Loss of exemption

Charitable and religious trusts which are eligible for exemption under sections 11 and 12 of the Income-tax Act, would not be entitled to the benefit of such exemption if any of the clauses of section 13(1) are attracted.

Section 13(1) provides for four situations in which the benefit of the exemption would not be available:

1. income from property held in trust for private religious purposes which does not enure for the benefit of the public;
2. income of a charitable trust/institution created/established after 1-4-1962 for the benefit of any particular religious community or caste;
3. any income of a charitable/religious trust/institution if any part of such income or any property of the trust is used or applied directly or indirectly for the benefit of persons specified in section 13(3) during the previous year; and
4. any income of a charitable/religious trust/institution if, for any period during the previous year, the trust/institution has not complied with the investment pattern under the provisions of section 13(1)(d) read with section 11(5).

Each of these aspects is analysed further in this article.

section 13 also contains other clarificatory provisions, such as sub-section (7), which clarifies that anonymous donations referred to in section 115 BBC would not be entitled to the benefit of the exemption under sections 11 and 12, and sub-section (6), which clarifies that in the case of a charitable/religious trust running an educational/medical institution/hospital, if the provisions of section 12(2) regarding taxation of medical or educational services being made available to any specified person are attracted, only the value of such services would lose the benefit of such exemption and not any other income.

Private Religious Trusts – S. 13(1)(a)

Section 13(1)(a) denies the benefit of exemption to income of private religious trusts. The need for this clause is on account of the fact that unlike charitable purpose, which is defined in section 2(15), there is no definition of religious purpose in the Income-tax Act. Further, charity by its very nature, as considered in tax laws, has to be for the benefit of the public or a section of the public, whereas religion could be for the benefit of the individual or certain specified individuals, and not necessarily for the public or a section of the public. The intention of the legislature is clearly that charitable or religious trusts which are for the benefit of the public or a section of the public alone should be entitled to the benefit of the exemption, and not trusts which are for certain specified individuals.

Had this prohibition not been contained in the Act, it may have been possible for any person to create a trust in respect of his own deity, which was being worshipped only by him and his family, and claim the exemption in respect of such a trust. Therefore, religious trusts which are primarily for private worship by certain members of a family, etc cannot claim the benefit of any exemption, if the trust is essentially for private religious purposes, even though members of the public may be allowed access for worship of the deity on certain festival occasions.

Charitable Trusts for particular Religious Community/Caste – S. 13(1)(b)

The benefit of the exemption under sections 11 and 12 is available to both charitable and religious trusts. section 13(1)(b) prohibits the exemption for a charitable trust set up for the benefit of any particular religious community or caste, if the trust was set up after 1-4-1962. Explanation 2 to section 13 clarifies that a trust/institution created/established for the benefit of scheduled castes, backward classes, scheduled tribes or women and children shall not be deemed to be a trust/institution created/established for the benefit of a religious community or caste.

An interesting question which therefore arises is whether a trust created for the benefit of, for example, Muslim orphans would be hit by the prohibition of section 13(1)(b). One view of the matter is that on account of the Explanation 2 to section 13, such a trust is not impacted by section 13(1)(b). However, if one looks carefully at the Explanation, the Explanation merely provides that the categories stated therein should not be regarded as religious community/caste. Therefore, children should not be regarded as a community/caste, and if the trust was for the benefit of all children, there would have been no difficulty. The fact that the trust is for the benefit of only Muslim children would attract the provisions of section 13(1)(b), and result in denial of the benefit of exemption.

Section 13(1)(b) does not affect trusts which are created prior to 1-4-1962, the date of commencement of the Income-tax Act, 1961. Therefore, the charitable trusts created more than 50 years before for the benefit of, say Parsis or any other communities, would not be affected by this provision. This provision also applies only to charitable trusts, and not to religious trusts, since religious trusts, by their very nature, can only be for the benefit of a particular religious community. Therefore, even if a religious trust is set up after 1-4-1962, such a trust would not be affected by this provision.

Interestingly, the courts have taken the view that this provision also does not apply to a trust which is partly charitable and partly religious in nature, since the very nature of a partly religious trust is that it is bound to be for the benefit of a particular religious community. The courts have held that section 13(1)(b) applies only to purely charitable trusts [CIT vs. Barkate Saifiyah Society 213 ITR 492 (Guj), CIT vs. Chandra Charitable Trust 294 ITR 86 (Guj)].

