Much has been written about the Stage 3 income tax cuts and how they mainly benefit high income earners (for example, see this recent ABC article). The tax advantages that high-net-worth individuals obtain from discretionary trusts also raise concerns about perpetuating and exacerbating economic inequality, but this issue did not receive attention in recent budget debates. Labor has formerly argued for discretionary trust tax reform in 2017 and 2019, but this was not part of its policy package when elected this year.
In this blog, I draw on my recent article on discretionary trusts and tax avoidance in Australian Tax Review to provide an overview of trust tax minimisation practices and the efficacy of relevant anti-avoidance tools.
The growing use of discretionary trusts for tax minimisation
Discretionary trusts are the most common type of trust in Australia, comprising around 80% of all trusts (see Australian Taxation Office trust statistics, Table 1A).
Traditionally, discretionary trusts were mainly used for estate planning, as means of effecting intergenerational wealth transfer. Since the 1970s, after the Government closed off many of the tax reduction techniques available to private companies, the use of discretionary trusts has accelerated. The flexibility inherent to the discretionary trust (to make allocations of income as the trustee sees fit, subject to the terms of the trust deed), and the fundamental basis upon which trusts are taxed in Australia means they can be used to confer significant tax advantages.
Tax policy on discretionary trusts raises serious social equity considerations. This is because trusts are overwhelmingly controlled by high-net-worth individuals. Australian Bureau of Statistics data shows that Australian households with a net worth in the highest quintile (top 20%) own 95% of the wealth in private trusts (data cube 7, ‘net worth quintiles’).
How tax minimisation practices operate
The scheme for taxing trusts is contained in two Acts: the long-standing regime in Division 6, Part III of the Income Tax Assessment Act 1936 (ITAA36), which taxes the ‘net income of the trust’, and Subdivision 115-C and Subdivision 207-B of the Income Tax Assessment Act 1997 (ITAA97), which (since 2011) separately assess trust net capital gains and franked distributions, respectively.
The legislation contemplates that beneficiaries are the primary taxing point (and creates tax disincentives to accumulate income within the trust). Under Division 6, Part III ITAA36, where a beneficiary is ‘presently entitled’ to a share of trust income, a tax liability is triggered at the tax rate(s) applicable to the beneficiary. Therefore, by allocating trust income to tax-preferred beneficiaries—such as a family member without other income or a corporate beneficiary with carry forward tax losses—tax liabilities can be significantly reduced.
For example, if a person on the highest personal tax rate of 47% (45% plus 2% Medicare Levy) uses a trust to allocate $40,000 investment income equally between their two adult dependent children who do not have other income ($20,000 each), a tax saving of $18,800 (47% x $40,000) is achieved compared with the position if the $40,000 were taxed in their own hands. In this example, the entire $20,000 to each adult child is tax-free as the effective tax-free threshold for Australian tax residents is $21,884 ($18,200 plus a further tax-free component as a result of the Low Income Tax Offset of $700).
It must be noted that it is not possible to use trusts, companies or partnerships to split personal services income (income earned as a result of personal skills or efforts) as there is a specific anti-avoidance regime (in Part 2-42 ITAA97) which requires that the income be included in the assessable income of the individual performing the services. Subject to certain exceptions, the tax law also contains economic disincentives to use trusts (and other structures) to distribute income to minors as such allocations are taxed at deterrent rates.
However, with investment and business income, there remains considerable scope to engage in income splitting. It is also commonly assumed that the use of trusts to split investment and business income is outside the purview of anti-avoidance provisions.
Part IVA and Section 100A of the Income Tax Assessment Act 1936
My article subjects the assumption that the use of trusts to split investment and business income is outside the purview of anti-avoidance provisions to critical examination. I consider the extent to which existing anti-avoidance mechanisms can tackle trust tax avoidance.
The main legislative mechanisms for addressing trust tax avoidance are the general anti-avoidance rule in Part IVA ITAA36 and the specific trusts integrity provision in section 100A ITAA36 on reimbursement agreements.
