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What would you be prepared to do for $9,500 a year?

"Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Nobody owes any public duty to pay more than the law demands. Taxes are enforced extractions and not voluntary contributions. To demand more in the name of morals is mere cant."

Judge Learned Hand, 2nd Circuit Court, 1947

The Ralph Reforms (which didn’t go ahead) were meant to make all business vehicles equal. That was an untruth. The new social security means test rules seek to ensure that however you hold your assets you receive comparable treatment. If you hold assets in a company, Testamentary Trust, Family Trust or fixed trust you should be treated the same as though you held those assets in your own name (beneficially). Is this another untruth by the government?

·        The new rules start 1 January 2002. (This gives us time to take stock of our position.)

·        They affect both existing and “future private trusts” and “private companies”.

·        They don’t affect “public unit trusts”, “public companies”, “wealthy companies” and “Superannuation” (including Self Managed Superannuation).

Control Test – 1. Private Trusts

You control the trust if you can:

1.     Dismiss and appoint the Trustee

2.     Veto a trustee’s decision

3.     Amend the Trust Deed

4.     Have an “associate” controlling the trust and you “informally control” the “associate”

There is little recognition on who has the day-to-day management issues of the vehicle. Centrelink is seeking out the ultimate controller. Generally the appointor, principal and guardian holds this position of power. The trustee of a trust may also hold some of these powers.

If you are the controller then you suffer “attribution”. The income is therefore attributed to you.

What is a Family Trust? A Review

Very few of our clients seemed interested in using Family Trusts in gaining Centrelink benefits. The name of the game is to:

1.     Keep control

2.     Reduce Tax (choose who suffers the tax and deferring the paying of tax)

3.     Protect Assets

4.     Protect Appointor, Trustee and Beneficiaries from insolvency in the trust

5.     Estate Planning (provide tax effective distributions through the estate)

6.     Stop assets being challenged in deceased estates applications

After partnerships Family Trusts are the most popular business structure. Your Tax Lawyer sets up a deed. They are very flexible. They provide your Adviser and Accountant with great scope in sharing the tax burden around your family.

Here is a story about Charles and Gianna …

Charles and Gianna control (through a family trust) a corner deli. They give themselves annual wages of $60,000 each. At the end of the year their Accountant tells them the good news that (after their “wages”) they have made $40,000. What would happen if Charles and Gianna individually took this additional income? They would pay almost half of it in tax - not much fun for all that hard work.

Because they are in a Family Trust they distribute $18,000 to their 18-year-old son. The son gets all the tax benefits of an adult and pays tax at the lower tax rates. The remaining $20,000 Charles and Gianna keep in their Family Trust at 30%. The Family Trust pays a lesser tax rate than Charles and Gianna.

A Family Trust can exist for up to 80 years. If Ralph reforms go ahead unchanged you have up to 80 years to try and get back some or all of the 30% that you paid that year in tax. In theory, given time, you may be able to get all the income out of a family trust without paying any tax. You do this by distributing to family members who pay tax at less than 30%. The ATO gives you back all or part of the 30%!

Who are the players in the Family Trust?

1.   Trustee – everything in the trustee’s name, but only as the legal owner. Not the “beneficial” owner (puppet only). The owner in name only. In the old days the Trustee of the Family Trust would be Dad or a company. These days the Trustees are generally Mum and Dad. Where there are two or more trustees their decision has to be unanimous (otherwise the Trust Deed needs amending). If the Ralph amendments ever get through it will continue to be the case that it is generally a waste of money to have a company as a Trustee.

2.   Appointor (Guardian) – hires and fires the Trustee (God!). The power to appoint and dismiss the trustee is given to the Appointor (sometimes called Guardian) of the trust. Usually the trust deed confers this power on one or two people.

3.   Trust Fund – The assets (business or other assets such as a home or shares)

4.   Beneficiary - The group of people who can benefit from the trust’s income and capital. Often 100’s of people that you have never met or who haven’t been born yet.

5.   Settlor – the Tax Lawyer who settles $10 on the trust. This just “starts” the trust. If the Settlor is a family member then there are adverse tax consequences; Income Tax Assessment Act (1936) section 102(1).

