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Welcome to the August newsletter.
Trusted Ways to Reduce Tax
Streaming income and capital gains to particular beneficiaries can significantly reduce your family tax burden.
Where a discretionary trust derives substantial income and capital profits, identifying the tax profiles of the beneficiaries and making distributions accordingly can result in significantly less tax. Where individual beneficiaries are on marginal tax rates in excess of the corporate tax rate (currently 30%), distribution of income to a corporate beneficiary can produce a ‘tax deferral’ advantage. Alternatively where a trustee makes capital gains, distributing them to individual beneficiaries may effectively reduce tax to 23.25% or less.
Where the trust deeds allow trustees to stream income and the accounting records allow for different types of net income to be identified (for example, capital gains, dividends, rental, interest income, etc), the streaming of different types of profits to different beneficiaries results in substantially reduced tax, as illustrated below.
Fred’s trust – a case study
Fred’s trust sold a rental property last June. For the year, it earned net rental of $100,000 and a $120,000 net capital gain from selling shares. Fred, a resident individual beneficiary, is on the highest marginal tax rate of 46.5%. His son, who lives abroad, and a family company are also beneficiaries.
(i)
The rental income
From a tax perspective, it would be beneficial to distribute the rental income to the family company. This is because the family company would only be taxed at a rate of 30% and be left with a better cash-after-tax position in the relevant income year, being $70,000. If the net rent went to Fred, his cash-after-tax position would be $53,500 due to a rate of 46.5%. Distribution of net rent to his son abroad would cost even more in tax.
(ii)
The capital gains
To minimise tax, the trustee should distribute the $120,000 net capital gain to Fred. Assuming that the shares were held for more than 12 months, Fred would be able to access the 50% CGT discount, which would bring the tax payable to $27,900 (an effective rate of 23.25%).
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Tax position of individual beneficiary
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$
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Net capital gain
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120,000
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50% CGT discount
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(60,000)
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Taxable capital gain
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60,000
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Tax payable at 46.5%
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27,900
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If the trustee distributed the $120,000 net capital gain to the family company, the tax payable would be $36,000, at a rate of 30%.
(iii)
The dividend income
If the $70,000 of franked dividend income were distributed to Fred’s son who is a non-resident, it would not attract any Australian tax. The viability of this depends on the distribution not being taxed in the country where Fred’s son resides.
Alternatively, the franked dividends could be streamed to the family company. This may be less advantageous; when the family company makes a distribution to its shareholders, the shareholders will have to pay ‘top-up tax’ (ie: the difference between 30% and their marginal tax rate).
That is, when the family company distributes the dividends received from the trust, being $70,000, to Fred, even if the family company fully franks the dividend, ultimately Fred will be left with only $53,500 after paying tax, which would be calculated as follows:
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Tax position of individual shareholder
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$
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Dividend
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70,000
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Franking credit*
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30,000
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Taxable income
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100,000
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Tax @ 46.5%
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46,500
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Less franking tax offset
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(30,000)
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Tax payable
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16,500
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Cash after tax
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53,500
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* Note: The maximum franking credit has been calculated using the following formula – amount of frankable dividend x30/70
The tax benefit of streaming franked dividends to the family company is based on the dividend income being ‘parked’ in the company for the long term (and not immediately distributed back to its shareholders).
The tax deferral advantage is not a payment of less tax. It is, however, a clever strategy for the deferment of taxes which will allow more cash to be left in a particular income year for investments to be carried out.
Conclusion
A good trust deed, good accounting and good tax advice can often legally save a lot of tax. Events such as children moving overseas or the taking of capital profits can increase your tax planning options. If you have a family trust, you should be getting your tax advice now.
Payments made to trustee by related company were deemed dividends under Division 7A
A unit trust structure was set up for the purpose of purchasing land and constructing a building. The applicants, Di Lorenzo Ceramics Pty Ltd (Ceramics) and Fresta Investments Pty Ltd (Fresta), were unitholders of the trust. To fund the purchase and construction, the corporate trustee of the trust borrowed monies from the bank as well as using monies from Ceramics.
At issue was whether the payment from Ceramics to the trustee was a loan. The Commissioner contended that Ceramics has loaned monies to the trustee and that the loan gave rise to a deemed dividend to the unitholders, as the trustee was an associate of Ceramics that had provided the loan, and the legislation did not exclude a loan by a company to another company in its capacity as trustee. The applicants argued that the payment was not a loan but an investment in the unit trust notwithstanding that the payment was referred to as a loan in various documents and shown as a current liability in the unit trust's tax return.
The Federal Court (Lindgren J) held that the payment was a loan and agreed with the Commissioner that Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) could apply to a loan made by a company to another company in its capacity as trustee. The result was that the payment from Ceramics was a deemed dividend of the trustee and the unitholders were presently entitled to such income of the trust under Division 6 of the ITAA 1936.
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Should you change your portfolio in light of recent market downturns?
Despite the current volatility in investment markets across Australia and the world, now may not be the right time to make significant changes to your portfolio. History indicates that investors who attempt to time the market following a major event will often miss out on market rebounds.
After the stock market crash of 1987, the share market entered one of the most significant growth periods in history. Those who sold at the time of the crash missed out on growth opportunities.
Everyone loves a winner, but just as a ‘sure thing’ may seem attractive, the idea of a ‘fall’ or ‘loss’ or ‘downturn’ can often induce unfounded fear. Too many investors lose money by chasing yesterday's winners rather than doing their homework to identify tomorrow's star performers. What might be doing well or poorly today isn’t necessarily going to be the same tomorrow, or in the longer term.
In addition, regularly switching investments in pursuit of elusive returns can lead to buying and selling at the wrong time. Any sudden reaction in response to market news can mean that investors risk selling in a panic just as the market hits rock bottom, or buying unreasonably when prices are near their highest.
However, on the flip side, investors can often take advantage of opportunities that emerge when the market undervalues certain stocks.
A good financial plan arranged with your adviser ahead of time, takes into account risk management for your portfolio, and with regular reviews you will have a time line and plan for all your investments to help reduce unnecessary and potentially damaging reactions.
If you are concerned about how the recent events have impacted on your investments and what steps you should be making right now, please contact us at your convenience to organise a review of your current portfolio.
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