2021 (8) TMI 1440 - HC - Income Tax

Set aside prior decision, remand matter for fresh review of foreign exchange loss deductibility under Section 37 and veil-lifting limits

HC set aside the Tribunal's order and remanded the matter for fresh consideration, holding that the Tribunal erred in treating foreign exchange loss as ... Nature of loss - Disallowance of foreign exchange loss - addition made holding that the amount is of the nature of capital loss - lifting of corporate veil - assessee had availed the foreign exchange loan for expanding its business by taking over Dunlop in South Africa through the subsidiaries - HELD THAT:- As in section 37 of the Act, it has also been stated that any expenditure which is expended wholly and exclusively for the purposes of the business or profession shall be allowed as an expense while computing the income chargeable under the head “income or gains” under the business or profession. The expenditure referred to in section 37 of the Act will undoubtedly include expenses incurred as a measure of commercial expediency. The words commercial expediency is a word of wide import. It has been held that the said word can include such expenditure that a prudent businessman would incur to improve his business. It is the admitted case of the assessee that the loan was taken for providing funding to its subsidiary company at Mauritius to acquire a company in South Africa for the purpose of enhancing its business and for procuring raw materials at reduced costs. Generally, any prudent businessman would attempt to indulge in such acts for increasing their profits by improving the business. However, the Tribunal has proceeded to treat these acts of the assessee as an attempt to acquire property and increase their capital base. For this purpose, the Tribunal has lifted the corporate veil. Tribunal has proceeded on a singular angle with an assumption that the ultimate aim of acquiring an asset was a measure of tax avoidance without even bearing in mind the principles of the Indo-Mauritius Double Taxation Avoidance Convention, 1983. The Tribunal has also not considered the concept of commercial expediency while determining the question whether the expenditure claimed is allowable as a deduction under section 37 of the Act. According to us, the answer depends upon the facts and circumstances of each case. The issue should have been approached from the point of view of a prudent businessman and not from the eyes of the taxing authorities. Whether the loan was taken as a measure of commercial expediency or not ought to have governed the consideration of the issue in this case rather than the motive behind establishing the two subsidiaries. The concept of lifting the corporate veil had no application in the instant case. The corporate veil is lifted only in certain specific instances, especially when fraud is committed, or when tax is sought to be evaded, or when the Company resorts to illegal activities. Formation of subsidiary company in Mauritius cannot be regarded as such an illegal act as explained in Union of India (UOI) and Others v. Azadi Bachao Andolan and Others [2003 (10) TMI 5 - SUPREME COURT] We feel that as a final fact finding authority, the Tribunal ought to have considered the matter from a practical point of view, bearing in mind the principles laid down by the Supreme Court in the above referred cases. We set aside the order of the Tribunal in [2013 (11) TMI 209 - ITAT COCHIN] and remand the same to the Tribunal itself, for fresh consideration. ISSUES PRESENTED AND CONSIDERED 1. Whether a loss from settlement of a foreign-exchange forward contract, incurred in relation to funds advanced to a wholly-owned subsidiary for acquisition of a foreign business, is allowable as a revenue deduction under section 37(1) or is a capital loss. 2. Whether the Tribunal was justified in lifting the corporate veil to treat the loss as capital in nature, absent findings of fraud, tax evasion or illegality, and whether such lifting constituted making a new case for the Revenue without supporting evidence. 3. Whether treating the subsidiary's acquisition as acquisition of a capital asset by the parent (thereby converting the loss into capital loss) is consistent with the separate legal entity principle and authorities addressing intermediary steps (including principles in the Indo-Mauritius context). ISSUE-WISE DETAILED ANALYSIS - Issue 1: Revenue v. Capital Character of Foreign-Exchange Loss Legal framework: Section 37(1) allows deduction for any expenditure (not being capital expenditure) laid out wholly and exclusively for the purposes of business. Loss or gain on foreign-exchange fluctuations may be revenue or capital in character depending on whether the foreign currency/transaction is held/incurred for revenue or capital purposes. Precedent treatment: Supreme Court authority has construed 'for the purpose of business' broadly to include commercial expediency and acts a prudent businessman would undertake (reference to Madhav Prasad Gatiya and SA Builders / Dalmia reasoning). Authorities establish that funds advanced to related concerns may be deductible if advanced as a measure of commercial expediency linked to business purpose. Interpretation and reasoning: The Court observed that forwards were entered into to hedge exchange exposure arising from funds borrowed to finance acquisition through subsidiaries. The core enquiry is fact-specific: whether the loss arose in the course of carrying on business (revenue) as a commercial expedient