By YOGESH A. THAR
Chartered Accountant
In the process of making a ‘living’, we
often forget to ‘live’. We start realising this fact, only when the time is
near for ‘leaving’. We then start the exercise of ‘leaving’ all that we have
gathered, for the benefit of our kith and kin such that there is least tax
leakage and they inherit maximum possible of what we ‘leave’ at the time of
‘leaving’ which we ourselves did not enjoy while we were ‘living’.
This takes us into the area of tax planning
for succession. This was more prevalent in the days India had estate duty law,
which got abolished in 1986 on the ground that the yield from the estate duty
was much lower than the cost of administering that law. This was despite the
fact that the maximum marginal rate of estate duty was as high as 85%! There
is, however, a fear that the draconian law may get resurrected on some pretext
or the other in the near future. While it is bad news for each one of us, it is
also good news for some of us who are engaged in tax practice!!
But before moving into that unknown terrain,
let us have a look at the basic aspects of taxation of the income and the
estate of a deceased.
Section 159
When a person dies, the assessment of his
income pertaining to the period prior to his death would be pending. Courts
held in the past that an assessment cannot be made on a dead person and, if so
made, would be a nullity in the eyes of law.
At the same time, however, it would be unjustifiable to say that upon death of
a person, the tax department cannot collect taxes on the income that he had
earned prior to death and in respect of which assessments are pending, or even
filing of the return may be pending for the last one or two assessment year(s).
In order to overcome this conundrum, section 159 was inserted in the Income-tax
Act, 1961 (“the Act”) to enable assessment of income of a person who was alive
during the relevant financial year but had died before filing the return of
income or before the income was assessed.
This section provides that when a person
dies, his legal representatives shall be liable to pay any tax or other sum
which the deceased would have been liable to pay if he had not died “in the
like manner and to the same extent” as the deceased. Thus, there would be
separate assessments of income in the hands of the legal representative which
he has earned in his personal capacity and that which the deceased had earned
prior to his death. The two cannot be assessed as part of the same return of
income of the legal representative. Consequently, therefore, arrears of tax of
deceased cannot be adjusted against refund due to the legal representative in his
individual capacity.
A legal representative is deemed to be an assessee for the purposes of the Act
by virtue of section 159(3). The liability of the representative assessee,
however, is limited to the extent to which the estate is capable of meeting the
liability and it does not extend to the personal assets of the legal
representative.
If, however, the legal representative has disposed of any assets of the estate
or creates charge thereon, then he may become personally liable. In such cases
also, the liability will be limited to the extent of the value of the assets
disposed of or charged.
A legal representative gets assessed in the PAN of the deceased, but in a
representative capacity.
Section 168
While the above provision deals with
taxation of income of the deceased in respect of the period prior to the date
of death, questions arise as regards taxing of the income that the estate of
the deceased earns after the date of death but prior to the date of
distribution of the assets of the deceased amongst the legatees. Section 168
deals with this income. This section essentially provides that the income of
the estate of a deceased person shall be chargeable to tax in the hands of the
executor to the estate of the deceased. The executor shall be assessed in
respect of the income of the estate separately from his personal income. Thus,
there would be a separate PAN required for filing the return of the executor.
Executor shall be so chargeable to tax u/s. 168 upto the date of completion of
distribution of the estate in accordance with the will of the deceased. If the
estate is partially distributed in a given year, then, the income from the
assets so distributed gets excluded from the income of the estate and gets
included in the income of the legatee. Legatee is chargeable to tax on income
after the date of distribution.
Even if the executor is the sole beneficiary, it does not necessarily follow
that he receives the income in latter capacity. The executor retains his dual
capacity and hence, he must be assessed as an Executor till the administration
of the estate is not completed except to the extent of the estate applied to
his personal benefit in the course of administration of the estate.
This section applies only in case of
testamentary succession, i.e. when the deceased has left behind a Will. In
cases of intestate succession, the income from the assets earned after the date
of death becomes assessable in the hands of the legal heirs as
“tenants-in-common” till the assets of the deceased are distributed by metes
and bounds.
The section provides that the executor is
assessable in the status of “individual”. If, however, there are more executors
than one, then, the assessment will be as if the executors were an AOP.
However, the Madhya Pradesh High Court has held, in the case of CIT vs.
