• Aug 4 2017 at 11:49 AM • Australian Financial Review (AFR)

• Updated Aug 4 2017 at 11:26 PM

Strategies to beat Labor's new trust rules

Bill Shorten: 'First, he has transformed the politics of patriotism in this country..' Janie Barrett

• Sally Patten

• Joanna Mather Emboldened by the public reaction – or lack thereof – to Labor's proposals to water down the capital gains tax and negative gearing benefits, Bill Shorten this week pledged to crack down on family trusts. The Labor leader's plan to tax distributions from family trusts at 30 per cent is estimated to raise about $1 billion a year over four years.

"Every year in Australia, there are high-income earners who use discretionary trusts to park their money in a lower tax bracket," Shorten told the NSW Labor conference last Sunday.

"That's not fair on Australians who'll never be able to afford this option. Our system should not be subsidising those who are already wealthy."

Some accountants say the Opposition's attack on trusts is misplaced. David Rowe Some accountants say the Opposition's attack on trusts is misplaced, arguing that family trusts are mainly set up by small businesses and professionals in an effort to protect their assets from potential lawsuits and for estate planning purposes, rather than to reduce tax bills.

"The tax benefit is the additional nice-to-have," says Chris Morcom of Hewison Private Wealth.

Furthermore, accountants argue that Labor's proposal will not hurt very wealthy families because income splitting inside trusts is insignificant to their investment strategies.

Serious threat

Labor's plans, of course, are a long way from being introduced. An election doesn't need to be called for another two years or so. Assuming Labor did win, it would presumably take a while for legislation to be passed. But experts are taking the threat seriously, particularly as financial structures are long-term affairs and there are no details on potential transition arrangements.

"The tax benefit is the additional nice-to-have," says Chris Morcom of Hewison Private Wealth. Erin Jonasson "That's why we are so curious. If you look at all the polls, Bill Shorten will be our next prime minister," Sean Cortis, chief executive of business advisory firm Chapman Eastway, says.

"People need to keep a watching brief on this," says Michael Parker, a partner at Hall & Wilcox. "The closer we get to an election, the more probable that it could come in sooner rather than later. What works now may not be appropriate if the rules change."

Broadly, trusts are used for two purposes: for the operation of a business or as an investment vehicle. In the case of the latter, the aim may either be to protect investments from potential lawsuits, or to minimise tax – or both. They are commonly used by small businesses, professionals, such as doctors, lawyers and accountants, and wealthy families.

Trusts are commonly used by small businesses, professionals, such as doctors, lawyers and accountants, and wealthy families. Luciano Lozano Some argue that changes to the tax treatment of family trusts will not turn many people off them because of their role in asset protection. If a doctor or a lawyer is sued by a patient or client, their personal assets cannot be touched if they are held in a discretionary trust.

"In a more litigious society that we have, personal assets are at risk if they are held in your own name. Maybe trusts will remain the best option because they provide asset protection and estate planning flexibility," Morcom says.

"For me, I think trusts will have a massive ongoing role. They still tick the boxes of asset protection, allowing for family succession and allowing assets to be owned collectively by a family," adds Cortis.

Others point to the capital gains tax benefits afforded to trusts, which do not apply to company structures. Companies must pay capital gains tax in full, whereas trusts have access to the 50 per cent discount – although under Labor's plans, that discount will be less.

Some argue that changes to the tax treatment of family trusts will not turn many people off them because of their role in asset protection. Louie Douvis

Potential for change

Still, there is a school of thought that suggests that if the landscape changes, accountants and their clients will change with it.

"This will frighten some people off trusts," says Ian Gillies, partner at Hamilton Wealth Management.

"There will be an incentive to reallocate assets to different structures," adds another adviser. Ian Burgess, private client services leader for Oceania and Asia Pacific at professional services firm Ernst & Young, argues that wealthy investors – as opposed to ultra wealthy investors – and small businesses will "need to restructure out of a discretionary trust".

The response to the Labor crackdown will depend on the objective of the family or discretionary trust. Frank Maiorana The response to the Labor crackdown will depend on the objective of the family or discretionary trust.

Small business owners 1. Companies Running a small business through a company rather than a family trust is the most obvious alternative to family trusts, say many experts, particularly if the capital gains tax discount is halved by Labor.

Parker says that in any case corporate structures have become more popular over the past few years as they tend to be a more efficient way to pump working capital into a business.

The tax rate for small companies is 27.5 per cent, but the upside is that dividends are fully franked. This means that if the profits from the company are paid to shareholders who earn less than $18,000 a year, those shareholders are entitled to a full refund of their franking credits. If shareholders earn less than $37,000, they will still receive a refund from the Tax Office because their tax rate is less than 27.5 per cent.

