The government wants trusts to pay a minimum 30% tax. What’s behind the changes?

This week, the federal government introduced into parliament proposed changes to discretionary trusts, imposing a new minimum 30% tax rate on income from trusts.

While these trusts can have legitimate uses, particularly for small businesses, they can also be used as a tax minimisation strategy for wealthy individuals.

Treasurer Jim Chalmers told parliament more than 95% of taxpayers do not receive income from trusts, and most trust income flows to the top 10% of households. He said:

This is all about better aligning the tax treatment of income from assets and income from work.

To consider whether these changes are warranted, we need to understand why discretionary trusts are used.

So, how do trusts work, and who benefits?

The basic set-up

A trust is a structure where trustees look after assets for beneficiaries.

Discretionary trusts are the most popular type of trust and are the object of the government’s reforms, but why? There are three reasons:

1. Asset protection: Trust property is protected from legal action against trustees and beneficiaries. If a sole trader goes bankrupt, property held in a trust cannot be sold to pay creditors.

2. Estate planning: Control of the trust property can be passed to future generations because trustees and beneficiaries can effectively replace each other upon death. Company trustees can live forever!

3. Tax minimisation: In a discretionary trust, the trustee can split income as they see fit. Tax is paid at the beneficiary’s tax rate. To reduce tax, income is allocated to beneficiaries on the lowest marginal tax rates first.

Whether a discretionary trust is effective in reducing tax bills depends on how many beneficiaries there are and how much they earn. Children under 18 who are not working full time are subject to very high tax rates on income they did not earn above $416 per year.

But wealthy families with non-working adult children can distribute income among the children to minimise tax with each child using the tax-free threshold of $18,200.

Is ‘legitimacy’ in the eye of the beholder?

Whether these three uses are legitimate or not depends on people’s perspective. Trusts can minimise tax, but for most families the amount is generally small.

Trusts are also an easy option to operate a business and keep it separate from personal affairs. Trusts do not cost much to set up or administer compared to companies. (Partnerships do not provide the same asset protection.)

But experts generally agree it is unfair for wealthy people to minimise tax on investments through trusts, while wage earners cannot use trusts at all.

When Chalmers first presented the changes in the May budget announcement, he said it was important to better align the tax rate paid on trust income with the rates paid by salaried workers.

He cited Treasury analysis that shows families with discretionary trusts faced an average tax rate around four percentage points lower than families with similar incomes who do not use a trust.

Avoiding the new rules

However, trustees of discretionary trusts have several options to avoid the new rules and the 30% minimum tax rate.

They can restructure to a company where the tax rate is likely to be 25% and beneficiaries will become shareholders. This would normally result in immediate capital gains on asset transfers, but the government is offering relief for this. Alternatively, trustees can give up their discretion by fixing each beneficiary’s interest in the trust property.

While the changes are expected to raise over $4 billion from 2029-30, the changes may not achieve that or improve fairness.

Examples provided by the government show an imaginary taxpayer called Steve, who earns $200,000 in income through a family discretionary trust. By splitting the taxable income among his family members, Steve’s family currently pays $24,008 in tax, for an average rate of 12%. Without a trust structure, Steve would have paid $59,602 in tax.

The budget papers do not show the effect on trusts that have incomes less than $200,000. These will pay more tax than wage earners earning the same income under the new rules.

Some legitimate concerns

Under the new rules, wealthy families who continue to use trusts will pay more tax, but how much more depends on how they respond and whether they can use other tax rules to continue minimising their tax payments.

If enough families restructure as companies, they will continue to reduce their tax bills – and the government will not achieve its forecast extra revenue.

The tax and accounting professional bodies have raised legitimate concerns about:

• the costs of obtaining professional advice and potential stamp duty on asset transfers
• how the rules will operate, especially with respect to charities and switching to fixed trust distributions, and
• ongoing compliance costs.

These concerns, if not addressed, may create a short-term win for accountants and state governments from providing advice and restructuring costs. Small trusts will be the losers. These uncertainties need to be resolved.

The question remains whether the government’s goals for increasing fairness and (let’s not forget) raising revenue will be achieved. As the old saying goes, the devil is in the detail.

This article provides general information only and not to be taken as financial or tax advice.