ITAT upholds that Distribution on Trust Dissolution not subject to tax in hands of Beneficiaries: Right conclusion, Wrong reason?
In a recent ruling of Ashok C. Pratap v. Additional Commissioner of Income Tax1, the Income Tax Appellate Tribunal (ITAT) ruled that the amount received by a beneficiary on the dissolution of a private family trust set up in India could not be considered ‘other income’ as contemplated under the provisions of the Income Tax Act, 1961 (ITA) and hence is not taxable in India. This is especially important in the backdrop of the amendment made to Section 56 of the ITA which provides that where an individual or a Hindu undivided Family receives any sum of money, without consideration, the aggregate value of which exceeds fifty thousand rupees, the whole of such sum shall be chargeable under the head of ‘Income from other sources’.2
The Taxpayer’s mother set up a private family discretionary trust for the benefit of her minor grand-daughters to which later on her son, the Taxpayer and his wife were added as beneficiaries. On the demise of the settlor, the Taxpayer and his wife were also appointed as trustees to the trust. Being a discretionary trust, the trust paid tax at the maximum marginal rate3 on an annual basis on all income earned by the trust. The grand-daughters, on turning major, relinquished their entire interest in the trust leaving the Taxpayer and his wife as the only beneficiaries. The trust was thereafter dissolved and the Taxpayer and his wife, being the only beneficiaries, received the entire trust property in distribution.
The Assessing Officer (AO) passed an order that the amount received by the Taxpayer and his wife as the trust beneficiaries on dissolution of the trust should be considered as ‘income from other sources’ in their hand, while completely ignoring the fact that the trust was already paying tax on a maximum marginal basis. The AO reasoned that since the Taxpayer had paid tax in a trustee capacity, he was now required to pay tax in a beneficiary capacity.
The Commissioner of Income Tax Appeals (CIT), before whom the appeal was filed, upheld the AO’s order, and additionally cited that the distribution was a without-consideration amount and did not fall within the exemptions provided under the ‘other income’, more specifically as that having been received from a ‘relative’.4 The Taxpayer appealed from this order before the ITAT
The ITAT rejected the order of the AO and CIT and ruled that the trust distribution received by the Taxpayer and his wife was in consideration of trust dissolution and hence cannot be treated as a “without-consideration” receipt in their hands. The reasoning given by the Tribunal was that since the distribution was received by the Taxpayer and his wife in the capacity as beneficiary, it cannot be said to be without consideration. The mere fact that it was a distribution pursuant to a dissolution does not change the finding that the amount was received as a beneficiary and in such case, it cannot be said to be without consideration.
Accordingly, distribution should not be treated as a no-consideration receipt and therefore cannot be taxed as income from other sources.
As a background, a trust, under the ITA, is not a separate taxable entity and the income of the trust is effectively taxed either in the hands of the Trustee as a representative assessee or in the hands of the beneficiaries.5 Accordingly, once tax has already been paid on the income, any distribution to the beneficiaries would not be subject to any further tax. However, the ITA had amended section 56 of the ITA to include any sum of money received by an individual without consideration to be subject to tax as other income. The question that has arisen as a result of the same is whether the settlement of a trust or a distribution of the proceeds of the trust can be brought to tax under section 56 of the ITA as “income from other sources’. This case reiterates the principle of taxation of a representative assessee, more so specifically in the case of trusts and has held that a distribution from a trust cannot be brought to tax under section 56 of the ITA.
Distribution of trust property on dissolution entails distribution of capital that was initially settled along with the income and capital accumulated over the term of the trust. A receipt is taxable if it is of the nature of income. The basic scheme of income-tax is to tax income not capital. Hence, capital received on dissolution of the trust should not be taxable in the hands of the beneficiary. It cannot tantamount to ‘other income’ since it is capital. Further, there is no requirement of any form of consideration for such distribution of a trust.
While the ITAT did uphold the right position of law by over-ruling the order of the AO and CIT, it is interesting to note the reason accorded by the ITAT for arriving at this conclusion, viz: ‘trust dissolution’ would constitute a distribution to a beneficiary and the same should be regarded as ‘consideration’ for distribution of the trust property. However, the ITAT has failed to provide any detailed explanation or analysis to arrive at this conclusion.
While the principles set out by the ITAT may be a subject matter of debate, however, this decision has given some comfort on the taxation of distributions to beneficiaries, which has been an issue post the amendment to Section 56 which taxes with no-consideration transfers in the hands of Indian resident persons.
While the resultant decision is desirable, the question arises whether there could be any negative repercussions that may arise on account of this interpretation provided by the ITAT.
1 IT Appeal No. 4615 (Mum.) of 2011.
2 Provided that this shall not apply to any sum of money received (a) from any relative; or (b) on the occasion of the marriage of the individual; or (c) under a will or by way of inheritance; or (d) in contemplation of death of the payer; or (e) from any local authority as defined in the Explanation to clause (20) of section 10; or (f) from any fund or foundation or university or other educational institution or hospital or other medical institution or any trust or institution referred to in clause (23C) of section 10; or (g) from any trust or institution registered under section 12AA.
3 Maximum marginal rate is defined as the rate of tax applicable in relation to the highest slab of income provided for association of persons in the relevant Finance Act. The maximum marginal rate is 30%, excluding surcharge and education cess.
4 Explanation to Section 56(2)(vi) of the Act provides the meaning of relative. It states that ‘relative’ means:
(i) spouse of the individual;
(ii) brother or sister of the individual;
(iii) brother or sister of the spouse of the individual;
(iv) brother or sister of either of the parents of the individual;
(v) any lineal ascendant or descendant of the individual;
(vi) any lineal ascendant or descendant of the spouse of the individual;
(vii) spouse of the person referred to in clauses (ii) to (vi);
5 Section 160-161 of the ITA