India: Sham Transactions: Recent Developments In Indian Tax Law

  • Delhi Tribunal holds that the mere fact that one of the steps in a transaction resulted in capital loss for the taxpayer would not make the series of transactions a sham.
  • Karnataka High Court holds that shares bought at a premium, and sold at a lower value to individuals (ex-employees / advisors of the seller group) on the same day amounted to a colourable device.
  • Based on commercial rationale provided by the taxpayer, Delhi High Court accepts that steps pertaining to a group acquisition were not structured for prima facie avoidance of taxes.


Indian tax jurisprudence has consistently dealt with the age old debate of 'form over substance'. Indian courts have traditionally followed the approach that since tax statutes must be literally and strictly interpreted, tax planning within the four corners and black letter of the law is permissible.1 Only in extraordinary circumstances could courts 'look through' the form of a transaction to examine its purpose and decide that its substance was to avoid taxes. This approach has sometimes been subsequently deviated from by Indian courts, which have observed that if an assessee resort s using a 'colourable device' or subterfuge to avoid taxes, it may be considered tax evasion rather than tax planning.2

The Supreme Court of India, in Union of India v. Azadi Bachao Andolan3 found a middle ground between the approach of Justice Chinnappa Reddy in the McDowell decision and the previous approaches of the court. While a colourable device could result in the transaction being considered a sham, that did not mean that tax planning within the four corners of the law would not be permitted. It observed that the decision of Justice Reddy in that case was at odds with the majority decision and the Westminister principle was still applicable in its country of origin and was therefore applicable in India.

In the Vodafone case4, the Supreme Court of India observed that there was no conflict between the judgment of Justice Chinnappa Reddy and the majority judgment; tax planning within the four corners of the law would be valid as long as it did not amount to a colourable device. Further, it observed that there was no conflict between the decisions of the Supreme Court in the McDowell and Azadi cases. Recent legislative amendments in India suggest a shift towards a substance based system especially with the introduction of indirect transfer tax provisions, and the general anti-avoidance rules ("GAAR") which come into play next financial year. The GAAR empowers Indian tax authorities with considerable discretion in taxing 'impermissible avoidance transactions', disregarding entities, reallocating income and even denying tax treaty benefits to a non-resident investor. Internationally as well, there is a push towards a resolution of issues relating to tax avoidance and double non-taxation. The OECD and various countries are engaged in efforts to prevent 'Base Erosion and Profit Shifting' and examine the extent to which current international double tax avoidance treaties ("DTAAs") would allow businesses to allocate profits to entities in low-tax jurisdiction where the majority of the business activity does not take place.

However, the concept of legitimate tax planning is a recognized principle in India, and has been given judicial sanction by Indian courts. The Supreme Court in the Vodafone5 judgment has adopted the 'look at' approach while examining Indian tax implications, in a case where a 'look through' provision is not contemplated in the Income Tax Act, 1961 ("ITA"). Reiterating the principle laid down in Azadi Bachao Andoloan6, the Supreme Court in Vodafone accepted the concept of tax planning (as opposed to tax avoidance) within the Indian legal framework. Thus, the first test that needs to be established before invoking any anti avoidance rule is whether the transaction is a 'sham' designed for the purpose of tax avoidance.

Recently, there have been a series of judgments where courts have looked into the substance of a transaction to determine whether there was a tax avoidance motive.


Mere fact of capital loss caused by transaction between sister concerns:

In Consolidated Finvest & Holdings Limited v. ACIT7, the Delhi bench of the Income Tax Appellate Tribunal ("Tribunal") examined a series of transactions between two related entities which resulted in capital loss in the hands of one entity and determined that there was no tax avoidance. The assessee, Consolidated Finvest & Holdings Limited ("Consolidated") gave several advances to a related entity, Jindal Polyfilms Limited ("Jindal"). Jindal was a public company promoted by Consolidated. When Jindal was unable to repay these loans, it restructured the transaction by issuing optionally convertible preference shares to Consolidated. Because of a change in guidelines issued by the Securities and Exchange Board of India which made promoter equity shareholding above a certain limit impermissible, these securities could not be converted into equity shares. Jindal modified some of these securities into redeemable convertible preference shares. Consolidated sold some of the optionally convertible securities and redeemed the remaining. Overall, after the sale and redemption, Consolidated claimed long term capital loss on these transactions. As it had no long-term capital gain to set-off the capital loss against, Consolidated claimed carry-forward of the loss in its returns.

