PROTECTING FAMILY WEALTH: RETIRING IN AUSTRALIA
By Robert Gordon, Barrister, St James Hall Chambers, Sydney
Presented at Legal Week “Private Client Legal Forum” Villa d’Este, Lake Como,
Italy 9-11 November, 2006
Introduction
Until very recently, the tax regime in Australia was such that a decision to retire in
Australia was more likely to have been made for non-income and capital gains tax
reasons, as the income and capital gains tax climate was certainly colder than the
weather.
However, one long standing positive was the absence since 1980 of any State or
Federal death or gift duty, so that retirees from countries with inheritance tax may
have sought to adopt an Australian domicile of choice, to escape the clutches of their
country of origin inheritance tax.
Ironically, non-domiciles of the United Kingdom, find it an attractive to reside but not
adopt a domicile of choice in the UK, in order to make use of the remittance basis of
taxation applicable to non-UK domiciles.
The previously frosty income and capital gains tax climate has now changed
significantly:
1.
2.
3.
4.
since 1999, capital gains made by individuals from holding assets for more
than 12 months, was halved, as was a gain made by a trustee for a
“presently entitled” individual beneficiary, without any reduction in the
ability to “negatively gear” income producing assets and get a full tax
deduction for interest expense;
the 2006 Budget resetting of the tax scales making the top marginal rate of
tax for individuals “kick in” at a much more reasonable A$150,000;
the 2006 Budget announcements reforming the taxation of Australia
superannuation (retirement funds), especially the ability to take out
benefits tax free from complying superannuation funds once the member
reaches the age of 60, even though they may still be working;
the abolition of Australian tax on the foreign investment income of
“temporary residents” with effect from 6 April, 2006.
The topic of protecting family wealth on retirement in Australia, is analysed on
the basis that taxation must be minimized to protect that wealth, and that the
structures in which that wealth is held, must to the extent possible, protect that
wealth from the family’s potential creditors. Those aims may sometimes, happily
co-exist.
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Foreign Income of Temporary Residents
It is perhaps the abolition of Australian taxation on the foreign source investment
income of temporary residents that is going to excite the imagination of many
prospective potential migrants.
As a permanent resident visa is not a simple matter for all but those with close family
connections already in Australia, obtaining a temporary visa is usually a first step.
However, a temporary (usually up to four years) visa is renewable, potentially without
the loss of the temporary resident status for tax purposes.
Prior to enactment of the provisions, a ‘temporary resident' was proposed to be
defined as someone who was an Australian resident for tax purposes for less than four
years, who was on a temporary visa and had not applied for a permanent visa, and
who had not been an Australian resident for tax purposes in the preceding 10 years.
The final enactment was liberalized.
The provisions are largely contained in Div 768 of the 1997 Act. Section 995 of the
1997 Act is the “definitions section” and specifies:
“temporary resident , you are a temporary resident if:
(a) you hold a temporary visa granted under the Migration Act 1958; and
(b) you are not an Australian resident within the meaning of the Social Security Act 1991; and
(c) your *spouse is not an Australian resident within the meaning of the Social Security Act
1991.
However, you are not a temporary resident if you have been an Australian resident (within
the meaning of this Act), and any of paragraphs (a), (b) and (c) are not satisfied, at any time
after the commencement of this definition.
Legislative Note:
The tests in paragraphs (b) and (c) are applied to ensure that holders of temporary visas who
nonetheless have a significant connection with Australia are not treated as temporary
residents for the purposes of this Act.”
Necessarily, the person who qualifies as a temporary resident is one who otherwise
would have been within the definition of “resident” under s6(1) of the 1936 Act:
“(a) a person…who resides in Australia and includes a person:
(i) whose domicile is in Australia, unless the Commissioner is satisfied that his
permanent place of abode is outside Australia;
(ii) who has actually been in Australia, continuously or intermittently, during more than
one-half of the year of income, unless the Commissioner is satisfied that his usual
place of abode is outside Australia and that he does not intend to take up residence
in Australia; or
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(iii) who is:
(A) a member of the superannuation scheme established by deed under the
Superannuation Act 1990; or
(B) an eligible employee for the purposes of the Superannuation Act 1976; or
(C) the spouse, or a child under 16, of a person covered by sub-subparagraph (A) or
(B)”
[Note the Superannuation Act 1990 and 1976 deal with government
employees only]
The concept of domicile is still largely governed by the common law (e,g. Udny v
Udny (1869) LR 1), although in both Australia and the UK (Domicile and
Matrimonial Proceedings Act 1973) there are statutory amendments dealing with the
domicile of married women and the domicile of dependent children. Section 10 of the
Australian Domicile Act 1982 codifies the common law to a certain extent, in that it
provides:
“The intention that a person must have in order to acquire a domicile of choice in a
country is the intention to make his home indefinitely in that country.”
