Economics and Tax

The tax treatment of private trusts

28 July 2017

Trusts remain a yawning gap in the integrity of the income tax system.

It’s unacceptable that while most people pay income tax at their marginal rate, a minority are able to use private trusts and companies to avoid paying their fair share. This means the rest of us must contribute more in order to fund essential services.

Along with super, negative gearing, and loopholes in Capital Gains Tax, private trusts are popular ways for people with higher incomes – and their well-paid financial advisers – to avoid tax.

This tax avoidance has gone on for too long.

ACOSS has called for curbs to tax avoidance using private trusts and companies for two decades.

Every year in the lead up to the Federal Budget, we urge the Government to tackle private trusts and companies. For instance, Recommendation 9 from our 2017 Budget submission asserts:

The use of private trusts to avoid personal income tax should be curbed

  • From 1 July 2018, private trusts (both discretionary and fixed) should be taxed as companies. This would not apply to collective investment vehicles or certain categories of trusts including complying superannuation funds, disability trusts, and trusts established pursuant to court orders.
  • From July 2018, the ATO should extend its public ‘corporate tax transparency’ data to provide information on all business and investment entities (including companies, trusts and partnerships) with annual turnover over $100 million.

Saving: $0 ($1,500 million in 2018-19)


Key points:

  • The use of private trusts to avoid tax was supposed to be fixed by the Howard Government in the 2000 GST package, but we ended up with the GST and no reform of trusts. Powerful interests have always opposed reforms of this kind.
  • The problem with private trusts is not that people use them: it’s that their tax treatment is very generous compared with individual taxpayers and companies, and more generous than in other wealthy countries.
  • Private trusts are regularly used to split income with family members on lower tax rates and to avoid Capital Gains Tax. They are also used to evade tax by concealing income in complex structures and by moving funds offshore into tax havens.
  • If super and negative gearing are tightened up, more high income-earners will turn to private trusts.
  • Tightening the tax treatment of private trusts is seriously overdue. The public must be confident that we are all contributing our fair share to the budget.
  • As part of a comprehensive review of our tax policies, ACOSS has been consulting with its members and other experts over the best ways to curb tax avoidance and evasion using private trusts and companies.
  • We have been advocating taxing private trusts as companies so that the trust would be taxed at the company tax rate. Other options are to tax trust income in the hands of the individual who controls it – as we do for social security purposes- and extending Capital Gains Tax to un-taxed income distributed to beneficiaries (as already applies to certain trusts).
  • This is not about penalising investment or effort: it’s about fair taxation. A minority with smart lawyers and accountants are paying tax at well below their proper rate
  • In order to curb tax evasion and money laundering, it is vital that more information is provided to the Tax Office, and the public, on who controls and ultimately benefits from private trusts.

What is a trust and what kinds of trusts are there?

Trusts were invented to avoid taxes imposed by the English crown in medieval times.

Henry VIII introduced the Statute of Uses to counteract tax evasion by users of trusts. The preamble includes the following:

Subtle inventions and practices have been used whereby hereditaments of this Realm have been conveyed from one to another … craftily made to secret uses … sometimes by signs and tokens. Peter Haggstrom SMH 18/7/2017

In recent times they have also been used to protect assets, to facilitate transfers from estates, and to set aside and grow wealth for people unable to care for themselves.

A trust is a legal obligation on the part of a trustee (who directly controls trust assets such as property or shares) to hold or accumulate income and assets for the benefit of a group of beneficiaries (usually family members of the individual who settled assets in the trust in the first place).[1]

There are different kinds of trusts.

Public unit trusts are used as investment vehicles (usually in property). There are few concerns about their use to avoid income tax. Most trusts however are privately controlled and often restricted to a family group.

The two main types of private trusts are fixed trusts (where beneficiaries have fixed entitlements) and discretionary trusts (where the trustee decides each year who should receive trust income). Trust income allocated to beneficiaries is usually held and accumulated within the trust. Trusts can either be used for investment purposes (investment trusts), or for an active business (trading trusts).

Trusts are taxed differently from companies. Companies are taxed on their income at 30% or 27.5% (depending on their size) and this tax is recouped by shareholders through ‘imputation credits’ in their tax returns. Some tax breaks such as the 50% discount for capital gains and depreciation allowances either do not apply to companies, or are ‘captured’ within the company and do not flow through to shareholders.

Trusts are only taxed if in a given year they do not distribute all of their taxable income to beneficiaries, in which case they are taxed at the top personal tax rate. However this rarely happens as the trustee generally distributes all annual income (whether in cash or on paper). To avoid taxation at any rate above 30%, discretionary trusts usually have a private company as a beneficiary. Similarly, another trust could be a beneficiary, as could the individual who controls the trust.

Unlike companies, tax breaks such as the capital gains tax discount and depreciation ‘flow through’ to beneficiaries, reducing the tax they pay (or which the trust pays on their behalf).


How many, how much?

