Taxation of charitable institutions has seen a paradigm shift in the recent times due to frequent amendments. One such amendment is related to the allowability of inter-trust donation which has been introduced through the Finance Act, 2023. 

Mr. Saurabh Kedia and Ms. Megha Dhandhania (Chartered Accountants) discuss the impact of the amendments related to inter-trust donations and the underlying intent to ensure effective application of income by the trusts. They further touch upon the pre-amendment provisions wherein such donations were allowed as application of income in the hands of the donor trust. The authors analyse how, after Finance Act 2023, the amount paid towards inter-trust donations shall be considered as application only to the extent of 85% of such inter-trust donation. They elaborate the effect of the amendments through illustrations capturing different scenarios. The authors also highlight the lack of clarity in the provisions which can lead to different interpretations inviting further litigation.

The authors conclude that “while the government’s efforts towards rationalising the trust’s provisions and curbing malpractices for tax avoidance are commendable, the charitable trusts are flummoxed by the plethora of amendments being introduced year on year and the lack of clarity thereon. Bringing more clarity to remove the ambiguities in the existing as well as newly inserted provisions relating to taxability of charitable trusts is the need of the hour.”

Fate of inter-trust donations – another jigsaw in the trust taxation landscape!

A. BACKGROUND

The provisions relating to taxation of charitable institutions have been enshrined in the Income-tax Act, 1961 (the Act) for decades. However, what remained a rather taciturn topic for years has now become a momentous keynote in the finance budget of recent years. In the past couple of years, the provisions relating to the taxability of charitable institutions have undergone paradigm shifts owing to the tax department's burgeoning interest in rationalising these provisions. 

Keeping up with the pace, the Finance Act, 2023 introduced significant amendments in the provisions relating to the taxation of charitable trusts. Among these, one of the amendments which will extensively impact charitable trusts is the amendment relating to allowability of inter-trust donations (i.e. donation made by a charitable trust to another charitable trust). Before delving into this amendment, it is important to understand the pre-amendment position.

B. TREATMENT OF INTER-TRUST DONATIONS PRIOR TO AMENDMENT

Prior to the amendment vide Finance Act, 2023, donations made by registered charitable institutions to another registered charitable institutions, having similar objects (for the sake of brevity, referred to as ‘inter-trust donations’) were allowed as application of income in the hands of the donor-trust.

The Finance Act, 2017 amended such provisions to provide that inter-trust donations made towards the corpus of donee-trust would not be allowed as application in the hands of the donor-trust [Explanation 2 to section 11(1) of the Act].

Therefore, donations, apart from corpus donations, made by a registered charitable institution to another registered charitable institution, having similar objects, were allowed as application of income in the hands of the donor trust.

C. AMENDMENT INTRODUCED VIDE FINANCE ACT, 2023

The Finance Act, 2023 has provided that any amount paid by a registered charitable institution to another registered charitable institution shall be treated as application for charitable or religious purposes only to the extent of 85% of such amount credited or paid [clause (iii) of Explanation 4 to section 11(1) of the Act]. The said amendment is effective from Financial Year (FY) 23–24.

The legislative intent behind the above amendment can be deciphered from the Memorandum explaining the provisions in the Finance Bill, 2023. The relevant extract of the same is quoted below:

‘3.2 Instances have come to the notice that certain trusts or institutions are trying to defeat the intention of the legislature by forming multiple trusts and accumulating 15% at each layer. By forming multiple trusts and accumulating 15% at each stage, the effective application towards the charitable or religious activities is reduced significantly to a lesser percentage compared to the mandatory requirement of 85%.

3.3 In order to ensure intended application toward charitable or religious purpose, it is proposed that only 85% of the eligible donations made by a trust or institution under the first or the second regime to another trust under the first or second regime shall be treated as application only to the extent of 85% of such donation……………’

As seen from the afore-quoted extract, to put a restraint on cases where multiple trusts are formed and 15% of income is accumulated at each layer, the Finance Act, 2023 has amended the provisions of sections 11 and 10(23C) of the Act to provide that the amount paid towards inter-trust donations shall be considered as application only to the extent of 85% of such inter-trust donation. The impact of the amendment is depicted in the illustration below:

As noted from the above illustration, in light of the amendment, the accumulation of income at each

layer of the trust would reduce. Now let us understand how this amendment would impact a charitable trust under different illustrative scenarios:

Let us discuss these scenarios briefly below:

Scenario A: In this case, the entire income is donated to another charitable trust. Hence, no further application would be required, as 85% of the total donation of INR100, i.e. INR85, will be considered as the application. There is no accumulation of 15% of income in this case since the entire income is being applied, and there is no cash remaining with the trust. Thus, it should not be impacted by the amendment.

Scenario B: In this case, the trust has donated INR85 to another trust, 85% of which, i.e. INR72, will be considered as application. Hence, INR13 (i.e. INR85 – INR72) needs to be further applied by the trust. The balance cash flow remaining with the trust is INR15, and the trust can make the further application of said INR13 towards charitable purposes out of this balance cash flow. Thereafter, the amount remaining for accumulation with the trust would be INR2 (i.e. INR15 – INR13).

Scenario C: In this case, INR70 has been donated towards another trust, 85% of which, i.e. INR 60, will be considered as the application. Moreover, INR25 has been applied by the trust towards other charitable purposes. Therefore, the total application in the hands of the trust would be INR85 (i.e. INR60 + INR25). Hence, no taxable income would arise in the hands of the trust. Also, no income shall be available for accumulation as the cash flow during the year gets exhausted.