Benefit to Specified Persons – S. 13(1)(c)

Unlike the provisions of the preceding two clauses of section 13(1), on application of which the trust is either entitled to the exemption every year or not entitled to the exemption at all, the applicability of this clause of section 13 has to be seen every year. This provision applies to both charitable as well as religious trusts, and gets attracted if a benefit has been given to any specified person during a previous year. If such benefit has been provided to such a person, the exemption is lost for that particular year under this provision. In fact, a large part of the audit report in Form 10B that has to be furnished under section 12A requires the auditor to express whether there has been any transaction which could possibly attract the provisions of section 13(1)(c).

The list of specified persons is contained in section 13(3), and includes the author/founder of the trust/institution, substantial donors who have made donations up to the end of the year exceeding Rs. 50,000, any member of an HUF which is an author/founder/substantial donor of the trust/institution, any trustee or manager, any relative of any such person, and any concern in which any such person has a substantial interest.

For the purpose of considering whether a person is a substantial donor, the total of all donations made by the person since the inception of the trust are to be taken into consideration. Practically, it is difficult to compile a list of such donors, particularly in the case of trusts which have been in existence for a long time. Therefore, generally, in accordance with the ICAI Guidance Note relating to such audits, auditors rely upon the list of such donors provided by the trustees and restrict their verification to such list with suitable disclosures.

This limit of cumulative donations of Rs. 50,000 has been in existence since 1995, when the limit was raised from Rs. 25,000. Considering the current value of Rs. 50,000, it is high time that such limit was enhanced to a more reasonable limit of at least Rs. 2,00,000, if not more. Further, given the practical difficulty of compiling a list of such substantial donors in cases of trusts which have been in existence for decades, if not for more than a century, the law really ought to have required consideration of the cumulative donations only during the 10 years preceding the relevant year and during that year itself.

Surely, if a person wants to obtain certain benefits from a charitable trust, he would not make a donation for that purpose 10 years in advance! Even the Income Tax Department does not retain its records of more than 6 years before. How can it therefore expect trusts, with their limited infrastructure, to keep such records of donors for decades?

Section 13(2) deems the income or property of the trust to have been used or applied for the benefit of such a person in the following situations:

1. if any part of the income/property of the trust is lent or continues to be lent to such person during the year without either adequate security, adequate interest or both;
2. if any land, building or other property of the trust is or continues to be made available for the use of any such person for any period during the previous year without charging adequate rent or other compensation;
3. if any salary, allowance or other payment is made to any such person during the year for services rendered by him to the trust, such payments being in excess of the reasonable payment for such services;
4. if the services of the trust are made available during the years to such person without adequate remuneration or compensation;
5. if any share, security or other property is purchased by the trust during the year from such person for consideration which is more than adequate;
6. if any shares, security or other property is sold by the trust during the year to such person for consideration which is less than adequate;
7. if any income or property of the trust is diverted during the year in favour of any such person, where the income or value of the property so diverted exceeds Rs. 1,000;
8. if any funds of the trust are or continue to remain invested for any period during the year in any concern in which any such person has a substantial interest.

If one examines the above provisions, one notices that there is some element of subjectivity to determine the reasonableness or adequacy of the compensation/ remuneration, etc. What is reasonable under the circumstances is often a matter of debate. This has resulted in unnecessary litigation. Unfortunately, other than the threshold of Rs. 1,000 under clause (g), there is no threshold limit for these provisions to apply. Had the legislature provided some threshold, it would have substantially reduced litigation in this regard.

To some extent, section 13(4) does lay down a threshold for the purposes of section 13(2)(h), of aggregate investment by the trust of its funds in a concern in which such person is interested, of 5% of the capital of the concern. It provides that if such investment is less than 5% of the capital, the loss of exemption will be restricted to the income from such investment and will not apply to the remaining income, which will continue to have the benefit of exemption. However, it may be noted that section 13(4) is subject to the provisions of section 13(1)(d), which provides for loss of exemption in the event that the investment pattern is not in accordance with the prescribed investments.

Interestingly, in the context of section 13(2)(h), the courts have interpreted the term 'funds are invested' as meaning a positive act of investment of monies by the trust. The courts have therefore held that the prohibition of section 13(2)(h) would not apply to investments received by the trust by way of donation, as there is no investment of funds by the trust in such a case [Trustees of Mangaldas N. Varma Charitable Trust vs. CIT 207 ITR 332 (Bom), CIT vs. Insaaniyat Trust 173 ITR 248(Guj), etc]. Similarly, a view has been taken in the context of section 13(2)(a), that if a trust received a deposit with a company as a donation, it did not amount to lending of the funds, property or income of the trust [CIT vs. Pittie Charitable Trust 207 ITR 1053 (Bom)].

