Tax Audit-an Instrument of Legislative Change

By R.S. Gupta, Director of Receipt Audit, India

In the audit of taxes, which are controlled more by laws than by financial rules and procedures, a positive role would, naturally, include improvement of the tax laws themselves. Occasions for this can arise in a number of ways. Audit may find that a literal interpretation of the legal provisions does not really effectuate the true legislative intention or there may be large scale tax avoidance. There may also be cases where certain situations are just not provided for in the law or there are apparent loopholes or lacunae in the law which enable taxpayers to evade and/or avoid payment of taxes. In highlighting the weeknesses of the legislative frame-work in such cases, Audit can be an instrument of legislative change. In making such suggestions, however, Audit has to be highly circumspect because without a very clear grasp of the facts and circumstances of the case and even of the total socio-economic milieu, it may not be easy to say that the true intention of the legislature is not what the plain language of the law says or that an escape route is a devise of tax avoidance rather than a deliberate concession.

The following paragraphs give a few case studies to illustrate this aspect of the role of audit of taxes in the light of Indian experience.

These case studies have been selected out of a very large number of legislative changes made in the last few years on the basis of points taken in the audit of taxes.

I. Fees for Technical Know-how-Taxation of

A non-resident person, i.e. a person who has not been physically present in India for the specified number of days during the particular tax year, is liable to income-tax in India only in respect of the income accruing or arising to him in India. By virtue of a deeming provision in the Income Tax Act, however, any income accruing or arising to such person through or from any business connection in India, is considered to be income accruing or arising in India. A business connection has been held to involve a relation between a business carried on by a non-resident which yields profits or gains and some activity in India which contributes directly or indirectly to the earning of such profits or gains. In the case of a business of which all the operations are not carried out in India, however, the income deemed to accrue or arise in India, is only such part of income as is reasonably attributable to the operations carried out in India.

In the audit of tax assessments of a steel company in India, it was noticed that the company had entered into a technical collaboration agreement with a foreign party. Under the agreement the foreign party was to provide technical know-how to the Indian company and to advise it on production processes and operating problems. It was claimed that the income accruing to the foreign party by way of technical fees paid by the Indian company under this agreement was, either totally exempt from tax in India on the ground that all copies of written formulae, standards, processes and technical and other data containing the technical know-how contemplated in the agreement were transferred to the Indian company outside India and the technical fees were paid outside India, or atleast it was partially exempt because all the operations of this transfer of technical know-how were not carried out in India. In audit, it was pointed out that in terms of the aforesaid technical collaboration agreement the transfer of technical know-how was not confined to the mere transfer of written documents, but was a continuing process of imparting knowledge to the Indian company over the entire period of the agreement, that there was a business connection between the foreign party and the Indian company and that the income accruing to the foreign party was, therefore, subject to Indian tax.

The case gave rise to innumerable questions to which the then existing provisions of the Income-tax Act gave no clear answers. If the technical literature was all transferred outside India and the payments were also made outside India, was there any taxable income under the doctrine of 'business connection' ? If the foreign party deputed technical personnel for providing training to the Indian party would that constitute 'business connection? Would it make any difference if such personnel deputed by the foreign party were paid directly by the Indian party instead of being paid by the foreign party? If all or any part of the income were subject to tax in India what would be the allowable expenses? It was evident that the law on the point was not clear and the position was unsatisfactory for the Revenue, for the foreign collaborator who could have no clear idea of his Indian tax liability and for the Indian entrepreneur whose attempts at importing much needed technology would be thwarted in the circumstances.

To overcome difficulties, the law was amended substantially. Under the amended provisions of the law the taxability of income of a non-resisdent from royalty or technical fees is no more determined under the aforesaid doctrine of 'business connection'. A source rule has been embodied in the law according to which such income is taxable in India if it represents payments made by:

government, or
a resident person except in connection with a business or profession or a source of income outside India, or
a non-resident person in respect of a business or profession or source of income in India.

Further, under the amended law, where such income is taxable on the basis of this source rule, it is taxed on gross basis without allowing any expenses, but at a reduced rate of 40% as against the normal rate, aplicable to business profits of a company, of 70%.

