Tax Avoidance Practices plugged by Department

Tax Avoidance Practices plugged by Department

Growing economy gives us an opportunity to earn more but increased compensation leads to incremental taxes too. Hence every person tries to minimise his tax liability through legitimate or illegitimate means. At times statute itself provides various options to reduce tax liability such as deductions for investments, Exemption of Income from certain investment, further re-investment to reduce Capital gain tax etc. However, still taxpayers try to avoid payment of tax or pay substantially less tax than actually payable. The common reason for evasion of income tax is that a considerable part of Income is paid to the government as taxes and people do not get benefit directly from such tax payment.

This tax liability reduction practise, either through legitimate or illegitimate options, is known as “Tax Avoidance”, “Tax Evasion” and “Tax Planning. Although the words “Tax avoidance” and “Tax evasion” and “Tax planning” sound similar but in practical scenarios they are radically different. 

Tax avoidance is legal use of law to reduce tax burden. Although tax avoidance is legal but there are some people who have a malafide intention also. Any planning which though strictly according to legal requirement defeats the basic intention of the legislature behind the statue. In simple terms we can say taking advantage of loopholes to reduce tax liability. These kinds of practises generally result in disputes between Department and taxpayer and these matters are settled by decisions of judicial authority. In such cases, judicial authorities interpret the objective of statute and decide the legal position.

Tax evasion, on the other hand, is an attempt to reduce your tax liability by deceit, shunning, or concealment. Tax evasion is a crime. It deliberately misrepresents the law and tries to reduce tax liability such as declaring less income, submitting forgery documents, inaccurate financial statements or overstating deductions. To curb these practises, statues contain necessary provisions for penalties and punishments and therefore, defaulting taxpayers punishable under relevant laws.

Tax planning is a very legal and handsome way to reduce your burden of income tax liability to stick yourself within the provision of law. It is very much permissible in law. Statutes generally do so to promote any geographical location, class of persons, nature of activities, area of investment etc. E.g. tax holidays are given under the Income Tax Act for setting up manufacturing plants in various geographical areas. 

Income tax Act is a highly lengthy and complicated statute and there is a scope for tax evasion and avoidance. Upon identifying such loopholes, governments plug loopholes and have made amendments in Income Tax Act from time to time so that people are not able to avoid or evade tax. 

In this article, we have discussed Some of these amendments: 

1. Bond Washing Transaction

1.1 What is a Bond Washing transaction?

Section 94(1) aims at preventing avoidance of tax by assessee where assessee transfer the securities before the due date of interest. What assessee do is, shifting the tax burden to some other person to rescue himself from tax liability. Such transfer transaction is made from a person whose income is taxable under higher tax slab and transfer is made to the person with income in lower tax slab. These transfer of securities by transferor to transferee shall be called Bond Washing Transaction.

1.2 Tax avoidance practise opted 

To overcome these types of transactions, section 94 provides that the interest from such securities is taxable in hand of the transferor rather than the transferee. However, clubbing of interest income shall not be made if transferor proves that :

  1. the said interest is taxable in hand of transferee at the same rate at which such interest is taxable in his hand, or 
  2. there was an urgent need for money and the transferor has not indulged in such type of activities for the past three previous years.

2. Bonus stripping

2.1 What is bonus stripping?

As per principle of demand and supply, price of a share increases when the company is about to announce allotment of bonus shares or distribution of dividend is due. In such a scenario, to generate loss, most of the shareholders buy shares immediately before allotment of bonus shares and post allotment of bonus shares, sales such originally held share at lower prices and generate loss in Income tax return.

