TAX/SALES TAX

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The McDowell Dictum—Vanishing Line Between Tax Avoidance and Tax Evasion*
by S.P. Gupta

Cite as : (2003) 5 SCC (Jour) 15

The decision in McDowell & Co. Ltd. v. CTO1 by a Constitution Bench of the Supreme Court so widened the net under different taxing statutes that several innocent commercial and financial acts and transactions of the assessees which were till then neither treated nor supposed to be treated as taxable suddenly found themselves threatened with being dragged within the pale of taxability and even penalisation. The observations in the judgment, particularly in the opinion rendered by Chinnappa Reddy, J., against tax avoidance have so emboldened the assessing and taxing authorities that it results in a lot of unreasonableness and high-handedness towards the assessees.

In particular, McDowell1 judgment has blurred the line of distinction between reduction of tax liability by an assessee on account of legally permissible, honest and justified means, on the one hand, and reduction due to some colourable device, design or subterfuge, on the other hand. For that reason, it has given rise to sufficient confusion and misunderstanding. Hence, the need to undertake a critical study of McDowell case1.

The facts in McDowell case

Under the A.P. Excise Act and Rules, the manufacturer was to remove the liquor from the distillery only upon payment of excise duty. However, the buyers of liquor from the assessee themselves paid the excise duty before the removal of the goods. The price of the liquor was collected by the assessee from the buyer but the excise duty paid by the buyer to the Excise Department was not shown as part of the price received by it from the buyer. The assessee continued to sell liquor in this manner and paid sales tax under the A.P. Sales Tax Act on the turnover returned by him which did not, as mentioned, include the amount of the excise duty. However, the Assessing Authority took the view and held that the assessee had failed to include in its turnover, the amount of excise duty paid by its buyers to the Excise Department. The assessee challenged that view but the High Court agreed with the Assessing Authority. The assessee appealed to the Supreme Court.

A Division Bench of the Supreme Court examined the excise laws as well as the sales tax laws. The Court took the view that

(i) the buyer was also legally responsible to pay the excise duty, and

(ii) the amount of excise duty never went into the till of the assessee.

On this view of the laws, the Supreme Court held that the excise duty, which had been directly paid by the buyers to the Excise Department, was not includible in the turnover of the assessee. This was in 1977, the first judgment of the Supreme Court on the issue in McDowell & Co. Ltd. v. CTO2

Consequent upon this judgment, the Rules were amended. The new Rule provided for payment of excise duty by the manufacturers, including the assessee, but the excise duty continued to be paid directly by the buyers as was done earlier. On the basis of the amendment in the Rules, the Assessing Authority again added the sum of excise duty to the assessee's turnover. The assessee again moved the High Court for quashing the notice. The High Court held that

"the turnover related to liquor; excise duty, which was payable by the (assessee) but, by an arrangement, had been paid by the buyer, was actually a part of the turnover (of the assessee) and was, therefore, liable to be so included (in the turnover) for determining (the assessee's) liability for sales tax".

The assessee appealed to the Supreme Court wherein the validity of the earlier judgment in the assessee's case was doubted and the matter was referred to a Constitution Bench of five Judges.

The issues and the verdict in McDowell case

There were only two basic issues before the Constitution Bench. One, whether the liability to pay excise duty was that of the assessee. And, the other, even if the liability to pay excise duty was of the assessee, whether the amount of excise duty, directly paid by the buyer, was includible in the turnover of the assessee for payment of sales tax.

Referring to several earlier precedents wherein the concept of excise duty had been elaborated, the Constitution Bench held that "the incidence of excise duty is directly relatable to manufacture" and its payment "is the primary and exclusive obligation of the manufacturer ... but (only) its collection can be deferred to a later stage as a measure of convenience or expediency". On a fresh appraisal of the law, the highest court found fault with and overruled its own decision rendered in 1977 in the same assessee's case.