Who are the beneficiaries?

The beneficiaries are divided into 2 classes:

1.     If you forget to distribute income and the trust deed hasn’t yet been updated for the proposed Ralph changes then the income goes to the default beneficiaries (“primary” beneficiaries).

2.     the remaining class of beneficiaries (“general” beneficiaries) receive income and capital amounts only if the Trustee so directs.

If Ralph ever goes ahead all Family Trusts need to be checked and often updated to allow income to stay by default in the Family Trust (at only 30% - which you then may be able to get back in a later year).

Who gets what in a Family Trust?

Who gets what in a Family Trust is up to the Trustee (acting under the advice of the Appointor). Therefore, the class of beneficiaries is as wide as possible - including the dreaded mother in law and the divorced spouse!

Why have your mother-in-law as a beneficiary?

Beneficiaries have no rights to demand any asset under a Family Trust. They have no property in the Family Trust. They only have a “mere hope” that they may get some income or capital from the Family Trust.

Twenty years ago the Family Law Court snubbed its nose at Family Trusts and said they would treat the assets as belonging to the wayward spouse. Today Centrelink is doing the same thing to allow it to “look through” to the real controllers of the Family Trusts.

What happens if the Family Trust goes broke?

The Trustee of the trust is indemnified out of the assets of the trust. The beneficiaries of a trust are likewise personally indemnified. This means that should the family business find itself in difficulty with creditors, provided you have followed the advice from your Accountant, advisor and Tax Lawyer then it is likely that the only assets that can be called upon to pay these debts are those owned by the Family Trust.

Personal assets owned by the Trustee outside the trust are generally not available for discharging any business liabilities.

The trust also limits the personal liabilities of individual members of the trust business. A director generally goes down with the company. However, the Trustee, Appointor and Beneficiary generally don’t go down with a Family Trust.

How long can a Family Trust exist?

Like a company a trust offers a greater degree of stability than a partnership because it is not dissolved on the death of a beneficiary or trustee. A trust can operate up to 80 years in Australia (even longer in some states).

Can family trusts avoid the defacto death taxes such as Capital Gains Tax and Stamp Duty?

Family Trusts allow legal avoidance of defacto death taxes because case law has held that the rights of beneficiaries in Family Trusts don't constitute an “interest” in your Will. Interestingly, the assets of a family trust do not form part of a deceased estate. A person could have millions in their Family Trust and yet die a pauper.

The only exception to this is “Loan Accounts”. These are moneys that someone has “loaned” to the Family Trust. These balances belong to the person making the loan.

Are Family Trusts still a useful vehicle if Ralph goes ahead?

Ralph, as mooted, has Family Trusts taxed at the same rate as companies - 30%. This applies to income whether “distributed” or “accumulated”. You “distribute” if you pay out income to the beneficiary. You “accumulate” if the Family Trust just keeps the money and pays the taxman 30% on the profits. Beneficiaries are entitled to the 30% “franking credit” for tax paid by the Family Trust in the year they get the income.

What is “franking credit”?

If the trust “accumulates” the income then it pays tax on that income at 30%. For example, $1,000 income means $300 in tax in that year. You don’t “lose” that $300 that you paid in tax. Next year you distribute “last years $1,000” to John Jr your son. If John Jr earns only a small income then he gets back all of the $300 that the Family Trust paid in tax.

What are the Advantages of Family Trusts?

Family Trusts provide great flexibility and less governmental interference than companies. You also get asset protection, income streaming, a fixed tax rate and are not subject to Will challenges. Wealth in your Family Trust doesn’t “belong” to you (you just “control” it.) Therefore your Will can’t touch or effect those assets. The Family Court often sees fit to ignore a Family Trust. However, a spouse can have a Prenuptial Agreement (legally called a “Binding Financial Agreement”). The Family Court has to follow a legal Binding Financial Agreement. A Binding Financial Agreement only became operational in December 2000.

The “informal” control of your family trust

The fourth category of control is “informal” control. Attribution is made to a person who has control via an associate.

