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Discretionary trusts and tax planning: tips and traps
22 November 2021 | Minutes to read: 5

Discretionary trusts and tax planning: tips and traps

By Greg Travers and Raffi Tenenbaum

Discretionary trusts are a unique and flexible structure that are particularly adapted to family arrangements. As well as the ability to cater for evolving family dynamics and to provide a level of asset protection, discretionary trusts can assist with tax planning within a family group.

Streaming

Streaming refers to the distribution of a particular type or character of income to a particular beneficiary. It is based on the idea that income retains its character when it flows through a trust.

For tax purposes, streaming is now limited to franked dividends and net capital gains. Streaming ‘franked dividends to a company can ensure no or limited ‘top up” tax is paid, whilst streaming franked dividends to an individual beneficiary with limited other taxable income could achieve a refund of the excess franking credits. For net capital gains, the objective is generally to stream these to individuals or other trusts and preserve access to the CGT discount, or to stream to taxpayers with capital losses.

Commonly, streaming will be use in conjunction with a corporate beneficiary strategy. For example, steaming the franked dividends or net capital gains to an individual to get the tax effective outcome, and distributing the balance of the income to a company to cap the tax rate.

The trust deed needs to include provisions that allow the trustee to stream classes of income to specific beneficiaries. In addition, there are requirements in the tax law that need to be followed to ensure that the decision to stream is effective.

Capital gains

Capital gains made by trusts can be reduced by both the CGT discount and the small business CGT concessions, subject to meeting the relevant eligibility conditions.

On distribution to a beneficiary, the CGT discount is reset based on the profile of the beneficiary, whereas if the trustee could apply the small business CGT concessions then the beneficiary can also apply them. Beneficiaries can utilise capital losses they have against capital gains distributed to them from a trust. The treatment of capital gains has made trusts the vehicle of choice for holding capital appreciating assets.

A discretionary trust can work really well as the shareholder in a private business where the small business CGT concessions are important. For passive investment portfolios, particularly where debt is being used or there is a longer-term investment horizon, going straight to the default option of a discretionary trust may be a mistake.

A trust gives access to the CGT discount but can’t retain income, so retaining income to build an investment portfolio either requires a more complex arrangement using corporate beneficiaries and Division 7A loans, or funding investments from income that has been subject to individual marginal tax rates (up to 47%).

Compare this to a company where income can be retained at the company tax rate (30%) meaning a simpler structure and more funds to reinvest or pay down debt. The trade off is the loss of the CGT discount. Whether the trade off is warranted will depend on your investment strategy and circumstances.

Negatively geared investments & tax losses generally

Negatively geared investments in a trust present a real challenge, but also a potential opportunity.

A negatively geared investment will produce a tax loss. Where a trust is in a loss position, the loss is ‘trapped’ in the trust and not available for beneficiaries to utilise.  This can be particular ‘tax inefficient’ where the trust also has franking credits that it wants to distribute but can’t due to the tax loss position.  Whilst tax losses can be carried forward, the benefit of the franking credits will be lost.

Where the opportunity arises is if you can get enough franked dividends into the trust to produce a small income for the trust (noting that the franking credits are not considered income).  The beneficiaries can be distributed the small amount of income but coming with it is a disproportionately large amount of franking credits – a situation referred to as an ‘over franked distribution’.  The limit on franking credits that applies to companies paying dividends doesn’t apply to trusts.

The tax advantage of this strategy is where the beneficiary can obtain a refund of the excess franking credits or can utilise the excess credits to offset a tax liability on other income.

In relation to tax losses more broadly, there is a very complex set of provisions that deal with discretionary trusts’ ability or otherwise to carry-forward and utilise tax losses against future income.  The good news is that these provisions become much more manageable for trusts that have made a family trust election. In many situations involving family and private groups, making a family trust election is appropriate and recommended, but advice should always be sought in this regard.

Non-resident beneficiaries

Where a trustee makes a distribution to a non-resident beneficiary, the trustee is generally required to pay tax on behalf of the beneficiary. This can be through the withholding tax system (for dividends, interest and royalties) or through a trust specific mechanism (for other income).

Under Australian tax laws, a non-resident would not usually pay capital gains tax on the sale of Australian assets (other than interests in Australian real property) or foreign assets. Where that gain is instead made by a discretionary trust and then distributed to a non-resident beneficiary, the capital gains would generally be taxable in Australia. The rules are contentious and complicated, but very important to consider for any tax planning.

Where a trust holds Australian real property, it is now common practice to ensure that non-residents cannot benefit under the trust. This is achieved through amendments to the trust deed to exclude non-resident beneficiaries. Where a non-resident is a potential beneficiary of a discretionary trust, the trust can be considered a non-resident person for land tax and stamp duty surcharge purposes (noting that the rules vary between states).

Reimbursement agreements

Buried within the complex maze of tax provisions applying to discretionary trusts is an old provision that will soon get much more prominence – section 100A. This provision is an anti-avoidance rule that was targeted at arrangements where one beneficiary was distributed the income for tax purposes, but the actual money flowed somewhere else. These arrangements are termed ‘reimbursement agreements’ and section 100A gives the ATO the ability to disregard them.

Like so many tax laws, section 100A was introduced to address a particular issue but was drafted broadly and so can potentially apply to a much wider range of situations. While section 100A does not apply to ordinary commercial or family dealings, the issue is that no one really knows with certainty whether something is an ordinary commercial or family dealing or not.

To address this, the ATO has been preparing updated guidance on section 100A which is due out next year. It’s worth noting that the ATO has been working on the guidance for many years now and its release has been promised and delayed a number of times before.

The use of children as beneficiaries will need consideration in light of the expected section 100A guidance. Will it still be acceptable to distribute taxable income to adult children if the intention is really to keep the funds in the trust?

Concluding comments

Discretionary trusts open up a range of potential tax planning opportunities and can deliver significant benefits to family groups. Each tax planning strategy brings with it a set of issues and consequences that need to be managed to ensure that the targeted tax outcomes are achieved. For practical advice on effective tax planning, contact your local William Buck Tax Advisor.

 

Discretionary trusts and tax planning: tips and traps

Greg Travers

Greg is the national leader of the Tax Services division. Recognised as one of Australia’s leading tax advisors, Greg has assisted countless businesses, individuals and families to deal with the often difficult situation of an ATO or State Revenue audit. Greg also specialises in international tax working with overseas businesses as they set up and operate in Australia, and assisting Australian businesses that are venturing overseas.

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Discretionary trusts and tax planning: tips and traps

Raffi Tenenbaum

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