Asset protection is a big issue for financial planners.
Failed insurance payouts, court payouts, and client litigation can be quite common in the financial planning industry. This means that much of a financial planner’s day can be spent proving that what they have advised their clients is in the clients’ best interests and that they have not breached their legal obligations. Planners can become quite anxious about the security of their own assets.
Often the cure can be worse than the complaint, and clients have been led into all sorts of transactions with dubious merit and efficacy and at great cost, in the name of asset protection.
We believe that in most cases the concerns are overstated. A financial planner, and any other professionals for that matter, who follows sound procedures and uses common sense, is unlikely to be involved in a court case. And the minority who are will be well supported by their professional indemnity insurer. Yes, one or two insurers did get into financial trouble ten years ago. But you can safely assume that the shaky insurers have been flushed out and those remaining are financially solvent and able to pay claims.
Common sense precautions
Having said this, we would hate to see one of our advisers defy the odds and face an uninsured legal action. To guard against this we routinely recommend basic precautions be taken. These precautions boil down to not owning valuable assets in a financial planner’s personal name, and instead owning them through spouses, family trusts and super funds. In each of these cases the assets will not be directly up for grabs in any professional negligence action against the financial planner. The financial planner does not legally own the assets, although he or she may control them. You cannot lose what you do not own.
The most important step: pay your premiums on time
The most important step in protecting your assets is to pay your professional indemnity insurance premiums on time. The rest is almost certainly unnecessary, but nevertheless recommended, for completeness’ sake if nothing else. Financial planners who are authorised representatives of a licensee will be covered by the licensee’s professional indemnity, unless the action in question was done out of scope of their authority.
Using a safe haven such as a spouse, a family trust or a super fund is easy with future assets, ie assets that you have not yet acquired. It’s simple to own them in someone else’s name from the beginning. You register the shares in the name of the company that is the trustee of your super fund, you put your spouse’s name on the title of your family home (assuming he or she is not also in an exposed occupation) and you buy your practice in the name of the trustee of your family trust. This is simple stuff and familiar ground and logic for most financial planners.
But what happens if your spouse is also in an exposed occupation, for example, a medical practitioner? It’s out of the pan into the fire to buy a home in your spouse’s name. For assets other than the home this is not a problem: just acquire them in the family trust or the super fund. But for the home it is a problem: the CGT principal residence exemption is not available if the home is owned in a family trust.
A decision has to be made. The financial planner has to decide whether the CGT advantage of owning the home in his or her own name is worth the risk of losing it in a professional negligence action.
The analysis is complicated by case law allowing family trusts to negatively gear homes leased to beneficiaries, provided a market rent is paid, and the inherent uncertainty of the CGT advantage; that is, what if there is no capital gain? What if we never realize the capital gain? And what if we can effectively tax plan for any capital gain?
Each financial planner’s decision will be made for different reasons. Two rational decisions are:
- where the spouse is in a lower risk occupation, say a receptionist and is only working part time due to family commitments, then the already small legal liability risk becomes much smaller again, and even less of an issue. Here it can make sense to buy the new home in the spouse’s name; whereas
- If the spouse is in a high risk area occupation, say obstetric medicine, and is working full time (or more than full time), then it can make sense to buy the new home in the family trust’s name. This is particularly the case where there are large potential depreciation, building allowance and interest deduction claims, so that the tax benefits of using the family trust are enhanced, and where the home is regarded as a “never to be sold” core asset, so that the loss of the principal residence exemption is not an issue.
If the home is owned by a person in an exposed occupation it can make sense to encumber it with a mortgage and a high level of debt. This means the mortgagee, ie the bank or other financial institution, has first claim on the proceeds of any sale: the loan has to be re-paid and the mortgage released before the purchaser can get good title. The loan can be a loan owed by another person, such as the trustee of a family trust. But make sure the repayment does not create another asset, in effect a loan to the other person, which can be recovered by a litigant.
Interestingly, a case can be made for owning heavily geared residential investment properties in the financial planners own name, where the financial planner and not the spouse is in the top tax bracket. Here the certainty of a deductible tax loss, rental yields, particularly after repairs, rates and so on are considered, are notoriously low, can mean maximising the tax benefit by having the loss in the hands of a top tax bracket tax payer is the best way to go. Even if there is some asset protection issues.
Existing assets are more problematic than future assets, because the transaction costs connected to transfers, mainly stamp duty and capital gains tax, have to be considered.
One preliminary question is always relevant where a financial planner owns a valuable asset in his or her name. And this is “how long do you plan to keep it?”. Take the situation of all or part of a family home being owned in the financial planner’s name. Often it will turn out that an upgrading, or a down sizing, is on the cards in the next few years. It does not make sense to transfer it around now, triggering transfer costs, if it is then going to be sold to a third party soon after. It can make better sense to speed up the upgrading or the down sizing process, and then simply gift the cash from the sale of the existing home to a spouse or a trust, and get it right from the beginning with the new home.
Another preliminary question is relevant too. It is “what are the costs of a transfer?”. An example may help. A client came in to see us about a suggested transfer of a rental property to a family trust. The property had been bought for $300,000 using 100% debt, and was now worth $500,000, which meant there was $200,000 of “exposed equity” to consider. The client had been told he should transfer the property to his family trust and that he had a serious asset protection problem.
We considered the matter. Our deliberations focused on what were the costs of transfer and what was the probability of a legal action? The costs of transfer were pretty easy to compute. They were:
|Stamp duty on a market value $500,000||$24,000|
|Income tax on a taxable capital gain of $100,000||$48,000|
|Other costs, ie solicitors, transfer fees, etc.||$2,000|
|Total cost of the transfer||$74,000|
The cost of $74,000 was not deductible, although the stamp duty and the other costs would be added to cost base for CGT purposes when the property was ultimately sold to a third party.
Think about it. Would you spend $74,000 to protect $200,000 of exposed equity? If you would, you must calculate that you have a 37% chance of losing the property in a legal action in the foreseeable future. That does not sound likely to us. Warren Buffet would leave the property in his own name for now. Whilst it would have been better to buy the property in the name of the family trust, it just did not make financial sense to transfer it to the family trust now.
