal, they resort to devices known as income splitting or tax fragmentation.

Income Splitting consists of dividing one composite contract into number of separate contracts which may be spread over a number of countries in such a manner that the bulk of the profits arise in low-tax a rate country. This is usually practiced in a contracting business. The profit is assessable in the country where such contract is undertaken whilst the sale of equipment supplied as part of contract arises in another country. A contract for work may involve sale of goods if there is an independent term in the said contract for sale of any specific goods. This is possible where not only work is to be done, but the execution of work requires material to be used. Thus, the execution of work is performed in one country and the sale of goods require for such execution, in the other. The contract agreed upon is thus divisible. The composite contract by arrangement is split up into many constitutes mainly two, one for sale of goods and other for work and labour.

A transaction may be split up into a series of such transactions so that each may be looked upon as an independent source of income; though the entire series is nothing but in substance constitutes one composite transaction. By fragmenting the transaction, income is also fragmented so as to appear arising in different jurisdictions. Till recently such arrangement would have been permissible, as a person is master of his own affairs who could arrange them in a manner most suitable and beneficial to him.

The doctrine that every man is entitled, if he can, to order his affairs so that the tax attracted under the appropriate Act is less than it would otherwise be, as pronounced by Lord Tomlin in IRC v. Duke of Westminister (1936) AC 1  and as followed in India in CIT v. A. Raman & Co.1967 (7) TMI 2 - SUPREME Court and some other cases, has long back been given a befitting burial in W.T. Ramsay Ltd. vs IRC (1981) 1 All ER 865, IRC v. Burmah Oil Co. Ltd. (1982) STC 30   and McDowell and Co. Ltd v. CTO 1985 (4) TMI 64 - SUPREME Court . In India Justice Desai of Gujarat Jigh Court recorded a sign of departure from this principle, in Wood Polymer Ltd., In re 1977 (1) TMI 35 - GUJARAT High Court  by refusing to accord sanction to the amalgamation of companies as that would lead to avoidance of tax. The departure was completed by the Supreme Court in the case of McDowell and Co. Ltd v. CTO 1985 (4) TMI 64 - SUPREME Court

1. Ramsay Principle

Tax fragmentation involves breaking one composite transaction into separate constituent parts or inserting self cancelling transactions, spreading them and consequently income s if arising in a number of countries, so that each constituent is subjected to different tax treatment. The sum total of all is considerably less than what would have been the tax consequence had the transaction been taken as composite one whole in one country. This is based on the principle as stated in W.T. Ramsay v. IRC (1982) AC 300 , known as Ramsay Principle. The principle lays down that while the court is obliged to accept documents or transactions found to be genuine, as such, it does not compel the court to look at the document or transaction in blinkers, isolated from the context to which it properly belongs. If it can be seen that a document or a transaction was intended to have effect as a part of the nexus or series of transactions, or as an ingredient of wider transaction intended as a whole, there is nothing in the Westminister Doctrine, to prevent it being so regarded: to do so is not to prefer form to substance, or substance to form. It is the task of the court to ascertain the legal nature of any transaction to which it is sought to attach a tax or a tax consequence and if that emerges from a series or a combination of transactions, intended to operate as such, it is that series or combination which may be regarded as a whole.

Lord Brightman in Furniss v. Dawson (1984) AC 474 (HL)  stated that the formulation of Lord Diplock in Burmal Oil Co. Ltd. (Supra)  expresses the limitation of the Ramsay Principle. First, there must be pre-ordained series of transaction; or, if one likes one single composite transaction. This composite transaction may or may not include the achievement of a legitimate commercial (i.e. business) end. Secondly, there must be steps inserted which have no commercial (business) purpose apart from the avoidance of a liability to tax, “no business effect”. If these two ingredients exist, the inserted steps are to be disregarded for fiscal purposes. The court may then look at the end result. Precisely how the end result would be taxed will depend on the terms of the taxing statute sought to be applied. Thus for rejecting a device aimed at saving the tax, formulation of law veers around two concepts:

• First, there should be pre-ordained series of transaction i.e., one single composite transaction;

• Second, there must be inserted steps which have no commercial purpose apart from the avoidance of tax liability.

