Succession Planning through Private Trusts (Part 2): Implications under the Income Tax Act, 1961
As discussed in our previous publication, the creation of private trusts has emerged as a widely adopted mechanism for succession planning in India. Part 1 provided an overview of the Indian Trusts Act, 1882. In Part 2, we consider the tax implications of private trusts under the Income Tax Act, 1961 (“IT Act”).
I. TAXATION OF PRIVATE TRUSTS UNDER THE IT ACT
The tax implications of private trusts depend largely on their classification. For tax purposes, private trusts can be categorized as follows:
(i) Revocable Trust: A revocable trust is a trust where the instrument through which the assets are settled by the settlor in the trust contains a provision for re-transfer of such assets or income arising from such assets to the settlor or gives a right to the settlor to re-assume power over such assets or income arising from such assets.1
(ii) Irrevocable Trust: An irrevocable trust is a trust where the transfer of assets by the settlor (along with any income arising from such assets) is not revocable during the lifetime of the beneficiary.
II. TAX IMPLICATIONS FOR A REVOCABLE TRUST
(a) Settlement of assets into the trust
- Taxability for settlor: Settlement of assets by the settlor into a revocable trust may attract capital gains tax, as there is no specific exemption under the IT Act. However, one may argue that there is no actual transfer in case of settlement of assets in a revocable trust, as such settlement contains a provision for re-transfer of such assets to the settlor. Accordingly, there should be no capital gains implications arising from settlement of assets.
- Taxability for trust / trustee: The receipt of assets from a settlor by a trust created solely for the benefit of relatives of such settlor is exempt from tax.2 However, if the beneficiaries include non-relatives, such a receipt may be taxable as “income from other sources” for the trust. Nonetheless, it may be argued that no definitive benefit accrues to the trust, and hence the receipt should not be taxable.
(b) Income generated from settled assets
- Taxability for settlor: Income arising from the assets transferred by the settlor to the trust is taxable in the hands of the settlor, by virtue of the clubbing provisions under the IT Act.3
- Taxability for trust/trustee: There are no tax implications on trust / trustee.
(c) Distribution of assets and income to beneficiaries
To effectuate the distribution of assets and income to the beneficiaries, the revocable trust would first be required to be converted to an irrevocable trust. Thereafter, the assets and income would be distributed to the beneficiaries. The tax implications of conversion of revocable trust to irrevocable trust (which is akin to initial settlement of an irrevocable trust) and distribution of assets by such irrevocable trust are outlined in Para III (a) and III (c) below.
III. TAX IMPLICATIONS FOR IRREVOCABLE TRUST
(a) Settlement of assets into the trust
- Taxability for settlor: The transfer of assets by a settlor to an irrevocable trust is specifically exempt from tax under the IT Act.4
- Taxability for trust / trustee: The receipt of assets from a settlor by an irrevocable trust created solely for benefit of relatives of such settlor is also exempt from tax.5 However, if one or more beneficiaries are non-relatives, settlement of assets in such trust would be taxable in hands of the trust.
(b) Income generated from settled assets
- Taxability for settlor: Income generated from assets settled in an irrevocable trust is not taxable for the settlor.
- Taxability for trust / trustee: Income generated from assets settled in an irrevocable trust is taxable for the trust / trustee. The tax implication on the trust / trustee depends on whether the share of beneficiaries in the property and income of the trust is defined or not at the time of creation of such trust. If the share is defined, the trust is called a determinate trust and if the share is not defined, the trust is referred as an Indeterminate trust.
Income of a determinate trust is taxable in hands of the trustee as representative assessee of the beneficiaries in the same manner as would have been taxable in the hands of the beneficiaries. However, in case, there is any income under the head “Profits and gains from business or profession”, then the entire income would be taxable at the maximum marginal rate.6
Income of an indeterminate trust is taxable in hands of the trustee at the maximum marginal rate (‘MMR’).
(c) Distribution of assets and income to beneficiaries
- Taxability for trust / trustee: There is no tax implication on the trust / trustee.
- Taxability for beneficiaries: The distribution of assets and income to beneficiaries in terms of the trust deed should not be regarded as receipt of assets or income for inadequate / nil consideration subject to taxation under the IT Act,7 as such distributions are made to the beneficiaries by virtue of their beneficial rights over those assets and income under the trust deed.
In Ashok C Pratap v. Addl. CIT,8 the assessee, one of the beneficiaries of a private trust, had received certain sum of money in terms of the dissolution deed on dissolution of the trust. The Mumbai Tribunal held that such receipt of money is not taxable for the assessee-beneficiary as the amount received in capacity of a beneficiary cannot be said to be received without any consideration to be taxable under the IT Act.
IV. CONCLUSION
The creation of private trust serves as an effective and tax-efficient mechanism for succession planning. While settlement of assets in a trust may be taxable (if the beneficiaries are non-relatives), its subsequent distribution to the beneficiaries is generally not taxable. Further, any income generated by the trust from settled assets is only taxable in the hands of the trust (if revocable trust) or the settlor (if irrevocable trust) and is not subject to tax in the hands of the beneficiaries. There is no incidence of double taxation. Accordingly, a properly constituted private trust, with appropriate guardrails, can provide a stable legal structure for orderly wealth transfer with minimal tax exposure.
1. Section 63 of the IT Act covers the meaning of revocable transfer
2. Proviso (X) to Section 56(2)(x) of the IT Act
3. Section 61 of the IT Act
4. Section 47(iii) of the IT Act
5. Proviso (X) to Section 56(2)(x) of the IT Act
6. Maximum marginal rate is the rate of income tax (including surcharge and cess) applicable to the highest slab of income
7. Section 56(2)(x) of the IT Act provides that any sum of money or property received without / inadequate consideration is taxable for the recipient
8. (2012) 23 taxmann.com 347 (Mum)