- Bangalore Tribunal holds that capital contributions made by contributors to a trust shall be taxed at the hands of the contributors as revocable transfers.
- For a transfer to be revocable, the power of revocation need not be exercised by the transferor.
- Power of revocation of the transferor does not have to be expressly conferred by the instrument of transfer.
- In the absence of an inter se agreement between beneficiaries determining ‘common purpose’, a trust cannot be taxed as an Association of Persons.
- To the extent that the beneficiaries are identifiable, and share of income of each beneficiary is ascertainable through the trust deed, the trust shall be considered as determinate.
- Position on determinate trust status taken by the Bangalore Tribunal is not in sync with the circular issued by CBDT on taxation of AIFs.
Recently, the Bangalore Income Tax Appellate Tribunal (“Bangalore Tribunal”) in the case of DCIT v. India Advantage Fund – VII1 held that income arising to a trust where the contributions made by the contributors are revocable in nature, shall be taxable at the hands of the contributors. It was further held that if the beneficiaries are identifiable, and share of each beneficiary is ascertainable through a mechanism/ formula prescribed under the trust deed, the trust cannot be said to be discretionary, and taxed at the maximum marginal rate (“MMR”).
The ruling comes as a big positive for the Indian fund industry. Funds, including Alternative Investment Funds (“AIFs”) that are not entitled to pass through status from a tax perspective (i.e. not covered under Section 10(23FB) of the Income tax Act, 1961 (“Tax Act”)) could seek to achieve a pass through basis of tax by ensuring that the capital contributions made by the contributors is on a revocable basis. The ruling also clarifies the basis on which a trust can demonstrate that it is ‘determinate’. The basis seems to be different from the position taken by the tax authorities in CBDT’s Circular dated July 28, 2014.
Mechanics of the Trust
- Formation of the Trust: India Advantage Fund – VII (the “Trust”) is a trust settled under the Indian Trusts Act, 1882 under an instrument of trust dated September 25, 2006 (“Trust Deed”) by ICICI Venture Funds Management Company Limited (in its capacity as the “Settlor”). As per the Trust Deed, the Settlor transferred a sum of INR 10,000 to The Western India Trustee and Executor Company Limited (the “Trustee”) as initial corpus to be applied and governed by the terms and conditions of the Trust Deed.
- Investment Management Agreement: The Trustee appointed ICICI Venture Funds Management Company Limited as the investment manager of the Trust (“Investment Manager”).
- Contributors: A Private Placement Memorandum (“PPM”) was issued on a confidential basis to prospective investors for them to consider investment in the Trust. Investors (“Contributors”) made contributions to the Trust fund under a specific and separate agreement (“Contribution Agreement”) entered into between each Contributor individually, the Trustee and the Investment Manager.
- The Contributors were also the beneficiaries of the Trust.
- Powers of the Trustee: The Trustee was empowered to call for contributions from Contributors, which would further be invested by the Trustee in accordance with the objects of the Trust (i.e. to make investment and achieve returns for the Contributors).
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Assessment proceedings before lower tax authorities: The Trust declared an income of INR 1,81,68,357 in its revised return of income. However, it was categorically stated by the Trust that while such income is being disclosed in good faith, the income shall be offered to tax by the beneficiaries i.e. Contributors. Consequently, the Trust declared its effective taxable income as nil. The Assessing Officer (“AO”) was of the view that the Trust is in the nature of a discretionary trust taxable at MMR. The AO further went on to hold that since the Trust filed returns in the status of an Association of Persons (“AOP”), and the Trust and Contributors were joined in a common purpose, the Trust is an AOP and should be taxed at MMR accordingly.
The Commissioner for Income Tax (Appeals) reversed the order of the AO and held that the Trust is in the nature of a revocable trust and directed the AO to treat the income of the Trust as nil. Aggrieved by this order, the AO preferred the present appeal before the Tribunal.
INCOME TAX PROVISIONS DEALING WITH TAXATION OF TRUSTS
To give a brief background, the various kinds of private trusts (under Indian tax law) and their taxation has been explained below:
- Determinate trusts: In determinate trusts (where the shares of each beneficiary is determinable, and beneficiaries are identifiable), the trustee assumes the same tax status as the relevant beneficiary with respect to such beneficiary’s share of income. The tax may be levied on the trustee in the like manner and to the same extent as it would be levied from the relevant beneficiary2.
