Recent comments by Shadow Treasurer Dr Jim Chalmers, have pointed in the direction of the Australian Labour Party (ALP) possibly re-proposing their 2019 policy for adult beneficiaries of a trust (Trust) to be taxed at a minimum rate of 30%, putting middle-market businesses at risk of losing out.
Projections suggest the increase in tax could raise $2 billion of additional annual tax revenue, with the ALP putting forward this policy as they believe that trusts are mainly being used by wealthy people to minimise their tax burden.
If these measures were to be legislated, it would have an impact on the current structuring of both a family’s personal investments and business affairs. As noted in the 2021 Pitcher Partners Business Radar report, middle-market businesses contribute 20% of Australia’s net tax revenue. Many of these businesses operate by way of a trust. A change to the taxation of trust distributions is likely to detrimentally impact business owners, more so than families utilising a trust as a passive investment vehicle.
A Trust is not a legal entity but is recognised as a separate entity for tax purposes. The trustee is legally responsible for the operation of the trust and is bound by the trust deed, which governs how the trust must operate.
The trust deed will identify persons or classes of persons, that may benefit from the trust. These may include individuals, their relatives, and entities controlled by them such as a company (corporate beneficiary). Each year, the trustee will generally be required to determine the distribution of income that has been generated by trust assets. Depending on the flexibility of the trust deed, it may be possible to distribute income in a way that produces a more efficient tax result than if the trust assets had been held by a particular individual.
Currently, income distributions from a trust are generally taxed at the beneficiary’s marginal income tax rate, with any income received by the trust retaining its character. On this basis, a beneficiary of a trust can access the capital gains discount if an asset is held for more than 12 months.
As an example, a trust generates $90,000 of net rental income in a given year. This example could equally apply to business profits. Under the deed, the trustee will have the power to allocate the income amongst several family members using its discretion. The trustee chooses to distribute $30,000 each to the adult children and the remainder to their Dad – each beneficiary has no other taxable income. We have compared this to the Dad and Mum owning the property jointly with Dad having no other income and Mum being on the highest marginal tax rate of 47%.
Based on the current income tax rates, the use of a trust could provide a potential tax saving of approximately $20,000 per annum. Tax is a significant cost of investing and this allows for potential increased return on investment over the longer term.
If the ALP policy of a minimum 30% tax rate on adult beneficiary distributions is legislated, rather than a $20,000 annual tax saving the trust beneficiaries would pay an additional $1,000 of tax annually. The result of the rule change is that it would be better for Dad and Mum to own the property jointly.
There is currently little detail on these measures, which means there are a number of unresolved practical considerations.
A common scenario would be a trust distributing to a corporate beneficiary that is taxed at 30%. The corporate beneficiary could pay a fully franked dividend. Australia’s imputation system currently allows a 30% tax credit to be attached to this dividend. The shareholder of the corporate beneficiary could be either the trust or an individual.
If the corporate beneficiary is owned by the trust, the question is whether this income would be exempt from the proposed measures on the basis that 30% tax has already been paid on the income. Alternatively, if the corporate beneficiary was owed by an individual (rather than the trust), could the individual beneficiary be entitled to a potential tax refund on franking credits, lowering the overall beneficiary tax rate.
The primary taxation benefit of a trust in comparison to a company is the ability for a trust to access the general 50% capital gains (CGT) discount. Currently, CGT on assets held for more than 12 months distributed to an individual beneficiary have access to the discount and potentially the small business CGT tax concessions. The proposed legislative change does not provide clarity as to how CGT will be taxed.
Currently, an individual beneficiary receiving a discount capital gain on the top marginal tax rate will pay a tax rate of 23.5% on the gross gain. If the 30% tax rate applies this could result in a penalty tax for the use of the trust in relation to taxable capital gains.
The ALP in 2019 suggested that the potential additional tax burden would fall on the individual beneficiary, payable via the annual income tax return. If this is not the case, would there be something similar to a company franking account to ensure additional tax payable by the trust is recorded?
If the ALP policy were to be legislated, there may be a significant shift towards business and passive investments being transferred into a company, where the company tax rate is 30% or alternatively 25% if the entity is a base rate entity. This could result in a lower tax burden in comparison to holding the same assets via a trust.
There will often be a significant cost of restructuring but considering the potential future tax costs and the potential for CGT rollover relief to apply, this may be considered feasible. It is likely this will apply particularly to middle-market businesses as they will be impacted the most by these proposals.
The small business capital gains tax concessions and the small business rollover are just two examples of CGT tax relief that can be utilised by middle-market business owners to restructure their business affairs to improve the tax efficiency of the structure under the ALP proposal.
Trusts are not always solely used for tax minimisation but are instead used to provide families with flexibility in building and passing wealth onto the next generation alongside potential asset protection benefits.
A trust is often a preferred vehicle for achieving family succession in an efficient and relatively seamless manner. Control of the trust may be passed on to the next generation through the transfer of control of the trustee company to the children. This allows for better management of stamp duty and capital gains tax issues that frequently arise in a succession scenario.
A trust may allow for improved asset protection as assets are not held personally and therefore if correctly structured, the trust allows a separation between personal assets that could be caught in legal actions and those held separate to the individual.
With limited available data, this is an area to be watched as we enter the 2022 election campaign. If this proposal is legislated it could be the case that the impact will be most felt by middle-market business owners rather than those using trusts for passive investment vehicles.