Trusts—arguably the most elegant way to say, "I don't want to own this, but I still want control over it." Whether you're setting one up to protect family wealth, optimize taxation, or simply because a lawyer convinced you it's a good idea, understanding the legal and tax framework is crucial. Governed by the Indian Trusts Act, 1882 (yes, it's been around since the British Raj), trusts in India come with their own set of rules, and complexities.
Trusts in India are regulated by the Indian Trusts Act, 1882 (the "Act"). Under the Act, a Trust is defined under section 3, as an obligation tied to the ownership of property, arising from confidence placed or declared and accepted by the owner, for the benefit of another party and themselves. The individual who places or declares this confidence to establish the trust is referred to as the author of the trust or settlor. The individual who accepts this confidence is termed the trustee. The party for whose benefit the trustee accepts the confidence is known as the beneficiary. The property forming the subject of the trust is referred to as the trust property. The beneficial interest or interest of the beneficiary represents their rights against the trustee in their role as the owner of the trust property. The document that formally establishes the trust is known as the instrument of trust, trust deed, or indenture of trust.
Requisites of Valid Trust
The three requisites of a valid trust are:
- the words used must be so couched that, taken as a whole, they could be regarded as being imperative;
- the subject-matter of the trust must be certain; and
- the objects or persons intended to be benefitted must also be certain.
These three requisites are commonly termed the "three certainties" of a trust.
When a trust is invalid in law: A trust created for an unlawful purpose is considered void. However, a key question arises when a trust is established for multiple purposes, some of which may be unlawful. In such cases, the issue is whether the entire trust will be invalid or if it can continue with only the unlawful purpose being disregarded.
The well-established principle in law is whether the unlawful purpose can be separated from the lawful ones. The answer to this question determines the outcome:
- If the unlawful purpose can be separated, the trust will remain valid.
- If the unlawful purpose cannot be separated, the entire trust will be considered void or invalid.
This principle is referred to as the Doctrine of Severability.
Benefits of Trust
- Asset Protection: Trust serves as a mechanism for asset protection in which legal ownership is vest with trustee rather than beneficiary. This help to shield the assets from the creditor, lawsuit or any liability. The trustee manages the asset as per the trust deed or the intent of the settlor to preserve the wealth for future generations.
- Immigration: When an individual and their family relocate to another country, it serves as an opportunity to establish a trust as a tool for asset protection and tax efficiency. By setting up a trust before becoming a tax resident in the destination country, families can mitigate potential tax liabilities, and ensure greater flexibility in wealth management.
- Forced Heirship: Residents of countries with fixed laws of inheritance may be able to use trusts to obtain the flexibility they offer in terms of distribution for all or part of their assets to beneficiaries who would otherwise not be entitled to benefit under the laws of their country of residence.
- Preservation of family wealth: Trusts are a useful for managing and preserving assets that could be difficult to divide among individual beneficiaries, including real estate or stock in a family business. People can profit from such assets without having direct ownership by putting them in a trust, which guarantees continuity and purposeful management while protecting their long-term worth for coming generations.
Revocation of Trust and Validity
A trust, once created, is generally irrevocable unless the power of revocation is expressly reserved by the settlor in the trust deed. Under Section 78 of the Act, a trust may be revoked only in the following circumstances: (i) if the settlor has expressly reserved the right to revoke the trust; (ii) if the trust is created for the settlor's own benefit, it may be revoked with the consent of all beneficiaries; or (iii) if the trust is unlawful or void under Section 6 (i.e., created for an illegal purpose). Furthermore, any revocation must comply with the procedural formalities outlined in the trust instrument and general principles of contract law. The validity of a trust depends on its adherence to the three certainties—certainty of intention, subject matter, and beneficiaries. If any of these elements are lacking, the trust may be declared void or unenforceable.
A trust can be created through a will, allowing the testator (the person making the will) to ensure that their assets are managed and distributed according to their wishes after their demise. This is commonly known as a testamentary trust. Under Section 6 of the Act, a trust may be created by any person competent to contract, including through a validly executed will under the Indian Succession Act, 1925. A trust created through a will comes into effect only upon the death of the testator and does not require separate registration during their lifetime.
A non-testamentary trust is a trust that is created and comes into effect during the lifetime of the settlor. Unlike testamentary trusts, which are established through a will and take effect upon the testator's death, non-testamentary trusts are typically created through a trust deed or settlement deed and are governed by the Indian Trusts Act, 1882 (for private trusts) or the Religious Endowments Act, 1863 and other relevant statutes (for public trusts).
Creation of Trust
As per Section 6 of the Act, following conditions are necessary to bring into a valid trust which are as follows:
- Settlor (Author of the Trust): The settlor must clearly express an intention to create a trust by setting aside specific property for the benefit of the beneficiary(ies). This intention must be explicitly manifested through written or spoken words or conduct and cannot remain undisclosed.
