Family Settlements and tax planning
S. Bagchi Advocate
The author deals with the ever – popular topic of tax planning in the context of family arrangements. He warns that while in a genuine settlement, tax avoidance comes merely as a providential or fortuitous side effect, if one targets family settlement as a tax saving device that may cast a cloud on the bona fides of the whole transaction and may be regarded as a subterfuge to hoodwink the revenue.
Tax planning as a concept had at a point of time suffered degradation and for a while seemed to be a euphemism for tax evasion. This was the fallout of some observations in McDowell’s case, [154 ITR 148 (SC)] especially in the separate opinion of Justice Chinnappa Reddy. But the libel did not stay too long. Sabyasachi Mukherjee, Justice of the Supreme Court salvaged its respectability by observing tax avoidance by genuine transactions is not evil. It is any subterfuge or simulation of a transaction or rather a hoax of a make-believe transaction which is despicable and cannot be countenanced. In Playworld Electronics, he observed [184 ITR 308 (SC)] : “It is true that tax planning may be legitimate provided it is within the framework of the law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges. It is also true that, in order to create an atmosphere of tax compliance, taxes must be reasonably collected and when collected, should be utilised for proper expenditure and not wasted. (See the observations in CWT vs. Arvind Narottam (1988) 173 ITR 479 (SC), it is not necessary, in the facts of this case, to notice the change in the trend of judicial approach in English (Sherdeley vs. Sherdeley (1987) 2 All ER 54 (HL). While it is true, as observed by Chinnappa Reddy J., in McDowell and Co. Ltd. vs. CTO (1985) 154 ITR 148 (SC) that it would be too much to expect the Legislature to intervene and take care of every device and scheme to avoid taxation and it is up to the court sometimes to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and to expose the device for what they really are and to refuse to give judicial benediction, it is necessary to remember, as observed by Lord Reid in Greenberg vs. IRC (1971) 47 TC 240 (HL), that one must find out the true nature of the transaction, it is unsafe to make bad laws out of hard facts and one should avoid subverting the rule of law”.
So tax planning is now rehabilitated as a normative phenomenon. It stands on its ethical plane without diminution in respectability.
Now I turn to address to the subjects assigned me.
Will in tax planning
This special favour unwittingly done by the legislature caused a proliferation of discretionary trusts under section 164 for the advantage of softer tax treatment. There had been a spate of discretionary trusts for tax avoiding advantage. This taxation of discretionary trust as an ordinary association of person came as a relaxation under the new Act because under the repealed Act of 1922, the tax rate for discretionary trust was the maximum slab rate of tax applicable to the association of persons. The error of relaxing the old provision through want of circumspection dawned on the legislature after at least a decade.
Though borrowed from English jurisprudence, the idea of the will was not wholly unknown to ancient Indian society. The idea of the will i.e. the distribution of the estate of the deceased person according to his wish and desire expressed in his Will was quite appreciated in ancient Indian society. But its actual use was scarce. Its existence in the present form can be traced back at least a century and its development was accelerated by British influence. So it can be said that, in effect though not in form, testamentary instruments have for long come into operation after the death of the maker of the instrument before the Raj days. In fact, in Bengal in the 18th Century, the testaments got recognition as part of the law of inheritance which the Courts recognised. Anyway, the history of Will as a subject does not belong here.
By now Will as a means of disposition of property by a person which takes effect after his death is widely used as part of the law of inheritance. As such, it becomes quite popular for the purpose of disposition of property in general and particularly, for its use in arrangement of property and more particularly, for it advantages in taxation and tax planning through testamentary disposition.
Its general popularity is for the reason that the owner of properties in old age, while commanding influence over and respect of younger generation and their attention, apart from bond of love, for the magnetic power of wealth, can retain the property during lifetime and at the same time leave his estate as the legacy according to his wish and desire for the near and dear ones.
The efficacy of Will for tax saving, however, has somewhat lessened after the abolition of Gift tax. From tax point of view, during the regime of Gift tax as an added tax, the old people would prefer Will to making in his life time gift to avoid gift tax which was a substantial levy, almost prohibitive of making gifts. But that cause for use of Will as a tax-saving device is no more after the legislature had done away with the gift tax.
But that does not mean that Wills have lost their use from the tax point of view. It assumed a new dimension and special importance after the amendment to the law relating to taxation of private trusts in 1970.
It requires a short introduction of the law relating to taxation of private Trusts. The private trusts for the purpose of Income-tax Act fall under two classes – specific trusts and discretionary trusts. The specific trusts are trusts where the beneficiary is known and definite and if the beneficiaries are more than one, each beneficiary’s share is known, definite and specified. For such trust, the taxation scheme is that the value of the benefit from the trust availing to a beneficiary shall be a component of his total income and he shall be taxed according to the total income that comprises his share of benefit from the trust.
