The Legal Challenges of Corporate Tax Evasion and Avoidance in India

This article has been written by Sathya Sruthi, currently in her 4th year pursuing BBA LLB in Symbiosis Law School Hyderabad.

ABSTRACT:

This article addresses the legal challenges of corporate tax evasion and avoidance in India. This is a critical issue due to the repercussions of affecting the revenue and economic stability of the government. Tax evasion is an unlawful means of tax avoidance, finding loopholes to avoid tax payment lawfully. However, both practices reduce tax liabilities and deface a nation’s tax base. These lead to the loss of government revenue and the convolution that the tax laws or regimes face, along with manoeuvring the tactics of corporations to avoid and evade taxes. The articles aim to address the difficulties faced by regulators during such processes. The need to address the legal framework, such as the Income Tax Act, 1961 and G.S.T. Act 2107, will be used to show the effective measures taken by the government to prevent the bolting out of tax liabilities. This article will address the issue of combating tax avoidance in the international framework. Lastly, They address the pressure between a robust tax regime or regulation and promoting a business-friendly environment. Unravelling those tensions with effective legislation, technological advancements, global framework adoption, and strategies to ensure smooth operation will address the issue.

INTRODUCTION:

The issues of tax evasion and tax avoidance cause crucial constraints on Indian tax authorities that impact the nation’s fiscal stability and economic growth. Tax avoidance and tax evasion increase scrutiny and undermine the government’s revenue base. This can lead to surging fiscal deficits and reduced capacity to fund public services. The various legislations that govern and regulate these practices would be the Income Tax Act of 1961 and the Goods and Services Act (GST) 2017, which aims to comply with and curb the prevailing tax evasion. Multinational Corporations (M.N.C.) leverage complex global structures that include transfer pricing and shifting profits in countries that don’t charge as much as in India,  as the tax liabilities are high compared to countries like the U.A.E., Bermuda, Qatar, Singapore, etc. To address and face these challenges, the government brought in reforms like the General Anti-Avoidance Rule (GAAR), Advance Pricing Agreements (A.P.A.), Tax Deducted Source(T.D.S.) and Base Erosion and Profit Shifting (B.E.P.S.). The enforcement part is a significant hurdle for the government amidst the complexities of growing corporate structures and prolonged litigation processes. All these disrupt the market competition and create income inequality, making Indian markets an uneven field for compliant business firms and corporations, which will be addressed in detail in this paper.[1]

UNDERSTANDING CORPORATE TAX EVASION AND AVOIDANCE:

Corporate tax evasion and avoidance affect the country’s economic growth and stability, causing difficulties for the Indian tax authorities. Tax evasion is an illegal method that corporations adopt through misleading documents and suppressing facts. The prohibited techniques, including untrue statements with knowledge, submission of misleading documents, suppression of facts and failure to maintain proper books of accounts and income, are examples of tax evasion. That is why it is termed as an intentional attempt to avoid tax payment as soon as the tax liability arises. Tax evasion, also called tax concealment, avoids tax liability through unfair means.

On the other hand, tax avoidance is legally permissible to reduce the tax liability that has arisen. This is done through legal loopholes in a legally acceptable manner and with a legal sanction. Tax avoidance is intentional tax planning right before the tax liability arises. It is also not a lousy morality as anybody can arrange their tax affairs or business incomes to minimise tax liability. In this case, corporations feel the burden of the taxpayer as taking a slight burden off the legal framework according to their flexibility, which is legally permissible. Tax avoidance is intentional tax planning that before the tax liability arises. Tax avoidance is bending the law but not breaking it and is called tax hedging and emphasises authorities in correcting the law and bringing in amendments in the tax framework.[2]

CORPORATE TAX AVOIDANCE AND EVASION: KEY INSTITUTIONAL FACTORS AND THEORIES

Corporate tax evasion and avoidance are influenced by institutional factors like governance mechanisms, the role of tax authorities and policies, and financial issues arising from the above-said practices. This topic explores the factors through various institutional factors, theories, economic models and legal frameworks for better analysis of corporate tax behaviour.

Agency Theory and Tax Evasion:

The agency theory proposed by Desai is said to be the central understanding theory concerning corporate tax evasion. This theory talks about how managers may structure complex transactions to evade detection of these affairs from the tax authorities and conceal such assets and deals from shareholders to attain personal benefits. This foul play conflicts between the Corporate Social Responsibility(CSR) and tax avoidance schemes. There will be tension between profit maximisation and CSR activities as both are antithesis [3].