II. Taxation of Foreign Companies-Head Office Expenses

After spelling out certain expenses allowable against business income, the Indian Income Tax Act goes on to lay down a general principle that any expenditure of a revenue nature, 'laid out or expended wholly and exclusively for the purposes of the business' shall be allowed in computing the income from business. This provision is wide enough to allow expenses, wherever incurred as long as it is established that these have been incurred for purposes of the business of which the income is to be computed for tax.

In the income-tax assessment of the Indian branch of a foreign company it was noticed that substantial amounts had been claimed by the company on account of general administrative expenses of its foreign head office. In allowing these claims no enquiries appeared to have been made whether all the amounts included represented legitimate business expenses much less whether all of them were correctly allocable to the Indian business of which the profits were being computed for tax. Further enquiries and examination of the revenue department by the Public Accounts Committee brought out the following facts:-

There were no guidelines in the Act, rules or departmental instructions about the correct allocation of head office expenses of foreign companies against the profits of their Indian branches.
The claims made by different companies comprised a variety of expenses such as, advertisement and publicity expenses, research and development expenses, general administration and management expenses, etc. These included expenses incurred by the head office specificially for the Indian branch, overhead expenses incurred by the head office for all foreign branches, as well as expenses incurred by the head office which could not be identified with any particular branch or branches. In the absence of any guidelines the revenue officials were not obtaining any detailed analysis of the expenses, nor following any understandable criteria for the apportionment thereof to the Indian branches. By and large, the claims made were being accepted without any scrutiny.
The claims made by different companies varied over a wide spectrum and ranged upto 78% of the Indian profits in some cases.
The exchange control authorities were permitting repatriation of these amounts without any particular scrutiny on the assumption that these had been accepted by the revenue department after proper examination.

It was apparent that substantial amounts of Indian profits were being repatriated free of tax.

under the guise of head office expenses. In fact, while these inquiries were going on, some companies 'voluntarily' surrendered substantial amounts to tax on account of excessive claims made in their tax returns in earlier years in respect of head office expenses 'by mistake'.

As a result of this examination and pursuant to the recommendations of the Public Accounts Committee on the subject, the following action was taken:-

Detailed guidelines were issued about the verification of head office expenses and their allocation to Indian business on rational criteria like gross income/receipts/trunover /working capital/expenses/assets.
It was clarified in consultation with the Ministry of Law that the impression carried by the revenue department that their officials had no authority under the law to call for the records of the foreign-based head offices of such companies was not correct and that they could, in fact, do so, if necessary, under the existing provision$ of the law.
A new provision was inserted in the Income-Tax Act which placed a ceiling on the amount of head office expenses admissible in the case of non-residents; such ceiling being related to their Indian profits of the particular year.

III. Tax Avoidance-Through Private Trusts.

Private trusts, i.e., trusts set up for the benefit of specified persons, have always been a favourite device of tax-avoidance with the moneyed people. The tax laws contained, interalia, the following provisions to counteract this device:-

If a person transferred any of his property to a trust for the benefit of his/her spouse and/or minor children, the value of such transferred property and the income resulting therefrom would be charged to wealth-tax and income-tax respectively in the hands of such person and not in the hands of the trustees or the beneficiaries,
If the individual shares of the beneficiaries were indeterminate or unknown, the income and wealth of the trust in the hands of the trustees would be charged to tax at certain flat rates if the normal slab rates applicable to such income or wealth of the trust happened to be lower.

In the audit of tax assessments of a few private trusts it was noticed that these provisions were not adequate. To understand the problem fully a special audit of the tax assessments of private trusts in selected revenue circles was taken up. It was found that there was large-scale avoidance of taxes through the device of private trusts such as could not be caught by the aforesaid provisions. Thus:-

Private trusts were being set up by certain family groups in such a way that the beneficiaries were not the specified close relatives (spouse and minor children) of the settlors themselves but such relatives of each other in various permutations and combinations.
Such trusts were set up mostly by people whose individual incomes or wealth would otherwise attract tax at rates higher than even the specified flat rates. By setting up large number of trusts in such cases they could get away by paying taxes at flat rates.
The income of a spouse or minor child of an individual from membership of a partnership firm was taxable in the hands of such individual. To get over this provision private trusts were being interposed so that it was the trusts which were members of partnership firms, though the beneficiaries of such trusts continued to be the specified relatives.

