Published On: November 4th 2025
Authored By: Vismaya P L
Government Law College, Thiruvananthapuram
“The difference between tax evasion and tax avoidance is the thickness of the prison wall.”[1] – Denis Healey. In the realm of taxation, tax evasion and tax avoidance are two indispensable terms. These often overlap, blurring the line separating them – the line of legality.
What is Tax Evasion ?
Although the term tax evasion is not defined in the concerned statute, it refers to a wilful act of failing to pay taxes due by a person to the government. It undoubtedly constitutes a crime with clear mens rea to evade tax on the part of the taxpayer. Tax evasion may be done using various means such as inflating deductions, underreporting income, hiding assets in offshore accounts or providing false information to authorities. It must be noted that it is not an accidental omission but a deliberate one intending to defraud the government. When viewed at a wide angle, evaders defraud the public funds meant for enhancing the welfare of the general public thus constituting a crime with a huge impact.
What is Tax Avoidance ?
Tax avoidance refers to the practice of legally reducing tax liability within the framework of existing tax laws. This practice involves legitimate deductions, exemptions, and tax-saving instruments provided by the tax system to minimize one’s tax burden. For example if one invests in tax-saving schemes like the Public Provident Fund (PPF), or claiming deductions under Section 80C[2], or structure business operations for tax efficiency it is covered under the title of Tax Avoidance.
The line that separates tax avoidance and tax evasion is that of legality. While the former is protected by law, the latter is a violation. However, many times individuals use the shade of tax avoidance to do what is in fact tax evasion. The difference between tax avoidance and tax evasion was explored in the case Mc Dowell & Company Limited vs The Commercial Tax Officer[3]. As stated by Justice Chinappa Reddy in the case, the shortest definition of tax avoidance that I have come across is “the art of dodging tax without breaking the law.” Much legal sophistry and judicial exposition both in England and India have gone into the attempt to differentiate the concepts of tax evasion and tax avoidance and to discover the invisible line supposed to exist which distinguishes one from the other. Tax avoidance, it seems, is legal; tax evasion is illegal. Though initially the law was, and law still is, there is no equity about a tax.[4]
Legal Boundaries and Anti-Avoidance Measures
A. General Anti-Avoidance Rule (GAAR)
India implemented the General Anti-Avoidance Rule (GAAR) on April 1, 2017, under Chapter X-A of the Income Tax Act, 1961. GAAR targets arrangements or transactions primarily designed for tax avoidance, allowing tax authorities to treat them as “Impermissible Avoidance Arrangements” (IAA). The rule applies when transactions lack genuine commercial substance or are entered into primarily to obtain tax benefits.
GAAR provisions contain a non-obstante clause under Section 95(1), giving them an overriding effect over other provisions of the Income Tax Act. This means GAAR can be applied even when specific anti-avoidance rules (SAAR) exist for particular transactions.
Section 95 of the Act with regard to the applicability of GAAR provides that an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement.[5]
The term arrangement is defined under section 102[6] and the term impermissible avoidance arrangement is defined under section 96[7]. The section further clarifies that the provisions of this Chapter may be applied to any step in, or a part of, the arrangement as they are applicable to the arrangement.
There are 2 conditions necessary to declare an arrangement as impersible avoidance arrangement:
- a) Purpose test: The purpose test requires that the main purpose or one of the main purposes is to obtain tax benefit. The term “tax benefit” has been defined in section 102 . The onus of of proving that the purpose is to obtain a tax benefit is on the taxing authority.
- b) Secondary test: Any of the following secondary tests needs to be satisfied for invoking GAAR which are:
- Transactions are not at arm’s length.
- Transaction results directly or indirectly, in the misuse, or the abuse, of the provisions of this Act.
- Arrangement to lack commercial substance:
- The substance of the arrangement as a whole differs from the form of its individual steps.
- Involves a transaction which disguises the value, location, source, ownership or control of funds.
- Location of an asset or of a transaction or of the place of residence of any party is without any substantial commercial purpose other than obtaining a tax benefit.
- No significant effect upon the business risks or net cash flows of any party to the arrangement apart from tax benefit that would be obtained.
Consequences of Impermissible Avoidance Agreement
If an arrangement is declared to be an impermissible avoidance agreement, the consequences, in relation to tax, of the arrangement, including denial of tax benefit or a benefit under a tax treaty, would be determined in an appropriate manner, in the circumstances of the case, including but not limited to the following:
- Disregarding, combining or recharacterizing any step in the impermissible avoidance agreement.