- Trustee: A trustee must be appointed to administer and manage the trust property for the benefit of the beneficiary(ies). The settlor must clearly define and specify the objects of the trust. Since the trustee, who may or may not be the settlor, is responsible for executing the trust's purpose, the objects must be clearly articulated to ensure proper administration.
- Beneficiary(ies): The person(s) for whose benefit the trust is created must be identifiable.
- Trust Property (Subject Matter): The trust must have a clearly defined and identifiable subject matter.
- Instrument of Trust: The trust must be evidenced by a trust deed, indenture of trust, or other formal instrument, which must expressly set out the objectives and terms governing the trust
The creation of a trust involves the transfer of rights in the trust property to the trustees, who hold these rights for the benefit of the beneficiaries. Depending on the nature of the trust, trustees may transfer the trust property, income, or earnings derived from it to benefit the beneficiaries. In India, trusts can be classified as either: (i) private trusts or (ii) public trusts.
A private trust is established and governed under the provisions of the Act, whereas public trusts are created under state-specific legislation for public trusts applicable in the respective state. For example, a public trust in Gujarat or Maharashtra must be registered under the Bombay Public Trusts Act, 1950. Other laws governing public trusts include the Charitable and Religious Trusts Act, 1920, the Religious Endowments Act, 1863, and the Charitable Endowments Act, 1890.
Typical Private Trust Structure
A private trust is created under the Act for specified individuals or beneficiaries identified in the trust deed. It serves a defined purpose and concludes either upon achieving that purpose, the occurrence of a specified event, or the death of the identified beneficiaries, as outlined in the trust instrument.
Taxation of Private Trusts
For income-tax purposes, the Income-tax Act, 1961 ("ITA") is the relevant statute dealing with the taxation of the income of such trusts through various provisions spread over the enactment. The term "trust" is not defined under the ITA but there is special treatment for the taxation of such trusts.
Further the taxation of trust depends upon its structure whether it is a Specific/Determinate Trust or Discretionary Trust. Specific trust is the trust where the beneficiaries and their shares are fixed but in the Discretionary trust shares of beneficiaries are not fixed it is left to the discretion of trustees to determine the shares.
Since a trust has been held not to be by itself, a juristic person or legal entity under the ITA. Thus, the income of the trust is taxed in the hands of the trustee(s), as "representative assessee(s)" or beneficiaries.
A "representative assessee" is defined under Section 160 of the ITA, which outlines the role of trustees in the taxation process. Specifically, Section 160(1)(iv) of the ITA stipulates that a trustee receiving or entitled to receive income on behalf of any person, under a valid trust instrument (whether testamentary or otherwise), will be considered a representative assessee. Thus, trustees who receive income on behalf of beneficiaries are liable to tax as representatives in discretionary trust.
Section 160(2) of the ITA further clarifies that a representative assessee is deemed to be an assessee, and under Section 161 of the ITA, the trustee is subject to tax in their representative capacity. This means that the trustee is taxed on the income as though it were received beneficially by them, even though it is ultimately for the benefit of the beneficiaries.
However, Section 166 of the ITA allows the tax authorities to directly assess the beneficiary, instead of taxing the trustee as a representative assessee. This provision indicates that while the income from trust property is generally taxed in the hands of the trustee, the authorities may choose to levy the tax directly on the beneficiary where the shares of the beneficiary is fixed. Therefore, the income of a trust, arising from property created by the settlor, is generally taxable in the hands of the trustee(s) as representative assesses. While a direct assessment on the beneficiary is permissible, it is not typically the default method of taxation.
Section 161(1A) of the ITA specifies that when a trustee receives income from profits and gains of a business or profession, the tax on such income will be charged at the maximum marginal rate. However, there is an exception where the trust is created by a will solely for the benefit of a relative dependent on the settlor for support and maintenance, and the trust is the only one declared by the settlor. Section 161(2) of the ITA establishes that a trustee acting as a representative assessee cannot be assessed under any other provision of the ITA.
Section 162 of the ITA addresses the recovery of tax by the representative assessee. If a trustee pays any tax under the ITA, they are entitled to recover the amount from the beneficiary or retain an equivalent amount. Section 162(2) of the ITA further provides that if there is a disagreement between the trustee and the beneficiary regarding the tax paid, the trustee may retain an amount equivalent to their estimated liability, with the Assessing Officer issuing a certificate for the amount pending final settlement.
Section 164 of the ITA provides an exception to the rules in Section 161 of the ITA, applying to situations where the shares of the beneficiaries are unknown or indeterminate. This is typically the case in an "indeterminate/discretionary trust", where the beneficiaries' entitlements are not fixed. In such cases, tax is levied on the trustee at the maximum marginal rate under Section 164 of the ITA. This contrasts with a "determinate/specific trust" where the beneficiaries' shares are known, and tax is levied under Section 161 of the ITA.
