Time for policymakers to address tax benefits from family trusts

Tax benefits have made family trusts an increasingly popular financial arrangement. Image from www.shutterstock.com

Family trusts have featured heavily as part of recent media reporting of the circumstances of two very high-profile families: the Rineharts and the Obeids. Of course, these are not the only families that have a family trust as part of their financial arrangements. In recent times, the growth in the use of family trusts far outstrips the growth in the use of partnerships and companies (and sole traders). All four of these “vehicles” are used in family settings.

Most families with a substantial asset or assets or a business will act on advice from professionals. Accordingly, it is very unlikely that the faster rate of growth in the use of family trusts is the result of uninformed decision-making. (Nearly all family trusts are discretionary trusts.) There is no systematic data on what is motivating families to prefer using family trusts. But, from even a quick glance at a small number of cases that have come before the tax tribunals, it is very clear that tax considerations feature very heavily in the choice of vehicle.

What is it about family trusts that makes them so attractive from a tax perspective? The short answer: the family tax liability is very likely to be lower when the family uses a family trust compared to the use of the sole trader, partnership or company. Why is this the case?

The central point is that with a family trust, the collective taxable income of the trust for a year can be allocated to family members (beneficiaries) so that the taxable income attracts the lowest rate(s) of tax possible. This is done by allocating income to family members who have the lowest income from other sources (e.g. 19-year old full-time university student, a stay-at-home spouse). After allocating the income tax “efficiently” to use up family members’ tax-free thresholds and low rate bands up to around 30%, any remaining income is often allocated to a family company (a so-called “bucket company”). The rate of tax for companies is capped at 30% and there is no Medicare levy.

The added advantage is that the allocation for one year does not lock in any allocations for subsequent years. This means that for a subsequent year, if a family member’s income profile changes, this can be taken into account in making the allocations for that subsequent year (e.g. a lower allocation to an over 18-year old, who now has a full-time salary; a higher allocation to family member who has lost their job). It should also be noted that these income allocations are valid for tax purposes even though the relevant family member has no entitlement to the capital that produced the income.

Another advantage of the family trust is that categories of gains that have a certain tax character or tax benefits attached (franked dividends, discount capital gains) can be “streamed” after the gain is made by the trust to family members that can make best use of the tax character of the gain or tax benefits attached by allocating a capital gain to a family member that has a personal capital loss so that the gain is protected from tax by the personal loss.

In short, the numerous advantages set out above are not available in the sole trader, partnership or company situation. Why not? These other vehicles simply are not flexible enough so that income allocations must be made in line with ownership interests in the vehicle. Where these other vehicles seek to replicate the flexibility of the family trust, the tax law will usually trigger a capital gains tax charge because a change in income allocations is usually accompanied by a change in ownership rights. Further, replicating the family trust’s flexibility will also usually be met with at least one anti-avoidance measure.

Defenders of the current system often say that a family trust is a trust which is recognised by the courts and part of that recognition is the flexibility of this trust. That is true. But, the tax law does not automatically accept (or blindly follow) the non-tax law position of a transaction. Further, defenders of the current position say the tax treatment of family trusts is simply taxing the beneficiary that obtains the money (i.e. tax liability follows the money). But our Tax Act does not simply follow the money. If it did, our Tax Act would be taxing people on receipt of gifts and giving deductions for gifts made. There is generally no rule in our Tax Act that taxes the recipient of a gift. But, this is exactly what the tax law is doing in regard to a beneficiary of a family trust; the beneficiary is getting a gift from the trust and the Tax Act is taxing that person on receipt of the gift. To say this is out of step with a fundamental principle of our income tax system would be a massive understatement.

Defenders of the current system also often assert that they use their family trust for asset protection purposes and for retaining assets in the family. This can be accepted. But, addressing the tax inequity need not undermine the use of family trusts for such purposes. The tax law is often amended to address tax anomalies (tax inequity), without changing the commercial position of the tax-reformed area.

Addressing unfairness or anomalies in our tax system is often a difficult task. Vested interests have and will continue to stand in the way of reform. But the use of family trusts has become so pervasive that even families with modest business or property assets (around $350,000) can gain a tax benefit from their use. This, perhaps along with an “aspirational” element that accompanies trusts, may explain the general reluctance of policymakers to take a serious look at scaling back the tax advantages from family trusts.