The position can be different for family homes, where the principal residence exemption usually means there is no CGT on a transfer. And in some states, such as Victoria, if the transferee is a spouse there is no stamp duty either. Sadly there is no such exemption in NSW, where stamp duty values tend to be the greatest.
It is not uncommon to encounter a valuable share portfolio in the financial planner’s hands. This is an obvious asset protection problem. Here the same logic applies as applied for the property in the above example: what are the costs of transfer and what is the probability of a legal action? The mechanics are little different though: stamp duty, if it exists, will be minimal and capital losses can be offset against capital gains. The idea is to transfer as much value as possible without triggering a significant net capital gain. It’s just a case of playing with the possibilities and seeing what can be done. For example, a financial planner had a share portfolio of nearly $500,000 in her name, made up as follows:
The object of the exercise is to transfer as much value as possible to the family trust without generating a significant taxable capital gain in the financial planner’s hands. We did this by transferring all the shares, except Share 4, to the family trust, so that a net capital loss of $1,000 is realised, and all but $100,000 of value is moved to the trust. Obviously there are many possible permutations, but the general approach is to transfer loss shares first, and to then transfer shares with capital gains up to or close to those losses, taking those with the highest value first. This normally means that a significant amount of wealth can be protected without unduly high transaction costs, particularly capital gains tax.
Family trusts and asset protection
Family trusts can be used by financial planners to put valuable assets beyond the reach of potential creditors, including litigious clients. We have seen family trusts save the day many times.
In most cases assets transferred to a family trust may not be able to be accessed by creditors if the transferor gets into financial difficulty or even goes bankrupt. This is because the transferor has no interest in the transferred property and has no interest in the family trust which is recognised at law.
For example, a financial planner acquired a home worth $300,000 through a family trust and rented it back off to the trustee. The financial planner also acquired a share portfolio worth $200,000 as an inheritance from a grandparent: the financial planner’s family trust was the beneficiary under the grandparent’s will. Some years later the financial planner guaranteed a large business loan for his brother. The brother’s business collapsed and the bank called up the guarantee. The bank could not touch the family home and the share portfolio. These assets simply did not belong to the financial planner. They belonged to the trust. As a result the bank could not do anything to get its hands on these assets.
This asset protection can go on down through the generations. For example, if the financial planner dies and leaves the share portfolio and the family home to a daughter, these assets will be a marriage asset should the daughter’s husband one day divorce her. If these assets remain in the family trust they will normally not be marriage assets in a divorce situation. This means that the (ex)son-in-law gets nothing. The same thing happens if a son gets into business or investment difficulties and is sued by creditors.
Australian Institute of Company Directors – Opinion: Safeguarding your personal assets
The Australian – Riches need to shielded: asset protection
In Part 6, we examined tax planning for financial advisers themselves, with a particular focus on practice structures and managing income flows. This part of the Dover Way examines the tax treatment that applies to that planners might either make themselves or recommend to clients.
In this Part, we introduce and further expand upon the idea of tax efficient investing. Tax efficient investing refers to the making and holding of investments in such a way as to optimise the tax treatment that applies to the income and capital returns on those investments. As the following will demonstrate, the same investment returns will be taxed in quite different ways depending on the type of investor that makes the investment. Tax planning of this nature is an on-going process whereby commercial issues and developments are constantly monitored and the implications of income and other tax practices considered.
Tax planning is a legitimate activity and occurs constantly over a client’s lifetime. For example, we encourage clients to pay optimal super contributions every year, they can. The primary purpose is to ensure a financially secure retirement, but like most strategies there are secondary purposes too. The protection of assets (for example, super is protected in bankruptcy) and reducing tax are common secondary purposes.
Traditional tax planning tools
The ATO accepts traditional tax planning ‘tools’ such as practice companies and practice trusts, service companies, service trusts and SMSFSs These are widely discussed by the ATO in its public rulings and there is no question that they are effective for tax purposes – provided, of course, that the conditions specified in the rulings are observed. Dover emphasises remaining compliant with the ATO’s public rulings and accepted practice at all times.
The established, ‘traditional’ tax planning tools are more than adequate to meet the tax planning needs of advisers and their clients. There is no need to push the envelope when it comes to tax planning. Always swim between the flags.
Private binding rulings
If in doubt about a particular tax matter, advisers or their clients can seek a private binding ruling. For obvious reasons, seek a ruling from the ATO before entering into the transaction! Rulings are the cheapest, simplest and safest way of making sure your tax profile will be accepted by the ATO.
For example, in private ruling 77061 the ATO considered whether a unit trust owned by family trusts could own and operate a medical practice. The ATO considered the specific facts and the established law and, in summary, concluded that the unit trust could own and operate the practice. Private ruling 77061 can be viewed here: ATO Private Ruling 77061.
Tax planning for businesses and practices – family trusts
In Part 4 of the Dover Way, we introduced the idea that a business (or practice, for professional clients) is often the best ‘investment’ available for clients who are suited to owning a business. Accordingly, we begin this discussion of tax efficient investing by examining the best way to own most small businesses.
The income tax treatment, capital gains tax treatment and asset protection advantages attached to trusts means that trusts are typically the preferred method of structuring a business activity for clients.
A family trust is a particular type of trust and is usually the preferred type of trust for a family-run business. The major advantages of a ‘family trust’ are related to inter-generational wealth creation and wealth protection. They also have tax and other advantages. These other advantages include:
- Asset protection (where the trustee of the trust is a company, which is a separate legal person to the beneficial owners of the company);
- Confidentiality of information, particularly regarding the financial affairs of the trust. There are no statutory disclosure requirements for trusts. There is no requirement for a trustee dealing with other people to disclose that it is acting as a trustee and not in its own right. Thus bank accounts can be opened, leases signed and investments made for the trust without other people knowing who the ultimate beneficiary is.
- The absence of formal audit requirements. Accounts do have to be prepared but this is only to enable the preparation of an annual income tax return. There is no rule that says trusts must be audited.
