A 360 degree view on employing Trust as a succession planning tool – Part 1

India is a family business driven economy for decades. Large, medium and small businesses are run very successfully by families and they have provided huge employment as well as returns to stakeholders. Many of these business houses have listed their shares on stock exchanges where public at large is also able to participate in the profits.

Over last few decades, families (both with their listed businesses as well as closely held businesses) have accumulated good amount of wealth and the succession is always a worry in the minds of a patriarch of the family.

Many a times, protection of wealth is more important than earning more profits. Also in addition to economic succession of assets (financial and business assets) of the family, management succession (handing over reins of business either within family or to professionals) is an important part of any succession planning.

The economic succession of assets can be effected on death of an individual (ie through a will) or even can be done during lifetime of an individual. The various modes are gift of shares, sale of assets, family arrangement or use of a Trust vehicle, etc.

This article focuses on succession of assets through a 'Private Trust' mechanism.

Succession Planning through a Private Trust:

Succession through a Private Trust mechanism is a common mode of transition of assets as the Trust provides better legal protection, certainty and flexibility. Also as a practice, it is an accepted mode of implementing succession planning.

In following paragraphs, we discuss use of Trust as a succession planning tool.

Trust is governed by Indian Trust Act, 1882 ("Trust Act").

Section 3 of Trust Act defines a "Trust" as an obligation annexed to the ownership of property, and arising out of a confidence reposed in and accepted by the owner, or declared and accepted by him, for the benefit of another, or of another and the owner.

Thus, trust is a declaration which is made by the owner of the property that going forward, the same will be held by him or some other person (say a trustee), for the benefit of someone (ie beneficiary) and will be handed over to that person immediately or in due course.

The Trust can be categorised as below:

- Public Vs Private Trust - depending on who the beneficiaries are (e.g. public at large,  community, religion, etc or private family members)

- Specific Vs Discretionary Trust (ie names of beneficiaries and/or their shares are determinate or not)

- Revocable Vs Irrevocable Trust (whether settlor settles asset forever or he can take it back at some time)

- Testamentary Vs Non-testamentary Trust (ie through will on death ie testamentary or transferred during life as non-testamentary).

For succession planning, the Trust usually used is a Private (non-testamentary) Trust - be it specific or discretionary based on settlor' swishes and is implemented during lifetime of the settlor.

STEPS FOR IMPLEMENTATION

Broad steps involved in implementing a private trust are as below.

- The settlor contributes his/her identified assets to a private trust formed for the purpose.

- Settlor appoints a trustee (can be individual, company or himself) to manage the trust properties.

- The trust deed will list names and % share of beneficiaries in case of specific private trust. If not, then the trust would be classified as discretionary trust where the names and/or % share of beneficiaries are unknown or indeterminate.

- Once the property is contributed by a settlor to the trust, then the property would be owned and controlled by the trustee for and on behalf of benefit of beneficiaries. The property can be any asset - be it cash or any other movable and/or immovable assets.

- Depending on commercial needs, there could be one trust or multiple trusts being used. Also there could be Master trust and/or sub-trust for legal protection and fencing of assets. For say Father and a son, there could be different Master trusts and sub-trusts with different trustees and different beneficiaries. The settlor can be one person say father or head of family. The illustrative structure is given in Annexure.

Before executing the succession planning, one needs to examine various tax, commercial and regulatory implications to preserve and protect value of assets being transferred/transitioned to the next generation.

These would include mainly following.

- Income tax

- Stamp duty

- SEBI Takeover Code (including Insider trading regulations)

- Foreign exchange regulations

- Estate duty/Inheritance tax.

Let's discuss these briefly.

INCOME TAX

This is further discussed under following heads.

# Taxation of beneficiary

# Taxation of settlor/transferor of assets

# General Anti Avoidance Rule

# Taxation of Trust.

These are discussed below.

# Taxation of beneficiary - Income under Section 56(2)(x)

- when a property is settled under a Trust, it is practically a gift and provisions of Section 56(2)(x) of Income tax Act (IT Act) are attracted.

- As per Section 56(2)(x) of IT Act, any cash or property (immovable or movable property) received by a person from anyone without consideration or for inadequate consideration is treated as income of the recipient.

- In the first instance, the settlor/recipient may argue that the trust is established as part of family arrangement and for succession planning and hence, it is not without consideration. The same may be litigative.

- Please note Section 56(2)(x) also lists down certain exceptions where the provisions of the section are not applicable.