Some of the instances where the courts have held that the provisions of section 13(1)(c) were attracted are:

1. In DIT(E) vs. Bharat Diamond Bourse 259 ITR 280, the Supreme Court held that income was utilized for benefit of the founder who was a subscriber to Memorandum of Association, by money being lent to the subscriber without adequate security or interest. The facts showed that the amount paid to the founder was not by way of deposit but was an advance to enable him to purchase a property in his own name.
2. In Ram Bhawan Dharmashala vs. State of Rajasthan 258 ITR 725 (Raj), the Rajasthan High Court held that when the finding of the lower authorities was that rent of that portion of the Trust property, which had been given to a firm, in which one of the Trustees of the assessee-trust was a partner, was inadequate, the trust was not entitled to exemption u/s. 11 of the Income-tax Act.
3. The Andhra Pradesh High Court held in Action for Welfare and Awakening Rural Environment (AWARE) vs. DCIT 263 ITR 43 (AP) that as funds of the society were used for personal gain of Chairman and member as shown by material on record, the assessment denying exemption was valid.
4. In CIT vs. VGP Foundation 262 ITR 187, the Madras High Court held that, where the Trust had advanced money to concerns in which Trustees had substantial interest and of which they were Directors, and the advance which was for construction of hospital was not utilized during the relevant accounting year, the Trust was not entitled to exemption.
5. In the case of Champa Charitable Trust vs. CIT 214 ITR 764, the Bombay High Court held that a trust is also a person within the meaning of s. 2(31). Therefore, when the assessee trust gave a donation to another trust from which it had earlier received a donation, section 13(1)(c) was attracted and the trust was not entitled to exemption under section 11.

Some instances where the courts have taken a view that the provisions of section 13(1)(c) were not attracted are:

1. In CIT vs. Shreeram Memorial Foundation 269 ITR 35, the Delhi High Court held that as the Trust had given loan without adequate security but the loan was not large and interest was adequate, exemption was granted.
2. The Gujarat High Court in CIT vs. Sarladevi Sarabhai Trust No. 2 172 ITR 698 has held that where a charitable trust donates an amount to the corpus of another charitable trust, which had been created by the same group of persons, s. 13(2)(h) would not apply.
3. In Shree Poongalia Jain Shwetamber Mandir vs. CIT 168 ITR 516 (Raj), amounts were lent to a firm in which Trustees were Partners, the firm had created Equitable Mortgage of immovable properties belonging to it and the rate of interest was equal to that charged by Banks on deposits. It was held that withdrawal of exemption was not justified.
4. Where the benefit of the trust is availed of by employees of the settlor as members of the public, exemption cannot be denied to the trust, as employees are not specified persons [CIT vs. Tata Steel Charitable Trust 203 ITR 764 (Pat)].

A charitable or religious trust forfeiting exemption by virtue of section 13(1)(c) will be liable to tax at the maximum marginal rate, on account of the proviso to section 164(2).

Non-compliance with Investment Pattern – S. 13(1)(d)

Section 13(1)(d) provides for loss of exemption on account of non-compliance with the investment pattern. The various clauses of this provision providing for such loss of exemption are in the following situations if for any period during the year:

1. Any funds of the trust are invested or deposited otherwise than in the forms or modes specified in section 11(5);
2. any shares in a company, other than shares in a public sector company or shares referred to in section 11(5)(xii) are held by the trust;

The permitted list of investments as per section 11(5) is as under:

1. Saving certificates, as defined in section 2(c) of the Government Saving Certificates Act, 1958 and any other securities or certificates issued by the Central Government under the Small Savings Scheme.
2. Deposit in any account with the Post Office Savings Bank.
3. Deposits in any account with a Scheduled bank, i.e., State Bank of India or any nationalised bank or any other bank included in the Second Schedule to the Reserve Bank of India Act, 1934 or with a co-operative society engaged in carrying on the business of banking (including a co-operative land mortgage bank or a co-operative land development bank).
4. Units of the Unit Trust of India.
5. Central or State Government securities.
6. Debentures, both the principal whereof and the interest where on are fully and unconditionally guaranteed by the Central/State Government.
7. Investment or deposit in any Public Sector Company. Where a charitable trust had invested its income in shares of a public sector company, which ceases to be such owing to disinvestment by the Government, the exemption will continue to be available for three years from the date of such cessation. Where the investment is by way of deposits etc., the exemption will continue till the date of maturity of the deposit or the other investment, as the case may be.
8. Bonds issued by a financial corporation, which is included in providing long-term finance for industrial development in India and which is approved by the Central Government for the purposes of section 36(1)(viii) of the Act.
9. Bonds issued by a Public company formed and registered in India with the main object of carrying on the business of providing long-term finance for construction or purchase of houses in India for residential purpose and which company is approved by the Central Government for the purposes of section 36(1)(viii) of the Act.
10. Immovable property, not including any machinery or plant other than machinery or plant installed in a building for the convenient occupation of the building.
11. Deposit with the Industrial Development Bank of India.
12. Deposits with or investments in any bonds issued by a public company formed and registered in India with the main object of carrying on the business of providing long-term finance (repayment with interest in 5 or more years) for urban infrastructure in India (project for providing portable water supply, sanitation, sewerage, drainage, solid waste management, roads, bridges and flyovers for urban transport)
13. Any other form or mode of investment or deposit as may be prescribed. Rule 17C specifies the following other modes:

