Tired after a day-long work, when I reached home, I saw a huge gathering outside my neighbour’s house. Wondering what had happened, I went to his house, just to realize that my neighbour’s uncle, who recently expired, had left behind a fortune for him. Like a good neighbour, I took him through the entire process of taxation of inheritance, leaving him daunting and gloomy.
A number of jurisdictions impose inheritance and estate taxes on transfer of property to a legal heir. India does not impose any inheritance or estate taxes. In case of death of an individual, his property/assets get transferred to the legal heir through a mutation, without triggering any inheritance or estate taxes. As per the Indian tax system, a transfer of property under a will does not trigger any income-tax. However, capital gains on sale of an inherited property would be computed with reference to the cost of acquisition of the deceased (actual cost or the fair market value as on 1 April 1981, whichever is higher). As per the proposed Direct Taxes Code (DTC), the capital gain is to be computed with reference to the fair market value on 1 April 2000. Therefore, Indian resident taxpayers are likely to be benefited by the changes proposed in the DTC with regard to taxation of gain on sale of inherited property.
In the liberalized exchange control regime, Indians are permitted to remit money to purchase property outside India. Further, with a large number of non-resident Indians returning to India to settle down, the population of Indians owning property abroad is on the rise. This trend has opened up a new issue that Indians were hitherto insulated from. The issue is pertaining to inheritance and estate taxes in other countries.
Difference between inheritance and estate taxes
Though India does not impose inheritance and estate taxes, a number of jurisdictions impose such taxes. Colloquially, inheritance tax and estate tax are used interchangeably. However, there is a slight difference between the two. While estate tax is a tax on the estate of the deceased payable only by the executor, inheritance tax is a tax liability of the inheritor individually. Most jurisdictions exempt transfer of property to the spouse from inheritance and estate taxes. If, under a will, the property needs to be transferred to any other person, the owner of the property needs to be aware of the potential risk of inheritance or estate taxes.
Inheritance tax is applicable in countries such as the Republic of Ireland, the UK, and the US. In the US, inheritance tax can also vary from state to state. In places such as Bermuda, there is an increased levy of stamp duty and in Canada, death increases the charge to capital gains tax. All these are broadly treated as forms of inheritance tax. Under some jurisdictions transfer of property upon death of the individual may trigger gift tax as in the case of Austria. Careful planning of investments in these countries could help mitigate inheritance taxes in these countries.
Illustration: Shyamal Banerjee/Mint
How to plan estate tax
Set up a trust: So, is there a way out, asked my neighbour. I explained him that one of the ways of planning one’s estate taxes is to set up a “trust” in which the individual sets aside assets in a trust rather than directly bequeathing the asset to his/her spouse/children. Though there is an exemption for transfers to a spouse, ultimately estate taxes may arise when the asset is bequeathed to the next generation. Typically, the surviving spouse becomes the “income beneficiary” of the trust and the children of the couple ultimately receive the “principal.” This structure can be implemented through an irrevocable trust created by the individual making his/her children the beneficiaries of the “principal”. Contribution to an irrevocable trust may not trigger Indian taxes, if appropriately structured.
Contribution to an Indian partnership firm: Alternatively, estate tax mitigation could be achieved through contribution of the assets to an Indian partnership firm, where the individual and his/her legal heirs are partners in the desired ratio. Contribution to a partnership firm may not be taxable in the hands of the individual. Upon the death of the individual, the surviving partners may get ownership interest in the assets automatically.
Gifting assets: Another possible structure for mitigating estate taxes would be to gift the asset, during the lifetime of the individual. Most countries have a window (in value terms) within which gift tax may not apply or even if it does, the tax rates may be usually lower than estate or inheritance taxes. Making use of low valuation of the property and gifting the asset at the right time may help mitigate estate taxes significantly.
It is evident that proper planning of global assets may help mitigate inheritance and estate taxes. Apart from Indian tax considerations, the tax laws in other countries may be very critical to design the appropriate structure for optimum results. Therefore, it may be prudent to design the optimum structure at the time of purchase of any foreign assets, including immovable properties and life insurance policies, among others, to plan for possible tax exposure to your legal heirs.
Sonu Iyer is tax partner, Ernst & Young.