Indian Education Sector: Outsourcing Trusted Services to Associated Service Companies

The regulated formal education sector in India is generally made up of schools (often classified as K-12 – kindergarten to 12) and higher education institutions. Although India has been proactive in liberalizing, the education sector has largely remained on the sidelines of the reform process. Archaic legislations require all formal educational institutions in India to be run as “non-profit” centers by non-profit entities viz. a partnership, trust, or section 25 company. All excess funds generated in the process of operating K-12 schools or institutions of higher education must be reinvested in the same school or educational institutions under the same trust and may not be distributed dividends to members of non-profit entities. . In addition, the constitution of the trust/company must be such that it does not give control to a single individual or members of a family, that is, the trust/company must not have the character of an owner and the educational institutions must operate on a “not for profit mode.

The ‘not-for-profit’ mandate is the biggest discovery that has kept serious corporate activity in the attractive K-12 segment at bay. Most schools in India are independent and until recently the chains used to be set up by private charitable, political and/or religious groups, including Vidya Bharti Schools (affiliated with the right-wing political organization RSS) with over 18,000 schools , Dayan and Anglo Vedic (DAV) schools with approximately 600 schools, and Chinmaya Vidyalaya with approximately 75 schools, among others.

Lately, corporate houses seeking to transform K-12 schools into a ‘for-profit’ proposition have been using indirect means such as lease rents, management fees, fees to provide support and ancillary services, etc. extract the surplus locked up in the trust. Taking a cue from these schools, the Indian education sector has seen some corporate activity in the K-12 space along similar lines, but in a formal version of these ancient structures. Strict regulations are being managed through an innovative two-tier structure, which complies with ‘trust’ regulations and allows promoters (at the corporate level) to generate company profits. In this way, the ‘surplus’ profit flows to the service entity in the form of rent/fees for providing the land and services and is available to the company to distribute as a dividend or use to finance another company.

However, it is important that the relationship between the trust and associated service company and infrastructure and management company be carefully structured to conform to educational and tax rules and regulations.

A charitable institution such as a trust is entitled to income tax exemptions under section 11 of the Income Tax Act 1961 (“IT Act”) subject to compliance with the requirements listed therein. Trust income that is exempt from tax includes income derived from property held in trust wholly for charitable or religious purposes to the extent the income is applied in India.

The terms ‘assets held in trust’ include a business enterprise whose business is incidental to the achievement of the trust’s objectives and separate books of account are maintained by said trust in respect of such business. For purposes of claiming the exemption, it is required that 85% of the total income of the trust be applied to the very object of the trust and the trust must not accumulate more than 15% of the income since the accumulation in excess, if any will be subject to income tax.

To take advantage of tax exemptions on income generated by the trust from the management and operation of schools, the trust should ensure that the predominant activity of the trust is to serve a charitable purpose of promoting education and not to make a profit. The trust may charge a reasonable fee to students as earning per se does not vitiate the 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 which does not seek or depend on any government funding”.

However, the corporate structuring must assess the implications of section 13 (1) (c) of the IT Act. In the event that part of the income or any property of the trust in question has been used or applied during the previous year, directly or indirectly, for the benefit of certain persons, such as the author/founder of the trust; any trustee or trust administrator; any relative of any author/founder; or any business in which any of the persons has a substantial interest (“Interested Persons”), then such income so used or applied shall not be excluded from the total income of the prior year trust.

It will be considered that the income or trust assets have been used or applied for the benefit of the Subject Persons, among others, if –

(i) any part of the income or assets of the trust is or continues to be held by any of the Persons Involved without any guarantee or adequate interest or both;
(ii) any land, building or other property of the trust is made or continues to be made available to any of the Persons Involved without charging adequate rent or other compensation;
(iii) any amount is paid as salary, allowance or otherwise to any of the Involved Persons for services rendered and the amount so paid exceeds what can reasonably be paid for such services;
(iv) the services of the trust are made available to the Subjects without remuneration or adequate compensation;
(v) any property is sold by or on behalf of the trust to any of the Involved Persons for a consideration that is less than adequate;
(vi) any property is purchased by the Interested Persons trust that is more than adequate; etc.

In view of the above, the expenses incurred by the trust to pay rents and service fees to associated service companies should be compared with the service fees paid by other trusts for services of a similar nature so that they are not perceived as unjustified and in contradiction. . excess of what is reasonably paid for such services to ensure continuation of tax exemptions. If the expenses incurred by the trust are determined to be in excess of what can reasonably be paid for such services, the tax authority may reject such expenses incurred for the benefit of the Persons Involved or even deny exemption from tax under article 11 of the IT Law and tax the net income of the trust less justified expenses under the heading of “income from other sources”.

The structure, discussed above, is certainly at risk of being challenged by regulatory authorities in view of education being a ‘socially sensitive’ sector in India, even more so at the K-12 level. However, the structure (which differs from the spirit of the ‘non-profit’ concept) has been around for a long time in the K-12 segment and the model has been adopted by various players in the education sector. .