In Budget 2022-23, the Government announced it would provide $652.6 million to the Australian Taxation Office (ATO) over two years to extend the operation of the Tax Avoidance Task Force to 30 June 2025 (see Budget Paper 2 at p.29). The Taskforce undertakes compliance activities targeting multinationals, large corporates, trusts and high wealth individuals.
This article focuses on trusts and provides a brief outline of typical ways in which trusts are used to obtain tax benefits. The article then explores government policy on trusts, current and potential integrity measures for tackling trust tax avoidance, and important recent developments in the ATO’s strategy. It highlights that addressing trust tax avoidance is important not only from a revenue perspective, but because of social equity considerations.
The use of trusts in Australia and the scheme for taxing trusts
In Australia, the number of trust tax returns lodged is close to 1 million, just below that of companies (see the ATO’s trust tax statistics). About 80% of trusts are discretionary trusts (see the ATO’s detailed trust tables, Table 1A). In a discretionary trust, the trustee has a discretion to determine the amount of income or capital appointed among potential beneficiaries. Since the 1970s, discretionary trusts have been widely used to obtain tax advantages for business and investment income (see Evans, Part IV.B).
The scheme for taxation of trust income under Australian law inherently creates opportunities to obtain tax advantages. The rules are in the long-standing regime in Division 6, Part III of the Income Tax Assessment Act 1936 (ITAA36) and in Subdivision 115-C (capital gains) and Subdivision 207-B (franked dividends) of the Income Tax Assessment Act 1997 (ITAA97). The legislation contemplates that beneficiaries are the primary taxing point and incentivizes the trustee to allocate the net income of the trust. The trustee is generally taxed at the highest personal income tax rate upon any unallocated trust income. A concept of beneficiary ‘entitlement’ to income (present entitlement or specific entitlement) is the essential construct that activates a tax liability.
Subject to the potential application of anti-avoidance provisions, trustees can achieve tax benefits by exploiting the favourable tax profiles of particular beneficiaries. For example, trustees could deliberately structure distributions to split income and obtain the advantage of multiple tax-free thresholds and lower marginal rates of some beneficiaries, or they could distribute income to entities with tax losses, who could use those losses to offset trust income entitlements.
Trusts anti-avoidance provisions
The opportunities for tax minimisation afforded by the trust tax rules are qualified by anti-avoidance provisions in the tax law. Three of the most important specific measures are section 100A ITAA36 on reimbursement agreements (see an explanation on the ATO webpage); Division 6AA ITAA36 about distributions to children; and the personal services income (PSI) rules in Part 2-42 ITAA97.
Section 100A ITAA36 was introduced in 1978 as a means of overturning schemes which have the purpose of allowing income derived by trusts to be passed on to individuals in a tax-free form. This provision has recently attracted considerable attention. Division 6AA ITAA36 was introduced in 1979 following a recommendation of the 1975 Asprey report (see at 11.9). It removes economic incentives to use trusts (and other vehicles) to split income with children (under age 18), by taxing their income (above a small tax-free threshold) at the highest personal rate. There is an exception for earned income of minor children.
The PSI rules, introduced after a Ralph review recommendation (see at 7.2), aim to tax income generated through the skills or efforts of an individual directly to that individual even if a vehicle (company, trust or partnership) is used to contract with clients.
Additionally, the general anti-avoidance rule in Part IVA ITAA36 applies where a scheme is entered into for the dominant purpose of obtaining a tax benefit. This could provide a further means of tackling cases of trust tax avoidance that is not addressed by specific rules.
Despite these various integrity measures, there is nonetheless considerable scope in practice to obtain tax advantages through the use of trusts—both through blatant and egregious tax avoidance (which has been targeted by the ATO for some time) and income splitting arrangements.
Blatant tax avoidance, income splitting and equity
The Government has consistently taken a clear stance against the use of artificial and contrived schemes using trusts that are designed to avoid substantial tax, and these are the focus of the trust compliance activities undertaken by the ATO Tax Avoidance Taskforce.
By way of background, the 2013-14 Budget allocated funding to a dedicated ATO Trusts Taskforce, targeting taxpayers involved in ‘egregious tax avoidance and evasion using trust structures.’ (see Budget Paper 2 at p.43). Since 1 July 2017, the ATO’s trusts compliance arm operates under the ATO’s Tax Avoidance Taskforce. ATO webpages and taxpayer alerts (such as TA 2013/1 and TA 2016/12) provide considerable detail on the types of arrangements that attract the ATO’s attention. For example, in TA 2013/1, the ATO indicates it would consider applying anti-avoidance rules where trust controllers exploit differences in the concepts of taxable income and trust distributable income to extract large capital gains in a tax-free form (capital gains are not part of trust distributable income unless there are trust deed provisions to the contrary).