Of course, in order to change one’s domicile of choice to Australia, it would be
generally necessary to have the legal capacity through visa status to “make his home
indefinitely” or “ends one’s days” in Australia (although see most recently Mark v
Mark [2005] 3 All ER 912, which casts some doubt on the status of Solomon v
Solomon (1912) WNNSW 68, and Puttick v A-G [1979] 3 All ER 463). This would
require the taxpayer to convert to permanent resident status, in the case of a UK
domicile, at least 3 years before the date of death in order to avoid UK IHT on worldwide assets: s267(1)(a) IHTA.
That a British person may find it easier to have evidence accepted of his acquisition of
a domicile of choice in Australia rather than a country which is more alien in terms of
language, culture, religion etc, although it is always a question of fact, can be seen in
Casdagli v Casdagli [1919] AC 145 at 156-157 and Qureshi v Qureshi [1971] 1 All
ER 325 at 339-340.
As seen above whether a person is a temporary resident depends upon whether a
person is an Australian resident within the meaning of the Social Security Act 1991 as
follows:
“7(1) In this Act, unless the contrary intention appears:
Australian resident has the meaning given by subsection (2)
.…permanent visa…[and] temporary visa… have the same meaning as in the Migration Act
1958.
7(2) An Australian resident is a person who:
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(a) resides in Australia; and
(b) is one of the following:
(i) an Australian citizen;
(ii) the holder of a permanent visa;
(iii) a special category visa holder who is a protected SCV holder [which can only apply
to persons who were resident on 26 February, 2001].”
Visa Categories
The Migration Act 1958 provides at s30:
“ Kinds of visas
(1)
A visa to remain in Australia (whether also a visa to travel to and enter Australia) may
be a visa, to be known as a permanent visa, to remain indefinitely.
(2)
A visa to remain in Australia (whether also a visa to travel to and enter Australia)
may be a visa, to be known as a temporary visa, to remain:
(a) during a specified period; or
(b) until a specified event happens; or
(c) while the holder has a specified status. “
For persons over 55 years of age (a spouse can be any age), but with no dependents,
the Investor Retirement (Subclass 405) visa may be appropriate. It requires the retiree
to have assets that can be brought to Australia worth a minimum A$750,000 and to
make a “designated investment” in the sponsoring State or Territory (which cannot be
NSW or ACT) of A$750,000, and that the retiree have an annual minimum income of
A$65,000 (which may be a pension). The retiree must have no intention of working
full-time in Australia, but is allowed to work for 20 hours per week while in Australia.
Whilst it is not a pathway to permanent residence, it is extendable if eligibility
continues. For truly independent retirees, these requirements are not particularly
onerous. See http://www.immi.gov.au/visitors/special-activity/405/how-the-visaworks.htm
For persons less than 55 years of age with business plans, a State/Territory Sponsored
Business Owner (Provisional) (Subclass 163) may be appropriate. It is a pathway to
permanent residence. See http://www.immi.gov.au/skilled/business/163/how-the-visaworks.htm
It should be noted that these types of visas invariably require the holder to have their
own private health insurance and deny access to social security.
2006 Budget Tax Scale
Whilst the marginal rates for resident taxpayers for the tax year ending 30 June, 2007
are still high by Asian standards, they are now compare probably marginally more
favorably than higher taxing European countries. In fact, the top marginal rate was
dropped by 2% and the level at which the top rate is applied was increased by
A$55,000, which is a dramatic change. The current scale is:
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Whilst the upper rate of taxation in the UK is 40%, the effect of the National
Insurance Contribution (roughly 11% for employees and much less for the selfemployed), which doesn’t directly accrue to the benefit of the individual taxpayer,
makes the effective rate considerably higher. It cannot be directly compared to the
Australian minimum superannuation contribution of 9% (which in any event only
applies to employees), as the superannuation contribution accrues directly to the
benefit of the taxpayer’s retirement fund, rather than to fund a State pension. The
flexibility of Australian superannuation is explored below.
Under the UK/Australia double tax agreement, which follows the OECD model, a
resident of Australia is subject to tax on a UK pension, only in the country of
residence.
