Family-run
businesses continue to be the norm rather than the exception in India; with
most progressing fast on the path to globalisation, succession planning has
never been as important as it is today. Succession planning is not only a means
to safeguard from potential inheritance tax, but also a method to ensure that
legacies remain alive and keep up with changing times with minimum conflict or
impact on business.
Succession
planning can be a complex exercise in India. Families are often large with
multiple factions involved in the business, making deliberations around
succession planning prolonged and difficult. The slew of regulations around tax
and other regulatory matters, in addition to personal laws, do not ease
matters.
Despite these
factors, it is imperative to plan for succession. A look back at the history of
corporate India reveals the immense disruption due to improper or absent
succession planning. Familial ties have been irreparably damaged, wealth
accumulated over generations has been squandered, protracted and endless
litigation between family members has taken up significant time and effort,
draining valuable resources that could have been put to better use, and most
importantly, once-leading business houses have taken a huge hit to their
finances, glory and reputations.
Use and limitation of wills
While a Will
remains the most oft-used mechanism for passing down wealth through generations,
it has its limitations. The chances of a Will being challenged, tying up the
family in litigation for years to come, are high. In addition, it is not
possible to keep ownership or control of assets in a common pool in a Will,
leading to fragmentation of family wealth. Since assets under a Will are
transferred only on the demise of the owner, they were subject to estate duty
under the Estate Duty Act, 1953 (ED Act), which was abolished in 1985. Although
estate duty is currently not on the statute, there have been apprehensions of
its reintroduction. While one cannot predict the provisions thereof, a
reasonable assumption is that passing of property on the death of the owner
would be subject to any such tax.
Such
limitations and other concerns, such as ring-fencing assets from legal issues
and setting family protocols, has led India Inc. to once again seriously
consider succession planning through a private Trust set up for the benefit of
family members.
Private trusts
As the name
suggests, a Trust means faith/confidence reposed in someone who acts in a
fiduciary capacity for someone else. Essentially, a Trust is a legal
arrangement in which a person’s property or funds are entrusted to a third
party to handle that property or funds on behalf of a beneficiary.
While oral
Trusts that were self-regulated have been part of Indian society since time
immemorial, the law relating to private Trusts was codified in 1882, as the
Indian Trust Act, 1882 (the Trust Act). The Trust Act is applicable to the
whole of India, except the State of Jammu and Kashmir and the Andaman and
Nicobar Islands. The provisions of the Trust Act should not affect the rules of
Mohammedan law with regard to waqf, or the mutual relations of the
members of an undivided family as determined by any customary or personal law.
The provisions of the Trust Act are also not applicable to public or private
religious or charitable endowments.
A private
Trust is effective for succession planning as the settlor can see its
implementation during his lifetime, enabling corrective action to be taken in a
timely manner. A Trust demonstrates family cohesiveness to the world and
provides effective joint control of family wealth through the Trust deed. Thus,
a Trust provides united control and effective participation of all members in
the decision-making process, leading to mitigation of disputes and legal
battles. It can also ease the path for separation within the family, making it
a smooth and defined process.
A Trust, as a
means of succession planning, is easy to operate and not heavily regulated. The
statutory formalities to be complied with are minimal. The Trust Act is an
enabling Act and does not contain regulatory provisions. Thus, a Trust provides
all types of flexibility. It allows the necessary distribution, accumulates
balance and allows ultimate succession, even separation, as planned. As against
being regulated by laws, a Trust is governed and regulated by the Trust deed.
Information
on private Trusts is not publicly available, unless such Trusts have been
registered, providing much- sought-after privacy.
Therefore, for several generations, private Trusts
have been a popular means of succession planning, and the spectre of
inheritance tax has only given a boost to its use.
A. Basic structure
The basic
structure of a private Trust is as follows:
Apart from
the settlor, Trustees and beneficiaries, who are the key players in any Trust,
there may also be a protector and an advisory board. The protector is
essentially a person appointed under the Trust deed, who guides the Trustees in
the proper exercise of their administrative and dispositive powers, while
ensuring that the wishes of the settlor are fulfilled and the Trust continues
to serve the purpose for which it was intended. An advisory board is a body
constituted under a Trust deed to provide non-binding advice to the Trustees,
often used more as a sounding board.