Scenario D: In this case, INR80 has been donated towards another trust, 85% of which, i.e. INR 68, will be considered as the application. No further amount has been applied towards other eligible charitable purposes. Thus, further application remaining to be made by the trust amounts to INR17 (i.e. INR85 – INR68). Now, in this scenario, apart from the inter-trust donation of INR80, corpus donation of INR10 (not considered as application of income) has also been made, and the cash flow remaining with the trust is INR10 (i.e. INR100 – INR80 – INR10), whereas further amount required to be applied is INR17.

While Scenarios A, B and C deliberated above seem rather simple, one needs to ponder upon the situation which has arisen in Scenario D. As discussed in the foregoing paragraph, in this case, the amount to be applied by the trust falls short by INR17 whereas the cash flow available with the trust is only INR10. Therefore, there is cash flow deficit of INR7 (INR17 – INR10), which the trust will not be able to apply towards charitable purposes out of its income of the current year.

At this point, let us revisit the legislative intent behind the amendment in discussion. The intent was to ensure that there is effective application of income by the trusts towards charitable purposes and that the trusts do not keep accumulating 15% of the income at each layer by forming multiple trusts. Thus, as long as the trust applies INR17, either out of the current-year income (i.e. out of the available cash flow of INR10) or from the retained earnings of the trust (i.e. income accumulated in preceding years – to the extent of INR7 in this case) for charitable purposes, no taxability should arise in the hands of the trust.

We will leave the audience with one last boulevard which can be deliberated upon, namely, if the trust is unable to apply INR17 (i.e. out of current year income as well as retained earnings) for charitable purposes arrived at in Scenario D above for any given reason. In this case, one needs to evaluate whether the said amount of INR17 can be set apart and accumulated by the trust for application towards charitable purposes in future years, and therefore, be considered as deemed application of income?

Section 11 of the Act provides the following for set apart of income:

(a) Set apart under the provisions of clause (2) to Explanation 1 of section 11(1) of the Act: This allows the trust to set apart its income where the income has either not been received or for any other reason.

(b) Set apart under the provisions of section 11(2) of the Act:

If one goes by the plain language of the Act and the legislative intent behind the amendment in discussion here, nowhere is it mentioned that the balance 15% of the inter-trust donation is to be considered as taxable income of the trust chargeable to tax at applicable rates. The amendment merely restricts the amount of application in case of inter-trust donation, and if the donor applies the remaining 15% of the inter trust donation or sets apart the said amount as per the provisions of Explanation 1 to section 11(1) and/ or section 11(2) the Act, the same should not become taxable in the hands of the trust. Additionally, wherever the legislation has so intended to tax a particular income in the hands of the trust at the maximum marginal rate, the same has specifically been inserted in the statute, be it exit tax under section 115TD of the Act, anonymous donation under section 115BBC of the Act or the tax rate of 30% specified in the more recently introduced section 115BBI of the Act.

However, given the lack of clarity, the law can be interpreted differently inviting litigation. While there is no direct precedence on the issue, it is pertinent to refer to a recent judgment of Rajkot Tribunal in the case of Prabhas Patan Jain v. ITO [TS-6043-ITAT-2023(Rajkot)-O]. In this case, the Tribunal denied the benefit of set apart of income where a particular amount was deemed to be income by virtue of the provisions of section 11(3) of the Act (i.e. where the set-apart amount could not be applied by the trust within the specified time limit).

Taking cue from the above judgment, one may argue that even in case of inter-trust donations, once an income has been considered not to be applied, by virtue of operation of specific provisions of the Act, then the benefit of the set-apart provisions [Explanation 1 to section 11(1) and/ or section 11(2)] cannot be obtained. If this view is followed, then the only avenue which will be available for the trust would be to apply the amount of shortfall in the same previous year in which the shortfall arises.

On the flip side, one plausible view is also that the above judgement is distinguishable as it deals with section 11(3) of the Act which is a deeming provision and provides that the set-apart amount not applied by the trust shall be deemed to be its income. Moreover, section 11(3) of the Act uses the expression ‘income of such person’ in contradiction to the words ‘income derived from property’ which is relevant in the context of section 11(1) of the Act.

The provisions relating to inter-trust donation are in the context of determining the amount of application of ‘income derived from property’. It merely restricts the amount of application to 85% of the amount donated to other charitable trusts; however, it allows the trust to either apply or accumulate the balance 15% of such inter-trust donation for charitable purposes to meet the condition of 11(1)(a) of the Act. 

In case the trust does not have retained earnings or is unable to apply or accumulate full amount of INR17 towards charitable purposes, the shortfall should get taxed in the hands of the trust at the applicable tax rates. As regards the rate of tax, as per section 164(2) of the Act, income of a trust, not exempt under section 11 of the Act, is taxable as Association of Persons (AOP) at slab rates. However, it would be interesting to note that post amendment in the Finance Act, 2023, section 115BAC of the Act has been made applicable to AOPs as well, subject to other conditions specified in the section. Hence, the trusts may evaluate the applicability of slab rates under section 115BAC of the Act in their cases post the amendment introduced vide the Finance Act, 2023.

D. CONCLUSION

While the government’s efforts towards rationalising the trust’s provisions and curbing malpractices for tax avoidance are commendable, the charitable trusts are flummoxed by the plethora of amendments being introduced year on year and the lack of clarity thereon. Bringing more clarity to remove the ambiguities in the existing as well as newly inserted provisions relating to taxability of charitable trusts is the need of the hour.

Disclaimer: The above content as well as any views expressed herein are entirely personal.