Tribunal gives tax relief for trusts investing in pass-through certificates

In a significant relief for trusts, the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) has upheld that tax liability of revenue generated via investment in pass-through certificates (PTCs) should fall upon investors and not the trust.

A large number of Mutual Funds (MFs) were investors in PTCs issued by Trusts.

Since MFs are exempt from any tax on income earned from PTCs, the department had sought to recover the tax from the trust but stating that it had made income. The trusts said that they had passed on the income to MFs and other investors holding their PTCs. MFs had backed off from investing in PTCs after the controversy, experts said.

Pass-through certificates

PTCs are instruments where mortgage back securities issued by lenders to private companies are underlying. The parent company, which holds the mortgage, sets up a special purpose vehicle (SPV) a trust that in turn issues the PTCs to MFs and other financial institutions. The MFs hold these PTCs and income from them is transferred to investor accounts. More than 40 MF schemes had invested thousands of crore in PTCs a few years ago but in 2012 income tax department sent notices to several trusts seeking tax on income from PTCs.

The trusts argued that income from PTCs were transferred to investor funds and hence the tax will not fall upon them but their investors holding PTCs. This argument has now been upheld.

The ITAT was hearing the case involving Mumbai-based India SME Asset Reconstruction Company (ISARC) and the tax department. In the instant case, the tax assessment officer (AO) observed that the investors comprising of two or more persons had come together for contribution of sufficient funds into an entity in order to invest in the specific entities with a sole intention to earn profits and accordingly the said entity should be construed as an ‘Association of Persons (AOP)’ and not Trust. Hence the AO observed that the assessee is not entitled for exemption from tax.

The AO observed that there was no ‘trust property’ to which the trustee needed to manage. The AO found that the trust created herein was an SPV for doing commercial transactions and further observed that the trust is not a revocable trust within the meaning of sections 61 to 63 of the Income Tax Act. Accordingly, the AO invoked the provisions of section 161(1A) of the Act by treating the assessee as an AOP as against the status of ‘Trust’ claimed by the assessee.

However, ITAT dismissed the OA’s arguments and held that all the beneficiaries of the trust were identifiable, traceable, assessable with their respective shares being determinate and were known.