ref--http://www.mondaq.com/india/x/316236/Capital+Gains+Tax/SUPREME+COURT+CLARIFIES+TAXATION+OF+OFFSHORE+DISCRETIONARY+TRUST
Conditions:
1) -it is an offshore trust
2) It is a discretionary trust (Where benefits are not determined)
Supreme Court reiterates the principle that income of a discretionary trust cannot be taxed in the hands of a beneficiary unless distributed to the beneficiary.
Where trustees have clearly retained the income of the trust and brought it forward year to year without disbursing it to the beneficiaries, the trust is discretionary.
Fallout of this judgment (although not raised in this dispute) is the uncertainty it creates on the taxability of capital/corpus distributions to beneficiaries.
INTRODUCTION:
In its decision in Commissioner of Wealth Tax, Rajkot v Estate of Late HMM Vikramsinhji of Gondal,1 the Supreme Court has reiterated the primary basis for difference in taxation of discretionary trusts versus determinate (or specific) trusts in respect of an offshore trust.
A discretionary trust is one where the specific shares of the beneficiaries are not known. That is, the trustee has the discretion to decide, from time to time, who (if anyone) among the beneficiaries is to benefit from the trust, and to what extent. In a determinate trust, the entitlement of the beneficiaries is fixed by the settlor, the trustees having no discretion in determining the amount of distributions to be made to the beneficiaries.
As per the Income Tax Act, 1961, the income of a discretionary trust is taxed in the hands of the trustee while the income of a determinate trust may be taxed either in the hands of the beneficiary or of the trustee in his capacity as the representative assesse. If it is the latter, the taxation in the hands of a trustee must be in the same manner and to the same extent that it would have been levied on the beneficiary. That is, the trustee would generally be able to avail all the benefits/deductions, etc. available to the beneficiary with respect to that beneficiary's share of income.
THE SUPREME COURT'S VIEW
The Supreme Court upheld the decision of the Gujarat High Court6 that the trusts were discretionary. The Gujarat High Court had noted that the Settlement Commission's order and the Supreme Court's decision were not binding on the present appeals due to different facts. In contrast to the previous round of litigation, the Taxpayer here did not admit to having received the income; he did not receive the income and he had not shown the income as taxable in his returns. The Gujarat High Court's reasoning (as listed below) was upheld by the Supreme Court:
The UK trusts were discretionary trusts. The trusts' income should not be includible in the Taxpayer's income for levying income tax since the trusts' income was retained in the trusts and not disbursed to the beneficiaries;
Mere failure of the Settlor or the Taxpayer to appoint additional trustees did not change the essential nature of the trusts as discernible from the terms of the trust deeds;
For the same reasons, the value of the trusts' assets could not be includible in the estate of the deceased Settlor for the purpose of wealth tax.
In support of its interpretation, the Supreme Court quoted Snell's Principles of Equity7: "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 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 so that 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."
WHAT DOES THIS DECISION MEAN IN PRACTICE?
Beneficiaries of a discretionary trust should not include any part of the trust's income in their individual returns unless it is actually received by them.
Taxation of the income of a trust and income of a beneficiary depend on the nature of the trust. The nature of the trust is determined by looking at the trust deed as a whole, supported by records of the trustees' decisions and the trusts' financial statements. The Settlor must make sure that his intention as to the nature of the trust is clearly reflected in the trust deed in unambiguous language. Further, trustees must maintain a record of their decisions and reasons for it.
One key issue that has not been addressed in the decision is whether it is only income distributions made by the trustee that would be taxed in India or even capital/corpus distributions from a trust to its beneficiaries are taxable. This question arises on a consideration of whether the distribution can be categorised to be in the nature of capital distribution that should generally not be taxed or if the same can be treated as 'income from other sources' under S. 56 of the Income Tax Act, 1961. Under S. 56(2) (vii), income received by an individual or Hindu Undivided Family from a person without consideration or for inadequate consideration (subject to meeting certain value thresholds) are chargeable to income tax under certain circumstances. Since a trust is not a 'person' under the Income Tax Act, there has been discussion on whether this would cover situations where the trustee of a family private trust makes income distributions to family beneficiaries.
In this decision, the Supreme Court has mentioned that the beneficiary can be taxed on a receipt basis. Considering that it has not addressed the issue of capital receipt v. income receipt, it would be difficult to consider this decision as laying down a principle that all distributions by a discretionary trust to its beneficiaries once received are taxable in the hands of the beneficiaries. However, what this judgement highlights is that both trustees and beneficiaries must take steps to clearly identify the nature of the distributions. Trustees must keep separate accounts for income and capital, clearly record when amounts are disbursed from the corpus and the purpose of the distribution. Similarly, it may also be helpful for beneficiaries to keep separate accounts for receiving income and capital disbursements from the trust, and in communications with the trustee to clearly indicate the right under which the beneficiaries claim the funds.