to improve the business or whether it was incurred in the process of acquiring a capital asset (capital). The Tribunal approached the matter by treating the ultimate acquisition as determinative of character, rather than assessing the contemporaneous commercial expediency and nexus to the parent's business operations as required by section 37(1). Ratio vs. Obiter: Ratio - where a loss results from ordinary commercial hedging or financing undertaken as a prudent businessman's measure to expand or improve trade, such loss can fall within section 37(1) as revenue expenditure. Obiter - general observations that any loss connected to a loan used ultimately for acquisition must be capital (not accepted as a general rule). Conclusions: Characterisation depends on facts and commercial purpose; the Tribunal erred by applying a blanket approach. The matter requires fresh fact-based consideration of whether the loan and hedge were measures of commercial expediency for the parent's business so as to attract section 37(1). ISSUE-WISE DETAILED ANALYSIS - Issue 2: Lifting the Corporate Veil and Making a New Case Legal framework: The corporate veil may be pierced in limited circumstances (fraud, sham, tax evasion, illegality) to look at the substance over form. Tax adjudicators, however, must respect intermediary steps and double taxation treaties when legitimately used unless misuse is established. Precedent treatment: Courts have warned against disregarding intermediate corporate steps absent clear evidence of abuse (authority on Indo-Mauritius treaty and Azadi Bachao Andolan). SA Builders and related jurisprudence emphasize examining commercial expediency rather than short-circuiting analysis by imputing improper motive. Interpretation and reasoning: The Tribunal lifted the corporate veil on an assumption that the subsidiaries were devices to acquire capital and avoid tax, without findings of fraud, illegality, or specific evidence supporting sham/subterfuge. The Court held that such lifting effectively made a new case for the Revenue and substituted its own view for fact-finding that the Tribunal had not supported by evidence. The Court emphasized that formation of a Mauritius subsidiary, in itself, is not illicit and falls within options recognized by treaty and corporate law; absent clear misuse, intermediary steps cannot be disregarded. Ratio vs. Obiter: Ratio - veil may not be pierced in tax adjudication absent evidence of wrongdoing; doing so without findings amounts to making a new case and constitutes error. Obiter - remarks on general impropriety of assuming tax-avoidance motive from legitimate corporate structuring. Conclusions: Tribunal's lifting of the corporate veil was unwarranted on record; it constituted making a new case without evidence and therefore must be set aside for fresh consideration without presuming sham or tax avoidance. ISSUE-WISE DETAILED ANALYSIS - Issue 3: Separate Legal Entity Principle and Treatment of Intermediary Steps Legal framework: Companies are distinct legal entities; transactions through subsidiaries are generally respected. Tax law and treaty jurisprudence acknowledge legitimate use of intermediary steps (e.g., cross-border holding structures) unless established as a façade for evasion. Precedent treatment: Authorities caution that courts should not ignore intermediate legal steps simply because the intended result is not achieved, nor should they treat lawful structures as non-existent based on hypothetical motive (Indo-Mauritius treaty jurisprudence). SA Builders and Dalmia principles require assessment from a business perspective rather than tax authority hindsight. Interpretation and reasoning: The Tribunal treated acquisition by a subsidiary as if the parent acquired the capital asset directly, contravening the separate entity principle. The Court stressed that the right approach is to examine whether the parent's advance and the hedging loss were intrinsically connected to the parent's business expediency, not to collapse corporate separateness absent evidence of misuse. The Tribunal's conclusion that the loss must be capital merely because acquisition occurred through subsidiaries was therefore contrary to the separate-entity doctrine and binding guidance on intermediary steps. Ratio vs. Obiter: Ratio - separate legal entity must be respected; intermediary corporate steps cannot be disregarded absent concrete findings of abuse. Obiter - observations that treaty-based corporate arrangements (e.g., Mauritius holdings) have 'great legal significance' and cannot be lightly ignored. Conclusions: The Tribunal's basis that acquisition by subsidiaries equated to capital acquisition by the parent is legally unsound without piercing the veil on proper grounds. The issue must be re-examined respecting corporate separateness and treaty principles, with primary focus on commercial expediency and factual nexus to parent's business. DISPOSITIONAL CONCLUSION The Tribunal's order is set aside and the matter is remanded for fresh consideration: the Tribunal must (i) determine, on the facts, whether the foreign-exchange loss arose as a revenue expense incurred wholly and exclusively for the purposes of the parent's business (commercial expediency test under section 37(1)); (ii) refrain from lifting the corporate veil in absence of findings/evidence of fraud, sham, illegality or tax evasion; and (iii) apply the principles regarding separate legal entity and intermediary steps consistent with established precedent and treaty considerations.