The assessing officer ("AO") disallowed the loss on the ground that the series of transactions was a sham designed to transfer funds from Consolidated to Jindal and enable Consolidated to show a capital loss. Jindal contended that at the earlier stages of the transaction, that is, granting of the loan and sale of the optionally convertible preference shares, the Indian tax authorities did not consider that there was a sham. Further, the facts of the case were different from the facts in the McDowell case relied upon by the tax authorities.

The Tribunal accepted the contention of Consolidated that there was no sham as it was a series of transactions, the earlier of which were considered genuine by the Indian tax authorities in earlier assessment years. It observed that the AO could not support its conclusion with any reasoning or evidence except to state that the fact that the transaction resulted in long term capital loss itself was grounds for holding it to be a sham. The Tribunal also observed that while the mere fact that a transaction between sister concerns resulted in a capital loss can be a grounds for deeper investigation, it cannot be a grounds for concluding that it is a sham. The Tribunal considered the question before it to be whether the entire series of transactions was a sham because its sole purpose was to transfer funds from one company to another so as to generate capital loss enabling one company to avoid taxes on its capital gains. Given the fact that the earlier steps of the series of transactions was c onsidered as genuine by the tax authorities, it was observed that the mere fact the last step resulted in capital loss for the assessee would not make the series of transactions a sham.

Valuation of shares factored into determination of sham:

In CIT and DCIT v. Wipro Limited8, the assessee, Wipro Limited ("Wipro"), claimed various deductions and exemptions under the ITA. The issue before the Karnataka High Court was whether the capital loss claimed by Wipro against short-term capital gains could be challenged on the grounds that sale of shares of a related entity to persons who were employees of the Wipro group for a consideration lower than the market value was a colourable device to show capital loss.

The Court examined the factual background in detail. Wipro sold 3 shares of Wipro Financial Limited ("WFL") to 3 individuals who had long relationships with the Wipro group of companies for a total of INR 75,000. Additionally, Wipro infused INR 95 crore of capital funding (equity shares) to WFL which it subsequently withdrew. WFL was a loss-making entity and since with Wipro's current level of shareholding in WFL, WFL would be considered a subsidiary of Wipro, it would be in the interest of Wipro to reduce its shareholding in WFL such that WFL was no longer its subsidiary, the profits and losses of which would be included in Wipro's consolidated financial statements. Wipro contended that these facts, while proximate to the transaction causing capital loss, did not establish existence of a colourable device. The AO calculated the total indexed cost of acquisition of the shares sold to be more than INR 107 crore. The facts that the AO considered were the valuation of shares o f WFL in a preceding year, valuation of the securities in transactions between Wipro and other third parties and the infusion of capital and divestment. With regard to the last mentioned fact, it was noted that Wipro contended that it had to invest and divest to comply with norms issued by the Reserve Bank of India ("RBI") regarding cancellation of a license of a non-banking financial company if it reported a negative net-worth, which could result in winding up of the company. Wipro claimed to set-off the capital loss incurred due to sale of WFL shares to these 3 persons against short-term capital gains incurred by way of sale of Wipro Net Limited shares.

Relying on the following facts, the AO considered the transactions to be a colourable device to avoid paying taxes on capital gains on the basis that: (i) the capital infusion was used to repay advances granted by Wipro to WFL; (ii) WFL shares were sold in the subsequent year for a nominal price; (iii) none of the investors invested more in WFL following a change in its management and these investors did not impose a condition that Wipro invest INR 95 crore in WFL; and (iv) the approval for the transaction by the board of directors of Wipro was post facto. It was observed that one of the 3 shareholders became a director of WFL. He did not take delivery of the shares. He attended one meeting of the board of directors of WFL to appoint another director, after which he did not attend the subsequent 45 meetings conducted. The AO also relied on various facts to conclude that post divestment of Wipro's majority stake in WFL, they continued to have a relationship of group companies. For example, WFL continued to use the Wipro brand name and guarantees were given by the chairman of Wipro for loans taken by WFL. The Commissioner of Income Tax (Appeals) upheld the order of the AO. The Tribunal reversed the order and observed that it was not possible to create such a plan for tax avoidance and that even if the shares were sold at a throwaway price, there was nothing against it.

