Broken trusts: The 70% tax trap facing corporate beneficiaries

The capital gains tax and negative gearing overhauls took the lion's share of the budget night focus, but the new minimum tax on discretionary trusts is going to impact hundreds of thousands of Australians.

Under the proposed changes, the trustee will pay a 30% tax on distributions and any non-corporate beneficiary will be taxed at marginal tax rates less a non-refundable credit for the trust tax.

Corporate beneficiaries will get slugged again and pay an effective tax rate of almost 70% (more on that later).

A whole range of Treasury charts have been floating around in the week following the budget. Whether they aim to illustrate the use of negative gearing, trusts, or the capital gains tax discount, what they all have in common is a massive spike on the top end of the wealth band.

One of these, Chart 4.17 from Budget Paper No. 1, shows that the wealthiest 10% of Australian households hold over 90 per cent of the value of private trusts.

While there are a wide range of trust types, the government has only targeted discretionary trusts in its taxation overhaul.

Why discretionary trusts?

According to the budget papers, the number of trusts has more than doubled over the last 20 years to roughly 1 million, with around 800,000 of these being discretionary trusts.

That high concentration has clearly caught the government’s eye.

“While trusts may be used to support legitimate family and commercial arrangements, including as a collective investment vehicle, for asset protection and for succession planning, the current taxation of discretionary trusts allows some taxpayers to reduce their taxes, weakening progressivity, equity and the sustainability of the tax system,” the budget papers noted.

“Other types of trusts, such as fixed trusts, do not have the same flexibility and tax advantages as discretionary trusts.”

According to Phil Broderick, principal of business law at Sladen Legal, the changes are targeting an issue that is not as widespread as the government seems to believe.

“I think it's really driven by this thought that a lot of people are using trusts for lowering an effective tax rate by income splitting, whereas I don't think that's necessarily the case in reality,” Broderick said.

“It seems a bit overblown from the reality of what most trusts are used for. If we end up with punitive tax rates on trusts and people are forced into other structures, there are other consequences from that. There’s loss of asset protection.

“From an estate planning perspective, people like to use trusts because they're concerned that someone might attack the estate. There are very common reasons for using trusts over and above the tax side of things.”

What are the options?

Broadly speaking, there are three main options for existing discretionary trusts: a fixed trust, a company structure, or stick with the discretionary trust.

Fixed trusts aren’t subject to the 30% minimum tax, so Broderick expects the structure to continue to be used as a flow through entity, while a company also pays tax at 30% but with a refundable franking credit.

How investors make the decision on the structure will largely come down to what is going to happen with excess profits.

“If they're going to go back into the business, that suggests a company structure because we pay 30% tax, we keep the 70% and it’s reinvested into the business. If one day we want to take that money out, then we can frank out a dividend,” he said.

“A fixed trust or fixed unit trust is probably going to be for assets where we're looking to take that income out of the system … We want the full profits to flow through to the investors and then they pay tax in the normal manner.”

In short, business structures will tend towards a company, investment structures will tend towards fixed trusts.

Where a discretionary trust may still be the right choice is for investors that are particularly concerned about asset protection, which could potentially make it worth paying the punitive tax rate.

When it comes to discretionary testamentary trusts - i.e. created through a will - there are exclusions for existing assets as of budget night.

“Therefore, the income (and gains?) will appear to be exempt from the trust 30% tax rate and flow through taxation will continue. This may make the trustee of such trusts reluctant to sell such grandfathered assets,” Broderick said.

Even with the exclusions, he argued many high-net-worth families will restructure their estates before death.

“Discretionary testamentary trusts may still be used for holding shares in companies and then dividends can be franked out as required,” Broderick said.

“More modest estates may go back to ‘basic will’ structures or fixed testamentary trusts. This will result in a loss of asset protection but avoids the 30% tax rate in the situation where the beneficiaries’ effective tax rate will be less than that.”

Bucket companies could face a 70% tax rate

If the tax treatment of individual trustees seems harsh under the changes, then things get much worse for corporate beneficiaries of discretionary trusts.

“If it goes as proposed, there will be no bucket companies going forward,” Broderick said.

Unlike a non-corporate beneficiary, any distributions paid to a company would not get the credit for the tax that the trustee already paid, so the income would be taxed a second time at the 30% company tax rate.

“If you don’t get the credit then it’s double taxation and no one’s going to use a corporate beneficiary,” Broderick added.

In a budget fact sheet, Treasury explains that this is designed to ensure a corporate beneficiary can’t simply convert the tax credits to refundable franking credits to avoid the minimum tax.

Where things get more complicated is that the company tax rate may be applied to the distribution before it is taxed at the trustee level.

Sladen Legal tax law principal Daniel Smedley put together an example of how this creates an effective tax rate of almost 70% for a hypothetical Jim, whose family discretionary trust earns $100 of taxable income distributed to a bucket company called JimboCo.

The table below compares the current law with both what he dubbed the “media model” based on some of the initial reporting of the proposal and the version described in Treasury’s fact sheet.

Under current law, total tax remains aligned with Jim’s 47% marginal rate. Under the fact sheet interpretation, the effective tax rate rises to nearly 70%.

Is there a death tax?

The answer to this is really all about perspective.

Broderick explains that it’s not a death tax in the traditional sense of estate duties.

“It’s not a tax on the assets of the estate, but it is a tax on a structure established by a will,” he said.

“That’s why you could still call it a death tax, but that’s also probably why the government says it’s not a death tax, because in its true technical sense it's not an estate duty.”

Beyond quibbles over the correct terminology, the measures are designed to increase the tax on assets from estates that are held in this structure.

“The government’s not hiding from that. They're saying that these structures are used for streaming income and reducing effective tax rates,” Broderick said.

“No one’s deliberately dying for the purpose of creating great tax structures. It’s a very extreme measure of trying to get some tax savings.

“People are just setting these up as the instrument that holds their estate. You only get to do it once when you die, so it seems like overkill to be attacking discretionary testamentary trusts, which are set up for asset protection reasons particularly for family law type claims and creditor claims.”

Key takeaways

• Fixed trusts are expected to be the preferred flow-through entity for investment assets.
• Company structures will make the most sense for businesses that intend to reinvest profits.
• Discretionary trusts are still viable if the primary concern is asset protection.
• Corporate beneficiaries are going to kick the bucket.
• High-net-worth families are likely to restructure their estate planning.