In a recently concluded edition of IFA’s International Tax conference in Bangalore, the topic of Form and Substance was discussed, albeit not for the first time. This time around however, there was a sense of urgency and uncertainty around it with the BEPS clouds gathering coupled with the General Anti Avoidance Rules (GAAR) thunder.

The Wikipedia definition of “Substance” suggests a very narrow connotation of the word, restricting it to financial statements showing the financial reality of the entity (economic substance) rather than the legal form of transaction (form). In the tax world today, this connotation has expanded exponentially. Here’s why.

Compare the Wikipedia definition with what the IBFD has defined in its International Tax glossary. There, substance over form is an “anti-avoidance doctrine under which the legal form of an arrange­ment or transaction is ignored, tax being levied in accordance with the economic substance. The legal form refers to the legal conditions used to define a tax rule and typically includes pri­vate law concepts. Although the doctrine is generally associated with common law legal systems, similar concepts exist in civil law countries.”

There are several other definitions of “substance” or “economic substance” in the context of taxation but I thought the definition used by the Internal Revenue Service (IRS) of The United States seems most appropriate. Per this definition, a transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside from the tax effect in order to be considered valid. The IRS follows this doctrine to determine whether tax shelters, or strategies used to reduce tax liability, are considered "abusive”.

The OECD Model Tax Treaty has laid down specific and general limitation of benefits in several clauses of the Model. The concept of beneficial ownership, qualifying persons and general purpose test enshrined in the Model and thereafter adopted in specific bilateral treaties signed between countries is well established. However, for the larger issue of treaty shopping or abuse, the OECD model commentary does indirectly indicate that jurisdictions should either incorporate limitation of benefit clauses in specific agreements or adopt anti avoidance provisions in domestic laws.

The genesis of this definitions is traced back to legal jurisprudence, particularly in the United Kingdom. In IRC v Fisher’s Executors (1926) and IRC v Duke of Westminster (1936) the law set forth the contention that 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. In other words, managing affairs in a manner that reduces the tax burden is legitimate tax avoidance and is different and distinct from what can be interpreted as deliberate tax evasion. Many years later, the rulings in IRC v W T Ramsay and IRC v Burmah Oil Co Ltd. (both 1982) and Furniss vs Dawson (1984) seemed to suggest, as was dramatically expressed, that the ghosts of Fisher and Westminster have been exorcised in the country of its origin. These subsequent cases were first interpreted as being diametrically opposite to the principles of Fisher and Duke of Westminster. However, subsequent application of mind revealed that the Ramsay case, for example, did not completely discard the principles of Fisher and Westminster. They merely looked at whether schemes resulting in reduction of tax were indeed genuine and compelled stakeholders to look at the “substance” of the matter to give effect to the true legal position.

In India, The McDowell case in 1985 had proceeded in the lines of Ramsay and Burmah Oil and referred to “colourable devices” and “dubious methods” to avoid Tax. The McDowell case was effectively the trend setter in Indian jurisprudence to establish that the ghosts of Fisher and Duke of Westminster were not existent in India. It was felt then that India would be harsh with tax avoidance and an extremely thin line would run between how tax evasion versus tax avoidance could be interpreted and distinguished.

However, Azadi Bachao Andolan in 2003 [TS-5-SC-2003-O] took the country by storm yet again. It was felt, before the ruling was pronounced by the Supreme Court, that given the existing jurisprudence as laid down by McDowell and the approach of the administration and judiciary in general, the Azadi Bachao case would drive the last nail in the coffin of any possible distinction between tax avoidance and evasion and render the Indo-Mauritius treaty as a deceitful misuse of the bilateral agreement. However, the ruling went against those expectations and the “ghosts” of Fisher and Duke of Westminster were resurrected. Azadi Bachao Andolan, in a nutshell, recognised the merits of both sides of the spectrum. The Supreme Court, in this case, iterated that it was unable to comprehend the majority ruling of the McDowell’s case. In layman terms, The Court felt, in their wisdom, that McDowell was extreme in its judgement. Then along came Vodafone, retroactive amendments following leading to the Protocol to the Indo-Mauritius Treaty in 2016 amending the Capital Gains exemptions enjoyed under the Treaty thus far. The Vodafone case, in my view, was not bad law. It merely exposed the clinks in the armour of how the domestic law was laid down and interpreted.

The interpretation of “Substance” is far from settled. The Base Erosion and Profit Shifting (BEPS) initiative shifts the entire focus to treaty shopping and other treaty abuse that undermines tax sovereignty by claiming benefits that were not intended to be granted. Dealing with Treaty interpretation is more complex in as much as, substance is not interpreted with regard to Legislative Intent (that goes into making laws) but regards the intent of the Parties or Countries entering into double tax avoidance agreements that make the interpretation that much more complex. I am not touching upon this aspect in this article since that is a separate matter of equal importance. I will also not deal with BEPS Action 6 dealing with Treaty Abuse and Treaty shopping since that again, is a separate matter of equal importance and immensely subjective.

Let us therefore, dive into how the General Anti Avoidance Rules (GAAR) that are coming into effect from April 2017 impact the concept and understanding of “Substance”. The question is, does the “substance” debate end when GAAR comes into force? The general perception of GAAR is that there is no room for any tax avoidance and the gap between avoidance and evasion is now effectively bridged. In GAAR, the concept of impermissible avoidance arrangements envisages situations where such an arrangement’s main purpose is to obtain a tax benefit and it lacks commercial substance.  The first limb gets specifically defined in section 96(2) of the Income-tax Act, 1961 (the Act). The second limb relating to commercial substance gets a definition in section 97 that leaves a lot open to interpretation. How these interpretations are going to pan out when GAAR comes into force from April 2017 open yet another chapter in the mystery surrounding the interpretation of “substance”. Will there be light at the end of the tunnel?