This subject came under extensive discussion throughout the world including Pakistan, after the Panama Papers and the Paradise Papers. These revelations transpired that in most of the cases properties held outside Pakistan, were owned by 'private trusts' authored by persons being citizens and tax residents of Pakistan who originally held such properties. Accordingly, after the settlement of a trust such properties and income therefore did not appear as 'assets' or 'income' of that person for corporate, fiscal, foreign exchange and other purposes. There can be a very extensive debate on the subject in the following paragraphs. This concept has been discussed from taxation perspective with a particular reference to ownership of assets by a person who creates the trust and income therefrom.The person who creates a trust is described as author/settler of the trust. This article does not deal with the subject of veracity of the 'sources of money' through which a trust is formed. At this stage, the purpose is to identify the correct understanding of a trust ownership.
Salmond's Jurisprudence on the subject explained the concept (7th Edition - pages 284 to 286) as under:
"A Trust is a very important and curious instance of duplicate ownership. Trust property is that which is owned by two persons at the same time, the relation between the two owners being such that one of them is under an obligation to use his ownership for the benefit of the other. The former is called the Trustee and his ownership is trust-ownership; the latter is called the beneficiary and his beneficial - ownership.
The trustee is destitute of any right of beneficial enjoyment of the trust property. His ownership, therefore is a matter of form rather than of substance and nominal than real. If we have to regard the essence of the matter rather than to the form of it, a trustee is not an owner at all, but amere agent. He is a person to whom the property of someone is factiously attributed by the law, to the extent the rights and powers vested in a nominal owner shall be used by him on behalf of the real owner. As between the trustee and the beneficiary, the law recognizes the truth of the matter; as between the two the property belongs to the later and not the former. But as between the Trustee and the third person the fiction prevails, the trustee is clothed with the rights of his beneficiary and is so enabled to personate or represent him in dealings with the world at large.
The purpose of trusteeship is to protect the rights and interests of persons who for any reason are unable effectively to protect them from themselves. The law vests those rights and interests for safe custody, as it were, in some other person who is capable of guarding them and dealing with them, and who is placed under a legal obligation to use them for the benefit of him to whom they in truth belong.
The chief classes of persons in whose behalf the protection of trustee -ship is called for, are four in number:
In the first place, the property may belong to persons who are not yet born; and in order that it may be adequately safeguarded and administered, it is commonly vested in the meantime in trustees, who hold and deal with it on account of unborn owners.
In the second place, similar protection is required for the property of those who lie under some incapacity in respect of the administration of it, such as infancy, lunacy or absence.
Thirdly it is expedient that property in which large number of persons are interested in common should be vested in trustees. The complexities and difficulties which arise from co ownership become so great as soon as the number of co-owner ceases to be small, that it is essential to avoid them and one of the most effective devices for this purpose is that scheme of duplicate ownership which we term a Trust.
Fourthly, when persons have conflicting interests in the same property (for example) an owner and encumbrance or different kind of encumbrances, it is often advisable that property should be vested in Trustees whose power and duty should be it is to safeguard the interests of each of the persons against the conflicting claim of the others."
In the case of a private trust, there is usually the question relating to a distinction between the settlements of property though the mode of formation of the trust and a properly documented will relating to such property. The primary differences have been identified in the following table:
Trust is a proper mode to handle the affairs, if there are issues in relation to compliance with 'inheritance' laws. In addition to the same, formation of a trust assures continuity of the desires of the settler.
From taxation perspective, the primary question is whether or not the property in trust and the income therefrom is the asset/ownership or income of the settler / author. The answer is not that simple, primarily on account of open ended nature of trust form of ownership and accretion of income at various stages. Apparently, it can be seen as a mode of avoidance of tax compliance. This raises the following questions:
(i) Can a settler go scot-free after the trust creation?
(ii) What are his liabilities under the tax laws?
(iii) Can a settler escape from taxation altogether by transferring assets to a trust and thereafter plead that the income is diverted at source and he should not be bothered about it all?
(iv) Can a settler step out by contending that he has transferred the income to a trust and only because he has interest in the assets, he should not be taxed on the very same income?
(v) Can the Income Tax Authorities lift the veil of a trust and then still pursue their actions on the settler even though a valid trust is created by way of law under any jurisdiction in or outside Pakistan?
In this author's view, these are all well settled matters under the Income tax jurisprudence throughout the world, including India and Pakistan. There is no tax avoidance in the case of a properly executed irrevocable trust, whether formed in Pakistan or outside Pakistan.
The matter has been dealt with in the UK tax statutes and the same has been carried through in the Pakistan's Income Tax Act, 1922, Income Tax Ordinance, 1979 and the present Income Tax Ordinance, 2001 ('the Ordinance'). This subject is dealt with under Section 90 of the Ordinance. It is actually one of the few provisions where there is no change in text or context of the matter since inception in 1922. Section 90 of the Ordinance states as under:
90. Transfers of assets. - (1) For the purposes of this Ordinance and subject to sub-section (2), where there has been a revocable transfer of an asset, any income arising from the asset shall be treated as the income of the transferor and not of the transferee.
