-
Receipt of property by trusts created solely for benefit of settlor’s relatives exempt from gift tax
-
The trust deed should ensure that the class of beneficiaries is restricted to relatives and does not permit the inclusion of non-relatives, even as a future possibility.
The Chennai Bench of the Income Tax Appellate Tribunal (“ITAT”) in VS Trust v. Income-tax Officer1 has held that contributions made by a settlor to a private trust established exclusively for the benefit of relatives are protected by the statutory exemption contained in the proviso to Section 56(2)(x) of the Income-tax Act, 1961 (“ITA”), thereby limiting the application of Section 56(2)(x) to genuine family trust arrangements.
BACKGROUND AND FACTS
VS Trust was a private discretionary trust (the “Taxpayer”) settled by an individual for the benefit of his family members:
-
Under the original trust deed dated 1 September 2021 (“Original TD”), there were 2 classes of beneficiaries: Class A, being the settlor, and Class B, being the relatives of the settlor. Class A beneficiaries were eligible only to receive the trust income, while Class B beneficiaries were eligible to receive the trust property.
The Original TD also allowed the trustees to add the following persons as beneficiaries inter-alia being trusts settled for the benefit of family or any member of the family, any entities majority owned or controlled, directly or indirectly, individually or collectively, by the settlor’s relatives (“Original Beneficiaries”). Further, the amendment power under the Original TD was subject to a restriction that no amendment could be made which, directly or indirectly, resulted in the settlor regaining control over the trust property, any power of disposition over such property, or altered the objects of the trust (“Amendment Restriction”).
-
The Original TD was amended by way of a supplemental trust deed dated 3 March 2022, operative retrospectively from 1 September 2021 (“Amended TD”). Under the Amended TD, the power to add beneficiaries was substituted, and the trustees were empowered only to reclassify beneficiaries (from Class A to Class B or vice versa) or remove beneficiaries from the benefits of the Trust by way of a written resolution. The removal of a Class B beneficiary required the prior consent of the settlor’s son, who was a Class B beneficiary (“Amended Beneficiaries”).
During Assessment Year 2022–23, the settlor transferred shares valued at approximately INR 15.78 crore to the trust i.e., Taxpayer. The Taxpayer treated the transfer as exempt from taxation on the basis that it had been created solely for the benefit of the settlor’s relatives, thereby falling within clause (X) of the proviso to Section 56(2)(x) which exempts “any sum of money or any property received from an individual by a trust created or established solely for the benefit of relative of the individual” (the “Exemption”).
Section 56 of the ITA brings certain items of income to tax under the head “Income from Other Sources.” Under Section 56(2)(x) of the ITA, the receipt of money, movable property, or immovable property, as gifts or for inadequate consideration, by any person are made taxable. Unless an exemption applies, the difference between the fair market value (“FMV”) of the property received and the consideration (if any) paid is deemed income taxable to the recipient under the head income from other sources.
CONTENTIONS OF TAX AUTHORITIES
The lower-level tax authorities denied the Exemption to the Taxpayer on the ground that the Original TD permitted the trustee to add persons other than the settlor’s relatives as beneficiaries of the trust. This conclusion was based on the provision in the Original TD allowing the trustees to add, as beneficiaries, entities that are majority-controlled by the settlor’s relatives. According to the authorities, this could result in minority shareholders or stakeholders of such entities—who may not be relatives of the settlor—indirectly becoming entitled to benefits from the Taxpayer (trust).
In relation to the Amended TD, the lower-level tax authorities held that the amendment to the Original TD was not valid considering the Amendment Restriction.
ITAT’s FINDINGS
The ITAT after a detailed analysis of the Original TA and Amended TD held that Taxpayer was entitled to the Exemption.
The ITAT held that the Amended TD was validly executed under the powers granted to trustees. The amendment neither restored control over trust property to the settlor nor altered the objects of the trust, which remained confined to benefiting family members. The ITAT observed that the lower authorities had erred in disregarding the Amended TD and in relying upon provisions that had ceased to operate from the trust’s inception.