The company could have just a couple as the shareholders, or it could have multiple shareholders, say, including adult children. The downside for a couple who agree to have their children as shareholders in the business is they will be granted fixed rights, including rights to an equal share of the dividend payments. One way around this may be to look at multiple classes of shares, such as preference and non-voting shares, says Burgess.

"For most people, you will be better off in a company with multiple shareholders than a discretionary trust with multiple beneficiaries," Burgess adds.

Running a small business through a company rather than a family trust is the most obvious alternative to family trusts, say many experts. iStock "Companies are good for families who work well together and think intergenerationally," Cortis says.

The unknown is the potential cost of transferring assets from a trust to a company. There could be stamp duty, capital gains, GST and income tax implications, depending on the extent of rollover relief a Labor government may offer.

"The biggest issue will be transitional relief," says Burgess.

"A whole lot of uncertainty has arisen. We are hungry for detail," adds Cortis.

The Institute of Public Accountants' Tony Greco points to the small business restructure roll-over regime that was announced in the 2015-16 budget as part of the "Growing Jobs and Small Business" package.

The measure allows business owners to move from one legal structure to another while deferring gains and losses that would usually be realised in such a move. In

other words, businesses can transfer "active" assets such as trading stock, revenue assets and depreciating assets between entities, such as from a trust to partnership or company, as part of a "genuine restructure of an ongoing business". But, warns Greco, the restructure cannot occur purely for tax reasons and there are strict anti-avoidance provisions in place.

"Nevertheless, Labor's policy will have the creative juices flowing for accountants," he says.

2. PAYG

If the rules change, businesss operators should think about using the tax-free threshold in the income tax system and pay themselves a wage. Jessica Shapiro Under a trust structure it is common for business owners to receive all their income from the business through trust distributions to themselves and potentially a spouse and adult children. If the rules change, businesss operators should think about using the tax-free threshold in the income tax system and pay themselves a wage, experts say.

"If trusts are taxed at a flat rate of 30 per cent, you are better off at least paying yourself up to $37,000 a year, the threshold of the 32.5 per cent tax, through salaries and wages," Parker says. Ditto for a spouse who is working in the business, although the work has to be genuine and the remuneration paid at an arm's length.

Still, says HLB Mann Judd's Peter Bembrick, "it shouldn't be to hard to justify someone earning between $35,000 and $40,000 a year".

Says another accountant: "I will be advising my business operating clients to pay a wage to family members to avoid paying thousands more in tax."

The downside is that beyond a certain threshold payroll tax will kick in, although this won't affect most small businesses.

Another challenge may be that business owners will need to be reasonably certain of their expected annual turnover in order to pay themselves a salary. Distributing income through a trust provides flexibility on this front.

3. Bucket companies Another option may be to maintain the trust and distribute more of business profits to an investment, or bucket company. The bucket company would then pay dividends to shareholders. If the shareholders of the bucket company earned less than $18,000 a year, they would effectively pay no tax on the dividend income because they would receive a refund for the franking credits. But, before business owners get too excited about this option, most advisers expect this loophole will be closed before the new regime gets off the ground.

Another option may be to maintain the trust and distribute more of business profits to an investment, or bucket company. Jessica Hromas "There will be all sorts of integrity measures," predicts Cortis.

Investors 1. Superannuation What's old is new. With the possibility of a flat 30 per cent tax being applied to discretionary trusts, superannuation is looking attractive once again.

This is in stark contrast to the mood about 15 months ago, when financial advisers predicted the super reforms introduced on July 1 would prompt investors to establish family trusts.

"We saw family trusts as rising in popularity, but now people may have to reconsider," says HLB Mann Judd partner Jonathan Philpott

Earnings in super are taxed at the concessional rate of 15 per cent. The downside is that super savings cannot be accessed until the superannuant is at least 56 and starts a super pension. The other downside is that it is hard to inject much more than $1.6 million into super, thanks to the Coalition's super reform package. Still, accountants predict that savers will be more inclined to ensure they have exploited the super contributions rules fully.

"People will be eyeing off super a bit more keenly," says Parker.

"We saw family trusts as rising in popularity, but now people may have to reconsider," says HLB Mann Judd partner Jonathan Philpott. Karl Hilzinger 2. Personal holdings The next port of call, says Burgess, is holdings assets personally, to exploit the tax-free threshold. This is particularly useful for people over the age of 65 who have access to the seniors and pensioners tax offset. This gives a couple about $60,000 of tax-free income a year, which assuming an earnings rate of 5 per cent, amounts to about $1.2 million of capital.

3. Testamentary trusts

Some argue that testamentary trusts will become a more popular estate planning tool than discretionary trusts if Labor gets its way. Distributions can be paid to any beneficiary at the marginal tax rate.