Supreme Court clarifies taxation of Offshore Discretionary Trust
In its decision in Commissioner of Wealth Tax, Rajkot v Estate of Late HMM Vikramsinhji of Gondal,1 the Supreme Court has reiterated the primary basis for difference in taxation of discretionary trusts versus determinate (or specific) trusts in respect of an offshore trust.
A discretionary trust is one where the specific shares of the beneficiaries are not known. That is, the trustee has the discretion to decide, from time to time, who (if anyone) among the beneficiaries is to benefit from the trust, and to what extent. In a determinate trust, the entitlement of the beneficiaries is fixed by the settlor, the trustees having no discretion in determining the amount of distributions to be made to the beneficiaries.
As per the Income Tax Act, 1961, the income of a discretionary trust is taxed in the hands of the trustee while the income of a determinate trust may be taxed either in the hands of the beneficiary or of the trustee in his capacity as the representative assesse. If it is the latter, the taxation in the hands of a trustee must be in the same manner and to the same extent that it would have been levied on the beneficiary. That is, the trustee would generally be able to avail all the benefits/deductions, etc. available to the beneficiary with respect to that beneficiary’s share of income.
Gondal’s2 former ruler, Maharaja Vikramsinhji had created two private trusts (“Settlor”) in the U.K.3 by executing two similar trust deeds in the U.K. in 1964. A foreign national was designated as the ‘Original Trustee’ under the two trust deeds. Beneficiaries of these two trusts were the Settlor, his children and remoter issue and any spouse of such children and remoter issue. The trust deeds defined the term ‘the Trustees’ to mean and include the Original Trustee or the other trustees for the time being appointed in terms of these deeds.
During his lifetime, the Settlor included the whole of the income arising from these trusts in his personal returns of income tax. After his death, the Settlor’s son (the “Taxpayer”) also included such income in his personal returns of income tax for certain assessment years. However, for later assessment years (which were in dispute in this appeal) the Taxpayer had not shown the income of the trusts claiming that inclusion of such income in earlier assessment years was done under a mistake. Notes attached to the statement of income claimed that the trusts were discretionary and the Taxpayer had not received any income from the trusts since the trustee decided to retain the net income. For this reason, the Taxpayer claimed that the trusts’ income was not includible in his income and was not liable to be taxed in his hands. However, the Assessing Officer added the income of the trusts to the Taxpayer’s personal return and assessed it to income tax.
The Taxpayer’s appeals against this order were decided against him both by the Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal. However, the Gujarat High Court held in favour of the Taxpayer and the Revenue appealed to the Supreme Court.
Clauses in dispute
In order to determine whether the income was taxable to income tax in the hands of the Taxpayer, the key question to be decided was the nature of the trusts as discernible from the terms of the trust deeds. In the trust deeds in question, the interpretation of two clauses4 was in dispute.
Clause 3(2) provided that the Trustees shall hold the Trust Fund and income upon trust for the Beneficiaries for their advancement and maintenance and education at the discretion of the Trustees or of any other persons as the Maharaja shall appoint at any time during the specific period provided always that such power of appointment shall not be capable of being exercised: (a) by anyone other than the Settlor or his elder son or younger son; or (b) in favour of the person making the appointment save with the consent of the Trustees (being at least two in number or a trust corporation) such consent to be testified by their being parties to the deed of appointment and executing it.
Clause 4 provided that, subject to Clause 3, the Trustees shall hold the Trust Fund and income upon trust under certain terms, being that: (a) income of the Trust Fund accruing during the life of the Settlor shall belong and be paid to the Settlor; and (b) subject to the above, income of the Trust Fund accruing during the life of the elder son shall belong and be paid to the elder son. There were similar additional conditions regarding the younger son and descendants of the elder and younger sons.
The Taxpayer took the stand that:
The Revenue argued that:
The Supreme Court’s view
The Supreme Court upheld the decision of the Gujarat High Court6 that the trusts were discretionary. The Gujarat High Court had noted that the Settlement Commission’s order and the Supreme Court’s decision were not binding on the present appeals due to different facts. In contrast to the previous round of litigation, the Taxpayer here did not admit to having received the income; he did not receive the income and he had not shown the income as taxable in his returns. The Gujarat High Court’s reasoning (as listed below) was upheld by the Supreme Court:
In support of its interpretation, the Supreme Court quoted Snell’s Principles of Equity7: “A discretionary trust is one which gives a beneficiary no right to any part of the income of the trust property, but vests in the trustees a discretionary power to pay him, or apply for his benefit, such part of the income as they think fit. The trustees must exercise their discretion as and when the income becomes available, but if they fail to distribute in due time, the power is not extinguished so that they can distribute later. They have no power to bind themselves for the future. The beneficiary thus has no more than a hope that the discretion will be exercised in his favour.”
What does this decision mean in practice?
One key issue that has not been addressed in the decision is whether it is only income distributions made by the trustee that would be taxed in India or even capital/corpus distributions from a trust to its beneficiaries are taxable. This question arises on a consideration of whether the distribution can be categorised to be in the nature of capital distribution that should generally not be taxed or if the same can be treated as ‘income from other sources’ under S. 56 of the Income Tax Act, 1961. Under S. 56(2) (vii), income received by an individual or Hindu Undivided Family from a person without consideration or for inadequate consideration (subject to meeting certain value thresholds) are chargeable to income tax under certain circumstances. Since a trust is not a ‘person’ under the Income Tax Act, there has been discussion on whether this would cover situations where the trustee of a family private trust makes income distributions to family beneficiaries.
In this decision, the Supreme Court has mentioned that the beneficiary can be taxed on a receipt basis. Considering that it has not addressed the issue of capital receipt v. income receipt, it would be difficult to consider this decision as laying down a principle that all distributions by a discretionary trust to its beneficiaries once received are taxable in the hands of the beneficiaries. However, what this judgement highlights is that both trustees and beneficiaries must take steps to clearly identify the nature of the distributions. Trustees must keep separate accounts for income and capital, clearly record when amounts are disbursed from the corpus and the purpose of the distribution. Similarly, it may also be helpful for beneficiaries to keep separate accounts for receiving income and capital disbursements from the trust, and in communications with the trustee to clearly indicate the right under which the beneficiaries claim the funds.
1 Civil Appeal No. 2312 of 2007.
2 Gondal is a former princely state now in the State of Gujarat.
3 The Maharaja had also settled 3 U.S. trusts for the same beneficiaries. The taxation of income of these trusts was also in dispute but the Revenue had accepted the Gujarat High Court’s decision in relation to the U.S. trusts.
4 These clauses being long have not been reproduced here but have been paraphrased. The original text of these clauses is reproduced on pages 4 and 5 of the judgment. The judgment can be accessed by clicking on http://www.stpl-india.in/SCJFiles/2014_STPL(Web)_335_SC.pdf.
5 Jyotendrasinhji v. S.I. Tripathi (1993) 111 CTR (SC) 370. In this decision, the Supreme Court held that the issue regarding the true nature of the trusts was purely academic because the Settlor and his son had included the income in their returns and they had never said that they did not receive the income from the trusts.
7 28th edition, p. 138