By Palak Pathak.
Piercing the corporate veil describes a legal decision to treat the rights or duties of a corporation as the rights or liabilities of its shareholders or directors. Usually a corporation is treated as a separate legal person, who is solely responsible for the debts it incurs and the sole beneficiary of the credit it is owed. Common law countries usually uphold this principle of separate personhood, but in exceptional situations may “pierce” or “lift” the corporate veil. A simple example would be where a businessman has left his job as a director and has signed a contract to not compete with the company he has just left for a period of time. If he set up a company which competed with his former company, technically it would be the company and not the person competing. But it is likely a court would say that the new company was just a “sham”, a “fraud” or some other phrase[1], and would still allow the old company to sue the man for breach of contract. A court would look beyond the “legal fiction” to the reality of the situation. Despite the terminology used which makes it appear as though a shareholder’s limited liability emanates from the view that a corporation is a separate legal entity, the reality is that the entity status of corporations has almost nothing to do with shareholder limited liability.[2]Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which the corporation has a small number of shareholders, limited assets, and recognition of separateness of the corporation from its shareholders would promote fraud or an inequitable result. There is no record of a successful piercing of the corporate veil for a publicly traded corporation because of the large number of shareholders and the extensive mandatory filings entailed in qualifying for listing on an exchange.
The application of the Salomon principle has mostly (as in Mr. Macaura’s case)[3]beneficial effects for shareholders. The price of this benefit is often paid by the company’s creditors. In most situations this is as is intended by the Companies Acts. Sometimes, however, the legislature and the courts have intervened where the Salomon principle had the potential to be abused or has unjust consequences. This is known as ‘lifting the veil of incorporation’. That is, the courts or the legislature have decided that in certain circumstances the company will not be treated as a separate legal entity.
The doctrine of piercing the corporate veil varies from country to country. In the opinion of two Corporate law scholars, apparently, there is a general consensus that the whole area of limited liability, and conversely of piercing the corporate veil, is among the most confusing in corporate law.”[4]
There are two existing theories for the lifting of the corporate veil. The first is the “alter-ego” or other self-theory and the other is the “instrumentality” theory.[5]The alter-ego theory considers if there is in distinctive nature of the boundaries between the corporation and its shareholders.[6]
The instrumentality theory on the other hand examines the use of a corporation by its owners in ways that benefit the owner rather than the corporation. It is up to the court to decide on which theory to apply or make a mélange of the two doctrines.
Courts are generally reluctant to pierce the corporate veil, and this is only done when liability is imposed to reach an equitable result.[7]
How is the corporate veil pierced in taxation matters?
Corporate Veil can be lifted if any corporate entity engages itself in the tax evasion. It is an exceptional case where any other authority rather than the judiciary is entitled to pierce the corporate veil. The Income Tax Authority is entitled to pierce the corporate veil. The ITA and the court are entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal facade. Supreme Court has stated that entities are treated as one taxable person, subject to assessment for the same taxable transaction. Since taxation is a power that is susceptible to abuse, it is subject to certain limitations to avoid its arbitrary exercise. One such limitation is the observance of due process.
As there are no statutory rules in this regard, it becomes necessary to throw some light on this matter with the help of certain judicial decisions. Some of such important Indian cases are discussed below:
In The Commissioner of Income-tax Madras vs. Shri Meenakshi Mills Limited, Madurai,[8] Ramaswami J. 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 corporate entity and to pay regard to the economic reality behind the legal facade. For example, the Court has power to disregard the corporate entity if it is used for tax evasion or to circumvent tax obligation.”
Further in Workmen Employed In Associated Rubber Industry Ltd., Bhavnagar vs. Associated Rubber Industry Ltd., Bhavnagar And Anr[9].the court observed, it is true that in law The Associated Rubber Industry Ltd. and Aril Holdings Ltd. were distinct legal entities having separate existence. But, if we think from different point of view, that was not an end of the matter. It is the duty of the court, in every case where ingenuity is expended to avoid taxing and welfare legislations, to get behind the smoke-screen and discover the true state of affairs. The court is not to be satisfied with form and leave well alone the substance of a transaction.
In Juggi Lal Kamlapat vs. Commissioner of Income-Tax, U.P.[10] the judiciary stated that:
“From a juristic point of view the Corporation may be a legal personality distinct from its members. But the Court is entitled to lift the mask of corporate entity if the conception is used for tax eviction, or to circumvent tax obligation, or to perpetrate a fraud.”
In Delhi Development Authority vs. Skipper Construction Company (P) Ltd. and another[11] Mr. Justice B. P. Jeevan Reddy has examined the question in considerable detail and it will be useful to reproduce the relevant paragraph of the judgment which is as under:
“Lifting the corporate veil: In Aron Salomon vs. Salomon & Company Limited[12], the House of Lords had observed, “the company is at law a different person altogether from the subscriber; and though it may be that after incorporation the business is precisely the same as it was before and the same persons are managers and the same hands received the profits, the company is not in law agent of the subscribers or trustee for them. Nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided by that Act”. Since then, however, the Courts have come to recognize several exceptions to the said rule. While it is not necessary to refer to all of them, the one relevant to us is “when the corporate personality is being blatantly used as a cloak for fraud or improper conduct.”[13]
Though the courts have encouraged the use of this doctrine whenever the corporate entities try to misuse their corporate personality to commit fraud, tax evasion etc, this should not be presumed that courts are being liberal in allowing such lifting. There have also been cases where the higher courts have overruled the decision of tribunals or lower courts to lift the corporate veil without any concrete grounds. One such case is that of:
There is a catena of decisions to warrant the conclusion that the doctrine of lifting the corporate veil or cracking open tile corporate shell, as it is very often said, is not confined only to cases of tax evasion and the Court would be well within its right and indeed be justified in lifting even the curtain rather than the veil and see what goes on behind it, concealed from the public gaze. Surely, the Courts will refuse to allow the corporate entity principle to be used as an instrument of fraud.
[1]HG Henn and JR Alexander, Corporations (3rd end, Hornbooks 1983) Ch. 7, 344, n 2
[2] Melvin Aron Eisenberg, “Cases and Materials on Corporations & Other Business Organizations (concise 9th Edition) Ch. 4, 171
[3]Macaura v Northern Assurance Co Ltd [1925] AC 619
[4]Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, (1985). 52 U.CHI.L.REV. 89
[5]Judith Waltz and Dan Reinberg, Foley & Lardner, Am i my company’s alter ego? theories of alternative liability for debts to the medicare program, http://www.foley.com/FILES/tbl_s31Publications%5CFileUpload137%5C1290%5Cliability.pdf
[6] supra
[7](University of London, student program, company law, chapter 4 pg 36) (http://www.londoninternational.ac.uk/current_students/programme_resources/laws/subject_guides/company_law/company_law_ch4.pdf)
[8] [1967 AIR 819, 1967 SCR (1) 934]
[9] AIR 1986 SC 1, 1985 (51) FLR 478, 1986 157 ITR 77 SC
[10] AIR 1969 SC 932, 1969 73 ITR 702 SC, 1969 1 SCR 988
[11]AIR 1996 SC 2005
[12](1897) Appeal Case 22
[13]Gower: Modern Company Law 4th Ed.(1979) at (P. 137)