(2) Sub-section (1) shall not apply to any income derived by a person by virtue of a transfer that is not revocable during the lifetime of the person and the transferor derives no direct or indirect benefit from such income."(emphasis is ours)
When these provisions were introduced in UK then commenting on the object of corresponding legislation in England, Lord Macmillan said in Chamberlain v IR, (25 TC 317)
"10. This legislation forms part of a code of increasing complexity, beginning with the Finance Act 1922, s 20, designed to overtake and circumvent a growing tendency on the part of taxpayers to endeavour to avoid or reduce tax liability by means of settlements. Stated quite generally, the method consisted in the disposal by the taxpayer of part of his property in such a way that the income should no longer be received by him, while at the same time he retained certain powers over, or interest in, the property or its income. The legislature's counter was to declare that the income of which the taxpayer had thus sought to disembarrass himself should, notwithstanding, be treated as still his income and taxed in his hands accordingly."(emphasis is ours)
Under Section 90 of the Ordinance,income which arises to any person (i) by virtue of any 'transfer' from assets if it remains to be the property of the transferor or (ii) by virtue of a revocable transfer of assets, is deemed to be the income of the transferor andtaxed as his income. However,Section 90 of the Ordinance has no application where the income stood diverted by an overriding title, as a matter of fact, even before the accrual of income. Similarly, Section 90 of the Ordinance cannot apply where, under an agreement for the purchase of a business, the management, possession and the right to carry on the business is taken over by the taxpayer even before the execution of the conveyance. The assignment of a part of the right to receive income from the residuary property is legal and valid, and such assignment would not be covered by Section 90 of the Ordinance. All this discussion revolves around a primary question whether or not a settlement can be considered as revocable in substance. This question primarily arises in case of a 'discretionary trust' or in the case of a trust where settler is also the beneficiary. Nevertheless, this matter has also been thrashed out in detail in various decisions of the courts in the UK, India and Pakistan.
The matter as referred above also requires a distinction between a 'discretionary trust' and a 'revocable trust'. This question can be phrased in another manner by saying whether or not a discretionary trust is by nature a revocable trust. This aspect was discussed in the decision of the Supreme Court of India in a case reported as 201 ITR 611. The Supreme Court reproduced the definition of a discretionary trust from Snell's Principles of Equity as under:
"A discretionary trust is one which gives the beneficiary no right to any part of the income of the trust property, but vests in the trustees a discretionary power to pay him, or apply for his benefit, such part of the income they think fit... . The beneficiary thus has no more than a hope that the discretion will be exercised in his favour."
This aforesaid decision and many others on the subject have unequivocally decided that a discretionary trust 'ispo facto' does not make a settlement of the trust as a revocable trust. This particular case law deals with the subject of foreign trust created by a settler. The Gujarat High Court as the decision reported as 326 ITR 594 elaborated the matter on page 624 as under:
"So far as the years under appeals are concerned, the assessee has been seriously challenging inclusion of income from the UK trusts in his hands stating therein that neither distribution has been taken place nor the same has been received by him. The assessee has also produced the accounts of the trusts wherein it is specifically stated that the income has been retained by the trustees and it was brought forward to the next years. It was also stated in such statement of accounts that the tax has been paid by the trustees of the U.K. trusts on the income so earned in the U.K.. It appears that any of the authorities below, including the Tribunal has not considered this vital aspect of the matter and proceeded on the footing that the facts are identical and that the notes are similar to the notes of earlier years. If the income were retained by the trustees and it has not been distributed, nor has it been received by the assessee and no evidence has been brought by the Department to show that the same has been received by the assessee in India, such income cannot be taxed in the hands of the assessee. Section 5 of the Act has also no application. When the income has neither accrued nor received by the assessee, nor has it been received or accrued on his behalf either in India or outside India, such income cannot be taxed under section 166 of the Act as it is not the income receivable. Section 166 of the Act can be invoked only when the income is received by the assessee. Unless and until the trustees exercise the discretion and distribute the income in favour of any of the beneficiaries, ie the assessee, such income cannot be said to be received by the assessee. Taking any view of the matter, it cannot be said that the income has been either received by or accrued to the assessee.
The aforesaid description leads us to the conclusion that an irrevocable trust has been recognized as a valid transfer of assets for income tax purposes also. In this context whilst handling the debate on the Panama Papers and the Paradise Papers there has to be proper apprehension of laws as otherwise a very valid provision of law may be misunderstood. The summary conclusion on the matter is as under:
-If a Pakistani citizen or a tax resident transfers a property within Pakistan or outside Pakistan to an irrevocable trust formed in Pakistan or outside Pakistan then such property does not represent an 'asset' of the settler for tax or any other legal purposes;
-The income arising from the property held outside in a trust formed outside Pakistan does not represent income of the named beneficiary (even if the beneficiary is a tax resident of Pakistan) unless the same is received by that particular beneficiary; and
-A foreign trust, formed outside Pakistan, by a Pakistani citizen holding Pakistani asset is not required to file return of income if there is no Pakistani source of income from a Pakistani asset or assets during the year under consideration.
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TRUST WILL
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Setting up of trust involves No transfer of
transfer of property property is involved
Legal ownership is No transfer of
transferred to the trustees ownership to any person
Settlor, trustee and beneficiary Properties are passed on
- all three roles can be through a WILL which is effective
played by the same person only after the death of the person
Trust can be revoked only if WILL can always be
there is a power contained revoked during the
in the trust deed or if life time of the person
all the beneficiaries agree
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Copyright Business Recorder, 2017