- Discretionary trusts: In a discretionary trust, the income earned by the trust (depending on the various streams of income) would be taxed in the hands of the trustee at the MMR (i.e. 30%)3. A discretionary trust is one where the trustee has discretion in relation to distributions from the trust and the beneficiary’s income from the trust is not determinable till there is an actual distribution.
- Revocable transfers: In case of income arising from a revocable transfer (made to a trust), such income is taxed at the hands of the transferor, and not the trustee4.
- Business trusts: In case of a trust (irrespective of whether discretionary or determinate) having income in the form of profits and gains of business, the income earned by the trust shall be taxed at MMR5.
RULING OF THE TRIBUNAL
Validity of the Trust: The Tribunal held that the Trust was validly constituted under the provisions of the Indian Trusts Act, 1882. It further held that the fact that the Contributors of the Trust were also the beneficiaries, would not affect the validity of the Trust. For this purpose, the Tribunal relied upon the ruling of the Authority for Advance Rulings in XYZ, In Re6 where the facts were similar to the present case.
Applicability of revocable transfer provisions: The Tribunal concluded that sections 61-63 of the Tax Act dealing with revocable transfers are applicable to the contributions made by Contributors. This was based on a conjoint reading of the documents described above, and specifically the following:
- Article 13 of the Trust Deed provided for termination of the Trust. Although such power was granted to the Trustee, in the view of the Tribunal, it was a general power of revocation which was sufficient for construing the transfer (i.e. the contributions) as a ‘revocable transfer’.
- The power of revocation need not be at the instance of the Contributor (or transferor), and section 61 of the Tax Act does not contemplate such a situation. The Tribunal further held that what is relevant is only the existence of the power to revoke a transfer, and not at whose instance such power is exercised. The Tribunal accepted the Trust’s reliance on the Supreme Court’s decision in ACIT v. Surat Art Silk Manufacturers Association7 for this purpose.
- The Tribunal also relied on the contents of the PPM which stated that the contribution made by a Contributor was akin to a revocable transfer, and therefore income arising from such transfer shall be taxed at the hands of the Contributor on a pro-rated basis, and not the Trust.
- The Tribunal also accepted the alternative contention of the assessee Trust that the provisions of section 63(a) of the Tax Act would render the transfers revocable. As per the PPM, if 75% of the Contributors revoke their contribution to the Trust, the Trustee will be required to terminate the Trust. Although such power has not been granted under the Trust Deed, the Tribunal held that it would still be sufficient to conclude that the Contributors had deemed powers of revocation. Reliance was placed on the Supreme Court’s decision in Jyothendrasinhji v. S.I.Tripathi & Ors.8 which held that section 63(a) does not contemplate that the deed of transfer must confer the power of revocation.
Assessment of the Trustee as representative assessee: The Tribunal noted that for provisions of section 164(1) to apply, two aspects need to be fulfilled – (i) identification of the beneficiaries and (ii) ascertainment of the share of the income of the beneficiaries. On these two aspects, the Tribunal held that section 164(1) was inapplicable based on the following reasoning:
- Naming all beneficiaries in the Trust Deed is not required, and the fact that the Trust Deed lays down that beneficiaries shall be investors that have made contributions to the Trust (i.e. the Contributors) would be sufficient to identify the beneficiaries.
- As regards ascertainment of share of the income of the beneficiaries, the Tribunal noted that in the present case the shares are capable of being determined based on the pre-determined formula prescribed under the Trust Deed. Further, the Trustee has no discretion to alter shares of the Contributors independently. It was concluded that the ascertainment of share of the beneficiaries was identifiable.
Assessment of Trust as an AOP: The Tribunal held that in the present case, the Contributors made contributions to the Trust under individual Contribution Agreements. No agreement was entered inter sebetween the Contributors (beneficiaries). Therefore, the AOP test of ‘common purpose’ fails.
As regards the filing of returns by the Trust as an AOP, the Tribunal held that the relevant assessment year did not contain a clause for filing return of income by a “trust”. The Tribunal stated that if the argument of the tax department that all trusts are AOPs were to be accepted, it would render section 161(1) (which deals with charge of tax on trustee as representative assessee) redundant.
Income cannot be taxed doubly: The Tribunal has upheld the principle that once a taxpayer is assessed and his assessment is completed, the tax department cannot assess the same income for that assessment year in the hands of the other person i.e. beneficiary or trustee. As regards the applicability of Circular 2014 regarding taxability of Alternative Investment Funds (“AIFs”), the Tribunal held that the circular cannot have retrospective effect.9
The Tribunal’s ruling comes as a great relief to the fund industry as it establishes fundamental principles of fund taxation. Interestingly, while the fund taxation principles have been dealt with extensively by the AAR inIn re: XYZ, this is one of the first rulings to apply the principles of revocable transfers to the fund taxation sphere.
