In India, rates of taxation are not only high but tax laws are also very complicated. Therefore, a tax­payer should plan his financial affairs in such a way that he is not trapped in the tax-net. He should make every effort not only to maximise his profits, but also try to maximise post-tax profits. He should keep the incidence of tax at minimum possible point so that the profits after tax can be maximised. Tax planning is a step in this direction and, therefore, it has become indispensable for every taxpayer.

Meaning of Tax Planning. Tax planning implies keeping the incidence of tax at lowest possible point in a lawful manner. Tax planning is neither tax-avoidance nor tax-evasion. Tax planning minimises in­cidence of tax in a legal framework by taking full advantage of various tax exemptions, deductions, re­bate, relief, beneficial circulars and judicial rulings.

Tax planning is the arrangement of one's affairs in such a manner that the tax planner may either reduce the incidence of tax wholly or reduce it to the maximum possible extent as may be permissible within the framework of the taxation land. It does not amount to evasion of tax. It is an act of prudence and farsightedness on the part of the tax-payer who is entitled to reduce the burden of his tax liability to the maximum possible extent under the existing laws.

Tax planning ensures not only accrual of tax benefits within the four corners of law, but it also en­sures that the tax obligations are properly discharged to avoid penal provisions.

Tax planning should be distinguished from "tax avoidance" and "tax-evasion". Tax planning is neither tax avoidance nor tax-evasion.

"Tax avoidance" is a device which technically satisfies the requirement of the law, but in fact it is not in accordance with the legislative intent. "Tax avoidance" is an attempt to reduce incidence of tax by taking advantage of loopholes in tax laws.​​ Take an example. Prior to the amendment by the Finance Act, 1997 the income from the shipping business of a non-resident was computed on deeming basis, that is, 7.5% of the amount paid or payable on account of carriage of passengers, livestock, mail or goods. In order to reduce the taxable income from this source, some assessees started splitting their re­ceipts in such a manner that the receipts in respect of carriage of passengers, livestock, mail, etc., were reduced and the receipt in respect of other charges, such as demurrage or handling charges, were inflated. The result was that while the liability of the client remained the same, the amount on which the deemed income was computed under Sec. 44B got reduced.​​ In order to avoid the loss of revenue on this account, the Finance Act, 1997 clarified that the expression "the amount paid or payable on account of carriage" will include any charges by way of demurrage or handling, by whatever name called, and any other charges of similar nature. The amendment was made operative retrospectively, from the assess­ment year 1976-1977 and subsequent years.

Take another example. In a sale transaction, the buver directly paid the excise duty on the removal of goods from the factory. The seller did not include excise duty in "sale price". Accordingly, sales tax was charged on "sale price" exclusive of excise duty. Thus, the sales tax liability was reduced. It was held to be a case of "tax avoidance" [McDowell & Co. Ltd. v. Commercial Tax Officer (1985) 154ITR148 (SC)]. The Supreme Court has held that "tax avoidance" is illegal.

Tax avoidance is not dependable because as and when the loopholes in tax laws become public, the legislature steps in to plug them. Besides, it is also risk-bearing because sometimes the law may be amended with retrospective effect. If the time-limit for reopening or rectification of completed assess­ments has not expired by that time, they can be re-opened or rectified creating additional liability for the tax-payer. Therefore, it is not​​ advisable for a tax-payer to adopt tax avoidance as a device for tax planning. Tax avoidance is against the spirit of law whereas tax planning follows legislative intentions and opinions.

"Tax-evasion" is a device to evade or reduce tax liability by fraudulent means like suppression or omission of receipts, inflating the expenses and claiming bogus deductions/losses in fictitious transac­tions.​​ It is illegal, immoral and highly risky. A tax-evader has to pay not only monetary penalty, but he also bears the risk of prosecution proceedings being launched against him.​​ For example, where a per­son is found guilty of concealment of income, a penalty may be imposed on him. Minimum penalty is 100% and maximum penalty may extend up to 300% of the amount of tax sought to be evaded [Sec. 271(l)(c)(iii)].​​ Besides this, he may also be prosecuted. Where the amount of tax sought to be evaded exceeds Rs 1,00,000, he may be prosecuted for a minimum period of 6 months and the maximum pros­ecution may extend up to seven years and with fine [Sec. 276C(1)]. Thus, tax-evasion is not tax planning because tax evasion amounts to breach of law, whereas tax planning is devised within the legal framework by following legislative intentions.

Tax planning and tax avoidance is constitutionally legitimate​​ 

Tax avoidance and tax planning are perfectly constitutionally legitimate. Taxes are indubitably an interference with the right to property because they involve expropriation by the State without a direct corresponding benefit to the taxpayer. Under article 300A of the Constitution, every person has a right to his/her property unless it is taken away by the authority of law. In relation to expropriation of property by a tax, this principle is specifically mandated by article 265, which reads,​​ "No tax shall be levied or collected except by authority of law."​​ The corollary of this principle is that even if a tax is levied with the authority of law, any exaction over and above the bare minimum required by law is illegal and is not required to be paid by any person. This, in my view, provides the constitutional backing for tax avoidance schemes. As Lord Clyde brilliantly puts it​​ : ​​ "No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores."​​ 

The Constitution in India and in England, it appears, specifically legitimizes tax avoidance and tax planning because the right to property is the rule and the tax is the exception-and it is well accepted in law that the rule is always read wider than the exception.​​ 

Tax avoidance v. Tax evasion​​ 

Thus, the right to property to me plays a crucial role in the distinction between tax avoidance and evasion and indeed in the debate on economic growth and development. Every person is possessed of a constitutional right to orient his property in such a way so as to pay the least amount of tax and so tax avoidance is very different from tax evasion.​​ Tax evasion involves an illegality and judges must attack this but tax avoidance is as Professor Wheatcroft has quipped the "art of dodging tax without actually breaking the law".