Australian Taxation Office data reveals almost 643,000 discretionary trusts (most private trusts are this kind) in Australia in 2014-15 (the most recent figures). This is almost twice the number (330,000) two decades earlier.

Figure 1: Discretionary Trusts

Source: Taxation statistics

Just over half are passive investment trusts (330,000) while just under half (260,000) are trading trusts for active businesses.

In 2013-14 their total taxable income was $80 billion.

Beneficial ownership of trust assets is highly concentrated in the top 20% of households by wealth (figure 2).

Figure 2: Average value of trust assets by household wealth group ($000s)

Source: Richardson D (2017) Trusts and tax avoidance, Australia Institute

About half of all trusts (including public trusts, though the majority are private trusts) are not assigned to an industry by the ATO (figure 3), which suggests they are investment rather than trading trusts.

The three main industries with trusts are construction, professional and technical services (for example doctors, lawyers and dentists), and finance and insurance. Contrary to an often-expressed view, less than 5% are farm trusts (farmers mainly use partnerships).

Figure 3: Trusts by industry (2014)

Source: Taxation statistics

How have trusts been used to avoid income tax?

Tax avoidance using private trusts (mainly discretionary trusts) is estimated to cost government at least $2 billion in lost taxes every year, though not all of this would be recouped by tax reform as people may shift to other tax shelters. [2]

Income tax has been avoided in the following ways using discretionary trusts:

  1. By splitting income with a family member on a lower income (income splitting can be done in other ways, but discretionary trusts are the ideal structure for that purpose).
  2. Avoiding tax on capital gains (distributions of untaxed capital gains from the revaluation of assets within a discretionary trust to beneficiaries does not attract Capital Gains Tax, though it does for fixed trusts).
  3. Beneficiaries receive tax breaks such as the capital gains tax discount and depreciation allowances even though they have no control over investment decisions, have no funds at risk, and may not even know they are a beneficiary.
  4. (Illegal) evasion of tax and money laundering by shifting funds through complex entity structures (e.g chains of trusts and companies), often to overseas tax havens such as Switzerland.
  5. Transfer of tax losses (mostly resolved via ‘trust loss measures’ but not for ‘family trusts’).
  6. Transfers of income to non-taxable entities such as charitable trusts that are directly controlled by the same individual who controls the private trust.

Some of these avoidance techniques take advantage of long-standing inconsistencies between ‘trust income’ and ‘taxable income’.


Transparency

Private trusts are opaque investment and trading structures. There is no public register of private trusts as there is for companies, and even the ATO often lacks information on who actually controls a private trust and who are the ultimate beneficiaries (especially where there are ‘chains’ of private trusts).

Tax authorities here and internationally are concerned about the implications of this for the integrity of the income tax system.

Private trusts, along with private companies, have also been used for money laundering purposes and this has attracted concerns from police and also counter-terrorism agencies internationally.

Consistent with commitments made by the G20 countries and through the OECD, many countries are establishing national registers of trusts and their ultimate beneficiaries – in some cases public (for example, Italy) and in others held by the tax administration (for example the UK). There is a push within the European Union to make this information public.

Greater transparency of information on private trusts, including their income, who controls them, and who ultimately benefits, is essential for both tax integrity and to expose money laundering.


Reform options

ACOSS has not advocated the ‘abolition’ of private trusts as they have some legitimate purposes (for example to hold and accumulate assets on behalf of a family member with a disability or to raise money for charity).

We have argued for at least 20 years, including in our 2017 Budget submission, for curbs on the use of private trusts to avoid tax.

People should not be able to avoid paying tax at their proper marginal tax rate by using a private trust or any other entity.

There are basically three approaches to curbing tax avoidance and evasion through private trusts.

  1. Tax private trusts as companies (who tax treatment is discussed above).
  2. Attribute trust income back to the controller (who is generally also the source of the funds settled in the trust), as we currently do in social security income tests.
  3. Apply Capital Gains Tax to distributions from discretionary trusts of untaxed or preferentially taxed income (as already applies to fixed trusts).
  4. Improve transparency by requiring trustees to disclose the controller and ultimate beneficiaries of private trusts, and setting up a public register of trusts (possibly administered by the ATO)

[1] ‘Family trusts’ are private trusts whose beneficiaries are limited to family members of the individual that established or controls the trust. In some ways, they have more generous tax treatment than other private trusts. Remarkably, the definition of ‘family’ in the tax law for this purpose extends to five generations from grandparents to grandchildren.

[2] Dale Boccabella (UNSW), ‘The Conversation’, July 2017



ACOSS economics and tax policy work

ACOSS economics and tax policy work is concentrated upon policies that will strengthen economic development and growth, meaning that people on low incomes benefit from more jobs and improved incomes. Another major focus is the reform of the taxation system in order to raise public revenue for the benefits and services people need.

We have participated in reviews of the tax and transfer system through the development of tax reform options; participation in tax reform working and reference groups; and submissions to the tax reform process.

ACOSS Economics and Tax Publications

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