- The easy entry and exit of beneficiaries, particularly in terms of who receives income and capital each year and on the winding up of the trust.
- Trusts are cheap to set up and run each year.
- Trusts are relatively simple to wind up.
These advantages should be stressed when the trust is being established, and should be recorded in writing at the time. This is to ensure that the adviser or client can demonstrate that the trust was established for purposes other than a simple tax advantage. (Arrangements entered into solely to gain a tax benefit may be set aside by the ATO).
Family trusts cannot be used to derive personal services income unless all the personal services income is distributed to the person who generated it. Family trusts can be used to derive business income, subject to the ATO’s public rulings and public statements on using trusts to own professional practices. Chapter 2 of Part 6 of the Dover Way discusses the distinction between PSI and business income.
Tax planning for investments
Now let’s turn our attention to investments other than a small business. If an investment generating a taxable 10% per annum is owned by a tax-free SMSF (ie an SMSF paying an income stream to its members), the after tax rate of return is 10%. If the same investment is owned by an investor with a marginal tax rate of 45%, the after tax rate of return is 5.5% (10% minus 45% tax). This is a huge difference – remember, this is the same investment. Making the investment in the hands of a tax-advantaged investor almost doubles the after-tax return. And, of course, the after-tax return is the actual return for the investor.
An SMSF in pension mode, and an investor in the top marginal tax bracket are the two extremes in terms of the tax treatment to which investment returns are subjected. The SMSF pays the least tax and the individual pays the most. The following table shows the tax treatment that applies to the same pre-tax return where the investment is held in the hands of various other entities.
Table showing effective after tax rate of return
|Earning rate before tax||Tax rate*||Type of Taxpayer||Earning rate after tax “ERAT”|
|10%||0%||SMSF tax rate (‘pension mode’) or personal tax rate up to $18,200||10%|
|10%||10%||SMSF capital gains tax rate (asset held for 12 months or more)||9%|
|10%||15%||SMSF investment income (eg rent) tax rate||8.5%|
|10%||19%||personal tax rate $18,201 to $37,000||8.1%|
|10%||28.5%||company tax rate||7.15%|
|10%||32.5%||personal tax rate $37,001 to $87,000||6.75%|
|10%||37%||personal tax rate $87,001 to $180,000||6.3%|
|10%||45%||top marginal tax rate $181,000 and above||5.5%|
* based on 2015/2016 tax rates excluding Medicare levy
Once these differential returns are compounded over time, the variations in after-tax returns become even more pronounced. The relative results after fifty years of investing $100,000 at a constant 10% per annum before tax – but with different tax rates – is shown here:
As this graph makes clear, the correct choice of investment structure can multiply the eventual after-tax return substantially. As a result, it is critical that, within the law and subject to the general anti-tax avoidance rules, clients minimise the tax paid on investment income.
Effective tax planning for investments basically boils down to investors applying three simple rules:
- select investments where the return is either tax-free or concessionally taxed;
- use tax efficient investment entities, ie spouses, companies, family trusts and SMSFS, to hold the investments; and
- do not buy and sell investments frequently. Instead, hold them for the very long term (decades or even generations), so the capital gain remains unrealised and therefore not taxable (yet).
We will examine each of these in the sections below.
Investments where the return is either tax free or concessionally taxed
An investment where the return is either tax-free or concessionally taxed will have a relatively higher after tax return than an alternative investment.
Which investments are tax-free?
At least three tax-free investments present to most people. These are:
- the family home, where the CGT principal place of residence exemption applies;
- a small business, where the CGT small business exemptions apply; and
- business premises, where the CGT small business exemptions apply.
(Notice that we have not said that super is a tax-free ‘investment.’ This is because super is a concessionally-taxed or tax-free investment vehicle, not an investment in itself. This is discussed further below). So, if clients are interested in minimising tax and maximising after tax returns on investments, it makes sense to first invest in a home, a business and, if appropriate, business premises. By making sure you do not derive taxable capital gains you increase the after tax rate of return and become wealthier more quickly than otherwise.
Which investments are concessionally taxed?
Most “growth assets” are concessionally taxed. Growth assets are essentially shares and properties. These assets are concessionally taxed because:
- a large part of the return is in the form of a capital gain, which is an increase in value over time. Capital gains are only taxed when the underlying asset is sold. This called ‘realising the gain.’ As-yet unrealised capital gains are not taxed; and
- the Australian tax system encourages people to invest in assets that are skewed towards capital gains, especially properties and shares. Briefly, where an asset is held for more than 12 months a capital gain on its disposal will be:
- 50% exempt if the asset was owned by an individual or a trust (but not a company); and
- 33.3% exempt if the asset was owned by an SMSF. Because the ‘standard’ tax rate in an SMSF is 15%, this makes for an effective tax rate of 10%.
So, to maximise after tax investment returns, canny investors typically prefer ‘blue chip’ shares (or managed funds/ETFs that hold these sort of investments) and properties that are held for the very long term (decades or even generations). Put simply, long-term investors pay less tax than short-term investors. This means long-term investors usually make more money than short-term investors.
regarding capital gains, some people view the ‘unpaid’ tax (bill the latent tax liability connected to the unrealised and therefore as-yet untaxed capital gain) as an interest free loan from the government that can be used to build further wealth.
Tax efficient legal structures
The second variable in the tax efficient investing equation concerns legal structures. Companies, trusts and SMSFs can all play a role in achieving one or both of the following functions:
- diverting investment income to a tax efficient investment entity, via trust distributions or deductible contributions, to be taxed at a lower tax rate than otherwise; and
- owning investments in the name of the tax efficient investment entity so the income is taxed at a lower tax rate than otherwise.
How are different legal structures taxed?
