Discretionary trusts are a unique and flexible structure particularly adapted to family arrangements. As well as the ability to support evolving family dynamics and 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 because it is not a separate legal entity but merely a relationship.
For tax purposes, streaming is limited to franked dividends and net capital gains. Streaming franked dividends to a company can ensure no or limited ‘top up’ tax is paid, while 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.
Streaming is commonly used in conjunction with a corporate beneficiary strategy. For example, steaming the franked dividends or net capital gains to an individual to get the most tax-effective outcome and distributing the balance of the income to a company to cap the tax rate at the lower company tax rate.
In order to stream, the trust deed needs to include provisions that allow the trustee to classify different types of income into different ‘classes’ and then stream those ‘classes’ of income to specific beneficiaries.
In addition, tax law requirements need to be followed to ensure that the decision to stream is effective from a tax perspective.
Use of a corporate beneficiary strategy
Since late 2009, the use of a corporate beneficiary strategy, particularly when the distributions owing to the beneficiary remained partly or wholly unpaid, e.g., an Unpaid Present Entitlement (UPE), came under more ATO scrutiny.
Prior to that time, distributions owing to a corporate beneficiary could remain as UPEs for as long as desired while the trust used the funds represented by these UPEs in its business and/or investment activities.
Since late 2009, the ATO has applied a Division 7A-like system to deal with these UPEs over the course of seven or ten years. In more recent times, particularly with respect to UPEs arising from 1 July 2022 onwards (i.e., FY23), the ATO further hardened its view and now treats most of these as full Division 7A loans rather than its more concessional approach between December 2009 – 30 June 2022.
However, the ATO’s position on UPEs was successfully challenged in the Federal Court in the recent case of Bendell and is currently on appeal to the Full Federal Court.
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 beneficiary’s profile. If the trustee could apply the small business CGT concessions, the beneficiary can also apply them, subject to certain conditions. Beneficiaries can utilise capital losses they have against capital gains distributed to them from a trust. The treatment of capital gains has, therefore, made trusts the vehicle of choice for holding capital-appreciating assets.
A discretionary trust can also work well as the shareholder in a private company where the small business CGT concessions are important.
Conversely, for passive investment portfolios, particularly those using debt or with a longer-term investment horizon, going straight to the default option of a discretionary trust may be a mistake.
While a trust gives access to the CGT discount, it cannot effectively 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, which can be up to 47%.
Compare this to a company where income can be retained at the company tax rate, 30% for passive companies, 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 and 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 is not available for beneficiaries to utilise. This can be particularly inefficient from a tax perspective if the trust also has franking credits that it seeks to distribute but can’t do so due to the overall tax loss position. While tax losses can be carried forward, the benefit of the franking credits will be lost.
If you can get enough franked dividends into the trust to produce a small distributable income amount for the trust, noting that the franking credits are not considered income for trust purposes, it can then distribute that income amount to beneficiaries, but accompanied with 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 dividends flowing through trusts.
The tax advantage of this strategy is that the ultimate individual beneficiary can obtain a refund of the excess franking credits or utilise the excess credits to offset tax liability on other income. This strategy, however, requires careful planning to ensure that there is sufficient distributable income so that franking credits aren’t lost.
A very complex set of provisions deals with discretionary trusts’ ability 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 this provision is appropriate and recommended, but advice should always be sought in this regard.
Non-resident beneficiaries
If 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, e.g., rental 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. When that gain is instead made by an Australian 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.
If a trust holds Australian real property, it is now common practice to ensure that ‘foreign persons’ cannot benefit under the trust because many states have introduced surcharge duties and land taxes on these trusts. This is achieved through amendments to the trust deed to exclude ‘foreign persons’ as beneficiaries.
Reimbursement agreements
Buried within the complex maze of tax provisions applying to discretionary trusts is an old provision that has gained significantly higher prominence in the last couple of years: section 100A.
This provision is an anti-avoidance rule targeted at arrangements where one beneficiary, presumably a lower-income beneficiary, was distributed the income for trust and tax purposes, but the actual money flowed somewhere else, presumably to higher-income beneficiaries. 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 originally introduced to address a particular issue but was drafted broadly and 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.
Discretionary trusts open 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.