Dual residence is resolved in Article 4:
“1 For the purposes of this Convention, a person is a resident of a Contracting State:
(a) in the case of the United Kingdom, if the person is a resident of the United
Kingdom for the purposes of United Kingdom tax; and
(b) in the case of Australia, if the person is a resident of Australia for the
purposes of Australian tax…
2 A person is not a resident of a Contracting State for the purposes of this Convention
if that person is liable to tax in that State in respect only of income or gains from
sources in that State.
3 The status of an individual who, by reason of the preceding provisions of this
Article is a resident of both Contracting States, shall be determined as follows:
(a) that individual shall be deemed to be a resident only of the Contracting
State in which a permanent home is available to that individual; but if a
permanent home is available in both States, or in neither of them, that
individual shall be deemed to be a resident only of the State with which the
individual's personal and economic relations are closer (centre of vital
interests);
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(b) if the Contracting State in which the centre of vital interests is situated
cannot be determined, the individual shall be deemed to be a resident only of
the State of which that individual is a national;
(c) if the individual is a national of both Contracting States or of neither of
them, the competent authorities of the Contracting States shall endeavour to
resolve the question by mutual agreement.”
2006 Superannuation Changes
Perhaps the most relevant change to the superannuation (retirement) system for
persons who are at first to be temporary residents, is due to the fact that any
employment related income will continue to be subject to marginal rates as above.
The 2006 Budget has enhanced the usefulness of “salary sacrifice” as a means to
reduce the tax liability on such employment income.
It has been a long standing feature of the Australian tax landscape for employee’s to
“salary sacrifice” into Australian complying superannuation funds (concessionally
taxed retirement funds). This had the effect of avoiding tax on that part of the salary
sacrificed, but was not hugely attractive as contributions by the employer were subject
to a contributions tax on their way into the fund of 15%, and for high income earners,
and additional superannuation surcharge of 15%. So if a taxpayer was subject to the
top marginal rate then, of 47% plus Medicare levy of 1.5%, the salary sacrifice was
effectively only a deduction of 18.5%, and there was more tax to pay when the
member retired and took their entitlement.
From 1 July, 2005 the superannuation surcharge was abolished. The 2006 Budget
changes continue to allow those aged over 50 at 1 July, 2007 to have their employer
make a tax deductible contribution of A$100,000 p.a. on their behalf (until 2012), and
on accessing super benefits after age 60, there is no tax on the withdrawal. Nor is
there any longer a requirement to retire from the workforce to access the super
entitlement.
It has also been a long standing feature of the Australian tax landscape, that
employees could set up a “self managed superannuation fund” (SMSF) so the
investments made by the fund could be controlled by the members. Entitlements of
employee could be “rolled over” to the SMSF from the employer controlled fund, in
the past only with the employer’s consent, but since 1 July, 2005, when the “Choice
of Superannuation Fund” regime became effective, usually without the employer’s
consent. As the contributions tax is still at 15%, and the top marginal rate is now 45%,
the saving from salary sacrifice is now 30% or 31.5% if the taxpayer is subject to the
Medicare levy.
SMSF’s are also used by the “self-employed” and as a result of the 2006 Budget,
there was an abolition of a discrimination against the “self employed”, in that there is
no longer a limit on deductible contributions by the self-employed of only 75% of the
contribution over the first $5,000.
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An Australian complying superannuation fund pays tax on its income at 15% and on
capital gains at 2/3 of that i.e.10%. Franking credits on dividends offset the tax
liability, and excess franking credits are refundable in cash.
Main residence exempt from CGT
There have been generous exemptions from capital gains tax for a taxpayer’s main
residence in Australia, since the inception of CGT in 1985. There is no limit to the
value of the house in question. Once a house has been a taxpayer’s main residence,
(subject to what is said below) significant absences are allowed with the exemption
remaining intact. The house must be in the name of the taxpayer personally, but for
asset protection reasons, the purchase price can be funded from a family discretionary
trust, which can take a mortgage over the house to secure the loan. Stamp duty on
acquisition varies from State to State but ranges up to 5.5% for property costing more
than A$1M. Foreign nationals buying Australian residential realty need Foreign
Investment Review Board approval, which will be granted in relation to existing
housing stock to temporary residents with at least 12 months remaining on their visas,
and on condition that the house is to be their main residence, and is sold if they do not
continue to hold a temporary (or permanent) visa. For new housing stock, such as
purchase of flats “off the plan”, approval is required for foreign nationals, but there is
no requirement to be a resident (of any type) and the realty can simply be an
investment.
