Trusts are often used as estate planning tools, but when it comes to taxes, things get a bit murky. Unlike companies or partnerships, a trust isn’t even considered a “person” under the Income Tax Act. So, how is its income taxed? In this first part of M2K’s Succession Planning Series on trust taxation, we look at how trusts are treated under Indian tax laws — including who pays the tax, how revocability changes everything, and how old and new laws compare.
Brief taxation of Private Trust
Taxation of private trusts isn’t straightforward. It doesn’t follow the typical structure applied to most legal entities, because a trust is not a person under section 2(31) of the Income Tax Act, 1961.
So how does the tax department handle it?
- The trustees or the beneficiaries become the ones assessed.
- The income of the trust is taxed either:
- Directly in the hands of the beneficiaries, or
- In the hands of the trustees, who are treated as representative assessees (acting on behalf of beneficiaries)
For taxation purposes, trusts are classified into two main types:
- Specific trusts – where individual shares of income are clearly defined
- Discretionary trusts – where the distribution of income is left to the trustee’s discretion
This classification has significant implications on who pays the tax and at what rate. A deeper dive into the difference between the two types is covered in the next parts of this series.
Taxability of the settlor on transfer of assets
If you’re the person setting up a trust (the settlor) and you transfer your assets into it, here’s what you need to know:
- If the trust is irrevocable, then under section 47(iii) of the Act, this transfer is not treated as a taxable capital gain.
- But if the trust is revocable, then the game changes. The income from those assets is clubbed back into your own income, and taxed in your hands as the transferor.
It’s important to note:
These tax rules are only about how the transfer is taxed. They do not affect the contractual or legal rights you set out in your trust deed.
So, even if you’re not paying tax when transferring the asset, make sure your trust deed is clear and enforceable — because that’s what defines how the trust functions legally.
Clubbing provisions under the Income tax Act
If a transfer of assets into a trust is considered revocable, then the income from those assets will be clubbed with the transferor’s own income.
Here’s when a transfer is considered revocable:
- If the trust deed contains a clause for re-transfer of assets or income back to the settlor — directly or indirectly.
- If the settlor has any right to re-assume control or power over the income or the asset.
Even if these powers are never exercised, just the presence of such clauses in the trust deed makes the trust revocable.
There’s one major exception:
If the trust is irrevocable during the lifetime of the beneficiary, then the income won’t be clubbed with the settlor’s income.
This is a critical clause, especially in succession planning for families — because a revocable clause, even unintentionally included, could trigger heavy taxation for the settlor.
Comparison of important clubbing provisions
The concept of clubbing is not new. Here’s how it evolved:
Under the Income Tax Act, 1922
Section 16(1)(c) said that all income arising to any person due to a revocable transfer would be taxed in the hands of the transferor.
Even back then, a trust, agreement, or settlement that allowed:
- Re-transfer of income or assets, or
- Re-assumption of power by the settlor
was treated as revocable — and hence taxable in the hands of the settlor.
Under the Income Tax Act, 1961
The same concept was retained and expanded:
- Section 61 says income from revocable transfer is taxed in the hands of the transferor.
- Section 63 defines when a transfer is revocable, including:
- Any provision for re-transfer of income/assets
- Any right of the settlor to reassume control
- And that “transfer” includes any trust, agreement, settlement, or covenant
This comparison highlights the consistency in tax treatment across decades — trusts that leave any backdoor for the settlor to reclaim control will always invite taxation at the transferor’s level.
Case laws relating to revocability
While the alert lists only the heading here (without individual judgments), the inclusion of this section signals that a full case law analysis is likely provided in future parts of the series. In Indian tax jurisprudence, several Supreme Court and Tribunal decisions have helped interpret what constitutes revocability and how courts weigh substance over form in such clauses.
We’ll watch out for these in the next editions.
Final Thoughts:
This first part of the series lays the groundwork for understanding the complex framework of private trust taxation. Unlike other legal structures, trusts operate through a delicate balance of control, discretion, and documentation. The Income Tax Act treats them uniquely, focusing not on the entity but on the people behind it — the settlor, trustee, and beneficiary.
For anyone setting up a trust, or advising on one, the message is clear:
- Draft the trust deed with extreme precision
- Avoid any revocable clauses unless you’re ready for clubbing of income
- Understand that tax treatment isn’t just about the structure — it’s about control
And finally, always check whether your trust is specific or discretionary, because that will determine how the income is taxed and in whose hands.
