Can income retained by the trustee be brought tax in the assessment of beneficiary?
A trust deed, also known as a deed of trust is a document sometimes used in real estate transactions in the U.S. It is a document that comes into play when one party has taken out a loan from another party to purchase a property. The trust deed represents an agreement between the borrower and a lender to have the property held in trust by a neutral and independent third party until the loan is paid off.
A trust is a three-party fiduciary relationship in which the first party, the trustor or settlor, transfers (“settles”) a property (often but not necessarily a sum of money) upon the second party (the trustee) for the benefit of the third party, the beneficiary.
Let us refer to the case of Commissioner Of Wealth Tax vs Estate Of Late Vikramsinhji where the main issue under consideration was whether income was taxable in the hands of the beneficiary given the fact that no income was distributed by a trust.
Facts of the Case:
- The ex-Ruler of Gondal, Shri Vikramsinhji executed three deeds of settlements (trust deeds) in USA in 1963 and two deeds in UK in 1964, all executed in identical terms for the benefit of the settler and the members of his family.
- The settler and post settler’s death, the assessee (the eldest son of Vikramsinhji), were declaring the entire trust’s income as taxable in India for initial years up to AY 1970-71.
- Post AY 1970-71, the assessee took the stand that, the income of the trusts need not be subject to tax in the hands of the taxpayer and no income was reported thereafter.
- The assessee also took the stand that, declaration of income for previous years was a mistake.
Proceedings of Settlement Commission
- The assessee then, approached the Settlement Commission with an application for settlement relating to income from the UK trusts and the US trusts.
- The Settlement Commission held that the US trusts were discretionary, but the UK ones were specific and therefore, its income was liable to tax in the hands of the assessee in India.
- Against Settlement commission’s order the taxpayer preferred an appeal to the Supreme Court of India (SC).
Observations of the Supreme Court (SC)
- The Supreme Court observed that, both the settlor and the Shri Vikramsinhji were receiving the income from these trusts during the several assessment years.
- It would have been unlikely that, they would have so included them unless it were really received.
- Hence the SC held that USA trusts were discretionary and since the assessee himself had declared the income with regard to UK trusts, the question was more of academic in nature and did not decide on it.
What happened after the Supreme Court Decision?
- For subsequent years, the taxpayer put a note to his Statement of Income stating that the UK and the US trusts were discretionary, and no remittances were made by the trusts to the taxpayer.
- The Assessing Officer (AO), however passed an order taxing the income of the trusts in the hands of the taxpayer like the previous years.
Proceedings of Appellate Authorities
- On appeal, CIT(A) held that, US trusts were discretionary trust whereas UK trusts were specific trusts.
- The Tribunal (ITAT), relying on the previous orders by the Settlement Commission and the SC in its support, held that the disputed UK trusts were specific trusts especially due to clauses 3(2) and 4 of the UK trust deeds.
- The ITAT further held that, even assuming the UK trusts were discretionary, such income of the trusts were taxable in the hands of the assessee as per section 166 of the Income-tax Act, 1961 which allows to tax the income of the trust in the hands of the trustee or the beneficiary.
Proceedings of the High Court (HC)
- On appeal by the taxpayer against the order of the ITAT to the HC, the HC held that section 166 can be invoked only when the income of the trust is received by the assessee, who is the beneficiary to the trust.
- The HC noted that, when no remittance was made by the UK trusts and that the entire income was retained by it and not distributed, such income cannot be taxable in the hands of the taxpayer in India.
- Further, the HC noted that Revenue had not produced any documents to establish that the taxpayer had received income from the UK trusts.
- Whereas, the taxpayer had produced statements from the trust to the effect that the income had been retained by trust and not distributed to the assessee.
- Therefore, HC held that, no income is taxable in the hands of the beneficiary/assessee.
- Aggrieved by the order of the High Court the Revenue preferred an appeal to the SC.
Observations of the SC
- SC observed that for the assessment years under consideration, HC had noted the following distinguishing features:
- assessee has not admitted having received the income
- assessee has not received the said income, and
- assessee has not shown as taxable income in the returns of all the years under appeal
- Having observed these distinguishing features, the HC was also of the view that, on interpretation of the relevant clauses of the deeds of settlement executed in UK, character of the trusts appeared to be discretionary and not specific.
- SC was of the view that a discretionary trust was one which gave a beneficiary no right to any part of the income of the trust property, but vested in the trustees a discretionary power to pay him, or apply for his benefit, such part of the income as they thought fit.
- The trustees had to exercise their discretion as and when the income became available.
- However, if they failed to distribute in due time, the power was not extinguished so that they could distribute later.
- They had no power to bind themselves for the future.
- The beneficiary thus, has no more than a hope that the discretion would be exercised in his favour.
- Thus, SC upheld the HC’s view that, the trusts were discretionary and not specific.
- SC observing the fact that the income was retained and not disbursed to the beneficiaries, held that the view taken by the High Court could not be said to be legally flawed.
- Merely because the Settlor and after his death, his son did not exercise their power to appoint the discretion exercisers, the character of the subject trusts did not get altered.
- Considering the facts, SC held that, the two UK trusts continued to be ‘discretionary trust’ for the assessment years.
- This position regarding the discretionary trust was equally applicable to the controversy in appeals under the Wealth-tax Act.
- HC took correct view that the value of the assets cannot be assessed on the estate of the deceased Settlor.
In conclusion, Income retained by the trustee cannot be brought tax in the assessment of beneficiary. Trustee has discretionary powers to distribute trust’s income. If the trustee did not exercise his power to distribute the income among the beneficiaries, it doesn’t mean that his power is extinguished and he can do it later on.