Could Labor's trust tax be as much as 60 per cent? Yes, but there's a reason

Try to understand Labor's proposal to levy a 30 per cent new tax on trust funds and you can fall quickly down a rabbit hole. This bewildering area of tax law can confuse even seasoned observers.

But you don't need expertise to raise an eyebrow at the claim, made by some of the government's critics, that some small business owners could be stung with a tax rate of 60 per cent or more. That sounds a lot higher than 30 per cent.

So is the claim true? Is this a hidden sting in the tail of the government's tax package? Asked on the ABC's Insiders on Sunday, Assistant Treasurer Daniel Mulino declined to answer, saying only that "each situation is different".

The short answer is easy: yes, there are circumstances where Labor's new tax could result in a tax rate of 60 per cent. But there's a reason why, and it sheds some light on what the government is trying to achieve with its trust tax.

How trusts can be used to pay less tax

A trust is a financial vehicle used to manage properties, businesses or other assets. It is a popular management tool for those with a lot of wealth, or with complex financial affairs, including many business owners.

For those who use them, trusts can offer greater privacy, control and flexibility than other financial vehicles. But there have long been concerns that they can be used to pay less tax — sometimes much less.

The simplest trust strategy is to split up one person's income among many people. For example, someone who earns $500,000 in a year could use a trust to split that income into five chunks of $100,000 for themselves, a spouse and three children.

To unlock more advanced tax opportunities, a trust owner can create what is known as a "bucket company" — effectively, a dumping place for their money. The company pays the 30 per cent company tax rate, and the family members are made shareholders.

The money can then be given out as dividends at any point in the future. The 30 per cent is refunded as a franking credit, and the family members pay their personal tax rates, opening up additional flexibility to time earnings for tax purposes.

It's complicated, but the use of a bucket company can dramatically expand the tax benefits of trusts. ANU academics Bob Breunig and Tristram Sainsbury have estimated someone can avoid $150,000 of tax on just $500,000 of income in this way.

How the government's trust crackdown works

The government says this is unfair and has proposed a 30 per cent minimum tax on trust income for "discretionary" trusts — those with the flexibility to allow this kind of planning.

The idea is to minimise any benefits from income splitting. Money can still be split up, but will be taxed at least 30 per cent from the very first dollar, whoever it goes to.

But for bucket companies, there is a harsher rule. This, at last, is where the 60 per cent tax rate comes in.

How 30 becomes 60

Under the government's proposal, money going into a bucket company from a discretionary trust will be taxed twice — first the 30 per cent trust tax, and then the 30 per cent company tax.

This double-up does not happen when the beneficiaries are family members. In this case, a refund rule ensures there is no double tax. The 30 per cent is paid only once (though it may be a higher rate if the person is in a higher tax bracket).

But the government has chosen not to extend this refund to bucket companies, to discourage their use.

The tax is not airtight. Trustees will be able to escape the minimum tax if they simply agree to give each beneficiary (people and bucket companies) the same share of income each year.

But Sonali Walpola, an associate professor of tax law at the ANU who supports the new tax, says she believes it will still make discretionary trusts and bucket companies less popular as an option for tax minimisation.

"On equity grounds, this is definitely a step in the right direction," she says. 

"I think it will curb some of the more aggressive uses of trusts for tax minimisation.

"Advisers actively market bucket companies as a tax minimisation tool. They are companies that have no operations and serve no other purpose than to cap residual trust income at the corporate tax rate."

Small business concerns

But the tax has encountered fierce opposition from business groups which say they are a legitimate vehicle used by small business owners who are already taxed enough.

Andrew McKellar, chief executive of business group ACCI, says discretionary trusts give small business owners the flexibility to keep family-owned businesses within the family.

"If you think family pharmacies, small and medium-sized home builders, small retailers, restaurants, cafes … they're using these trusts as a flexible mechanism to protect the assets that they have and to provide succession planning," he said.

"We're not saying that there isn't a way to ensure that tax avoidance or tax minimisation is not occurring where it's illegitimate. But what we're not open to is an assault on legitimate small businesses who are trying to have a go."

Jenny Wong of CPA Australia says bucket companies are useful "to hold profits for reinvestment, to buy equipment, hire staff and get through a bad year … Taking [tax] twice on the way in goes well beyond closing a deferral advantage".

Some critics say the worst examples of tax minimisation can be stamped out with guidance from the tax office, or with "integrity provisions" in the law, rather than a new tax. 

Sonali Walpola says the integrity provision in the tax law for trusts has been largely ineffective in practice.

"There have been less than 10 litigated cases over more than 45 years," she says.

"Administratively, it's very difficult for the ATO to apply."