Despite these developments, successive Governments have taken a lenient position with respect to income splitting arrangements through trusts. In the late 1990s, the (Coalition) Government stated that ‘trusts would be able to continue to realise the benefits of income splitting’ when launching its (unimplemented) policy proposal to tax discretionary trusts like companies (p.113 of the 1998 White Paper).
In recent years, the Australian Labor Party, while in opposition, had proposed introducing a minimum 30% tax on discretionary trust distributions if elected to office (it is noted that Labor has abandoned this policy pre-election in 2022). A 2017 Labor publication gave an example of a taxpayer on the highest personal rate (based on their personal exertion income) who achieves considerable tax savings by using a discretionary trust to split investment income (which they controlled) with their dependent adult children (who are beneficiaries of the trust). The Labor publication emphasised (at p.5) the inequity that results from permitting income splitting given it is only wealthy Australians with additional (investment) income and the means to engage the necessary specialist legal and financial advice who can access tax benefits from discretionary trusts.
However, the question remains whether income splitting arrangements could be captured by anti-avoidance rules. Notably, in February 2022, the Commissioner of Taxation signalled the intention to make wider use of s100A, including in relation to family discretionary trusts. The Commissioner’s draft Ruling TR 2022/D1 and Taxpayer Alert TA 2022/1 indicate the ATO will consider applying s100A to the scenario where a trust controller (parent) purportedly confers on their dependent adult children (who are beneficiaries of the trust) entitlements to trust income, but these are unpaid and the benefit accrues to the parent, or another person.
The Commissioner’s position attracted immediate controversy among tax advisors who perceive it as a significant policy shift that should not be retrospectively applied (for example, see commentary by Chartered Accountants ANZ). Treasury subsequently issued a press release stating that trusts are a ‘legitimate and important way’ for families, ‘particularly those running small businesses,’ to ‘manage their financial affairs,’ and indicated the ATO would only apply the new ruling prospectively. While the Treasury press release indicates a somewhat softened stance, assuming prospective application of the recent policy shift, it would seem incontestable that the Commissioner is entitled to fully exploit existing tax law integrity measures in relation to trust arrangements that are potentially being used for tax avoidance.
Additional funding supports further ATO trust compliance
The extension of funding in the budget for the ATO’s trust compliance activities is a welcome development in light of the tax integrity risks posed by trusts. While the extent of revenue loss is unknown, an ATO-commissioned report suggests it is considerable, between $672 million to $1.2 billion per annum (see at p.2).
The need to address trust tax avoidance is amplified by social equity considerations, given that the tax advantages afforded by trusts are essentially a privilege of the wealthy. Australian Bureau of Statistics data indicates that households with a net worth in the highest quintile control 95% of the assets in discretionary trusts (see data downloads item 7 net worth quintiles, table 7.2).
Other Budget Forum 2022 articles
Vehicle Taxing Dilemma Between Environment and Inequality, by Yogi Vidyattama, Robert Tanton and Hitomi Nakanishi.
Budget Reveals No Plan for Disaster Volunteering, by Jack McDermott.
A Fairer Tax and Welfare System for Australia, by Ben Phillips and Richard Webster.
Claiming Crypto Donations under Division 30, by Elizabeth Morton.
The Budget, Fiscal Policy and an Outbreak of Inflation, by Chris Murphy.
Natural Disasters and Government Policy Challenges, by John Freebairn.
Petrol Excise Cut in the Budget! What About the Transition to Zero-Emission Cars? by Diane Kraal.
For Social Infrastructure and Tax Reform, We Need a New Federal Fiscal Bargain, by Miranda Stewart.
A Free Lunch From Government Debt? It Certainly Looks That Way, by John Quiggin and Begoña Dominguez.
On the Limits of Fiscal Financing in Australia, by Chung Tran and Nabeeh Zakariyya.
What’s wrong with income splitting through trusts? The inequity is that only wage and salary income can’t be split with family members in most cases whereas property income can be. Incidentally, where a married couple is married under a civil law community property regime, they should file a partnership return in Australia in respect of community incomes, being a joint receipt of income and therefore a tax law partnership. It surprises me that no Australian State or Territory has sought to amend its Married Women’s Women’s Property Act to vest all rights to income in the spouses jointly unless elected otherwise. Tax law has to follow State property law and that was what forced income splitting on the US Congress in the 1930s.
What’s wrong with income splitting through trusts? The inequity is that only wage and salary income can’t be split with family members in most cases whereas property income can be. Incidentally, where a married couple is married under a civil law community property regime, they should file a partnership return in Australia in respect of community incomes, being a joint receipt of income and therefore a tax law partnership. It surprises me that no Australian State or Territory has sought to amend its Married Women’s Property Act to vest all rights to income in the spouses jointly unless elected otherwise. Tax law has to follow State property law and that was what forced income splitting on the US Congress in the 1930s.