1.1. Meaning of “Preordained Series of Transaction”:

The expression “Pre-ordained Series of Transaction” has been subject-matter of discussion in three English Cases viz. Baylis v. Gregory (1987) STC 297 (CA) IRC v. Bowater Property Developments Ltd .(1987) STC 297 (CA)  and Craven v. White (1987) STC 297 (CA). Slade LJ said:-

“I conclude that two successive transactions, each of which have legal effects are not properly to be regarded as a pre-ordained series or a single composite transaction within the meaning of First Ramsay condition as stated by the House of Lords unless, at the time when the first transaction was effected, all essential features (not merely the general nature) of the second transaction had already been determined by a person or persons who had the firm intention and for practical purposes the liability to procure the implementation of second transaction.”

Thus, the expression “preordained series of transactions” contemplates that the person has in contemplation the sequence of transactions when he takes the first steps, to follow that step with intention of saving tax. If there is no planning without the next step being arranged or the next step was expected but did not in fact materialize or the next step was one and probably more likely of the two possible outcomes that the subsequent steps cannot be said to be preordained series of transactions. What is required is to be proved that at the time of the First Transaction it was intended by the taxpayer that the first transaction is used as conveyancing machinery in order to achieve the final object of saving tax. One cannot have composite transactions unless the second part has been pre-arranged or pre-ordained at the time of the first. In Ramsay and Dawson the reasoning had been that there is no difference between series of steps which are followed through as part of an arrangement which falls short of a contract and a series which are carried out under a contract. By the same reasoning a quasi-contract in the absence of one of the parties being identified cannot be said to be an arrangement through a contract. If there is an uncertainty and difficulty in practice about the next step, it is very difficult to tax the income at first stage on the basis that second stage is bound to happen. The court of Appeal in the aforesaid decisions, therefore, pointed out that preordained series of transaction or a single composite transaction cannot be taken to be the one where the next step has not been arranged or has not in-fact materialized or the next step is one and probably the more likely of the two possible outcomes.

2. Tax Avoidance

Tax avoidance occurs when the taxpayer takes advantage of a provision of law, the formulation of which is obscure or incomplete or very complex so that he can reduce or avoid his liability while remaining within the limits of law. If, however the taxpayer is acting against the will of legislature even if he remains within the literal interpretation of law, he can be said avoiding the tax. The revenue authorities cannot brush aside any and every attempt at saving the tax if an attempt is sanctioned or hold the assessee guilty of avoidance when the saving is the result of series of steps which at the time of taking the first step could not be in contemplation of or devised by the assessee.

2.1. Circumstances under which tax avoidance is inferred:

Only under the following circumstances tax avoidance can be inferred:-

• There is no economic or other significant reason which could justify the transaction;

• The existence of the intent to avoid tax can be clearly established;

• Acts leading to its occurrence are unusual or artificial and give rise to situation where the letter of the tax regulation does not apply but differs so little from a situation provided for under the regulations that the purpose and the spirit of the regulations would be frustrated if it were to be declared inapplicable.

2.2. Tax Avoidance is presumed if no valid Business Purpose:

Tax avoidance is presumed to be intended if there is no valid business purpose. For example in National Securities Corp. v. Commissioner 137 F.2d 600 (3^rd Cir.) (1943) , transaction was disregarded (non-recognition transaction) which involved transfer of stock from parent to subsidiary followed by the subsidiary’s sale of stock and realization of a loss that had substantially more favorable tax consequence for the subsidiary than for the parent. In Northwestern National Bank v. United States 556 F.2d 889 (8^th Cir.) (1977) , transfer of appreciated property was followed by donation to charity under preconceived plan to make the contribution through the parent for tax reason, was not recognized. In another case transaction involving distribution of Treasury Bonds as dividends to parents in effort to obtain more favorable tax treatment or gain was not recognized. Southern Bancorporation v. Commissioner; 67 T. C. 1022 (1977) Any presumption that the transfer was designed merely to obtain more favorable tax treatment of a planned disposal of the assets by the controlled group can be eliminated if the transferred assets is used rather than disposed of. See Bank of America v. United States; 79-1 U.S. TC (CCH) 9170 (N.D. Cal. 1979; Eli Lilly & Co. v. Commissioner 84 T.C. 996 at 1123-24 (1985) The US Tax Court in Eli Lilly rejected the Commissioner’s view that exchange of manufacturing intangibles by the parent to the subsidiary for stock was entirely voidable and that the subsidiary ownership of the intangibles should be disregarded for purposes of allocating income under Section 482.

