Determinate trust

Most Category III AIFs are set up as trusts under the Indian Trusts Act, 1882. Whether that trust is determinate decides how much tax the fund pays.

A determinate trust is one where the beneficiaries — the unit holders — and the size of each one's beneficial interest can be read off the Indenture of Trust or Trust Deed at all times during the fund's existence. An indeterminate trust is one where they cannot.

The distinction is not paperwork. In a determinate trust the trustee is assessed as representative assessee of identifiable people, so the tax can be levied "in the like manner and to the same extent" as it would be on those people. In an indeterminate trust there is nobody to stand in for, and Section 164 charges the lot at the Maximum Marginal Rate.

Two tests have to be passed, and the paper tests both.

Determinacy. The Income Tax Appellate Tribunal has clarified that beneficiaries and their beneficial interests must be capable of being ascertained on the date of the trust deed itself, without being left to be decided later by a person other than the settlor. Crucially, a deed that authorises further contributors to join at later points in time does not make the beneficiaries unknown or their shares indeterminate — a fund can hold several closes and stay determinate.

Irrevocability. A transfer is revocable if the contribution agreement provides for re-transfer of the income or asset to the transferor, or gives the transferor a right to reassume power over any part of it. Under Section 61, income from a revocable transfer is taxed as the transferor's income — so a revocable trust gets no pass-through at all, on anything.

Put them together, for a Category III AIF that is irrevocable and determinate:

• Business income → taxed at MMR, payable by the trustee (Section 161(1A)).
• Capital gains and income from other sources → the Assessing Officer may permit assessment in the trustee's hands as representative assessee (Section 161(1)), at the rates that would apply to the unit holders.

Once the trustee has been taxed, there is no further tax when the income is distributed. Where the trustee has not been taxed, Section 166 lets the Assessing Officer assess the beneficiaries directly, and tax the trustee has paid is in principle available as credit against their liability.

A Category III AIF earns Rs 13 crore in a year: Rs 8 crore of gains on index futures (business income) and Rs 5 crore of long-term gains on listed equity with STT paid.

Structured as an irrevocable, determinate trust:

Business income   Rs 8,00,00,000 at MMR 30% + 25% surcharge + 4% cess
                = Rs 8 cr × 39.00%            = Rs 3,12,00,000  (paid by trustee)

Capital gains     Rs 5,00,00,000 assessed in the hands of the unit holders
                  under Section 112A at 12.5% above Rs 1.25 lakh
                ≈ Rs 5 cr × 12.5%             = Rs   62,50,000  (before sc. and cess)
                                                ---------------
Total tax burden                                Rs 3,74,50,000

Structured as an indeterminate trust, Section 164 charges everything at MMR:

Rs 13,00,00,000 × 39.00%                      = Rs 5,07,00,000

An extra Rs 1.32 crore of tax on the same Rs 13 crore of income — 10 percentage points of the fund's return, lost to how the deed was drafted.

Structured as a revocable trust, the arithmetic does not even get started: under Section 61 the income is taxed as the transferor's, there is no pass-through on any stream, and the fund's tax position becomes a function of each contributor's own slab.

Chapter 9 (Taxation), section 9.2 is devoted to this and it is examined heavily, both definitionally and as a decision tree. Expect: the definition of a determinate trust (beneficiaries and their beneficial interests ascertainable from the deed); which section taxes an indeterminate trust at MMR (164); which section covers business income of a determinate trust (161(1A)); which section lets the AO assess beneficiaries directly (166); and scenario questions that give you a trust's determinacy and revocability and ask for the tax treatment of a named income stream. Figure 9.1 in the workbook is the decision tree the questions are built from.

• Determinate does not mean fixed membership. A deed permitting later contributors is still determinate — the ITAT said so, and the question is designed to make you answer the other way.
• Determinacy and revocability are separate tests. A trust can be determinate and revocable, and revocability defeats pass-through on everything regardless of determinacy.
• Even a determinate trust pays MMR on business income. Determinacy rescues capital gains and other sources, not business income — and all derivatives gains are business income.
• Indeterminate trusts are not necessarily discretionary. The workbook notes indeterminate trusts can also be discretionary; a non-discretionary trust administered strictly per the deed is a different thing.
• Section 166 applies only where the trustee has not been taxed. Once the trustee pays as representative assessee, the beneficiaries are not taxed again on distribution.
• The workbook says the concessional capital gains rates should take precedence over Section 164 MMR — but adds that the tax authorities may take a contrary view. Both halves of that sentence are examinable.