The general public know there is something “not right” with the tax treatment of family trusts (discretionary trusts). Accountants and tax lawyers working with discretionary trusts know first hand that the income tax treatment has trouble passing the “smell test”. Even the most aggressive tax minimisers would concede that.
Yet, the tax treatment of discretionary trusts has had little attention in government tax reviews. The 2010 Henry Review did not consider the appropriateness of the tax treatment of discretionary trusts - this was a shortcoming.
So, what is the odour around discretionary trusts? The short answer is that the tax rules treat the discretionary trust (and their beneficiaries) quite differently to other situations that are legally and economically similar. This contravenes the equity (fairness) and neutrality tax policy criteria, the two key guiding principles that should shape the tax rules.
For example, the discretionary trust allows for the “dishing out” of gifts to family members such that the gift recipient becomes the proper taxpayer on the trust income under the income tax law. This allows the pool of trust income to be spread across numerous “family members”, instead of being taxed to, say Mum and Dad. Aside from a very odd and narrow exception, the tax rules do not permit this (gift recipients are taxpayers) in any other part of the Tax Act.
What is even worse is that in many cases, the designated gift recipient knows full well, before the event, that that are not really entitled to keep what has been allocated to them. At times, the gift recipient does not even know they are a potential beneficiary or that they have been allocated an amount. The clear message to the gift recipient - and the world generally - is that this is “just for tax purposes”.
Another example is the arm’s length test. Virtually everywhere else in the Tax Act, related party transactions (e.g. gifts of property) are treated as taking place at arm’s length (i.e. impose market value). Yet, in the discretionary trust, the arm’s length standard does not feature at all in regard to profit “distributions”. If arm’s length rules were applied, and admittedly problematic, it is very likely we would see higher taxation of the controller of the discretionary trust.
Even though there is overlap with the above, the questionable aspects of the tax treatment of the discretionary trust goes on and on (e.g. open-ended income splitting of business and property income, taxation of a person who has no property right). In short, for non-discretionary trusts (e.g. company), the tax advantage flowing from these questionable aspects are not tolerated.
In many areas, the treatment of discretionary trusts outside the income tax system fundamentally departs from the income tax treatment. When the income tax treatment of an entity departs significantly from its non-tax legal treatment, some credible justification should be provided for its continuance.
Under the income test and assets test in the social security system, the person who contributed the assets to the discretionary trust or the person who controls the assets in the trust is deemed to own the income and own the assets. In other words, control of assets and being the source of assets is regarded as effective ownership. Yet, this is not the case with income tax. The controller of income is not the taxpayer.
It is worth remembering that the social security system is really just a negative income tax; to the plaudits of many around the world, need and capacity are at the core of both these systems (or more correctly, one system). Accordingly, the inconsistent treatment is hard to justify.
On property division on family breakdown, a divorcing spouse (usually male) cannot claim that assets held in a discretionary trust are not owned by him and therefore should stay out of the divisible property pool. Instead, the Family Court will look to see who controls the disposition of the assets inside the trust and who can benefit from that dispositive power when determining the divisible property pool and potential sources of future income. That is, “hiding” behind the [legal] suspended ownership feature of a discretionary trust is not accepted. Yet, it is for income tax.
There is no room in this article to make an estimate of lost revenue, and importantly, the basis for such an estimate. However, we are not talking “just” millions; even on very generous non-minimisation assumptions, we are easily talking above $1b annually.
Small business and farmers are heavy users of discretionary trusts, partly on the basis of non-tax reasons (e.g. “asset protection”). In addition, significant wealth is now passing on death “to” children and grandchildren into discretionary trusts. These circumstances provide a significant political hurdle to reforming the income tax rules.
Further, there are undoubtedly some discretionary trusts (likely to be small in number) that are not being used for much tax minimisation (e.g. where income allocations are regularly made to beneficiaries already on the top marginal rate of tax).
However, all of this does not change the fact that the income tax treatment of discretionary trusts is “way out of kilter” with the tax treatment of other entities and other taxpayers. Like any odour, I cannot see how it will go away without a full and rigorous examination of the source of the odour.