Joe Hockey on the Taxation of Trusts

In the space of 24 hours over 6 and 7 April, 2011, the Opposition Treasury Spokesman Joe Hockey made some comments about the taxation of Trusts, only to be criticised and effectively silenced (as he probably knew he would be).

Clover Law does not wish to analyse Joe Hockey's comments from a political perspective.

However, it is worth using them as the basis of a more considered policy debate.

What Did Joe Hockey Actually Say?

Hockey's comments are contained in seven very succinct paragraphs of his speech to the ICAA National Tax Conference on 6 April, 2011.

This is what he said:

"Currently we have a maximum personal income tax rate of 47.5% (including the Medicare levy and the Flood Tax); a corporate tax rate of 30%; and trusts which pay no tax in their own right but with income taxed in the hands of recipients.

"The difference in tax rates according to the type of legal entity seems to have no basis in logic.

"It creates a complex system and it provides incentives to arrange business affairs to minimise tax rather than to focus on business activity.

"It would be simpler and more logical for all three types of legal entity to have the same or a similar tax rate.

"This would best be achieved by lowering the personal income tax rate, and as I noted in my comments on welfare to work, that is likely to involve a simpler and flatter structure.

"Standardisation would also involve taxing trusts in their own right and at the same rate as companies.

"That is likely to be contentious but is worthy of serious consideration."

What is the Evil that Hockey is Trying to Remedy?

The real evil that Hockey was speaking about is the differential rate of tax that applies to different entities.

The differential creates complexity.

However, as a result of this differential, a lot of professional energy goes into trying to structure the commercial and tax affairs of Families and Businesses, so as to minimise the total amount of tax that the same amount of income would be subject to.

Hockey obviously sees this effort as a waste of resources.

He is obviously right.

Understanding the Context

Before analysing Hockey's proposed remedies, it is important to clarify his comments about the different types of entity and the tax rates that apply to them.

The Tax Legislation deals with a number of different types of "entity".

The most important of these entities are:

Individuals;
Companies;
Trusts; and
Partnerships.

Other types of entity are mentioned in the Legislation. However, they are not material to this discussion.

It is worth noting that Hockey did not mention Partnerships.

Individuals

The tax System is built on the taxation of Individuals.

Each Individual has a tax-free threshhold, below which no income tax is payable.

Once the threshhold is reached, income tax is payable at different marginal rates.

Historically, around the world, the marginal rate has been as high as 95% (listen to the Beatles' song, "Taxman", to hear George Harrison's views on this tax rate).

However, over time, the rates have been radically reduced.

Now, the highest marginal rate in Australia is 46.5% (plus the flood levy).

Companies

A Company is a different legal entity to its Shareholders.

A Company is a separate legal entity as a result of being "incorporated" under the Corporations Act.

As a result, a Company is taxed in its own right.

Hockey correctly identifies that the corporate tax rate is 30%.

He also correctly identifies that this rate is lower than the highest marginal tax rate applicable to Individuals.

However, what he doesn't say is that, when a Company distributes a dividend to an Individual Shareholder, the Shareholder:

obtains a "franking credit" for the 30% tax paid by the Company; but
must pay additional tax in accordance with the marginal rate applicable to the Individual Shareholder.

Thus, subject to the timing of the tax liability, when corporate profit is ultimately distributed to Individual Shareholders, the total tax imposed is comparable to the rate applicable to the Individual Shareholder.

Retained Profits and the Significance of Timing

One of the characteristics of a Company is that it is a separate entity with its own tax liability.

Once it has paid its tax liability, it can retain its after-tax profit for working capital purposes.

There is no commercial, legal or tax obligation to distribute its after-tax profit to the Shareholders.

Thus, if the Company wishes to use its after-tax profit for business purposes, it can limit the effective tax paid with respect to this profit to 30%, at least until it decides to distribute the after-tax profit as dividends.

This effectively delays the imposition of tax at the higher marginal tax rate of the Individual Shareholders, until the after-tax profit is no longer required by the Company.

This creates a tension between the interests of Companies and Shareholders.

This outcome does not necessarily benefit Shareholders who are looking for high income.

However, normally, the retained profit would enhance the capital value of the Company and therefore its shares.

Thus, the retention of profits suits Shareholders who are seeking Capital Gains.

Trusts

The Tax Legislation describes a Trust as an entity.

However, it is not an entity that has to pay income tax in its own right.

A Trust is actually a relationship between two categories of person:

the Trustee; and
the Beneficiaries.

The income tax on the Income of the Trust must be paid by either the Trustee or the Beneficiaries.

Because Trustees pay income tax at a higher rate than Beneficiaries, normally all of the Income of the Trust is distributed to the Beneficiaries (who are "presently entitled" to the Income) and it is taxed in their hands at their marginal tax rates.

Income Splitting

Trusts are a vehicle for income splitting.

Depending on the age of the Beneficiaries, the same amount of income might attract less income tax when it is distributed to the Beneficiaries, because:

each Beneficiary would have a tax-free threshhold; and
each Beneficiary's income might be taxed at a lower marginal rate than might have applied if all of the Trust Income was distributed to one Beneficiary or Taxpayer.

Retained Profits

Because a Trust must effectively distribute its Profit to the Beneficiaries, it is unable to retain Profits or after-tax Profits in the same way as a Company.

This means that, if it requires some or all of the Profit as working capital of the Trust, it must effectively borrow the Profit back from the Beneficiaries.

However, the Beneficiary must have paid tax on the distribution of Profit (at its marginal rates), which means that it can only lend back the after-tax Profit in its hands.

