Smells like legacy tax in budget - Levy looms on private trusts through which wealth is passed on to heirs

Sambit Saha, TT, Calcutta, March 14: The worst fears of some wealthy Indians have come true: the Centre has imposed a pseudo-inheritance tax in its recent budget that could wreck succession planning and tear down the tax shields the affluent have traditionally used to pass on their estates to their heirs without diminution of value.

The inheritance tax - it hasn't been billed as one - is the result of a series of changes in several sections of the Income Tax Act that raises the spectre of the estate duty tax that India levied between 1953 and 1985 before it was scrapped by V.P. Singh.

The budget made three important changes in the tax benefits that private trusts have enjoyed till now, effectively blowing away the tax shelter that has been used traditionally to pass on wealth and property to heirs.

Effective from April 1, private trusts will have to pay tax on dividend income from shares and capital gain arising from the sale of shares acquired by means of gift. The transfer of assets (shares, property, gold and paintings, among others), either without consideration, or after inadequate consideration, to these trusts will also become taxable.

Corporate India is already scrambling to get to grips with the new tax regime. Several promoters have got their lawyers and financial advisers to work on plans to tweak their family holdings of assets to beat the April 1 deadline. Some business owners have also put their corporate restructuring plans on hold, pending passage of the Finance Bill 2017 in the ongoing session of Parliament.

"The Modi government has decided to indirectly tax private trusts which used to be established for the purpose of succession planning. This is nothing but a pseudo-inheritance tax," said N.G. Khaitan, partner at solicitor firm Khaitan & Co, who sits on the boards of several companies.

Estate duty tax in India could go up to as high as 85 per cent. It was scrapped as there was strong opposition to a levy that was seen as "confiscatory".

In its 2017 survey, the Organisation for Economic Co-operation and Development (OECD) had noted that personal income tax collections in India amounted to 2 per cent of its GDP compared with 9 per cent in the OECD nations. The survey spoke of the need for India to widen its tax net and ensure a reasonable tax rate. It also suggested the introduction of an inheritance tax with a higher exemption threshold and lower tax rate.

Several countries in the world have either no inheritance tax or have abolished it. The majority of the EU, barring the big five, has no inheritance tax. Sweden abolished it in 2005, Singapore in 2008 and Norway in 2014. China wanted to impose the levy in 2002 but chose not to do so.

Australia abolished its estate tax in 1979. But it levies a capital gains tax on the sale of an asset or the transfer of ownership, with the death of the owner being classified as a "crystallising action" for the imposition of the levy. India seems to have embraced the Australian model to deal with inheritance levies.

The provisions

Under the existing provisions of Section 10(38) of the Income Tax Act, 1961, income arising from a transfer of long-term capital assets, being equity shares of a company, is exempt from tax if the sale transaction was undertaken on or after October 1, 2004, and is chargeable to the Securities Transaction Tax (STT).

UPA finance minister P. Chidambaram introduced the STT in 2004 as a way to check avoidance of capital gains tax.

The Modi government said that a lot of sham transactions in shares were taking place to take advantage of the tax break under this section. That is why it has decided to limit it to only transactions on which the STT has been paid. Otherwise, the transaction will become subject to capital gains tax.

This subtle change blows the tax cover for private trusts as the STT was not payable on shares that were gifted because it was not considered as a transfer of capital asset under the IT Act.

As a result, capital gains tax will now have to be paid when people gift shares to either relatives or private trusts from April 1 onwards.

Moreover, under existing provisions of Section 115BBDA, income by way of dividend in excess of Rs 10 lakh is chargeable to tax at the rate of 10 per cent in case of a resident individual, Hindu Undivided Family (HUF) or firm. This implied that dividend paid to private trusts was not subject to the dividend distribution tax (DDT).

However, the budget has amended the section to include all resident assesses, except domestic companies and some other institutions.

Finally, Section 56 (2) (vii) of the IT Act provides that if any sum of money or any property is received without consideration or for inadequate consideration (in excess of the specified limit of Rs 50,000) by an individual or HUF, it is chargeable to income tax in the hands of the recipient under the head income from other sources. Relatives (according to IT Act) were exempt from this.

