Tax reform appears to be on the agenda of the government, amongst other things. Given the numerous attempts made at reforming the tax treatment of discretionary trusts over the last 25-30 years, most readers would be aware of the tax minimisation that can be (and is) achieved through use of these trusts (often called a family trust).
The “plain vanilla” or “straightforward” tax planning adopted by many discretionary trusts is where the trustee’s annual income allocation discretion is exercised with a close eye to the tax profile of available beneficiaries. Many allocations are in amounts just on the tax-free threshold of available beneficiaries, or in amounts putting the beneficiary just below where a higher tax rate band kicks in. For example: (i) around $22,000 for an over 18-year old with no other income; and (ii) around $22,000 for an under 18-year old (for example, two-year old) in the case of a testamentary discretionary trust.
On top of that, amounts are often allocated to a company beneficiary owned by the controllers of the discretionary trust. These amounts will usually attract the normal 30% company tax rate. This so-called bucket company strategy is deployed where the income of other available beneficiaries has reached a 30% or above tax rate band.
It is widely known that many controllers of discretionary trusts take the view that the income allocations are only for income tax purposes and are not meant to be legally effective for general trust law purposes. Many beneficiaries, often after a falling out within a family, have discovered the meaning and effect of “just for income tax purposes” to them. Not every discretionary trust is being used in the way set out above, but the key point is that all discretionary trusts can be so used and many are so used.
This article sets out, as briefly as possible, some of the tax technical and administrative reasons why the current treatment of the taxation of taxable income made through discretionary trusts fails to reach even the lowest standard of fairness (tax equity).
Trust law
Starting with the non-tax law. For annual income allocations to be effective for income tax purposes, they need to be effective under the general law of trusts (tax law applies to general law transactions).
Given the case law on these trusts (for example, Owies v JJE Nominees Pty Ltd (as trustee for the Owies Family Trust) [2022] at paras 82-98 and the authorities therein), it is possible that many of these allocations are not valid for trust law purposes because the trustee has not given real and genuine consideration to the relative economic needs amongst the available beneficiaries in allocating trust income. Instead, the trustee’s main if not sole focus is often on overall tax minimisation. If the trust law allocations are not valid, the tax allocations should not proceed as per the trustee allocation, which is likely to result in more tax than would be the case had the allocations been valid.
To my knowledge, the Australian Taxation Office (ATO) has not run a case challenging the effectiveness of the allocations made (under trust law) in a discretionary trust where tax appears as the main or governing focus of the trustee. However, properly administering this area of the trust tax rules (through enforcing the general law of trusts) at a credible scale would require considerable human resources; it involves labour-intensive investigations. A component of sound tax law design should be whether the regulator can check for compliance without incurring disproportionately high costs.
Income tax provisions
The income allocated to a beneficiary under a discretionary trust is a gift; the beneficiary gives nothing for it, and it does not flow from any meaningful asset or investment owned by the beneficiary. No where else in our income tax system do our tax rules tax the recipient of a gift. Because of this, some would say this is unfair on beneficiaries.
The short answer is that many beneficiaries are “taxpayers of convenience” in the discretionary trust situation and the “taxed money” (gift) is coming from pre-tax dollars. That means, no tax has been paid on the amount supporting the gift. Further, the position throughout the income tax law is that those giving gifts of non-money assets are taxed on the giving of the gift. The controller of the trust (controller of trustee) is often in the effective position of owning trust assets and is therefore effectively making gifts to beneficiaries.
Somewhat related to some comments above especially those concerning “income allocations are only for tax purposes”, section 100A of the Income tax Assessment Act 1936 has been part of the tax law for some 45 years. Briefly, this section is broadly targeted at those situations where a valid income allocation is made to one beneficiary, but the relevant money accrues or is applied to the benefit of someone else (hence similarity to “just for tax purposes” point). If the conditions for the section are satisfied, the income allocation is taxed at the top marginal rate.
With due respect to the ATO, it appears that the ATO’s compliance work in this area is only a recent thing. The issue by the ATO in 2022 of Taxation Ruling TR 2022/4 and Practical Compliance Guideline PCG 2022/2 (both dealing with section 100A) supports this. Again though, testing for the application of this provision requires considerable human resources.
Australia’s income tax has a general anti-avoidance rule (GAAR). In general, where the dominant purpose of a transaction (action) is to obtain a tax benefit (broadly, tax reduction for someone), the GAAR can be applied to reverse the tax benefit.
To my knowledge, the ATO has not run any case challenging the effectiveness of plain vanilla income allocations made in a discretionary trust where, objectively viewed, the dominant purpose of the trustee is to reduce a person’s tax. It should be noted that the ATO has run the GAAR argument, with success, in a limited number of situations of very aggressive (egregious) income allocations away from a “principal” using discretionary trusts (for example, Hart v FCT [2018]).
There is “one more” tax rule that is available to discretionary trusts (and fixed trusts but these trusts do not usually access it because there is no benefit) and that is an election to classify the discretionary trust as a “family trust”. If this election is made, a host of concessional tax rules get triggered and apply to the trust and its beneficiaries.
For example, the normal rule is that a taxpayer must have a beneficial ownership interest in the shares that pay a franked dividend to get franking credits on the dividend. If the discretionary trust, is a family trust as defined, beneficiaries of the discretionary trust are excused from having to have a beneficial ownership interest in the shares and therefore can get franking credits.
The family trust concept effectively introduces a “family” as the taxpayer for a range of tax purposes, but the individual remains the tax unit for the crucial aspect of levying tax at the applicable rate schedule. In other words, a significant contradiction appears to be at work in a fundamental area of the income tax system, and one that is deployed by many to obtain significant tax reductions. Nothing like the family trust concept applies to a closely held partnership or closely held company.
Lost tax revenue
It is not possible to make an accurate estimate of lost tax revenue because of the current treatment of discretionary trusts. That would only be possible if a credible system for taxing discretionary trusts and their beneficiaries was put forward as a benchmark.
However, in the absence of canvassing alternate models here – no space for that in this article – a back of envelope calculation comfortably suggests lost tax revenue of $2 billion per year on the (very) conservative assumptions that 400,000 discretionary trusts (there are around 900,000 of them) are each minimising $5,000 per year against a credible benchmark system. If one lifts the minimised tax per trust assumption to the more credible $10,000, the lost revenue is $4 billion.
Rethink the taxation of discretionary trusts
Put shortly, the unfairness with the taxation of discretionary trusts is pervasive. The above only covers some of the inequities in tax rules around discretionary trusts vis-à-vis other taxpayers.
While the ATO is a highly respected regulator, world leading in the tax area, it could do more to challenge the tax minimisation by testing the scope of some of the current legal and tax rules around discretionary trusts. However, this comment is offered against the background that the current entitlement-based approach, which has a focus on the creation of (or perception of the creation of) an entitlement for a beneficiary, is unfit for purpose and hard to administer. Even the tax advisor of the 1970s and 1980s would have known that this system is unfit for purpose.
For the long-term health of our income tax system (sustainability in government-speak), examining change to the foundations of the tax treatment of discretionary trusts and those associated with it is the preferred approach.
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