G. B. J. Seth and Anr (1982) 133 ITR 192 (MP), that though the
assessment is on the executor or executors, for all practical purposes it is
the assessment of the deceased. The Court has held that the status of AOP is for
statistical purposes and that notwithstanding the status of the assesse being
an AOP, the executors were entitled to claim set-off on account of the balance
of brought forward losses incurred by the deceased prior to his death.
Inheritance – extent of
tax exposure
A transfer of a
capital asset under a gift or a will is not regarded as “transfer” for the
purposes of capital gains. Referring to this clause, the learned author, Arvind
P. Datar, in his treatise, “Kanga and Palkhivala’s The Law and Practice of
Income-tax”, Tenth Edn., on page 1206, has said that “However, these
clauses expressly grant exemption where none is needed”. Indeed, wealth
transmitted under a Will is not a ‘transfer’ but a ‘transmission’. Also, there
is no consideration for the same.
Hence, the question of capital gains tax can
never arise. The section does not deal with transfer under intestate succession,
it refers only to a transfer under a will. Yet, for the reasons aforesaid,
there can be no capital gains on such transmission.
For the recipient, amounts or property
received by way of inheritance is a capital receipt and not “income”.
Ordinarily, therefore, such receipt is not chargeable to tax. Section 56(2)(x),
however, charges to tax money or value of certain properties received by a
person without consideration or for inadequate consideration. Proviso thereto
exempts, inter alia, money or property received “under a will or by way
of inheritance”. There is thus no tax in the hands of the recipient under this
section.
In an interesting decision of the Mumbai
Bench of the Income Tax Appellate Tribunal, in the case of Purvez A.
Poonawalla [ITA No. 6476/Mum/2009 for AY 2006-07], it was held that sum
received by the taxpayer from the legal heir of a deceased in consideration of
the taxpayer giving up his right to contest the Will of the deceased is not
chargeable to tax under the then prevailing section 56(2)(vii), which
corresponds to present section 56(2)(x) in principle.
Section 49 provides that when a capital
asset becomes the property of an assessee, inter alia, under a Will
[section. 49(1)(ii)] or inheritance [section 49(1)(iii)(a)], the cost of
acquisition of the asset shall be the cost to the previous owner.
Correspondingly, section 2(42A) provides (in clause (i)(b) of Explanation 1)
that in computing the period of holding the asset by an assessee who had
acquired the property under a will or inheritance, the period of holding by the
previous owner shall be counted. The asset will qualify as a long-term capital
asset or a short term capital asset accordingly.
Expenses incurred in connection with
obtaining probate are held to be not allowable expenses in an early decision of
the Privy Council in the case of P.C. Mullick vs. CIT (6 ITR 206)(PC).
Leaving a ‘Will’ – pros
and cons
‘Will’ is a document by which a person
directs his or her estate to be distributed upon his death. It is also termed
as “testament”. Organising succession through a ‘Will’ is certainly a preferred
option as compared to leaving no such written document from the point of view
of certainty. A Will becomes operative upon the death of the testator and
hence, unlike a gift given during the life time, the person is in full
ownership and control of his wealth till the time of his death. Wealth
inherited under a will is not subject to stamp duty. A Will can be amended at
any time during the lifetime of the testator.
While these are the pros of writing a
‘Will’, in today’s day and age, one encounters some challenges in
implementation of wills in the form of some claimants emerging from the blue
and throwing spanner in the works to scuttle smooth and easy succession of the
estate. Besides, under a Will simpliciter, it is not possible to segregate the
economic interest of the legatee from controlling interest in a particular
asset. Say, for example, the testator desires to give the benefit of the income
from the shares held by him in a company that he controls to his son, but is
not desirous of handing over control of such shares to him as such control
gives him voting power qua the company. In such a case, simply writing a Will
in favour of the son for bequeathing the shares will not solve the problem.
Finally, the fear of estate duty that we talked about earlier looms large and
if property worth significant value is transmitted under a Will, and if on the
date of death, estate duty law is resurrected, then there would be a sure liability
to estate duty.
Planning succession
through trusts
The above cons of a ‘Will’ bring to table
the option of planning succession by creation of trusts. A trust is a structure
involving three persons, namely, a Settlor (or author); a Trustee; and a Beneficiary.