2.2 Tax avoidance practise

As per Section 94(8) of the Income Tax Act 1961, deals with the provisions related to the Bonus stripping.

section 94(8) provides that the loss, if any, arising to an investor on account of purchase and sale of Original units shall be ignored for the purpose of computing his total income chargeable to tax, subject to the following conditions-

ConditionsUnits (Bonus stripping is not applicable for shares)
Bought or acquired (Original units)Within a period of 3 months prior to the record date
Allotment of additional units (Bonus units)Without any payment on the basis of holding original units on such record date
Sold or transferred (Original units)Within 9 months after the record date
Holds at least one additional bonus unitOn the date of such sale or transfer of original units

*Record Date means the date fixed by the company for the purpose of determining entitlement of shareholders to bonus shares.

However such loss, generated from sale of original units, will be considered as cost of acquisition (COA) of the bonus unit held on the date of sale (indexation benefit available on such cost of acquisition). 

Please note that section 94(8) shall not not apply if all additional units are transferred before original units are sold.

Example1: Suncare mutual fund declares 1:1 bonus units on its units on 28th April, 2019. The record date for bonus units was fixed to be 30st of June, 2019. Mr A purchases 1000 units (Original units) of Suncare on 20th May, 2019 at a rate of Rs.100 per unit. Mr A sells 1000 original units on 20th January, 2020 at a rate of Rs.75 per unit.

ParticularsAmount (Rs.)
Sales value as on 20.1.2020(1000 x 75)[A]75,000
Cost of acquisition as on 20.5.2019(1000 x 100)[B]100,000
Short term capital Loss [A-B]25,000*

*As per section 94(8) of Income Tax Act 1961, the Short term capital loss amount to Rs.25000 shall not be considered in computing the total income and such short term capital loss shall neither be set off nor be carried forward. Thus, loss of INR 25,000 will be considered as cost of acquisition of bonus units (1000).Therefore, cost per unit of bonus shares will be INR 25.

If in above example, Mr A sells 1000 original units on 20th January, 2020 at a rate of Rs.75 per unit and 500 units of such bonus units at a rate of Rs.75 per unit on 25h January, 2020 then

ParticularsAmount (Rs.)
 1000 Original units500 Bonus units
Sales value as on 20.01.2020[A]75,00037,500
Cost of acquisition [B]100,00012,500#
Short term capital (Loss)/Gain [A-B](25,000)*25,000*

# Cost of acquisition of 500 bonus units 25,000 x 500 = Rs.12,500

                                                                    1000

*As per Section 94(8), the Short term capital loss amount to Rs.25000 shall not be considered in computing the total income and such short term capital loss shall neither be set off nor to be carried forward. Thus cost of acquisition of bonus units (1000) taken is of Rs.25000.

The Short term capital gain on sale of bonus units Rs.25000 shall be taxable.

Example2: If in example1, Mr A sells all the 1000 bonus units on 15th November, 2019 at the rate of Rs.75 per unit and 1000 original units on 15thJanuary, 2020 at a rate of Rs.75 per unit then

ParticularsAmount (Rs.)
 1000 Original unitsAs on 15th January 20201000 Bonus unitsAs on 15th Nov, 2019
Sales value[A]7500075000
Cost of acquisition[B]100,000NIL
Short term capital (Loss)/Gain [A-B](25000)*75000

*In this case, the provision of Bonus stripping (Section 94(8)) does not apply as all additional units are transferred before original units are sold.

The Short term capital loss amount to Rs.25000 is allowed to set off and be carried forward. Simultaneously, Short term capital gain of INR 75,000 will be taxable.

3. Dividend Stripping

3.1 What is dividend stripping?

Similar to Bonus stripping, same principle of price fluctuations are also applicable in case of declaration of dividend. Therefore, Dividend stripping strategy is opted to generate capital loss in Income tax return and also to generate exempted income of dividend.

Dividend stripping is a short-term trading strategy. It’s when you buy a stock shortly before a dividend has been declared at the higher price and intention of selling shares is immediately after the dividend is paid at the lower price.