McDowell and Co. Ltd. v. CTO (SC) Tax Avoidance v. Evasion​​ 

An interesting decision as to the impact of the judgment of the Supreme Court in McDowell & Co. v. CTO [1985] 154 ITR 148 has been rendered by the Gujarat High Court in Banyan and Berry v. CIT [1996] 222 ITR 831 (Guj). It was a case of dissolution of a firm consequent on takeover of the business of such firm as a going concern by a company. After the dissolution, additional claims in a contract were settled, but according to the terms of the dissolution agreement, such additional amount belonged to the partners in their profit sharing ratio and such share of such claim was offered by the partners individually. The Assessing Officer took the view that under section 176(3A), the firm will be liable to be assessed notwithstanding the dissolution. It was assessee's case that section 176(3A) would apply only to a case of discontinuance of business but not to a case where there has been dissolution of firm. The first appellate authority while upholding the assessment order sought to find support from McDowell's case [1985] 154 ITR 148 as in his view dissolution was prompted by the intention to avoid tax on further amounts receivable after dissolution. The Tribunal upheld the appellate order in principle, though it restored the matter to the Commissioner of Income-tax (Appeals) as to the year in which such profit will be assessable. The Gujarat High Court found that the factum of transfer of business subject to the right of​​ recovery of arrears was not found to be non-genuine. Since there was no other business or activity of the firm except for pending recovery on disputed claim, dissolution cannot also be lightly described as a device to avoid tax and there is nothing unusual in such an arrangement.​​ 

It was in the above context that the court discussed the concept of tax avoidance in the light of the Westminster principle enunciated in Duke of Westminster v. IRC [1935] 19 TC 490 and the decision in Furniss v. Dawson [1984] 1 All ER 530 (HL), which diluted the Westminster principle by setting limits within which the principle could operate. The High Court held that neither McDowell's case [1985] 154 ITR 148 (SC) nor the precedents on which the principle in that case was based applied to the assessee's case where it is only a suspicion, which treated dissolution as a device for avoidance of tax irrespective of legitimacy or genuineness of the act.​​ While McDowell's case [1985] 154 ITR 148 deprecated the methodology of tax avoidance, its objection was to tax avoidance by resorting to colourable devices or "dubious methods" or "subterfuges".​​ The Gujarat High Court observed in Banyan and Berry v. CIT [1996] 222 ITR 831 at page 851 as under:​​ 

That is to say what has been deprecated as tax planning for avoidance of tax are those acts which have doubtful or questionable character as to their bona fides and righteousness.​​ Not all legitimate acts of a taxpayer which in the ordinary course of conducting his affairs a person does and under law he is entitled to do, can be branded as of questionable character on the anvil of McDowell's case [1985] 154 ITR 148 (SC).​​ We are unable to read in the aforesaid decision that any act of an assessee which results in reduction of his tax liability or expectation of tax benefit in future amounts to colourable device, a dubious method or subterfuge to avoid tax and can be ignored if the acts are unambiguous and bona fide, merely on the ground that treating those as deliberate would result in tax liability in future.​​ 

While the planning adopted as a device to avoid tax had been deprecated, the principle cannot be read as laying down the law that a person is to arrange his affairs so as to attract maximum tax liability, and every act which results in tax reduction, exemption of tax or not attracting tax authorised by law is to be treated as device of tax avoidance."

It also relied on the view of a subsequent decision of the Supreme Court in CWT v. Arvind Narottam [1988] 173 ITR 479, where it was held that the legal consequences of a transaction cannot be ignored where the language of the document is plain and creates legal rights or liability.​​ It was observed by Sabyasachi Mukharji J. as he then was in a separate concurring judgment in CWT v. Arvind Narottam [1988] 173 ITR 479 at page 487 as under:​​ 

". . . where the true effect on the construction of the deeds is clear, as in this case, the appeal to discourage tax avoidance is not a relevant consideration. But since it was made, it has to be noted and rejected."

The High Court further found that it was not a case of discontinuance of business and that a firm that is dissolved cannot be resurrected as to bring it to tax. Since the Revenue seeks to read more into McDowell's case [1985] 154 ITR 148 (SC) than what it lays down, this decision of the Gujarat High Court in Banyan and Berry's case [1996] 222 ITR 831 should help to reduce the abuse of McDowell's case [1985] 154 ITR 148 (SC) in dealing with bona fide business arrangements with incidental fallout by way of tax benefits. The concept of introducing tax avoidance as a test for considering taxability or otherwise in a transaction has created unnecessary controversies. McDowell's case [1985] 154 ITR 148 (SC) in substance can have application only where colourable or artificial devices are adopted and not to transactions which are otherwise legitimate and are undertaken bona fide in the ordinary course of business.​​ 

The frequent use of McDowell's case [1985] 154 ITR 148 (SC) has led to a cynical inference that all successful attempts at evasion can pass as legitimate tax avoidance, while unsuccessful attempts, even if it be a case of legitimate tax reduction, may well be inferred as evasion. The borderline is often too thin but then the decision in Banyan and Berry's case [1996] 222 ITR 831 (Guj) does throw some further welcome light on the subject.