Current issues with trusts and the tax system
Focusing on trusts used to deliberately avoid tax
While the majority of trusts are used for genuine business and family dealings, there are some trusts which engage in behaviour that attract our attention.
The Tax Avoidance Taskforce – Trusts is focused on those trusts engaged in high risk tax avoidance and evasion arrangements.
The taskforce has focused its compliance activities on trust risks including:
- income tax 'shuffles’
- complex distributions
- structures designed to prevent transparency.
Over the past six years, the Tax Avoidance Taskforce – Trusts, and the previous Trusts Taskforce, have:
- completed more than 95 audits
- completed more than 950 reviews
- raised $1.2 billion in liabilities
- collected more than $467 million.
There have also been two successful convictions for serious tax fraud, with a further four matters referred to law enforcement agencies for criminal investigation.
The Tax Avoidance Taskforce – Trusts uses a range of sources when developing strategies to address non-compliance.
As part of our ongoing program of work, we commissioned the Royal Melbourne Institute of Technology (RMIT) to conduct independent research and provide another perspective on tax issues involving trusts.
The research paper Current Issues with Trusts and the Tax System is one of many sources we have used to assist our compliance activities and develop mitigation strategies to address trust mischief.
The ATO is grateful to the RMIT for their research and insights provided into trusts and the tax system. However, the ATO does not agree with all aspects of the findings or the methodologies adopted.
The ATO has issued a range of public advice and guidance to address trust risks including:
- Trust Vesting (TR 2018/6)
- the meaning of Income of the Trust Estate (TR 2012/D1)
- section 100A Reimbursement Agreements.
If you're aware of potential tax avoidance or evasion arrangements involving trusts proposed to you by other taxpayers or advisers, email TrustRisk@ato.gov.au.
The executive summary from the research paper is below.
By 2022, it is expected that over 1 million trusts will exist in Australia. Trusts are used as a vehicle for business, investment and estate planning by various segments of Australian society. There are many types of trusts, the most common type being discretionary trusts. In total, trust income in 2013–14 exceeded $340 billion, making this vehicle a defining feature of the Australian economy with trusts in the financial services sector alone accounting for over $24 billion.
Another central feature of Australia’s economic landscape is its tax system and in particular the way in which it regulates the behaviour and activities of trust users. The purpose of this investigation was to examine the efficacy of the current system of taxation of trusts. Key highlights of our study include:
- The interactions between the trust and tax laws are being manipulated which could contribute to the sheltering of significant amounts of tax. At conservative levels this amount is estimated to be between $672 million and $1.2 billion per annum.
- Chains of trusts and interlinking trusts are common which may reflect a deliberate intent to create a degree of opacity with relation to trust income.
- Trust tax lodgment patterns differ according to trust type, however these are difficult to ascertain given the current level of information available.
- The current system of trusts presents significant challenges in implementing international transparency obligations and recommendations.
- Australian trust taxation law is remarkably different from other common law jurisdictions.
These highlights are based on an in-depth investigation which:
- Analysed Australian Tax Office (ATO) de-identified data, relating to various discreet groups of taxpayers (Wealthy Australians, Potential High Net Wealth Individuals, High Net Wealth Individuals and other private groups), in order to assess:
- current effectiveness of the tax system in relation to the tax use of trusts, including taxpayers’ responses to administrative or legislative changes;
- trends or indicators as to future tax use of trusts and their impact on the performance of the tax system, including suggestions of how to improve taxpayers’ voluntary compliance; and
- administration issues arising from the current interaction of tax and trust law.
- Examined how other common law jurisdictions (a) tax trusts (with a particular focus on jurisdictions with similar legal systems to Australia), (b) deal with similar tax use of trusts (c) address similar issues that arise from the interaction of tax and trusts law and (d) regulate trusts. Instructive comparisons are made with the Australian trusts’ taxation system.
- Assessed other known commercial or legal matters that are relevant to the use of trusts and may have an impact on the ATO’s tax administration.
In particular, the investigation focused on the following areas:
- The income tax shuffle: How inconsistencies between trust and tax income definitions can be used to shelter income from higher rates of tax. This opportunity is brought about by creating and subsequently utilising the mismatch between income for tax law purposes (net income) and income under trust law purposes (distributable income)
- Complex distributions: How distributions between trusts can be effectively used to disrupt ATO oversight of income streams.
- Non-lodgment and trust lodgment patterns of trust tax returns: How effective the current system is in identifying the number of trusts and monitoring their activity.
- Transparency: How the current system for the taxation of trusts in Australia is positioned to meet the requirements and expectations of Australia’s international treaty partners.
In addition, this report also includes a review of the taxation of trusts in Canada, New Zealand, the United Kingdom and the United States and how they compare with the Australian context. A critical review of the roles of accountants and legal professionals in providing advice in relation to the use of trusts is also presented. Finally, industry practitioner perspectives were gathered via in-depth interviews to provide insight on motivations and behaviours in relation to the use of trusts.