- The last proviso (X) to Section 56(2)(x) states that the section will not apply to 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 term 'relative' is defined as the same meaning assigned in Explanation to Section 56(2)(vii).

- Thus if a trust (be it specific or discretionary, whether irrevocable or revocable or whether testamentary or non-testamentary) receives any sum of money or property from an individual solely for the benefit of relative of the individual, then trust should be exempt from provisions of Section 56(2)(x).

- Please note the exemption under Section 56(2)(x) applies only if the trust is created solely for the benefit of relative of the individual. What if one of the beneficiaries is settlor himself together with his relatives? It appears that in a situation where the settlor is also one of the beneficiaries, on strict interpretation, the exemption may not apply. This is possibly not envisaged. Another argument could be that there cannot be tax on 'self' when the settlor himself/herself is a beneficiary. A clarification from Central Board of Direct Taxes (CBDT) would be appropriate in this regard.

# Taxation of settlor/transferor of assets:-

- Section 47(iii) exempts transferor from capital gains tax any transfer of capital asset under an 'irrecovable' trust. Please note if the trust is revocable trust, then exemption under Section 47(iii) is not available and such transfer would be subject to capital gains tax.

- Considering above, the trust vehicle should be 'private irrevocable trust'. This will be non-testamentary trust as it is formed during life time of settlor.

- If the trust is testamentary (i.e happens on the death of the settlor) as a part of will, then one can take stand that transfer is under will and exempt in the hands of settlor under Section 47(iii) (taxation will be on representative assessee).

# General Anti Avoidance Rule (GAAR)

- Creation of multiple trusts in the structure could be complex and Tax authorities could question the same being subject to GAAR. However, the commercial rationale of having multiple trust entities can be explained which would be for legal protection of assets and done for family realignment. Also this is a normal practice adapted for last several decades by families for succession planning.

- Interestingly, FAQ no 3 dealing with GAAR (dated January 27, 2017) issued by CBDT states that the choice of entity for effecting an arrangement is the prerogative of the assessee and does not per se attract GAAR only due to the choice being made.

# Taxation of Trust:

- Section 2(31) of IT Act defines the term 'person'. The term 'person' does not specifically cover 'trust' but the definition is inclusive in nature and hence, Trust should be specifically taxed as an entity under IT Act even though it may not be a legal entity as per Trust Act. There have been precedents that status of trust is linked to status of Trustee. Thus, if trustee is an individual, then the residential status of the Trust should be that of an individual. This residential status of trust is a debatable issue in the past.

- Specific Trust - Taxation of specific trust is done on the trustee in a 'representative capacity' for and on behalf of beneficiaries [Section 160(iv)]. This will be applicable in case of specific trust. Although the computation of income is done separately for each beneficiary, the tax is levied in the hands of the trust. Beneficiaries are not separately taxed.

- Discretionary Trust - In case of discretionary trust where the share of beneficiary is unknown or indeterminate, the tax is levied at the maximum marginal rate on the discretionary trust (Section 164).

STAMP DUTY

Stamp duty is levied under Indian Stamp Act, 1899 (Central Stamp Act). Power to levy stamp duty is divided between central and state government. States do have the right to adopt Central Stamp Act with or without modifications.

Stamp duty is levied on the instrument of transfer and hence, location or state of transfer assumes importance.

Relevant articles for Trust in Central Stamp Act (Schedule I) are as below.

- Article 58 - Settlement

- Article 64 - Trust

As per these entries, stamp duty on instrument of transfer (ie Trust deed) attracts a stamp duty of 2-3% of value of assets transferred under the Trust deed. However, the State Stamp Act will be the final authority to decide actual levy of stamp duty. Generally, the duty is levied on transfer deed and there should be no further duty on distribution of assets to beneficiaries in future.

It is to be noted that gift of assets to relative (defined) attracts a very nominal stamp duty irrespective of value of assets transferred e.g. Stamp duty on immovable property being transferred in State of Maharashtra is 5% of value of the property. However, if the same property is gifted to a relative, the stamp duty is Rs.200. Similarly, in State of Karnataka, the stamp duty is approx Rs.1,000. There is a possible view/argument that the same should apply to assets transferred under Trust deed where the trust is formed for the benefit of relatives. This has to be examined for the respective states before a call is taken to form a Trust.

SEBI TAKEOVER CODE REGULATION

- SEBI has prescribed rules on substantial acquisition of shares beyond 25% of share capital and same need to be adhered by Promoters of shares in a listed company. The acquirer needs to make an open offer to existing shareholders of at least 26% of shares at a price determined based on a formula.