- Treating the impermissible avoidance agreement as if it had not been entered into or carried out.
- Disregarding any accommodating party or treating any accommodating/another party as the same person.
- Deeming connected persons as one and the same person for the determination of treatment of any amount.
- Reallocating amongst the parties to the arrangement any accrual or receipt of a capital nature; or any expenditure, deduction, relief or rebate.
- Treating the place of residence of any party to the arrangement; or the situs of an asset or of a transaction; at any place other than the residence, location of the asset or location of the transaction as provided in the arrangement; or considering or looking through any arrangement by disregarding any corporate structure.
B. Substance over form doctrine
This is a doctrine adopted under law of taxation wherein the taxing authorities take into consideration the substance of an agreement or arrangement over the legal form. This is to ensure that unfair tax avoidance arrangements are identified and put to an end. It is to ensure that taxpayers do not take undue advantage of the form of arrangement to avoid tax which is otherwise not permissible directly. This doctrine is applied when the authorities reasonably believe that the transaction is sham.
An example of substance over form doctrine is a sale disguised as a loan. Let’s say a company sells an asset to another party but agrees to buy it back later at the same price with an extra amount. In form, it is mere sale and repurchase. However, it is a secured loan wherein the extra amount is the interest. Here, the substance over form doctrine is applied and the transaction is treated as a loan and not a sale.
Another example is a lease disguised as a sale. A business leases machinery to another company under a long-term lease contract. The lease term is equal to the useful life of the asset and ownership automatically passes to the lessee at the end for a nominal amount. On paper it’s a lease but in substance it’s a sale of machinery on installment terms.
The doctrine arose from the landmark case Gregory v. Helvering (1935)[8], establishing that “the incident of taxation depends on the substance rather than form of the transaction”.
C. Limitation on Benefits (LOB) Provision
The LOB provision is implemented to prevent tax avoidance in case of cross-border investments. In order to understand the concept of LOB, we need to know what “treaty shopping” is. India has several tax treaties with countries across the world. These treaties are made to avoid double-taxation in both countries there by saving the tax payer from unnecessary burden. India has established over 94 comprehensive DTAAs and eight limited DTAAs.[9] The phenomenon of taking advantage of the DTAA between 2 countries by a person belonging to the 3rd country is called “Treaty Shopping”. This is an unethical “tax avoidance”. It is to put an end to such tax avoidance by misuse of tax treaties that the limitation on benefits provision was incorporated.
Example: An investor from the US sets up a shell or holding company in Mauritius. The Mauritius company invests in India and earns capital gains by selling shares or assets in India. Because the India-Mauritius DTAA exempted capital gains for Mauritian residents, the investor avoided Indian tax. The US investor would not have enjoyed this exemption under a direct India-US investment because the India-US treaty did not grant such a benefit. Mauritius often imposed negligible or no tax on these gains, so the investor paid little or no tax overall.
Conclusion
As explored, tax evasion and tax avoidance are two discrete phenomena which could however overlap leaving scope for misuse. Tax evasion has always been a major concern for the government and the taxing authorities. However, tax evasion disguised as tax avoidance is a much greater concern to be catered to in order to protect the economy’s balance. Apart from the existing legal provisions and boundaries, an exploration on the possibility using blockchain-based record-keeping and artificial intelligence, maintaining public registry for beneficial ownership, incentivizing internal reporting for corporates and maintaining a common reporting standard and automatic exchange of information across jurisdictions can expose unethical avoidance and restrict taxable assets routed through tax havens.
References
[1] The Economist (2000) 354(8152–8163) 186.
[2] The Income Tax Act 1961, s 80c.
[3] McDowell & Company Ltd v Commercial Tax Officer [1985] 154 ITR 148 (SC).
[4] Ibid 233 (Chinnappa Reddy J).
[5] The Income Tax Act 1961 (n 2), s 95.
[6] Ibid, s 102.
[7] Ibid, s 96.
[8] Gregory v Helvering (1935) 293 US 465 (US SC).
[9] Lotus Ledgers, Double Taxation Avoidance Agreements (DTAAs) (blog post, [date]) https://lotusledgers.com/blog-details/double-taxation-avoidance-agreements-dtaas accessed 12th September 2025.