Taxation of revocable transfers v. discretionary trusts: While the Tribunal examines the applicability of revocable transfer tax provisions to a determinate trust, the same principles should equally apply to discretionary trusts as well. The Tribunal has clearly stated that in light of the contributions being revocable, the determinate status of the Trust need not be examined. This would imply that once a trust has been characterized as a revocable trust, taxation would be governed by the revocable transfer tax provisions (sections 60-63 of the Tax Act). Consequently, tax principles otherwise applicable to business trusts or determinate trusts would no longer apply to trusts accepting revocable transfers.
Structuring contributions as revocable transfers could also positively impact AIFs which have not been granted tax pass through status specifically under the Tax Act (i.e. funds that are not registered under the venture capital fund sub-category under Category I AIF and therefore will not be eligible for exemption under section 10(23FB) of the Tax Act). Such AIFs had the risk of potentially being treated as a business trust and taxed at MMR. Therefore, using this method, Category III AIFs such as hedge funds can also avail of a tax pass through status by structuring capital contributions as revocable transfers.
This technique upheld by the Tribunal could potentially be used by such funds to ensure that it may still be possible for such pooling vehicles to get a tax pass through status that has not been explicitly granted by the Tax Act.
Impact on 2014 Circular relating to AIFs : Earlier this year, the Central Board of Direct Taxes (“CBDT”) issued Circular No. 13 of 2014 (“Circular”) to provide clarity on the taxation of AIFs registered under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. The Circular states that if ‘the names of the investors’ or their ‘beneficial interests’ are not specified in the trust deed on the ‘date of its creation’, the trust will be liable to be taxed at the ‘maximum marginal rate’.
As discussed in our previous hotline (that examined the implications of the Circular), this Circular has posed problems to the domestic funds industry where AIFs often look at admitting new investors through multiple closings, particularly in a tough fundraising environment where it is not uncommon for some investors (particularly domestic institutions) to track the performance of an investment manager and the fund’s portfolio before committing their capital or substantially increasing their allocations. While the ruling of the Tribunal may not impact the validity of the clarification provided under the Circular, it nevertheless offers considerable room for structuring investments into AIFs as revocable contributions. The fund documents typically contain certain provisions including termination, right to demand distributions (in cash and in specie) which convey the power of revocation to various counterparties and which, if triggered, would result in the assets of the fund being distributed pro-rata to the transferors (i.e. the investors). This should help in making a defendable case that investments into an AIF are in the nature of revocable transfers. In fact, the ‘distribution waterfall’ clause which is a standard feature in fund documents (including the private placement memorandum) and which empowers the trustee to make distributions to the investors on the basis of a pre-defined sequence and order should also meet the test laid down by the Bangalore Tribunal.
Assessment as AOP: In the past couple of years, there have been an increasing number of assessments where the tax authorities have sought to tax an investment fund as an AOP. The Tribunal also lends further clarity on this issue by stating that in the absence of an agreement between the investors inter se, the common purpose test is not fulfilled.
Revocable trust as an anti-avoidance provision: Historically, the revocable transfer tax provisions were introduced and used as a specific anti avoidance measure by the tax authorities. These provisions were used to curb situations where the transferor transferred property to a third party, so that income from such property was never ‘received’ by him, but at the same time he retained control over such property or its income. This ruling seems to have implicitly upheld that it is possible for the taxpayer and not just the tax authorities, to rely on the revocable transfer provisions to his advantage.
While revocable transfers could be used to the taxpayer’s advantage, one would still need to be conscious of the general anti avoidance rules that come into play next financial year (but are applicable to structure put into place after August 30, 2010).
The ruling offers some degree of certainty on the rules for taxation of domestic funds that are set up in the format of a trust by regarding such funds as fiscally neutral entities.
Globally, funds have been accorded pass through status to ensure fiscal neutrality and investors are taxed based on their status. This is especially relevant when certain streams of income maybe tax free at investor level due to the status of the investor, but taxable at fund level.
A circular issued by the CBDT is binding only on the tax department, and can be binding on the taxpayer only in a situation where it is favorable to the taxpayer’s position.
The Circular and the ruling of the Tribunal seem to provide contradictory views on when a fund (specifically an AIF) can be assessed on the basis of being a determinate trust. Considering that circulars issued by the CBDT have limited binding value on taxpayers, it will be interesting to see how things pan out in future.