The High Court observed that on an application to the RBI relating to operation as a non-banking finance company, WFL had been called upon to repay certain public deposits and other outstanding liabilities of the company. It also observed that one of the 3 persons was a legal advisor of Wipro, another was previously an employee of Wipro and another was previously CEO of WFL. It was contended that, inter alia, the fact that shares of WFL were bought at a premium and sold for a much lower amount and that the amount infused into WFL to meet RBI norms was withdrawn on the same day showed that there was a colourable device. The High Court held that the cumulative effect of the entire arrangement was a colourable device for avoidance of tax. It held that if the previous purchase of shares at a premium and capital infusion transactions were considered genuine, then the sale to the 3 persons for a low price would be considered a sham. Since the Tribunal had not decided the question of whet her the previous sale of shares of WFL were made at the market price or whether for business reasons they had been made at a loss, it was directed to do so. The Tribunal observed that as per the decision of the Supreme Court in the Azadi case, a citizen is free to carry on its business within the four corners of the law. Even where transactions are pre-planned, if there is nothing to impeach their genuineness, they would not amount to tax avoidance.

Delhi High Court analyses tax avoidance in the context of a group acquisition:

In DIT v. Copal Research Limited9, the primary issue before the Delhi High Court was whether the taxpayer's transaction amounted to a prima facie avoidance of tax. To give a background, the writ was filed by the Revenue against a ruling given by the Authority for Advance Rulings ("AAR"). The AAR is precluded from considering a particular transaction if it has been designed prima facie for the avoidance of tax, and such applications are not admissible before the AAR for a ruling.

The transaction under question was the acquisition of control by Moody's group over Copal group's holdings. The acquisition was structured in three parts – separating the transfer of the underlying Indian entities from the transfer of the offshore holding company.

The Revenue's main contention was that the transactions were carried out for the purpose of avoidance of capital gains tax arising from the indirect transfer of underlying Indian assets. It was further contended that had the transfer of underlying Indian subsidiaries been effectuated through the transfer of the offshore holding company, there would have been a tax incidence in India.

On the issue of tax avoidance, the Delhi High Court held that the taxpayer's transaction was not structured primarily for the purpose of tax avoidance. This was on the basis that the taxpayer had sufficient commercial reasons for carrying out the transaction in that manner.

Interestingly, another contention of the tax authorities in the present case was with respect to relocation of residence of a Mauritius based company, on the basis that key decision making of the Mauritius based company was carried out by a UK resident. Consequently, the tax department argued that the control and management of the Mauritius companies should be said to be carried out in UK, the place of residence of such key person. On this issue, the Delhi High Court was of the view that although key decisions were carried out by the UK resident, this fact cannot alone lead to disregarding the Mauritius based company (an operating company which had generated revenues, and was involved in providing inter-company services).


The subtle difference between tax avoidance and tax planning has time and again been tested by Indian courts. With GAAR looming around the corner, one would need to wait and watch to see whether such transactions or structures can withstand the test of GAAR.

What is sufficient commercial rationale for GAAR?: While looking at transactions from the perspective of GAAR, it is important to note that GAAR shall apply only in the case where the main purpose of the transaction is tax avoidance. The Delhi High Court in Copal Research has given sufficient weightage to commercial rationale to conclude that the transaction was not primarily tax driven. On the basis of such commercial rationale provided by the taxpayer, it was held that the transaction was not devised for the prima facie avoidance of tax. Justifications provided by the taxpayer were business oriented and sought to ensure that the understanding between the parties (Copal and Moody's) with respect to control and management of the entities was maintained, and fund flows were captured as per negotiations between parties.