As to the other issue relating to turnover also, the Supreme Court referred to various Indian and English decisions and held that excise duty is a part of the consideration which a buyer pays to purchase liquor and is includible in the turnover of the assessee (manufacturer) although the buyer had directly paid it to the Excise Department. Thus, on this issue also, the Supreme Court differed from its own earlier view.

The assessee thus lost the case in the Supreme Court. There was no scope for discussing tax avoidance or tax evasion in the case of the assessee.

The non-issues and other observations in McDowell case

However, it appears from the judgment of Misra, J. that a "further contention" was made on behalf of the assessee that

"it is open to everyone to so arrange his affairs as to reduce the brunt of taxation to the minimum and such a process does not constitute tax evasion; nor does it carry any ignominy". (SCC pp. 252-53, para 41)

This submission was sought to be supported by the observations of Shah, J. in the cases of CIT v. A. Raman & Co.3 and CIT v. B.M. Kharwar4 The observation from the latter case reads as follows: (ITR p. 607)

"The taxing authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it is open to the taxing authorities to unravel the device and to determine the true character of the relationship. But the legal effect of a transaction cannot be displaced by probing into the 'substance of the transaction'."

It appears that the Supreme Court took notice of the said "further contention" and considered it proper to lay down the law on the subject.

Misra, J., who delivered judgment on behalf of himself and three other Judges (other than Reddy, J.), extracted the following observation from the judgment of the Gujarat High Court (ITR pp. 200-01) in the case of CIT v. Sakarlal Balabhai5 (affirmed by the Supreme Court in CIT v. Vadilal Lallubhai6): (SCC pp. 253-54, para 43)

"Tax avoidance postulates that the assessee is in receipt of amount which is really and in truth his income liable to tax but on which he avoids payment of tax by some artifice or device. Such artifice or device may apparently show the income as accruing to another person, at the same time making it available for use and enjoyment to the assessee as in a case falling within Section 44-D or mask the true character of the income by disguising it as a capital receipt as in a case falling within Section 44-E or assume diverse other forms.... But there must be some artifice or device enabling the assessee to avoid payment of tax on what is really and in truth his income. If the assessee parts with his income-producing asset, so that the right to receive income arising from the asset which theretofore belonged to the assessee is transferred to and vested in some other person, there is no avoidance of tax liability: no part of the income from the asset goes into the hands of the assessee in the shape of income or under any guise."

Then, Misra, J. responded: (SCC pp. 254-55, para 45)

"45. Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges."

The appeal was dismissed. The Court did not record any finding that the assessee had adopted any colourable device or design or dubious method or subterfuge to avoid or evade tax. The levy of tax on the assessee was not upheld on any such finding. It was upheld, as pointed out earlier, on a pure interpretation of law.

It is in this background that the observations of the other learned Judge, namely, Reddy, J., which have become a handle for the tax authorities, were made. Reddy, J. examined certain English cases to show how the law relating to the controversy of tax avoidance was changed even in England. First, he examined IRC v. Duke of Westminster7 wherein it was ruled thus:

"Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioner of Inland Revenue or his fellow tax-gatherers may be of his ingenuity, he cannot be compelled to pay an increased tax."

After citing several other cases highlighting the march of the law against tax avoidance schemes, the learned Judge adverted to the decision in the case of W.T. Ramsay Ltd. v. IRC8 which marked a significant departure from the earlier view of law in the case of Westminster7, the learned Judge cited extracts from the speeches of the Law Lords in the case of Furniss v. Dawson9 such as the following one from Lord Scarman: (All ER p. 533a)

"What has been established with certainty by the House in Ramsay case8 is that the determination of what does, and what does not, constitute unacceptable tax evasion is a subject suited to development by judicial process."

And borrowing the metaphor of "ghost" from the speech of Lord Roskill, he posed the question: (SCC p. 241, para 13)

"13. Thus the ghost of Westminster7 (in the words of Lord Roskill) has been exorcised in England. Should it be allowed to rear its head in India?"

