Are trusts a ‘tax loophole’ exploited by the wealthy?

People who say this are just demonstrating their ignorance. Here’s why.

The ability to use a trust as a ‘tax loophole’ was pretty much closed out in the 1970-80s.

To suggest that trusts somehow make tax disappear for the ‘wealthy’ is plain silly.

Let’s start with how trusts are taxed. As a general rule, they’re not. That’s right, as a general rule, trusts pay no tax. When trusts make income they distribute it to other taxpayers, i.e. individuals and companies. It is these individuals and companies that then pay tax on the income.

If a trust does not distribute the income, then trusts are taxed. But guess what? They are taxed at the highest marginal rate for individuals (47%) on every single dollar. That’s right, companies pay tax at 30% (or 26%)[1] individuals pay tax at rates from 0% to 47%, but trusts pay tax at the top marginal rate. Hardly a great result.

What trusts do allow you to do is distribute income to more than one taxpayer, and to vary the amount each taxpayer gets from year to year. This is called income ‘streaming’ or ‘splitting’. So how tax-effective is this?

Let’s assume you have two taxpayers in a family, a husband and wife. Let’s also assume the trust is making $360,000 a year.  If that $360,000 was distributed all to one of them, the total tax would be $135,097.  If the $360,000 is split between them, the total tax would be $108,194 (or $54,097 each). That’s a saving of $26,903. Not bad.

But here’s the rub – when the total income reaches $360,000 there are no further tax benefits to having a trust and splitting the income. Okay, $360,000 is a good amount of income for a family to earn. But it’s not anywhere near the levels of the ‘wealthy’ – it’s pretty much the average family income in inner Sydney.

Do you really think Packer, Murdoch or Rinehart care about this level of tax saving? They probably spend more than $26,903 a year on champagne.

So when people say that trusts are used by the ‘wealthy’ to avoid tax, what they are really saying is that your average family business is using trusts to ‘save’ in the order of $26,900 in tax each year… Not bad, but not very exciting if you are ‘wealthy’. This also assumes that the taxpayers in the family earn no other income.

Incidentally, let’s consider what would happen if the same family earned their income through a company, in which both the husband and wife held a share. Not only would they get the same eventual result, but they would initially only pay $93,600 in company tax. This results in a further tax benefit of $15,694 (or a total tax ‘saving’ of $42,597).

So how do wealthy people minimise their tax? They simply keep income within a company group. They pay an average rate of 30% (or 26%), and then pay ‘top up’ tax to their individual marginal rate on any income they need to live on.

The really wealthy also usually leave Australia and take up residency in a low-tax country, where they can access their wealth with no further top-up tax. How do they do this? Well, an Australian company can pay dividends to a non-resident shareholder with no further tax applied. So every dollar of income has 30% Australian tax on it, and nothing more. This represents a 17% saving on every dollar. So if you are making $10 million in profits, the tax saving by having a company versus having a trust is around $1.7m each year. And the tax saving keeps increasing the more money you make.

Often the same people who say trusts are a ‘vehicle for the wealthy’ also say we need to reduce the tax rate on companies to be ‘internationally competitive’. I wonder who is writing these newspaper articles? It is certainly not small to medium-sized business owners.

So what if we tax trusts like companies? The Howard Liberal Government looked at this concept very closely in the early 2000s. They even had draft legislation. But what they worked out is that it would cost taxpayers hundreds of millions in additional compliance costs, and not really raise any extra tax. Actually, it may have even reduced tax collections (as the above illustrates). This is because Australia operates a ‘dividend imputation’ regime that works very much like how the current trust taxation works. The only difference is that companies pre-pay 30% (26%) tax before distributions to shareholders, whereas trusts pay no tax if they distribute all of their income to individuals and companies each year.

At its heart, trusts are what we refer to as a ‘conduit’ entity. Income passes through trusts to other taxpayers. To tax the conduit only changes who pays the tax, not how much is ultimately paid. In fact, taxing trusts like companies would actually assist the really wealthy people, as they would no longer need to distribute income to companies in order to access the benefits of the flat company tax rate.

Go figure.

[1] This applies to ‘base rate entities’ which are companies with less than $50m turnover, and have less than 80% of their income from passive sources (i.e. at least 20% of their income is from ‘active’ business activities.  Note this rate will reduce to 25% after 1 July 2021.

The information contained in this post is current at 11 March 2021.

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