On the other hand, in Wipro Limited, the Karnataka High Court has analyzed a series of transactions entered into by the taxpayer in relation to sale of shares of its subsidiary, WFL. While the taxpayer sought to provide commercial rationale behind capital infusion into WFL prior to sale, the High Court rejected such rationale on the basis that such sums were used by WFL to repay previous dues. However, currently a specific anti avoidance rule under section 56 of the ITA seeks to tax the recipient of shares, when shares of an Indian company have been received without consideration or for a consideration below the fair market value of the shares.

Interestingly, the requirement of having commercial rationale has not been specifically referred to by the Supreme Court in Azadi. However, while elaborating on the prevalence of Duke of Westminister's rule in England, the Supreme Court took note of the judgment of the House of Lords in Craven v. White10 which makes a reference to business rationale.

In fact, the Karnataka High Court in Wipro has made a reference to the same decision where the House of Lords has specifically made observations on transactions taking place in a series of 'steps', and has further gone on to state that while examining such transactions, it is relevant to take into account whether such steps were driven by a business purpose, or merely by a tax motive. Thus, while Azadi does not make any specific reference to requirement of commercial substance or elaborate on what constitute sufficient commercial reasons, substance requirements are in tune with the various authorities relied upon, and discussed by the Supreme Court in Azadi.

Factual inferences indicate a sham: In DCIT v. Wipro Limited, the Karnataka High Court particularly paid importance to important ancillary findings to conclude that the sale was sham – such as WFL continued to use the 'Wipro' logo despite not being part of the group and that the buyers were former employees/ advisors of the Wipro group. Most importantly, the High Court took note of the fact that the shares of the subsidiary were bought at a premium, and sold at a much lower price. Since the taxpayer was unable to provide sufficient commercial justification for the sale, the High Court concluded the transaction to be a sham.

Previous position taken by tax authorities: The Tribunal in the case of Consolidated Finvest & Holdings has also analyzed the series of long drawn transactions taking place between the taxpayer and its sister company. In this regard, it was noted that the tax authorities have accepted the various steps and dealings between the sister entities in the previous years. The Tribunal further held that the tax authorities have not provided any evidence that could indicate that the transactions between the entities were bogus or sham. Mere fact that the taxpayer made use of a tax benefit (in this case – carry forward of capital losses) cannot lead to the conclusion that the transaction is a sham.

It is interesting to note that the Tribunal has taken into account the position of the Indian tax authorities in relation to the taxpayer and its sister concerns. On the basis of lack of evidence and also the fact that the tax authorities have accepted the earlier steps of the transaction without probing into the same, the Tribunal ruled in favor of the taxpayer.


Determination of whether a transaction or series of transactions amounts to a colourable device or sham for avoidance of tax depends on the facts and circumstances of each case. However, where the primary reason of an arrangement is not for tax reasons, the Indian tax and judicial authorities have considered various factors in arrangements to be tax planning rather than tax avoidance. Some factors considered in recent cases include whether or not there were other commercial considerations for the arrangements and whether the arrangements or part of them were considered colourable devices or shams in the earlier assessment years by the Indian tax authorities.

Presently, the principles for determining whether there is tax avoidance or tax planning are primarily created by landmark decisions of Indian courts. It would be interesting to see how determinations would vary in interpreting GAAR. In such a case, it is likely that would be more objectivity since the principles to be considered by the Indian tax authorities would be provided for in the legislation and the rules. In such a situation, there would be determination of specified facts to check if the device is one for tax planning or tax avoidance.


1 The source of this approach is the decision of Lord Tomlin in Duke of Westminster v. IRC (1936) AC 1.

2 This approach is elaborated upon in the judgment of Justice Chinnappa Reddy in McDowell and Co. Ltd. v. Commercial Tax Officer (1985) 3 SCC 230

3 [2003] 263 ITR 706 (SC)

4 [2012] 341 ITR 1 (SC)

5 341 ITR 1(SC)

6 Union of India v. Azadi Bachao Andolan [263 ITR 706 (SC)].

7 ITA No.494/Del/2011

8 ITAs Nos. 1394 and 1395 of 2006.

9 W.P.(C) 2033/2013.

10 (1988) 3 All ER 495 (HL)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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