The Supreme Court of India (SCI) in the recent case of Commissioner of Income-tax, Rajkot vs. Estate of Late HMM Vikramsinhji of Gondal Civil Appeal No. 2312 of 2007 dated April 16, 2014 (unreported) laid down an important view that once a trust has been settled/ created as a discretionary trust with powers to the trustees to distribute the income of the trust to the beneficiaries, even if the trustees do not exercise their powers for several years, the trust would still be treated as a discretionary trust. Interestingly, in this case, one of the clauses of the trust deed mentioned that if the trustee does not exercise his powers in distributing the income then the trust income will be accrued and be paid to the beneficiaries. The SCI held that even if such clauses are found in the trust deed, it would still be treated as a discretionary trust and not as specific one and that income of the trust will be taxed in the hands of the beneficiaries only when they are actually distributed and cannot be taxed on accrual basis.
Facts of the case
The taxpayer was the eldest son of one Vikramsinhji, Ex-Ruler of Gondal State (the Ruler), who during the years 1963 and 1964, had executed three trust deeds in USA and two trust deeds in UK for the benefit of the settler and the members of his family. The Ruler had appointed Mr. McGill as the trustee for the UK trusts. The Ruler and the taxpayer were declaring the entire trust’s income as taxable in India for initial years (i.e. up to assessment year (AY) 1970 – 1971).
Post AY 1970 – 1971, the taxpayer was advised that the income of the trusts need not be subject to tax in India. Based on which no income was reported in India thereafter. The Assessing Officer (AO) passed an order taxing the income of the trusts in the hands of the taxpayer like the previous years. On appeal by the taxpayer, the appellate authority accepted the plea of the taxpayer that such income was not subject to tax in India. However, the Income Tax Appellate Tribunal (ITAT) on the appeal preferred by the AO, held that the income were taxable like the previous years and remanded the matter to the AO for fresh assessment.
The taxpayer, in the meantime, filed an application to the Settlement Commission (SC) to settle the dispute with regard to the trusts’ income. The SC held that the US trusts were discretionary but the UK ones were specific and therefore, its income is liable to tax in the hands of the taxpayer in India. Against this order the taxpayer preferred an appeal to the Supreme Court of India (SCI) where the SCI held that US trusts were discretionary and since the taxpayer himself had declared the income with regard to UK trusts, the question was more of academic in nature and did not decide on it.
However, for subsequent years the taxpayer had put a note to his statement of income that the UK and US trusts were discretionary and also no remittances were made by the trusts to the taxpayer and therefore, the income of the trust is not taxable in India. The taxpayer also produced a statement from the trustee of the UK trust that its income is being retained and that no remittances were made. However, the AO did not accept this argument. The Commissioner of Income-tax (Appeals) [CIT(A)] concurred with the AO.
On appeal to the ITAT, it held that the UK trusts (which were in dispute) are specific trusts especially due to clauses 3(2) and 4 of the UK trust deeds. It further held that even assuming the UK trusts were discretionary, such income of the trusts were taxable in the hands of the taxpayer as per section
166 of the Income-tax Act, 1961 (the Act) which allows to tax the income of the trust in the hands of the trustee or the beneficiary. The ITAT relied on the earlier SC and the SCI orders in its support.
On appeal by the taxpayer against the order of the ITAT to the Gujarat High Court (the HC), the HC held that section 166 of the Act can be invoked only when the income of the trust is received by the taxpayer i.e. the beneficiary to the trust. The HC further held that when the taxpayer states that 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 held that the Revenue had not produced any documents to establish that the taxpayer in fact received income from the UK trusts. Whereas, the taxpayer has produced statements from the trust to the effect that the income has been retained by trust and not distributed to the taxpayer. Therefore, the court held that no income is taxable in the hands of the beneficiary/ taxpayer.
Aggrieved by the order of the HC, the Revenue preferred an appeal to the SCI.
Arguments of the Revenue
The arguments of the Revenue were dependent on clauses 3(2) and 4 of the UK trust deeds. As per clause 3 of the UK trust deeds, the trustee shall have possession over the Trust Fund and its income. As per clause 3(2), the trustee at his discretion shall have the duty to take care of the beneficiaries of their maintenance and education. The clause also mentioned that the settler of the trust i.e. the Ruler shall have powers to appoint additional trustees to the trust. Clause 4 stated that subject as aforesaid i.e. clause 3, the trustee shall have possession of the Trust Fund and its income for the benefit of the settler and his sons and grandsons.
The Revenue contended that the trustee i.e. McGill did not exercise his power in distributing any income for the benefit of the beneficiaries as per clause 3(2) of the trust deed and that all the income of the trust was accrued and received by the settler during his lifetime and after him by the taxpayer. Since the trustee did not fulfil his duty at any point in time all the income have been accruing and being received only by the settler and the taxpayer, the trust is specific in nature. Therefore, whether or not any income is distributed by the trust to the taxpayer it should be subject to tax in India. For this the Revenue relied on the order of the SC which held that the UK trusts were specific trusts.
Arguments of the Taxpayer
The taxpayer’s main contention was with regard to the interpretation of the trust deed. The taxpayer interpreted clauses 3(2) and 4 in such a manner to establish that the UK trusts were discretionary trusts and not specific ones and therefore, no income that has accrued to the trust will be automatically taxable in the hands of the taxpayer especially when no distributions were made by the trust to the beneficiaries.
The taxpayer contended that SC and the ITAT wrongly construed clause 3 of the trust deeds. He argued that the trust had already come into existence with the appointment of the sole trustee, Mr. McGill, and that the coming into existence of the trust did not depend upon the appointment of additional trustees. The SC and ITAT were wrong in holding that until and unless the additional trustees are appointed, the trust in clause 3 does not come into existence. Properly construed, clause 3 creates a discretionary trust. Inasmuch as the clause 3(2) does not prescribe any time limit within which the trustees must decide to distribute the income among the beneficiaries, clause 4 does not come into operation. The trustees never decided not to exercise their discretion under clause 3. In the sense, they would have exercised the discretion had there been a need.
Therefore, no income ever arose or accrued to the settler or the taxpayer under clause 4. If the trustee does not exercise his discretion as per the deed then the only remedy available to the beneficiaries is to approach the court to direct the trustee to discharge his duty. But this does not mean that the income of the trust has accrued to the beneficiaries.
The taxpayer further argued that since clause 4 starts with the words ‘Subject as aforesaid’ i.e. clause 3. So, only if no trustee is appointed by the settler, clause 4 would come into operation and the trust income would automatically accrue to the settler and after him to the taxpayer. Therefore, the taxpayer argued that the trusts were discretionary throughout their existence.
Ruling by the Court
The SCI initially held that the case involves more of interpretation of the terms of the trust deeds and there is no question of law much less substantial question of law. However, in order to decide the case the SCI upheld the views of the Gujarat High Court that the trusts were indeed discretionary and not specific. The SCI further held that it appears from the records that the taxpayer has not admitted having received the income from trusts, the taxpayer has not received the said income and taxpayer has not shown as taxable income in the returns of all the years under appeal.
The SCI while settling the law relating to taxation of trusts held that a discretionary trust is one which gives a beneficiary no right to any part of the income of the trust property, but vests in the trustees a discretionary power to pay him, or apply for his benefit, such part of the income as they think fit.
The SCI further held that the trustees must exercise their discretion as and when the income becomes available, but if they fail to distribute in due time, the power is not extinguished and they can distribute later. They have no power to bind themselves for the future. The beneficiary thus has no more than a hope that the discretion will be exercised in his favour.
The SCI held that in the earlier case of the same taxpayer also this Court had held in case of US trusts having similar clauses as discretionary trusts1 and since the income has been retained by the trust and not disbursed to the beneficiaries, the trusts were discretionary. The SCI concluded that merely because the settler and after his death, his son did not exercise their power to appoint the trustees, the character of the trusts does not get altered. Therefore, the UK trusts continued to be ‘discretionary trusts’ for the relevant taxable years.
