The world has witnessed a colossal damage like never before. No country has been spared, no individual too, whether physiologically or cognitively. The mortality count is accrescent, coupled with the double whammy of the insurmountable adverse economic impact.
The question therefore is what does one do, where does one start? While the answer may differ from person to person, a common fear engulfing most is the need to protect what is left. The ‘rainy day’ is here as the idiom we have grown up on is in its implementation stage. But have we done enough? How long will this last? What measures will the government resort to in aiding a steady recovery?
Given the precarious nature of the pandemic, addressing financial anxiety could be a challenge. Hence, by way of this article, we have tried to present a formidable alternative of a trust structure, while we await an end to this mayhem.
Trusts in India are governed by the provisions of the Indian Trusts Act, 1882 (“the Trust Act”). The Trust Act, has permeated through time and continues to be a very relevant reference more so today, in the protection of wealth spanning generations and planning succession.
Before we dive deeper into the process of protecting wealth and succession planning, it is important to assess reasons giving rise to the need for such planning.
We have often heard people loosely claim that they have wealth that can last seven generations. However, data suggests that most wealthy families lose 70 percent of their wealth by the second generation and 90 percent of it by the third generation, a far cry from the seven generations claim made by many.
While three generations is its likely life, certain force majeure occurrences such as the Covid-19 that we are presently grappling with, could further truncate the tenure and hence, protecting wealth no longer remains a choice but takes priority over most other aspects of our life.
As a first step in that direction, understanding one’s options is critical. Family arrangements, settlement on Trusts, drawing up wills, gifts of assets, mergers, etc. are some of the options commonly available.
A very common tendency amongst people is to draw up a Will and consider the job done. While drawing up a Will is a simpler process to undertake, a Will when compared to a Trust, does have several inherent limitations mainly related to insulation of assets named in a Will from the levy of estate duty/ inheritance tax. A Will can be changed at any time and hence, an element of uncertainty prevails, which takes away most of the advantages that succession planning has to offer. Unlike a Will or other options available, settlement of trusts provides the flexibility to an individual to distribute assets during the life as well as posthumously. In case of a Trust, the legal ownership is immediately transferred to the trustees and is under complete control of the trustees. The trustees have a fiduciary responsibility to distribute the trust property to the beneficiaries in accordance with the Trust Deed. Distribution of Trust Assets does not require a probate from the High Court, unlike in case of a Will, which is an expensive as well as a lengthy process.
An effective succession plan therefore is one which would provide separation of ownership and management, allow effective control over properties, flexibility and certainty about the ultimate distribution, all of which is possible under a Trust structure. However, separating ownership from management may have several practical challenges such as opting for neutral/ professional trustees over known family members, baring assets/ wealth before unrelated professionals, factoring consequences in the event of death of trustees, etc. Hence, pre-empting such scenarios and ring fencing them, while drawing up the deed is imperative, to achieve the desired objectives.
Given the economic inequality and increasing need for public spending by the Government, reintroduction of the erstwhile Estate Duty regulations in an altered form may soon be a reality.
While we are not new to Estate Duty regulations, having prevailed in India since 1953 until 1985 with some asset classes being subjected to 85 percent duty at the time of its repeal, public memory is short lived and hence, it is only prudent to plan for the worst while hoping for the best.
In light of this, a well thought through and effectively documented trust structure can act as an effective succession plan as well as a wealth management tool to cope with life’s uncertainties and for overall insulation of assets.
Introduction to Private Trusts
By way of this article, we share with you an introduction into the Private Trust arena, with a brief on the income-tax implications for Private Trusts.
A Trust usually comprises of settlors, trustees, Trust Property, beneficial interest, Trust Deed, protector. A protector is a person appointed under the Trust Deed to direct or restrain the trustees in relation to administration of the Trust.
Very often, identifying the beneficiaries of a Trust, can help classify the Trust as a Private Trust or a Public Trust. A Private trust is created for the benefit of specific persons, usually family, creditors, employees, unlike a Public Trust, which is created for society at large. In this article, we have restricted our discussion to Private Trusts.
A Private Trust can be:
- Determinate / Specific
- Discretionary
- Revocable
- Irrevocable
- Any of the above combinations
We have highlighted certain key issues pertaining to the various stages of transfers to and from the Trust and income-tax implications vis-à- vis the different types of Private Trusts.
A. Transfers to and from a Private Trust
1. On receipt of Trust Property by a Private Trust
Trust property is generally introduced into the Trust both at the time of creation of the Trust as well as during the life of the Trust. Such introduction is largely pro-bono and no consideration is associated with the transfer of the said property. However, certain compliances such as obtaining approval from the Securities Exchange Board of India (SEBI) at the time of settlement of listed company shares in the Trust, will have to be duly complied.
