Family Arrangements and Taxation – An Eternal Saga?

Concept of Family Arrangement

In India, majority of the businesses have traditionally been seeded by a family and the baton of management and control of such business is passed to the members of the same family across multiple generations. Further, in the Indian scenario, often, several unrelated businesses are housed in a single vehicle (such as a common holding company) but are distinctively managed and controlled by different members of family with no interference from the other family members.

Therefore, more often than not, owing to the family sensitivities (such as mismatch of inter-generational ideology, style of management and control, lifestyle, etc.) being interwoven into the business fabric, possibility of a dispute is inevitable. Further, it may so happen that certain family members are active participants in the daily functioning of the business while certain family members, although not active, may enjoy economic benefits from the profits of such businesses due to their holding of shares in the holding company leading to a rift between the active and the passive family members. These issues coupled with a fear of potential future disputes may negatively impact the strategic and tactical functioning of such businesses.

Therefore, in order to settle such existing disputes or avoid any potential litigation among the family members, such families arrive at a “family arrangement” either by way of a mutually agreed deed for family settlement or in the form of an arbitration award or a court decree.

Such family arrangements serve two purposes: firstly, the ownership of businesses is sought to be aligned with the family members who manage and control such respective businesses; and secondly, the umbilical cord between the shareholding of the passive family members and the family holding vehicle is sought to be broken by way of settlement in cash to such passive family members. While achieving the aforementioned purposes, family arrangements seek to ultimately secure the peace and harmony within the family.

However, such family arrangements face an uphill task of execution owing to a complex tax and regulatory scenario in India. This article focusses on various tax issues in the context of family arrangements and the stand taken by various Courts in India.

Broad Contours of Income-tax Act, 1961 (“Act) vis-à-vis Family Arrangements

Generally, family arrangements could be divided into two main baskets:

Inter-se transfer of properties or cash settlement between family members; or

Transfer of assets or businesses or shares of operating company from a common holding company to respective family members who manage and control such businesses or companies.

Such transfers would mostly be at a much lower or higher valuation arrived at pursuant to a settlement between the family members and would not generally reflect the fair market value of the underlying assets or businesses. This is due to the fact that transfers pursuant to a family arrangement would mainly seek to align the antecedent interests of the respective family members with the assets/ businesses/ operating companies being transferred and would not be normal transfers as generally understood in a commercial sense.

Therefore, this valuation mismatch has historically led to litigation both from the transferor’s perspective (i.e. the holding companies) and also from the transferee’s perspective (i.e. the recipient family members or any holding company incorporated by such family members). The tax department has sought to tax such transfers to capital gains tax u/s 45 of the Act considering that such transfers fall within the definition of “transfer” u/s 45 of the Act. Further, the tax department has also sought to tax such receipt of property for inadequate consideration (vis-à-vis its fair market value) as receipt of “gift” and this latter aspect is now further compounded by section 56 of the Act, if the recipient family member is not a “relative” as defined under the said section.

Wearing the lens of a Transferor – whether “transfer”?

Scenario 1: Inter-se transfer between individual family members

If we consider the first scenario i.e. inter-se transfer of property (which may include shares, securities, immovable properties, paintings, etc.) between the individual family members, it is a settled position that a transfer pursuant to a bona fide family arrangement entered into between the individual family members could not be called as a “transfer” within the meaning of section 2(47) of the Act  and therefore, any capital gains which may arise in the hands of the transferor should not be exigible to capital gains tax u/s 45 of the Act.

As a corollary, once it is established that such transfer of properties is not a “transfer” which is exigible to capital gains tax u/s 45 of the Act, none of the other deeming fictions such as section 50C or 50CA of the Act (to impute the fair market value of unlisted shares and land or building as deemed consideration) should trigger despite the fact that such transfer may be at a lower valuation than the fair market value.

