The popular view is that the discretionary trust (often called a family trust) is essentially an income tax minimisation vehicle that causes large losses to income tax revenue and is grossly unfair to other taxpayers. This view is fully justified. The consistent growth in the number of discretionary trusts is largely if not solely explained by the irresistible income tax advantages.
This article sets out some of the preferential tax rules that apply to discretionary trusts, and which are not present for other taxpayer situations. The article also identifies two non-tax areas where a discretionary trust is treated in a materially different way to that adopted for income tax. The overwhelming conclusion is that the tax treatment of the discretionary trust is significantly out of step with key foundational structures in the income tax.
What is a discretionary trust?
A discretionary trust is an “entity” (strictly, a relationship) that can be used to own investments and operate a business. It is an alternative to the sole trader, partnership, fixed trust and company as an entity. A key thing is that assets and property inside the discretionary trust are not beneficially owned by anyone. They are in suspended beneficial ownership, while being legally owned by the trustee. This same point can be made regarding trust income (yearly profits). When a potential beneficiary is allocated income through the trustee’s discretion, the beneficiary is getting a gift.
The other feature of a discretionary trust is its flexibility. The choice of beneficiaries, and amounts, regarding income allocations can change year-to-year. In addition, the rules governing the discretionary trust can be (and are) tailored to provide for an endless array of situations and often these are drafted (much like contracts) with an eye to facilitating a tax advantage. Regrettably, this flexibility attracts those who pursue aggressive tax planning.
A discretionary trust can be set up both by a living person, or through the will of a deceased person (so-called testamentary trusts). For testamentary trusts, there are some generous tax advantages through use of an under 18-year old as a “taxpayer of convenience”.
Why are discretionary trusts so often used?
Two key reasons or motivations emerge for adoption of the discretionary trust. They are limiting liability and minimising income tax. Limited liability, much like a company situation, can be achieved for enterprise failure in a discretionary trust that has a corporate trustee where the failure is due to a straightforward situation. In addition, people with substantial assets also often adopt the discretionary trust to try and limit the divisible property pool on relationship breakdown (a party to a marriage does not beneficially own property in a discretionary trust). The family law reports contain many cases of attempts, sometimes successfully, to frustrate a divorcing spouse (usually female) from obtaining a fair allocation of property on relationship breakdown.
What is the actual tax practice with discretionary trusts?
In short, the income allocations (creation of “entitlements”) under numerous discretionary trusts are overwhelmingly made to minimise income tax. Put another way, the trustee discretion is focused on “taxpayers of convenience”. This usually means a member of the class of potential beneficiaries with a zero or low tax rate.
A beneficiary with an unused (zero or minimal other income) adult tax-free threshold is the most used taxpayer of convenience. This shields $22,000 from tax. A child over 18 fits this category. In addition, a child under 18 (for example, a 2-day old baby) also has access to the adult tax schedule if the trust is a testamentary trust. Another taxpayer of convenience that is very popular is the “bucket company”. The income allocated to a bucket company beneficiary is taxed at a maximum of 30%.
In the case of many beneficiaries allocated income under a trustee’s discretion, the beneficiary does not have access to the money. Very often, a loan back to the trustee is put in place. Also, often the beneficiary gifts the money to another person or the trustee. It is generally understood in advance that this will be the case. There are also times where the beneficiary allocated income does not even know about it.
How discretionary trust taxation sits with fundamental structure of the income tax
Taxing recipients of a gift
Nowhere else in the income tax is a recipient of a gift treated as a taxpayer (to be “taxed”). Yet, that is what the rules do in a discretionary trust situation.
Under the income tax, a donor of an asset is taxed on the basis that a realisation of the asset has occurred, and the recipient is not taxed. One could assert that by taxing gifts in the hands of the recipient, this means the discretionary trust is taxed more heavily then. The answer is no. Although somewhat complicated because assets in discretionary trusts can come from various sources, the key observation is the true provider (or their representative) of the gift is not being taxed on the making of the gift. Put another way, the gift made to the beneficiary is not coming out of after-tax dollars.
Beneficiary entitlement is just for tax purposes
The extensive use of a taxpayer of convenience is a strong indication the “taxpayer” does not obtain the benefit from the money; the money goes elsewhere or is applied elsewhere. It is a fundamental pillar of our tax system that the proper taxpayer is the person who benefits from the money in a beneficial sense. There should be very good reasons to justify a departure from this. This principle is also reflected in section 100A, an anti-avoidance provision.
The main rule in section 100A is that where an income entitlement is made to a beneficiary, but the money is applied elsewhere or to another person, section 100A applies to tax the money at the top marginal rate. However, the major exception to section 100A applying is where the arrangement is an ordinary family dealing. Controllers of some discretionary trusts have argued that the application of a child’s income entitlement towards parents’ current expenses (for example, home mortgage) is an ordinary family dealing because it is appropriate for a child to reimburse their parents for the cost of raising them. This argument has not yet been tested.
