Dale Boccabella

The tax treatment of family trusts (meaning discretionary trusts) regularly attracts the “tax rort” or the “tax minimisation” criticism. Rarely though are the reasons for the criticism articulated; the criticism(s) remain at the general level. This article provides a foundation for the criticisms.

The key reason for their tax unfairness lies in their flexibility and the fact that tax law permits the flexibility to go unchecked. They allow a given level of taxable income to be split across family members, and thereby accessing multiple tax-free thresholds and multiple low rate bands (income splitting). There is generally no limit on the family members that can be beneficiaries to “receive” income. In addition, if there are insufficient beneficiaries to absorb the income into tax brackets below 30%, then the income can be allocated to a company beneficiary where the company tax rate applies. This caps the tax on this income at 30% (so called bucket companies).

The discretionary trust can also vary the income allocations in subsequent years to take account of changed circumstances of beneficiaries (e.g. reduce an adult child’s allocation this year because they have just landed a high-paying job).

Some argue that the partnership and the company vehicle can also achieve income splitting amongst family members. This is correct, to an extent. But, these vehicles do not have the flexibility that is available through the discretionary trust. Where these vehicles attempt to replicate the flexibility of the discretionary trust, there are often rules that impose a tax charge on such attempts, and there are numerous tax integrity rules that may apply. The key point here is that the discretionary trust is not faced with such tax charges and is not faced with such integrity rules.

Some argue that the current position results in the tax liability “following the money”, and that this is an appropriate income tax outcome.

First, the beneficiary being taxed is very often just the legal owner of the money, and he/she has no real right to enjoy that money. That is, the legal criterion of entitlement to attract tax liability is satisfied, but it is made clear by the controller of the trust and its assets that beneficiaries are not to enjoy the money. Evidence of this strategy comes from the fact that the amount of money “loaned back” by “beneficiaries” to their discretionary trust has reached staggering sums. Thus, calling the current position one of tax liability following the money is hardly accurate.

Secondly, and accepting the legal entitlement approach as appropriate for now, the tax law in this area is actually taxing the recipient of a gift. This is what the beneficiary allocated income in a discretionary trust is getting (i.e. money for nothing). Overwhelmingly, elsewhere in the Tax Act, recipients of gifts are not taxed. Yet, for some reason we do this in the case of a discretionary trust. The Tax Act does tax providers of gifts, but not recipients. A strong case can be made that the controller of the assets in the discretionary trust and/or the person who is the source of those assets and the income thereon is making a gift to beneficiaries.

Thirdly, the tax law is failing to tax the income to the people who contributed the wealth that produced the income. Alternatively, for a testamentary trust (a discretionary trust created under the will of a deceased), the tax law fails to tax the person who controls the wealth that produced the income. In short, in numerous parts of the Tax Act, attempts at alienating or diverting income away from oneself, without the transfer of the underlying wealth that creates the income, are not tax effective. Yet, we permit this in the case of the discretionary trust.

In addition to the above, there are many other rules in the Tax Act that are inconsistent with the tax treatment accorded to the discretionary trust.

Looking outside the Tax Act, and especially in legal regimes that are required to deal with the “ownership” of assets and income in a discretionary trust, we see approaches that are quite at odds with the Tax Act. In the Tax Act, the assets of the discretionary trust are treated as being in “suspended ownership”, and the income belongs to the beneficiary to whom it is allocated.

First, under the assets test for the aged pension, assets held in a discretionary trust can be counted as assets of a person under the assets test if: (a) the assets in the trust are “controlled” by the person or (b) the person gifted the assets to the trust. The key point is that a person who has control over assets of a discretionary trust and/or who contributed those assets is effectively being treated as owning the assets and the income thereon for social security purposes.

Secondly, in the marriage breakdown area of family law, the assets of a discretionary trust could be held to be “property of the parties to the marriage”. This will be the case where a person has the capacity to control the income or capital allocations of a discretionary trust so that allocations could be made to the person. This can be the case even where the person is not the trustee of the discretionary trust, provided that he or she is the appointor (or nominator) of the trust and thereby has the power to change the trustee. Even where a party is not a beneficiary but has the capacity to become a beneficiary, and from there obtain an allocation of assets or income, it will be sufficient to make the discretionary trust’s assets property of the parties to the marriage.

These two regimes do not tolerate the “legal niceties” of the discretionary trust and/or the affront to equity that would otherwise arise if left unchecked. However, the most important of these is the social security treatment of discretionary trusts. The social security system is closely related to, or even the other side of, the income tax (i.e. negative income tax). The two systems both deal with economic capacity. Why a different approach should be taken in each system is not clear.

The above is a brief outline of the favourable tax treatment given to the discretionary trust. But even from this, those criticising the tax treatment of discretionary trusts (family trusts) have a very strong foundation for their criticism. The guiding principle should be that similarly placed activities or transactions should be taxed in a similar manner. It is very hard to see how this is occurring in the case of the discretionary trust.

At the very least, the issue requires a close and independent examination. To the author’s surprise, the Henry Review did not do this. The government’s tax white paper on the tax system should not repeat that failure.

Dale Boccabella is an associate professor of taxation law in the School of Taxation & Business Law in the Australian School of Business, The University of New South Wales, Sydney, Australia