The settlor is the creator of a trust who settles his asset into the trust and
hands it over to the trustee (who becomes the legal owner) to be held for the
benefit of the beneficiary. Thus, the segregation of controlling interest and
beneficial interest happens whereby the control remains with the trustee while
the economic interest travels to the beneficiary.
A trust structure may get created during the
lifetime of the testator or may be incorporated in the will so as to create a
trust under the Will. However, creating the trust under a Will may not address
the issue of the Will being challenged by some claimant. It also does not
address the issue of attracting estate duty on death, if such duty is
re-introduced. So, a trust created during the lifetime of the deceased would be
a preferred option from that point of view.
When a person creates a trust, he divests
himself of the property which, upon creation of the trust, vests in the
trustee. Hence, at the time of his death, he is no more the owner of that
property and consequently is not liable to estate duty, if such duty becomes
applicable. He can appoint a third party as a trustee or he may himself be a
trustee during his lifetime. He may plan a successor to the trustee as part of
the trust deed itself. If he continues to be sole or one of the trustees, he
retains control over the assets settled in the trust, but in a different
capacity, namely, as a trustee of the named beneficiary. The trustee carries an
obligation to hold the property for and on behalf of the beneficiary and hence
he does not own economic interest in the property so held by him and thereby
such property so held by him as trustee has no economic value. In absence of
any value, there can be no estate duty exposure even if he is himself the
trustee.
Care, however, will have to be taken while
choosing the beneficiaries in as much as section 56 of the Indian Trusts Act,
1882 empowers a beneficiary who is competent to contract to require the trustee
to transfer the property to him at any time if he is the sole beneficiary
without waiting for the period mentioned in the trust deed. If there are more
than one beneficiaries, they can so compel the trustee if all of them are of
the same mind. It may therefore be better to have in the list of beneficiaries
a minor and he gets absolute interest in the trust only on his attaining
majority. It may also be better to plant a person as one of the beneficiaries
who enjoys complete confidence of the settlor so that the wishes of the settlor
are not vitiated by the ‘not so matured’ beneficiaries coming together. It
would also be advisable that the trust be a discretionary trust rather than a
specific trust so that none of the beneficiaries have any identified interest
in the trust property.
Specific Trust vs.
Discretionary Trust
A Specific Trust is a trust where the
beneficiaries are all known and their shares in the income and assets of the
trust are defined by the settlor in the trust deed. On the other hand, if
either the beneficiaries are not identified or their shares are not defined by
the settlor, the trust would be a discretionary trust. The distribution of
assets and income is left to the discretion of the trustee. A beneficiary of a
discretionary trust does not have any identified interest in the income. He
only has a hope of receiving something if the trustee so decides.
Taxation of income of a specific trust is
governed by section 161 of the Income-tax Act, 1961, (“the Act”) while the
rules for taxation of a discretionary trusts are contained in section 164 of
the Act. For tax purposes, a trustee or the trustees is a “representative
assessee”. Trustee of a specific trust is taxed “in the like manner and to the
same extent” as the beneficiaries. In other words, theoretically, there can be
as many assessments on the trustees as the number of beneficiaries. However,
there is only one assessment, but the income is computed as if the shares of
the beneficiaries are taxed. Section 166 provides an option to the assessing
officer to either tax the trustee or the beneficiaries separately on their
shares of income from a specific trust. In practice, we often find it simpler
that the beneficiaries of specific trusts offer their respective share of
income from a specific trust in their respective returns of income and get
assessed.
On the other
hand, trustees of a discretionary trust are taxed at the trust level in view of
the provisions of section 164. This section provides that the income of a
discretionary trust is taxable at maximum marginal rate. Only in cases where
all the beneficiaries are persons having income below taxable limits, then the
trust may be taxed at the slab rates applicable to an AOP. Also, a testamentary
trust, i.e. trust created through a will, enjoys this exception provided it is
the only trust so created under the will. If a discretionary trust has business
income, then such trust (barring a testamentary trust) is taxed at maximum
marginal rates. In cases where the income of a discretionary trust is
distributed by the trustees to the beneficiaries during the year in which is
earned, then, as held by the Supreme Court in the case of CIT vs.