Economic Models of Tax Behaviour:

This economic model of Becker and Allingham & Sandmo recommends laying the foundation for tax evasion by applying the utility theory about how tax-payers decision-making ability is addressed. All these models refer to taxpayers as rational actors that make decisions based on cost efficiency and cost-benefit, weighing their potential financial benefits and underreporting their income against the risks of being audited and facing penalties. The key factors to be noted in these models would include:

 Weighing the benefits and risks:

In the context of corporate tax avoidance and tax evasion, these models suggest that all firms, entities, and even individuals estimate the value that will be evaded. The immediate financial savings and income underreported outweigh the severity of punishments and perceived likelihood, and companies are motivated to make such decisions and engage in such activities. When tax authorities detect such activities through audits or raids, the severity of penalties and punishments becomes critical. When these factors are weak and occasional, the businesses tend to be incentivised to commit tax evasion.

Influence of Higher Tax Rates:

These models also emphasise how tax evasion leads to surging tax rates. The higher the tax rate, the potential financial gain from underreported taxable income creates greed in corporations, forcing them to opt for loopholes. It means altering the financial statements and accounts to reduce tax liability. When the company saves more through tax evasion, they are more likely to believe and convince themselves that they save more through tax evasion as the risk of getting caught seems to be low comparatively and is to be considered equally relevant in cases where tax authorities jurisdiction is unstable and inconsistent allowing the firms to opt for more aggressive tax strategies or techniques.[4]

Social and Widespread Evasion Influence:

The economic model of Allingham and Sando also talks about the influence of social behaviour on tax compliance. If The corporate taxpayer becomes aware of the widespread tax evasion and is followed by his competitors and players in the field, it will only create a bandwagon effect. The general thinking is that if everyone does it, I will also do it, lowering the reputational risk of engaging in tax avoidance and evasion along with morals that any corporation would hold. The social dynamics that prevail in the corporate world and the political dominance make tax evasion a more acceptable and normal norm in the business circle that weakens the tax compliance of the nation.

Tension between Tax Savings and Legal risks:

The financial gains through tax avoidance seem glittering to a corporation’, but they should also consider the business, legal and reputational risks they will face while engaging in such practices. When a company is caught committing an offence of tax evasion, it not only damages the financial affairs but potentially damages the reputation of its relationship with the investors, shareholders, goodwill, and customer loyalty. The Becker model, where the trade-off between the spontaneous financial benefits and risks that can continue in the long term, i.e., imprisonment and penalties, shapes the firm’s approach to tax compliance. Therefore first, choose to engage in moderate tax evasion strategies that minimise tax liabilities rather than outrightly engaging in illegal tax evasion.

Corporate Social Responsibility and Tax Compliance:

Various firms focus on CSR activities where those companies’ decisions are based on ethical corporate values. Those companies that upheld those considerations view tax compliance and not engaging in illegal tax evasion as a step to contribute to society’s welfare that reduces even willingness to engage in aggressive tax avoidance. Corporations that operate on profit maximisation with aggressive corporate goals would achieve this through any means, including prioritising short-term financial gains over compliance, particularly when they misconceive that their competitors and co-players engage in tax avoidance.[5]

Strategic Decision-making by firms:

Corporate taxpayers’ decision-making process concerning tax avoidance by incorporating the models mentioned above is not a matter of defying legal compliance but a strategic move. These corporations evaluate the amount of risk they are willing to take based on financial decisions and the effectiveness of the tax enforcement authorities in their country. They also measure the potential competitive advantage that might come along with paying less tax. This calculus shows the rational choice model, which refers to companies aiming to optimise financial outcomes while minimising potential tax liabilities.[6]

INSTITUTIONAL FACTORS:

These institutional factors can be divided into three categories:

Tax Authorities and Policies – Tax evasion is often driven and encouraged due to loopholes in legislation, inefficient audits, and corrupt tax officials. These businesses with political ties also incentivise corporations to evade more taxes easily and without legal stress, leveraging weak enforcement and politically motivated tax policies.

1. Financial Issues– Financial factors like social costs and networks must also be considered when tax evasion affects firms’ tax behaviour. While facing financial stress or political connections, these firms are more likely to encourage aggressive tax evasion. This is done through fake expenses, underreporting financial gains and profits, overstated depreciation, manipulating reports, etc.

Corporate Governance Mechanisms– These mechanisms include firm-level characteristics such as moral obligation, tax fairness, and influence of tax avoidance. Solid corporate governance would consist of more prominent audit committees that can reduce tax evasion thoughts and strategies. Contrastingly, the political backing, weak audit mechanism, and widespread influence lead to corporations opting for tax evasion.

