Trusts have been widely used by accountants, family, businesses and investors as a legal structure to effectively reduce the burden of tax and to protect wealth in structures which can be passed on to future generations. With Governments of all persuasions continuing to increase tax collections, trusts in many areas are being scrutinised more and practices that were once the norm are now being challenged. In this article we will focus on how changes to the enforcement of current laws impact those using trusts.
Current Laws – Trusts
1. Trusts have a finite period.
Trusts must end 80 years after they are established. Whilst this may not be an issue for the people that establish a trust, the next generation that inherit the wealth inside a trust will ultimately have to deal with capital gains and stamp duty on the transfer of assets held within the trust when it comes to an end.
Planning point: If you have significant wealth in a family trust make sure you know when the trust will end and have a plan in place with regards to disposal of those assets.
2. Limiting the tax on profits of a trust to the company tax rate (30%) is not that simple.
For family trusts that run significant trading businesses or hold significant investments it has been commonplace for some or all of the taxable profits of the trust to be allocated to a corporate beneficiary that would then pay tax at 30% on those profits. This would ensure that the profits were not taxed at a higher marginal tax rate. In many cases these allocations (or distributions) were never paid to the company and created an unpaid entitlement owed by the trust to the company.
Over the past 20 years Governments have sought to close this tax minimisation strategy by introducing integrity measures to restrict the effectiveness of these distributions through what is commonly known as Division 7A. The current Liberal Government is introducing new measures which continue to tighten and limit the use unpaid trust distributions to companies. For those considering making such distributions or those with existing unpaid entitlements to companies we recommend people exercise caution and ensure they effectively manage their tax liabilities.
3. Valid distributions to family members
In a similar way to using companies, many trusts have distributed taxable profits to low income family members to effectively reduce the overall tax burden to the family group. Where these distributions have not been paid to those family members then an unpaid entitlement accrues to that person. This amount can legally be called upon by that person to be paid to them. In order to address this issue some trusts have used re-imbursement agreements to cancel this entitlement of the family member without ever receiving any economic benefit of that distribution.
There is a provision within the Australian tax law which states that in these circumstances such distributions made are not valid for tax purposes and are subject to tax in the hands of the trustee at the highest marginal tax rate (currently 47%). The Commissioner of Taxation has for many years not applied this provision of the law however in recent times has issued some guidance advising that it will seek to apply this provision of the law except where the arrangement is part of an ordinary family or commercial dealing. Whilst the ATO has provided some guidance in this area it remains uncertain as to how far this law is intended to apply. Some of the practical steps taxpayers can undertake in these areas to limit any possible exposure are as follows:
- Where unpaid entitlements exist look at what expenses the trust pay may for that family member and ensure they are appropriately recorded and charged against that person’s entitlement (eg school fees, university fees, health care fees). Note these expenses will not be tax deductible to the trust.
- Ensure that the trust transactions are on arm’s length commercial terms, examples include:
- Loans to related entities are at the very least compliant with Division 7a
- Any private use by related parties of assets held by the trust is charged to that party
- Be mindful if distributions of the trust are made to a tax-exempt entity, foreign resident or where tax losses exist
- Ensure that trust distributions are documented and signed prior to the end of the financial year.
4. Capital Gains and Trusts
One of the major benefits trusts enjoy over company structures is that the benefit of the 50% Capital Gains Tax Discount (applicable to investments held for 12 months or longer) can be passed through to individual beneficiaries of the trust. For a person on the highest tax rate they would currently pay a tax rate of 23.5% (50% x 47%) on the capital gain as opposed to a company paying 30% tax rate.
We note proposals in place from the Labor party would reduce the CGT discount to 25% meaning that the underlying tax rate for a high income taxpayer on a capital gain would be approximately 35% compared with the company tax rate of 30%.
Planning point: For high income earners the use of trusts as the structure of choice for trading and investment vehicles is changing. Profits in company structures are taxed at a flat rate of 30% and any further tax payable can be controlled depending upon when dividends are paid to the shareholders.
Whilst we have raised more questions than given answers we trust that the above information provides you with food for thought about the current and future structures you use.