The existing definition of property for the purpose of this section includes immovable property, jewellery, shares and paintings. These provisions are now only in the case of individuals and the HUF. Therefore, receipt of sum of money or property without consideration, or inadequate consideration, does not attract these provisions in the case of other assessees.

In this budget, a new clause (x) has been introduced in sub-section (2) of Section 56 so as to provide that receipt of a sum of money or the property by any person without consideration or for inadequate consideration in excess of Rs 50,000 shall be chargeable to tax in the hands of the recipient under the head "income from other sources".

The upshot of this change is that other than relatives specified under the IT Act, the transfer of assets will be treated as income for the recipient and tax will have to be paid thereon. Consequently, transfer of assets to private trusts will also become taxable.

Succession planning

Kavil Ramachandran, clinical professor at the Indian School of Business and executive director of Thomas Schmidheiny Centre for Family Enterprises, said the idea to reintroduce the tax came up during the UPA regime.

"But there have been strong views expressed against it in the context of our cultural orientation to view continuity of the business as a family responsibility," Ramachandran said.

He reckons the growing interest in private trusts over the years could be attributed to a combination of factors.

"People who are worried about a family split and splintering away of ventures have created trusts; wealth management companies, including banks, have promoted trusts and offer to manage the trust funds; and, fear of introduction of the estate duty in India have led to the formation of trusts," he said.

According to the professor, several families are now looking at establishing private limited companies as a vehicle in preference to a private trust.

"Recently, promoters of companies such as Aurobindo Pharma transferred a large number of shares to a private limited company to avoid the dividend tax that has been imposed on trusts this year," he added.

Kartik Jhaveri, director of Transcend Consulting (I) Pvt Ltd, said many of his clients were worried about the inheritance tax.

"I have advised them not to panic. If the law of the land changes, you have to abide by it. There is no getting away," said Jhaveri, who writes wills and sets up trusts for high net worth individuals.

According to him, the need to ring-fence assets from legal issues or the desire to use such assets for certain pre-determined purposes (for instance, education) also warrant the creation of trusts.

Khaitan highlighted the irony of withdrawing the tax benefits that had been extended to private trusts.

"Most often the beneficiaries of such trusts are family members. When you gift directly to family members, the transfer of asset will not be taxable. But when you gift to the trusts to save the legacy from being split into many hands, it will become taxable," he said.

"We must realise that tax planning is not an offence but tax avoidance is. There is a difference between the two," Khaitan added.

Your questions

Who will be affected by the so-called inheritance tax?
Those who have formed private trusts.

What is a private trust?
A trust that is not a charity. A private trust is usually formed to ensure that inheritance is not splintered. For instance, let’s take A who has four children. In the absence of a trust, A’s wealth — which can include shares, property, gold, paintings, etc. — may have to be split into four if the children insist so. But if a private trust is created with the four children as the beneficiaries, the assets can remain undivided. Or, if the asset is an industrial enterprise, the continuity of the business can be ensured even while the children are being assured of the inheritance.

What does the budget propose?
Till now, dividend the trust earned from the companies under its watch was exempt from the dividend distribution tax, which works out to 10 per cent of the dividend. But after April 1, if the budget is passed unchanged, the trust will have to pay the dividend distribution tax.

Two, capital gains tax (15 per cent) will have to be paid if the trust sells the shares of the company. Till now the sale of shares acquired as gifts did not attract the capital gains tax.

Three, even if the assets are transferred to the trusts without payment or after inadequate payment, it will be treated as income and the trusts will have to pay tax on that income. Till now, such transfers did not qualify as income.

Who are likely to be hit the most?
Industrialists who had finalised succession planning that involves private trusts will be affected. Corporate restructuring plans driven by inheritance concerns will also be hit. Some industrialists fear that the changes are precursors to a formal inheritance tax.  The “anti-rich” discourse — underscored by demonetisation and the Prime Minister’s barbs such as “kadak chai (strong tea)” — is further fuelling this fear psychosis.