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Doctrine of 'Substance over form' in lieu of Indirect taxes

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Doctrine of 'Substance over form' in lieu of Indirect taxes
Palak Rawat By: Palak Rawat
June 13, 2022
All Articles by: Palak Rawat       View Profile
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Doctrine of ‘Substance over form’ - Will there be light at the end of the tunnel?

Abstract -

The doctrine of substance over form is an accounting principle which determines the economic impact of the transaction instead of its legal form. This doctrine dates back in the 1930s and since that time the doctrine has taken on different forms with case laws. In India it was the Mcdowell's case which actually incorporated the doctrine for its application on taxation statutes. Later with cases like Azadi Bachao, In re Hari Chand, Acer India etc. a new tussle over interpretation was triggered which favoured the legal form over economic substance when it comes to deciding the taxing liability. This is followed by developments in the Vodafone case and coming up with GAAR principles. The SC in its recent case of CCE v. Northern Holdings re-triggered  the debate on ‘substance over form’ and the implication of GAAR principles on the same. The court explicitly favoured the implementation of doctrine in the indirect tax regime.

This note in its first part deals with the introduction of the doctrine and the reason/aim/objective behind its implementation. The second part deals with the evolution of doctrine with the first case of Gregory v. Helvering, the contradicting decisions and divisions over Fisher and Westminster case with Ramsay and Burmah Oil case, coming up with GAAR principles etc. The third part consists of two areas - first deals with case laws in which the court has discussed and applied the doctrine in taxation regime and the other part deals with case laws in which the court favoured legal form over substance. The fourth part deals with the recent SC ruling which has opened a whole book for interpretation and discretion to the authorities in relation to GAAR principles. This is an attempt to answer - if there will be an end to the debate of ‘substance over form’ and ‘form over substance’ in taxation matters i.e will there be light at the end of the tunnel? 

Introduction -

The substance over form principle is a tax doctrine, also widely referred to as the “economic substance” doctrine, gaining currency across diverse legal systems for its effectiveness in redefining the legitimate reach of the sovereign tax net. It is a pretense for the seemingly invasive discretionary power vested in the revenue authorities to inquire into the subject matter of a suspicious transaction in order to ascertain if the transaction is taxable in essence but tends to escape the tax liability under its deliberately designed elusive legal form. The doctrine implies that a tax benefit or exemption from liability that cannot be achieved directly, cannot be achieved indirectly either. Its application is based on the rationale that entities in the same economic position should bear the same tax burden. It challenges the legal form of transaction and substitutes it with economic form i.e commercial reality to tax it accordingly. It is to be applied only when the authorities are able to establish that the transaction is a sham. 

The main objective is to serve the overall importance of faithful representation and to give effect to the main objects of tax statutes and treaties. This common law concept has developed through time as a counter-tool to expose and determine the tax avoidance purpose of varied corporate legal tax arrangements that exploit the grey areas of tax legislation and treaties. Thus, filing the financial statements and accompanying documents should reflect the realities of accounting transactions to avoid misleading intentions to escape tax and debt liabilities which are to be reflected in any entity’s balance sheets. In certain transactions there might be situations when legal and economic aspects of a transaction are not concentrated at one place i.e they are segregated and thus it becomes difficult to levy tax correctly. However this economic aspect/substance has no relation with possession or use but is done on the basis of risks and rewards. 

Evolution - 

One of the earliest applications of this doctrine can be traced back to the American case of Gregory v. Helvering, wherein the US Supreme Court concurred with the decision of the Commissioner of Internal Revenue that the corresponding corporate reorganization by the appellant was solely a means to evade tax liability. Although the form of the transaction was legal but in substance and spirit it was a violation of the law. Hence, a question over the conformity with the letter of law versus the intent of the act was raised and the Court held that the ultimate test for legality of a transaction would be its conformity with the intendment of a statute. Thereby, it gave primacy to the intent or substance of the transaction. The scope of the doctrine determined till date, depending on the judicial and legislative treatment of the doctrine, consists of the following cognate principles and facets - wrong characterization, step transaction, sham transaction, business purpose and economic substance. Thus, the principal advocates a check on certain germane issues like sham and step transactions, business purpose, and economic substance.

However, considerable uncertainty regarding the ‘economic substance’ doctrine was observed in the global legal fraternity, especially with the ruling in the Westminster case which somewhat favored the ‘form over substance’ doctrine. The judgment ascribed legitimacy to tax planning measures as long as they did not breach the legal threshold, emphasizing the difference between tax avoidance and illegal tax evasion practices and applying the strict rule of interpretation for taxing statutes. 

