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In the world of chartered accountants, taxation is a major area of engagement. Particularly these days, provisions pertaining to trusts and the like are constantly attracting the attention of stakeholders for wealth preservation, succession planning etc.  There are generally two types of trusts, namely public trusts and private trusts. Usually, public trusts are established for the benefit of society as a whole.  A private trust can be further subdivided into specific trusts, family trusts, or business trusts.  Sections 161 to 164 of the Income-tax Act, 1961 deal with taxation of trusts.  The concept of a Private Trust is pretty simplistic.  It is created by a Settlor on behalf of certain beneficiaries, normally relatives or individuals who are either economically or socially connected to the Settlor.

Taxation of Private Trusts

Although Trust is not a person, some laws refer to it as one. In tax law, trustees are treated as representative assessees. A private trust is a representative assessee acting on behalf of a beneficiary.

A private trust is usually established to benefit one or more beneficiaries. There are two main types of private trusts: specific and discretionary.

As a result of difficulties with the e-filing software at the time, CBDT issued a press release on 31 July, 2012 referring to private discretionary trusts as individuals and stating that in law, the status of a private discretionary trust was that of an individual.

Private trusts are taxed under Sections 160 to 164 of the Income Tax Act. Taxation of Private Trusts depends on their type and activities.  Revocable Trusts disallow transfers of income, and the income is considered the property of the Settlor or Transferor.  As a result, in this case, Trust does not qualify as a separate tax entity. A trust that is irrevocable is governed by Sections 160 to 164 of the Income Tax Act.

Accordingly, section 161(1) plays a key role in determining how the Income Tax return in a trust arrangement will be filed, who will file it, what income will be generated, and how the tax liability will be calculated. The Trustee’s personal income will be treated separately for the purposes of determining taxable income and filing an income tax return.

According to section 160, a Trustee is treated as a representative assessee [section 160(1)(iv) and section 160(1)(v) – Trusts created by written instruments (160 (1) (iv) or oral trusts [160 (1) (v)] (a) Taxation for trusts where beneficiaries’ shares are known.  According to section 161, the income tax is levied in the same manner as for beneficiaries of a trust [161(1)].

This implies that the tax will be calculated according to the individual slab rates applicable to the beneficiaries (maximum marginal rate).

Some taxation and Foreign Exchange Management Act (“FEMA”) rules pertaining to private Trust are as follows –

Payment made by an Indian resident to a non-resident

If a resident of India wishes to pay a non-resident or to credit his account, the payment must fall under FEMA guidelines. Generally, business payments can be made under current account rules. Other specific transactions, such as investments abroad by Indian companies, including gift transactions is to be undertaken as permitted under the FEMA guidelines.

Repatriation of funds

A resident of India who receives a sum abroad is required to remit the same to India within a specified period (generally 180 days).  Such realized or unutilized funds have to necessarily be repatriated to India and cannot be retained abroad.

Returning Indian

Non-residents of India who acquire assets outside India without violating FEMA rules can retain those assets abroad.  The income from these assets can be retained, sold, and reinvested, or gifted outside of India. Similar benefits apply to Indian residents who inherit foreign assets from Returning Indians.

FDI policy in an eligible Indian entity

Non-residents investing in India are typically allowed to invest in companies and limited liability partnerships which are considered as an “Indian entity” along with investments being permitted in investment vehicles such as Real Estate Investment Trusts (REITs) governed by the SEBI (REITs) Regulations, 2014, Infrastructure Investment Trusts (InvITs) governed by the SEBI (InvITs) Regulations, 2014 and Alternative Investment Funds (AIFs) governed by the SEBI (AIFs) Regulations, 2012.

Nomination as a trustee

A trustee’s appointment by itself is acceptable.  A trustee’s appointment does not mean that assets are transferred to the Trustee.  According to the Reserve Bank of India, appointment as a trustee on an Indian trust is permissible.

Discretionary trust distributions

In accordance with section 56, if a person receives a sum without appropriate consideration, the recipient is liable to pay taxes on that sum. Receipts from relatives are not subject to tax.

The beneficiary of a specific trust has a clear interest in the Trust’s assets and income. Income is taxed similarly to what it would be if it came from the beneficiary. When income is taxed, the beneficiary does not have to pay taxes on it. The settlor/donor must take section 56 into account when gifting assets to the Trust.

Beneficiaries of discretionary trusts do not have any rights to the Trust’s assets.  The application of section 56 here is to be made at the time of distribution, not at the time of settlement/gift to a trust.

Non-resident beneficiaries’ taxation

If the non-resident beneficiary is not liable to tax in India due to the application of beneficial provisions of the Double Taxation Avoidance Agreement or otherwise, the trustee would not be taxed on that portion of the income.

Further, when such income is distributed to the non-resident beneficiary subsequently, the same would also not be taxable in the hands of the non-resident beneficiary in India.

The above is a high level summary of key issues governing private trust and the tax aspects.  However, there are several issues which would need to be examined while setting up a trust along with the taxability of income in the hands of the trustee/ beneficiary as also the time of taxability based on various revenue streams such as dividend, income earned but not distributed etc.