At last, a major side of politics (Labor) is addressing the tax stain that is the discretionary trust. Note though the Liberal Party did attempt to address the abuse 19 years ago but eventually abandoned the measure under political pressure.
The current income tax treatment of the discretionary trust is grossly inequitable compared with other entities and other taxpayers. It causes large losses of tax revenue and significantly undermines the integrity of our income tax system; it is widely seen as a joke.
There are around 650,000 discretionary trusts and their number is rising fast. The Coalition government’s recent superannuation integrity reforms have caused many wealthier people to move to the discretionary trust as the next best alternative for minimising tax.
Discretionary trusts are used by families to operate businesses across a wide range of industry sectors and to hold passive investments. They hold around $580 billion in assets and have around $80 billion of annual taxable income. They are just as significant as family companies.
Various reform options are available to address the tax minimisation issue. But Labor has adopted a form of alternative minimum tax.
In the end, Labor ought to be congratulated for tackling the discretionary trust stain on our income tax system
From July 1, 2019, the Labor proposal will tax allocations (distributions) of a discretionary trust’s taxable income to those over 18 years of age at a flat 30%. However, if the tax payable under the beneficiary’s normal tax rate scale on the distribution is more than 30% (for example 37% or 47%), the distribution will be taxed using the beneficiary’s normal tax scale.
The new rule will not apply to special disability trusts, deceased estates, testamentary trusts and farm trusts.
Labor’s decision not to “tax as a company” is a sensible one. In addition to avoiding the considerable complexity involved with such a model, the model would not have addressed the tax minimisation issue because of the refundable franking credit feature of the company tax system.
However, such a model would have clawed back some extra tax revenue through removal of the capital gains discount now currently available to discretionary trusts.
The attribution model used in the social security system (and effectively in the family law area on division of property on relationship breakdown) was this author’s preferred approach. This model attributes assets and income to those that control the assets and income and/or were the source of those assets and income.
However, it is conceded that the attribution model has some challenges in both the design stage and enforcement, and it is understandable why Labor has not gone down this path.
As expected, there is no attempt to modify the general law concerning discretionary trusts so that all the current ‘legitimate advantages’ associated with them are maintained.
Labor’s approach involves minimal change to the tax law thereby not adding complexity and administrative costs. It uses a technique already widely used in our income tax law of ‘stamping’ a particular category of taxpayers’ income so it can be taxed outside the normal rate scale; a technique used in the area of distributions outside a ‘family group’ for family trusts.
The current regime for income of under 18s will continue including the exclusion of testamentary trusts (discretionary trust created under a will) from the new measure. This is of concern as the tax minimisation in this area is significant.
The practice of a two-day-old baby being allocated $20,500 with zero tax thereon offends fairness. There probably is a natural cap on the lost revenue in this area of tax planning, but the expected growth in testamentary trusts ought to be of concern.
There appears to be no principled reason why farmers’ discretionary trusts are excluded from the measure. The comfort from this failure is that there are ‘only’ around 19,000 of such trusts. The other exceptions (for example, disability trusts, deceased estates) can clearly be justified.
The flat 30% minimum tax may raise the old ‘overtaxation’ and ‘undertaxation’ fairness issue. It is a similar issue that arises where a company retains taxed profits, and it has some shareholders on marginal rates above and some below the flat company tax rate.
Overtaxation could be said to occur under the Labor proposal where a trust’s taxable income combined with its beneficiaries’ outside income (outside trust) cannot generate an average rate of tax above 30%. In these cases, the new measure can be said to be overtaxation. There may be a case for further thinking in this area.
Undertaxation, in the sense of taxpayers driving down the tax rate to the new minimum 30%, is less of a problem because taxpayers mostly already have access to such a mechanism in the form of the bucket company (with a flat 30% rate).
The bucket company phenomenon is where a company is added as a beneficiary of a discretionary trust, so that when the average rate of tax of natural person beneficiaries reaches 30%, allocations are made to the bucket company. Overwhelmingly, they exist to cap tax payable.
One concern with Labor’s proposal is that the use of a bucket company may circumvent the 30% minimum tax measure. For example, if a company beneficiary is allocated 100% of the discretionary trust’s taxable income, the company will be taxed at 30%. The company may be a company with numerous classes of shares and many or most will be discretionary dividend shares held by low rate natural person taxpayers in the ‘family’.
When the bucket company distributes its profits, the [low] tax rate applying to the shareholders will apply; Labor’s new 30% minimum rate will not apply to that company distribution of profit. This type of planning can easily be addressed.
In the end, Labor ought to be congratulated for tackling the discretionary trust stain on our income tax system. The policy is not perfect, but it is significantly better than allowing the current position to continue unchecked. There will be many urging further improvements to the policy as consultation proceeds.
Dale Boccabella is an associate professor in the school of taxation and business law at UNSW Business School. A version of this post appeared on The Guardian website.