Family as a tax unit
A trust can elect to be a family trust. In effect, the family becomes the tax unit for the purpose of some tax rules. Although the family trust election is available to other trusts, the trust that overwhelmingly makes use of this election is the discretionary trust. The reason is that if the tax unit were the individual beneficiary, certain tax benefits would not be available in the discretionary trust situation. Only one example is given.
Generally, a beneficiary in a discretionary trust cannot obtain franking credits on dividends passed through to the beneficiary because the beneficiary does not beneficially own the underlying shares that produced the dividend. However, if a discretionary trust elects to be a family trust, the beneficiary can get the credits. In other words, a special rule is made available that changes the tax unit from an individual to a family for ownership purposes.
In short, the family as a tax unit is not made available to other taxpayer situations, which raises an equity issue. This also tends to undermine the argument that the discretionary trust is “just another trust”. There would be no need for a special rule if it were just another trust. Further, there is also an air of selectivity in the analysis, namely, let the normal tax rules apply to the discretionary trust but let there be some special rules for certain situations.
Capital “returns”
There is a structural rule in the income tax system that if an owner of an entity receives a return of capital over and above the capital they paid for their interest, the excess becomes taxable. For a discretionary trust though, when a beneficiary receives a capital distribution, the normal rule does not operate because the ATO has made a binding ruling that the normal rule does not apply. This has not been tested by the courts. This situation is often exploited by aggressive tax planners.
No obvious reason(s) jumps out as to why this approach has been taken. The discretionary beneficiary is obtaining money above the amount she paid for her interest (paid zero) in the discretionary trust.
Non-tax law treatment of the discretionary trusts: Social security law and family law
I have limited this to just these two areas of Australian law, but there are other examples. Our social security system is a negative income, or to put it another way, the social security system and the tax system are part of one system because they are both based on economic need and economic capacity. A fundamental structural feature of the social security system is the income test and the asset test. If a claimant has sufficient private income or assets, entitlement to social security payments is reduced or eliminated.
Under rules introduced around 22 years ago, the assets and income inside a discretionary trust can be attributed to people involved with the trust. Control over the disposition of the trust’s assets and income and/or contribution to the generation of those assets and income are the key criteria for attribution. The idea that no one beneficially owns the assets and income in a discretionary trust is set aside in favour of looking at control over and source of assets and income. In short, if it is appropriate enough to view the discretionary trust in this manner for social security purposes (need and capacity), on principle, it is hard to see why the discretionary trust ought not be viewed in a similar way for income tax purposes.
Very briefly, under the family law rules, assets inside a discretionary trust can be attributed to spouses for the purpose of establishing the divisible property pool of parties to a relationship breakdown. Again, in a similar way to the social security law, control over the disposition of the assets, and to a slightly lesser extent, the source of the assets are the governing criteria.
In short, the income tax system view of the discretionary trust is at odds in a material sense from the view taken of such trusts by the social security law and family law. Like the tax law, “ownership” is a central feature of these two regimes.
Conclusion
This short article cannot point out all the areas in the income tax where the tax treatment of the discretionary trust is at odds with other fundamental features of the income tax. Similarly, all areas outside the income tax where the discretionary trust is treated in a manner quite different to that underlying the tax treatment (for example, no one beneficially owns assets in discretionary trust) cannot be explored. The disproportionate ATO regulatory costs of regulating discretionary trusts also cannot be set out here.
However, just from this short article, one can see how the treatment of the discretionary trust departs considerably from the fundamental structure of the income tax. Further, favourable treatment and preferences are provided with no apparent policy justification.
The time for reviewing the tax treatment of discretionary trusts arrived some 25-30 years ago. It is hoped that this does not extend too much further because the general body of other taxpayers have made up the shortfall for too long.
The Physiocrats would have thought this as a bit naive, if one considers society as a living organism. Because the individual income tax fails to recognise income sharing within groups and between individuals, mainly but not exclusively within families and the so-called concessional deductions for spouses and children have been abolished, people look for ways to adjust.
What is stigmatised as tax avoidance is thus often an attempt by taxpayers to restore neutrality and equity. Discretionary trusts are a good example of this, being income sharing vehicles. What is sad is that labour income cannot be so easily re-attributed to the ultimate beneficial recipient (e.g. a spouse or child) as can property income.
As for income being in suspense in a discretionary trust, the same is true for companies and partnerships where income allocation takes place at the end of the year. You cannot run an income tax with instantaneous attribution of income from minute to minute. In any case, the annual accounting period is arbitrary and losses should be able to be carried back and/or distributed from year to year.
As for the tax and social security systems being a “system” – they aren’t. If they were a logical system, one would not be taxing people at the same time as sending them money.
The evolution of tax policy over the last 50 years at least has been usually a story of progress from inequity, through anomaly, to further inequity as each new “reform” creates new unfairness – and, strangely, seems usually biased in favour of maximising the revenue – and welfare dependency.