Tax Planning vide colourable device u/s 45(3) not allowed?

Is tax planning an offence or not? From the Apex Court's decision in the case of Union of India vs. Azadi Bachao Andolan [2003] 263 ITR 706 (SC), it is transpired that once the transaction is genuine, merely because it was entered into with a motive to plan tax, it would not become a colourable device, nor does it earn any disqualification. However, the Courts have their way of distinguishing transactions. The same also depends upon the representations made. Let's understand the case of ASHA NIMMAGADDA Vs ASST. COMMISSIONER OF INCOME TAX [2023-VIL-1372- ITAT-HYD], at hand.

To plan payment (or non-payment) of tax on the capital gains arising out of sale of shares, a piece of land owned by the assessee is transferred to an LLP, which the assessee is controlling as a partner. The agricultural Land is transferred at a loss to such LLP by the assessee. The conversion of a Pvt. Ltd. Company to an LLP was made because section 45(3) of the Income tax Act is applicable only to a firm or other association of persons or body of individuals and its specifically excludes a company or a cooperative society. Possibly such a transaction does not furnish any meaning or purpose having regard to the timing. Possibly only to bring the transaction within the purview of section 45(3) of the Act, the conversion took place. However, the question is whether the tax laws or department or Courts prohibit tax planning and even otherwise, can they direct as to when to do or not to do a transaction?

It was argued by the revenue in this case that the Hon'ble Apex Court in the case of Sunil Siddharth Bhai vs. CIT [1985] 156 ITR 509 (SC) held that if the transfer of the personal asset by the assessee to a partnership in which she is or becomes a partner is merely a device or ruse for converting the asset into money which would substantially remain available for his benefit without liability to income-tax on a capital gain, it will be open to the income tax authorities to go behind the transaction and examine whether the transaction of creating the partnership is a genuine or a sham transaction and, even where the partnership is genuine, the transaction of transferring the personal asset to the partnership firm represents a real attempt to contribute to the share capital of the partnership firm for the purpose of carrying on the partnership business or is nothing but a device or ruse to convert the personal asset into money substantially for the benefit of the assessee while evading tax on a capital gain.

The Court held in favour of the revenue.

However, it may be noted that post this decision in the case of Sunil Siddharth Bhai, Section 45(3) has been introduced in the Income-tax Act, 1961 (Act) by the Finance Act, 1987 w.e.f 01.04.1988. The reason for insertion of sub-section (3) in section 45 has been explained, inter alia, by CBDT in circular no. 495 dated 22.09.1987. A perusal of para 24.1 and 24.2 of the said circular would show that section 45(3) has been introduced in the statute apparently to legislatively overrule the decision rendered by the Hon'ble SC by way of a common judgment in Sunil Siddharth Bhai v. CIT and Kartikeya V. Sarabhai v. CIT.

Therefore, we may see this matter being contested in the higher forums on this ground going forward as the same case if invoked when the situation is reverse, may be against the revenue.