Succession planning is a crucial aspect in everyone’s life. The happenings in the last one year have further enforced upon us the criticality of the same. There are various ways and means through which intergenerational transfer of wealth can be ensured. For movable properties, such as shares of group companies, bank balances, fixed deposit and other financial assets, the next generation may simply be appointed as nominees to ensure that these assets get transmitted to them on demise of the current owners. Further, other movable assets, such as jewellery, artifacts, and other valuables are usually gifted during the lifetime of the individual. However, rather than providing for a piecemeal wealth transition plan, people generally do a Will or, of late, have started settling Family Trusts to ensure seamless transfer of economic interest to the next generation.
A Family Trust may be considered to be a more effective mechanism for ensuring unfettered and seamless succession planning. This is because the Trust is implemented during the lifetime of the patriarch, and therefore, he can ensure that the same is functioning in the manner he would like it to operate and, if required, make amendments to make it more effective and efficient. Further, in case of a Family Trust, the privacy of the document is maintained as the same is not required to be executed through a court process, as it may be in case of a Will.
Seeing the growing trend around creation of Family Trusts for wealth succession, it is imperative that more clarity is brought about certain provisions of the tax laws in India in relation to Family Trusts.
Creation of a Family Trust structure
At the time of formulation of the Family Trust structure, various promoter groups opt for a dual Trust structure, consisting of Master Trust and Sub-Trusts, in order to provide a mechanism for effective succession planning for not just their generation, but for the future generations as well.
Section 56(2)(x) of the Act requires receipt of property by any assessee at the fair value of such property. Therefore, migration of family wealth (such as corporate shareholdings, family assets such as jewellery, etc.) to a Trust structure would have required transfer of the same at fair value, in order to comply with Section 56(2)(x). However, an exemption has been provided in the said Section, wherein transfer of property from an individual to a Trust, which has been created solely for the benefit of relatives of the individual, is exempt from applicability of Section 56(2)(x). Further, the term ‘relative’ has been defined to include only individuals.
Therefore, on the basis of a literal reading the provision, exemption would be available only in case of a single Trust structure, i.e. wherein individual family members are direct beneficiaries in the Trust. However, in case a dual Trust model is created, i.e. a Sub-Trust is a beneficiary of the Master Trust, availability of the exemption is ambiguous.
Accordingly, a clarity should be provided in Section 56(2)(x) that if a Sub-Trust is a beneficiary of the Master Trust and the beneficiaries of the Sub-Trust are individuals who are relatives of the donor of the Master Trust, then the exemption from 56(2)(x) should be available. Since the ultimate beneficiaries of the Master Trust would eventually be individual relatives of the donor, the same would be in line with the spirit of the above-mentioned exemption. Such clarity would facilitate creation of more efficient Trust structures for the promoter groups.
Taxability of capital gains of a Discretionary Family Trust
A Discretionary Trust is a Trust wherein the beneficial interest ration of the beneficiaries is not defined at the time of creation of the Trust. The Trustees have the discretion to decide the timing and quantum of distribution of assets and income of the Trust amongst the beneficiaries. As per Section 164 of the Act, all income of a discretionary Trust is taxable at Maximum Marginal Rate, i.e. the tax rate (including surcharge) applicable in relation to the highest slab of income in the case of an individual. The tax rate prescribed for the highest slab of income for individuals is 30%, plus applicable surcharge and education cess.
The rate of tax leviable on capital gains has been specified under Section 112, 112A and 111A of the Act, and ranges from 10%-20%. Therefore, in case of a discretionary Family Trust, capital gains should also be chargeable at the rate of 10-20% in order to ensure that it is at par at the rate applicable to the underlying individual beneficiaries.
Any other interpretation would be illogical, because in that case, if capital gain accrues to the individuals directly, then they would be taxable at a lower rate as compared to the effective rate applicable to them through the Family Trust.
Availability of deductions to Family Trusts
A Family Trust with individuals as beneficiaries should be taxed as an individual. This principle has also been upheld by various courts in the past, wherein taxability of a Trust has been analyzed. There are certain deductions under the Act which are available to individuals and HUFs, e.g. deduction under Section 54F, various deductions prescribed under Chapter VIA (Section 80C, 80CCA, etc.). Benefits of such deductions should also be extended to Private Family Trusts to ensure that the taxability of the Family Trust is completely at par with that of its individual beneficiaries.
Taxability of dividend received by a Family Trust
Pursuant to abolition of Dividend Distribution Tax (‘DDT’) in Finance Act, 2020, dividend is taxed in the hands of the shareholders at the income tax rate applicable to them. In case of Family Trusts or High Net Worth Individuals (‘HNIs’), the applicable rate of tax on dividend income may be as high as 35.88% (including maximum applicable surcharge of 15% and cess of 4%).
Prior to the aforementioned amendment, dividend income was taxable in the hands of the recipient @ 10% (under Section 115BBDA). Therefore, amendment has increased the tax liability of the recipient on receipt of dividend income.
Dividend is declared by a company out of its post-tax profits. Therefore, levy of further tax on dividend received by the shareholders leads to double taxation of the same income.
Abolition of tax on dividend income would bring corporate structures in line with profit distribution by partnership firms or LLPs, wherein profit share received by the partners are not taxable.
With the increased impetus for creation of Private Family Trusts for holding corporate and personal assets, the above mentioned clarifications from an Income Tax perspective are imperative and would be a welcome move by the legislature.
One of the primary benefits of a Family Trust is that it is a very transparent mechanism of inheritance planning and therefore, helps avoid family disputes, which in turn ensure business continuity and brand protection. It would not be wrong to say that Family Trust is the new age ownership vehicle for family wealth and for housing the family office. Therefore, it is imperative to have absolute clarity around the tax provisions applicable to a Family Trust to ensure business and economic prosperity in the country.