Discretionary trusts are prevalent in the small to medium enterprise (SME) market due to their income tax effectiveness, distribution flexibility, and asset protection features. However, this may be about to change. The Australian Labor Party (ALP) has proposed a number of amendments to existing tax laws should they win the election on 18 May 2019. These proposals include:
a reduction of the capital gains tax (CGT) discount for assets held for more than 12 months from 50% to 25% with the effective date currently proposed to be 1 January 2020; and
a 30% tax rate on distributions from discretionary trusts to individual beneficiaries over the age of 18 years, to apply from 1 July 2019.
We caution that these are only proposals and many hurdles would need to be overcome prior to their implementation, including the ALP actually winning the election and being able to pass the relevant legislation through the Senate.
Nevertheless, these proposals as well as Coalition-backed changes to Division 7A, the reduction in the corporate tax rate and the potential increase in the marginal tax rate means that many SME taxpayers may, irrespective of the election result, contemplate transitioning from a trading trust structure to a company. Whilst access to the CGT discount (though reduced), distribution flexibility and asset protection will remain favourable aspects of trusts, do the various proposed changes mean that trusts may soon no longer provide the necessary advantages to justify their retention as a trading entity?
With simplified tax rules, lower and potentially lowering corporate tax rates and the ability to reinvest trading profits in the business without triggering complex unpaid present entitlement rules, is a corporate trading entity in which the shares are held by a passive discretionary trust going to provide the same or similar benefits as a trading trust?
What’s missing from the proposals?
Clearly absent from the ALP’s proposal are the technicalities of how they will work in practice. Whilst the effective date for some measures is as early as 1 July 2019, it is unlikely that legislation will be tabled and passed before that time. Therefore, many taxpayers may consider a ‘wait and see’ approach in respect of these technicalities.
However - could waiting affect a taxpayer’s eligibility for the 50% CGT discount on assets acquired prior to 1 January 2020?
Subject to certain conditions, including the nature of the taxpayer itself, Division 115 of the Income Tax Assessment Act 1997 (Act) provides for capital gains on CGT assets held for more than 12 months (the 12 months rule) to be discounted by 50%. Special rules apply to determine the acquisition date for the purpose of the 12 months rule of the replacement assets (shares) received in exchange for the transfer of the CGT assets to the company. Specifically, section 115‑34 may affect the time when the trust is treated as having acquired the shares in the company for the purpose of the 12 months rule. For instance, section 115-30 provides that when a taxpayer disposes of shares acquired via a 122-A roll-over (122-A roll-over). for the purpose of the 12 months rule they will be deemed to have acquired those shares when they acquired the CGT asset exchanged in the roll-over. We discuss these rules in further detail here.
To illustrate this scenario, take a business operated by the trustee of a discretionary trust. The trust acquires all of its business assets in 2015. In light of the proposed changes to the tax law the trustee transfers the trust’s business assets to a wholly owned company on 31 December 2019 and seeks CGT relief via a 122-A roll-over. Three months later the shares the trust holds in the company are sold. As per section 115-30, for the purpose of the 12 months rule the trust will be deemed to have acquired the shares in 2015 when it acquired the business assets. Therefore, the trust is treated as if it had held the shares for longer than 12 months and the resulting capital gain will be subject to a 50% reduction.
However, lets now change the facts. The trustee decides to instead wait until the new year when clarity on the rules is provided. On 1 January 2020 the new rules are introduced, and the CGT discount is reduced to 25%. In light of the changes to the tax laws generally the trustee decides that operating the business via a company would be more advantageous. On 2 January 2020 the trustee transfers the business assets to a wholly owned company and seeks CGT relief via a 122-A roll-over. Three months later the shares in the company are sold.
Whilst the original business assets were acquired in 2015 and therefore for the purpose of the 12 month rule would have been eligible for the 50% CGT discount due to the deemed acquisition rule, the shares were acquired after the reduction of the CGT discount to 25%. How will the proposed new ALP rules regarding the date of acquisition for 25% discount purposes integrate (if at all) with the 12 month rule in Division 115? In this second example do we have a 50% discount, or 25% discount? Will the ALP rules adopt the same or similar rules about deemed dates of acquisition as the 12 month rule in Division 115? Or will they operate strictly based on the time of the event? That is, could the taxpayer find that although it is still deemed to have held the asset for 12 months so it can use the discount capital gains provisions, that discount is now only a 25% discount, not the current 50%? This result could follow as the shares received in exchange for the roll-over of the CGT assets were acquired after 1 January 2020.
The example above has roll-overs occurring only 2 days apart, yet they could see a substantial difference in the ultimate tax liability upon a realisation event. In the absence of further clarity provided by the ALP the exact result is unknown. However, with the potential ramifications so significant, is it better for businesses to consider planning now for a roll-over prior to 1 January 2020?
Where to from here?
We understand that taxpayers may be considering transitioning assets from trusts to companies and in light of the uncertainties, contemplating whether this should be done prior to any potential rule change or not. Regardless of timing, we caution that transitioning from a trust to a company is not a simple task. There are many traps taxpayers can fall into when undertaking the change. For example, whilst a 122-A roll-over can provide tax relief at a federal tax level, that is often not matched in respect of state taxes. Also, the roll-over has strict requirements and documentation which must be prepared. Importantly, the roll-over does not cover a number of business assets such as trading stock and contracts.
Over the coming weeks, we will be releasing a series of articles providing guidance on transitioning from a discretionary trust to a company and highlighting some on the many traps which can arise. In the meantime, if you have any questions contact one of our tax specialists: