Succession Planning And Its Taxation
Powers Of Enforcement Directorate (ED)
October 26, 2021Succession Planning And Its Taxation
Introduction
Many businesses find it difficult to maintain their growth and success when they are passed onto the successor of the business. While many individuals in strategic roles invest in talent management during their tenure, however, few spend time and efforts in selecting and grooming the next generation. This is, primarily, due to their failure to adopt succession planning
Succession planning is a systematic process which ensures individuals in an organization are capable of inducting leadership roles in the hierarchy of an organization.
It also refers to the systematic method of ensuring the transfer of management of business and wealth accumulated. The method of succession planning allows for a seamless transition of ownership and management of business and its assets to the future generation of promoters. Succession Planning is the process by which one bequeaths one’s property to private trusts, instead of bequeathing it to one’s successors via testament directly, ensuring that the heavy hand of Inheritance tax (or Estate Duty, abolished in 1985) does not fall on one’s property after death.
Succession planning is essential for longevity of the business and an efficient succession structure ensures it. It is an effective method to reduce the scope of any conflict which may have an adverse impact on the business. Businesses which have successfully invested in this mechanism have avoided unnecessary disputes which cause irreparable damages to the family ties and business, alike. Succession Planning is necessarily a multi-pronged strategy, as it involves a combination of a business strategy and a legal strategy aimed at securing a safe and complete transfer of assets to the successors while keeping in mind the multiple laws and regulations in various countries.
There are three methods of succession planning:
- Will
- Family Trust
- Family Arrangement
Will
A Will is the most common and conventional means of passing the legacy to one’s successors. A Will is a way of bequeathing one’s wealth and estate after death. A Will comes into effect only after the death of the testator. In order to give effect to a Will, it has to be probated, i.e. proved before a Court of law that it is a valid, authentic and final declaration of a deceased person.
Although a Will provides the benefit of flexibility by allowing the testator to change the terms of the testament during his/her lifetime, it suffers from limitations which would deeply disrupt, halt or end business of a going concern. It has been witnessed that a large number of Wills are susceptible to litigation due to disputes that arise during the execution of such Wills. These litigations continue for many years, thus affecting the smooth functioning of the business in the meanwhile. Moreover, wills can bequeath property only to persons living at the time of drafting and registering the will.
A Will is widely used because it is relevantly easier to make than the other options of succession planning. However, the assets are fragmented and cannot be held in a common pool under a Will.
Family Trust
A family trust is established for the benefit of the Beneficiary and consists of a Settlor, Trustees and Beneficiaries.
The Settlor is the person whose assets are contributed to the trust. He is known as the ‘author of the trust’.
The trustee is the person who accepts the confidence of managing and administering the trust property. He is the legal owner of the property, as there is no concept of equitable ownership.
The beneficiary is the actual owner of the property for whose benefit the trust has been established.
Family trust is another mode of succession planning and is increasingly being used as an alternative to Wills due to its ability to overcome the limitations of Wills. It is characterized by certainty and clarity regarding the successor and the manner of transferring the assets. It allows the trustee to choose the mode of dividing and distributing the wealth, thus, providing more flexibility and discretionary power to the trustees. The trustees can decide the interest of beneficiaries immediately or at a date in future, according to either the directions of the Settlor or a manner predetermined by the Settlor. Family trusts also allow the separation of management and operation of the family business from the control and management of family wealth.
Besides the above discussed key persons in a trust, a trust may also have a protector and an advisory board. The protector of the trust is entrusted with the responsibility of ensuring that the directions of the Settlor are given effect and that the trustees administer and dispose off the properties in an appropriate manner. The protector must also ensure that the trust is carried on for the purpose it was originally established. An advisory board is set up under a Trust Deed to advise the trustees. However, the trustees are not bound by the advisory board.
Under section 63 of the Income Tax Act, ‘revocable transfer’ has been defined as any transaction wherein there is any provision for re-transfer, directly or indirectly of the assets or incomes to the transferor, if it, in any way gives power to the transferor to re-assume power and control over the above. The Courts have taken varied opinions when discussing whether the trust may be deemed revocable or irrevocable.
Whether the transfer is capable of being revoked by the assessee or not? There can be no doubt that a trust deed is capable of being revoked. It may be that before the power is exercised the consent of two beneficiaries might have to be taken, but even so although the revocation may be contingent or conditional, still the deed remains a revocable deed of trust . A settlement, disposition or transfer shall be deemed to be revocable if it contains any provision for the retransfer directly or indirectly of the income or assets to the settlor', disponer or transferor, or in any way gives the settlor, disponer or transferor a right to reassume power directly or indirectly over the income or assets . The power of the settlor to choose among many objects of the trust does not make it a revocable trust, and does not attract section 63.
Family Arrangement
According to Halsbury’s Law of England, family arrangement is an ‘agreement between members of the same family, intended to be generally and reasonably for the benefit of the family either by compromising doubtful or disputed rights or by preserving the family property or the peace and security of the family by avoiding litigation or by saving its honour.'
Family arrangement has not been defined under any law. The meaning of family arrangement has evolved from customs and precedents. In Court in S.K. Sattar S.K. Mohd. Vs. Gundappa Ambadas described ‘family arrangement’ as ‘a transaction between members of the same family for the benefit of the family so as to preserve the property, peace, and security of the family, avoidance of family dispute and litigation and for saving the honour of family. Such an arrangement assumes that there was an antecedent title in the parties and the agreement acknowledges and defines what title is.
Taxation impact of Succession Planning
1. Will
Earlier, assets transferred under a Will were liable for payment of estate duty under the Estate Duty Act, 1953. However, this was abrogated in 1985, thus, putting an end to taxing of wealth of deceased persons. Currently, such assets are not liable to any income tax as there is no provision of inheritance tax in India.
However, the person who inherits a property has to pay regular tax on the income earned on the property so inherited, as the owner of the property. Section 56(2)(x) provides a specific exemption under Income-tax Act, if any sum of money or any property is received under a will or by way of inheritance.
For example: if a person inherits a property which has been let out, then the income earned from letting out such property is chargeable under Income Tax laws. Such a person is also required to file an Income Tax Return for income earned during the year from such inherited property.
It may also be noted that, while there is no inheritance tax in force currently, there are apprehensions of the estate duty being levied again in the future. Though there is no such confirmed notice from the legislators, the possibility of its reintroduction cannot be ruled out entirely.
2. Family Trust
Assets transferred by a Settlor into a trust which is set up only for the benefit of relatives is fully exempt from income tax and not taxable to the Settlor, and once the income of the trust has been taxed while in the hands of the trustees, it will not be taxed when the beneficiary receives the share. It may also be noted that, according to Finance Act 2017, the provisions related to taxation of gifts do not apply to trusts. In short, setting up a trust provides neither a tax advantage nor does it levy a tax burden under the Income Tax Act, 1961. It has a neutral impact with respect to taxation.
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.
Taxation of Private trusts in India is as per under section 161 (specific/ determinate trust) or section 164 (discretionary trust) of the Income Tax Act. The tax is levied on the any income of the Private Trust based and this is dependent on the nature of the Trust:
- Determinate trust: the income of such a trust is taxable as the entitlement of the beneficiaries is fixed. It is taxable to the extent and manner in which the beneficiaries would be taxed.
- Discretionary trust: the beneficial interest of the beneficiaries is determined at a date in future and hence, ‘the income received by the trust (other than exempt income) is taxable in the hands of the trustee at the maximum marginal rate, as applicable.’
a.) Taxation of the settlor:
The income from the asset would be taxable in the hands of the transferor i.e. the settlor if the following conditions provided under section 60 of the Act, 1961 are satisfied:
1. The taxpayer owns an asset
2. The ownership of asset is not transferred by him.
3. The income from the asset is transferred to any person under a settlement or agreement
However, Section 47(iii) provides that any transfer of a capital asset under a gift or will or an irrevocable trust is not regarded as transfer and thus not subjected to capital gain tax, unless in case of an irrevocable trust where gains arise out of transfer of capital e.g.: shares, debentures etc.
Hence, no tax is levied on the settlor for the settlement of an irrevocable Trust. Revocable trusts are taxed as income in the hands of the transferor.
b.) Taxation of beneficiaries:
Section 56(2)(x) of the Act specifies that where a person receives a property for an inadequate or no consideration, then the value of such property is taxable in the hands of the recipient as ‘income from other sources’. However, no such tax may be levied on assets transferred to a Trust where the beneficiaries are defined as ‘relatives’ under the Act. Earlier Section 41 of the Indian Income-tax Act, 1922 provides that, the receiver/beneficiary who is sought to be assessed must be the person who has in fact received the income in the previous year relevant to the assessment year or was a person who was entitled to receive the income in that year.
c.) Taxation of Trustees:
Section 56(2)(x) does not apply to trustees, as trustees hold the property as an obligation and for the benefit of the beneficiaries. The obligation is a sufficient consideration for receiving the property. Hence, the aspect of no or inadequate consideration does not arise here.