Reddy, J. justified the relevance of English decisions thus: (SCC p. 241, para 14)

"14. I have referred to the English cases at some length, only to show that in the very country of its birth, the principle of Westminster7 has been given a decent burial and in that very country where the phrase 'tax avoidance' originated the judicial attitude towards tax avoidance has changed.... The courts are now concerning themselves not merely with the genuineness of a transaction, but with the intended effect of it for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it."

Referring with disapproval to the observations of Shah, J. in the cases of CIT v. A. Raman & Co.3 and CIT v. B.M. Kharwar4, Reddy, J. declared: (SCC pp. 242-43, para 17)

"17. We think that time has come for us to depart from the Westminster7 principle as emphatically as the British courts have done and to dissociate ourselves from the observations of Shah, J. and similar observations made elsewhere. ... In our view, the proper way to construe a taxing statute, while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it."

The learned Judge then proceeded to further observe: (SCC p. 243, para 18)

"18. It is neither fair nor desirable to expect the legislature to intervene and take care of every device and scheme to avoid taxation. It is up to the court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and to consider whether the situation created by the devices could be related to the existing legislation with the aid of 'emerging' techniques of interpretation (sic as) was done in Ramsay8, Burmah Oil10 and Dawson9, to expose the devices for what they really are and to refuse to give judicial benediction."

The two cases of Raman3 and Kharwar4 became the central point of criticism in the judgment of Reddy, J. In the former case, the case of the Government was that the assessee had sold goods to certain HUFs and those HUFs had earned substantial profits on the resale of the goods over and above the margin of profit earned by the assessee and that the creation of the family business was merely a subterfuge and contrivance by the partners of the assessee for diversion of the profits. The Supreme Court held: (ITR pp. 17-18)

"By adopting a device, if it is made to appear that income which belonged to the assessee had been earned by some other person, that income may be brought to tax in the hands of the assessee,.... Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income Tax Act. Legislative injunction in taxing statutes may not, except on peril of penalty, be violated, but it may lawfully be circumvented.

If the goods were nominally transferred to the Hindu undivided families, the latter acting merely as benamidars for the assessees, and the profits were earned in truth by the assessees, income earned by sale of the goods by the Hindu undivided families may be held chargeable to tax as income which has escaped assessment to tax in the hands of the assessees." (emphasis supplied)

In the latter case, Kharwar4, though a passage from the case of Westminster7 was quoted by Shah, J., the learned Judge did rely also on the Supreme Court's decision in CIT v. Motors & General Stores (P) Ltd.11, wherein the Court had observed thus: (ITR p. 699)

"In the absence of any suggestion of bad faith or fraud the true principle is that the taxing statute has to be applied in accordance with the legal rights of the parties to the transaction. When the transaction is embodied in a document the liability to tax depends upon the meaning and content of the language used in accordance with the ordinary rules of construction." (emphasis supplied)

It was thereafter that Shah, J. held in his own words: (ITR pp. 607-08)

"The taxing authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it is open to the taxing authorities to unravel the device and to determine the true character of the relationship. But the legal effect of a transaction cannot be displaced by probing into the 'substance of the transaction'. This principle applies alike to cases in which the legal relation is recorded in a formal document, and to cases where it has to be gathered from evidence—oral and documentary—and conduct of the parties to the transaction."

(emphasis supplied)

Reddy, J.'s observations—whether justified

The judgment in either Raman case3 or Kharwar case4 had not laid down any such principle which runs contrary to the principles that eventually came to be laid down in McDowell case. The observations in the judgment of Reddy, J. in McDowell case, purporting to dissociate from the said two judgments, were neither pertinent nor justified. They were so vitriolic and so strongly worded that, while purporting to be in criticism of the judgments of Shah, J. in the cases of Raman3 and Kharwar4, they themselves became an excessively aggressive and indiscriminate indictment against the time-honoured and useful distinction between tax avoidance and tax evasion.

