Introduction
Income derived from Trust property has been exempt under Income-tax laws since the Act of 1886. Voluntary contributions received by Trusts also became exempt by virtue of Act of 1918. Exemption to trusts was further expanded with the Act of 1922, which permitted the trusts to either apply or accumulate such income from property. For the purposes of the present Income-tax Act, 1961, trust income accrues in three manners:
- Income from property held under trust (regulated by Section 11);
- Voluntary contributions (regulated by Section 12 read with Explanation 1(1) to Section 11);
- Voluntary contributions towards corpus (regulated by Section 11(1)(d)).
For the purposes of this Article, income-tax implications will be restricted to income from property held under trust. The income-tax implications of utilisation of trust funds will be better understood if we examine the legislative history leading up to the present law.
Legal position up till 1961 Act
The Income-tax Act, 1961 as introduced granted exemption to income from property held under Trust, so long as a minimum of 75% of the same is applied to charitable or religious purposes within that assessment year.[1] Such accumulated sums could be used for charitable activities in the future period.
The 1961 Act also introduced Section 13 to deny Section 11 exemption to any Trust where any part of such income of the Trust enured directly or indirectly for the benefit of the author or founder of the trust.
Amendment by Finance Act, 1970
Section 13 of the Act was made more stringent vide Finance Act, 1970. As per this amendment, direct or indirect use of trust income for the benefit of the specified person would result in total denial of under Section 11 exemption on the entire trust income.
Newly introduced Section 13(2) deemed certain categories of transaction to be regarded as use of income of the Trust for the benefit of the specified persons. These included:
- Loans to specified persons without adequate security and/or adequate interest;
- Any property of the trust let out to specified persons without charging adequate rent;
- Salary, allowance, etc. to specified persons in excess of what is reasonable;
- Provision of services by the trust to specified persons without adequate remuneration;
- Purchase of property by the trust from specified persons for excess consideration;
- Sale of property by trust to specified persons without adequate consideration;
- Substantial diversion of income or property of the trust towards specified persons; and
- Investment (shares, debentures, etc.) of trust funds in any concern in which specified persons has a substantial interest.
Finance Act, 1970 also introduced Section 13(4) of the Act, as an exception to Section 13(1)(c) (restriction on use of Trust income for the benefit of specified persons). Under Section 13(4), if the investment does not exceed 5% of the total capital of the investee concern (concern in which specified person has substantial interest), then Section 13(1)(c) would not apply, and the trust can still claim Section 11 exemption. However, the provision also states that the income arising from such investment shall not be entitled to Section 11 exemption.
Amendment by Taxation Laws (Amendment) Act, 1975
While Section 13(1)(c) r/w Section 13(2)(h) imposed restriction on investment of Trust funds in concerns in which the author had substantial interest, the legislature vide Taxation Laws (Amendment) Act, 1975 – III inserted new provisions to further restrict investment of Trust funds.
Section 13(1)(d) was introduced as an independent bar on Section 11(1) exemption to specifically restrict investment of Trust funds in manners other than specified modes, such that violation of Section 13(1)(d) will result in total denial of under Section 11 exemption on the entire trust income. Specified forms or modes provided in Section 13(5), inter alia, included:
- investment in savings certificates
- deposit in Post Office Savings Bank account, nationalised banks, scheduled banks
- investment in government securities
- investment in shares of government company
Section 13 begins with the words “Nothing contained in Section 11 or Section 12 shall operate so as to exclude from the total income”. Consequentially, this non-obstante clause requires all incomes exempted under Section 11, including sums accumulated under Section 11 [sub-section (1) and sub-section (2)], to comply with Section 13(1)(d) r/w specified modes under Section 13(5).[2]
Amendment by Finance Act, 1983
In 1983, Section 13(1)(d) was expanded to specifically prohibit investment of Trust funds in shares of non-Government Companies[3]. Specified forms or modes of investment were now provided in Section 11(5),[4] which was introduced as replacement of Section 13(5).
Vide Finance Act 1983, expression “without prejudice to the provisions contained in clause (d) of that sub-section” was inserted in Section 13(4). With reference to Section 220 of the Income-tax Act, 1961, the Supreme Court in ITO v. Gwalior Rayon Silk Manufacturing (Weaving) Co. Ltd.[5] explained the expression ‘without prejudice to’ to mean that the provision which contains this expression must neither be inconsistent with nor prejudicial to the provisions contained in the other provision that follows this expression.
Thus, as per the aforesaid interpretation of the Apex Court, amendment to Section 13(4) made it specifically subject to Section 13(1)(d) which previously only acted as an exception to restrictions of Section 13(1)(c) (restriction on use of Trust income for the benefit of specified persons). This meant that for the availability of Section 13(4) as an exception against the restrictions of Section 13(1)(c), investment must not only be within 5% of the total capital of the investee concern (concern in which specified person has substantial interest), but also comply with Section 13(1)(d) r/w specified modes under Section 11(5). In other words, while Section 13(4) envisages protection to violation of Section 13(1)(c), but this protection does not extend to investments that fall within 13(1)(d) of the Act.