B. Trust deed
A private
Trust is usually governed by a Trust deed. A Trust deed, as an instrument, is
similar to an agreement and contains clauses similar to an agreement between
two parties, in this case, the settlor and Trustee, however, which would have
implications for the beneficiaries. Therefore, like any other agreement, a
Trust deed usually provides for rules in relation to each of the three parties
and is a complete code by itself for operating the relationship within them.
A Trust deed
would—apart from information regarding the relevant parties and Trust
property—also cover aspects such as:
u Rights, powers (and restrictions
thereon), duties, liabilities and disabilities of Trustees, including the
procedure for their appointment, removal, resignation or replacement and
minimum/maximum number of Trustees
u Rights, obligations and
disabilities of beneficiaries, including the powers and procedure for addition
and/or removal of beneficiaries, including the person who would be entitled to
exercise such powers
u Terms of extinguishment of
the Trust
u Alternative dispute
resolution, etc.
It is
preferable that a Trust deed is in simple language and contains clear
instructions, including the process and provisions for amendment thereof.
C. Type of private
trust
Usually, when
property is settled into a private Trust for the purpose of succession
planning, it is done through an irrevocable transfer, i.e., the settlor does
not retain or reserve the power to reassume the Trust property/income or to
transfer it back to himself. Thus, once the assets are settled in an
irrevocable Trust, the property no longer belongs to the settlor or the
transferor, i.e., it belongs to the Trust. Since the settlor has no right left
in the Trust property, this typically provides adequate protection to the
assets against claims by creditors, or in case of a divorce, etc. Under the
erstwhile ED Act, if the settlor reserved any right for himself, including
becoming a beneficiary in the Trust, such property may be considered to be
passing only on the death of settlor, resulting in a levy of estate duty. This
is another reason why irrevocable Trusts are typically used for succession
planning, unless some special extenuating circumstances exist.
Based on the
distribution pattern adopted by a private Trust, it may be classified as either
a specific (also called determinate) or a discretionary Trust. If the Trust
deed provides a list of beneficiaries specifying their beneficial interest, it
would be a specific Trust. On the other hand, if the Trust deed does not
specify any beneficiary’s share, but empowers someone (usually the Trustees) to
determine such share, it is considered as a discretionary/ indeterminate Trust.
Such discretion may be absolute or qualified.
Under the ED
Act, in case of a specific Trust, since the interest of each beneficiary was
identified, the same was considered as passing to others on the death of such
beneficiary, and therefore, subject to estate duty.
However, as
no interest was identified in case of a discretionary Trust (based on the
decision of the Trustees, each beneficiary’s share could be anywhere from 0% to
100%), no estate duty was levied upon the death of any beneficiary, as no
property was considered to be passed, making it a commonly used mechanism.
Often—and
depending on the requirements—a combination of specific and determinate Trusts
(in either case irrevocable) may be used for succession planning and planning
around the potential levy of estate duty.
D. Key aspects of
taxation of a private trust
In general,
moving to a Trust structure is neutral from the point of view of taxation,
i.e., neither a tax advantage nor an additional tax burden is imposed by the
Income-tax Act, 1961 (IT Act).
1. Settlement of a
Trust
Taxation of the settlor
Section
47(iii) contains a specific exemption for any capital gains that may be
considered to arise to the settlor on transfer of capital to an irrevocable
Trust. Therefore, the settlor should not be liable to any tax on settlement of
the irrevocable Trust.
Taxation of beneficiaries
Section
56(2)(x), which was introduced by the Finance Act, 2017, provides for taxation
of the value of the property in the hands of the recipient of such property, if
received for nil or inadequate consideration. Certain exceptions, including for
receipt of property by a Trust created for the benefit of relatives of the
transferor of the property have been carved out from the purview of these
provisions.
Thus, when assets are settled into a Trust, assuming the beneficiaries are
considered as “relatives” of the settlor within the definition prescribed for
this purpose under the IT Act, no tax implications would arise u/s. 56(2)(x) of
the IT Act. It is important to note the following aspects:
u Fundamentally, for
determining taxability u/s. 56(2)(x), the definition of relative is to be
tested in relation to the recipient of the property. However, the exception for
Trusts requires the relationship to be tested with reference to the
giver/settlor. This could give different results, such as in the context of
uncle and nephew/niece, and therefore, should be examined closely.
u The argument may be that
the provisions of section 56(2)(x) ought not to apply in context of Trusts set
up for beneficiaries who do not fall within such definition of “relatives,”
including corporate beneficiaries, notwithstanding that there is no specific
exception carved out; however, its applicability cannot be ruled out. Hence,
adequate care is necessary in such cases, e.g., separate Trusts may be set up
for relatives and non-relatives.
