After decades of trying, the Australian Tax Office (ATO) has finally found a federal government that could be persuaded to tax discretionary trust income.
From 1 July 2028 tax will be paid by the trustee of a discretionary trust at a minimum rate of 30%. The tax-paid balance of the income distributed to individuals and “other non-corporate beneficiaries” will receive non-refundable tax credits for the tax paid at the trustee level.
According to the recent Federal Budget briefing paper, there are 840,000 discretionary trusts in Australia. This number, which is based on ATO registry data, constitutes the vast majority of the 1million plus registered trusts.
However, there is no explanation in the briefing paper for the discrepancy between the total 840,000 discretionary trusts and the 350,000 small businesses “operating” through discretionary trusts – nonetheless by definition, these 490,000 discretionary trusts (58% of the total) must be reporting income to be included in the ATO’s count.
There is no doubt that some of them fall outside the ATO’s definition of “small business”, which is an individual, partnership, company or trust that has an aggregate turnover of less than $10 million. For others, it is likely that although the business is not being “operated” through the discretionary trust, it plays a vital role in the business’s total ownership structure. This role may be to hold the assets used by the business owners in “operating” the business, together with the other assets accumulated by them from the fruits of their efforts.
Unfortunately, most of these businesses (which leverage this structure as it delivers numerous benefits such as the protection of personal assets from business liabilities, flexibility with profit distribution to beneficiaries in lower tax brackets, and an allowance for a 50% discount on CGT), will potentially face a higher tax burden under these proposed reforms, simply because they have selected a structure which enables them to operate a business safely and efficiently.
Certain limited types of trusts will be excluded from these changes such as fixed trusts, widely held trusts, complying superannuation funds, special disability trusts, deceased estates and charitable trusts. Furthermore, the reforms are not anticipated to apply to certain types of income, such as primary production income, certain income relating to vulnerable minors, income to which non-resident withholding tax and income from assets of discretionary testamentary trusts exist at the time of the announcement.
How will the new trust reforms work?
From 1st July 2028, income generated within a discretionary trust will be taxed at 30%. This tax will be paid out of the trust before it distributes any payments to beneficiaries.
Each individual beneficiary (not corporate beneficiaries) will receive a non-refundable credit for the tax paid.
This operates in a similar manner to the corporate taxation system in which businesses pay tax, and individual shareholders receive franking credits for any tax already paid. Shareholders can then offset the franking credit against their personal income tax, to ensure they are not taxed twice for the same income.
Asset protection is key
Here at Antcliffe Scott we act frequently for clients starting new businesses. Whilst every business owner believes in what they are doing, they also know that the odds are not in their favour, as most new businesses fail in the first few years.
Aware of the risks, in most cases these start-up entrepreneurs integrate a discretionary trust as an essential element of their ownership structure, to protect their assets against the risk of business failure.
Whilst they do appreciate any tax benefits that may flow, tax minimisation is rarely the major reason for using a discretionary trust. In fact, for most start-ups the tax benefits are negligible, particularly in the early years, and certainly not a reason to justify the cost and added complexity of establishing and maintaining a discretionary trust. The key reason for using a discretionary trust is simply asset protection.
The Federal Assistant Minister for Science, Technology and the Digital Economy, Andrew Charlton, acknowledged as much when interviewed on Sky News:
I set up a business, like many Australians who set up a business. … This is what they do: they walk into their accountant, they tell them that they’re setting up a business, and their accountant says, ‘Great, here’s your Pty Ltd company, and here is the trust that goes with that extremely standard process for many Australians setting up a business.’
The purpose of that is not for a tax reduction; the purpose of that is for asset protection.”
That purpose and reason for using a discretionary trust as part of your business planning does not go away with these reforms – it is still the simplest and most cost-effective way to protect your personal assets, and your family’s security, from the vicissitudes of business life.
Unfortunately, the budgetary changes do not simply neutralise the position of discretionary trusts as compared with other business structures. In fact, the Federal Government is actively seeking to push businesses away from discretionary trusts and into other business structures. The Federal Budget briefing paper emphasises the relative tax advantages that will be available to small businesses that restructure as companies or fixed trusts. However, it does not address the loss of asset protection that would follow.
This is not surprising from the Australian Tax Office, which has never believed that discretionary trusts have a purpose other than tax minimisation. However, it is disappointing that Federal Treasury does not have a more sophisticated understanding of the importance of discretionary trusts for asset protection.
The reality is that these reforms and the additional burden they place on businesses in terms of higher ongoing tax costs and the associated impact on cash flow, growth and more, will in many cases, force businesses to reconsider their business structure and reshape how their business operates over the long-term, which can potentially reduce flexibility for wealth protection and succession planning.
Restructuring out of a discretionary trust
Making the decision to restructure out of a discretionary trust is not a straightforward one. It is a choice that needs to take into consideration a range of relevant factors (not just tax), including but not limited to:
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- Asset protection. Moving assets into a company structure or individual names may change the risk profile of the group.
- Financial implications. Transferring assets may involve the updating of banking arrangements and finance facilities, require refinancing or result in borrowing capacity changes.
- Legal support and administration. Restructuring may require new contracts with clients, suppliers, real estate and staff.
- Stakeholder management. A clear communication campaign which incorporates all internal and external stakeholders is needed to ensure continuity, compliance and client retention.
- CGT implications and loss of indexation: Where assets are transferred, CGT consequences must be carefully considered as tax outcomes may differ.
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Rollover relief will be available from 1 July 2027 for three years for those who wish to transition from a discretionary trust structure into other entity types, such as companies or fixed trusts. This will help small businesses and families restructure out of discretionary trusts without triggering immediate income tax or capital gains tax.
Looking at the path ahead
In the context of these proposed changes, sometimes it helps to take a long view. It is generally agreed that legal structures broadly analogous trusts first appeared in English law (on which Australian law is based) in about the 12th century, as a means of enabling Franciscan monks, whose vows of poverty precluded the ownership (and hence inheritance) of property nonetheless to enjoy the benefits of that property.
It did not take long for astute lawyers to realise that similiar devices could be applied across a variety of other situations to overcome feudal restrictions on inheritance, and the associated fees payable to the King, assisted by the Courts of Chancery, which derived their authority from the Church, not the Crown.
Henry VIII, as part of the Dissolution of the Monasteries, legislated to put an end to these practices, but over time the lawyers and the courts found new creative solutions to circumvent the King’s legislation – and so it has continued for some nine centuries.
The more things change, the more they stay the same. Right now, a bright spark somewhere is no doubt beavering away, figuring out how the changed trusts tax regime can be turned to some new advantage!
In the interim? There is no need to hit the panic button. There is a substantial amount of time until these changes come into effect, and it is quite possible that the Government will listen to the voices of common sense and modify the proposed rules around discretionary trusts moving forward. But whatever happens, the discretionary trust will continue to have an important role in protecting the assets of those Australians who are prepared to give it a go in the tough world of small and medium-sized business.