“Associate” includes your:

·        spouse (including defacto but not mistresses?);

·        parents, grandparents;

·        children and their spouses, and the children of those children and their spouses;

·        siblings and their spouses;

·        nephews and nieces and their spouses;

·        uncles, aunts and their spouses, and the children of those parties and the spouses of those children;

·        professional adviser e.g. an accountant, solicitor or financial adviser who may be expected to act in accordance with the person’s wishes.

·        a trustee of a trust from which the person can benefit, either directly or indirectly;

·        a partner of the person or a partnership in which the person is a partner; and

·        a company where:

(a)   the directors could reasonably be expected to act in accordance with the directions or wishes of the person; or

(b)   the person and associates can cast more than 50% of the votes at a general meeting of the company;

·        A specified class of persons who, in the opinion of the Secretary, should be treated as an associate of the person.

Control Test – 2. Private Company

As you can see, working out who “controls” the trust is a lot of work. Now we need to look at who can control the private company. You have effective control if you:

1.     Hold 50% of voting rights

2.     Have “governing” director’s powers (eg Class A Management Shares)

3.     Exercise formal or informal control over an Associate who holds the share

This reflects the absolute power you have. Centrelink is fearful of you:

·        retaining profits within the company

·        reducing or eliminating profits by paying higher wages and director's fees

·        issuing more shares to yourself (diluting the value of minority share holdings)

·        preventing the company from being wound up

Source Test – Gifting assets into trusts and companies

We have finished looking at how you control you trust and company. Now we need to deal with you gifting assets into the trust or company. These rules only apply were you gifted the asset or service into the trust or company after 7.30pm WST on 9 May 2000.

The big assumption:

If you gift an asset to the trust then you retain some control of it. Therefore under the source test you are a controller.

Can you get around the rules by:

·        transferring assets into the trust for “inadequate” consideration?

·        transferring assets “indirectly”?

·        giving “services” instead of “assets”? (i.e. work for free)

The answer is no for all of the above.

“Genuine Gift Exemption”

What if you did give the asset away but truly don’t “control” the trust or company?

The source test is not absolute. There is compassion. Just because you transferred assets to the company or trust doesn’t automatically trigger the attribution. You need to look at the facts on a case-by-case basis. The question of control is only one factor to be considered. If you can clearly show that:

·        a genuine gift has been made

·        you have no ongoing involvement in the trust or the company at all

then you don’t suffer attribution under the source test. (You still suffer the deprivation rules.)

When do the “Gifting Rules” apply?

When you actually gift assets to the trust or company is important. Centrelink is kind. It doesn't want you to suffer both the Deprivation (5 year gifting rule) and Attribution (control test). Therefore -

1.     If you made the gift before 1 January 1997 – no change. This is because Deprivation is only for 5 years anyway. Five years will be up by 1 January 2001. However, the above Attribution rules still apply if you still remain in “control” of the trust or company.

2.     If you made the gift between 1 January 1997 and 31 December 2001 – If Attribution (still in control) applies to the trust or company then Deprivation ceases. (This is even though the 5-year Deprivation period is not yet expired.) If you don’t have “control” of the Trust or Company then Attribution won’t apply. The Deprivation assessment continues for the full 5 years.

3.     If you make the gift on or after 1 January 2002 – If you are in control then Attribution applies and no gift is taken to have occurred - no Deprivation. However you may have made the gift but not stayed in control. Therefore there is no Attribution. Instead you suffer the 5-year Deprivation gifting rule.

1. What happens to the income generated in the company and trust?
Attribution Rules - Income

You either have a trust or company that you control (Control Test) or you have put assets into a company or trust (Source Test). Either way you are caught. Any income from the trust or company is attributed to you – even if someone else gets the income and pays tax on that income.

If you as controller choose to distribute the income to other people then:

1.     The amount you distribute is a “gift” and caught by the 5 year Deprivation gifting rule.

2.     The person that got the “gift” pays tax because the ATO doesn’t see it as a gift. The ATO sees it as income.

Exemption 1: Genuine Investor getting Reasonable Dividend Exemption

What about genuine investors? All is OK if the dividend is “reasonable”. (I have never seen a “reasonable dividend”.) A reasonable dividend is not attributed to you as the controller. Similarly, you don’t treat it as a gift.

