CONCEPT OF SUBSTANCE OVER FORM IN TAXATION

[Dr. Sanjiv Agarwal]

Generally, the phrase substance over form is used in accounting and auditing to explain that the substance of the transaction should prevail over the legal form.

General accounting principle that transactions are accounted for in terms of their commercial reality (substance), not their legal form. Creative accounting, for example, does not follow this principle.

Substance over form is an accounting concept according to which the substance and not merely the legal form of transactions and events governs their accounting treatment and presentation in financial statements.

The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form (IAS, Para F.35 (1.20)].

According to Wikipedia, substance over form is an accounting principle used "to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, then the financial statements will convey the overall financial reality of the entity (economic substance), rather than simply reporting the legal record of transactions (form). In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form. Substance over form is critical for reliable financial reporting. It is particularly relevant in cases of revenue recognition, sale and purchase agreements, etc. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company's financial statements.

Substance over form in accounting refers to a concept that transactions recorded in the financial statements and accompanying disclosures of a company must reflect their economic substance rather than their legal form. Whoever prepares the financial statements of a company needs to use their judgement to derive the business sense from the transactions and events in order to present them in a manner that best reflects their true essence. At certain times the ‘legal form’' of a transaction may not provide its true image. Although the legal form can be of importance, it may be disregarded in order to present more relevant knowledge to the users of financial statements, who should not be misled.

In accounting and auditing, substance over form is an important principle used “to ensure that financial statements give a complete, relevant and accurate picture of transactions and events”. If an entity practices the ‘substance over form’ concept, then the financial statements will show the overall financial reality of the entity (economic substance), rather than the legal form of transactions (form). In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form. Substance over form is critical for reliable financial reporting. It is particularly relevant in cases of critical for reliable financial reporting. It is particularly relevant in cases of revenue recognition, sale and purchase agreements, etc. In taxation, the substance over form principle prevails all over the world. 

Relevant Judicial Pronouncements

The following judicial pronouncements further explain the concept and relevance of substance over form:

• In SUNDARAM FINANCE LTD. VERSUS THE STATE OF KERALA AND ANOTHER - 1965 (11) TMI 123 - SUPREME COURT, the Supreme Court has held that the true effect of transaction must be determined from the terms of the agreement considered in the light of surrounding circumstance. In each case, the court can, unless prohibited by statute, go behind the documents and determine the nature of transaction whatever may be form of documents.

• In W.T. SUREN AND CO. (P.) LTD. VERSUS COMMISSIONER OF INCOME-TAX, BOMBAY I. - 1968 (11) TMI 40 - BOMBAY HIGH COURT, it was held that it is an established principle of law that commercial documents must be construed in a manner as are understood in commercial parlance. These are business agreements and must be read as a businessmen would read them.

It is a settled rule that in the determination of liability to taxation under a taxing Act, the court has regard to the substance rather than the form of the transaction sought to be taxed, that is to say, in the case of an instrument that the court is not bound by its apparent tenor but will decide according to the real nature of the transaction. It is not the name of the tax but its real nature which must determine into what category it falls, at the same time it is not proper to take the motives of the assessee, in bringing about a particular arrangement, into consideration, and a subject is entitled, if he can, in any legal manner, to circumvent the incidence of a particular taxing or financing Act. It is open to parties to conduct themselves of any camouflage that the law allows and does not forbid especially in the case of an enactment for revenue purposes, such as Court Fees Act. It is not open to a court in such circumstances to neglect the actual form of the instrument and determine the question of court-fees having regard to what may be said to be the substance of the claim. Lord Summer in Levene v. Inland Revenue Commissioners, observed as follows:

"It is trite law that his Majesty's subjects are free, if they can, to make their own arrangements so that their cases may falls outside the scope of the taxing Acts. They incur no legal penalties and, strictly speaking, no moral censure if, having considered the lines drawn by the legislature for the imposition of taxes, they make it their business to walk outside them." [Based on THE JOINT COMMERCIAL TAX OFFICER, HARBOUR DIVISION II, MADRAS VERSUS YOUNG MEN´S INDIAN ASSOCIATION, MADRAS AND OTHERS   - 1970 (2) TMI 87 - SUPREME COURT; IBRAHIMSA ROWTHER VERSUS COMMISSIONER OF INCOME TAX - 1928 (2) TMI 14 - MADRAS HIGH COURT; Organon (India) Ltd. v. Collector of Excise (1977) MP LJ 119] In THE BHOPAL SUGAR INDUSTRIES LTD. VERSUS SALES TAX OFFICER, BHOPAL- 1977 (4) TMI 151 - SUPREME COURT, the court held as follows:

"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 ‘seller’ 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".

• In MOPED INDIA LIMITED VERSUS ASSISTANT COLLECTOR OF C. EX., NELLORE AND OTHERS - 1985 (2) TMI 42 - SUPREME COURT, the Supreme Court held that while interpreting the terms of an agreement, court has to look to the substance rather than the form and observed as follows:

"Now it is true that this amount allowed to the dealers has been referred to in the agreement as commission but the label given by the parties cannot be determinative because it is, for the court to decide whether the amount is trade discount or not, whatever be the name given to it."

• In BHARAT SANCHAR NIGAM LTD. (BSNL) VERSUS UNION OF INDIA - 2006 (3) TMI 1 - SUPREME COURT, it was held that before determining the nature of the taxes which can attract in the context of the Agreements, it is essential to determine the intention of the contracting parties and the true nature of the transaction as per the law declared by the Hon'ble Supreme Court in various judgment.

In judiciously examining the question of retrospectively or otherwise, the relevant considerations include the circumstances in which legislation was created and the test of fairness. The principles of statutory interpretation have expanded. With the development of law, it is desirable that the Courts should apply the latest tools of interpretation to arrive at a more meaningful and definite conclusion. A restriction was introduced providing that a person shall not be a member of a Panchayat or continue as such, if he has been elected as Councillor of Zilla Parishad or as a member of the Panchayat Samiti.

• In M/S. SUPER POLY FABRIKS LTD VERSUS COMMISSIONER OF CENTRAL EXCISE, PUNJAB - 2008 (4) TMI 31 - SUPREME COURT, the Hon'ble Supreme Court has specifically laid down the ratio as under:

"8. There cannot be any doubt whatsoever as 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 documents nor any particular activity undertaken by the parties to the contract would be decisive."