Discretionary Trust in contrast is one where the beneficiary is not known and determinate or when known, in the case of multiple known beneficiaries, the share of each beneficiary amongst multiple beneficiaries is not determinate and depends on the discretion of the trustee. Thus, the discretionary trust is one where the trust income is not specific for any known person or in other event the shares of beneficiaries are not known and determinate. So for income tax the test of discretionary trust lies in the manner of conferment of the benefit on the beneficiary than in the amount of discretion permitted to be exercised by the trustees. Indefiniteness or uncertainty of the beneficiary or his share in the trust income is the hallmark of a discretionary trust under the Income tax law.
The Income-tax Act when re-enacted in 1961 repealing the old act of 1922, ordained that such a discretionary trust should be taxed in the manner an ordinary association of persons is taxed at the progressive rates prescribed by the Finance Act. This had the effect of giving a premium for discretionary trust because the rates for taxation as an association of persons would be less for the trust income than in the case of a specific trust where the trust income goes to swell the other income of a beneficiary of a specific trust.
Another interesting controversy has arisen with regard to testamentary discretionary trust. The controversy is with regard to the treatment of the income arising from monies received by a testamentary trust from outsiders. The question is whether in regard to such donations, the punitive rate of maximum tax rate shall apply with regard to the income attributable to such donations.
This special favour unwittingly done by the legislature caused a proliferation of discretionary trusts under section 164 for the advantage of softer tax treatment. There had been a spate of discretionary trusts for tax avoiding advantage. This taxation of discretionary trust as an ordinary association of person came as a relaxation under the new Act because under the repealed Act of 1922, the tax rate for discretionary trust was the maximum slab rate of tax applicable to the association of persons. The error of relaxing the old provision through want of circumspection dawned on the legislature after at least a decade. In 1970, section 164 was amended enjoining that discretionary trust shall be taxed as an association of persons at a flat rate of 65%. It can be said to be a punitive taxation measure to counteract the tax payers’ spur in creating discretionary trusts to bring their corpus as discretionary trust fund for lure of lower taxation.
Here, the Wills come in as a means of averting this punitive taxation of discretionary trusts. The amendment gives a concession for testamentary trust in taking effect from assessment year 1971-72 whereby a trust of discretionary nature is subjected to an ordinary rate applicable to an association of persons both for income tax and wealth tax. The punitive rate of discretionary trust does not operate where it is created by a will. The reason is obvious. Where the transfer is by a will which takes effect only after the death of transferor, no advantage can conceivably be derived from such transfer by the transferor. The efficacy of the Will as a means of tax planning thus survives.
Where the beneficiary of a testamentary trust has income from their own sources, he will not be hit hard if he derives benefit from a discretionary trust created by a will because the trust income allocated to him by the trustee in his discretion shall not be assessed at the maximum marginal rate or any punitive rate. The trust income is not to be included in his individual income but to be assessed separately as that of an association of persons. The income of such a testamentary discretionary trust shall be treated as income of any ordinary association of persons at its usual rate. This benefit results in lower taxation. Even if no beneficiary is ascertained or no income is distributed among the beneficiaries the taxation shall be on the trust income in the status of an ordinary association of persons. As a matter of fact, in recent times, the trend creating discretionary trust under a will has caught on. This position has come to stay for over four decades. But for this relaxation, one important condition is that the trust created by the will must be one. If the testator makes more than one trust, the trusts forfeit the benefit.
A more generous plan of testamentary trust may be conceived. When the will creates a number of trusts, each trust deriving income below the taxable limit, it may virtually give to the beneficiaries total tax holiday for all times to come. The attempt at creating such multiple-trusts, will or testament is no more unprecedented.
Another interesting controversy has arisen with regard to testamentary discretionary trust. The controversy is with regard to the treatment of the income arising from monies received by a testamentary trust from outsiders. The question is whether in regard to such donations, the punitive rate of maximum tax rate shall apply with regard to the income attributable to such donations. The donations to a testamentary trust by themselves is in the nature of trust. With regard to the donations, the trust ceases to be testamentary. It is non-testamentary and the exception admissible for a testamentary trust under the amended provision of section 164 shall not be available. This interpretation is almost irresistible. Therefore, the punitive rate of taxation shall apply with regard to the property so donated to an existing testimony trust.
A few words can be said about the mode of executing a will. It does not require any stamp paper. It can be executed by simply signifying the intention on the document signed by the testator himself with two witnesses. All the persons – the testator and the two witnesses shall sign in presence of each other. Registration is optional. Therefore, the execution of a will virtually costs nothing; though obtaining a probate involves more agony than cost for tardy process of obtaining probate. Anyway, the abolition of gift tax does not take away all the winds from the sails of will as a means of tax planning.
Family Settlement or family arrangement and Tax planning
Family settlement or family arrangement is a transaction effecting distribution of family assets. This has fortuitous effect of division of a family’s assets and income resulting therefrom. But it is a misnomer to describe family settlement or arrangement.
As a means of tax planning because the object of such settlement or arrangement is resolving the actual dispute or the potential threat of a dispute striking or threatening to strike at unity and dignity of the family and bringing it to disrepute through public exposure.
Paradoxically, though the family ties are nowhere as strong as they are in the Indian society, the concept of so resolving a family dispute through internal amicable settlement has travelled from England to India. It followed the flag.