A special comittee appointed for a comprehensive examination of the whole matter brought out still more loopholes in the existing provisions of the law which were being taken advantage of.

Following these investigations very substantial amendments were made to the tax laws to plug the loopholes. These included the following:-

It was provided that where shares of beneficiaries were unknown or indeterminate the income and wealth of the trust would suffer tax at the maximum marginal rates,
It was further provided that the individual shares would be deemed to be indeterminate or unknown unless these were expressly stated in the instrument of trust.
The existing concession of lower rates in favour of trusts whose beneficiaries had no individual incomes or wealth was confined to trusts none of whose beneficiaries was a beneficiary in any other trust.
It was also provided that the income accruing to a trust from the membership of the trust in a partnership firm would be added in the assessment of the settlor in so far as the beneficiaries of the trust happened to be the spouse and minor children of the settlor.

IV. Exemption from Excise Duties-Small Scale Sector

Duties of excise are levied on goods manufactured in India under the Central Excises and Salt Act, 1944. The Central Excise Tariff containing a list of excisable goods and the rates of duty forms part of this Act. Powers are, however, delegated to the government for allowing, by notification, general as well as specific exemptions, partial or total, in respect of any excisable goods. Such exemption notifications issued by Government, of which the number is quite large, form part of the excise law and determine the effective rates of duty from time to time.

One of the elements of the industrial policy of the Government of India is to encourage the small-scale sector so as to widen the entrepreneurial base in the country. A small scale unit is defined with reference to the monetary value of investments in fixed assets in plant and machinery. As a part of this policy of encouraging the small-scale sector, the Government of India issued a notification granting exemption from the payment of excise duty to the small-scale manufacturers of certain specified goods. The notification did not contain the aforesaid definition of the small-scale units; instead it linked the exemption to the total value of goods of the specified description manufactured and cleared during a year not exceeding certain limits.

It was noticed in the audit of excise duties that the concession given in this notification was actually being availed of by large manufacturers through the simple device of producing the specified goods within the specified limits, in addition to their normal line of production. It was pointed out to Government that the notification was not properly worded and the basic objective was, therefore, not being achieved. The government amended the notification so as to withdraw the concession in the case of a manufacturer whose total production and clearance of excisable goods falling under more than one tariff item exceeded a specified limit. It was pointed out in audit that even this amended notification would not serve the purpose because the list of specified goods was not coterminous with the list of goods in the excise tariff and the concession would extend to a large manufacturer producing goods falling under a single tariff item in respect of his production of the specified goods falling within the same tariff item. The Government then amended the notification for a second time linking the concession with the value of production and clearance of all excisable goods of a manufacturer not exceeding a certain limit in the year.

V. Invoice Manipulation-Leakage of Foreign Exchange

Under the Indian Customs Act, 'value' of goods for the levy of ad valorem import and export duties is, 'the price at which such or like goods are ordinarily sold, or offered for sale, for delivery at the time and place of importation or exportation, as the case may be, in the course of international trade, where the seller and the buyer have no interest in the business of each other and the price is the sole consideration for the sale or offer of sale.

In the audit of import documents of certain goods imported through a minor port in 33 consignments, it was observed that the goods were grossly over-valued; the invoice value was about 20 times the value of similar goods coming from the same area at about the same time through other ports. Twenty four consignments had already been cleared. The remaining nine consignments were detained and later sold by auction. The price fetched in the auction was only about 4% of the invoice value of the consignments. Further enquiries revealed that such over-invoicing was not confined to this particular import; it had been resorted to in many other cases.

Tax Audit-an Instrument of Legislative Change

On an investigation by the Central Bureau of Investigation, it transpired that a certain group of people had been engaged in a racket in underinvoicing exports and overinvoicing imports to acquire illegal foreign exchange for use in smuggling contraband goods like gold into the country. On the recommendations of the Public Accounts Committee in this matter, Government appointed a Study Team to examine in depth and report on the question of leakage of foreign exchange through invoice manipulation. The study resulted in very substantial amendments to the laws noting to customs, exchange control and import and export trade control.