Historically, there were no significant income-tax implications in the hands of the transferee on receipt of such property. However, section 56(2)(x) of the Income-tax Act, 1961 (‘Act’), as it stands today, does pose a threat to the tax position adopted by transferees hitherto, especially where the group of persons forming a part of the trust structure i.e. settlor, trustee and beneficiaries, are not relatives, as defined under the Act. Hence, the key issue is to determine whether an obligation attached to the Trust Deed can be deemed as a consideration or otherwise and accordingly determine the applicability and impact of section 56(2)(x) of the Act.
2. On receipt of Trust income by a Private Trust
Income arising to a Private Trust is effectively the income of the beneficiaries and should be taxed as such. Trustees appointed under a Trust who receive or are entitled to receive income on behalf or for the benefit of the beneficiaries shall be the representative assessees in respect of such income, for levy of income tax (Reference – section 160 of the Act). Accordingly, the Trust is not liable to income-tax, instead the trustees are liable to income-tax on behalf of the Trust
3. On distribution of Trust Property to beneficiaries
Distribution of assets to beneficiaries without any consideration does not result in any tax liability for the Trust. However, on receipt of consideration by the Trust towards such distribution, capital gains tax should be computed in accordance with the prescribed mechanism.
B. Taxation of Private Trust
Taxation of income received by a Private Trust varies in accordance with the type of Trust.
1. Irrevocable Specific Trust
In the absence of business income, such Trust shall be liable to tax at the rates applicable to each beneficiary in the manner prescribed (Reference – section 161(1) of the Act). Such Trust earning business income shall be chargeable to tax at the Maximum Marginal Rate (MMR) or in specific circumstances at the rates applicable to an Association of Persons (AOP) (Reference – section 161(1A) of the Act).
Tax is payable in the year of receipt / accrual in the hands of the trustees, irrespective of whether such income is distributed or not.
2. Irrevocable Discretionary Trust
In the absence of business income, such Trust shall be liable to tax at MMR, with certain exceptions (Reference – section 164 of the Act).
Like taxation of an irrevocable specific trust, an irrevocable discretionary trust earning business income shall also be chargeable to tax at the Maximum Marginal Rate (MMR) or in specific circumstances at the rates applicable to an Association of Persons (AOP) (Reference – section 161(1A) of the Act).
MMR refers to the highest rate applicable in relation to a particular type of income in case of an individual. For example, the MMR in relation to business income for FY 2020-21 would be 42.74% while MMR for dividend income and long-term capital gains would be 35.88% and 28.496% respectively
There has been a lot discussion about the status of a discretionary trust vis-à-vis return of income – whether it is an Individual or an AOP?
The status of a Trust in relation to income is usually the same as the beneficiary, unless the beneficiaries share is not specified. Hence, in such cases, the status of the Trust is irrelevant.
However, in case of a discretionary trust, the status of a trust becomes relevant more so in cases where the beneficiaries comprise of individuals, corporates and other persons.
In the instant case, trustees and the beneficiaries cannot be said to have come together with the object of earning income. Further, the beneficiaries have not set up the Trust and the trustees have derived their authorities under the terms of the Trust Deed as settled by the settlor. Therefore, the status of the Trust ought to be an Individual and not AOP.
3. Revocable Trust
Income earned by such Trust is to be taxed in the hands of the transferor (Reference – section 61 of the Act).
C. Taxation of certain parties to a Trust
1. Taxation of Trustees
Trustees are liable to tax in their representative capacity.
2. Taxation of Settlor
The role of a settlor is generally restricted to settling the Trust and handing over the properties to the trustee without any consideration. Specific exemption is provided for transfer of capital to an irrevocable Trust (Reference – section 47(iii) of the Act).
In case of a revocable Trust, the settlor continues to be liable to tax in relation to future income earned from such Trust.
3. Taxation of Beneficiary
Distribution of assets to beneficiaries by the Trust is probono and no consideration is associated to such distribution. Hence, implications under section 56(2)(x) of the Act ought to be examined. In case of a Trust, trustees hold the properties for the benefit of beneficiaries. Thus, it is important to evaluate whether beneficiaries had a preexisting right in the value of properties.
Given the various facets to a Private Trust and the numerous advantages it poses over other forms of succession, it merits a serious consideration for anyone desirous of protecting their life earnings / savings. Planning appropriately while there is time can circumvent a significant exposure in the future. As we know, a stitch in time saves nine. So, act Today!
Source : taxmann.com