Trusts & Tax
Few structures are as widely used but as little understood as trusts, especially when it comes to the potential tax consequences which can arise where they are misused. A trust is basically a structure that allows a person or company to hold an asset for the benefit of others. The person who controls the asset is the ‘trustee’ and those who benefit are the ‘beneficiaries’. The assets held in a trust can vary – property, shares, businesses and business premises are all commonly held in trust structures. The creator of the trust (the ‘settlor’) sets out the specific rules as to how these assets should be managed in a document called the trust deed.
By putting assets in a trust, you don’t own the assets in your name. The assets are legally controlled by the trustee. However, you can potentially control exactly how those assets are managed now and in the future. You have the power to set out who receives the income arising from the assets and when they receive it, as well as who receives the underlying capital represented by the assets themselves and when. Discretionary Trusts (sometimes known as Family Trusts) are the most common type of trust used by business owners in Australia. They are generally created to hold a family’s assets and/or business so as to protect those assets and to facilitate tax planning for family members.
From a tax perspective, the main advantage is that any income generated by the trust from business activities and investments, including capital gains can be distributed to beneficiaries in lower tax brackets (often spouses or children). Because the trustees of the trust have the “discretion” to distribute income and capital as they see fit – and no beneficiary has a fixed entitlement to receive anything – the trustees are able to “stream” income in a tax-effective way on a year to year basis. The downside is that to the extent that they don’t distribute the income of the trust, the trustees themselves are liable to tax on the undistributed income – and a rate of tax usually higher than the beneficiaries themselves would have to pay. Note also that there are limited circumstances when the trustee has to pay tax on behalf of certain beneficiaries, the most common ones being where beneficiaries are children under the age of 18 or people with certain disabilities.
In most cases, from an asset protection perspective, assets held in a family trust cannot be attacked by creditors or lawsuits so they are ideal for protecting assets from business or personal disputes and they can also facilitate the transfer of assets from generation to generation tax-free.
The problem with trusts is that they have become – in the minds of the ATO at least – synonymous with tax avoidance, particularly where they are used by the highly wealthy. The perception has grown that trusts are increasingly being used to hide income altogether, to conceal the underlying ownership of assets and to facilitate transfers of funds tax-free between family and business groups through mechanisms such as interest-free loans.
To combat this perceived tax risk, a couple of years ago the ATO announced the creation of a special Trusts Taskforce, given the job of looking into non-compliance amongst the millions of trust structures in place. Amongst the areas the task force will be looking at are the following:
- Trusts or their beneficiaries who have received substantial income and are not registered, or have not lodged tax returns or activity statements (meaning that in many cases, distributions of income from trusts have never been disclosed on a tax return)
- Trusts involving offshore dealings through tax havens
- Agreements with no commercial basis which direct income entitlements to a low-tax beneficiary (a spouse or child for example) while the benefits are enjoyed by others (a business owner or partner, for instance)
- Where there is an artificial characterisation of amounts, such that tax outcomes do not reflect the economic substance of what actually took place, with the result that some parties have received substantial benefits from a trust while the tax liabilities corresponding to that benefit have gone elsewhere – for example, by making trust resolutions that artificially reduce trust income in an attempt to direct minimal entitlements but full tax liability to entities with no capacity or intention of paying the tax
- Where there has been a mischaracterisation of revenue activities to achieve concessional CGT treatment – for example, by using special-purpose trusts to attempt to re-characterise mining or property development as discountable capital gains (a very common situation arises where profitable property disposals are claimed as capital to enjoy the 50% discount whilst loss-making disposals are claimed as income to enjoy the full benefit of the tax losses)
- Where changes have been made to trust deeds or other constitutional documents to achieve a tax planning benefit, and are not credibly explainable for any other reason
- Where transactions have excessively complex features or sham characteristics, such as round-robin circulation of income among trusts (which basically means that income flows through a convoluted and hard to follow trail of entities before ending up back where it started, without a corresponding tax liability arising anywhere)
- Where new trust arrangements have materialised that involve taxpayers and/or tax scheme promoters who have histories of or connection to the previous non-compliance – for example, people connected to liquidated entities that had unpaid tax debts.
So, where does this leave you? Well, if you have substantial personal and/or business assets and have never considered setting up a trust for the benefit of your family, there is plenty to be gained by talking to your tax adviser or lawyer about the pros and cons. If you already have a trust structure in place, now is probably the time to do some due diligence – look at what you’ve got, how you’ve used that structure and consider the motives behind your planning, talk to your advisers and get their sign-off that nothing you’ve done is likely to fall foul of the ATO.