Exemption 2: Interest Repayments on Genuine Loan Exemption

Reasonable interest repayments on genuine loans are an allowable deduction from the company’s and trust’s gross profits.

2. What assets of the trust are means tested for my pension?
Attribution Rules - Assets

If the control or source test catches you then the assets used in the means test are your net assets minus amounts attributed to genuine investors.

·        The value of the Assets is “market value”.

·        If the family home is in the trust or company then the assets are reduced by its market value. The value of the family home is not attributed to the controller. In effect you, as the controller, are treated as the owner of the family home.

·        Net assets are determined by deducting allowable liabilities from gross assets.

·        For genuine investors, the historical value of the investment (not market value) is attributed to the genuine investor.

The situation is different for:

1.     Testamentary Trusts

2.     Lunatic Trusts

3.     Farmers

1. Testamentary Trusts

A Testamentary Trust is no different than any other type of trust. You just have to die to get one. They are a fantastic Estate Planning tool to reduce Capital Gains Tax and Stamp Duty. In my experience few clients care more about saving tax than gaining Centrelink benefits.

Testamentary Trusts are treated slightly differently to other trusts.

·        If the testamentary trust was activated as a result of a person dying on or before 31 March 2001, then the trust assets and income are attributed to the formal controller. However, if the testamentary trust is administered for the benefit of the surviving spouse and he/she has informal control attribution is to the surviving spouse.

·        If the testamentary trust is activated as a result of a person dying after 31 March 2001, then the surviving spouse is attributed with the trust assets and income if:

o       The surviving spouse directly controls the trust, irrespective of whether they are a beneficiary, or

o       An associate has control and the surviving spouse is a potential beneficiary.

2. Lunatic Trusts

If you are under 18 years of age or of unsound mind then your carer can take some joy.

If you set up a discretionary trust before 7.30pm 9 May 2000 for a disabled person then attribution will NOT be made to you (as controller). This is provided that you can show that the trust is for the exclusive benefit of the disabled person. “Exclusive benefit” means that the assets of the trust and all income earned (except for costs to maintain the trust) are used solely for the disabled person. Attribution is made to the disabled person.

If you set up a discretionary trust after 7.30pm 9 May 2000 for a disabled person and you retain control then attribution is to you (as the source). Attribution to the disabled person only happens when:

·        You die; or

·        You resign control and interest in the trust

provided the trust is for the exclusive benefit of the disabled person.

3. You have to look after the farmer

A survey of farmers conducted by the Rural Industries Research and Development Corporation (RIRDC) showed the following reasons for the delay in the transfer of the family farm:

1.     Can’t work out how to treat ALL children fairly

2.     Can’t think of alternative

3.     We are still actively involved in farming

4.     Fear of family breakdown in succeeding generation

5.     The cost involved in transferring title

6.     We don’t have sufficient information about how to transfer our farm

7.     Our family farm will only just support one family

8.     The financial future of farm too uncertain

9.     Too many problems associated with the transfer

It seems like the farmer has more pressing concerns than Centrelink benefits.

If you have a business under $750,000 and want to pass it on to your children, retire, and get Centrelink benefits then bad luck. Bad luck unless you are a farmer. A farmer can even keep some control.

You have to be a primary producer or married to a primary producer.

You need all of this:

1.     To own or control a net primary production assets under $750,000 (indexed from 1 July 2000)

2.     The trust and company is made up of at least 70% of primary production assets. (Non-farming assets contaminate the Trust.)

3.     An average farm income over the previous 3 years is less than $28,200 (indexed from 1 July 2000)

4.     A family member is operating the farm enterprise

A RIRDC survey asked a number of farmers to rank the source of their retirement income. They gave the following results:

1.     The farm

2.     Pension

3.     Superannuation

4.     Investments (shares etc)

5.     Sale of farm assets

6.     Sale of non-farm assets

Superannuation was ranked as the second most likely source of retirement income, but only 57% of those surveyed had Superannuation. This shows that some farmers have not considered the future sufficiently, nor the possible problems they may encounter in retirement. Perhaps they will need to pull out all stops to get the pension.