In India, the courts have applied the Substantial compliance test over a period of time in matters of taxation along with the strict rule of interpretations. This test dispenses complete compliance with statutory provisions and it is sufficient for taxpayers to demonstrate that provisions are complied with substantially. This test had been in vogue in Indirect taxes although indirectly. In the case of CCE VERSUS M/S HARI CHAND SHRI GOPAL [2010 (11) TMI 13 - SUPREME COURT] the court ruled that -

“…..Substantial compliance means actual compliance in respect to the substance essential to every reasonable objective of the statute and the court should determine whether the statute has been followed sufficiently so as to carry out the intent of the statute and accomplish the reasonable objectives for which it was passed. Fiscal statute generally seeks to preserve the need to comply strictly with regulatory requirements that are important, especially when a party seeks the benefits of an exemption clause that are important. Substantial compliance of an enactment is insisted, where mandatory and directory requirements are lumped together, for in such a case, if mandatory requirements are complied with, it will be proper to say that the enactment has been substantially complied with notwithstanding the non-compliance of directory requirements. In cases where substantial compliance has been found, there has been actual compliance with the statute, albeit procedurally faulty.”

The decisions In re Hari Chand Shri Gopal and In re Meridian Industries Ltd. were rendered in the context of taxability of products and application of rate of tax. This lack of consistent approach could also be seen in the Indian legal framework where a tussle between a strict and more purposive interpretation of tax statutes remained pertinent.

Application of Doctrine in case laws - Indian Scenario

The most important case in respect of ‘substance over form’ is McDowell and Co. Ltd. v. CTO as it had imported the ‘substance over form’ doctrine by diffusing the distinction between tax avoidance and tax evasion and holding them in a similar light. 

It pressed on an individual’s duty of paying their tax liabilities without resorting to any subterfuge, thereby narrowing down the definition of legal tax planning. The case was about mitigation of sales tax by having the buyers separately pay the excise tax such that this is not covered in the taxable basis of sales tax to be paid by the company. The court held that the excise duty did not become part of the circulating turnover of the Mcdowell's distillery as the same was paid directly to the excise authorities by the buyers thus not becoming part of the sales tax over the turnover of the company. 

This view was, however, not followed in the Division Bench judgment of Azadi Bachao Andolan which reverted back to the ‘form over substance’ principle which explicitly disowned the McDowell case ruling and marked a retreat to the narrow ‘form over substance’ dictum of the West Minster case, which was accepted by the Privy Council in the Bank of Chettinad case. 

After quoting a passage from the judgment of the Privy Council in the case of Bank of Chettinad Ltd. v. CIT this Court stated -

“.....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'. (p. 607)”

The same judge, speaking for himself, Ramaswami and Grover, JJ. in COMMISSIONER OF INCOME-TAX, GUJARAT II VERSUS BM KHARWAR  [1968 (8) TMI 14 - SUPREME COURT] case (supra) expressly followed Westminster and observed and cited the same. 

Further it was also exemplified in State of Rajasthan v. Basant Agrotech (India) Ltd. wherein the Supreme Court quoted with approval the opinion of the Privy Council in the celebrated Bank of Chettinad case and other leading decisions to conclude that taxation based on ‘substance of the matter’ was antithetical to the settled jurisprudential norms. The court observes - 

“14. The said passage, as has been stated in the said pronouncement, was quoted with approval by the Privy Council in Bank of Chettinad v. CIT AIR 1940 PC 183 and the Privy Council had registered its protest against the suggestion that in revenue cases "the substance of the matter" may be regarded as distinguished from the strict legal position. Proceeding further the learned Judge stated that:

"It is no doubt true that in construing fiscal statutes and in determining the liability of a subject to tax one must have regard to the strict letter of the law and not merely to the spirit of the statute or the substance of the law. If the Revenue satisfies the Court that the case falls strictly within the provision of the law, the subject can be taxed. If, on the other hand, the case is not covered within the four corners of the provisions of the taxing statute, no tax can be imposed by inference or by analogy or by trying to probe into the intentions of the legislature and by considering what was the substance of the matter." [Emphasis supplied]”

A five-Judge Bench in Kone Elevator India (P) Ltd. v. State of T.N. reversed an earlier three-Judge Bench decision which had inter alia opined that it is settled law that the substance and not the form of the contract is material in determining the nature of transaction.

