One does not have to look at the annual Taxation Statistics to know that many young people are being used as the central element of the tax minimisation practices of a significant number of parents and grandparents; a “taxpayer” of convenience.
The tax profession plays a facilitative, if not leading role, in this practice. Subjected to the tax rules, the practice in many situations will be in breach of the tax law. The practice is costing the public revenue a considerable amount. The use of children as a taxpayer of convenience is largely limited to the discretionary trust.
Use of children as a taxpayer of convenience
The tax unit or taxpayer under the Australian income tax system is a person, and not a family. This means each person (an individual or company) is a taxpaying unit. This includes a two-day-old baby. In turn, each individual gets their own tax rate schedule. Australia has a progressive tax rate schedule for adults with a tax-free threshold of effectively around $21,880. After that, generally, the 19% rate applies to taxable income above $21,880 all the way to $45,000, and after $45,000, the 32.5% rate applies all the way to $120,000. After $120,000, the 37% rate applies up to $180,000 and after $180,000, the 45% rate applies.
Regrettably, Australian families with discretionary trusts have a long history of using taxpayers of convenience. Probably the most high-profile example known to tax advisors was a case (facts) 40 years ago called East Finchley Pty Ltd v Commissioner of Taxation (24 November 1989). In this case, the trustee of a discretionary trust passed a resolution for the year allocating the discretionary trust’s taxable income to 126 foreigners (non-residents) who were relatives of the people behind the trust. Each foreign beneficiary was allocated $585. At that time, the tax rate schedule for foreigners had a tax-free threshold of, you guessed it, $585. A director of the trustee company travelled to the foreign country to request that each beneficiary loan back their entitlement to the trust.
While the taxpayer of convenience is more prevalent for an over 18-year-old with little or no independent other income and who lives with parents, the taxpayer of convenience continues in the area of children under 18 years of age. The normal tax rate schedule for an under 18-year-old (for example, 2-day-old baby) is $416. There are many cases in the law reports with examples of $416 allocations to under 18-year-olds.
However, for some under 18 years old, the adult tax rate schedule applies. These are usually hardship situations. The most widely known “hardship” situation is where a discretionary trust is created over assets by a grandparent under her will for beneficiaries, including grandchildren under 18. The taxpayer of convenience is in full operation here with allocations to under 18-year-olds of $21,880.
For completeness, the staggering amounts held in “bucket companies” (as a beneficiary of a discretionary trust) is another example of a taxpayer of convenience. A key transaction driver here is capping the tax rate to 30% (usual company tax rate). This prevents the discretionary trust’s taxable income being potentially exposed to the higher 32.5%, 37% or 45% rate that would otherwise apply if an allocation were made to an individual.
Getting back to children. For some situations, the child may actually receive the income (money) or get its benefit (for example, credited to a bank account for the child and parents do not use the money). However, in many cases, the child never gets the money; it is used by the parents, which is likely a breach of trust. In many cases, the child never even knows they have been allocated money under the trust. The parent treats the child’s allocation as their own, and the allocation to children is explained as “that was just for tax purposes”.
Section 100A of the Income Tax Assessment Act 1936
Section 100A is an anti-avoidance provision that applies to discretionary trusts. It broadly states that where a beneficiary is entitled to income, but the money entitlement of the beneficiary accrues to or is applied to the benefit of another person, the beneficiary is not taxed. Instead, a penalty tax rate of 45% applies to the income and the trustee pays the tax. Section 100A would catch many taxpayer-of-convenience situations involving children.
One key exception to section 100A operating is where, generally, the situation is an ordinary family dealing. It is apparent from the ATO’s Taxpayer Alert TA 2022/1 that some parents are claiming their children are reimbursing them for the costs of the child’s upbringing so that when the parents appropriate the child’s entitlement to their own use, section 100A does not apply because it is an ordinary family dealing. Yes, you read that correctly. It is submitted this argument is unlikely to succeed.
One hesitates to criticise the ATO, but a case can be made that the ATO has not been making full use of section 100A, that is, enforcing it, in taxpayer-of-convenience situations. Aside from the East Finchley case, it is hard to find any case brought to the court or the tax tribunal on taxpayers of convenience under section 100A. Further, a similar claim can be made about the general anti-avoidance rule (Part IVA), namely, the ATO has not tested it in taxpayer of convenience situations. There can be little doubt that in most situations, allocating an amount of income equal to the tax-free threshold to a child has a 100% tax driven purpose.
In fairness to the ATO though, properly policing this area of the tax law requires considerable fact gathering and therefore human resources.
Time to reform
Whether the use of children, and here the focus may mainly be on under 18-year-olds, as taxpayers of convenience breaches any child welfare law or laws concerning rights of children is debatable. Irrespective, such use of children is likely to rate poorly when a moral or ethical lens is considered. It is time the tax law in this area is properly reviewed and administered so that use of children in this way is stamped out.
We have no express statement in the tax legislation on what is the precise purpose or policy behind the tax-free threshold in the adult tax rate schedule. However, much can be gleaned from its content, context and to who it applies.
The progressive tax rate schedule clearly embodies some notion of economic capacity to contribute to the public revenue, which in turn can take account of a taxpayer’s expenditure needs. The tax-free threshold of around $21,880 can be seen as a “living-income” level a person needs to meet their basic expenditure needs; hence there is no spare economic capacity to contribute to the public revenue. When the taxable income reaches into the lowest rate band (now 19%), the person has some capacity to make a small contribution to the public revenue. And after that, at $45,000, there is capacity for a slightly larger contribution, and so on and so on.
The adult rate schedule is applied to an individual, not a collection of individuals or a family.
What these tax settings imply is that an adult individual, a person with a high degree of “independence”, is responsible for meeting living expenses from their own resources or own income. An adult child with no or little independent income and who is allocated (gifted) an amount from a discretionary trust that equals the tax-free threshold is hardly to be seen as an independent person. The same point applies with even more force to an under 18-year-old, whether they are allocated $21,880 (adult schedule) or $416 (normal under-18 schedule).
Given the above, it seems hard to justify a tax system that gives a taxpayer of convenience the current adult tax rate schedule with its tax-free threshold. Indeed, given their “dependency” on parents it is hard to see why they are being treated as a taxpaying tax unit at all.
In the end, the issue discussed here is just another aspect of the tax abuse the general body of taxpayers are suffering through others’ use of the discretionary trust. Children have been and continue to be used on a large scale as taxpayers of convenience. Hardly a lesson in civic responsibility. This is just another reason why the tax treatment and/or tax administration of discretionary trusts needs reforming.
I beg to disagree. The tax system discriminates viciously against families by denying income splitting or additional tax free thresholds for taxpayers sharing income with dependants- or anyone else for that matter.
Furthermore, at a basic level, children are to labour what renewals and replacements are to physical capital. As Adam Smith recognised, labour has a cost of supply – it’s called the cost of raising children. That was why Pitt the Younger put generous allowances for dependent spouses and children in the original income tax of 1799.