In Part I of the Taxation of Trust series, we explored how private trusts are taxed and how the trust’s classification (specific or discretionary) shapes the liability. Now in Part II, we dig deeper into some important technical areas — starting with how capital gains are computed when property is transferred into a trust, how gift tax rules apply, and whether trustees themselves attract tax when assets are settled into the trust. These insights are crucial for anyone creating, managing, or benefitting from a private trust in India.
Cost of acquisition on settlement to trust
When a capital asset becomes part of a trust — whether it’s revocable or irrevocable — one question comes up immediately: what’s the cost of acquisition?
According to Section 49(1)(iii)(d) of the Income Tax Act:
- The cost is treated as the cost at which the settlor originally acquired the asset.
- Any improvements made to the property by the settlor can also be added to this cost.
- Importantly, indexation (for capital gain calculation) is available from the year the settlor acquired the asset, not from when the trust received it.
This principle was upheld by the Bombay High Court in CIT vs Manjula J. Shah (2013) 355 ITR 474, which confirmed that the tax benefit of indexation goes all the way back to the settlor’s period of ownership.
Also, the way capital gains are taxed depends on whether the trust is specific or discretionary. (That’s covered in later parts of the series.)
Analysis of Applicability of gift tax provisions
The gift tax angle enters the picture when property is moved into a trust. This is handled under Section 56(2)(x) of the Income Tax Act, which says:
If any person receives a property without consideration, or for inadequate consideration, the difference between fair market value and what was paid will be taxed as income from other sources.
But there are exceptions — and one big exception applies to trusts.
Exemption:
This gift tax rule does not apply when the property is transferred by an individual to a trust that is set up solely for the benefit of their relatives.
So what counts as “relative”?
The law defines it quite clearly (in the context of an individual) as:
- Spouse
- Siblings of self or spouse
- Siblings of parents
- Lineal ascendants or descendants
- Spouses of all the above
If a trust is created exclusively for these people, property can be transferred without triggering any tax under Section 56(2)(x).
This exemption, however, has boundaries.
- Only applies if the transfer is from an individual.
If a firm, HUF, or company transfers the property — the exemption doesn’t apply. - Settlor doesn’t need to be the transferor.
Even if someone else (like a spouse) contributes to a trust created by another person, the exemption still applies — as long as the trust is for the benefit of the relative of the person who made the trust.
Example:
- If Mr. B creates a trust for his son, and Mrs. B contributes property to it — the exemption still applies.
But here’s where things get tricky — especially when viewed from different angles.
Relative test depends on who’s looking:
Normally, “relative” is determined from the recipient’s side. But in this trust-related exemption, it’s judged from the donor’s perspective.
This switch in viewpoint can lead to very different tax outcomes.
Examples:
- Nephew gives property to a trust for his uncle
✅ No tax. “Uncle” is a relative from the nephew’s side. - Uncle gives property to a trust for his nephew
❌ Taxable. “Nephew” is not a relative when viewed from the uncle’s perspective.
This distinction is subtle but crucial. Misinterpreting it can lead to tax exposure.
Section 56(2)(x) implications in the hands of the trustee (on settlement)
Now what happens at the trustee’s end? Does the trustee become liable under gift tax rules?
Let’s break it down.
When a trust is created, the settlor transfers property to a trustee, who holds it for the benefit of the beneficiaries.
Here’s why that transfer is not taxed under Section 56(2)(x):
- The trustee receives the property under an obligation — to manage it on behalf of the beneficiaries.
- That obligation acts as a form of consideration — which prevents it from being treated as a “gift” under the law.
- Also, the trustee is not the beneficial owner — just the legal holder. The economic benefit goes to the beneficiaries.
Legal backing:
This principle was affirmed by the Bombay High Court in the case of CGT vs G.G. Morarji (1965) 58 ITR 505 (Bom).
Here’s what the court said:
“The fundamental attribute of ownership is the power to transfer and enjoy the property. A trustee cannot transfer the property for his own benefit, nor can he enjoy its benefits personally.”
That makes the trustee’s role very different from a typical recipient. They don’t “own” the asset in the real sense — they manage it for someone else, under legal obligation.
So even though they physically possess the asset, there’s no income tax liability under Section 56(2)(x) at the trustee’s level.
This reasoning — though originally made in the context of gift tax law — applies equally to Section 56(2)(x) under the Income Tax Act.
Final Thoughts:
This part of the Taxation of Trust series dives into the nuances that often get missed — like how the cost of acquisition is calculated, or how gift tax rules differ based on who gives and who benefits.
If you’re planning to create a trust, or are a trustee handling property, it’s critical to:
- Understand when gift tax provisions apply, and when they don’t
- Make sure the trust deed clearly states the beneficiaries and their relationship to the donor
- Avoid assuming that trustees are “owners” — the law treats them differently
Stay tuned for the next part of the series, which will likely go deeper into specific vs discretionary trust taxation and their tax treatment under various scenarios.