- The Takeover Code provides exemption from open offer in certain situations including 'inter se transfers between promoters'.  Also Promoters can approach SEBI for Takeover Code exemption (ie open offer) by making a specific application. The relevant rules are Rule 10 (prescribing exemptions) and Rule 11 (making specific application for exemption). It is understood that SEBI also provides informal guidance on this matter.

Considering that the matter is complex in case of transfer of assets (assuming these include substantial shares of listed company held as a promoter group/family), it would be advisable to seek a specific exemption under Rule 11 from making an open offer (rather than seeking recourse to Rule 10 and claim exemption) or in the alternate, seek an informal guidance before the transfer is effected under Trust deed.

- SEBI has also prescribed rules on Insider trading regulations which need to be strictly adhered while the transfer of shares is effected under the Trust deed.

FOREIGN EXCHANGE REGULATIONS

- Provisions of Foreign Exchange Management Act ('FEMA'), 1999 are relevant for creation of trust by a settlor.

- A trust outside India (ie overseas trust) can be created by a resident owning a foreign asset for the benefit of beneficiaries whether resident or non-resident. The overseas trust can be specific or discretionary trust.

- Similarly, a trust in India can be created by a resident owning assets in India including a non-resident beneficiary.

- There are no specific regulations under FEMA governing trusts. However, it appears that the transfer of assets under Trust should be a 'capital account transaction' under Section 2(e) of FEMA.

- Interestingly, Master Direction on "remittance of assets" does make some reference as below.

'iii. in case of settlement is done without retaining any life interest in the property ie during life time of the owner/parent, it would tantamount to regular transfer by way of gift' (emphasis supplied).

- Thus one argue that settlement of property under trust is akin to gift and provisions dealing with gift under FEMA may be applied (which in most situations are freely permitted).

- Having said that there is no absolute clarity on the subject and a specific clarification from RBI would be desirable.

- Also in the context of a resident being a beneficiary in an overseas trust with overseas assets, the long standing question is whether RBI approval is required when the beneficiary may not be aware if he/she is the beneficiary in the trust (....if done without his/her knowledge by the settlor) and certainty there is no identification of share of income. Under Black Money law, such questions were raised and Tax authorities' view was that such beneficial interest in discretionary trust should be disclosed by the resident in the Return of income.

ESTATE DUTY/INHERITANCE TAX

- India had estate duty on transfer of assets on death of an individual but the same was abolished in 1985. Since then, there is no estate duty or inheritance tax . Also currently, there is no wealth tax since last few years.

- There were talks of re-introduction of estate duty or inheritance tax in India 5-6 years back but in the recent past, the same have died down.

- Having said that there is estate duty in developed countries like USA and U.K. It is also possible that the same may be re-introduced in future in India considering socio-economic objectives and balancing wealth and removing inequalities. These are all hypotheses which may or may not happen and difficult to predict future outcomes.

- Succession Planning through Trust was one of the important mechanisms to protect wealth being subject to estate duty during estate duty days.

- Also under erstwhile Estate Duty Act (Section 6), gift done within 2 years of death of an individual was ignored and was subject to estate duty. These aspects may be considered while doing potential planning for estate duty or inheritance tax for future. Therefore, transition of assets as early as possible could protect the same from estate duty assuming similar provisions come into effect as and when the law is re-introduced. On a parallel situation, it is understood that protection under Insolvency and Bankruptcy Code, 2016 is not available for assets gifts during last 2 years. Thus legislature considers 2 year window as reasonable time frame.

- If a settlor has set up a revocable trust or is one of the beneficiaries in the trust, the estate duty protection may not be available as per erstwhile Estate Duty Act.

- Setting up a discretionary trust without a settlor being a beneficiary would be ideal.

In summary, succession planning is a process and should be planned in an organised manner. Planned succession can help in protection and smooth transition of wealth whereas an unplanned succession can lead to erosion of family wealth and could create bitterness and feuds in family. Finally, Trust is an established mechanism of succession planning tool and provides protection, flexibility and transition of assets to next generation.

(Contributed by Uday Ved, Chartered Accountant)

CAVEATS: Views expressed are personal. It is possible that Regulators may take an adverse view on any issue and there is no guarantee or assurance on this count. Author does not undertake any responsibility for any decision taken based on contents of this article. This is a complex subject and suitable professional help may be taken before any decision is taken.