The formal regulated education sector in India broadly comprises of schools (often classified as K-12 – kindergarten to 12th) and higher education institutions. While India has been proactive on liberalization, the education sector has remained largely untouched by the reforms process. Archaic legislations mandate all formal educational institutions in India to be run as ‘not-for-profit’ centres by not-for-profit entities viz. a society, trust or a section 25 company. Any surplus funds generated in the process of running K-12 schools or higher educational institutions have to be ploughed back into the same school or educational institutions under the same trust and no dividends can be distributed to the members of the not-for-profit entities. Further, the constitution of the trust/society should be such that it does not vest control in a single individual or members of a family, i.e., the trust/society should not be proprietary in character and the educational institutions should operate in ‘not for-profit’ mode.
The ‘not-for-profit’ mandate is the single largest deterrent that has kept serious corporate activity at bay in the otherwise attractive K-12 segment. Most schools in India are standalone and any chains till recently were usually set up by private charitable, political and/or religious groups – including Vidya Bharti schools (affiliated to the right wing political organization RSS) with more than 18,000 schools, Dayanand Anglo Vedic (DAV) schools with approximately 600 schools and Chinmaya Vidyalaya with approximately 75 schools among others.
Of late, corporate houses looking to transform K-12 schools into ‘profit-making’ proposition have been using indirect means like lease rentals, management fees, fees for providing support and ancillary services etc. to extract the surplus locked in the trust. Taking a cue from these schools, the Indian education sector has been witnessing some corporate activity in the K-12 space on similar lines, but in formal version of these age-old structures. Stringent regulations are being dealt through an innovative two-tier structure, which complies with the ‘trust’ regulations and enables promoters (on corporate level) to generate profits from the venture. In this way, the ‘surplus’ profit flows to the services entity in the form of rental/fees for providing the land and services and is at the company’s disposal to be then distributed as dividend or used to fund another venture.
It is however important that the relationship between the trust and the associate services company and the infrastructure and management company should be carefully structured so that it conforms to the education and tax rules and regulations.
A charitable institution such as the trust is entitled to exemptions from income tax in terms of section 11 of the Income Tax Act, 1961 (“IT Act”) subject to compliance with the requirements enumerated therein. The income of the trust which is exempted from tax includes the income derived from property, held under trust wholly for charitable or religious purposes to the extent to which the income is applied in India.
The terms ‘property held under trust’ include a business undertaking whose business is incidental to the attainment of the objectives of the trust and separate books of accounts are maintained by such trust in respect of such business. For purposes of claiming exemption, 85% of the total income of the trust is required to be applied towards the object of the trust itself and the trust must not accumulate more than 15% of the income as the excess accumulation, if any, will be liable to income tax.
To avail tax exemptions from income generated by the trust from running and operating schools, the trust would need to ensure that the predominant activity of the trust is to serve a charitable purpose of promotion of education and not earn profit. The trust can charge a reasonable fee from the students as earning of profits per se does not vitiate exemption granted by the tax authorities. The Supreme Court of India confirms this view by holding that “the decision on the fee to be charged must necessarily be left to the private educational institution that does not seek or is not dependent upon any funds from the government.”
However corporate structuring should evaluate the implications of section 13(1)(c) of the IT Act. In the event part of the income or any property of the concerned trust is during the previous year used or applied, directly or indirectly, for the benefit of certain persons such as the author/founder of trust; any trustee or manager of trust; any relative of any author/founder; or any concern in which any of the persons has a substantial interest (“Concerned Persons”), then such income so used or applied will not be excluded from the total income of trust for the previous year.
Income or property of trust will be deemed to have been used or applied for the benefit of the Concerned Persons, inter alia, if -
(i) any part of the income or property of the trust is or continues to be lent to any of the Concerned Persons without any adequate security or interest or both;
(ii) any land, building or other property of the trust is or continues to be made available to any of the Concerned Persons without charging adequate rent or other compensation;
(iii) any amount is paid by way of salary, allowance or otherwise to any of the Concerned Persons for services rendered and the amount so paid is in excess of what may be reasonably paid for such services;
(iv) the services of the trust are made available to the Concerned Persons without adequate remuneration or compensation;
(v) any property is sold by or on behalf of trust to any of the Concerned Persons for consideration which is less than adequate;
(vi) any property is purchased by the trust from the Concerned Persons which is more than adequate; etc.
In view of the above, expenses incurred by the trust for paying rentals and services fees to associated services companies would need to be benchmarked against service fee paid by other trusts for services of a like nature so as not to be perceived as being unjustified and in excess of what is reasonably paid for such services to ensure continued tax exemptions. If expenses made by the trust are found to be excessive of what may be reasonably paid for such services, the tax authority may disallow such expenses made for the benefits of the Concerned Persons or even deny the tax exemption under section 11 of the IT Act and bring the net receipts of the trust less justified expenses to tax under the head “income from other sources”.
The structure, discussed hereinabove, undoubtedly, runs the risk of being questioned by the regulatory authorities in view of education being a ‘socially sensitive’ sector in India, more so at K-12 level. However, the structure (which is at variance to the spirit of the ‘not-for-profit’ concept) has been in existence for a long time in the K-12 segment and the model has been adopted by several players in the education sector.