For
more
information,
see
the
FIRB
website:
http://www.firb.gov.au/content/real_estate.asp
The disposal of a permanent residence in the UK and the acquisition of one in
Australia would be one of the steps that could be taken firstly, to ensure that dual
residence is resolved in favor of Australia under the ‘tie breaker” in the UK /
Australia DTA, and secondly, as an assistance on the path to acquiring an Australian
domicile of choice for UK IHT purposes.
HMRC has shown resistance to claims of loss of UK domicile of origin: see Anderson
v IRC [1998] STC (SCD) 43; F v IRC [2000] STC (SCD) 1; Civil Engineer v IRC
[2002] STC (SCD) 72; Moore’s exec v IRC [2002] STC (SCD) 463; Surveyor v IRC
[2002] STC 501
Offshore Trusts for Australian (Permanent) Residents
On loss of temporary resident status, to attempt to achieve an Australian domicile of
choice, the taxpayer is then confronted with all the complexity of the Australian tax
system.
Prior to the introduction of anti-deferral legislation in 1990, Australian residents could
be the beneficiaries of offshore discretionary trusts with foreign source income, and
provided that they were not made presently entitled to the offshore trust’s income,
they had no Australian tax liability on it. As can be imagined, there were likely to
have been a great many of such offshore trust in existence for Australian beneficiaries.
The so called Transferor Trust (TT) rules (contained in Div 6AAA of the 1936 Act)
sought to prevent such deferral by attributing the offshore discretionary trust’s income
and gains to the party who had transferred property or services to the trust, unless the
trust had borne tax at normal rates in one of seven (7) nominated high tax countries,
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or the transfer was to a trust under an arm’s length dealing, and the transferor did not
control the trust. At the time of the introduction of the TT measures, an amnesty was
offered, whereby 10% of the assets of such trusts wound up would be taxed in
Australia. By all accounts the amnesty was a failure, and it is likely that many of the
trust in question are still in existence.
Creation or transfer to a non-resident trust pre-immigration (a simple “drop off” trust)
doesn’t work, as on becoming an Australian (permanent) resident, the trust will still
become a TT with respect to the transferor. Previously, there was an exemption for a
“drop off” trust that the transferor didn’t control when he became an Australian
resident, but that has now been abolished. As can be seen below, the position may be
different if a relative who is not to become an Australian (permanent) resident
establishes and funds the trust for the future Australian (permanent) resident.
In 1993 further anti-deferral legislation was introduced which dealt with Foreign
Investment Funds (FIFs). The most common form of FIFs which those measures
caught (Part X1 of the 1936 Act) were “roll up” offshore unit trusts, where the income
of the trust was accumulated, allowing the investor to defer tax on the accumulated
income until he realised his investment. Under the FIF measures, the Australian
resident needed to have an “interest” in the trust, such as by being a unit holder. A
mere discretionary object in a discretionary trust should not have an FIF interest
(Gartside’s case [1968] AC 553) and so there is not usually an overlap between the
two measures, at least in relation to the common offshore discretionary trust with an
independent trustee, where there is no beneficiary who has an interest as a taker in
default of appointment, except a charity. However, where by some planned means or
the happening of some designated event specified in the trust instrument, a mere
discretionary object was to become entitled, s96B of the 1936 Act could deem the
entitlement to have happened from the beginning, and there was also a similar
provision in the FIF regime . These provisions created considerable uncertainty in a
self assessing environment where the mere discretionary object may not have known
even about being a potential beneficiary, let alone the details which could cause a
deemed present entitlement. Thankfully, on 10 October, 2006, the Treasurer
announced a complete review of all anti-deferral legislation, to alleviate unnecessary
complexity and uncertainty. It is expected that s96B will be repealed.
The TT rules were drafted with the view to catching most offshore discretionary trusts
with an Australian transferor. The notable intentional exception is the testamentary
trust. Accordingly, an Australian resident individual can provide for the creation of a
testamentary trust with a non resident trustee, and on his demise, the offshore trust
which then comes into existence is outside the TT rules. Obviously cash or foreign
assets would be left to such a testamentary trust.
