This part of the Succession Planning Series focuses entirely on discretionary trusts, a structure where beneficiaries do not have defined shares. While these trusts offer flexibility in estate planning, they attract different tax rules—particularly under Section 164 of the Income Tax Act. This blog explains what makes a trust “discretionary,” how the tax liability shifts between trustee and beneficiary, and when the Maximum Marginal Rate (MMR) applies or is avoided. We also dive into key judicial precedents and clarify how tax departments interpret such structures under Indian law.
Special provisions for discretionary trusts
A discretionary trust is one in which the beneficiaries and/or their individual shares are not specifically defined at the time the trust is created. In simpler terms, the trustee has the discretion to decide how much each beneficiary receives, and when. This flexibility comes at a cost — higher tax.
Under Section 164 of the Income Tax Act:
- The trustee is treated as a representative assessee.
- The trust’s income is taxed at the Maximum Marginal Rate (MMR), which currently includes:
- 30% base rate
- Surcharge
- Health and Education cess
But there’s more to it. Under Section 166, the Assessing Officer (AO) has the power to assess the beneficiaries directly in respect of income received through the trustee.
It’s also worth noting that most taxation of private trusts is governed under Section 161, where the trustee is assessed in the same manner and to the same extent as the beneficiaries. But discretionary trusts are an exception, specifically pulled under the purview of Section 164 due to their structure.
Exceptions from MMR taxability
While MMR is the default rate for discretionary trusts, the law does provide certain exceptions. In these cases, the trust can be taxed at normal slab rates applicable to an AOP (Association of Persons).
Here’s when the exception applies:
- None of the beneficiaries are beneficiaries in any other trust
This reduces the risk of income layering or duplication of benefits. - Trust is created under a Will by a person
If the trust is created:- By a Will
- For the benefit of a dependent relative
- And is the only trust created by the settlor
then even if the trust earns business income, MMR does not apply.
- All beneficiaries have income below the basic exemption limit
If none of the beneficiaries (other than trust income) earn more than ₹2.5 lakh, the trust may be taxed at AOP rates. - Trust under Will with no business income
Similar to exception 2, but with a further condition — the trust’s income must not include business income.
These exceptions allow family-created trusts to avoid punitive tax rates, especially where the intention is clearly succession planning rather than tax arbitrage.
Principles w.r.t taxation of discretionary trust
Two important court rulings shape the understanding of taxation for discretionary trusts:
Gujarat High Court – Niti Trust vs CIT (1997) 221 ITR 435
In this case, the court clarified that when a trust earns income that is otherwise taxable at special rates (like long-term capital gains), then that portion should not be taxed at MMR, but at the relevant special rate.
This distinction matters. Even if a trust is discretionary:
- Long-term capital gains can be taxed at 20% (with indexation)
- Instead of lumping the entire trust income into a 30%+ bracket
The court stated:
“Once the status of an assessee is determined as an individual, then clause (a) of sub-section (1) of section 112 will be made applicable… There is no apparent error in applying special rates to special income, even in case of a discretionary trust.”
This prevents unfair taxation and aligns with broader income tax logic.
Madras High Court – CIT vs Saroja Raman & T.G. Ranjini Trust (1999) 104 TAXMAN 163
Here, the court addressed a key scenario: when the trust has only one beneficiary, and trustees are obligated to use the income solely for that person.
The verdict:
- Section 164 does not apply, even if the trustee controls the timing and extent of payments.
- What matters is the obligation, not the control.
In short: even if a trust is technically “discretionary,” if the beneficiary is known and fixed, and there is a clear obligation to use income for their benefit, MMR taxation doesn’t apply.
Section 164 is not a standalone rule
The law is clear: Section 164 should not be read in isolation. It must be interpreted in conjunction with Section 161, which deals with representative assessees more broadly.
This means:
- Even in discretionary trusts, trustees may still be taxed in the same manner and to the same extent as beneficiaries if conditions are met.
- And thanks to Section 166, the AO retains the right to tax the beneficiary directly.
This legal structure ensures flexibility in how the Income Tax Department can recover taxes — depending on who has access or benefit of the income.
What if income is distributed in the same year?
If the trustee distributes trust income to beneficiaries in the same financial year, then:
- The AO may choose to assess either the trustee or the beneficiary.
- Because the income has been received by the beneficiary, it becomes part of their total income under Section 5.
- And therefore, it triggers taxation under Section 4, the charging section of the Act.
Supreme Court – CIT vs Smt. Kamalini Khatau (1994) 209 ITR 101
This is one of the most important rulings on discretionary trust taxation.
Key takeaways:
- Discretionary trusts are not tax shelters. The Income Tax Department can tax the income in either the trustee’s or the beneficiary’s hands — whichever is more effective or practical.
- The mere fact that income passes through a trustee does not shield it from tax liability.
So even if the trust structure is complicated, the core principle remains: tax will follow the income, either at the trustee or beneficiary level.
Final Thoughts:
Discretionary trusts can be powerful tools in estate planning, especially when the settlor wants to allow flexibility in how and when assets are distributed. But that flexibility comes with tax complexity.
This blog shows that:
- Discretionary trusts typically attract MMR taxation, but there are notable exceptions.
- If income is distributed within the same year, beneficiaries can be taxed directly.
- Courts have ruled that certain types of income retain their special tax rates, even in discretionary setups.
- And if there’s only one beneficiary, and the trustee must use income solely for their benefit — the trust may not be taxed at MMR at all.
In short, while the default is to treat discretionary trusts as high-tax structures, thoughtful structuring and clear drafting of the trust deed can reduce tax liability significantly — without compromising on the core goal of family succession planning.