In contrast to a Company, the Profit is effectively taxed at the ultimate Individual Beneficiary rates upfront, rather than when the Dividend is ultimately paid to the Shareholders.

This is a timing issue.

However, because of the disparity in Company and Individual tax rates, it is a material amount in financial terms.

Corporate Beneficiaries

One result of this method of taxation is that the Beneficiary has had to pay tax at its own marginal tax rates, even though it does not have the ability to benefit personally from the Trust Income upon which it has paid tax (assuming it has lent the funds back to the Trust).

Its balance sheet might have been improved by the amount of the Loan that it has made back to the Trust.

However, it does not have the freedom to spend this money for its own non-business purposes.

The timing issue can be minimised by the distribution of Trust Income to a Corporate Beneficiary.

Because the Beneficiary is a Company, the Income that needs to be lent back to the Trust can be taxed at the 30% rate applicable to the Corporate Beneficiary.

Thus, this practice achieves a comparable tax result to the situation that would apply to a Company, although it does require a Trust and a Company, and a Loan Account between the two entities.

Partnerships

Joe Hockey did not mention Partnerships.

Like a Trust, a Partnership is an entity for the purposes of the Tax Legislation.

However, it is not liable to pay tax in its own right.

In the same way that the Income of a Trust must be distributed to the Beneficiaries, the Income of a Partnership must be distributed to the Individual Partners.

The Individual Partners then pay income tax at their marginal tax rates.

Retained Profits

Like Trusts, a Partnership cannot retain Profits.

If the Partnership requires working capital, it must borrow funds from the Individual Partners after they have paid tax on the Income of the Partnership at their marginal tax rates.

In contrast to a Company, the Profit is effectively taxed at the ultimate Individual Partner rates upfront, rather than when the Dividend is ultimately paid to the Shareholders.

Again, this is a timing issue.

However, because of the disparity in Company and Individual tax rates, it is a material amount in financial terms.

Implications

One of the implications of the above analysis is that the Tax Legislation effectively taxes Trusts and Partnerships in a manner much more analogous to the manner in which it taxes Individuals.

The rate of tax and the timing of the tax liability is more or less the same as would apply to an Individual.

The manner in which the Tax Legislation taxes Companies is different.

It results in a lower upfront tax rate and a delay in the timing of the ultimate additional tax liability that would be payable by the Individual Shareholder until the Shareholder actually receives a dividend.

This is partly a product of the fact that Trusts and Partnerships are not separate legal entities to the Beneficiaries and the Partners.

A Company is "incorporated", whereas a Trust or a Partnership is not.

Many commentators consider that a Trust is analogous to a Company, whereas it is clear that the logic of the Tax Legislation is that a Trust is more like a Partnership and an Individual than it is like a Company.

Significance of Joe Hockey's Comments

As mentioned above, Joe Hockey did not mention that Shareholders subsequently pay tax at marginal rates on the dividends paid by the Company (subject to the availability of a franking credit).

Thus, he failed to recognise that, if you ignore the timing issue, all three entities are more or less taxed the same at the point of the Individual Shareholder, Beneficiary or Partner.

However, perhaps the most important comment made by Hockey is his suggestion that "it would be simpler and more logical for all three types of legal entity to have the same or a similar tax rate."

Thus, if the rate of tax payable by Individuals was reduced, then some of the evil he identified would be removed.

For example, if the highest marginal tax rate payable by an Individual was reduced to the Company rate of 30%, then the franking credit available to the Shareholder would normally satisfy its tax liability on the dividend.

Similarly, the tax rate applicable to Trusts and Partnerships would effectively be the same as the Company rate.

As a result, there would be no need to use Corporate Beneficiaries in the case of Trusts.

The rate of tax payable by a business entity would also cease to be a factor in determining what Business Structure a Business should adopt.

Increasing the Company Tax Rate

It is worth noting that Hockey did not make any suggestion about the level of the rate that should apply to all of the different entities.

I have used the Company rate of 30% as an illustration.

However, obviously, this would involve a substantial reduction in personal Income Tax.

Another option would be to increase the Company rate.

For example, the Company rate could be increased to 35%.

This seems to be contrary to the direction that most countries (including Australia) are moving towards.

One reason it would be undesirable is that a higher Company tax rate would reduce the amount of retained profits that were available for working capital.

Thus, this strategy would work against the goal of encouraging growth in the business sphere.

Standardising Entity Taxation

Hockey goes one step further and suggests the standardisation of Company and Trust taxation.

This is where he has got himself into trouble politically.

However, two issues arise from the above analysis.

Firstly, he did not take into account the additional tax payable by Shareholders.

Secondly, he did not recognise that there is already a level of standardisation within the Tax Legislation.

Only, what is being standardised is the treatment of Trusts, Partnerships and Individuals.

What is not being standardised is Companies.

And that occurs, primarily because a Company is a separate legal entity from its Shareholders, as a result of the legal act of "incorporation" under the Corporations Act.

Adverse Implications of Treating a Trust like a Company

In 2002, the Board of Taxation found no convincing reasons to tax Trusts like Companies.

One of the reasons it identified was the different treatment of exempt income.

In the case of a Trust or Partnership, exempt income flows through to the Beneficiaries and Partners, and remains exempt in their hands.

In the case of a Company, the Shareholders do not obtain any exemption with respect to dividends that might be attributable to exempt income.

Thus, they are effectively taxed on income that was exempt in the hands of the Company.

You can get exempt income into a Company, you cannot get it out (as exempt income).

If there is to be a standardisation of the tax treatment of Companies and Trusts, there needs to be a thorough investigation of adverse implications like this.

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