It is worth noting that the testamentary trust, even onshore, may have significant asset
protection advantages, because assets left by a deceased to children or grandchildren
who are professional persons, or directors of particularly public companies, or any
companies that may be at risk of trading while insolvent, may be “gobbled up” by the
beneficiaries’ creditors after the death of the deceased. That is, the deceased whole
life’s accumulation of wealth may be wasted e.g. by professional negligence of one’s
professional partners, if the liability is uninsured, as many professionals found
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themselves after the collapse of HIH Insurance in early 2000s, at the time Australia’s
largest general insurer.
However, there are at least a few other types of offshore discretionary trusts which
may be outside the scope of the TT rules. The first is the trust which is settled inter
vivos by a non resident without the involvement of an Australian resident party, and to
which no Australian resident party makes a transfer. For example, if an Australian
resident’s non resident relative created an offshore trust using there own money,
naming the Australian resident relative as a mere discretionary object. While the trust
is not controlled by the Australian resident relative, it cannot be a TT with respect to
him. If the trustee of the trust is exercising their duties properly, they will be in
control of the trust even if they communicate with the beneficiary as to his
preferences as to investment alternatives: Cf Abdel Rahman v. Chase Bank (CI) Trust
Company Limited and others, a decision of the Jersey Royal Court reported at [1991]
JLR 103 . Obviously, such a case is very fact specific. However, a similar situation
may happens if an offshore trust company causes trusts to be formed with no specific
individual beneficiaries in mind and only a charity named as a taker in default of
appointment, and the deed is drafted such that parties who have some specified
dealing with the trustee will automatically become mere discretionary objects i.e. a
“shelf trust”. A common dealing which might trigger an Australian resident person as
mere discretionary object is the lending of money to the trustee on arm’s length terms:
a so called “debenture trust”. It is understood the Australian Taxation Office (ATO)
are currently considering their position in relation to such trusts.
It is worth noting that if an Australian self managed superannuation fund (SMSF) has
loaned money to a “debenture trust”, the argument was that it hasn’t breached the so
called “in house asset rules”, as the SMSF has made an arm’s length investment in an
entity that it does not control.
However, as SMSF’s have since 1 July, 2005, not had the FIF regime applied to them,
and so the holding of portfolio investments that would attract the FIF regime if held
outside such a fund, can be now be quite straightforwardly be held by an SMSF.
Another planning tool used since the introduction of the TT rules, but in which I
understand the ATO have only recently shown much interest, is the situation where
there is a trust which has come into existence without any involvement of an
Australian resident, but in which an Australian resident is nominated as a taker in
default of appointment, and which at that stage is not a TT, which uses its own funds
to acquire a shelf company, and to which the Australian resident then gifts a
substantial sum. Whilst the gift is no doubt for the benefit of the company, as the
transfer is not to the trust, the transfer to the company has been argued by many not to
have the effect of causing the offshore trust to become a TT. This proposition must
be treated with extreme care.
At this stage it should be observed that if the trust in question is indeed a TT, and the
Australian resident transferor is attributable with income or gains from the TT but
fails to disclose that income or gain, then the taxpayer will have been involved in tax
evasion (unless the taxpayer had a “reasonably arguable position” that the trust was
not a TT), which may result in a criminal prosecution.
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However, there are some cases where a trust which is clearly a TT can have some use
for Australian residents. It is not having an interest in a TT which is proscribed, it is
the failure to declare the existence of the TT, and the income and gains from the TT.
If the taxpayer’s concern is asset protection and they are happy to pay Australian tax
on the earning of the trust, but want to protect its capital from potential creditors, a
trust formed under the Labuan Offshore Trust Act (Malaysia), or similar regime,
would fit the bill. See a paper on the topic written by my colleague Peter K Searle at
www.ectrustco.com As discussed below, based on Burton v Wily, an Australian court
will not allow the substitution of the Australian resident controller’s trustee in
bankruptcy to vest the trust in favour of the bankrupt’s creditors.
Also, for family planning purposes, assets which may not produce income but
potentially large capital gains, can be held in a TT without any attribution, as it is only
realised gains which are attributable. It may be that when the gain is to be realised,
that one or more of the mere discretionary objects is living in one of the seven (7)
high tax countries which are excluded from the TT regime, but whose tax rate may be
substantially lower than Australia. Indeed, the TT may produce some income, but as
long as it is declared as attributable, the fact that it flows from a significantly
appreciating asset does not cause any issue in relation to that appreciation unless and
until the gain is realised.
