The Interconnect

Trusts, Taxation and Takeover Code – a Timeless Tussle!

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
May 11, 2017

Complexity in business environment has grown multi-fold owing to the impact of globalisation on geopolitical and financial markets. While the global economy has remained lull, India has been an exception to the same with the Indian promoter families having steered their businesses onto the path of profitability and growth and in the process have amassed significant wealth for themselves and their families. A recent trend shows that in order to facilitate seamless transition of wealth from one generation to another, Indian promoters have favoured “trust” as a holding vehicle. 

Why Trusts?

Traditionally, Indian companies have been held either through individual family members directly or through holding companies. The “trust deed” as the governing charter of trusts ensures that there is segregation of management from ownership of the operating companies; thereby achieving a smooth transition of wealth from one generation to another without adverse income-tax and estate duty (if reintroduced) implications.

Taxation upon settlement of a Trust

Typically, there are four parties to a trust, viz., a) settlor: one who creates (or, in legalese, “settles”) the trust i.e. typically a friend or family member; b) contributor: one who actually transfers the shares/ other assets i.e. typically a promoter (who could also come in as the settlor); c) trustee: one who is  the legal owner of the trust property holding the assets for the benefit of the beneficiaries; and d) beneficiaries: person(s) for the benefit of  whom the trust property is contributed/ settled.

Where the shares/ properties are directly held by the promoters themselves, such assets are contributed directly to the trust without any consideration. This contribution would not attract any adverse capital gains tax implications owing to specific exemption u/s 47(iii) of the Income-tax Act, 1961 (the “Act”). In case of shares of unlisted companies, section 50CA of the Act (which deems the “fair market value of the shares” as full value of consideration if the consideration for the transfer is for less than the fair market value) would not be attracted since the said contribution would not be considered as a “transfer” u/s 47 of the Act; therefore, outside the purview of capital gains tax. 

From the recipient’s perspective i.e. receipt by the trustee of the trust, there was a question as to the applicability of section 56(2)(vii). Since the said shares would be received without any consideration by the trust (which is assessed as an individual), one school of thought held that such receipt would be deemed as income from other sources in the hands of the trust. However, more often than not, since all the beneficiaries of the trust are relatives of the contributor (i.e. the promoter), such transfer would be considered as an inter-se relative transfer and hence, outside the purview of section 56(2)(vii) of the Act. Further, there is also a view that the obligation of the trustee to discharge its responsibilities is itself a consideration for receipt of trust property; thereby falling outside the purview of section 56(2)(vii) of the Act. 

These differing schools of thought were converged by insertion of item (x) of proviso to section 56(2)(x) of the Act vide Finance Act, 2017. It provided that any receipt of any property from an individual by a trust created or established solely for the benefit of relative of the individuals would be not attract any adverse tax implications in the hands of the trust. It is pertinent to note that only a limited leeway for a property settled by is given. If the property is held indirectly through various entities (such as holding companies, limited liability partnerships, etc.), then any contribution by such entities to a trust would attract adverse tax implications u/s 56(2)(x) of the Act. 

While the legislature has taken a significant constructive step to facilitate succession planning, certain open-ended questions would need to be clarified. For example, this section was inserted with effect from 1 April 2017, accordingly, grandfathering of any property contributed after 1 April 2017 to a trust which was created prior to 1 April 2017 would need to be clarified; though logically, the trustee being the legal owner, the fact that the trust was created prior to 1 April 2017 should not be relevant. Further clarity as to non-applicability of section 56(2)(vii) of the Act on trusts settled prior to 1 April 2017 if such trusts were settled only for the benefit of relatives of the promoters in line with the legislative intent as is apparent u/s 56(2)(x) of the Act is also required. 

Furthermore, since this leeway is available only where the beneficiaries are “relatives” of the person contributing the property, it may lead to an unintended lacuna in certain cases. The definition of “relatives” may recognise a certain relationship within its ambit if looked at from one perspective; however, it may not recognise the same relationship within its purview from a reciprocal perspective. For example, a lineal descendant of the brother of the transferor who is a beneficiary of the trust is not a “relative” from the transferor’s perspective within its definition u/s 56(2) of the Act. Going by the intent u/s 56(2)(vii) of the Act, he would be an “inter-se relative” transfer and hence, outside the purview of section 56(2)(x) of the Act; this is based on the common-sense interpretation of reciprocity; nonetheless, CBDT should expressly clarify this position.

Trusts and the Takeover Code

In case of listed companies, any transfer to any person in excess of certain prescribed limits triggers open offer under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Code”). However, such trigger is not attracted if, inter alia, it is a transfer between promoters who are disclosed as such for a period of more than 3 years or if it is a transfer between relatives. 

In case of settlement of shares of listed company in a trust, usually, the beneficiaries would either be relatives or members of the promoter group; therefore, in substance and in spirit, the provisions of open offer under the Takeover Code should not be triggered since the control over the listed companies is retained within the promoter group.  

In the above context, it may so happen that the trust itself would not be a disclosed promoter for a period of three years. Further, it may also so happen that the beneficiaries may not be the individual family members but private family trusts settled in favour of them. Therefore, in such cases, since direct exemption from giving an open offer is not available under Regulation 10(1)(a)(ii) of the Takeover Code, despite the fact the trustee may be a disclosed promoter and the ultimate beneficiaries are relatives and that the shareholding of the promoter family would ultimately remain the same. Therefore, promoters have been seeking specific exemption under regulation 11 of the Takeover Code from SEBI. 

Although SEBI has been granting exemptions for such cases, it has prescribed certain conditions while granting the exemption. SEBI has stipulated that any change in the trustees/ beneficiaries and any change in ownership or control of share or voting rights held by the trust shall be disclosed to the concerned stock exchanges and that such ownership not only directly vests with the trustees but also indirectly with the beneficiaries. Further, SEBI stipulates to provide an undertaking that it does not contain any provision limiting the liability of the trustees/ beneficiaries in relation any SEBI regulations and that any subsisting liabilities under the SEBI regulations will not be diluted pursuant to the said transfer. SEBI has also mandated the trusts to file an annual compliance report with the listed companies and also file the same with the stock exchanges and SEBI duly certified by an independent auditor.

However, it is to be noted that, while granting such exemptions, SEBI does not appear to grant any exemption where a professional trusteeship company. SEBI is of the view that the transparency issues in relation to the ultimate control are not adequately addressed in such cases. Therefore, for example, this would pose a substantial impediment in cases where there is an individual promoter who is settling the trust for the benefit of his children and wants to appoint a professional trusteeship company as the trustee in absence of any sibling or any other trustworthy immediate relative. 

The Road to be paved…

Although the income tax law has been amended to facilitate succession planning partially, it still is shrouded with plethora of questions (as cited earlier).  A clarification from the Central Board of Direct Taxes (“CBDT”) clarifying such gaps would be a welcome move. Further, amendments to the Takeover Code (with adequate safeguards) is the need of the hour in order to facilitate genuine cases of succession planning/ family arrangements. The combined effect of clarifications under the income-tax and SEBI would definitely have a significant positive impact on the ease of doing business scenario in India. 

* This article has been co-authered by Binoy Parikh. 

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