The following is a summary of key findings presented in the order in which they appear in this report.
Income tax shuffle
Income tax shuffles exploit the differences in the definitions of income under trusts law and tax law. Beneficiaries are made liable for tax on the amounts which they do not receive resulting in a separation of economic and tax outcomes.
This separation, following the decision in FCT v Bamford (2010) 240 CLR 481, takes the form of trustees and/or the terms of trusts reducing distributable trusts law income to below the level of tax law income. The amount calculated for trusts law purposes (distributable income) is then distributed to presently entitled beneficiaries. However, the tax liability of these beneficiaries is calculated from their share of the trusts tax law (net income) income. Presently entitled beneficiaries to whom reduced distributions are made may be concessionally taxed or insolvent. Amounts withheld by the trust (being the difference between the net income and distributable income) are distributed tax-free to other beneficiaries in subsequent years. Findings from this investigation suggest:
- The major indicator that an income tax shuffle has occurred is that a trust has a smaller amount of distributable income than net (taxable) income, however it should be noted that there may be other explanations for this indicator. Nevertheless, an income mismatch is present in every case of an income tax shuffle – a review of five cases (some spanning more than one year) featured 18 arrangements involving income sheltering estimated to be in excess of $700 million with potential tax leakages of $195 million.
- Most subordinate indicators in relation to income tax shuffle are beneficiary-specific – such as the use of ‘bucket’ companies, loss-making entities/companies. The use of companies and trusts in combination provide several avenues through which an income tax shuffle could be fully exploited.
- Anti-avoidance provisions may not be sufficient to deal with common cases of income tax shuffles, and such arrangements can be easily enacted by taxpayers.
Recent case investigations by the ATO reveal the ease with which wealthy taxpayers can utilise trusts in private groups and reduce their tax liabilities. The analysis of five investigations included in this report demonstrates the range of taxpayer behaviours in relation to the full exploitation of income tax shuffles. In just these five cases alone, the tax leakage is estimated to be approximately $195 million. The data analysis carried out as part of this report clearly shows that the potential for widespread use of income tax shuffles exists given the current regime of the taxation of trusts.
Specifically, analysis of de-identified trusts’ tax return information provided by the ATO revealed:
- Strong evidence of income mismatches.
- Distributions to company beneficiaries accompanied by franking credits to permanently limit the tax liability and cap the tax rate at 30%.
- On average, ‘loss-making’ company beneficiaries received 22% of trust total distributions while ‘non-loss-making’ company beneficiaries received only 14%.
- A conservative estimate indicates that $672 million to $1.2 billion of tax revenue could be sheltered annually.
- Less conservative estimates suggest the amount of tax sheltered could be several billion dollars which will be further inflated as the corporate tax rate decreases.
These findings demonstrate that orchestrating income tax shuffles can be particularly advantageous for high wealth individuals. Further, some of these schemes appear to be (deliberately) complex.
Complex distributions were the second area of focus for this investigation. It was observed that taxpayers can derive income from trusts in convoluted ways in order to defer, reduce or extinguish tax liabilities.
Based on analysis of ATO supplied case studies, four key traits emerged:
- Multiple trust structures: Chains of trusts make it difficult for the ATO to identify the ultimate beneficiaries to assess. “Circular entitlements” are an extreme example whereby at least two trusts make each other presently entitled.
- Questionable present entitlements: Low-taxed and tax-preferred entities – charities, tax exempts, loss companies and ‘bucket companies’ - agree with existing trust beneficiaries that they will become trust beneficiaries and transfer the (low-taxed) distributions they receive in that capacity, less a service fee.
- Association with income tax shuffles: Income tax shuffles seem to be a common feature of complex distributions, in particular added complexity aids individuals in having arrangements whereby a trust’s trusts law income happens to be less than its tax law income, or a distribution that is made to an unlikely tax exempt or corporate beneficiary.
- Income Re-characterisation: Provisions of the Tax Act may be manipulated through the use of trusts in complicated transactions. For example, substitution of income character to achieve a lower rate of withholding tax for non-resident beneficiaries.
Analysis of ATO data revealed:
- Approximately 80% of inter-trust complex distributions are only one level deep (i.e., trust A distributes to trust B), while 13% engage in a further third tier distribution (i.e., trust A distributes to trust B and trust B distributes to trust C).
- Five tier deep trust chains were not uncommon.
- Distributions from trust A to trust B more than doubled over a three year period: $21 billion (2012) to $50 billion (2015).
- Circular distributions were observed.
- Distribution amounts decrease (in aggregate) at each successive level.
- A “spread thin then thick” approach was apparent, where the intention, and the outcome, is to create a degree of opacity around trust income and the ultimate beneficiaries to which the funds flow.
These observations suggest there is a significant administrative challenge for the ATO, particularly in levying the correct tax burden on the appropriate ultimate beneficiary or entity. In addition, administrative costs are likely to be inflated due to the deliberate attempt to confound oversight. This also increases the amount of tax sheltered and hinders equitable and transparent tax outcomes.