What are the costs in transferring the family farm?

Farming Succession Planning does not necessarily mean any transfer of the farm. However, the cost involved with the transfer of the farming business often consists of:

1.            The stamp duty on the transfer of land

2.            The fees associated with the use of professional advice

3.            Capital Gains Tax

If the farm is covered by Part III BAA of the Stamp Act 1921 (WA), then your client can apply to the Commissioner to have the stamp duty exempted or partially exempted. The application of this Act is very broad. It eliminates only one major cost barrier involved in the transfer of the family farm.

How are you going to help your client?

There are a lot of pensioners out there that fall prey to these rules. In an unholy alliance Centrelink dug into the records of the ATO and ASIC. Companies are over-regulated and over watched by the government. Centrelink was able to cross match it pensioners against ASIC records. Unit Trusts and Family Trusts are less regulated and harder to spy on. There are pensioners in Family Trusts (with no corporate trustee) that Centrelink don’t know about.

In February 2001 Centrelink sent out information to pensioners to who they feel may have an interest in a Family Trust or Company. In blind arrogance Centrelink demanded completed written responses by 2 April 2001. The deadline was extended to 31 May 2001.

Even after this second deadline each day Accountants bring Family Trust Deeds to the office and together we try and decipher the Deed to complete the Centrelink form. The questionnaire for private trusts is 19 pages long (69 questions). For private companies this is 15 pages long (51 questions). But wait - there is more. Centrelink wants trust and company income tax returns. Centrelink wants personal income tax returns. Centrelink is recommending that the pensioner speak to their professional tax advisers.

Clients may authorise you or a trusted friend to make enquiries on their behalf. You need a written client authority or statutory declaration to this effect. Such authority can be for a limited period and be revoked at any time.

What does Centrelink do with the forms?

Centrelink looks at your written response. If it can reduce your entitlements today, under the current laws, then it does so.

If they can’t get you now then they will get you as of 1 January 2002. Centrelink will write to you in December 2001 to let you know the bad news.

What advice can you give your pensioner client? These are some suggestions:

1. Why do I exist?

Most people have Trusts to:

1.     protect assets

2.     help with succession planning

3.     dealing with Estate Planning

4.     avoid challenges to deceased estates (family provision claims)

5.     bankruptcy (creditor protection)

6.     reduce tax (income splitting, capital gains tax, generation skipping, stamp duty)

Companies have some of these advantages as well.

However your client’s main reason for having a Family Trust or Company may be to maximise social security benefits. If so then the vehicles are no longer of use. You need to work out whether it is worth keeping the vehicle alive.

2. “It wasn’t me” excuse

Your client may have not have been involved in the trust or company for many years. Alternatively your client may have no idea what Centrelink is talking about and have no knowledge of the trust or company.

There are 2 short forms available: No Knowledge of Involvement and Declaration – No Longer Involved.

The “no longer involved” argument needs support such as proof of sale.

3. “You can stick the pension up your jumper”

This is a rare opportunity to tell Centrelink that they can keep “their” money. Sure you fought in the war to protect Australia. Sure you have been paying tax all your life. But it has become all too hard. Complete the Voluntary Surrender form. This will save you from having to complete the Private Trust form. You still however have to produce trust and company income tax returns and financial reports for the last financial year. This is solely to help Centrelink find away to cut your benefits before 31 December 2001.

3. Winding it up

You can wind up both a private company and a family trust. You can also sell all your shares in the company.

The usual CGT and loss of creditor protection arise. From a social security perspective any distributions of capital received on winding up the company or dissolving the trust will not be treated as income.

What do you then do with the assets?

4. Giving up control

Now this is the fun part. You decide that you don’t want to control the private company and trust. Centrelink accepts resignations as genuine where both you and your spouse:

1.     Relinquish all formal roles and control

2.     Relinquish shares and directorships

3.     Relinquish all beneficial interests

4.     Make a written declaration that you won’t exert any control over, or benefit in any way from the trust and company

5.     Demonstrate that there is no ongoing use and enjoyment of trust assets

6.     Show no “leaseback” arrangements

7.     Show there are no non-genuine loans back to the ex-controllers

This works even if the new controller is your “associate”.