2.3. Test for Business Purpose – Limitations:

The proposition cannot be accepted in its entirety that transaction may be disregarded for tax purposes solely on the basis that it was entered into without any bonafide business purposes. A strict business purpose test in certain circumstances would run counter to the apparent legislative intent which in the modern taxing statutes may have dual aspect. Income-tax legislation is no longer a devise to raise revenue to meet the cost of governing community. It is also employed to attain economic policies. The economic policy element of the Act sometimes takes the form of an inducement to a taxpayer to undertake by or redirect a specific activity. Without the inducement, the activity may not be undertaken by the taxpayer for whom the induced action would be otherwise having no bonafide business purpose. Thus, by imposing a positive requirement that there be such a bonafide business purpose, the taxpayer might be barred from undertaking the very activity Legislative wishes to encourage. At minimum, a business purpose requirement might inhibit the taxpayer from undertaking a specific activity which the Parliament has invited in order to attain economic and social policy goals. Indeed where the Parliament is successful and the taxpayer is induced to act in a certain manner by virtue of the incentives prescribed by the legislation, it is at least arguable that the taxpayer was attracted to this incentive for business purpose of reducing his cash outlay for taxes to conserve his resources for other business activity. The tax authorities may presume that tax avoidance was intended if the taxpayer chooses to carry out the transaction which may be regarded an unusual.

3. The look through doctrine and interpretation of section 9 of the Act as laid down by the Vodafone Case

The Hon’ble Court while interpreting the section 9 of the Income Tax Act, 1961 mentioned that it was not a “look through” provision so as to cover the indirect transfers of the capital assets situated in India.

The crux of the issue was whether the deeming provisions of section 9(1) (i) triggering capital gains taxation for non-residents is a 'look through' provision, so as to cover indirect transfer of capital assets situated in India.

The judgment held that the essential condition for triggering capital gains taxation under the source rules is that the capital asset must be situated in India. Accordingly, the charge of capital gains requires the existence of all the three essential elements, (i) transfer, (ii) existence of a capital asset, and ( iii ) situation of such asset in India. If the term 'indirect' is also read into the provision, it would render the above requirement nugatory. The judgment further held that the word 'directly or indirectly' would go only with the term 'income' and not with the term 'transfer of capital asset'. Further, it has also been observed that as the proposed Direct Taxes Code 2009 and 2010 expressly provided for taxation of indirect transfers, the existing provisions in the Act does not cover such situations. It was, accordingly, held that the question of providing a 'look through' or 'limitation of benefits' provision in the Act or in the tax treaty, is a matter of policy, and needs to be expressly provided by way of a specific legislation.

The judgment in this manner lays down various cardinal principles of interpretations of taxing statutes that might impact the tax jurisprudence of the nation deeply. Perhaps most importantly, the judgment lays down the cardinal rule on how to interpret transactions for tax purposes, i.e. , one has to "look at" a transaction, rather than "look through" it. A balance, however, appears to have been struck, with the Court observing that the tax authorities could invoke the "substance over form" principle or pierce the corporate veil, but only if they were able to establish that the transaction was a sham or a tax avoidant. This test will undoubtedly have far reaching ramifications and may apply to several other controversies. The Court has unanimously rejected the contention of the tax authorities that section 9(1) (i) must be given a purposive interpretation so as to include within its ambit indirect transfers of assets in India. This is a very positive finding and will have a significant impact on several other similar cases that are currently at various levels of litigation.

On one hand the judgment is brought under questions for giving restrictive interpretation by excluding the ‘indirect transfers, it is also appreciated to facilitate the certainty in law especially regarding the scope of taxing statutes. In its judgment, the Court specifically talked about the importance of certainty in tax policy from an investor's point of view and observed that it was for the Government to incorporate doctrines like "limitation of benefits" and "look through" by appropriate legislative action to avoid disputes. This is similar to the approach adopted by other countries.

Similar transactions have been sought to be taxed in other countries, though by legislative diktat, rather than judicial process. China, Indonesia, Peru, Australia are among the countries who have specifically made changes in law to deal with such issues. Interestingly, while India too has proposed a legislative change under the Direct Taxes Code to bring similar transactions to tax in India, the Indian approach is significantly wider in scope than those followed in other countries, who have sought to limit the applicability of such provisions to cases of tax avoidance, or transfer of real property interests. The phrase "directly or indirectly" used in section 9(1) (i) is associated with or qualifies the word "income" which may accrue or arise in India, or which may be deemed to have accrued or arisen in India and not with the word "transfer". Therefore, even if there may be an indirect transfer of capital assets in India, capital gains therefrom cannot be taxed in India.

4. The case of Dongfang Electric Corporation v DDIT  [2012 (6) TMI 687 - ITAT, KOLKATA]

Background:

The Assessee, a Chinese company, had entered into contracts with Indian entities for setting up of turnkey thermal power projects. Each of these contracts were divided into two parts – one for supply of equipment and materials of thermal power plant and second for erection and services of units of main plant along with some common facilities. The Assessee had a project office in India which constituted a permanent establishment (PE) for the assessee in India under the India-China DTAA.

The consideration receivable by the assessee was separately provided in respect of

(i) offshore supply of equipment, spare parts and tools outside India (offshore supply) and
(ii) for local supply, design, engineering, construction, erection, installation, testing and commissioning of thermal power units (onshore activities).

While the scope of work and consideration were part of separate agreements, such agreements contained a ‘cross-fall breach clause’ ensuring that performance of entire project was treated as single point responsibility and non-performance of any part would be treated as a breach of whole contract.

Tax Authorities’ arguments

• The contract was manipulated and artificially split up at the convenience of the foreign contractor i.e. assessee in such way that its onshore activities in India will always result in losses.

• The assessee’s PE in India had some role to play in overall execution of the contract (including offshore supply which was a continuous process). Accordingly, income in India should be computed by attributing profits to the PE under the provisions of the DTAA as well as transfer pricing provisions.

• Accordingly, on a reference to the TPO, profits were attributed to the PE in India in connection with both offshore and onshore components and adjustments were made resulting in taxable income of the assessee in India.

HELD:

• The AAR, in a ruling in the case of Alstom Transport SA held that a composite contract for installation and commissioning cannot be split up into separate parts and the contract has to be read as a whole having regard to its object and the purpose it sought to be achieved. This was held by applying the ‘look at’ principle adopted by the Supreme Court in the case of Vodafone International Holdings (2012 (1) TMI 52 - SUPREME COURT OF INDIA).

• The observations of the AAR are certainly applicable in the cases in which the values assigned to the onshore services are prima facie unreasonable vis-à-vis values assigned to the offshore supplies, which make no economic sense when viewed in isolation with offshore supplies contract.

• The views of the AAR are accepted for the limited extent where the transactions are to be essentially looked at as a whole, and not on a standalone basis, when the overall transaction is split in an unfair and unreasonable manner with a view to evade taxes.

• Presence of ‘cross-fall breach clause’ indicates that the contract could be viewed as an integrated one.

• In the assessee’s case, as per the audited financial statements, losses were incurred not only in respect of onshore activities, but also on offshore supplies executed from China. If losses are incurred on the entire project, the mere fact that losses were incurred on onshore activities cannot be a sufficient reason to show or indicate that this was done to avoid taxes.

• Even if the contracts are taken together as an integrated whole and if there are no profits earned under the contracts, there can be no occasion to tax income from such contracts in India. The workings of the overall losses given by the assessee must be examined by the Revenue and if the Revenue does not have any issue regarding these workings, the very foundation of the actions of the Revenue ceases to be good in law.

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