The decision in McDowell & Co. Ltd. v.

CTO by a Constitution Bench

of the Supreme Court so widened the net under different taxing statutes
that several innocent commercial and financial acts and transactions of
the assessees which were till then neither treated nor supposed to be
treated as taxable suddenly found themselves threatened with being
dragged within the pale of taxability and even penalisation. The
observations in the judgment, particularly in the opinion rendered by
Chinnappa Reddy, J., against tax avoidance have so emboldened the
assessing and taxing authorities that it results in a lot of
unreasonableness and high-handedness towards the assessees.
In particular, McDowell1 judgment has blurred the line of distinction
between reduction of tax liability by an assessee on account of legally
permissible, honest and justified means, on the one hand, and reduction
due to some colourable device, design or subterfuge, on the other hand.
For that reason, it has given rise to sufficient confusion and
misunderstanding. Hence, the need to undertake a critical study
of McDowell case1.

FACTS
Under the A.P. Excise Act and Rules, the manufacturer was to remove
the liquor from the distillery only upon payment of excise duty.
However, the buyers of liquor from the assessee themselves paid the
excise duty before the removal of the goods. The price of the liquor was
collected by the assessee from the buyer but the excise duty paid by the
buyer to the Excise Department was not shown as part of the price
received by it from the buyer. The assessee continued to sell liquor in
this manner and paid sales tax under the A.P. Sales Tax Act on the
turnover returned by him which did not, as mentioned, include the
amount of the excise duty. However, the Assessing Authority took the
view and held that the assessee had failed to include in its turnover, the
amount of excise duty paid by its buyers to the Excise Department. The
assessee challenged that view but the High Court agreed with the
Assessing Authority. The assessee appealed to the Supreme Court.
ISSUES
A Division Bench of the Supreme Court examined the excise laws as
well as the sales tax laws. The Court took the view that
(i) the buyer was also legally responsible to pay the excise duty, and
(ii) the amount of excise duty never went into the till of the assessee.
On this view of the laws, the Supreme Court held that the excise duty,
which had been directly paid by the buyers to the Excise Department,
was not includible in the turnover of the assessee. This was in 1977, the
first judgment of the Supreme Court on the issue in McDowell & Co.
Ltd. v. CTO2
Consequent upon this judgment, the Rules were amended. The new Rule
provided for payment of excise duty by the manufacturers, including the
assessee, but the excise duty continued to be paid directly by the buyers
as was done earlier. On the basis of the amendment in the Rules, the
Assessing Authority again added the sum of excise duty to the assessee's
turnover. The assessee again moved the High Court for quashing the
notice. The High Court held that
"the turnover related to liquor; excise duty, which was payable by the
(assessee) but, by an arrangement, had been paid by the buyer, was
actually a part of the turnover (of the assessee) and was, therefore, liable
to be so included (in the turnover) for determining (the assessee's)
liability for sales tax".
The assessee appealed to the Supreme Court wherein the validity of the
earlier judgment in the assessee's case was doubted and the matter was
referred to a Constitution Bench of five Judges.