This may be done either by an ordinary investor as an investment strategy, or by a company’s Owners or associates as a tax avoidance strategy

Let us understand with the help of example: Suppose Company XYZ announces dividend at a Record Date – 1.08.2019 (Date of which shareholding will be considered for the purpose of distribution of dividend_its registered shareholder). On 30.06.2019 Mr Y purchased shares of XYZ from Mr X for Rs.250. On 1.08.19 Mr Y earns a dividend of Rs10. On 20.08.2019 Mr Y further sold shares for Rs.200. Now Mr Y has following incomes:

Income from capital gainIncome from other source
ParticularsAmount (Rs.)ParticularsAmount(Rs.)
Sale price200Dividend Income10
Purchase price250Less: Exempt u/s 10(34)10
Short term capital Gain/(Loss)(50)Income

Mr Y claims that he is allowed to set off against any other capital gain income and carry forward the loss for 8 years. Hence taxpayers enjoy a twofold benefit by claiming a capital loss and exempt dividend u/s 10(34). 

3.2 Tax Avoidance practise

To plug this loophole section 94(7) has been introduced which says, the loss on purchase and sale of shares shall not be allowed to be set-off or carried forward to the extent of the amount of dividend (Rs.10 in above example). Only loss of Rs.40 (50-10) shall be allowed to be set off or carry forward.{Before Amendment}

Note: If we see from practical point of view the concept of Dividend stripping has no such relevance after amendment as exemption u/s 10(34) i.e. dividend income and u/s10 (35) i.e. dividend declared by Mutual Fund is fully taxable irrespective of amount in hands of shareholder/unit holder.

But still there is no such clarification issued by the Department on dividend stripping.

4. Amended Provision: Dividend stripping post Abolishment of DDT provisions and Dividend income becomes taxable in receiver’s hands

The FM in her budget speech removed DDT and adopted the classical system wherein the dividend or income from units shall be taxed in the hands of the recipients at their applicable slab rates and companies or mutual funds will no longer be required to pay DDT.

For Resident Shareholder

Individual: – For individual shareholders the dividend shall be taxable as per the applicable slab rates.

Further TDS will be deducted at 10% on dividends received above INR 5,000 in a year

Companies: – For corporate shareholders the dividend shall be taxable as per the effective tax rates, which would range from 25.17% to 34.94%.

Mutual Funds:- The insertion of section 194K under the Act in which Mutual Funds, on payment of dividend to residents, will be required to deduct TDS at the rate of 10%.

For Non-Resident Shareholder

Indian companies shall be liable to withhold taxes at 20% on payment of dividend to a non-resident shareholder

Prior to amendment, taxpayers were trying to generate exempted Income of dividend and capital loss through dividend stripping. However, abolishment of DDT and its taxability in hands of taxpayers has removed the aspect of exempted income. However, generation of capital loss continues to be the same. Department is yet to come up with any clarification on dividend stripping transaction post amendment.

5. Penalties for Tax Evasion

There are various penalties that the income tax department can impose on anyone who is found guilty of evading or avoiding taxes. These penalties can also apply to companies that either fail to report or pay their own taxes when they are supposed to. Some of these are:

SectionNature of offenceMinimum period of rigorous imprisonmentMaximum Period of Rigorous Imprisonment
276C(1)Under reporting of incomeIf tax on under reported income not exceeds Rs.25lac: Imprisonment which may extend upto 6months and fineIn other cases:Imprisonment which may extend upto 3months and fineIf tax on under reported income exceeds Rs.25lac: Imprisonment upto 7years and fine In other cases: Imprisonment which may extend upto 2years and fine
276C(2)Wilful attempt to evade payment of TaxImprisonment upto 3months and fine as determined by concerned authorityImprisonment upto 2years and Fine as determined by concerned authority

Read latest UNION BUDGET 2020: KEY CHANGES | INCOME TAX ACT

DISCLAIMER: The views expressed are strictly of the author and VJM & Associates LLP. The contents of this article are solely for informational purpose. It does not constitute professional advice or recommendation of firm. Neither the author nor firm and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any information in this article nor for any actions taken in reliance thereon.

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