Having accepted the validity of the amendment, the ITAT held that the trust was created exclusively for the benefit of the settlor and his relatives, with no possibility of benefits accruing to non-relatives under the trust deed. Accordingly, the case fell within the exemption under clause (X) of the proviso to Section 56(2)(x)(c) of the ITA. The addition of INR 15.78 crore made by the assessing officer was therefore deleted.
ANALYSIS
The ruling in VS Trust must be understood against the legislative evolution of gift taxation under the ITA. Following the abolition of the Gift Tax Act, 1958 in 1998, Parliament gradually reintroduced gift taxation through Sections 56(2)(v), (vi), (vii) and (viia). These provisions incrementally expanded the regime from monetary gifts received by individuals and Hindu Undivided Families (“HUFs”), to the receipt of immovable property and specified movable assets, and subsequently to the receipt of shares of closely held companies by firms and companies not being companies in which the public are substantially interested, without or for inadequate consideration.
The Finance Act, 2017 consolidated these fragmented provisions into Section 56(2)(x), extending deemed gift taxation to “any person,” including companies, partnerships, LLPs and trusts. This marked a significant shift: provisions originally designed to regulate personal gifts were expanded to cover legal and fiduciary vehicles, thereby bringing trust structures within the potential ambit of taxation.
Importantly, however, Section 56(2)(x) preserves exemptions reflecting the longstanding principle that genuine family transfers are not intended to be taxed as income. Earlier provisions exempted gifts between relatives in the hands of individuals and HUFs; with the expansion of the regime in 2017, Parliament correspondingly excluded receipts by trusts established solely for the benefit of relatives. The exemption therefore seeks to maintain parity between direct gifts to relatives and transfers routed through bona fide family trusts, provided the trust benefits exclusively such relatives.
Within this statutory framework, the decision in VS Trust provides important guidance on the interpretation of the exemption available under Section 56(2)(x) in the context of family trusts. The ITAT clarified that the availability of the exemption must be assessed with reference to the operative trust deed as validly amended. While a trust deed may permit future additions to the class of beneficiaries, such additions must remain clearly defined and restricted to relatives; any provision enabling the inclusion of indeterminate or non-relative beneficiaries could jeopardize the availability of the exemption.
In contrast, in the Buckeye Trust2 case, the taxpayer sought to rectify a similar issue by executing a supplementary deed to amend the original trust deed, which had permitted the inclusion of non-relatives as beneficiaries. However, this amendment was executed only after the Principal Commissioner of Income Tax had passed an order under Section 263 setting aside the assessment and directing the Assessing Officer to undertake a fresh assessment in accordance with the ITA, including conducting the necessary enquiries and verifications. The Bangalore ITAT held that such a subsequent amendment could not cure the underlying defect, particularly since the issue had already been identified in the revision proceedings and the procedural lapses on the part of the Assessing Officer remained unaddressed.
Taken together, the decision also underscores that transfers of family wealth should not attract tax merely because they are implemented through a trust structure. At the same time, the ruling suggests that the exemption would be available only where the beneficiaries of the trust are identifiable individuals who qualify as “relatives” under the ITA.
These rulings also highlight the importance of careful drafting of the trust deed at the outset. In VS Trust, the revenue even challenged the trustee’s power to amend the deed, demonstrating that both the scope of beneficiaries and the extent of amendment powers may become areas of dispute.
It is common for trust deeds to include a general provision granting the trustees the power to add beneficiaries at a later stage. In practice, however, such powers are typically exercised within the intended family framework and non-relatives are generally not added as beneficiaries. Nonetheless, the mere presence of broad drafting that permits the inclusion of persons beyond the defined class of relatives may attract scrutiny from the tax authorities.
Seemingly minor drafting flexibility, particularly in relation to who may be included as beneficiaries in the future can therefore have a bearing on the tax treatment of contributions to the trust. Accordingly, the trust deed should clearly identify the present beneficiaries, define the class of any future beneficiaries with sufficient certainty, and specify the powers of the trustees, including the scope and limits of any amendment power. While amendments may be legally permissible, reliance on subsequent modifications to address drafting gaps may expose the trust to litigation risk. Careful drafting at inception therefore remains critical.
|