Taxation of Trustees
The
provisions of the aforesaid section 56(2)(x) ought not to apply to the Trustees,
as a Trustee receives the property with an obligation to hold it for the
benefit of the beneficiaries. This obligation taken over should be good and
sufficient consideration for receipt of properties by the Trustees, and
therefore, the receipt of property cannot be said to be without/for inadequate
consideration.
2. Income earned by
a Trust
Broadly, a
specific Trust’s tax is determined as an aggregate of the tax liability of each
of its beneficiaries on their respective shares (unless the Trust earns
business income). A discretionary Trust, on the other hand, is generally taxed
at the maximum marginal rate applicable to the type of income earned by the
Trust.The additional tax on dividends earned from domestic companies (as
provided u/s. 115BBDA)
would also apply.
Once taxed,
the income should not be taxed once again when distributed to the
beneficiaries.
3. Distribution
of assets/termination of a Trust
There are no
specific provisions under the ITA dealing with dissolution of Trust/taxability
on distribution of assets of the Trust.
Since a Trust
holds property for the benefit of the beneficiaries, when the properties are
distributed/handed over to the beneficiaries, it should not result in any
income taxable under the ITA for them.
Since the Trust does not receive any consideration
at the time of distribution, no capital gain implications ought to arise.
In the past,
tax authorities have attempted to treat a Trust as an AOP, and apply the
provisions of section 45(4)
of the IT Act on dissolution of a Trust. However, the Hon’ble Bombay High Court
has held that Trustees cannot be taxable as an AOP, and therefore, the
provisions of section 45(4) are not applicable.
Hence, the
distribution to the beneficiaries at the time of termination of the Trust or
otherwise ought not to result in any tax liability.
E. Implications
under other regulations
Depending on the kind of property settled into a
Trust, implications under various other provisions may also arise:
1. Shares of a
listed company
It is
increasingly popular to settle business assets, in the form of shares of listed
companies into a Trust. A family may decide to put part or all of their holding
into a single Trust or multiple Trusts, depending on their specific needs.The
key consideration is whether this triggers any implications under the
regulations framed by the Securities and Exchange Board of India (‘SEBI’),
notably the SEBI (Substantial Acquisition of Shares and Takeover) Regulations,
2011 (Takeover Code).
Under the
Takeover Code, if there is a substantial change in shareholding/voting rights
(direct or indirect) or change in control of a listed company, the public
shareholders are supposed to get an equal opportunity to exit from the company
on the best terms possible through an open offer. Certain exceptions have been
carved out, whereby, upon compliance with certain conditions, the open offer
obligations would not be applicable.
There are arguments
that may be taken as to why the Takeover Code ought not to have an implication,
especially since there is no change in control. However, in the absence of
specific exemptions, especially in the context of transfer to a newly set-up
Trust or a Trust, which does not already own shares in the listed company for
at least three years, as a matter of precaution, several families approached
SEBI for seeking a specific exemption. SEBI has, subject to certain conditions
or circumstances being met, generally approved such transfers to a Trust,
albeit with safeguards built in.
In December
2017, SEBI released a circular highlighting the guidelines that would need to
be adhered to while seeking exemption for settling shares of a listed company
into a Trust, which broadly mirrors the principles applied by SEBI in its
earlier orders.
2. Immoveable
property
Immoveable
properties in which family members are residing or those acquired for
investment purposes may also be transferred to a Trust. However, typically, stamp
duty would be levied on any such settlement of immoveable property, which
becomes a major deterrent. Often, residential property is gifted to individual
members, since in states such as Maharashtra, the stamp duty on gifts to
specified relatives is minimal; such exception is not available for transfer to
a Trust even if the beneficiaries are such specified relatives.
