Section 164(1) of the Income-tax Act,1961 (‘the Act’) provides for charge of tax where the shares of beneficiaries in a trust are not known. According to the relevant provisions, where individual share of beneficiaries is not ascertainable on the date of the instrument, income earned by the trust shall be chargeable in the hands of the trustee at the maximum marginal rate. Therefore, determining the share of each beneficiary is an important aspect in the trust taxation. The recent Karnataka High Court ruling1 has laid down important principle in this regard, summarized as below:
India Advantage Fund-I, ICICI Emerging Sectors Fund and ICICI Econet, Internet and Technology Fund were three different trusts (“taxpayer” or “the fund”) constituted under different instruments of trust. The trust was to facilitate investment by the contributors (resident in India) and achieve returns for such contributors. The trust deed provided that contributors to the fund shall also be its beneficiaries. An investor who wishes to contribute to the fund, enters into a contribution agreement with the trust, the trustees acting on behalf of the trust and the settlor acting in his capacity as investment manager. The beneficiaries contributed to the fund for making investments.
During the revenue audit, the taxpayer claimed that pursuant to the provisions of section 61 to section 63 of the Act (dealing with taxation in case of irrevocable transfers), the income earned by the fund has been included in the return of income of the beneficiaries and offered to tax directly by them. The tax officer referred to the trust deed and observed that the shares of the beneficiaries are not specifically mentioned therein. The fact that the trust deed provides that share of the beneficiaries would be in proportion to their investments in the fund, do not make their share in the fund ‘determinate or known’.
The tax officer further held that the taxpayer and the beneficiaries have come together for a common purpose or common action, the object of which was to produce income, profits and gains and therefore, it constituted an association of persons (AOP).
Order of the Tax Tribunal
Applicability of Section 164(1): The Tax Tribunal noted that for applicability of provisions under section 164(1), two important aspects are required to be fulfilled:
- identifying the beneficiaries; and
- ascertaining the share of each beneficiary.
While evaluating the above two aspects, the Tax Tribunal held that section 164(1) was inapplicable and provided the following reasoning in this respect:
- The trust deed lays down that beneficiaries shall be investors that have made contributions to the trust (i.e. the contributors) and this would be sufficient to identify the beneficiaries. Therefore, naming the beneficiaries in the trust deed is not required.
- As regards ascertaining share of income of the beneficiaries, the Tax Tribunal noted that the shares are capable of being determined based on the pre-determined formula prescribed under the trust deed. Also, the trustee has no discretionary right to alter shares of the contributors independently. Therefore, it was concluded that the share of the beneficiaries was identifiable.
The Tax Tribunal further observed that contributions to the trust were made under individual Contribution Agreements. However, no agreement was entered inter-se between the contributors (beneficiaries). Therefore, the AOP test of ‘common purpose’ does not stand true.
Question before the High Court
Identical questions were raised by the tax authorities regarding the applicability of section 164(1) of the Act.
Contentions before the High Court
Contentions of tax authorities: It was contended that the Tax Tribunal has erred in holding that the taxpayer cannot be assessed as an AOP on the basis that the requirements of section 164(1) of the Act were not fulfilled. This is based on reasoning that the shares of the beneficiaries were not known / indeterminate since the shares were not clearly mentioned in the trust deed. It was argued that the shares should specifically come in existence with the quantification and it should not depend upon the future share of the benefits or upon any contingency, such as investment through contribution. Therefore, the tax officer was justified in invoking the provisions of section 164(1) and assessing the taxpayer at the maximum marginal rate.
Contentions of taxpayer: The taxpayer contended that so long as the trust deed gives the details of the beneficiaries and the description of the person who is to be benefited, the beneficiaries cannot be said to be uncertain. Reliance was placed on the CBDT Circular No.281 dated September 22,1980 which explained that for identification of beneficiaries, it is not necessary that the beneficiary in the relevant previous year should be actually named in the trust deed. The only requirement is that the beneficiary should be identifiable with reference to the trust deed on the date of such deed. Further, the taxpayer also argued that it is not the requirement of law that trust deed should prescribe the percentage share of the beneficiary, for the trust to be determinate. The fact that shares are capable of being determined based on the provisions of the trust deed shall suffice. Even where there is an addition in the number of contributors, if the trust deed expressly sets out the manner in which the beneficiaries are to be ascertained then it cannot be said that the trust deed does not name the beneficiaries or that their shares are indeterminate. To substantiate the above contentions, the taxpayer had relied on several judgements in its submission before the tax officer.
The High Court Ruling
The High Court has upheld the decision of the Tax Tribunal in favour of the taxpayer. While holding so, the High Court made reference to the relevant clause in the trust deed whereby the beneficiaries were defined to mean the contributories who have made or agreed to make contributions. The High Court stated that the said clause was sufficient to identify the beneficiaries. Regarding the ascertainment of share, the High Court held that it is sufficient that the shares are capable of being determined based on the provisions of the trust deed, how-so-ever complex the manner of computation may be.
The CBDT Circular No. 13/2014 dated July 28, 2014 for Alternative Investment Trusts (AIF) provided that in a situation where trust deed either does not have the name of the investors or it does not specify the beneficial interests, provisions of section 164(1) of the Act shall apply. Though, a pass-through status is granted to Category I and Category II AIFs vide Finance Act 2015, the applicability of provisions of section 164(1) to Category III AIFs is still debatable. In this context, this is a welcome ruling, further confirming the principles of trust taxation as applicable to funds not set-up as Category I and II AIFs. The principles laid down by the High Court may also be squarely applied to trusts not set up as a fund and the existing venture capital funds operating under Venture Capital Fund guidelines of SEBI. Interestingly, the proposed amendments to section 115BBDA of the Act vide Finance Bill 2017 provide that dividend income shall be taxable in the hands of trusts, other than specifically excluded. In light of above ruling, question arises as to whether such dividend income will be taxable in the hands of trusts or the beneficiaries. Further, if dividend income is once taxed in the hands of the trust, will such income be again taxed in the hands of the beneficiaries, needs to be evaluated.