For resignations made after 1 January 2001 - if you as controller relinquish control then you suffer Deprivation for 5 years.

Now for the good bit -

For resignations made before 1 January 2001 –

·        Under the current rules you aren’t a “controller” (the new rules only operate from this January 2001) of a Family Trust. Therefore if you stop being controller before January the Deprivation rules can’t touch you.

·        The situation is similar for the company. Deprivation only affects the actual net asset value of the share you are giving away. Class A Management shares generally have a value of only a few dollars.

You can therefore hand over the reigns of the Family Trust before you die. See it as an early bequest to your children. This means that your children can do what ever they want with the wealth. It isn’t yours anymore. Only hand over after your child has entered into a pre-nuptial agreement (Binding Financial Agreement). Otherwise your child’s spouse can seek to grab the goodies in the trust if there is a family breakdown or your child dies. Binding Financial Agreements only became law in December 2000. They are fantastic. We are doing lots of them. If you are getting married walk down the isle with your Accountant.

Before you hand over all this wealth think about what you are giving up. The pension for a single person is about $9,500 per year. For a couple it is about $16,000 year. Is it worth it. At a 5% return $200,000 - $300,000 would buy you that level of income.

All pensions are taxable except for:

·        Disability Support Pension (if under Age Pension age)

·        Carer Payment (not always)

·        Wife Pension (if both are under Age Pension Age)

Centrelink issues group certificates at the end of each financial year to all persons who were in receipt of a taxable payment that year. Therefore after tax you may be getting less than $9,500 in the hand.

Centrelink won’t accept any dutiable documents until they have been stamped.

You should only amend a Family Trust Deed with Deeds of Variation. Amending a Trust Deed by Minutes is considered foolhardy. The ATO and stamps office keep telling us that if you change the classes of beneficiaries or the beneficiaries themselves then you have a re-settlement issue. The stamps office has stated this. The ATO have a discussion paper on this. The courts have discredited this position. However amending Trust Deeds and Class A Management shares is a delicate operation. If carefully handled changing the Appointor and Trustees doesn’t trigger either ad valoreum Stamp Duty or CGT. Once again don’t attempt this by Minutes. Changes in Trustees and Appointors should be done by doing a Deed of Variation.

Taxes are only one consideration. To change a Trustee may require transferring real estate. The bank may require new loans with all the costs associated with that. This is a cost that needs to be factored in to get your few silver pieces from Centrelink.

5. A Super solution

You may be able to wind up the vehicle and transfer assets in to your Superannuation. If you are under 55 years of age then you avoid the 5-year gifting Deprivation rule.

You may be able to get CGT roll over relief. Also have a look at claiming a personal tax deduction on the Superannuation contribution.

6. Buy an exempt income stream and a bigger house

This is working the system. Certain assets are means tested. Other assets such as your family home and some income streams are not means tested. With ordinary money you can purchase asset test exempt annuities. You don’t have to satisfy any “eligibility to contribute to superannuation rules”. Of course if you can satisfy a condition of release from your Super then you can start an asset test exempt income stream. You also get a nice 15% tax rebate on assessable income payments.

If you are of pension age the income stream can be for life or of life expectancy. If you are under the pension age only lifetime income streams are asset test friendly.

Exempt income streams come at a price. You are denying yourself access to substantial capital. This has additional merit perhaps in a high interest rate period.

7. Buy stuff

No surprises here:

·        Funeral Bonds - $5,000

·        Gift - $10,000 per pensioner year

·        Spend money on your home.

8. Try and confuse Centrelink

What happens if you have multiple controllers? Attribution is based on the level of control each person exercises. Lets say you have 3 controllers. You each have equal power. Then you are only attributed to 1/3^rd of the trust income and assets. Be careful of partnered couples. Poorly drafted Family Trust Deeds state that the Appointors work on majority rule. Partnered couples, as far as Centrelink are concerned conspire together to take full control. The partnered couple is then generally attributed with all the trust’s income and assets.

9. Review Estate Planning matters