The issues and the verdict in McDowell case

There were only two basic issues before the Constitution Bench.
1.Whether the liability to pay excise duty was that of the assessee. And,
the other, even if the liability to pay excise duty was of the assessee, ?
2. whether the amount of excise duty, directly paid by the buyer, was
includible in the turnover of the assessee for payment of sales tax.
Referring to several earlier precedents wherein the concept of excise
duty had been elaborated, the Constitution Bench held that "the
incidence of excise duty is directly relatable to manufacture" and its
payment "is the primary and exclusive obligation of the manufacturer ...
but (only) its collection can be deferred to a later stage as a measure of
convenience or expediency". On a fresh appraisal of the law, the highest
court found fault with and overruled its own decision rendered in 1977
in the same assessee's case.
As to the other issue relating to turnover also, the Supreme Court
referred to various Indian and English decisions and held that excise
duty is a part of the consideration which a buyer pays to purchase liquor
and is includible in the turnover of the assessee (manufacturer) although
the buyer had directly paid it to the Excise Department. Thus, on this
issue also, the Supreme Court differed from its own earlier view.
The assessee thus lost the case in the Supreme Court. There was no
scope for discussing tax avoidance or tax evasion in the case of the
assessee.
OTHER OBSERVATIONS
1. However, it appears from the judgment of Misra, J. that a "further
contention" was made on behalf of the assessee that
"it is open to everyone to so arrange his affairs as to reduce the brunt of
taxation to the minimum and such a process does not constitute tax
evasion; nor does it carry any ignominy". (SCC pp. 252-53, para 41)
This submission was sought to be supported by the observations of
Shah, J. in the cases of CIT v. A. Raman & Co.3and CIT v. B.M.
Kharwar4 The observation from the latter case reads as follows: (ITR p.
607)
"The taxing authority is entitled and is indeed bound to determine the
true legal relation resulting from a transaction. If the parties have chosen
to conceal by a device the legal relation, it is open to the taxing
authorities to unravel the device and to determine the true character of
the relationship. But the legal effect of a transaction cannot be displaced
by probing into the 'substance of the transaction'."
2. It appears that the Supreme Court took notice of the said "further
contention" and considered it proper to lay down the law on the
subject.
Misra, J., who delivered judgment on behalf of himself and three other
Judges (other than Reddy, J.), extracted the following observation from
the judgment of the Gujarat High Court (ITR pp. 200-01) in the case
of CIT v. Sakarlal Balabhai5 (affirmed by the Supreme Court
in CIT v. Vadilal Lallubhai6): (SCC pp. 253-54, para 43)
"Tax avoidance postulates that the assessee is in receipt of amount
which is really and in truth his income liable to tax but on which he
avoids payment of tax by some artifice or device. Such artifice or device
may apparently show the income as accruing to another person, at the
same time making it available for use and enjoyment to the assessee as
in a case falling within Section 44-D or mask the true character of the
income by disguising it as a capital receipt as in a case falling within
Section 44-E or assume diverse other forms.... But there must be some
artifice or device enabling the assessee to avoid payment of tax on what
is really and in truth his income. If the assessee parts with his income-
producing asset, so that the right to receive income arising from the asset
which theretofore belonged to the assessee is transferred to and vested in
some other person, there is no avoidance of tax liability: no part of the
income from the asset goes into the hands of the assessee in the shape of
income or under any guise."
Then, Misra, J. responded: (SCC pp. 254-55, para 45)
"45. Tax planning may be legitimate provided it is within the framework
of law. Colourable devices cannot be part of tax planning and it is wrong
to encourage or entertain the belief that it is honourable to avoid the
payment of tax by resorting to dubious methods. It is the obligation of
every citizen to pay the taxes honestly without resorting to subterfuges."
The appeal was dismissed. The Court did not record any finding that the
assessee had adopted any colourable device or design or dubious method
or subterfuge to avoid or evade tax. The levy of tax on the assessee was
not upheld on any such finding. It was upheld, as pointed out earlier, on
a pure interpretation of law.
CRITICAL ANALYSIS