This is an exemplary case to show that while drafting trust deeds the clauses are extremely important vis-a-vis taxes and have to be explicitly worded, as it is the deeds which speak out the intent of the settler after his/ her death. Much of the confusion in these trust deeds was as to how to interpret clauses 3(2) and 4 of the UK trust deeds2. The Supreme Court clearly held that once the terms of the deeds state that the trustee has discretionary powers to distribute trust income that is sufficient to hold that the trusts are discretionary even though the trustee does not exercise his discretionary powers.
As per the facts of the taxpayer, it is understood that he was receiving money from the trusts for the initial years while he was resident in India. Therefore, he paid tax on such income in India. For later years, the trustee did not distribute any income from the trust. The tax department held that even during subsequent years the taxpayer is required to pay tax as clause 4 of the trust deeds mentions that the taxpayer has rights over the trust income. The HC and the SCI did not accept this contention of the Revenue and read clause 4 that only if no trustees were appointed it could be said as specific trust. Since a trustee was appointed in the first place with discretionary powers, the trusts will continue to be discretionary even if no incomes are distributed by the trustee.
However, it is interesting to note that the settler of the trust i.e. the Ruler was also the beneficiary of the trust and also retained with him the exclusive power to appoint additional trustees3. This has much exposure to section 63 of the Act which defines revocable transfer as a transfer which in any way gives the transferor (settler) a right to reassume power directly or indirectly over the whole or any part of the income or assets. However, the SCI did not have the occasion to deal with this issue in detail.
3. THE Settler hereby directs that the Trustees shall and accordingly the Trustees shall stand possessed of the Trust Fund and the income thereof upon the trusts following that is to say :-
(1) UPON TRUST to raise and pay out of the capital thereof any further estate duty which may still be payable thereon in respect of the death of the Settler’s father His Late Highness Shri Bhojrajji Maharaja Saheb of Gondal who died on the Thirty-first day of July One thousand nine hundred and fifty-two and any interest payable on such duty and any costs incurred in connection with the ascertainment or payment of such duty and interest.
(2) Subject as aforesaid UPON TRUST for all or such one or more exclusively of the others or other of the Beneficiaries at such age or time or respective ages or times if more than one in such shares and with such trusts for their respective benefit and such provisions for their respective advancement and maintenance and education at the discretion of the Trustees or of any other person or persons as the person who for the time being is the Maharaja or (if the title is abolished) would have been the Maharaja had the title not been abolished shall at any time during the specified period by any deed or deeds revocable or irrevocable appoint AND in default of any subject to any such appointment UPON the trusts and with and subject to the powers and provisions hereinafter declared and contained concerning the same PROVIDED ALWAYS that the foregoing power of appointment shall not be capable of being exercised:-
(a) by anyone other than the Settler or the Elder Son or the Younger Son; or
(b) in favour of the person making the appointment save with the consent of the Trustees (being at least two in number or a trust corporation) such consent to be testified by their being parties to the deed of appointment and executing the same.
4. SUBJECT as aforesaid the Trustees shall stand possessed of the Trust Fund and the income thereof upon the trusts following that is to say:-
(1) The income of the Trust Fund accruing during the life of the Settler shall belong and be paid to the Settler.
(2) Subject as aforesaid the income of the Trust Fund accruing during the life of the Elder Son shall belong and be paid to the Elder Son.
It is settled principle of trust taxation that a settler can be a beneficiary, a trustee can also be a beneficiary but the settler cannot be the sole trustee or he cannot be a settler, a trustee as well as a beneficiary as in the latter two cases it may be treated as a revocable transfer and the income of the trust will continue to be liable to tax in the hands of the settler.
Originally published in Corporate Professionals Today Magazine June Edition, Taxmann Publications.
1 Jyotendrasinhji vs. SI Tripathi and others 1993 Supp. (3) SCC 389
2 Clauses 3 and 4 of the Trust Deeds read as under:-
3 As per Clause 3(2)(a) of the Trust Deed which gives power to the settler to appoint trustees