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Splitting of Composite Contracts as a means to Tax Avoidance in light of Ramsay Principle

Income Tax - Direct Tax Code - DTC - By: - Pratik Raoka - Dated:- 22-7-2015 Last Replied Date:- 30-12-1899 - Introduction Multinational Enterprises operate in a number of countries. So that the combined tax effect on their income should be minimal, they resort to devices known as income splitting or tax fragmentation. Income Splitting consists of dividing one composite contract into number of separate contracts which may be spread over a number of countries in such a manner that the bulk of the .....

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e execution of work is performed in one country and the sale of goods require for such execution, in the other. The contract agreed upon is thus divisible. The composite contract by arrangement is split up into many constitutes mainly two, one for sale of goods and other for work and labour. A transaction may be split up into a series of such transactions so that each may be looked upon as an independent source of income; though the entire series is nothing but in substance constitutes one compo .....

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Duke of Westminister (1936) AC 1 and as followed in India in CIT v. A. Raman & Co.1967 (7) TMI 2 - SUPREME Court and some other cases, has long back been given a befitting burial in W.T. Ramsay Ltd. vs IRC (1981) 1 All ER 865, IRC v. Burmah Oil Co. Ltd. (1982) STC 30 and McDowell and Co. Ltd v. CTO 1985 (4) TMI 64 - SUPREME Court . In India Justice Desai of Gujarat Jigh Court recorded a sign of departure from this principle, in Wood Polymer Ltd., In re 1977 (1) TMI 35 - GUJARAT High Court b .....

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to different tax treatment. The sum total of all is considerably less than what would have been the tax consequence had the transaction been taken as composite one whole in one country. This is based on the principle as stated in W.T. Ramsay v. IRC (1982) AC 300 , known as Ramsay Principle. The principle lays down that while the court is obliged to accept documents or transactions found to be genuine, as such, it does not compel the court to look at the document or transaction in blinkers, isola .....

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tax or a tax consequence and if that emerges from a series or a combination of transactions, intended to operate as such, it is that series or combination which may be regarded as a whole. Lord Brightman in Furniss v. Dawson (1984) AC 474 (HL) stated that the formulation of Lord Diplock in Burmal Oil Co. Ltd. (Supra) expresses the limitation of the Ramsay Principle. First, there must be pre-ordained series of transaction; or, if one likes one single composite transaction. This composite transact .....

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r rejecting a device aimed at saving the tax, formulation of law veers around two concepts: First, there should be pre-ordained series of transaction i.e., one single composite transaction; Second, there must be inserted steps which have no commercial purpose apart from the avoidance of tax liability. 1.1. Meaning of Preordained Series of Transaction : The expression Pre-ordained Series of Transaction has been subject-matter of discussion in three English Cases viz. Baylis v. Gregory (1987) STC .....

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ond transaction had already been determined by a person or persons who had the firm intention and for practical purposes the liability to procure the implementation of second transaction. Thus, the expression preordained series of transactions contemplates that the person has in contemplation the sequence of transactions when he takes the first steps, to follow that step with intention of saving tax. If there is no planning without the next step being arranged or the next step was expected but d .....

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ordained at the time of the first. In Ramsay and Dawson the reasoning had been that there is no difference between series of steps which are followed through as part of an arrangement which falls short of a contract and a series which are carried out under a contract. By the same reasoning a quasi-contract in the absence of one of the parties being identified cannot be said to be an arrangement through a contract. If there is an uncertainty and difficulty in practice about the next step, it is v .....

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of a provision of law, the formulation of which is obscure or incomplete or very complex so that he can reduce or avoid his liability while remaining within the limits of law. If, however the taxpayer is acting against the will of legislature even if he remains within the literal interpretation of law, he can be said avoiding the tax. The revenue authorities cannot brush aside any and every attempt at saving the tax if an attempt is sanctioned or hold the assessee guilty of avoidance when the s .....

