Discuss the use and functions of ‘Discretionary Trusts’ and the non-tax advantages of the using a ‘Discretionary Trust’.
A relationship under which the people have the obligation of holding a property for the purpose of benefiting other people is known as a trust. The term of the trust deed define the way in which the trustees are obliged to act. The parties to this form of deed are the settlor and the trustee. The legal owner of a trust property is known as a trustee and those who have the beneficiary interest in the property are known as the beneficiaries[1].
A discretionary trust in Australia is a form of trust where entitlements of the beneficiaries in relation to the trust are not fixed. These entitlements are calculated based on the criteria which are provided through the trust instrument. These criteria are set out by the settlor. Discretionary trust is also known as family trust. The parties who are involved in the trust are trustees and beneficiaries. In case this kind of trust if also the features of testamentary trust are included that the settlor generally creates a letter of wish which act as a guide for the trustees to exercise their discretions according to it. However this document is not legally binding on the trustees. In this form of trust it is upon the trustees to decide to which beneficiaries the income and capital of trusts is to be provides and how are they going to receive them. However the descrition of the trustees under this form of trust is not absolute. The trustees have to act in accordance to the terms set out by the trust deed and can only make discretion in relation to beneficiaries of a nominated class as provided by the deed[2].
There are several reasons and benefits for which a discretionary trust is used by the parties. One of such benefit is in relation to tax. However this section of the paper throws light upon the non tax benefits and uses of discretionary trust:
Asset protection
A trustee in relation to a discretionary trust has the duty of holding the property for the benefits of the beneficiaries. In case of bankruptcy the property which is held under this trust cannot be attached by the creditor until the debt is related to trust. Only the creditors of the particular trust can make a claim in relation to the property of the trust.
Estate planning
The use of discretionary trust also has a benefit in relation to estate planning. The uses of this trust ensure that members of a particular family group are able to indulge in estate planning in case someone dies.
Probate avoidance
One of the most significant benefits which are provided by this form of trust is in relation to avoidance of probate. In case such a trust is not held than all assets belonging to a person after death go through the process of probate. The process of probate consumes significant time as well as legal fees which may not be beneficial for the family members[3]
Incapacity
In situation where a beneficiary is temporarily incapacitated this trust ensures that the assets are managed by a professional or the family in the benefit of the beneficiary rather than an external agency.
It has been discussed above that a discretionary trust has many non tax advantages and used. However it has been argued by Harrison (2015) that discretionary trust are unfair grossly when it comes to others who pay taxes and often result in significant loss of revenue[4]. At present the treatment of income arising out of a discretionary trust is held as grossly inequitable as compared to others who play tax and organizations as per figure 1. The integrity of the income tax system is significantly undermined through the use of discretionary trust as it results in the loss of considerable revenue. The numbers of discretionary trust is significantly high in the country and are continuing to rise as per figure 2. Families use discretionary trust for the purpose of operating various businesses as well as holding investments. The assets which these trusts hold in Australia are worth $580bn and the income generated through this are worth $80bn of annual taxable income. They operate in the system in form of factory companies. It has been stated by Russell (2016) that discretionary trust is a form of stricture which has no parallel to it when it comes to saving of tax. It has been reported by ABC News (2018) that discretionary trust is being used by high earners to minimize their tax liabilities[5]. It has been provided that the taxation department is mining out on 3.5 billion roughly every year. The responsibility of managing the tax affairs on the trust is in the trustees. These responsibilities consist of registering the trustees in the system of taxation, filing tax returns and paying the tax liabilities. There is a simple way through which this form of trust is used for the purpose of minimizing tax returns and defrauding the government. The process through which tax avoidance is done by the high earner group is known as “income splitting”[6].
The person or company who is the trustee of a discretionary trust has the right to distribute the income which is earned by a trust to the beneficiaries according to the trustees. How the income is to be divided is decided by the trustee. If the income is provided to those who do not have any other income such as students, or elderly person the tax they would have to pay is very less as they are taxed at a very low rate as compared to others. On the other hand if the income is provided to others they would be liable to pay more tax as an income over $180,000 is currently taxed at 47 per cent. The primary benefit which people belonging to a high income group get through the use of discretionary trust is that they have to pay tax at a lower rate. This is done as they assign the income to those who belong to a low income group and they do not have to pay tax on the first $18200 and the rest income is taxed at staggered rates rather than the rate of 47 per cent which they would be liable to pay otherwise. The situation becomes even more lucrative if the income can be divided into quite a few family members which they have. This situation evidently makes the high income groups who use discretionary trust to carry out business activities significantly reduce their tax liability which is in return harmful for the government as it losses considerable revenue[7].
An example have been provided by Professor Robert Deutsch belonging to the Taxation Institute in relation to how which taxes can be saved through the use of discretionary trusts. He provided the situation of a business which has a taxable income of $180,000 and as a result would be legally liable to pay $54,432 as tax. However when this business is run under a discretionary trust and the trustee makes the distributions in a discriminatory manner to three adult family beneficiaries there will be a significant reduction in the amount of tax payable. The amount of tax which would be paid in this situation would only be $33,141 (3 x $11,407). It can be depicted through the example that the family is able to save about $21,000 on taxes every year. In addition maximum tax benefit may be derived in this situation where the people to whom the income is distributed have little or no income of their own[8].