Non-lodgment and lodgment trust patterns
A complicating administrative challenge is non-lodgment of trust tax returns. The Commissioner has limited sources of information on trusts and these are insufficient given the increasing complexity surrounding the use (and misuse) of trusts. Current information sources include:
- Taxpayers’ voluntary disclosure in their tax returns.
- Internal data-matching and information corroboration from government and public sources.
- Audit specific information and tax-related record-keeping obligations imposed on taxpayers. It is notable that ITAA36 s262A does not require taxpayers to produce or maintain a trusts’ constitutive documents or other trust-related information.
Lack of information is a major problem given the importance of trusts to the nation’s economic activities. Some trusts law jurisdictions have trusts registries which assist in the management of this sector.
Analysis of ATO data suggests that different types of trusts have different lodgment patterns. However, there was no way to corroborate this given the lack of information available. The limited information is not just a domestic concern but has broader implications as Australia is party to a number of global initiatives including:
- The OECD’s Standard for Automatic Exchange of Financial Account Information in Tax Matters (CRS Standard) which Australia committed to from the 1 July 2017.
- The Financial Action Task Force (FATF) which is an inter-governmental body established in 1989 by the finance ministers of 35 member jurisdictions (including Australia). Standard-setting is FATF’s primary task to further legal, regulatory and operational responses to money-laundering, terrorist financing and other threats to the international finance system.
The implementation of OECD Financial Action Task Force recommendations in Australia will be difficult without some means of identifying the beneficial ownership of trusts. Other jurisdictions, including the United Kingdom, New Zealand, South Africa and India, are better equipped to address these recommendations as they have a central registry of trusts and trust assets.
Other common law jurisdictions
In the United States and Canada, tax on trust income (including capital gains) is attributed to trustees at a high marginal rate subject to the trustees being entitled to a deduction for income distributed or distributable to beneficiaries. New Zealand trustees are taxed on trust income at a 33% rate amounting to a tax credit for beneficiaries to whom the income is distributed. The Australian ITAA36 s97 present entitlement formula is not applicable in these countries.
Canadian capital gains tax charges occur when property is transferred to a trust, when trust property is disposed of and, as an anti-deferral measure, every 21 years all the property of a trust is deemed to be disposed of unless it has “vested indefeasibly”. In Australian terms, this means that the subsisting assets of discretionary trusts (before appointment) will be taxed once every 21 years — limiting some of the remarkable immunities of the Australian discretionary trust.
Unauthorised legal practice
Non-lawyer tax agents (and accountants) are known to regularly advise their clients about trusts and supply trust deeds. It is questionable whether they are able to perform this work without appropriate legal expertise. Analysis of the Tax Agents Services Act 2009 and state-law Legal Profession Acts indicates that tax agents may not be authorised by federal law to engage in legal practice as unqualified persons, contrary to state-law prohibitions.
Finally, in-depth interviews complemented the investigation. Interviews were conducted with ten industry practitioners (tax/accounting and legal experts) and explored the behaviours and attitudes surrounding the use of trusts with a particular focus on any taxpayer/industry practices which may facilitate tax avoidance strategies. The data provided the following insights with regard to the use of trusts, the complexity of the current system and potential reform:
- Trusts provide flexibility in terms of structuring businesses and tax affairs when compared to establishing companies or partnerships.
- Trusts are viewed as useful vehicles for asset protection and estate planning since legal ownership and beneficial ownership are separated.
- Most if not all high net worth and wealthy groups utilise multiple trusts and companies within their structures. In many cases it was suggested that one of the aims is to reduce the effective tax rate to the corporate rate of 30%.
- The participants identified several legal complexities (but they did not advocate for substantial reform), with the major one pertaining to the separation of distributable income (income according to trusts law principles) and net income of the trust (income according to taxation laws).
- Most participants claimed that extreme cases of tax avoidance were rare.
- Participants generally held the view that the ATO currently has sufficient powers under Part IVA of the ITAA 1936 to prosecute ‘egregious cases’ of tax avoidance through the use of trusts.
- Participants suggested that any reform could include a withholding tax regime similar to that in place for salary and wage earners or taxing the trust/trustee as an entity and maintaining the current flow through features of trusts.
In conclusion, the findings presented in this report highlight a number of issues associated with the current system pertaining to the taxation of trusts. However, suggestions as to how these areas could be addressed is beyond the scope of the report.
You can obtain a copy of the full report on the Freedom of Information disclosure logExternal Link
Associate Professor Ashton de Silva
Professor John Glover
Dr Venkateshwaran Narayanan
Dr My Nguyen
Associate Professor Kate Westberg
This is an independent report commissioned by the Australian Tax Office. Interpretations and opinions expressed should be ascribed to the authors only.
Independent report commissioned by the ATO examining the operation of the tax system in relation to discretionary trusts linked to high net worth individuals.