Budget 2019 brought a steep 22% rise in surcharge rates for individuals having taxable income of more than Rs 5 crore, making the effective tax rate as high as 42.74%. And for this reason, a lot of high net worth individuals (HNIs) started to shift their income and asset base to tax haven countries.
However, the Income Tax Act provides several avenues to taxpayers to reduce their tax liabilities in a legitimate manner. Some options include creation of Hindu Undivided Family (HUF), formation of Limited Liability Partnership (LLP) and family trusts.
Under the Act, HUF is considered as a separate legal entity and is taxed as the same rates as an individual. HUFs can be formed by Hindus, Buddhists, Jains and Sikhs. The head of HUF is called the Karta, who is also the senior most male member of the family. Male members are called as coparceners whereas females are referred to as members.
Only coparceners can demand partition of HUF. However, this gender discrimination was removed in 2005 whereby both sons and daughters became coparceners of their father’s family on birth.
HUF usually has assets which come as a gift, a will, or ancestral property, or property acquired from sale of joint family property or property contributed to common pool by members of HUF. Deductions under Section 80C and other exemptions can be claimed by HUF in its tax return. It can also take an insurance policy on the life of its members, pay salary to its members if they contribute to the functioning of HUF (which expense can be claimed as deduction from the income of HUF), can make investments from HUF’s income (which income shall be taxable in the hands of HUF). Any asset received by a member from HUF upon its partition shall not be taxable in the hands of members under the Act.
Let’s take an example to understand this better. Say, Mr. Kapoor has inherited a property after his father’s death. He decides to start an HUF with his wife and son. The property held by his father was transferred in the name of HUF. This property earns an annual rent of Rs 10 lakh. Mr. Kapoor also earns salary of Rs 30 lakh. By creating an HUF and transferring the rental income of ancestral property to it, Mr. Kapoor can make tax savings of almost Rs 190,000 a year!
Having said the above, one may ask, if females can be a Karta of an HUF? Interestingly, in 2016, the Delhi High Court ruled in favour of a female being the Karta of an HUF. However, the same has not been incorporated in the law as yet.
Another avenue that can be explored by HNIs, who are promotors of firms, is to float LLPs. Broadly, there are three features that distinguish an LLP from a normal partnership firm viz. limited liability, separate legal entity status and perpetual succession. Partners to the LLP may infuse capital into the firm in numerous ways viz. tangible (movable and immovable) property, intangible property, monetary contribution, etc. Apart from partners, it can also raise funds from banks, corporates and NBFCs as well. Over the years, FDI norms have been relaxed for LLPs, whereby, non-residents can also invest into LLPs operating in sectors where 100% FDI is permitted.
Furthermore, distribution of income from LLP to partners does not attract tax. The effective tax rate on LLPs is about 35%, which is lower than the effective tax rate of 43% applicable to HNIs. This structure helps in cost reduction on account of savings made in costs related to compliance, documentation and decision making.
The LLP structure has found wide acceptance among professionals and entrepreneurs for its tax efficiency. The benefits and administrative ease of this structure will certainly help entrepreneurs sail through the current times of ‘new normal’ where the objective is cost savings coupled with increased efficiency.
One may also evaluate the option of forming a family trust. As the name suggests, it is a vehicle independent of its beneficiaries and therefore enjoys a relatively permanent nature and greater flexibility in terms of managing the assets held in the trust, in terms of investing, acquiring, disposing and otherwise dealing with the assets of the trust.
In a family trust, assets are transferred by one party (settlor) and held by another party (trustee) for the benefit of a third party (beneficiaries). Typically, family homes are transferred as assets to these trusts, but other things of value like cash, bank deposits, shares, etc. can also be included in the trusts.
Family trusts are popular structures that offer a variety of benefits such as asset protection, maintenance of family harmony, preservation of wealth, regulation of a third-party entry into family business, relief from the probate process, etc.
Contribution of property from a family member to a trust that has been created for the benefit of his relatives is tax exempt. Furthermore, any distributions of assets or income from the trust to its beneficiaries under a private family trust will not attract any tax liability – either in the interim period or at the time of the dissolution of trust.
However, income that is earned by the trust, will be taxed depending on whether the trust is specific or discretionary. If it is a specific trust, where the share of each beneficiary is fixed, income can be assessed either in the hands of trustee or in the hands of individual beneficiaries at tax rates applicable to individuals or maximum marginal rate (MMR), depending on the income stream and certain other criteria specified in the Act.
If it is a discretionary trust, where the share of each beneficiary is not fixed, income of the trust is taxed at MMR. Following the discharge of tax liability, subsequent distributions to the beneficiaries are tax-free.
Family trusts are very effective and convenient, and if used prudently can be a great tool for managing assets, finances, investing in securities and utilising returns earned by trust for the benefit of its beneficiaries. Considering the above, it surely is time to re-think and plan your investments legitimately!
(CA Rajeshree Sabnavis, Founder & Devanshi Gala, Manager, Rajeshree Sabnavis & Associates. The authors are part of a boutique tax consultancy firm, Rajeshree Sabnavis & Associates. Views expressed are personal)