Further, it has also been held that the word ‘family’ in the context of a family arrangement is not to be understood in a narrow sense[1] of being a group of persons who are recognized in law as having a right of succession or having a claim to a share in the property in dispute. The term “family” has to be understood in a wider sense so as to include within its fold not only close relations or legal heirs, but even those persons who may have some sort of antecedent title, a semblance of a claim or even if they have a spes successionis, so that future or existing disputes are sealed for ever. The Courts have, therefore, leaned in favour of upholding a family arrangement instead of disturbing the same on technical or trivial grounds.

However, notwithstanding the settled position, time and again, litigation has arisen in relation to transfers to family members especially when an antecedent title between the family members is not established or which involves cases elaborated in Scenario 2 hereunder. 

Scenario 2: Transfer of assets or businesses or shares of operating company from a common holding company to respective family members who manage and control such businesses or companies

Most of the businesses are either operated through a common holding company or operating companies owned by such common holding company as opposed to such businesses being operated directly by the individual family members directly. It is also obvious that bulk of the family wealth would be derived from such businesses operated through such common holding company.

Therefore, as noted above, if the family arrangement involves inter-se transfer of shares of such common holding company between the family members, such settlement should not be considered as “transfer” within the meaning of section 2(47) of the Act. However, litigation arises when the common holding company transfers such assets/ businesses/ shares of operating companies. This is due to the fact that a “company” has a separate corporate existence and is distinct from its members. In a recent case of B.A. Mohota Textiles Traders (P.) Ltd. [TS-234-HC-2017(BOM)], the Bombay High Court any transfer of shares by a “company” would not be the same as transfer by its “members” despite the fact that such transfer by the company is pursuant to a family arrangement (by way of an arbitration award) between the family members. Therefore, while noting that any inter-se transfers between the family members pursuant to a family arrangement would not be considered as “transfer”, any transfer by a company (having a distinct identity) would nonetheless be considered as “transfer” and therefore, be exigible to capital gains tax u/s 45 of the Act on the difference between the consideration charged and the cost of acquisition (as indexed).

As a corollary, if the transfer concerns transfer of shares of unlisted companies or immovable property and the said transfer is at a lower valuation than Rule 11UA valuation (in case of unlisted companies) or the reckoner value (in case of immovable property), then the said Rule 11UA valuation or the reckoner value, as the case may be, would be deemed as consideration for such transfers.

However, it is to be noted that in the aforementioned case, it was not clear if the approval of the members of the transferor companies was required prior to the transfer of such shares. Therefore, one could contend that if any approval of members is required for transfer of properties (such as approval u/s 188 of the Companies Act, 2013 for transfers between related parties or u/s 230-232 for transfers pursuant to a Scheme of Arrangement involving mergers/ demergers) and if the members are obligated to vote in a particular manner, as dictated by the terms of the family arrangement, such transfers by companies should not be considered as “transfer” u/s 2(47) of the Act as it could be contended that such transfers are effectively at the behest of the family members and not that of the companies.

Wearing the lens of a Transferee – whether receipt without “inadequate consideration”?

From the transferee’s perspective, if the property is received for inadequate monetary consideration, then the next aspect which would need to be dealt with is whether deemed income provisions u/s 56(2)(x) of the Act would get triggered. (Section 56(2)(x) of the Act was introduced vide Finance Act, 2017 with effect from 1 April 2017).

The Memorandum to Finance Bill, 2017 explained that section 56(2)(x) of the Act sought to widen the scope of section 56(2)(vii) and section 56(2) (viia) of the Act in order to tax receipt of any property or sum of money from any person by any person for inadequate consideration. Referring further to the legislative intent of introducing section 56(2) (vii) and section 56(2) (viia) of the Act, the Memorandum to the Finance Bill, 2010 explained that the provisions of section 56(2)(vii) of the Act were introduced as a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts, particularly after abolition of the Gift Tax Act, 1958. The provisions were intended to extend the tax net to such transactions in kind. Thus, the intention to introduce section 56(2)(vii) was to cover only property which is transferred under garb of gifts and was introduced as an “Anti-Abuse Measures”, which as the nomenclature connotes, covers specific provision the practice of avoidance of tax by the assessee through artificial means.

