Introduction

This case deals with section 42(1) of the Income Tax Act, 1922 (IT Act) and the Court is entitled to lift the corporate entity if the entity is used for tax evasion or to circumvent tax obligation.

Facts

• There were three companies that make and sell yarn in Madurai. Each of these companies has a branch in Pudukottai, where they produce and sell cotton yarn.
• The money earned from the sales in Pudukottai was regularly deposited in the Pudukottai branch of Madurai Bank Ltd.
• The bank was established in 1943, with Thyagaraja Chettiar as the founder director. Thyagaraja Chettiar, his two sons, and the three assessee companies together held the majority of shares in the bank.
• Those three assessee companies borrowed money from the Madurai branch of the bank, using fixed deposits made by their Pudukottai branches as security.
• However, the loans given to the assessee companies were much more than the profits generated in Pudukottai.
• The companies appealed to the Appellate Assistant Commissioner of Income-tax. After reviewing the structure of the companies and the bank, as well as the deposit and overdraft figures, the Commissioner found that the deposits from the assessee companies and closely related companies make up a significant portion of the bank's total deposits.
• The Commissioner also noted that the Pudukottai branch of the bank mainly deals with fund collection and doesn't have many other significant transactions.
• The Appellate Assistant Commissioner also considered that the Pudukottai branch of the Bank had no other appreciable transactions except the collection of funds and on the facts found Section 42(1) of the IT Act applied to the case.
• They believed that the assessee companies should be aware of the activities of their Pudukottai branches, including the remittances sent from the Pudukottai branch to the Madurai head office.
• The Tribunal concluded that the entire set of transactions was part of a planned arrangement or scheme.

Issues Involved

• Whether the taxing of the entire interest earned on the fixed deposit made out of the profits earned in Pudukottai by the assessee’s branches in the Pudukottai branch of State Bank of Madurai is correct?

Observations

• The Court discussed Section 42(1) of the IT Act and observed that this section accordingly requires,
  • In the first place, any money should have been lent at interest outside the taxable territory.
  • In the second place, income, profits or gains should accrue or arise directly or indirectly from such money so lent at interest, and,
  • In the third place, the money should be brought into the taxable territories in cash or in kind.
• If all these conditions are fulfilled, then the section lays it down that the interest shall be deemed to be income accruing or arising within the taxable territories.
• The Court further said that the Appellate Tribunal war right in its conclusion that there was a basic arrangement or scheme between the assessee companies and the Bank that the money should be brought to British India after it was taken by the borrower outside the taxable territory.
• The Court further observed that it is well-established that in a matter of this description the Income-tax authorities are entitled to pierce the veil of corporate entity and to look at the reality of the transaction.
• It is true that from the juristic point of view the company is a legal personality entirely distinct from its members and the company is capable of enjoying rights and being subjected to duties which are not the same as those enjoyed or borne by its members.
• But in certain exceptional cases the Court is entitled to lift the veil of a corporate entity and to pay regard to the economic realities behind the legal facade.

Conclusion

The Court finally held that the company could lift the corporate veil if the corporate entity is used for tax evasion.