Similarly a three-Judge Bench in BSNL v. Union of India reversed a two-Judge Bench decision in State of U.P. v. Union of India which had stressed upon the substance test stating that the terminology employed to describe an activity as sale or service is not conclusive in itself. By calling sale as service or vice versa, the substance of the transaction will not get altered. The question has to be determined, by discerning the substance of the transaction in the context of the contract between the parties or in a case of statutory contract in the light of the relevant provisions of the Act and the Rules. Thus before determining the taxes which could be imposed in relation to an agreement the intention of the parties and nature of transaction is to be determined as per law laid down by the Apex court. Thus clearly, the substance over form debate has generally been rejected in its application in the realm of indirect taxes. The decision in Bharat Sanchar Nigam Ltd. wherein it has been clearly stated that the dominant nature test has no application. The said principle has been reiterated in Larsen & Toubro Ltd. by stating thus -

“97.6. The dominant nature test has no application and the traditional decisions which have held that the substance of the contract must be seen have lost their significance where transactions are of the nature contemplated in Article 366(29-A). Even if the dominant intention of the contract is not to transfer the property in goods and rather it is rendering of service or the ultimate transaction is transfer of immovable property, then also it is open to the States to levy sales tax on the materials used in such contract if such contract otherwise has elements of works contract. The enforceability test is also not determinative.”

Having said that, it would not be correct to state that in the indirect tax realm the “substance” debate has never arisen. For illustration, tax benefits have been denied by the courts in situations where allegations of fraud and subterfuge have been factually demonstrated.

Over the years, the judiciary has vacillated between adopting a literal/strict interpretation of statutes and a purposive one established on facts and documentary evidence. In Ardex Investments Mauritius Ltd., it was held that while determining the substance of a transaction, the Department must undertake an objective test based on documentary evidence and lifting the corporate veil, rather than presuming the transaction to be a sham. It must be noted here that while the literal interpretation is given primacy, the judiciary has evolved to adopt a construction favorable to the assessee in case of any uncertainty or ambiguity regarding the statutory interpretation. Thus, if the transaction does not specifically fall under the provision, the scope of the tax statute must not be unnecessarily widened to implicate the assessee. On the other hand, if the taxing provisions are unambiguous, full thrust must be given to them without any consideration of equity. It is also established that a liberal interpretation must give way to a reasonable one to avoid causing any infraction to the plain language of the statute. Hence, it becomes quintessential for the Department to analyze the factual matrix of the case while determining the nature of the transaction, i.e., whether the ‘investment transaction is for participation’ or is it a ‘pre-ordained transaction for tax evasion.’ 

One of the leading decisions in indirect taxation is the three-Judge Bench verdict in the CCE v. Acer India Ltd. While determining the valuation of supply a unanimous Supreme Court categorically ruled out the application of the substance over form test in this sphere of tax laws. Explaining the relevant propositions in the decision, under the heading “principles of interpretation of a taxing/fiscal statute”, the Supreme Court inter alia culled out the following rules governing the interpretation -

“33. It is also a well-settled rule of construction of a charging section that before taxing a person it must be shown that he falls within the ambit thereof by clear words used as no one can be taxed by implication. It is further well settled that a transaction in a fiscal legislation cannot be taxed only on any doctrine of “the substance of the matter” as distinguished from its legal signification, for a subject is not liable to tax on supposed “spirit of the law” or “by inference or by analogy.” The taxing authorities cannot ignore the legal character of the transaction and tax it on the basis of what may be called “substance of the matter.” One must find the true nature of the transaction.”

Thus the ‘substance over form’ test was held to be falling with the prescription against taxation by ‘inference or analogy.’ Notwithstanding, it goes without saying that the emphatic emphasis placed in decision on the substance over form test poses issues in the specific context of indirect taxes. Having thus concluded that a factual reappreciation was indeed warranted, the Supreme Court culled out the underlying aspects of the contractual terms which were perceived to exist by it. The court even reflected upon the changing global economic dimensions and international hiring of labour to re-emphasise the need for applying the test of ‘substance over form’ requiring a close look at the terms of the contract, or the agreements.