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situation where the letter of the tax regulation does not apply but differs so little from a situation provided for under the regulations that the purpose and the spirit of the regulations would be frustrated if it were to be declared inapplicable. 2.2. Tax Avoidance is presumed if no valid Business Purpose: Tax avoidance is presumed to be intended if there is no valid business purpose. For example in National Securities Corp. v. Commissioner 137 F.2d 600 (3rd Cir.) (1943) , transaction was dis .....

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t recognized. In another case transaction involving distribution of Treasury Bonds as dividends to parents in effort to obtain more favorable tax treatment or gain was not recognized. Southern Bancorporation v. Commissioner; 67 T. C. 1022 (1977) Any presumption that the transfer was designed merely to obtain more favorable tax treatment of a planned disposal of the assets by the controlled group can be eliminated if the transferred assets is used rather than disposed of. See Bank of America v. U .....

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in its entirety that transaction may be disregarded for tax purposes solely on the basis that it was entered into without any bonafide business purposes. A strict business purpose test in certain circumstances would run counter to the apparent legislative intent which in the modern taxing statutes may have dual aspect. Income-tax legislation is no longer a devise to raise revenue to meet the cost of governing community. It is also employed to attain economic policies. The economic policy element .....

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ment might inhibit the taxpayer from undertaking a specific activity which the Parliament has invited in order to attain economic and social policy goals. Indeed where the Parliament is successful and the taxpayer is induced to act in a certain manner by virtue of the incentives prescribed by the legislation, it is at least arguable that the taxpayer was attracted to this incentive for business purpose of reducing his cash outlay for taxes to conserve his resources for other business activity. T .....

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he deeming provisions of section 9(1) (i) triggering capital gains taxation for non-residents is a 'look through' provision, so as to cover indirect transfer of capital assets situated in India. The judgment held that the essential condition for triggering capital gains taxation under the source rules is that the capital asset must be situated in India. Accordingly, the charge of capital gains requires the existence of all the three essential elements, (i) transfer, (ii) existence of a c .....

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ting provisions in the Act does not cover such situations. It was, accordingly, held that the question of providing a 'look through' or 'limitation of benefits' provision in the Act or in the tax treaty, is a matter of policy, and needs to be expressly provided by way of a specific legislation. The judgment in this manner lays down various cardinal principles of interpretations of taxing statutes that might impact the tax jurisprudence of the nation deeply. Perhaps most important .....

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apply to several other controversies. The Court has unanimously rejected the contention of the tax authorities that section 9(1) (i) must be given a purposive interpretation so as to include within its ambit indirect transfers of assets in India. This is a very positive finding and will have a significant impact on several other similar cases that are currently at various levels of litigation. On one hand the judgment is brought under questions for giving restrictive interpretation by excluding .....

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transactions have been sought to be taxed in other countries, though by legislative diktat, rather than judicial process. China, Indonesia, Peru, Australia are among the countries who have specifically made changes in law to deal with such issues. Interestingly, while India too has proposed a legislative change under the Direct Taxes Code to bring similar transactions to tax in India, the Indian approach is significantly wider in scope than those followed in other countries, who have sought to l .....

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ectric Corporation v DDIT [2012 (6) TMI 687 - ITAT, KOLKATA] Background: The Assessee, a Chinese company, had entered into contracts with Indian entities for setting up of turnkey thermal power projects. Each of these contracts were divided into two parts - one for supply of equipment and materials of thermal power plant and second for erection and services of units of main plant along with some common facilities. The Assessee had a project office in India which constituted a permanent establish .....

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s-fall breach clause ensuring that performance of entire project was treated as single point responsibility and non-performance of any part would be treated as a breach of whole contract. Tax Authorities arguments The contract was manipulated and artificially split up at the convenience of the foreign contractor i.e. assessee in such way that its onshore activities in India will always result in losses. The assessee s PE in India had some role to play in overall execution of the contract (includ .....

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