Individuals pay tax at a range of tax rates depending on their income level. For individuals earning an above-average income, much of that income is taxed at 37% or 45% plus Medicare levy. In addition, for the years ending 30 June 2015 to 2018, a 2% budget repair levy on incomes above $180,000 applies. The full table of individual tax rates is here (the Medicare levy of 2.5% should be applied to each of these rates):
Tax on this income
0 – $18,200
$18,201 – $37,000
19c for each $1 over $18,200
$37,001 – $87,000
$3,572 plus 32.5c for each $1 over $37,000
$87,001 – $180,000
$19,822 plus 37c for each $1 over $87,000
$180,001 and over
$54,232 plus 45c for each $1 over $180,000
Companies pay tax at 30% (or 28.5% for small business entities since 1 July 2015). However, the 30% tax payment is just ’round one’ of a multi-round game. This is because the ultimate rate of tax is not known until the company’s after-tax profits are paid out as franked dividends to the eventual beneficial shareholder. It will be the marginal tax rate of that shareholder that determines the ultimate rate of tax paid on the company’s profits.
If, in the year in which the company’s profits are paid out, the shareholder’s tax rate is more than 30%, extra tax will be paid. This means the ultimate rate of tax will be more than 30%. If, in the year in which the company’s profits are paid out, the shareholder’s tax rate is less than 30%, there will be a part or full refund of franking credits. This means the ultimate tax rate is less than 30%.
Companies thus create income distribution flexibility over a number of income years. Remember, as long as a company pays its own tax for a given year, it does not need to pay out a dividend. It can retain its profits. This means that the eventual payment of a dividend – including the paying out of retained profits – can be ‘timed’ for those years when the shareholders’ other taxable income is low. This might occur after children turn 18, for example, but before they start working in highly-paid employment.
Trusts are normally not taxed. A trust’s net income is instead attributed to its beneficiaries (‘unit-holders’ if the trust is a unit trust). These beneficiaries are taxed on the net income they receive depending on their own tax profile. The trust income is added to the beneficiary’s other taxable income to calculate their total taxable income. Sometimes net income passes through a series of trusts until it is ultimately received by an individual or a company, in whose hands it is ultimately taxed.
Discretionary trusts, or family trusts, do not have units. Instead, they allow the trustee to allocate net income among the beneficiaries. These beneficiaries are usually family members or other trusts and companies controlled by family members, who will pay a lowered amount of tax on income they receive. Trusts create income distribution flexibility among related persons in a particular income year. Often, an investment company might be used where the shares in the company are owned by a discretionary trust. This allows the client to enjoy the ‘best of both worlds.’ That is, the client enjoys multi-dimensional distribution flexibility, over time and between beneficiaries, due to:
- the income distribution flexibility amongst related persons within a particular year, created by the discretionary trust; and
- the income distribution flexibility over a number of income years created by the company; and
- the dividend franking protocols.
Super funds and in particular SMSFs have a more complex tax profile and it is best summarized in table form:
|Income||Tax rate in accumulation mode (ie under age 60)||Tax rate in pension mode (ie over age 60)|
|Dividends||15%, less franking credits||Nil%, less franking credits (ie refunds are paid)|
|Realised capital gains < 12 months||15%||Nil%|
|Realised capital gains > 12 months||10%||Nil%|
|Un-realised capital gains||Nil%||Nil%|
The role of debt
Interest on debt is deductible if used to acquire income producing assets. Investors can use ‘deductible debt’ to speed up and leverage the wealth creation process. Debt is typically used by individuals, companies or trusts. SMSFs can make limited use of gearing.
The tax effect of interest being deductible depends on the tax profile of the borrower. For example, an SMSF paying tax at 15% reduces the effective interest paid by 15%, whereas an individual earning more than $180,000, and therefore paying tax at 45%, reduces his or her effective interest paid by 45% if the interest is deductible.
Expected income yield
For clients with higher marginal tax rates, the higher the income-yield on an investment, the less likely the investment will be owned by the client as an individual. This is particularly the case where the yield exceeds the interest rate, such that the investor makes a profit while holding the investment (a ‘cashflow positive’ investment).
It does not make sense to hold high yielding assets in the hands of a client with a high personal marginal tax rate. Most such clients do better to own a high-income yielding asset in an SMSF (15% tax rate) or in an investment company (30% tax rate). Alternatively they could own the investment in a family trust and distribute and pay the net income to an investment company each year, to limit the tax to 30% (with the possibility of a refund of company tax in a future year). Either way, the tax paid on the investment income will be minimised. This will maximise the after-tax return.
Expected capital gain
Capital gains are taxed differently to income. Individuals and trusts enjoy a 50% exemption from capital gains tax on capital gains on assets held for more than 12 months. For SMSFs the exemption is 33% for assets held for more than 12 months (this 33% exemption reduces the applicable tax rate within an SMSF from 15% to 10%).
The way capital gains tax works is that the taxable part of the gain is added to the asset-owner’s other taxable income and taxed at their marginal tax rate. So, if an individual with other taxable income of $100,000 makes a $50,000 capital gain, half of the $50,000 is added to the $100,000 and the individual pays tax on a total income of $125,000.
(In this way, the term ‘capital gains tax’ is arguably a misnomer: capital gains are added to income and then taxed as income).
When a Company May be Warranted
Companies do not enjoy any CGT concessions. This means that investments which are expected to generate substantial capital gains are more likely to be owned in the hands of an individual, a family trust or an SMSF. A family trust would be used where the individual has a high personal income tax rate and this is expected to continue into the future, and where an SMSF may not be available for a particular kind of investment (for example, if gearing is involved in the purchase of direct shares or managed funds). The less likely the capital gain, or the more remote in time it is, the more likely it will be that the asset will be owned in a company.
Some specific comments regarding the potential use of an investment company are warranted. The shares in most private investment companies will be owned by a discretionary trust. This trust will have little to do until the first franked dividend is paid from the investment company. When this happens, the shareholder trust (which does not pay tax itself) will start to distribute franked distributions to low tax rate beneficiaries of the trust. These are typically family members such as children who have turned 18 but are not yet earning large amounts in their own right. The marginal tax rate of these family members will therefore be something less than 30%.
Companies of this nature are only useful for clients with high marginal income tax rates (which is another way of saying ‘high incomes’) and the capacity to make investments that warrant this level of planning.