Some guidance in this regard has been provided in the Vodafone case wherein a few parameters were laid down by the Hon'ble Supreme Court to distinguish between the same; namely the concept of participation, period of existence of the holding structure, period of business in India, generation of taxable revenues, the time of exit and continuity of business during such time. The Apex Court, in this case, ruled that the Department must employ the ‘look at’ test by looking at the transaction holistically rather than the ‘look through’ test by splitting/dissecting the transaction. The Court also advised against the authorities reaching any premature conclusions premised on suspicions and cautioned against applying the ‘substance over form’ test until evidence was found indicating the duplicitous nature of the transaction. Thereby indicating the importance of the initial factual and functional assessment based on the ‘look at’ test and substance over form principle undertaken by revenue authorities while determining tax liability cases. The court observed that -

“68. When it comes to taxation of a Holding Structure, at the threshold, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and/or use of such structure(s). In the application of a judicial anti-avoidance rule, the Revenue may invoke the “substance over form” principle or “piercing the corporate veil” test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant. To give an example, if a structure is used for circular trading or round tripping or to pay bribes then such transactions, though having a legal form, should be discarded by applying the test of fiscal nullity. Similarly, in a case where the Revenue finds that in a Holding Structure an entity which has no commercial/business substance has been interposed only to avoid tax then in such cases applying the test of fiscal nullity it would be open to the Revenue to discard such inter-positioning of that entity. However, this has to be done at the threshold. In this connection, one may reiterate the "look at" principle enunciated in W.T. Ramsay Ltd. case (supra) in which it was held that the Revenue or the Court must look at a document or a transaction in a context to which it properly belongs to. It is the task of the Revenue/Court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach. The Revenue cannot start with the question as to whether the impugned transaction is a tax deferment/saving device but that it should apply the "look at" test to ascertain its true legal nature.

75. This Court in CIT v. Sri Meenakshi Mills Ltd., AIR 1967 SC 819 held that the Court is entitled to lift the veil of the corporate entity and pay regard to the economic realities behind the legal facade meaning that the court has the power to disregard the corporate entity if it is used for tax evasion. In Life Insurance Corporation of India. Escorts Ltd. (1986) 1 SCC 264, this Court held that the corporate veil may be lifted where a statute itself contemplates lifting of the veil or fraud or improper conduct intended to be prevented or a taxing statute or a beneficial statute is sought to be evaded or where associated companies are inextricably as to be, in reality part of one concern. 

84. House of Lords, later in Inland Revenue Commissioner v. McCruckian (1997) BTC 346 said that the substance of a transaction may be considered if it is a tax avoidance scheme.”

Further, in the earlier case of Super Poly Fabriks Ltd. v. Commissioner of Central Excise, Punjab  the Supreme Court held that a contract or an agreement has to be read as a whole to understand the purpose and object of the parties agreeing to the laid down terms and conditions. Moreover if the terms used in the agreement are not conclusive one has to look at the substance of the transaction over form such that it is not always possible that the name given to a transaction would depict the real nature of the transaction to ascertain valid taxes. 

“8. There cannot be any doubt whatsoever that a document has to be read as a whole. The purport and object with which the parties thereto entered into a contract ought to be ascertained only from the terms and conditions thereof. Neither the nomenclature of the document nor any particular activity undertaken by the parties to the contract would be decisive.”

In the case of Nilkanta Narayan Singh v. CIT, the court held that even though the agreement was by the name ‘operating agreement’ but the company involved i.e IHCL has also provided services in terms of management and business consultancy thus looking at the substance of the transactions performed by the company. 

“…..But in the application of the law relating to income-tax, the principle is well established that the name given to a transaction by the parties does not necessarily decide the nature of the transaction. It is the substance and not the form of the contract that should be regarded. In analysing the transaction it is not necessary that the documents should be construed from the purely legal aspect. It is open to the High Court not merely to look at the documents but consider the surrounding circumstances so as to conclude what is the real character of the transaction.”

In the case of Bhopal Sugar Industries limited v. STO the issue was in relation to the terms used in an agreement i.e whether the use of words agent, buyer, seller etc. would be sufficient to depict the status of the concerned parties? The court held that -

“It is well settled that while interpreting the terms of the agreement, the Court has to look to the substance rather than the form of it. The mere fact that the word 'agent' or 'agency' is used or the words 'buyer' and 'sell- er' are used to describe the status of the parties concerned is not sufficient to lead to the irresistible inference that the parties did in fact intend that the said status would be conferred. Thus the mere formal description of a person as an agent or buyer is not conclusive, unless the context shows that the parties clearly intended 'to treat a buyer as a buyer and not as an agent.”