a. Investment in Units issued under any scheme of Mutual Funds referred to section 10(23D):

b. Any transfer of deposit to Public Account of India;

c. Deposits made with an authority constituted in India by or under any law enacted either for the purpose of dealing with and satisfying the need for housing accommodation or for the purpose of planning, development or improvement of cities, towns and villages or for both;

d. investment by way of acquiring equity shares of a depository as defined in section 2(1)(e) of the Depositories Act, 1996;

e. investment made by a Recognised stock exchange referred to in section 2(f) of the Securities Contracts (Regulation) Act, 1956, (hereafter referred to as investor) in the equity share capital of a company (hereafter referred to as investee)—

(A) which is engaged in dealing with securities or mainly associated with the securities market;

(B) whose main object is to acquire the membership of another recognised stock exchange for the sole purpose of facilitating the members of the investor to trade on the said stock exchange through the investee in accordance with the directions or guidelines issued under the Securities and Exchange Board of India Act, 1992 by the Securities and Exchange Board of India established under section 3 of that Act ; and

(C) in which at least fifty-one per cent of equity shares are held by the investor and the balance equity shares are held by members of such investors.

f. investment by way of acquiring equity shares of an incubatee (notified by the Ministry of Science and Technology, Government of India) by an incubator (Technology Business Incubator or Science and Technology Entrepreneurship Park notified by the Ministry of Science and Technology, Government of India).

A few points which may be noted in connection with the above list of permitted investments are:

1. Indira Vikas Patras and Kisan Vikas Patras are saving certificates and are therefore permitted investments as clarified by CBDT circular number 566 dated 17-7-1990.

2. Units of all schemes of mutual funds are eligible investments.

3. The above list is that of permitted investments. A loan is not an investment, as held by the Delhi High Court in case of DIT(E) vs. Alarippu 244 ITR 358.

4. While the prohibition for all investments (other than shares) is on investing in assets other than those specified in section 11(5), the prohibition in respect of shares is on holding of such shares. Therefore, prohibited investments other than shares received by way of donation would not be hit by the prohibition of section 13(1)(d), since there is no positive act of investment by the trust. In case of shares, the prohibition would apply even for shares received by way of donation, which are held by the trust.

5. Deposits with a scheduled bank would include deposits with Indian branches of foreign banks listed in Schedule II to the Reserve Bank of India Act, with co-operative banks which are scheduled banks, and would include current accounts [ADIT vs. Murugappa Chettiar Trust 303 ITR 361 (Mad)], savings accounts, and recurring deposits, besides fixed deposits.

The proviso to S. 13(1)(d) exempts the following assets from this requirement of permitted investments. These assets which can continue to be held in the non-specified form are:

i. any assets forming part of the corpus of the trust as on 1st June, 1973;

ii. any bonus shares received on such shares forming part of the corpus referred to above;

iii. any debentures issued by a company acquired by the trust before 1st March, 1983;

iv. any asset not specified in section 11(5) which is not continued to be held as such beyond the expiry of one year from the end of the year in which the asset was acquired;

v. any funds representing the profits and gains of business, provided separate books of account are maintained in respect of such business.

Therefore, if a trust invests by mistake into an investment which is not in accordance with section 11(5), it would not lose exemption if it disposes of such investment by the end of the year following the year in which the investment was made. Even if shares are received by way of donation by the trust, the trust can dispose of the shares within the same year or the next year and still retain the benefit of exemption.

In the event that the trust loses the exemption under sections 11 and 12 by virtue of the provisions of section 13(1)(d), the question arises as to what is the rate of tax applicable to such income. From the language of section 13(1)(d), it is clear that the entire income of the trust loses exemption. However, it is only the income from such prohibited investment that is taxable at the maximum marginal rate under the proviso to section 164(2), and the balance income is taxable at the slab rates applicable to an association of persons. This view is supported by paragraph 28.6 of the CBDT circular no. 387 dated 6-7-1984, where it has been clarified that “the maximum rate of income tax would apply only to that part of the income which has forfeited the exemption under the said provisions”, and by the decision of the Bombay High Court in the case of DIT(E)

Article by Mr. Gautham Nayak, a renowed Chartered Accountant