The following diagram sets out how this structure would look:
Dover generally recommends growth investments be held for at least twenty years, if not a lot longer. We even recommend the expected holding period extend across the generations: that is, we see clients as often investing for their children and even their grandchildren, rather than themselves. For inter-generational investments, holding the investment in the hands of an entity that will outlive the current ‘elders,’ such as a company or a trust, can make good sense. This is because control of the company or trust can pass from one generation to the next without the asset needing to change ownership. Changes of ownership typically represent a ‘disposal’ for tax purposes and trigger a tax event. Where the investor is a company, the company can appoint the next generation as directors and allow the older generation to retire as directors. The younger generation thereby takes over managing the investment without the ownership of the asset being affected.
For investments that are likely to be realised within a client’s lifetime, for example to finance a client’s retirement, an SMSF may be warranted. The SMSF would time the disposal of the asset for some time after the SMSF commences a pension and the capital gains within the SMSF become untaxed.
Going in the ‘other direction:’ there is no CGT advantage of holding an asset as an individual, in a trust or in an SMSF if it is bought and sold within 12 months. The 50% discount is not available unless the asset is held for more than 12 months.
Other issues impacting the choice of structure
There is a range of other issues impacting the choice of structure and they differ from client to client. These include the client’s age, income level, family profile, (material) living standards and attitude to borrowing.
The client’s age
Clients aged between 35 and 70 and can concessionally contribute $25,000 a year to a super fund. For couples this means up to $50,000 a year can be contributed to super in a tax-advantaged way. Investment earnings in the fund before the member turns 60 are taxed concessionally, at tax rates of 10% or 15% (10% for capital gains and 15% for income).
After age 60 super benefits can be withdrawn tax-free and the investment earnings in the super fund can become tax-free. For clients who can afford to invest/contribute this type of money, a SMSF becomes a very viable option. Accordingly, the remainder of this section will discuss SMSFs as the preferred form of super. The preferential tax treatment means there is a powerful tax incentive to invest through a SMSF. This incentive becomes stronger and stronger as age 60 approaches, to become virtually irresistible from age 55 on.
Therefore Dover usually recommends that clients pay the maximum affordable amount of concessional contributions to their SMSF each year. We also usually recommend client also make non-concessional contributions to their SMSF if at all possible, particularly as they get closer to age 60, ie the age where the tax free status of the SMSF starts.
For example, consider a client who got in touch with a Dover adviser in 2012. John was age 55, and was reasonably well off. His youngest child was just finishing University. He and his wife Mary, also aged 55 felt their time and money was finally their own. Their assets comprised:
|Residential property investments in Mary’s name||$700,000||$600,000||Nil||$600,000|
The advice was simple. In summary it was to migrate the wealth from their hands, particularly Mary’s hands, to the SMSF. The SMSF will be concessionally taxed on its investment income until age 60 and from then on its investment income will be tax free. Sell the residential property and pay the net sale proceeds of $600,000 to the SMSF as a non-concessional super contributions ($300,000 each) before 30 June. These properties were thought to have low future capital gains prospects and the sale realised a capital loss of $100,000.
The SMSF was then advised to invest the ‘new’ $600,ooo into index-tracking ETFs (using dollar cost averaging over a three year period).
The primary purpose of this strategy was to maximise expected future retirement benefits for John and Mary as members of the SMSF. By age 60 John and Mary’s only assets comprised the home, which is tax free, and their SMSF, which is tax free as well once their pensions commence.
The client’s attitude to borrowing
Subject to some common-sense cautions, Dover is generally in favour of borrowing to acquire investment assets. Gearing usually increases the net return (positive or negative) on the investment and hence impacts on the client’s wealth level. Most clients who have borrowed money to buy sensible assets over the last two decades have done well. Common sense cautions when borrowing to invest include:
- observing a prudent debt to equity ratio, both on an overall level and an individual asset level (what is prudent will differ from client to client, but we become uneasy where total debt is 60% or more of total assets, except where the level of assets is low, for example a young client buying a first home);
- ensuring “representative” assets are acquired, that is, assets which will behave pretty much in line with the general movement in prices for that asset class, and which are less risky than otherwise (investments like index-based ETFs, blue chip shares and residential property); and
- avoiding too much negative gearing, where the shortfall must be made up out of other income.
Tax planning for super
Superannuation is a powerful financial planning tool that integrates tax planning with investment strategies producing very powerful long-term results. For many clients the super rules present a ‘new world’ of investing where an SMSF becomes a tax-free family investment vehicle. Paying tax is becoming (almost) optional for persons over age 60 – a large, and increasing, proportion of the population.
How can a client best use the super rules?
Careful planning over the years, even the decades, leading up to age 60 is the key. Clients should start super planning as early as possible. Certainly making the maximum affordable deductible contributions each year, for both themselves and their spouse, is a good start. Get the super balls rolling as early as they can and, if clients are already over 50, make a big effort to pay the maximum allowable deductible contributions every year.
Gearing of concessional contributions
Self-employed clients can consider whether their super contributions ought to be paid by debt. The contribution cap for concessional contributions is $25,000. It is usually good to make this level of contributions if you can.
If cash flow is a problem consider gearing the contributions. This has always been a relevant strategy but becomes even more so as a person approaches 60 as there is no tax, or limit, on the amount of the lump sum benefit able to be taken out of the SMSF at age 60, or later, to retire the debt recently taken on to finance the contributions.
For example, a 59 year old client can borrow (through his or her business) in one year, make the contributions and achieve an immediate tax benefit in the form of a much-reduced personal tax liability, and then withdraw from the super fund in the second year to retire the debt. This strategy boils down to tax deductible debt reduction, and can be a powerful strategy, particularly for those who have left super planning a little late.
For example, a fifty-five year old self-employed client using a trust to run his or her business can have the trust borrow to pay a $25,000 deductible employer sponsored super contribution to a SMSF, pick up a tax break each year and then pay the benefits out, tax free, at age 60 to retire the original borrowing. Trusts facilitate such strategies because, unlike companies, there is no rule against loan accounts from trustees to beneficiaries. This means a trust can borrow to pay a large deductible super contribution of, say $50,000 ($25,000 for each member of the couple running the business) and then remit an equal amount, i.e. the $50,000 cash generated by the business, to the owner without triggering a tax charge.