The sanctity of a family and its preservation caused the evolution of it as a manner of realignment of family properties for family peace, the motto being that the society must have self-respecting and self-adjusted families, at peace with itself.
That way, the concept of family settlement had its voyage from England and has had a good harbour in the law of this land. Though upholding the family dignity is not a matter alien to Indian genius, the idea of settlement as a form of legal transaction was not there. So we are indebted to the English jurisprudence. Halsbury defines the settlement in the following words :
A family 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 honour. The agreement may be implied from a long course of dealing. But it is more useful to embody or to effectuate the agreement in a deed to which the term family agreement is applied.
It is an agreement for the division of the family property by way of compromise to avoid family quarrel or litigation.
The arrangement results in dividing family property.
It becomes an agreement among the members of a family to share equitably whatever they obtained.
It is an agreement between co-heirs dividing the property between them to conduce to the family peace.
It quite often emerges as an agreement between the heirs and the person supposed to be entitled under a lost will.
In India this mode of transfer is recognized by the Supreme Court in Sahoo Madhab Das vs. Mukand Ram AIR 1955 SC 481. According to this decision, the dispute need not be a present dispute, even the threat of it to erupt imminently is also considered a good cause for such settlement. What would be the test of existence of a dispute will depend on the circumstances of each individual case. No strait jacket formula is possible. There must be some circumstances indicating some forms of controversy threatening the family unity. Another test may be that whether the settlement really removes the cause of discord and makes the family more secure and happier.
That apprehended conflict can also be a ground for such settlement draws support from the decision of Calcutta High Court AIR 1932 Cal 600, AIR 1932 Cal 664. Even the parties to family settlement need not belong to the same family. The word ‘family’ in this context is quite flexible. The family is not to be taken in its rigid connotation in common parlance. It is enough if the parties are relations. Even collaterals having a remote common ancestor may join in an arrangement and can have relinquished or altered even their interest in expectancy. In this connection, reference may be made to Krishna Baharilal vs. Gulab Chand & Ors. AIR 1971 SC 104. The court, in that case, encountered by the question whether the want of direct family bond amongst the parties to the settlement detracts from the family character of the settlement. The answer is in the negative. Even though the parties were nothing but mere relations and not members of the same family, the dispute between the parties was in respect of certain property which was originally owned by their common ancestors, that was considered sufficient for a family settlement or arrangement. Thus, the family for the purpose of such settlement has a broad sense to embrace parties not belonging to the family.
But the most important aspect for such settlement is that the parties to the family settlement or arrangement must have same antecedent title, claim or interest, even a possible claim in the property. The meaning of antecedent title taken out from the dictionary means existing or occurring before any time or order often with consequential effects. Thus, it refers to some prior right or pre-existing right but it is not to be understood in the sense too pat on the dictionary meaning. In the context of Lord Halsbury’s definition, it means not only existing or prior right but also presumptive right. So a family arrangement cannot be denounced or struck down on the plea that the parties or anyone of the parties did not have pre-existing right at the time of settlement. This view is vindicated by the decision of the Supreme Court in Kale vs. Deputy Director – AIR 1976 SC 807. It says that even if one of the parties to the settlement has no title but under the arrangement the other party relinquishes all his claims or title in favour of such party and acknowledges him to be the sole owner, the antecedent title could be said to be there residing in such party.
Antecedent title according to the decision must be assumed in such a situation and the family arrangement was upheld.
The last important view is that the family settlement is not a transfer because here property goes to parties who had antecedent rights. The Supreme Court observed in Sahoo Madodas vs. Mokand Ram (supra) that a compromise or family arrangement is based on the assumption that there is an antecedent title of some sort in the parties and the agreement acknowledges what the title is, each party relinquishing all claims to properties other than his share under the agreement and recognizing right of the others to the portion allotted to them respectively. The court has widened the concept of antecedent title by holding that antecedent title would be assumed in a person who may not have any title but who has been allotted a particular property by the other party to the family arrangement by relinquishing his claim in favour of such a donee. In such a case the party in whose favour the relinquishment is made would be assumed to have an antecedent title.
Thus, the family arrangement being a realignment of title among parties having antecedent rights and interest does not lead to any transfer. It is akin to distribution of properties under a partition of a HUF and needs no conveyance.
Now, the terms of a family arrangement may have tax saving effect because the property is deconcentrated and divided. So is income yield of the property. This would certainly go to minimize taxation if the distribution of income resulting therefrom comes in for taxation at lower slab rate as a result of such diffusion. It is also equally true about Wealth Tax. It also used to save gift tax when gift tax had been in vogue.
But family arrangement or settlement cannot have as its object that of saving tax. It then becomes a fraud. The sole object of family arrangement is preservation of family dignity, unity and peace. So if one targets family settlement or arrangement as the tax saving device, that would certainly cast a cloud on the bona fides of the whole transaction. It would be a subterfuge to hoodwink the revenue.
So in the genuine settlement, tax avoidance comes merely as providential or fortuitous side effect.
[Reproduced with permission from the Paper presented at AIFTP’s Two Day National Tax Conference held on 13th and 14th December, 2008 at Kolkata.]