The application of Section 164 of the ITA versus Section 161 of the ITA is a subject of legal debate, with courts and quasi-judicial authorities interpreting the provisions in various ways based on the facts of each case. Section 164 of the ITA applies only when the beneficiaries shares or entitlements are indeterminate or unknown.
The ITA also recognizes various other types of trusts which are as follows:
- Revocable Trust: A revocable trust is a trust
that allows the transferor to reclaim the assets or income
transferred to the trust under certain conditions. Section 63 of
the ITA outlines the nature of a revocable transfer. Specifically,
under Section 63(a)(i) of the ITA, a transfer is deemed revocable
if:
- It includes a provision that permits the retransfer, directly or indirectly, of all or part of the assets or income back to the transferor.
- It grants the transferor, directly or indirectly, the right to reassume control or power over all or part of the assets or income.
- Irrevocable trust:Section 62 of the ITA
addresses irrevocable trusts and specifies exceptions to the
application of Section 61 of the ITA. It states that Section 61
does not apply to income arising from a trust transfer that is
irrevocable during the lifetime of the beneficiary, or in the case
of other transfers, irrevocable during the lifetime of the
transferee. This exception also applies to transfers made before
April 1, 1961, which are irrevocable for a period not exceeding six
years. However, for this exception to apply, the proviso to Section
62 of the ITA mandates that the transferor must not derive any
direct or indirect benefit from the income generated by the
trust.
As per Section 62(2) of the ITA, if the transferor retains the power to revoke the transfer, any income arising from the trust will be treated as the transferor's income for tax purposes, and it must be included in their total income when the power to revoke the transfer becomes exercisable. This ensures that any potential future control or benefit derived by the transferor from the trust is subject to taxation. - Discretionary trust:A private discretionary trust is defined as a trust in which the trustees have full discretion to distribute both the income and capital of the trust as they deem fit, without any obligation to allocate any part of it to specific beneficiaries. According to Mozley & Whiteley's Law Dictionary, such trusts grant the trustees absolute discretion over the application of trust assets. The beneficiaries, therefore, have no fixed entitlement to the trust property, and their only expectation is that the trustees will exercise their discretion favorably (Snell's Principles of Equity). However, this discretion cannot be exercised arbitrarily; if it is, the beneficiaries may seek remedies under the ITA.
Section 165 of the ITA addresses situations where only a portion of the trust income is chargeable to tax. The formula for determining the taxable portion is as follows: the proportion of the income attributable to the beneficiary, based on the part of the trust income that is taxable, will be treated as the trust's income. In other words, the portion of the trust income that is taxable will be calculated by applying a ratio based on the beneficiary's share.
Section 167 of the ITA provides that remedies available against the property of a representative assessee are the same as those available against the property of any person liable to pay tax. This ensures that the enforcement of tax obligations extends to the representative assessees' property, similar to any other taxpayer's liability.
In CIT v. Manilal Dhanji (1962) 44 ITR 876 (SC), the assessee created a trust and, along with other trustees, set apart ₹25,000 as the corpus. The interest earned on this amount during the financial year (₹410) was to be added to the corpus and eventually distributed to the assessee's daughter Chandrika upon attaining majority. The Revenue sought to tax this interest income in the hands of the assessee as settlor of the trust under Section 16(1)(b) of the Indian Income-tax Act, 1922, which corresponds to Section 64 of the ITA.
The Supreme Court held that for Section 16(1)(b) of the ITA to apply, there must be accrual or receipt of income by the beneficiary. Since Chandrika had not attained majority during the accounting year, no income accrued to her. Thus, the interest income could not be taxed in the hands of the assessee. The Court clarified that unless the beneficiary has some beneficial interest in the income, it cannot be taxed as income of the trustee or settlor.
Further, In Kum. Pallavi S. Mayor v. CIT (1981) 127 ITR 701 (Guj), the Gujarat High Court examined the taxation of income where it was not specifically receivable by the beneficiary. The Court held that in such cases, the income should be taxed in the hands of the trustees under Section 164 of the ITA. If the trustees had discretion over the corpus and its utilisation, and income such as capital gains arose from the corpus, it could not be directly taxed in the hands of the beneficiary.
The Court reasoned that income utilised by trustees for further investments or corpus creation does not accrue to the beneficiary and thus cannot be taxed as their income. This decision highlighted that the absence of a specific beneficial interest prevents the income from being taxed in the hands of the beneficiary.