The strategy does not work for a business being operated via a company: the loan to the owner would be treated as an unfrankable dividend in the owner’s hands, which creates an effective total tax charge of more than 60%. And the strategy does not work for an individual owner (i.e. a sole trader operating in his or her own name) because interest on amounts borrowed to pay a self-employed person’s super contributions is not deductible (whereas interest on loans for employer contributions is deductible). The strategy of a business trust combined with large geared deductible super contributions can routinely reduce tax bills down to 15% or less of taxable income. Diagrammatically speaking, it looks like this:
Borrowing to pay deductible contributions is first and foremost an investment strategy. Borrowing to invest is a sound idea, when done prudently. This is because economic theory and economic history show that in the long run, on average, the rate of return on each of the major asset classes will be greater than the cost of borrowing. Given the tax deduction on the contribution, the prudential element of the borrowing is enhanced, because the reduced tax burden is immediate.
Super for a spouse – the ATO View
Married, self-employed clients can apply the above strategy for both spouses. The ATO accepts that a spouse who is an employee can be superannuated up to the deductible contribution limit, i.e. $25,000 pre year. This is so even where the amount is excessive relative to the market value of the work done by the employee spouse. You can read the ATO view in Taxation Determination 2005/29 released 28 September 2005 which can be downloaded here: ATO Determination on spouse contributions. For the strategy to completely ‘pass muster’ the business should ensure the spouse is a general law employee and actually completes an appropriate amount of real work for the business, and is paid a market salary for the work. This will best prove the employment relationship.
Indirect gearing of non-concessional contributions
For self-employed clients who are already reasonably wealthy and getting closer to age 60, consideration should be given to the client making un-deducted contributions to the limit of $100,000 per person per annum for themselves and their spouse each year. An issue here is that there is no deduction for interest incurred on amounts borrowed to pay non-concessional contributions. The solution therefore is to not borrow to pay them, but to instead borrow to pay any other costs where the ATO accepts that interest is deductible. This ‘frees up’ cash flow to pay the non-concessional contributions.
Summary of super planning techniques
|Maximum contributions paid||$25,000 per person, per year|
|Superannuate spouse||Employee spouse or director spouse able to be superannuated to age based limits regardless of market value of work done ($25,000).|
As for spouse. Work test must be satisfied if over age 65. Estate planning issues must be considered (the contributions will be paid out according to the wishes of the adult parent).
|Superannuate children||As for spouse, and also consider risk of future divorce (the contributions will be a divisible asset in any settlement).|
|Spouse split contributions||85% of concessional contributions may be split to older spouse to bring forward end of preservation period and the start of the tax free investment period. Alternatively, they may be split to a younger spouse to facilitate Centrelink planning.|
|Borrowing to pay deductible employer super contributions||Interest on employer contributions is deductible. Interest on other contributions is not deductible.|
|Indirect borrowing to pay other (i.e. non-employer) super contributions||Interest is effectively deductible. Technique can create powerful tax-advantaged investment returns over and above organic investment performance. Suited to older and higher income financial planners|
|$500 Government co-contribution for low income relatives such as 15 year old children||$500 contribution will activate a $500 co-contribution. Lower income threshold of $35,454 and higher income threshold of $50,454 for the 2015/16 financial year|
|Transition to retirement pension after age 55 without stopping work||Works best for lower income clients with large super benefits and large unrealized capital gains in the SMSF. Tax benefits in SMSF need to be balanced against tax payable on pension income|
|Transition to retirement pension after age 60 without stopping work||Mandatory at age 60. SMSF becomes tax free and no tax paid on pension income|
|Superannuation as a debt reduction technique||The closer you are to age 55 the more attractive it is to pay large deductible super contributions rather than pay off debt, particularly tax deductible debt|
|Salary sacrifice||Prospective substitution of super in place of salary is accepted by the ATO|
|Re-contribution strategies||Withdraw concessional benefits tax free after age 60 and re-contribute them as non-concessional contributions to minimize or eliminate any death benefits tax|
Where clients are employed, there is potential to reduce the total income tax and fringe benefits tax costs by carefully structuring the composition of the employee’s reward package and its allocation between salary, fringe benefits and super contributions. Each of these benefits has different tax consequences and this creates the potential to improve the cost-effectiveness of a particular employee’s reward package by carefully setting the mix of the three benefits.
How is employee reward packaging different from salary packaging?
It’s the same thing but employee reward packaging is a more descriptive and more accurate phrase. Salary packaging implies salary has some special status in the employee reward mix, and suggests any planning must involve an employee giving up salary and substituting it for lower tax fringe benefits or super. This is not correct. An employee and an employer are free to agree any combination of employee reward, whether salary, fringe benefits or super contributions. For example, there is nothing wrong in principle with a new employee taking all their reward as a loan fringe benefit and none as traditional salary.
However, if an existing employee decides to give up all or part of their salary and take fringe benefits in its place just to get a tax benefit, there is a risk the ATO will apply the anti-tax avoidance rules to the arrangement, particularly if the employee substitutes an existing right to receive salary as an earned bonus for a low-tax fringe benefit. However, there are actually few examples of the ATO doing this. Nevertheless, it is wise to leave a paper trail saying something was not done just to gain a tax benefit, and to in fact make sure something was not done just to gain a tax benefit. Starting off with the concept of employee reward packaging rather than salary packaging is an important first step in getting the paper trail right.
It is wise not to interfere with the form of existing benefit entitlements. For example, if an employer is due to pay a reward of $8,000 to an employee and it was agreed this reward will be salary, the anti-tax avoidance rules could apply to any subsequent attempt to substitute a less-taxed form of reward, such as super contributions. This is certainly the ATO’s point of view, as expressed in Taxation Ruling TR 2001/10. You can access this ruling here: Taxation Ruling TR 2001/10.