TAX ADMINISTRATION CHALLENGES:

The primary reason for the tax evasion and increased tax evasion strategies and techniques to be opted by corporations arises from weak tax administration. This is due to factors like distrust in the government[i], low detection costs[ii], Corruption within tax authorities[iii], Complex tax processes[iv], politically motivated tax policies[v], and lack of policy coordination[vi].

Distrust in the Government- A pervasive distrust in government institutions negatively impacts morale and tax compliance. The taxpayers tend to perceive that the government is either ineffective or corrupt and feel tax evasion is justified due to such reasons. They also evade taxes, thinking their contributions will not be used for public benefit.

1. Low Detection rates and Minimal Penalties- The chances of being audited are low, and the penalties for tax evasion are always insufficient to deter non-compliance. The firms also analyse and understand that getting caught is meagre and decide to outweigh the financial benefits and short-term gains rather than reputation risks. This can be attributed to the lack of stringent punishments and appropriate provisions to penalise the tax evaders.[7]

Corruption inside Tax Authorities- Corruption in every department and every level of authority, from the peon to the CEO. Tax evasion is also justified and widespread due to corrupt officials in tax departments, which further facilitates tax evasion. The firms also resort to bribing tax officials to avoid scrutiny and reduce tax liabilities, perpetuating a non-compliance culture.

1. Complex Tax Process and Structure- The complicated and complex tax regulations, regimes, and norms can confuse and perceive tax liabilities and payment processes as long and technical, giving rise to tax evasion strategies. The complexity also leads to exploiting loopholes, allowing aggressive and illegal tax evasion just because of misinterpreted tax structures that diminish compliance rates and increase evasion rates.

Politically motivated Tax Policies- Politically driven tax policies often lack consistency and transparency due to the companies having their key and primary partners as politicians, which can result in confusion and frustration among taxpayers. Such instability may encourage firms to evade taxes, as they cannot rely on a stable tax environment. They tend to do it without fear and risk as they have legal backing and political dominance.[8]

1. Lack of Policy Coordination- The fragmented approach in the tax policy can worsen challenges in tax administration. The strategies and solutions tend to plummet due to a lack of coordinated efforts among various governmental bodies and tax compliance, making it more complex and challenging and opening up a door for firms to exploit and misuse the inconsistencies prevailing in the system and government.

CASE LAWS:

• In the McDowell [9]case, the tax avoidance strategies used by McDowell, which is an alcohol manufacturing company, were used to minimise its tax liability. The legal challenges in this case were that the company claimed that transactions were legitimate and within the legal framework and raised the question of when tax planning crosses the line into tax avoidance. In this, the SuThe held that tax planning that leads to tax avoidance using colourable means or strategies, including sham transactions, will be considered tax evasion and not permissible law. The impact of this landmark case is that this judgement is a precedent for how aggressive tax avoidance strategies could be struck down if they were found to be mere tax-dodging schemes, reinforcing the doctrine.
• The Azadi Bachao Andolan v. U.O.I.[10] case involved abuse imposed between India and Mauritius due to Double Taxation Avoidance Agreement (DTAA). These companies were routing investments through Mauritius and using them to avoid payment of capital gain tax in India. The arguments raised by the petitioners are that companies were taking undue advantage of the treaty, which resulted in revenue loss for India. The Supreme Court held that treaty shopping was not illegal despite being undesirable. The legitimacy of the DTAA was upheld, and the companies benefitted from it. The legal impact of this case would be that it brought attention to the misuse in DTAA to carry out tax avoidance, but the ruling was criticized for permitting treaty shopping in the first place. Later on, certain DTAAs, including Mauritius, were renegotiated to avoid loopholes.
• In the Kharwar [11]case, a significant case concerning tax evasion as the central issue in the instant case, the distinction between tax planning and tax evasion focuses on whether income from the sale of assets should be treated as capital gains or considered business income. The SC held that tax authorities could look into a transaction beyond the need to determine and examine the actual substance that paved the way for tax authorities to challenge and question the artificial tax arrangements. The after-effect of this case would be that this ruling strengthens the ability of tax authorities to question and chase corporations that engage in tax evasion strategies to reduce their tax liabilities.
• In the case of PNB Housing Finance Ltd v. DCIT [12], a 2020 case and a recent one that dealt with the misuse of deductions that were taking place under Section 80-IA of the Income Tax Act, it was brought in to promote specific infrastructure projects. The legal challenge was that the company argued that these deductions on profit were not arising out of eligible business transactions. In this case, the Supreme Court ruled against PNB, holding the deductions above were wrongly claimed and amounted to tax avoidance. The legal impact of this case would be that it reinforced the need for stringent scrutiny of tax incentives to ensure that firms do not misuse them.
• The Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 is a legislation which was introduced to deal with the challenges that arise out of tax evasion related to undisclosed foreign income and assets. This legislation also provides for strict penalties and prosecution of individuals and corporations if they attempt to evade tax through offshore entities. The act was also aligned with the Prevention of Money Laundering Act (PMLA)[13] to address tax evasion through money laundering.

