102 Accounting: Business Reporting for Decision Making
REALITY CHECKIs it time to get tough on the tax benefits of family trusts?
The use of discretionary trusts can be a great tool for managing family wealth. It can also be a good way
of avoiding tax. Should the government close the loophole? Dale Boccabella surveys the facts.
The ICAC enquiry into the dealings of NSW parliamentarians has indirectly thrown the spotlight onto
the tax treatment of family trusts and raised an important question: should the government close the tax
loophole offered by discretionary trusts?
Even financial advisers who recommend the discretionary trust to their clients would concede that
these trusts offer big tax advantages.
It is difficult to quantify just how much tax has been lost to the government because of the favourable
way discretionary trusts are taxed: there is no reference benchmark approach.
Yet there’s no doubt that reform of these trusts would bring in considerable extra revenue.
But is it right to see foregone revenue as the central reason for a re-examination of the way dis-
cretionary trusts are taxed?
The fact is that inequitable treatment alone should be the guiding motivation.
In other areas of federal law the concept of ‘suspended ownership’ is not tolerated. Suspended own-
ership is a central feature of discretionary trusts because no one beneficially owns the assets.
Prior to 2002, pensioners could place their assets in a discretionary trust and claim they do not own
the assets for the purpose of means testing under the assets test. In addition, making income allo-
cations to non-pensioner beneficiaries would also ensure the income from the assets would not be
counted as income of the pensioners.
In 2002, the Howard Government amended the Social Security Act 1991 so that pensioners could no
longer use this strategy.
From 2002, assets in a discretionary trust are attributed, or ‘treated as owned’, to the person who
controls the assets, such as a trustee, or the person who provides the assets to the trust. A similar
approach is taken to income from the assets.
In family law, assets in a discretionary trust can be counted as property of the parties to the marriage
and therefore effectively be available in making the property division. Capacity to control the assets in
the trust is the key test to be satisfied.
Yet, when it comes to income tax, the law rules that income from the assets belongs to no one until
the trustee allocates it to someone — ranging from close or distant family members and even a bucket
company. But even then the tax law continues to treat the assets as not having a beneficial owner.
Given the close link between the social security system and the income tax and the fact that the
social security system is really a negative income tax, it is very hard to see how the markedly different
treatment can be justified.
One set of rules allows the advantages of the discretionary trust vehicle to be retained; the other does not.
It is hard to understand why there is no momentum to reform the taxation of discretionary trusts.
Yet, there are some clues.
Firstly, there is a chance that some if not many politicians might not really appreciate the
tax-advantaged position of discretionary trusts.
Secondly, there is no doubt that the small-to-medium sized business sector is a heavy user of
discretionary trusts.
There can also be no doubt this sector has considerable political clout which can not be ignored by
the main parties. The perception or reality is that there are votes at stake.
Anyone who needs to be reminded of this should look at the fairly generous income tax concessions offered
to the small business sector. The politics of the issue are also obvious in the government’s decision to reject a
Henry Review recommendation to remove two of the four small business capital gains tax concessions.
Thirdly, and perhaps a sub-set of the point above, is that the farming community is a heavy user of
discretionary trusts.
The farming sector also has considerable political influence and we should not forget that lobbying
from the Nationals (a Coalition partner) was designed to force the Howard government to change its
policy to tax trusts like companies.
This measure would only have had a limited impact on the tax advantages of discretionary trusts but
the perception was one of having a major impact on those advantages.