Interaction between the income and the fringe benefits tax rules
Since fringe benefits tax (FBT) was introduced in 1987, employee reward packaging has leveraged itself off the differences in the effective tax rates applying to each type of employee reward and, in particular, the low effective tax rates applying to some concessionally taxed fringe benefits. The basic rules are straight forward. Salary income is included in the employee’s taxable income computation and progressive tax rates are applied to that figure, culminating in a tax rate, including the Medicare levy, of 47% on taxable incomes above $180,000.
Fringe benefits tax is levied on the employer. The tax rate of 47% (including Medicare levy) also applies to the taxable value of the fringe benefits, grossed up by a factor of 2.0802 (assuming the employer can claim GST credits and the employee cannot – the ATO refers to this as “Type 1 gross-up rate”). These factors are designed to create equitable tax treatment between the two different forms of reward, assuming the employee is at the top marginal tax rate.
The FBT tax and gross-up rates up to 2018 FBT year are provided below:
|FBT year||FBT rate|
|Ending 31 March 2014 (and prior years)||46.5%|
|Ending 31 March 2015||47%|
|Ending 31 March 2016 and 31 March 2017||49%|
|Ending 31 March 2018 onwards||47%|
|FBT year||FBT rate||Type 1 gross-up rate|
|Ending 31 March 2014 (and prior years)||46.5%||2.0647|
|Ending 31 March 2015||47%||2.0802|
|Ending 31 March 2016 and 31 March 2017||49%||2.1463|
|Ending 31 March 2018 onwards||47%||2.0802|
Grossing up the employer’s taxable value and then allowing a tax deduction for the resulting FBT liability means the total effective tax rate is the same irrespective of which form of reward is chosen. This structural emphasis on a level playing field has two main consequences for tax planning for high income clients. These are that giving up salary for fringe benefits will only be sensible where the fringe benefit is a concessionally-taxed fringe benefit, and that it will be more attractive when the marginal tax rate faced by the client is 47%. Employee reward packaging has to be considered within the broader financial planning strategy, particularly the tax planning strategy for the client and related persons. For example, a large spouse super contribution strategy may work to drag the client’s taxable income down to a much lower tax bracket and hence render certain employee reward packaging strategies at best unnecessary and at worst counter-productive.
Some basic technical concepts underpin this, including:
- A reward will either be taxed in the hands of the employee as salary, or taxed in the hands of the employer as a fringe benefit; it cannot be taxed as both.
- Where a benefit is specifically exempt from FBT in the hands of an employer it will be exempt from income tax in the hands of the employee.
- The taxable value of a fringe benefit will be reduced by any contribution paid by the employee. The employer has to include the contribution in assessable income. The ATO says these contributions can be made via year-end book entries, without cash being paid, where the employee and the employer are related parties.
- The taxable value of a fringe benefit will be reduced to the extent that the cost of providing the benefit would have been tax deductible to the employee had they incurred the cost. For example, an employer can pay the deductible interest on an employee’s investment loan without triggering an FBT liability but the employee cannot claim the interest because they have not incurred it.
- FBT is a deductible loss or outgoing in the employer’s hands.
Car fringe benefits
The car is the most common fringe benefit provided to clients who are employees. This is not surprising because it is actually what the government wants – deliberate concessional rules for valuing car fringe benefits have been a feature of the FBT rules since they were introduced in 1987. These concessions are intended to keep the new car manufacturing industry alive and well. The fear is that if employers, easily the largest buyers of new cars, stopped buying new cars the industry would die overnight.
The family car is one of the biggest investments and expenditures clients make, apart from the home, and holding the car in a way that minimises after-tax cost is sensible. For self-employed clients, the best way to buy a car is through a family trust and for the car to be provided as a fringe benefit as part of the client’s salary package. The employee then contributes to the cost of running the car such that the taxable value of the car is reduced to nil and no FBT is payable, although the amount of the contribution must be returned as assessable income by the employer. The contribution can be made through a loan account at year-end, so a cash contribution need not be paid to the employer.
An exception to the normal rule that it is cheaper to have a car owned by an employer and provided to the employee as a fringe benefit may arise when the car has a high dollar-value, is driven less than 10,000km a year and has a high business usage percentage. In this situation it can be better to own the car in the employee’s name and to claim a tax deduction for the costs of running it, including depreciation and any interest, or lease payments if the car is leased, multiplied by the business percentage.
There is no limit on the number of cars able to be taken as a fringe benefit by an employee or an associate of an employee and there is no requirement that the employee drive the car. The employees can use the first car, the spouse can use the second car and children or grandparents can use a third or fourth car. The cost of each car is deductible to the employer and there is no tax payable on the benefit. FBT is payable as above. There tends to be little FBT payable on the third and fourth cars. Under the statutory method FBT is a function of cost, and if the car did not cost much in the first place there can’t be much FBT.
What is business travel?
Travel expenses from home to work are generally not an allowable deduction. The leading case that decided this was the decision of the Full High Court in Lunney v FCT (1958) 7 AITR 166. The reasons are twofold. “First, merely because certain expenditure must be incurred in order to be able to derive assessable income, in that unless one arrives at work it is not possible to derive income, does not necessarily mean that the expenditure is incidental and relevant to the derivation of assessable income or that it is incurred in the course of gaining or producing assessable income. It is a prerequisite to the earning of assessable income rather than being incurred in the course of gaining that income. Hence, it does not fulfil the positive limbs of s 8-1(1). “Second, the essential character of the expenditure is of a private or domestic nature, relating to personal and living expenses as part of the taxpayer’s choice of where to live, in choosing to live away from and at what distance from work. The negative limbs of s 8-1 (2) are therefore also breached. “There are, however, some exceptions. Certain employees such as professional footballers and musicians, have been held to have a base at their home and consequently from the moment they leave that home they are engaged in connection with their work and are entitled to a deduction in respect of the travelling costs incurred: Ballesty v FCT (1977) 7 ATR 411. This is particularly so where transport of bulky equipment is a necessary part of the job: FCT v Vogt (1975) 5 ATR 274. A GP was able to obtain a deduction on these grounds in AAT Case 9235 (1994) 27 ATR 127.” (emphasis added)
GST on company cars
An often-forgotten but significant side benefit of a company car is that 100% of the GST is refunded in the Business Activity Statement for the quarter of purchase.