CONCLUSION:

Corporate tax evasion and avoidance in India presents many legal and administrative challenges and involves complex financial transactions, cross-border deals and other loopholes in domestic and international tax laws. Irrespective of evolving legal frameworks that include GAAR and other legislations that help the Indian government avoid tax evasion, a smooth balance between compliance enforcement and a friendly environment for taxpayers and tax regulating authorities is required. Financial, governance and other regulatory factors shape corporate tax evasion and avoidance. In the agency and economy model, the former discusses the motive behind tax avoidance and taxpayer behaviour regarding risk and reward. The solutions to these practices would be strengthening corporate governance, meliorating tax administration, and addressing political ties, among other factors essential to reducing tax evasion.

REFERENCES :

• https://fiuindia.gov.in/files/AML_Legislation/pmla_2002.html#:~:text=PMLA%20is%20an%20act%20to,connected%20therewith%20or%20incidental%20thereto.
• https://www.indiacode.nic.in/handle/123456789/2147?view_type=browse
• https://www.emerald.com/insight/content/doi/10.1108/AJAR-09-2023-0305/full/html#sec006
• https://www.sciencedirect.com/science/article/abs/pii/S1061951818301071
• https://www.hdfclife.com/insurance-knowledge-centre/tax-saving-insurance/what-is-tax-evasion-tax-avoidance-and-tax-planning#:~:text=Tax%20avoidance%2C%20while%20legal%2C%20involves,practices%20to%20reduce%20tax%20burden.
• https://taxjustice.net/faq/how-do-corporations-abuse-tax/
• https://www.sciencedirect.com/science/article/abs/pii/S001429212300199X
• https://www.jstor.org/stable/1593759

[1] Anshu Duhoon & Mohinder Singh, Corporate Tax Avoidance: A Systematic Literature Review and Future Research Directions, LBS J. Mgmt. & Res., ISSN: 0972-8031

[2] Kong-Pin Chen & C.Y. Cyrus Chu, Internal Control Versus External Manipulation: A Model of Corporate Income Tax Evasion, 36 RAND J. Econ. 151, 151-64 (2005)

[3] Desai, M.A. and Dharmapala, D.,Corporate tax avoidance and high-powered incentives, Journal of Financial Economics, Vol. 79 No. 1, pp. 145-179,(2006)

[4] M.G. Allingham & Agnar Sandmo, Income Tax Evasion: A Theoretical Analysis, 1 J. Pub. Econ. 323, 323-38 (1972)

[5] M.M. Rahman & A.M. Karim, Is Tax Policy Responsible for Inclination in Practicing Earnings Management: A Case Study Analysis Among Accountants in Non-Listed Companies of Bangladesh, 2 Asian J. Acct., Econ. & Fin. 91, 91-99 (2016).

[6] N. Sritharan, S. Salawati, C.C.S. Sharon & M.A. Syubaili, Corporate Tax Avoidance: A Systematic Literature Review and Research Agenda, 12 Int’l J. Acad. Res. Bus. & Soc. Sci. 1160, 1160-1180 (2022).

[7] Mannan, M. A., Rahman, M. M., & Hossain, M. J. (2021). Factors Influencing Tax Compliance in South Asia: A Study on Bangladesh. International Journal of Public Sector Management, 34(5), 451-466.

[8] Islam, M. R. (2020). Factors Influencing Tax Evasion: A Study on Bangladesh. Asian Journal of Accounting Research, 5(2), 122-135.

[9] McDowell & Co. Ltd. v. CTO, (1985) 3 S.C.C. 230

[10] Azadi Bachao Andolan v. Union of India, (2004) 10 S.C.C. 1

[11] C.I.T. v. B.M. Kharwar, (1969) 72 I.T.R. 603

[12] PNB Housing Finance Ltd. v. D.C.I.T., (2020) 422 I.T.R. 479

[13] The Prevention of Money Laundering Act, No. 15 of 2003