As there is no stamp duty on assets transferred
through a Will, it becomes a more commonly used means of migrating large
immovable properties held by individuals. However, this could lead to a
potential estate duty liability, as it would only pass on on the demise of the
owner. Thus, apart from the concerns around the ownership of the property or
any friction between family members, the trade-off between immediate stamp duty
outflow and potential future estate duty outflow would need to be considered.
In case
properties are not held directly by individuals but through entities, the
ownership of the entity itself may be transferred to the Trust. In such case,
stamp duty implications, if any, are likely to be significantly lower than that
which would have arisen on transfer of the immovable property itself.
Family wealth may include intangible rights in the
properties, such as development or tenancy rights, which are not transferable
without the approval of landlord/owner of the property. Depending on how such
rights are held and whether such approval is forthcoming, a decision may need
to be taken if they ought to be settled into the Trust.
3. Assets located
overseas
Increasingly,
many families hold assets overseas, be it in the form of shares (strategic or
portfolio investments) or immoveable property. For any such assets to be
transferred to a Trust, or if any of the family members are non-residents, not
only would the provisions of the Foreign Exchange Management Act, 1999 need to
be considered, but also the laws of the country where the assets are located.
4. Business assets
In the
current environment, considering the size of business and other factors, it is
usually not possible or advisable to carry on business from a Trust. Therefore,
it is inevitable that the business is continued or transferred to a company or
other entity.
If the
business is carried on through a company, whether wholly owned by the family or
not, the securities in such company will be transferred to a Trust. In case the
business is housed in non-company entities (such as a partnership firm or
Limited Liability Partnership firm), it may be necessary to make the Trust
(through its Trustees) a partner in such an entity. However, it would be
advisable that in case a partnership firm is conducting the business, a
separate Trust is set up to ring-fence and protect other properties, since
partnership firms have unlimited liability for its partners.
F. Examples of trust
structures
Depending on
the requirements, a Trust structure may be set up in multiple ways. No
one-size-fits-all approach would work.
If it is a
nuclear family, setting up a single Trust may suffice. On the other hand,
multiple factions within the family would require multiple Trusts to be set up.
For example, a family of two brothers owned their business in a company. Their
father created the business, and with his wife (the mother), owned 100% shares
in the company. The parents settled their entire holding in the company to a
master Trust, wherein they were the Trustees, thereby retaining control with
them. The beneficiaries were two separate Trusts (often referred to as baby or
sub-Trusts) set up for each of their sons and their respective families. This
is depicted here as a base structure:
Another
variation could be with multiple master Trusts. In this example, a family of
father and two sons owned two businesses. They decided to have:
u Two master Trusts for
holding the two businesses through existing companies
u One master Trust for owning
other assets
u Three baby Trusts for each
segment of the family
Clearly, the
facts of each case, combined with the requirements of all stakeholders will
need to be considered while establishing any Trust structure.
G. Migration
Any
succession plan would fail unless it is implemented properly, through
appropriate migration of assets to the structure. Not all assets would be
directly owned by the settlor, which can easily be settled into the Trust. In
some cases, they may be owned by companies, partnership firms, LLP, even Hindu
Undivided Families. In such case, the existing structure would first need to be
unwound before the properties are introduced into the Trust.
To do so,
especially to unwind a structure, various methods may be used, e.g.:
u Settlement into a Trust
u Gift of assets
u Sale of
assets/business/shares
u Family
arrangement/settlement
u Primary infusion
u Mergers/demergers
Any migration
strategy would typically be a combination of the above. Each of the above modes
of transfers could have implications under various statutes, which would need
to be examined closely, e.g.:
u Income tax
u Stamp duty
u SEBI
u FEMA
u Laws of foreign
jurisdictions
Further, one
would also need to consider the potential levy of inheritance tax/estate duty,
and plan appropriately, considering that there is no law in place currently,
not even in draft form; one can only draw an analogy from the erstwhile ED Act
or even from laws of foreign countries.
To conclude
Succession
planning through the use of Trusts has been in use in India since several
generations and is not a new concept. However, with the various complications
of business, the multitude of laws that today surround any kind of action, the
glare that any business house comes under, and the uncertainty surrounding the
reintroduction of inheritance tax, makes it an exciting subject. The intent is
to capture a flavour of Trust structures; however, various nuances would need
to be considered before embarking on such a journey.