Arguably, amendment of 1983 did not change the scope of Section 13(4), i.e., it effectively remained the same as it stood post amendment of 1975. In other words, amendment of 1983 merely clarified and reinforced and made it beyond doubt that Section 13(1)(d) applies irrespective of protection of Section 13(4).
Amendment by Finance Act, 2022
Disputes arose as to whether violation of Section 13 would result in denial of exemption under Section 11 in toto, or only to the extent of such violation. Conflicting judicial views persisted on this question of law. The Supreme Court in DIT v. Bharat Diamond Bourse Courts[6], the Delhi High Court in DIT v. Charanjiv Charitable Trust[7] and the Kerala High Court in Agappa Child Centre v. CIT[8] held that the violation of Section 13(1)(c) would result in complete denial of Section 11 exemption. While this interpretation is detrimental from the perspective of Trusts, the law declared by the Apex court is more accurate.
On the other hand, the Bombay High Court in CIT(E) v. Audyogik Shikshan Mandal[9] and the Madras High Court in CIT v. Working Women’s Forum[10], held that the violation of Section 13(1)(c)/ 13(1)(d) would result in the amount of violation alone being subject to denial of Section 11 exemption. Notably, in arriving at these judgments, Courts relied on Bombay HC’s ruling in DIT v. Sheth Mafatlal Gagalbhai Foundation Trust[11] which dealt with purchase of shares before 1993 [protected by Clause (iia) of Proviso to Section 13(1)(d)] and not application / investment of Trust income.
Considering the legislative history, and the reason for which Section 13 was introduced, violation of Section 13(1)(c) / 13(1)(d) would result in denial of complete exemption under Section 11. Therefore, in our view, the reliance placed by Courts on Sheth Mafatlal Gagalbhai Foundation Trust (supra) with respect to application / investment of Trust income is inaccurate.
The first amendment by Finance Act, 2022 to Section 13(1)(c) and Section 13(1)(d) sought to put an end to this conflicting view. The amendments clarify that only that part of income which has been applied / invested in violation of the Section 13(1)(c) / Section 13(1)(d) shall be liable to denial of Section 11 exemption.
Second amendment brought by Finance Act of 2022 was introduction of Section 115BBI to the Act laying down that income-tax shall be payable on any specified income in the following manner:
- at the rate of 30 percent on the aggregate of specified income; and
- normal rate of income-tax which would have been chargeable to the assessee had the total income of the assessee been reduced by the aggregate of such specified income.
Clauses (c) and (d) of Explanation to Section 115BBI defines the expression ‘specified income’ to include income as has been applied / invested in violation of the Section 13(1)(c) / Section 13(1)(d). This is further evident from the words ‘All the above income are also required to be taxed at special rate. Hence, it is proposed to insert new section 115BBI in the Act’ found in para 5.2(d)(e) of Memorandum to Finance Act 2022. Therefore, as per Section 13(1)(d)(iii), only investment in shares of public sector company or under Section 11(5)(xii) read with Rule 17C of the Rules will not attract Section 115BBI, but by implication, any investment in shares of a private limited company will attract income tax at the rate of 30% of such investment under Section 115BBI.
Conclusion
In case of all charitable or religious Trusts, any part of Trust income applied / invested:
- violates Section 13(1)(c) where it is, directly or indirectly, for the benefit of specified person;
- violates Section 13(1)(d) where it is not invested in public sector company or modes specified under Section 11(5).
The legislative history leading up to the present iteration of Section 13(1)(c) / Section 13(1)(d) makes it evident that only that part of income which has been applied / invested in violation of the Section 13(1)(c) / Section 13(1)(d) shall be liable to denial of Section 11 exemption. Such application / investment will be taxed at the rate of 30 percent on the aggregate of such investments under Section 115BBI of the Act.
Section 13(1)(c) and Section 13(1)(d) function as independent bars on Section 11 exemption. Section 13(4) has been drafted in such a manner that stipulations of Section 13(1)(c) can be disregarded, but stipulations of Section 13(1)(d) must be given due regard. In other words, any protection guaranteed by Section 13(4) may relax requirements of Section 13(1)(c), but Section 13(1)(d) will continue to apply towards any exempted income under Section 11.
[The author is an Associate, Direct Tax Team, Lakshmikumaran and Sridharan Attorneys, Mumbai]
[1] Requirement of application of Trust income under Section 11(1) was subsequently increased to 85% vide Finance Act 2002 (w.e.f. 1 April 2002).
[2] By virtue of Direct Tax Law (Amendment) Act, 1987, corpus donations were also subsequently required to comply with Section 13(1)(d) r/w specified modes under Section 11(5).
[3] “Government company” was substituted with “public sector company” vide Finance Act, 2007.
[4] Investment in shares Depositories, National Skill Development Corporation, among others were subsequently permitted under Section 11(5)(xii) r/w Rule 17C of the Income-tax Rules, 1962.
[5] [1975] 101 ITR 457 (SC).
[6] [2003] 259 ITR 280 (SC).
[7] [2014] 267 ITR CTR 305 (Del).
[8] [1997] 226 ITR 211 (Ker).
[9] [2019] 101 taxmann.com 247 (Bom).
[10] [2014] 365 ITR 353 (Mad).
[11] [2001] 249 ITR 533 (Bom).