Kamalini Khatau (1994) (209 ITR 101) (SC), the beneficiaries can be
taxed directly on such income instead of the trustees being taxed.
Status in which a trust is generally assessable
is as an “individual” and not as an AOP. It is only in cases where the
beneficiaries have come together voluntarily to form a trust, then, they may be
assessed as an AOP.
Such would never be the case where a settlor settles a trust for the beneficiaries
as part of his succession planning.
Revocable vs.
Irrevocable Trusts
Trust may be revocable or irrevocable. It is
revocable when the settlor retains with himself the right to revoke the trust
after having created it. In substance, therefore, he remains to be the
effective owner of the property settled. It is irrevocable if he retains no
right to revoke it once it is created by him.
Sections 61 and 63 of the Act deal with
taxation of revocable trusts. Section 63, by a fiction of law, deems certain
instances where the trust shall be deemed to be revocable. These cases are
where the trust contains any provisions for re-transfer directly or indirectly
of the part or the whole of the income or assets of the trust to the transferor
or it gives right to the transferor to re-assume power directly or indirectly
over part or whole of the income or assets of the trust. Tax implication of
such revocable or deemed revocable trusts is that the income that arises to the
trust by virtue of such revocable or deemed revocable transfer is taxable in
the hands of the transferor and not in the hands of the trust or the
beneficiaries. Thus, in cases where the settlor is himself a beneficiary, such
trusts are deemed to be revocable trusts even though the trust deed may say
that the trust is irrevocable. In such cases, the income of the trust that
arise by virtue of the assets transferred to the trust by the settlor who is
also the beneficiary (or one of the beneficiaries), becomes taxable in the
hands of the settlor and not in the hands of the trustee or the other
beneficiaries, if any.
Creation of a trust –
application of section 56(2)(x)
As noted earlier, section 56(2)(x) charges
to tax money or value of certain properties received by a person without
consideration or for inadequate consideration. Having regard to the legal
position that when a trustee of a trust receives any property from a settlor,
he receives it with an obligation to hold it for the benefit of the beneficiary
and not for his absolute enjoyment. The obligation so cast on the trustee can
be viewed as the consideration and an adequate consideration for his receiving
legal ownership of the property. In this view of the matter, receipt by a
trustee of a trust of an asset settled by the settlor in trust for another
beneficiary cannot give rise to a taxable event in the hands of the trustee.
But that does not seem to be the way the law makers seem to view this. In the
proviso to section 56(2)(x), the law provides a clause granting exemption from
this taxing provision in respect of 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”. Now, is this exemption inserted out of abundant
caution or is it an exemption to relieve the trusts created for relatives from
the rigours of this section is a vexed question. If I am right in the view
expressed earlier, receipt by a trustee can never be subjected to this tax
since his obligation is an adequate consideration. However, another view of the
matter is that but for this exemption, even trusts created for relatives would
be subjected to the rigours of this taxing provision.
Be that as it may. While one is planning his
affairs, one may have to go by the conservative interpretation that but for the
exemption, every trust would be chargeable to tax under this provision.
Consequently, this provision may have to be kept in view while making the
succession plans. It may be stated here that the amounts received under a Will
or by way of inheritance are exempt from the purview of section 56(2)(x) and
hence, if there is a testamentary trust (i.e. a trust created through a Will),
then, this section will not be applicable in any case, whether all the
beneficiaries of the trust are relatives of the testator or not. If one ignores
a possibility of resurrection of estate duty law, then, this seems to be an
efficient mode of planning succession so as to achieve the objective of
segregating the control of the assets from the economic benefits thereof and
pass on only the economic benefits to the legatees and not the control over the
asset which can be retained with the desired trustee or trustees.
The way forward
If you have crossed fifty, and if you are not enjoying
life, i.e. Not lavishly spending the wealth you have created, prepare a ‘will’,
whether you have a ‘will’ to give away everything or not, because it is his
‘will’ that will ultimately prevail and if the affairs are not well planned,
the ‘will’ of the devil will ruin the empire created by you in future. If you
are just worried about the tax on your estate, then, forget everything, start
spending your every rupee, enjoy life. Remember that punch line from the film “Anand”
– “jab tak zinda hoon, tab tak mara nahin. Aur jab mar gaya, to saala mei hi
nahin”.
