Why business houses put their faith in a trust

Given the continuously evolving tax and regulatory environment in India, and the attendant uncertainty, promoter-owned businesses and affluent families today are increasingly migrating to a ‘trust’ structure for wealth management and succession planning.

A trust enables segregation of ownership and control. Management of properties through a trust creates a legal framework within which assets can be protected and maintained effectively while safeguarding the interests of family members. A trust is a vehicle by means of which property (trust property) is transferred by the owner (settlor/ donor) to a person (trustee) who holds it for the benefit of another person (beneficiary).

A trust should be structured appropriately, to ensure control over all the group’s assets, separation of economic interest from management control, ease of income and assets distribution, and protection of assets from potential recourse by business creditors.

Typically such trusts are private, either specific or discretionary, governed by the Indian Trusts Act, 1882. In a specific trust, the interest of each beneficiary is defined. A discretionary trust, on the other hand, may either specify the beneficiaries or provide an indicative list of beneficiaries, which may change at a later stage. The trustees have the discretion to decide the distribution amount or ratio amongst the beneficiaries.

The taxing provisions are complex and various aspects have to be considered before analysing the taxability — tax on settlement or contribution to the trust, tax on income, who should be assessed, applicable rate, tax on distribution of assets by a trust, and so on.

On settlement of a trust, the assets transferred by a settlor/ donor to a trustee are specifically exempt from income tax. Also, on contribution of assets to a trust wherein the contributor and beneficiaries are close relatives, Section 56 (assets acquired without or inadequate consideration is taxable in the hands of recipient) should not apply as the donor and beneficiaries will be eligible relatives. However, contribution of immovable properties to the trust may be liable to stamp duty.

A trust is a pass-through entity for income-tax purpose. As trust property is held by trustees for the beneficiary, the tax burden is effectively borne by the beneficiary. However, for convenience, the obligation to pay tax is on the trustees in the representative capacity. Alternatively, the trust income may be directly assessed in the hands of beneficiaries.

The tax rate depends mainly on the type of the trust, income received and legal status of the beneficiary. In the case of a specific trust, if the trust income includes profits from business, the whole income would be taxable at maximum marginal rate (MMR) or in the manner in which the beneficiaries would have been taxed. For a discretionary trust, the trustees are taxed at MMR. Exempt income such as dividend is not taxable in the hands of the trust. In the case of a trust liable to tax at MMR and with income subject to concessional rates, there are contrary views on whether such income should be taxed at MMR or at concessional rate.

As the trustee (except in his/her capacity as beneficiary) has no interest in the trust property and holds it for the beneficiaries, there is no tax incidence on the distribution of assets to the beneficiaries. Similarly, there is no tax on the distribution of regular income to beneficiaries. However, in order to minimise litigation related to the distribution of current year income taxed both in the hands of trustees and beneficiaries, all distribution should come from the corpus of the trust, wherein the current year income is not distributed but retained to form the corpus for distribution in subsequent years.

Although there are some open issues regarding the taxability of trusts, the benefit of a trust structure outweighs the cons, and it remains the preferred choice for flexible and seamless wealth management and succession planning.

Kotak is Co-Head Tax, and Poddar is Senior Manager, M&A Tax, KPMG in India