However, in case of a bona fide family arrangement, the main objective is to secure and maintain peace and harmony within the family. Various judicial precedents[2] in the context of Gift Tax Act, 1958 held that gift-tax under the said law should not be triggered in case of a bona fide family arrangement entered voluntarily between the family members. Therefore, section 56(2)(x) of the Act should not apply since the said section is a specific section to curb anti-avoidance tax practices and should not extend to genuine family arrangements.

Further, even for the sake of argument, one were to contend that the provisions of section 56(2)(x) of the Act were attracted in case of family arrangements, the next test would be satisfy if the receipt of property pursuant to a family settlement is indeed “without adequate consideration”.

In this context it is pertinent to note that the word “monetary” or “money or money’s worth” in relation to the term “consideration” is conspicuously absent. Therefore, it could be construed that the purview of the term “consideration” used in relation to section 56(2)(x) of the Act is wider than merely “monetary consideration”.

Further, in the context of the erstwhile Gift Tax Act, 1958, various judicial precedents[3] have held that a transfer under a family arrangement should not be considered as a transfer without consideration since the non-monetary consideration in a case of “family arrangement or settlement” should be construed as prevention of any protracted litigation and for preserving the family property, or the peace and security of the family and avoiding litigation, or for saving its honour. Therefore, owing to adequacy of consideration, albeit non-monetary, any receipt of property pursuant to a family arrangement should not trigger provisions of section 56(2)(x) of the Act. However, if such receipt is by a company (and not an individual family member), then such receipt may be subject to tax u/s 56(2)(x) of the Act on the lines of what was held by the Bombay High Court in the case of B.A. Mohota Textiles (P.) Ltd., as discussed above.

Family Arrangements: Summing up

As discussed, above while there are host of judicial precedents available for inter-se transfer of properties or cash settlement between individual family members, there could be challenges when a company is involved directly or indirectly to effectuate the transfer of properties/ businesses/ shares held by such holding companies. Further, owing to the section 45 of the Act from a transferor’s perspective and section 56 from the transferee’s perspective, it could result in double taxation in the hands of two persons if the transfer of property is at a lower valuation than a fair market value and such fair valuation is deemed as consideration in the hands of the transferor.

However, given the fact that businesses in India are family-driven and such businesses are spread across multiple generations, the possibility of a family arrangement is inevitable for the reasons noted earlier. Therefore, a clarity in the income-tax law in this regard would be welcome and transfers pursuant to genuine family arrangements should not further be marred by lack of clarity in this regard.

Further, also from the perspective of regulatory laws (such as the SEBI Takeover Code, Competition Law, etc.) since the same would most likely result in change of control various family companies from joint to sole, exemption from the rigours of open offer obligations under the SEBI Takeover Code or a prior approval of the Competition Commission of India under the Competition Act, 2002 would be a welcome change.

Thus, a synchronised reform both in the tax and regulatory laws is a need of the hour and could serve as a bedrock to smoothen the process of family arrangements.

This article has been co-authored by Mr. Binoy Parikh.

[1] Madras High Court in the case of CIT v. Kay Arr Enterprises [TS-5560-HC-2007(MADRAS)-O]

[2] Madras High Court in the case of CGT v. D. Nagarathinam [2003]

Delhi High Court in the case of CWT v. Santokh Singh [TS-5243-HC-2001(DELHI)-O]

Gauhati High Court in the case of Ziauddin Ahmed v. CGT [TS-5414-HC-1975(GAUHATI)-O]

Chennai Tribunal in the case of Smt. A. Omera Parvez/ Smt. Shameena Banu/ Smt. Ameera Parvez/ Smt. A. Ameena Begum v. GTO [TS-5471-ITAT-1982(MADRAS)-O]

[3] Madras High Court in the case of CGT v. Pappathi Anni [1981]

Bombay High Court in the case of Pannalal Silk Mills (P.) Lts. V. CIT [2012]