Ever since then, the tax authorities have been applying Reddy, J.'s opinion, without understanding its true import and appreciating its true applicability or validity. For instance, under the Income Tax Act, as soon as the authorities find a situation in which taxable income could accrue, they apply the opinion of Reddy, J. as a magic wand and treat the income as having accrued even if it had not actually and legally accrued. Likewise, under other taxing statutes, even in cases where the tax liability of the assessee stands reduced as a consequence of an honest, genuine and lawful act, to reduce or even avoid tax, the taxing net is made wide enough to devour the assessee.

The judgment of Reddy, J. does not contain limitations on its applicability—objective or otherwise. However, some subsequent judicial opinions have tried to mitigate its rigour and put limitations thereon by placing healthy riders and restrictions on the unduly wide and indiscriminate application of the observations of Reddy, J.

For instance, in CWT v. Arvind Narottam12, rejecting a plea based on McDowell case, Mukharji, J. held: (SCC p. 121, para 14)

"... where the true effect on the construction of deeds is clear ... the appeal to discourage tax avoidance is not a relevant consideration."

As for the moral justification against tax avoidance, Mukharji, J. further observed: (SCC p. 121, para 13)

"13. It is true that tax avoidance in an underdeveloped or developing economy should not be encouraged on practical as well as ideological grounds. One would wish, as noted by Reddy, J. that one could get the enthusiasm of Justice Holmes that taxes are the price of civilisation and one would like to pay that price to buy civilisation. But the question which many ordinary taxpayers very often in a country of shortages with ostentatious consumption and deprivation for the large masses ask is does he with taxes buy civilisation or does he facilitate the wastes and ostentatiousness of the few. Unless wastes and ostentatiousness in government's spendings are avoided or eschewed, no amount of moral sermons would change people's attitude to tax avoidance."

Similar discussions are to be found in the Supreme Court decision in Union of India v. Playworld Electronics (P) Ltd.13 and in Shubham Fabrics v. IAC14

The applicability of McDowell case has been restricted by many judgments of High Courts also, for instance, in CIT v. Modest Enterprises Ltd.15, CIT v. Nandkishore Sakarlal16, Bhaktimala Beedi Factory v. CIT17 and in CIT v. Joytsna Poddar18

On the other hand, there are cases which have justified the liability to tax with the support of the dictum in McDowell case. The truth of the matter, however, is that in all those cases, the same results would have been achieved even by following the decision of Shah, J. in Raman3 and Kharwar4 cases or, for that matter, the rule recognized by the Gujarat High Court in the case of Sakarlal Balabhai5 (as affirmed by Misra, J. in McDowell case). Reddy, J.'s judgment has contributed confusion rather than clarity.

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*    Senior Advocate, Allahabad High Court. Return to Text

1. (1985) 3 SCC 230 Return to Text
2. (1977) 1 SCC 441 Return to Text
3. (1968) 67 ITR 11 (SC) Return to Text
4. (1969) 72 ITR 603 (SC) Return to Text
5. (1968) 69 ITR 186 (Guj) Return to Text
6. (1973) 3 SCC 17 Return to Text
7. 1936 AC 1 : 1935 All ER Rep 259 (HL) Return to Text
8. 1982 AC 300 : (1981) 1 All ER 865 (HL) Return to Text
9. (1984) 1 All ER 530 (HL) Return to Text
10. IRC v. Burmah Oil Co. Ltd., 1982 STC 30 (HL) Return to Text
11. (1967) 66 ITR 692 (SC) Return to Text
12. (1988) 4 SCC 113 Return to Text
13. (1989) 3 SCC 181 Return to Text
14. (1988) 174 ITR 502 (All) Return to Text
15. (1994) 207 ITR 618 (Cal) Return to Text
16. (1994) 208 ITR 14 (Guj) Return to Text
17. (1996) 219 ITR 6 (AP) Return to Text
18. (1998) 232 ITR 759 (Cal) Return to Text