The manner of taxation of income under a trust settled for business purposes before insertion of section 161(1A) by the Finance Act, 1984, with effect from April 1, 1985 was the issue before the Bombay High Court in CIT v. Marsons Beneficiary Trust (1991) 188 ITR 224 (Bom). The Department contended that the trustees are an association of persons having been formed with the object of earning business income and, hence, liable to be taxed under section 164 since income from business would not be taxable in the manner provided under section 161. The Department also contended that the beneficiaries had appointed the trustees to earn business income.
The Bombay High Court held that the contention that business income stood on a different footing than other income was already negatived by the Bombay High Court in CIT v. Balwantrai Jethalal Vaidya (1958) 34 ITR 187 (Bom). The court stated that the settlor constitutes a trust for the beneficiaries and the beneficiaries do not direct the trustees to earn business income. Hence, there is no question of levying tax on the trustee-assessee otherwise than under section 161 where the shares are determinate.
Furthermore, In Gosar Family Trust v. CIT (1995) 215 ITR 55 (SC), the Supreme Court addressed the issue of taxation concerning discretionary trusts, a decision that has since become a landmark in this area of tax law. The case involved trustees who had complete discretion to manage the trust's income, including the ability to accumulate it for the trust's entire 18-year duration or decide whether to distribute it among beneficiaries. The Court held that the purpose of Section 164 of the ITA is to discourage discretionary trusts by taxing their income at the maximum marginal rate, except in specified circumstances. The assessees argued that income was not receivable on behalf of certain beneficiaries, such as corpus beneficiaries, and therefore, the shares of the beneficiaries were determinate and identifiable. However, the Supreme Court rejected this argument, holding that beneficiaries include both corpus and income beneficiaries, and Section 164 applies in both instances. If income is not distributed to the income beneficiary, it becomes attributable to the corpus beneficiary, making both categories subject to taxation. The Court emphasized that the entitlement of beneficiaries is not negated merely because the shares are not explicitly distributed; as long as income could be distributed to any beneficiary, the shares cannot be considered determinate or known.
In Bankim Ch. Datta v. CIT (1966) 62 ITR 239 (Cal), it was held that the word "share" used in section 164 means a fraction or some specific or definite part of the income of the trust property. If the fraction is not definite or ascertainable, it can hardly be said that the share of the beneficiary is ascertainable. Hence, the share or the amount receivable by the beneficiaries has to be determinate or known to avoid payment of tax at the maximum marginal rate under section 164 of the ITA.
Implication of Takeover Code
When a promoter settles shares of a listed entity into a Private Trust created for the benefit of his family members, the settlement entails an open offer obligation on the acquirer trust since the substantial acquisition of shares is involved in the settlement. Securities and Exchange Board of India ("SEBI") (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 ("Takeover Code") compels the 'Acquirer' to give a mandatory open offer as soon as the trigger point is nudged as mentioned in Regulation 3, 4 and 5 of the Takeover Code.
Major professionals opine that this acquisition doesn't entail a mandatory open offer requirement on the acquirer trust as the control of management and ownership of shares vest with the family members only post settlement too. Also, the shareholding post-settlement would remain the same in substance and mirror of promoter's shareholding.
Since the settlement in the trust would require the acquirer trust to give a mandatory open offer, it would be necessary for the acquirer trust to take an exemption order from SEBI for the proposed acquisition under Regulation 11 of the Takeover Code.
Regulation 11 (Exemptions by the Board) of the Takeover Code empowers SEBI to grant exemption(s) from the mandatory open offer on a case-to-case basis by passing an order subject to such conditions which it deems fit to impose in the interest of investors in securities and securities market. The order is passed by assessing the exemption application submitted by the proposed acquirer.
An increase in exemption applications under Regulation 11 of the Takeover Code more specifically with respect to transactions involving trust was observed in past. With a view to streamline the process of filing SEBI came out with a circular no. SEBI/HO/CFD/DCR1/CIR/P/2017/131 dated December 22 ("Exemption Circular"), 2017 providing for a standard format containing the guidelines and conditions along with undertakings to be given by the acquirer trust whilst applying for exemption under the Takeover Code. SEBI clarified their position on "settlement of trust" and made a standard operating procedure for application under Regulation 11 of the Takeover Code. The Exemption Circular has been made in accordance with the SEBI orders imposing conditions as imposed by SEBI in past numerous exemption orders.
Conclusion
In conclusion, trusts in India provide a valuable tool for wealth management and estate planning. Understanding the legal framework, including the Act, and the tax implications, is crucial for effectively utilizing trusts. Thus, as far as taxation is concerned, the ITA is beneficiary-centric, and the duties of trustees would, along with other provisions under the Act, form part of the civil-commercial law only and would not be relevant for tax purposes. Hence, taxation of private trusts is a self-contained code in itself. Therefore, careful planning and expert legal advice are essential to ensure the trust aligns with individual needs and complies with all applicable laws.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
