Family trusts face new limits: Cousins & non-relatives no longer eligible as 'beneficiaries'

Family trusts, often used to ring-fence wealth and enable smoother succession planning by ageing patriarchs of Indian households, will not have the freedom to add cousins, nephews, niece, or other `non-relatives’ as ‘beneficiaries’ in future.

If a trust deed gives trustees the liberty to include such persons even years later, the trust could be taxed today on all properties, securities and funds that have been transferred to it, according to a judicial pronouncement this week.

A discretionary trust is formed by the settlor (often the head of the family who transfers the assets). Immediate family members are named as beneficiaries, and independent professionals or a trusteeship company serve as trustees responsible for distributing a trust's earnings from like interest, rent, and capital gains to the beneficiaries in proportions that are not predetermined. A trust pays no income tax on the assets it receives provided all the beneficiaries are relatives (as defined under the Income Tax Act).


In the wake of the recent ruling by a tax tribunal, even if all the current beneficiaries are sons, daughters, and their spouses, the trust would be taxed upfront if trustees simply have the freedom to make non-relatives as beneficiaries at a later date.

However, many families prefer to retain the flexibility to bring in non-relatives in a trust to factor in unforeseen situations : if current beneficiaries or their children stay unmarried or are childless, or die, or undergo divorce, or marry a person belonging to another faith etc.

According to Dr. Anup Shah, partner at the CA firm Pravin P. Shah & Company, “The fact that the Trustees had powers to add any person as a beneficiary weighed with the Income tax Appellate Tribunal (Bangalore). The exemption under the I-T Act is only if all beneficiaries are defined relatives of the settlor --- say, a nephew is not a relative. The decision takes away the flexibility. If a father sets up a Trust for the benefit of his son and his children but the son dies without any children, the Trust would come to an end if there is no other beneficiary. Tax laws should aid succession planning and not be a hindrance. Trusts are a tool to overcome disputes, litigations, probates, associated with wills and hence, should be encouraged. It is high time that the current exemption enshrined in section 56(2)(x) of the Act is liberalised and made more progressive.”

Under section 56(2)(x), a person has to pay tax if the value of gift received is more than Rs 50,000.

‘PARTNERSHIP INTEREST QUALIFY AS SHARES’
The ITAT ruling, pertaining to the tax return filed by Buckeye Trust -- a private discretionary trust in Bangalore where the trustees have certain freedom to choose beneficiaries --- has also said that the transfer of 'interest in a partnership firm' would attract tax. The settlor of Buckeye settled investments of over Rs669 crore --- the predominant part of which is ‘partnership interest’ --- to the trust “out of natural love and affection”. It probably drew the taxman's attention as the amount was large and the trust had filed ‘nil income’ in 2018.

The decision is being closely tracked by practitioners. According to Ashish Karundia, founder of the CA firm Ashish Karundia & Co, “For Section 56(2)(x) to be attracted, the receipt has to be absolute in the hands of the recipient whereby the recipient can enjoy the property as per his wish. Since trust is an obligation, the trustee does not have the power to appropriate the assets in the manner it desires, and the assets are purely to be applied as per the trust deed. In such a case, the provision fails on basic principles.”

Turning down the argument that the trust was playing a fiduciary role and partnership interest is not a property (like securities, immovable assets etc), the tribunal ruled that ‘interest in a partnership firm’ qualifies as 'shares'. “The Supreme Court has stated that when a term is not specifically defined in the applicable law, its ordinary natural meaning can be used. Yet, if the term has gained a distinct legal meaning, the ordinary meaning ceases to be useful for interpretation. In interpreting the term 'share', the relevant reference should be The Companies Act, 2013, which restricts its meaning to a share in a company's share capital,” said Karundia.

Whether ‘partnership interest’ can be categorised as security may be challenged in higher courts. But since ITAT rulings can set a benchmark, going forward it would be tougher to create family trusts where trustees are allowed to include non-relatives as beneficiaries in future --- a power which can be misused too.


HIGHLIGHTS:
· Trusts pays no tax when assets are transferred

· This benefit is given when trust beneficiaries are ‘relatives’

· Cousins, nephews are not ‘relatives’ as per the law

· But trusts may like the freedom to induct them in future

· The ruling will make this difficult