Private trust is an instrument used mainly by HNI families or families having special needs children, for effective succession planning. There are many benefits of forming a private trust, over a will. However private trust creation and ongoing trust management necessitates a cost, which makes it viable only if a high corpus is available. In India, a trust structure is regulated by Indian Trusts Act, 1882.
Trusts are of two kinds of trusts – private and public. In this post, focus will be on taxation of private trusts in India.
Overview of the applicable provisions on trust taxation in ITA
Under the Income Tax Act, 1961 (ITA), “trust” is not recognised as a separate person u/s 2 (31).
The provisions for trust taxation are contained in Section 56, 61, 160, 161, 164 and 166 of ITA.
Section 56 covers cases where transfer without consideration is deemed as income of recipient. However, the provision has been amended by Finance Act, 2017 which says that transfer to the trust is exempt if made by individual for a trust solely created for benefit of a relative of that individual. Also, the provision has expanded the scope of donor to “any person” instead of erstwhile individual/HUF Hence, while there is a certainty that settlement to a trust is not taxable to the beneficiary, there is no clarity as to what is the taxation of distribution of income/assets from the trust to the beneficiary.
Also read: Analysis of Finance Bill 2017 & Implications for NRI
Section 61 is a specific anti-avoidance provision which says that if the transfer of assets (for example, settlement of assets in a trust) is revocable in nature, taxation of income will be in the hands of the settlor of the trust.
Section 160 (specifically clause 4) recognises trustee as a “representative assessee”
Section 161 imposes an obligation on the trustee to be liable in his “representative capacity” w.r.t. the beneficiaries for their liabilities under the ITA. It also says that in case of business income of the trust, it will be taxable at maximum marginal rate. However, if all of the following conditions are satisfied, the taxation shall be as an Association of Persons (AOP):
- Trust is the only trust declared by such person
- Trust is formed out of a will
- Trust is exclusively set up for support of a dependant relative.
Section 164 applies to a situation where shares of beneficiaries are not mentioned in trust deed – such trusts are called s discretionary trusts. In such a case, the provision is that the entire income of the trust will be taxed in the hands of the trust at maximum marginal rate. Once the trust is taxed on that income any distribution later on to the beneficiaries out of that post tax income should not be taxed in the hands of the beneficiary.
Section 166 says that Assessing Officer (AO) will have the right to tax either the trustee or directly the beneficiary.
However, there is also a CBDT Circular No. 157 dated 26.12.1974 that says that assessment can be made either on trustee or on beneficiary, NOT BOTH.
So, a combined effect of Section 166 and Circular No. 157 is that once AO has exercised the choice to assess, for a particular assessment year, trustee, he cannot later change his mind and assess the beneficiary for the same assessment year. This view has also been upheld by the Karnataka High Court in [2012] 25 taxmann.com 259 (Kar.) Commissioner of Income-tax v. Smt. Indramma
Stage wise tax incidence in case of a private trust
To find out the tax payable, it is important to first establish whether the trust is a specific or a discretionary trust. In a specific trust, the beneficiaries and their shares are clearly identifiable however in a discretionary trust, it is not so, and the trustees reserve the right to distribution.
Tax incidence needs to be examined at three stages – when the settlor settles assets in the trust, when the trust earns income and when the trust distributes income/assets to beneficiaries.
Stage 1: Settlement of assets to the trust:
Here, taxation will depend on whether trust is revocable or irrevocable.
When a person settles assets to an irrevocable trust, it is excluded from a definition of “transfer” u/s 47 – hence, there is no tax liability on the trust/beneficiaries on this settlement.
However, in case a person settles assets to a revocable trust, it is covered in the definition of “transfer” and any income (e.g. by way of capital gains) will be chargeable in the hands of the settlor, and not the trust or the beneficiaries, by virtue of Section 61 of ITA
Stage 2: Income of the trust:
In case of a specific trust, Section 161 applies and the tax is applicable on the beneficiary as per his share. Either the trust can file the return in representative capacity or the beneficiary can file the return showing the share of income from the trust, in the same heads (e.g. other sources, capital gains etc.) as earned by the trust. In case of business income though, tax is applicable to beneficiary at maximum marginal rate (MMR). It may be noted that MMR for FY 2017-18 is 35.535%
In case of a discretionary trust, since no income accrues to the beneficiary, and Section 164 is attracted, the trust will pay tax at MMR. There is no taxability in hands of beneficiaries.
A question in case of specific trust may arise – in case the trust does not distribute any income/assets till beneficiaries reach a certain age etc., would the beneficiaries still be taxed on an accrual basis, or can it be deferred till distribution?