Low dollar-value and irregular gifts can be provided by employers to employees without a FBT charge for the employer or an income tax charge for the employee. Gifts can be a great way to lift employees’ morale and show appreciation of their efforts. In the employment context, there is much to be said for the old adage “it is better to give than to receive”. It’s a human resources truism that people respond more to empathy and appreciation than they do to just money. For example, a gift of a $200 shopping voucher to each employee before Christmas can be a great way to say “thanks”. Other shopping ideas include a bottle of spirits, perfume, a food hamper, a CD, a book or a clothes or toy shop voucher.
The gift does not have to be consumed on the premises and there is no reason why it cannot be something that the employee in turn gives to someone else. The ATO applies some rules in order for the gift to be treated as tax-free. These are that any one gift must be “modest in value”, valued under $300 per gift, and that it is unreasonable to treat as a fringe benefit. The gift must not specifically relate to the employee’s work performance and there should be no more than four special occasions (ie, gifts) per employee per year.
Some clients travel for business purposes. Many clients claim the exact costs they incurred, such as airfares, accommodation, taxi fares, meals, etc. For clients who are employees – and all clients who practice through a practice company are technically employees – there is an alternative way that can result in hundreds of dollars of after-tax cash savings. Rather than paying for or reimbursing costs for accommodation and incidentals, an employer may give the employee a travel allowance, which is fully tax-deductible to the practice company, and assessable in the employee’s hands. The employee can then claim expenses against this allowance as work-related expenses. This makes sense. Provided the claim is reasonable, an employee does not need to satisfy the detailed substantiation requirements normally applying to extended interstate or international travel.
In Income Tax Ruling TR 2000/13, the ATO sets out which levels of expenditure they consider reasonable and that consequently need not be substantiated. These levels are often much higher than the actual costs many clients incur and claim.
The otherwise deductible rule
The taxable value of a fringe benefit will be reduced to the extent that the cost of providing the benefit would have been tax deductible to the employee had they incurred the cost themselves. For example, an employer can pay the deductible interest on an employee’s investment loan without triggering an FBT liability, although obviously the employee cannot claim the interest as well, since they have not incurred it. Some client’s travel a lot. The tax law is mainly favorable to their claims for deductions for extended domestic travel and overseas travel, but some basic ground rules have to be followed if the correct tax treatment is to be demonstrated to the ATO.
The basic principles are straightforward. If a client incurs losses or outgoings when travelling overseas for the purpose of increasing their current or future assessable income, a deduction is generally allowed. The difficulties arise when the trip has is a mix of private and business purposes. If a client travels to Vienna for a seven-day conference, and then spends another five days sightseeing, how are the costs divided between the deductible business purpose and the non-deductible private purpose? The High Court says that there must be a fair and reasonable apportionment based on the facts of each case. This makes sense, but a perusal of cases shows a bewildering array of apportionment methodologies that serves more to confuse than to explain. Some cases are scarcely distinguishable from each other, but somehow the courts and tribunals make distinctions and different tax results flow on from them.
The burden of proof regarding taxable income and claiming deductions lies always with the taxpayer. The basic rule is to document, document and document again so the purpose of the travel may be demonstrated to the ATO. The Tax Act actually creates a special requirement for this. Detailed log books must be kept for all overseas travel and extended domestic travel (ie, more than five days). But more substantiation is needed if a claim is to be put beyond any doubt. The documentation should cover the whole exercise, from the time the trip is first conceived, through to your return and the implementation of the knowledge you gained.
Case W73 (89 ATC 659) is instructive. Two junior police officers, a wife and husband, successfully claimed $25,000 of costs incurred on a trip to the UK to visit a selection of police stations for the purpose of gaining knowledge of new police methods. Sightseeing was not on the agenda. Case W73 is applicable to other occupations as much as police officers. For example, there are many examples of GPs who travel to the UK to visit general practices for the purpose of improving knowledge of community medicine and international standards of care. If a GP does this and can document the purpose of the trip as a business trip, the costs will be tax-deductible. The emphasis should always be on improving an existing body of knowledge and experience, rather than creating a new one. There is a risk that costs incurred in creating a new body of knowledge and experience will be seen as a non-deductible capital outgoing. Make sure the documents evidence the improvement of an existing body of knowledge and experience.
Purpose counts, not time
The apportionment between private and business will be based on your purpose rather than how you spent your time. A client visiting the UK does not have to spend the bulk of their time at business purposed visits, but visiting the businesses needs to be the primary purpose of the trip if the bulk of the costs are to be treated as deductible. For example, the costs of a 20-day stay in the UK with 15 two-hour visits to different businesses spread around the country would be 100% deductible if the visits were on average one per working day and the sole purpose of the trip was to visit the businesses. This is so even if only 15% of time was spent on the business visits.
The key word is substantiation. A properly completed log book is just the start. The client must be able to prove that the purpose of the trip is to improve their occupation knowledge.
The paper trail will be important: from the initial requests/advices to colleagues for sabbatical leave, to invitations to visit the UK businesses, letters to travel agents to organise the logistics, notes taken while visiting, and the dissemination of the information to peers and colleagues on your return to Australia.
It boils down to making sure you can prove why you did it, as well as that you did it. Nothing beats contemporaneously created documents involving third parties as evidence of intention. Simple assertions regarding why you did something have little evidentiary weight if the matter is reviewed by the ATO, but a clear paper trail evidencing what you did and why you did it will make sure there is never any dispute in the first place.
Australian Taxation Law 28th edition 2018
- Chapter 1 – Introduction to income tax law
- Chapter 7 – Capital gains tax: general topics
- Chapter 8 – Capital gains tax: concessions and special topics
Australian Master Financial Planning Guide
- Chapter 1 – Income tax
- Chapter 2 – Capital gains tax
- Chapter 3 – Superannaution
- Chapter 4 – Self managed super funds
ATO – Tax planning
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