Thus while interpreting the terms of an agreement the court has to look into the substance of the same rather than its form only i.e a mere formal description of a person as agent or buyer will not be sufficient to conclude that the parties clearly intended to treat a buyer as a buyer and not agent. This is inferred by looking at the whole context and activities of the parties to an agreement. 

In the case of Moped India ltd. v. Assistant Collector Central Excise the court observed that in any commercial transaction the substance must be recognised rather than its form. The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form. Thus while determining the liability in a taxing statute the court has to decide according to the real nature of the transaction as it is not the name of the tax but the real nature of its transaction to decide which category the event falls into to be taxed.


“......the true effect of a transaction may be determined from the terms of the agreement considered in the light of the surrounding circumstances. In each case, the Court has, unless prohibited by statute, power to go behind the documents and to determine the nature of the transaction, whatever may be the form of the documents.”

This is however in complete variation to the long standing and universally accepted strict rule of interpretation in taxing statutes as it was held in the case of Cape Brandy Syndicate v. IRC - in a taxing statute one has to merely look at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to tax. Nothing is to be read in, nothing is to be implied. 

Coming up of the GAAR Principles -

These principles were formulated to deal with certain sets of transactions entered into by entities, with the sole objective of reducing or shifting the tax base, etc to the detriment of the Exchequer. The net effect of the GAAR provisions is to disregard the legal form of these transactions and look only at the substance, that is the ‘Commercial Reality/Economic substance’ and tax the entity accordingly. Obviously, these relate to a specific set of transactions entered into with the only significant objective of reducing tax liability. 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. Just after the Vodafone judgment the government announced the introduction of GAAR principles which allow authorities to look at the substance of a transaction over rule and the same is applied with retrospective effect codifying substance over form doctrine. However, the application of GAAR is permitted only in the wake of an elaborate set of procedural regimentation and substantive declaration of safeguards of taxpayer’s rights. 

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 opens yet another chapter in the mystery surrounding the interpretation of “substance” and thus the question which arises is, does the “substance” debate end when GAAR comes into force? 


The taxing regime recently had a spur of debate because of the Supreme Court judgment in Commr. of Customs, Central Excise and Service Tax v. Northern Operating Systems (P) Ltd. in which the court declared that they have consistently applied one test - Substance over Form. The court had ruled the same in spite of previously revalidating the taxpayers choice of form of transaction which continue to hold the field in view of the conspicuous parliamentary abstinence to enact “general anti-avoidance rules (GAAR)” in the indirect tax paradigm unlike the income tax law and following the general rule of interpretation i.e legal structure is the essence when it comes to taxing a transaction. In this case the debate arose on the nature of the transaction and the economic relationship underlying the agreements entered by Northern Operating Systems with its group companies located in other countries in relation to seconded employees and for a demand of service tax raised by the tax authorities. 

The Court observed that - 

“3. One of the cardinal principles of interpretation of documents, is that the nomenclature of any contract, or document, is not decisive of its nature. An overall reading of the document, and its effect, is to be seen by the courts. Thus, in State of Orissa v. Titaghur Paper Mills Co. Ltd. it was held as follows:

“120. It is true that the nomenclature and description given to a contract is not determinative of the real nature of the document or of the transaction thereunder. These, however, have to be determined from all the terms and clauses of the document and all the rights and results flowing therefrom and not by picking and choosing certain clauses and the ultimate effect or result as the Court did in the Orient Paper Mills case (1977) 2 SCR 149)”.

54. This principle was reiterated in Prakash Roadlines (P) Ltd. v. Oriental Fire & General Insurance Co. Ltd.

55. The task of this court, therefore is to, upon an overall reading of the materials presented by the parties, discern the true nature of the relationship between the seconded employees and the assessee, and the nature of the service provided - in that context - by the overseas group company to the assessee.

58. As discussed previously, there is not one single determinative factor, which the courts give primacy to, while deciding whether an arrangement is a contract of service (as the assessee asserts the arrangement to be) or a contract for service. The general drift of cases which have been decided, are in the context of facts, where the employer usually argues that the person claiming to be the employee is an intermediary. This court has consistently applied one test : substance over form, requiring a close look at the terms of the contract, or the agreements.”

Thus, a question arises whether substance over form test is permissible within the confines of indirect tax laws given the Parliament’s abstinence to enact such laws in this space despite making amends in income tax framework  or does it indicate a paradigm shift in national and transnational tax frameworks towards substance over form principle which could spark a divide and debate within the taxation community over application of this doctrine.


By: Palak Rawat - June 13, 2022



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