The Federal opposition recently announced that it will now be their policy to ensure that all distributions from discretionary trusts are taxed at a minimum rate of 30%.
Taxation of trust income is one of the most complex areas of tax law, but the fundamental principle is that beneficiaries of a trust are taxed according to the share of the income of the trust that they have an entitlement to receive (with the entitlement determined by the terms of the trust and any distributions declared by the trustee for each financial year; see the Wolters Kluwer commentary on this topic).
This principle makes discretionary trusts an attractive method for income splitting, as the trust income can be allocated to members of a family group, for example, in a way that takes advantage of the lower marginal tax rate applied to members with little or no other income.
The real complexity in the taxation of trusts arises where there is a significant difference between the net income of the trust (as determined under trust law) and the taxable income of the trust, and in determining what happens to trust income that has particular tax characteristics (such as franking credits or capital gains subject to the 50% discount).
View the roadmap to Wolters Kluwer’s detailed commentary on the taxation of trusts.
According to a report in the Sydney Morning Herald (7 April 2017) tax office data shows the number of discretionary trusts in Australia to be around 643,000, which is almost double the number in Australia in the late 1990s, and the recent changes in superannuation have led to a further increase in the use of discretionary trusts.
There have been many previous moves to change reform the taxation of trusts, with some getting no further than the planning stage before being abandoned, but there have been two significant changes that have been implemented.
In the early 90s, the Howard government introduced a rule so that any trust income distributed to minors is taxed at the highest marginal tax rate. This means that trust income can only be split in a tax-effective way between adult beneficiaries, and it is no longer possible to use the tax-free thresholds of infants to minimise tax.
More recently, the rules governing the streaming of franking credits and capital gains were legislated, ensuring that franking credits received by a trust, for example, could not be allocated to a beneficiary with a high income while the dividend income that gave rise to the credits is allocated to a low-income beneficiary (see Wolters Kluwer’s procedure for streaming franking credits here, and the procedure for streaming capital gains here).
The proposed changes
The opposition has announced that it will, if elected, apply a minimum 30% tax rate to distributions from a discretionary trust to individual beneficiaries aged 18 and over (with distributions to minors still taxed at the maximum marginal tax rate).
A number of types of trusts will be exempted from this rule. In particular, this will not apply to:
- special disability trusts
- testamentary trusts (ie trusts established under a will)
- charitable trusts, or
- farm trusts.
The proposal has the advantage of being relatively straightforward to implement, unlike some alternatives proposed in the past (for example, taxing trusts in the same way as companies, or deeming the trust income to be derived by the entity with practical control over the trust). However, some steps may need to be taken to avoid penalising the use of trusts by “overtaxing” trust income. For example, if the total income of a trust is below the individual tax-free threshold and is all distributed to an individual with no other income, it might be considered unreasonable to tax that income at 30% when it would have been tax-free for the individual if they had derived it directly.
The exemption for testamentary trusts is understandable, as these trusts are also exempt from the rule that distributions to minors are taxed at the maximum marginal tax rate. However, it should be recognised that this can allow individuals who inherit significant wealth to access tax benefits not available to anyone else.
Find more information on Trusts on CCH iKnow.