With regard to Part IVA, there are very few (only four) litigated cases where the Commissioner has alleged that a trust comprises a key component of a tax avoidance scheme that enabled a tax benefit. This case law indicates that it is difficult for the Commissioner to show that the taxpayer has established a trust for the ‘dominant purpose’ of obtaining a tax benefit as required by Part IVA. For example, in FCT v Mochkin (2003) 127 FCR 185, the Commissioner failed to establish that Part IVA applied to the trusts in question because the taxpayer (a stockbroker) was successful in arguing that his main objective in creating the trusts was to immunise himself against liability for client defaults. This was despite the court’s finding that the taxpayer had ‘tax advantages in mind in choosing a discretionary tax structure’ to operate his business (at 208), and that his purpose of avoiding personal exposure could have been achieved merely through use of a company.
By comparison, section 100A fares better, and I argue that it has considerable (under-utilised) potential to address trust tax avoidance. It applies where a beneficiary is made presently entitled to trust income in circumstances where the economic benefits attaching to the distribution are passed (often tax-free) to another person. Where section 100A applies, the Commissioner is entitled to tax the trustee on the relevant trust income at the highest personal rate applied as a flat rate. Although there are not many litigated cases concerning section 100A, the only High Court decision, Raftland v Commissioner of Taxation (2008) 238 CLR 516, indicates a flexible, non-technical approach to applying section 100A requirements. The chief advantage of section 100A over Part IVA ITAA36 is that it does not require the Commissioner to establish a dominant tax avoidant purpose (it is sufficient if one purpose of the arrangement is to reduce tax).
A principled approach for identifying tax avoidance
In light of the social equity concerns, I also develop a ‘first principles’ basis for identifying when trust arrangements can be regarded as tax avoidant.
It is instructive to note that the 1975 Asprey report, which analysed the problem of income splitting in some detail, did not restrict its analysis or recommendations to the personal services income setting. I rely on argument in the Asprey report and case law (particularly the High Court’s decision in Hollyock v Commissioner of Taxation (1971) 125 CLR 647 decided under the former general anti-avoidance rule (section 260 ITAA36)) to argue that the practical retention of control over trust income or income-producing trust assets provides a principled basis to attribute trust income to a taxpayer, even if the trustee has purported to create present entitlements in others.
This is essentially the underlying rationale of section 100A ITAA36, noted above, which enables the Commissioner to disregard purported present entitlements where the beneficiaries in question do not actually benefit from the apparent income allocations. In a draft 2022 Tax ruling, the Commissioner indicated that the ATO would make wider and more frequent use of section 100A ITAA36, including in relation to family discretionary trusts. Although this change in administrative policy has attracted disquiet among professional advisors, the Commissioner’s approach appears to be justified in law.
The draft ruling attests to practices where trust controllers purportedly create present entitlements in adult child beneficiaries, but do not actually pay the relevant trust amounts (even satisfying the tax liabilities from trust funds). The analysis in my paper indicates that this type of practice can be characterised as tax avoidant, given the trust controller retains control of the income purportedly allocated to beneficiaries.
Policy intervention to address tax avoidance by discretionary trusts is important, not only from a revenue perspective, but also because of social equity considerations—this is because the assets in trusts are controlled by wealthy and extremely wealthy households. My recent article attempts to provide a principled basis for identifying tax avoidant conduct in a trust setting, and specifically argues that the Commissioner would be justified in extensively invoking section 100A to tackle trust tax avoidance.
Ideally, however, a legislative solution should be considered to address unfair tax minimisation using trusts. For example, Labor has formerly suggested a 30% compulsory tax on discretionary trust distributions. From the perspective of reducing economic inequality and enhancing fairness in the tax system, a proposal of this type warrants serious consideration.
Other 2022 October Budget articles
Click here for 2022 March Budget articles.