In my view, the answer will depend on the facts of the case. U/s 5 of ITA, the tax liability is fastened on “accrual” or receipt whichever is earlier, so taking a strict interpretation of this section, the income should be taxable at accrual stage itself. This view is supported in CIT vs. Dr. David Joseph (214 ITR 658)
It may also be noted that wherein private trust is charged at MMR under section 164(1), no basic exemption limit is applicable – Surendranath Gangopadhyay Trust vs CIT [142 ITR 149]
Here, another important decision that can be referred to is in case of [1962] 44 ITR 876 (SC) Commissioner of Income-tax v. Manilal Dhanji where Hon’ble SC has said that in a case When, however, the minor child derives no benefit under the trust deed in the year of account, it is not consistent with the scheme of section 16 to say that even though there is no accrual of any income or benefit in the year of account in favour of the minor child, yet the income must be included in the total income of the individual concerned.
Stage 3: Distribution to the beneficiary:
When we speak of distribution, there are two legs of it – distribution of income vs. distribution of assets.
Why this distinction is important is that while beneficiary is taxed every year on the income on accrual basis (in case of specific trust) or trust is taxable at MMR every year (in case of discretionary trust), it is a settled principle of law that the same income should not be taxed to the beneficiary on receipt basis, as it would result in double taxation of the same income.
Will a distribution of income in hands of beneficiaries be taxed as “Income from Other Sources” u/s 56? Here, there is a favourable decision of ITAT in [2012] 23 taxmann.com 347 (Mum.) Ashok C. Pratap v. Additional Commissioner of Income-tax, Range-11(2), Mumbai where it was held thatthe amount received in pursuance of dissolution of trust could not be termed to be an amount received by the beneficiaries ‘without consideration’ and hence will not fall within the clutches of Section 56
As regards distribution of assets, the benefit of exemption available u/s 56 for settlement of assets in an irrevocable trust and exclusion of such transfer from definition of Section 47 is not available in a case where trust distributes to the beneficiary – hence, prima facie, the distribution of assets IS taxable in hands of beneficiary.
Here, an argument can be taken that the trust holds money for beneficiary only – hence, the transfer is from a settlor to a beneficiary only, and if relationship between settlor and beneficiary is that of a “relative”, then it is not covered u/s 56 and hence taxability will not arise. However, if that relationship is not there, then it is very difficult to avoid taxability in hands of beneficiaries.
Finance Act 2017 amendments to Section 56 has opened a floodgate for litigation on distribution of income/assets so tax consultants need to tread carefully and evaluate the implications properly before suggesting solutions to clients.
Some other case laws on trust taxation
- If there is only one beneficiary in a trust, the even if his share is not defined in the trust deed, the trust remains as a specific trust and does not assume a character of discretionary trust – [2006] 152 TAXMAN 69 (PUNJ. & HAR.) Commissioner of Income-tax v. Poonam Trust
- Whether where board of trustees of assessee-trust, in exercise of their powers, adopted a resolution and demarcated shares in favour of beneficiaries of trust in ratio of 50:50, it could be said that shares of beneficiaries were definite and ascertainable and trust was held to be assessable as a specific trust – [2005] 148 TAXMAN 444 (BOM.) Commissioner of Income-tax v. Devshi Trust
- So long as the trust deed had given the details of the beneficiaries and the description of the persons who were to be benefitted, the beneficiaries could not be said to be uncertain, merely because wives/children could not be known until their marriage and begetting of children by the stated beneficiaries – [2009] 180 TAXMAN 277 (MAD.) Commissioner of Income-tax, Coimbatore v. P. Sekar Trust
Trust taxation – Grey areas
- There is no clarity as to the taxation rules for distribution of income/assets from the trust to the beneficiary.
- Section 166 says that AO has the power to choose whether to assess the trust or beneficiary. Now, imagine a case where the specific trust files return and pays the tax on behalf of beneficiary. AO sends scrutiny notice to beneficiary and asks him to pay the tax. Beneficiary will have to comply – in such case, how can beneficiary claim refund of tax paid by trust – trust cannot now revise the return as there is no “error/omission” here – this issue has been specifically discussed in [2012] 25 taxmann.com 259 (Kar.) Commissioner of Income-tax v. Smt. Indramma
- A trust can fall under the claws of Benami Prohibition Act. For example, settlor purchases properties from his ill gotten wealth in the name of a trust. (Also read: Benami Prohibition Act: An Analysis)
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