[Post by Shreya Rao.
An earlier post in this series can be found here.]
There is a coyness surrounding the term “lifting of the corporate veil”. It conveys a fragility of form and suggests that the legal personality of a company isn’t as robust as we assume it to be. Common law is most dismissive of such suggestions; over the 120 years since the ruling of the House of Lords in Salomon v. Salomon, English courts have emphasised again and again (and again) that the corporate form is to be respected, and that it may only be disregarded/ pierced upon satisfaction of a periodically fine-tuned list of exceptions.
Tax law has tended to be somewhat more adventurous in this regard. The defining debate in tax has been that of the relevance of substance (versus form) in construing tax statutes. This debate adds an additional prong to exceptions such as fraud and agency, which allow a disregarding of legal personality in corporate law.
Unfortunately, Indian tax cases have taken confused and often inconsistent positions on the scope and application of these exceptions, i.e., on the meaning of “substance”, “fraud” and “agency” and the situations that justify their application. Too many cases choose instead to conflate different exceptions – they apply “lack of substance”, “fraud” and “agency” as extensions of each other, without due attention to each rule. Others base their entire reasoning on “colourable device” and “sham”, easy one-size-fits-all terms that are made applicable to any situation that has or is purported to have a tax avoidance motive, or doesn’t appear quite “above board”.
This approach is problematic, squarely lacking in nuance and makes for arbitrary adjudication. A large chunk of tax jurisprudence suffers from this issue, and the ruling of the Delhi ITAT in the NDTV case is no different. This post is the second in a three-part series of posts and provides an introduction to the law on disregarding of entities in tax matters (the first post is available here). The third and last post will examine the application of these principles to NDTV and conclude with some comments on a morality-based taxation.
Grounds Allowing Piercing
Smadar Ottolenghi, in an old but enduring essay in the Modern Law Review, makes a distinction between penetrating and peeping behind the corporate veil. (See also Lord Sumption’s judgment in Prest v. Petrodel). One may “peep” behind the corporate veil to determine the true economic circumstances of a transaction, the colour of the corporate entity so to speak, without disregarding the entity. An example of this would be that of foreign owned and controlled companies under the Foreign Exchange Management Act, 1999 (FEMA). In comparison, a penetration of the corporate veil involves a true disregarding of form and could be based on the following grounds:
– Fraud and impropriety: Fraud is the foremost exception allowing a piercing of the veil. If a corporate entity is a mere device designed to defeat the interests of shareholders, creditors and other stakeholders, a court has leeway to disregard the corporate form in the interests of justice. The most important aspect of “fraud” is that it should be sufficiently proven that the stakeholder had an interest, and that incorporation was a means to subvert it. Tax evasion as a ground for piercing may find its roots in this conceptualisation of the most fundamental exception to Salomon.
– Agency: Agency implies that a company is fully directed by its shareholders and is an agent of its shareholders. As emphasised in Salomon, agency is not a true exception because its existence assumes that the agent and principal, i.e., the company and its parent, both exist. This distinction is subtle but important because the relationship of the company and shareholders (and related liabilities) should then be evaluated based on terms relevant to agency, rather than as an exception allowing piercing of the corporate form.
Under tax law, the distinction is relevant because the Income Tax Act, 1961 (ITA) is built around the concept of “tax units” or taxable persons who pay tax on a progressive basis depending on their personal circumstances. This creates a possibility of “income shifting” between tax units which are subject to differential treatment. The ITA resolves this by disregarding certain income/ asset transfers (as in the case of sections 61 and 64) or by taxing the representatives of beneficiaries with fluid/ fungible incomes (as under section 163). Select provisions also address situations of agency – for example, section 160(1)(i) of the ITA specifically states that if payments are received from an agent in India, the agent shall then be treated as a representative assesse of the non-resident in India.
However, in the absence of such a specific rule, tax law sometimes functions differently from private law, on the issue of taxing a principal on income earned by a duly authorized agent, particularly in a cross-border context. For example, in Article 5(4) of most tax treaties, a principal only has a taxable presence in India if the agent is a dependent agent who habitually concludes contracts on behalf of the principal. If an independent agent earns income as part of a one-time agency, there is no tax obligation for the principal on its business income. If this is the case, there is a critical difference between saying that “the company does not exist” versus saying that “the company is the agent of the shareholders”. Applying this principal, rulings such as the Bombay High Court ruling in Aditya Birla Nuvo may need to be re-evaluated in their analysis of agency as a condition of “piercing” of the corporate veil.
– Colourable Device: A colourable device is a “dubious” method put in place to avoid a legal liability. The key difference being that a fraud results in the evasion of an existent liability, whereas a colourable device involves an unacceptable form of avoidance that is not within the framework of the law. It is relevant to note that “acceptability” is a shifting standard and that courts today are likely to be far more conservative in outlining the limits of acceptable avoidance than courts in the past. The introduction of a GAAR regime also influences the interpretation of what may be considered colourable. However, a colourable device can only avoid an existing liability, and proving such a liability would be paramount.
– Sham: Sham assumes artificiality. The most widely accepted definition of sham is that provided by Lord Diplock in Snook v. London & West Riding Investments, [1967] 1 All ER 518, where he defined it to include acts intended to give third parties the appearance that certain legal rights and obligations have been created, which are different from the actual legal rights and obligations (if any) which the parties intend to create. Although sham, fraud and colourable device all accomplish a disregarding of corporate form, the key difference is that a fraud and colourable device turn upon subversion of an existing liability through an existing legal form, whereas a sham questions the form itself as being non-existent.
The law on these points is evolving, and reference should also be made to the “principal purpose test” and the ability to disregard a structure on the basis that it lacks commercial substance (see Vodafone International Holdings v. Union of India for some observations in this regard). Alternatively, in other common law countries, the ruling of Ramsay v. IRC, [1981] 1 All ER 865, has often been interpreted as applying a purposive interpretation to determine whether the relevant provision was intended by the legislature to apply to the transaction in question. This approach has not found favour in India.
Grounds Not Allowing a Piercing
The following circumstances are not (in themselves) sufficient to pierce the veil although they may be relied upon to support allegations of fraud, agency, colourable device and sham:
– A controlling shareholding interest. To quote para 74 of Vodafone: “A company is a separate legal persona and the fact that all its shares are owned by one person or by the parent company has nothing to do with its separate legal existence… even though a subsidiary may normally comply with the request of a parent company it is not just a puppet of the parent company. The difference is between having power or having a persuasive position.”;
– A lack of business activities;
– A commonality of directors across group company boards;
– Poor corporate governance practices such as investments/ divestments being made without requisite diligence.
Non-tax reasons such as the evidence of money laundering could be sufficient to pierce the veil. However, in the absence of evidence that the money laundering structure is intended to avoid/ evade tax, tax principles cannot form the basis of piercing. The entities should then be disregarded under the relevant principles of fraud, agency etc. under company law, or under specific provisions relating to money laundering.
To sum up the above, under tax law, a disregarding of entities would only be possible if the structure was (a) a fraud/ colourable device intended to subvert an existing obligation or (b) a sham transaction intended to create the appearance of rights and obligations that the parties did not intend to give legal effect. While agency is one of the exceptions to Salomon, as discussed above, its application does not achieve a “disregarding” of corporate form.
The next post examines the concepts of sham, agency and colourable device as applied in the judgment.
– Shreya Rao