A determinate 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). Taxation is at Maximum Marginal Rate (MMR) if it is specific and has business income (section 161(1A)) . If it does not have business income, it is taxed as income in the hands of the beneficiary, or in the hands of the trustee as a representative assessee (when true assessee is minor, lunatic, non-resident). The exception applies when the beneficiary is a dependent relative, or if it is the only trust declared by the author.
A discretionary Trust is generally taxed at the Maximum Marginal Rate applicable to the type of income earned by the Trust. The income should not be taxed again when distributed to the beneficiaries. If a discretionary trust has business income, it is ordinarily taxed at the MMR, however, if none of the beneficiaries’ income exceeds the basic exemption limit, or if they are not beneficiaries of any other trust, individual tax rates apply instead of the MMR.
Discretionary trusts cannot be converted into Determinate trusts unless it is mentioned in the trust deed. The status as Private trust or AOP Trust remains the same; it cannot be altered merely for the purposes of section 194A, i.e., tax deductible at source on Interest other than Interest on Securities. A private discretionary trust should be assessed as an individual and not as an Association of persons, under section 164(1).
The judicial treatment of succession planning is quite optimistic. However, from a succession planning perspective overall, India is not an attractive destination to create a trust, as the statutory and regulatory treatment is not as mild. Income from trusts is either taxed at the Maximum Marginal Rate, or at the individual rate in some exceptions. Therefore, trusts are primarily created for charitable or religious purposes than for succession planning purposes in India. However, estate duty exemptions exist (and would continue to exist even when governments express a desire to reinstitute estate duties) when private trusts are created in India, and one of the major incentives to create one would be the minimization of estate disputes in the country.
In case the family holds assets in foreign countries, it will attract provisions of Foreign Exchange Management Act, 1999 and the laws of the country in which the assets are situated.
Under the Indian exchange control regime, it is not possible for a trust holding immovable property to have a non-resident trustee. However, it is not specified under which Indian control regime there is such a bar. On the contrary, provision of Section 6(5) of FEMA 1999, a person resident outside India can hold, own, transfer or invest in Indian currency, security or any immovable property situated in India, if such currency, security or property was acquired, held or owned by such person when he was resident in India or inherited from a person who was resident in India. Thus, there is no specific bar under Section 10 of the Trust Act for an appointment of NRI as trustee of an Indian Trust. At least one trustee must be resident in order for the trust to remain valid.
Assets acquired under Limited Remittance Scheme (LRS) can be settled via trust: specific or discretionary. A foreign trust will not be able to invest in India as it is considered as an unincorporated entity and is ineligible to invest. RBI Approval is necessary for most transactions involving a trust, non-resident beneficiaries, non-resident trustees, capital account transactions, transactions above the LRS limits and transactions involving immovable assets.
3. Family Arrangement
Properties under family arrangements are not taxable as per Section 45 of the Act under capital gains as properties under a family arrangement are not considered ‘transfer’. In B.A. Mohota Textile Traders Pvt. Ltd vs. DCIT before the Bombay High Court, it was contended that ‘no capital gains would be attracted as there was no transfer.’ A family arrangement is a realignment of interest and not a transfer under section 45 of the Transfer of Property Act. Therefore, settlements under such arrangements are not taxed under capital gains.
However, family arrangement can be disregarded on grounds of collusion to avoid payment of tax. There need not be in existence an actual title in law or a claim sustainable in law, in order to constitute dispute, in order to create a family arrangement. Setting up competing claims, and creating family arrangement to secure peace and amity constitutes an actual family arrangement.
The three elements of a family arrangement are: (1) a bona fide settlement to resolve family disputes and rival claims by fair and equitable division of properties; (2) it must be voluntary and not induced via fraud; and (3) it may even be an oral memorandum and remain unregistered. Where there is no dissolution of the firm created via family arrangement, assessment under section 45(4) of the Income Tax Act is not attracted; however, transfer of assets to a retiring partner would amount to a capital gains and business profits which are chargeable to tax under section 45(4).
It must be proved before the Court that the parties to the family arrangement have an antecedent title, interest or claim in the property which is the subject matter of the settlement. Once the title is proved, the period of holding the said property by the recipient will be the period for which the transferor held the property.
