The concept of a ‘bucket company‘ is used to describe a company into which distributions from a discretionary trust are made to cap the tax rate on the trust’s income to the flat company rate of 30%.
Generally the trustee will first look to distribute the trust’s income to a number of individuals who are on marginal tax rates at or below 30%. When those marginal rates have been fully utilised, any residual trust income is then directed to the company, i.e. it is put in the ‘bucket’.
Not surprisingly, the Tax Office is not a big fan of bucket companies, so great care needs to be exercised in the use of this strategy.
In particular, if the cash funds are left outstanding from the trust to the company – in the form of an ‘unpaid present entitlement‘ – then Division 7A (ITAA 97) can apply to deem the unpaid amounts to be assessable dividends. These dividends are generally treated as ‘unfranked’, so the effective rate of tax on the trust income can then exceed 64%. Division 7A issues can also arise if the cash is paid to another party, i.e. an associate of a shareholder in the company.
If the cash is actually paid to the company, then the company will need to do something with it. If the company invests the cash in its own name then any investment income will also benefit from the flat company tax rate of 30%. However, any capital gains that the company may make on such investments will not benefit from the 50% CGT discount. Accordingly, investing the cash through the company may not result in the best longer-term tax outcomes.
The best thing the company can do with the cash is lend it to another entity under a complying Division 7A loan, and for that other entity to then invest the cash so as to qualify for a deduction on the interest paid back to the company. The company will then also pay a series of dividends over time to enable the other entity to fund the principal repayments on the loan.
So in short, the bucket company concept can be useful in managing short term and lumpy tax obligations of a trust. However, the strategy is not without its difficulties, and must be implemented extremely carefully.