.It is in this background that the observations of the other learned Judge,
namely, Reddy, J., which have become a handle for the tax authorities,
were made. Reddy, J. examined certain English cases to show how the
law relating to the controversy of tax avoidance was changed even in
England. First, he examined IRC v. Duke of Westminster7 wherein it
was ruled thus:
"Every man is entitled if he can to order his affairs so that the tax
attaching under the appropriate Acts is less than it otherwise would be. If
he succeeds in ordering them so as to secure this result, then, however
unappreciative the Commissioner of Inland Revenue or his fellow tax-
gatherers may be of his ingenuity, he cannot be compelled to pay an
increased tax."
After citing several other cases highlighting the march of the law against
tax avoidance schemes, the learned Judge adverted to the decision in the
case of W.T. Ramsay Ltd. v. IRC which marked a significant departure
from the earlier view of law in the case of Westminster7, the learned
Judge cited extracts from the speeches of the Law Lords in the case
of Furniss v. Dawson9 such as the following one from Lord Scarman:
(All ER p. 533a)
"What has been established with certainty by the House in Ramsay
case8 is that the determination of what does, and what does not,
constitute unacceptable tax evasion is a subject suited to development by
judicial process."
And borrowing the metaphor of "ghost" from the speech of Lord
Roskill, he posed the question: (SCC p. 241, para 13)
"13. Thus the ghost of Westminster7 (in the words of Lord Roskill) has
been exorcised in England. Should it be allowed to rear its head in
India?"
Reddy, J. justified the relevance of English decisions thus: (SCC p. 241,
para 14)
"14. I have referred to the English cases at some length, only to show
that in the very country of its birth, the principle of Westminster7 has
been given a decent burial and in that very country where the phrase 'tax
avoidance' originated the judicial attitude towards tax avoidance has
changed.... The courts are now concerning themselves not merely with
the genuineness of a transaction, but with the intended effect of it for
fiscal purposes. No one can now get away with a tax avoidance project
with the mere statement that there is nothing illegal about it."
The two cases of Raman3 and Kharwar4 became the central point of
criticism in the judgment of Reddy, J. In the former case, the case of the
Government was that the assessee had sold goods to certain HUFs and
those HUFs had earned substantial profits on the resale of the goods
over and above the margin of profit earned by the assessee and that the
creation of the family business was merely a subterfuge and contrivance
by the partners of the assessee for diversion of the profits. The Supreme
Court held: (ITR pp. 17-18)
"By adopting a device, if it is made to appear that income which
belonged to the assessee had been earned by some other person, that
income may be brought to tax in the hands of the assessee,.... Avoidance
of tax liability by so arranging commercial affairs that charge of tax is
distributed is not prohibited. A taxpayer may resort to a device to divert
the income before it accrues or arises to him. Effectiveness of the device
depends not upon considerations of morality, but on the operation of the
Income Tax Act. Legislative injunction in taxing statutes may not,
except on peril of penalty, be violated, but it may lawfully be
circumvented.
If the goods were nominally transferred to the Hindu undivided families,
the latter acting merely as benamidars for the assessees, and the profits
were earned in truth by the assessees, income earned by sale of the
goods by the Hindu undivided families may be held chargeable to tax as
income which has escaped assessment to tax in the hands of the
assessees." (emphasis supplied)
In the latter case, Kharwar4, though a passage from the case
of Westminster7 was quoted by Shah, J., the learned Judge did rely also
on the Supreme Court's decision in CIT v. Motors & General Stores (P)
Ltd.11, wherein the Court had observed thus: (ITR p. 699)
"In the absence of any suggestion of bad faith or fraud the true principle
is that the taxing statute has to be applied in accordance with the legal
rights of the parties to the transaction. When the transaction is embodied
in a document the liability to tax depends upon the meaning and content
of the language used in accordance with the ordinary rules of
construction." (emphasis supplied)
It was thereafter that Shah, J. held in his own words: (ITR pp. 607-08)
"The taxing authority is entitled and is indeed bound to determine the
true legal relation resulting from a transaction. If the parties have chosen
to conceal by a device the legal relation, it is open to the taxing
authorities to unravel the device and to determine the true character of
the relationship.But the legal effect of a transaction cannot be displaced
by probing into the 'substance of the transaction'. This principle applies
alike to cases in which the legal relation is recorded in a formal
document, and to cases where it has to be gathered from evidence—oral
and documentary—and conduct of the parties to the transaction."
(emphasis supplied)
Reddy, J.'s observations—whether justified
The judgment in either Raman case3 or Kharwar case4 had not laid
down any such principle which runs contrary to the principles that
eventually came to be laid down in McDowell case. The observations in
the judgment of Reddy, J. in McDowell case, purporting to dissociate
from the said two judgments, were neither pertinent nor justified. They
were so vitriolic and so strongly worded that, while purporting to be in
criticism of the judgments of Shah, J. in the cases of Raman3
and Kharwar4, they themselves became an excessively aggressive and
indiscriminate indictment against the time-honoured and useful
distinction between tax avoidance and tax evasion.
Ever since then, the tax authorities have been applying Reddy, J.'s
opinion, without understanding its true import and appreciating its true
applicability or validity. For instance, under the Income Tax Act, as
soon as the authorities find a situation in which taxable income could
accrue, they apply the opinion of Reddy, J. as a magic wand and treat the
income as having accrued even if it had not actually and legally accrued.
Likewise, under other taxing statutes, even in cases where the tax
liability of the assessee stands reduced as a consequence of an honest,
genuine and lawful act, to reduce or even avoid tax, the taxing net is
made wide enough to devour the assessee.
The judgment of Reddy, J. does not contain limitations on its
applicability—objective or otherwise. However, some subsequent
judicial opinions have tried to mitigate its rigour and put limitations
thereon by placing healthy riders and restrictions on the unduly wide and
indiscriminate application of the observations of Reddy, J.
For instance, in CWT v. Arvind Narottam12, rejecting a plea based
on McDowell case, Mukharji, J. held: (SCC p. 121, para 14)
"... where the true effect on the construction of deeds is clear ... the
appeal to discourage tax avoidance is not a relevant consideration."
As for the moral justification against tax avoidance, Mukharji, J. further
observed: (SCC p. 121, para 13)
"13. It is true that tax avoidance in an underdeveloped or developing
economy should not be encouraged on practical as well as ideological
grounds. One would wish, as noted by Reddy, J. that one could get the
enthusiasm of Justice Holmes that taxes are the price of civilisation and
one would like to pay that price to buy civilisation. But the question
which many ordinary taxpayers very often in a country of shortages with
ostentatious consumption and deprivation for the large masses ask is
does he with taxes buy civilisation or does he facilitate the wastes and
ostentatiousness of the few. Unless wastes and ostentatiousness in
government's spendings are avoided or eschewed, no amount of moral
sermons would change people's attitude to tax avoidance."
Similar discussions are to be found in the Supreme Court decision
in Union of India v. Playworld Electronics (P) Ltd.13and in Shubham
Fabrics v. IAC14
The applicability of McDowell case has been restricted by many
judgments of High Courts also, for instance, in CIT v. Modest
Enterprises Ltd.15, CIT v. Nandkishore Sakarlal16, Bhaktimala Beedi
Factory v. CIT17 and in CIT v. Joytsna Poddar18
On the other hand, there are cases which have justified the liability to tax
with the support of the dictum in McDowell case. The truth of the
matter, however, is that in all those cases, the same results would have
been achieved even by following the decision of Shah, J. in Raman3
and Kharwar4 cases or, for that matter, the rule recognized by the
Gujarat High Court in the case of Sakarlal Balabhai5 (as affirmed by
Misra, J. in McDowell case). Reddy, J.'s judgment has contributed
confusion rather than clarity.