Another example as provided by Slater Gordon states that where Mary has left her estate to Tom who pays 47% tax being in the top margin and they have two minor children and where after the death of Mary the estate generates $40,000 per year, without the use of discretionary trust the tax on the estate would be $18,800 (Medicare levy included) and with the use of the trust there would be not tax on the income at all as it would be distributed to the minor children[9].
Thus in the given situation it is clear that the use of discretionary trust is very simply and easily done for the purpose of avoiding and minimizing tax liabilities in a legal manner. This is one of the primary disadvantages which the society is subjected to in relation to then use of discretionary trusts.
This section of the report argues that potential exploitation to avoid tax outweighs the overall benefits of using ‘Discretionary Trusts’. It has been discussed above that a discretionary trust has many non tax advantages and used. In addition the use of discretionary trust is very simply and easily done for the purpose of avoiding and minimizing tax liabilities in a legal manner. This is one of the primary disadvantages which the society is subjected to in relation to then use of discretionary trusts.
It has been argued by Palmer and Rickett that there is not much if any evidence which is available to talk in favor of discretionary trusts[10]. Although there are a few benefits which are brought through the use of discretionary trust such benefits are overlapped by the damaging and destructive features. The primary purpose for which trusts are used is in relation to the allocation of money to members of a family or group. Under this form of trust only if the trustee chooses to provide money to the beneficiary will be able to receive such money. In Australia in order to minimize tax often family companies are included as beneficiaries.
Due to lack of proper records it is difficult to identify how much tax is lost in relation to the under of Discretionary trust. According to a conservative assumption made by Burns (2017) the country is losing A$2 billion per year in relation to the use of discretionary trust. Where a discretionary trust takes the shape of a family trust they can also be used for the purpose of frustrating creditors as they are not able to make a claim against the properties[11]. Creditors, who have an unsecured nature like suppliers in relation to the business of the trustee, are not able to settle their assets with trust where the trust does not adequate assets. Usually a company having a very little share capital is made the trustee to manage the trust[12].
According to the data obtained for the ATO a significant amount of family wealth is held under the control of a discretionary trust. In situation of a breakdown of relationship it can be legally argued by a spouse that as the property is under the control of a discretionary trust it does not have any owner and cannot be divided as the assets of the company[13]. However as stated by Lam (2017) there are wide powers which have been provided to the courts in order to decide what can be divided in relation to the assets under a discretionary trust.
The use of discretionary trust is also done in relation to succession planning. This is done in situation where a person wants to give away his property and needs flexibility in relation to the time of doing such distributions. The change in payments in relation to the circumstances and needs are also allowed under the trust. However such facility is available for any person who is alive and thus the need of discretionary trust in the light of tax avoidance is under considerable doubts[14].
In the light of the above discussed situation it can be stated that abolition of this form of trust outright would not be a practical option. There are a few recommendations which have been made in relation to the future use of discretionary trusts.
Conclusion
From the above discussion it can be stated that there are significant issues which the government has to face in relation to lost revenue when the exploitation of ‘Discretionary Trusts’ to avoid tax is carried out. Although discretionary trust has a few benefits such as estate planning and asset protection the detriment they bring in form of tax avoidance is significantly harmful of the government and the society. There have been several reforms proposed in relation to addressing the issue crated by such trust. However the implementation of these reforms in yet to be carried in the light of the legal and political barriers.
ABC News. (2018). What are trusts and how are they used to cut tax bills of the wealthy?. [online] Available at: https://www.abc.net.au/news/2017-07-28/trusts-and-tax-minimisation-explained/8752480 [Accessed 13 Apr. 2018].
Ato.gov.au. (2018). Tax issues for trusts – tips and traps. [online] Available at: https://www.ato.gov.au/General/Trusts/In-detail/Trust-tax-time-toolkit/Tax-issues-for-trusts—tips-and-traps/ [Accessed 13 Apr. 2018].
Burns, A., 2017. Don’t lose sight of losses when succession planning. Taxation in Australia, 52(5), p.241.
Harrison, L., 2015. Discretionary trusts without vesting dates. Tax Specialist, 18(3), p.94.
Harrison, L., 2015. Property investment through discretionary trusts. Taxation in Australia, 50(2), p.84.
Lam, D., 2017. The discretionary beneficiary-Thoughts on defining the beneficiary class. Tax Specialist, 20(5), p.280.
McLean, C. and Paull, C., 2017. Alternative assets insights: When is a trust a unit trust?. Taxation in Australia, 51(7), p.392.
Morrison, D., 2017. Proposed change to tax treatment of discretionary trusts in Australia: Reductio ad Absurdum. Trusts & Trustees, 23(10), pp.1046-1050.
Palmer, J. and Rickett, C.E., 2017. The Revolution and Legacy of the Discretionary Trust.
Slater Gordon, Taxation Benefits Explained (2018) Slatergordon.com.au <https://www.slatergordon.com.au/discretionary-trust-tax-benefit-explained>.
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