(1985) 154 ITR 148 (SC)
Tax planning, avoidance and colourable devices
Legitimate tax planning within the law is permissible, but colourable devices and dubious methods adopted to avoid tax are not. The substance of an arrangement may be examined rather than accepting its form.
How far may a taxpayer arrange its affairs to reduce tax, and when will the courts decline to give effect to the arrangement?
The case arose in the context of excise duty on liquor and whether duty paid directly by buyers to the authorities formed part of the assessee manufacturer's turnover for sales tax. The arrangement had been structured so that the duty was discharged by purchasers rather than by the manufacturer, with the object of keeping it outside the taxable turnover. The Court considered the arrangement and, in doing so, addressed the broader question of how the law should regard schemes designed to reduce tax.
The matter was decided by a Constitution Bench of the Supreme Court. The leading judgment and a separate concurring judgment expressed the position on avoidance in different terms, which has shaped the debate ever since.
For the assessee
A taxpayer is entitled to arrange its affairs so that the tax attaching is less than it otherwise would be, and there is no obligation to structure transactions so as to maximise the revenue. So long as the arrangement is lawful, the authorities must give effect to it as made.
For the Revenue
The arrangement had no commercial purpose beyond reducing the tax burden, and its form did not reflect its substance. The authorities should be entitled to look at what was actually achieved rather than the structure adopted to describe it.
The Court held that the arrangement in question did not succeed on its own terms, and went on to address avoidance more broadly. The leading judgment held that tax planning may be legitimate provided it is within the framework of the law, but that colourable devices cannot be part of tax planning, and it is wrong to encourage the belief that it is honourable to avoid payment of tax by resorting to dubious methods. The separate concurring judgment went further in criticising avoidance schemes and urged that they be judged by their substance rather than their form. The relationship between the two judgments, and the extent to which they displaced the older principle that a taxpayer may lawfully arrange its affairs, generated extensive debate in later cases. That debate was substantially settled in Vodafone, where the Court clarified that McDowell does not condemn legitimate tax planning: the distinction is between a genuine arrangement having commercial substance, which must be respected, and a preordained scheme inserted with no purpose other than avoidance, which may be disregarded.
The foundation of India's judicial approach to avoidance, and the backdrop against which the general anti-avoidance rules were enacted. Those statutory rules now supply the operative test — impermissible avoidance arrangements, main purpose, lack of commercial substance — so McDowell is the origin of the doctrine rather than the current mechanism. It must be read with Vodafone and Azadi Bachao, which mark the boundary between planning and avoidance.