It should be noted that for Australian Federal family law purposes, an Australian
resident spouse may be in contempt of court for not disclosing the existence of
offshore trust assets, even though they may be safe from other creditors. It should also
be note that there is legislation in most States providing protection to persons in de
facto relationships, which is only a proposal in the UK at this stage.
Note that no Australian case has dealt with the TT rules. However, a recent set of
“Taxpayer Alerts” expressly note the TT rules (Div 6AAA) as potentially applicable
to offshore trusts: viz TA2005/5-8.
Offshore Companies for Australian (Permanent) Residents
As mentioned above, a TT which simply holds offshore appreciating assets, does not
cause an Australian tax liability until income arises, or a gain is realized. If at that
time the transferor is not an Australian (Permanent) Resident, there can be no
Australian tax liability from the TT.
As Australia now has a full participation exemption for dividends received on nonportfolio shareholdings, and capital gains made on disposal of shareholdings in nonresident companies that carry on an active business (Div 768G of the 1997 Act), the
TT can be used to create flexibility in relation to holding such non-portfolio
shareholdings (10% or more of the voting shares).
A non-resident company controlled by five (5) or fewer Australian residents will be a
“controlled foreign company” (CFC) for Australian anti-deferral tax purposes.
However, provided it has only business income which is not “tainted”, none of the
income is attributable to the Australian controllers, even if the foreign income has not
been subject to tax (from 1 July, 2004). In contrast to the UK anti-deferral provisions
that are potentially attracted to such trading companies if they bear tax at less than 3/4
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the UK rate, unless they employ at least two (2) full time employees resident in the
tax haven, the Australian anti-deferral regime as it applies to trading companies is
quite liberal, especially as there is no prescription for resident employees.
For more information on the use of Labuan trading companies controlled by
Australian residents, see an article I have written with Peter K Searle entitled “Why
Labuan (Malaysia from an Australian perspective, post 1 July, 2004) EC Trust
website: http://www.ectrustco.com/documents/contents/whitepapers/WhyLabuan.htm
If the migrant might cease to be an Australian tax resident for instance, if a
sufficiently large capital gain was to be made on a non-resident non-portfolio
shareholding, the non-resident holding entity might be a tax haven trading company
with two (2) classes of shares. To enable tax free dividends to come back to Australia
in the years before the sale, one class of share (with 10% of the voting rights) with
discretionary dividend entitlement, would be owned by an Australian company in its
own right (and entitled to s23AJ tax free dividends), while a TT might hold another
class of shares which would also have discretionary dividend entitlement, which
would only be used if the Australian (permanent) resident, ceased to be so, in an
Australian tax year before the offshore company made the sale. Whilst this is an
oversimplification of the concept, it is a workable plan if implemented carefully. It
will be observed that the use of the TT will also protect value in the non-resident
trading company from potential creditors of the Australian resident principal. The
Australian company that would hold the shares paying s23AJ dividends, would itself
be owned by an Australian discretionary trust, also for asset protection and flexibility
reasons.
Labuan, Malaysia is an attractive tax haven for Australian purposes, as it is in a more
convenient time zone for Australia, and is also much closer than European and
Caribbean havens, and is also outside the EU Savings Directive.
Use of discretionary trusts in Australia
The use of Australian resident trusts for Australian resident private clients is
widespread and by all accounts, increasing.
It is standard planning to advice private clients to use Australian resident discretionary
trusts both for asset holding, and for trading activities, due to their inherit flexibility
and the fact that provided beneficiaries are “present entitled” to the income and
capital gains of such a trust, the trust is “transparent” for tax purposes.
Having said trusts have been used as standard planning, occasionally there have been
scares, such as the now abandoned Entity Taxation regime (proposed in 2000), where
it was proposed discretionary trusts would be treated from a tax point of view, worse
in many ways than companies. Recently we have seen the farce of Commissioner
trying to undermine longstanding arrangements with professional firms’ service trusts
under Phillips case 78 ATC 4361, essentially trying to bring into the domestic arena,
the concept of arm’s length dealings which are required in an international
transaction, under Div 13: see TR2006/2.
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Whilst such presently entitled beneficiaries are taxed at their appropriate marginal
income rate, which currently is as high as 45% plus the Medicare Levy of 1.5%, a
corporate beneficiary can be used to attract the current corporate rate of 30%,
although there are complex rules designed to “top up” the tax rate to the top marginal
rate for individuals if the shareholders access funds from such companies (Div 7A of
the 1936 Act).
Capital gains on assets held for more than 12 months are usually channelled to
individual beneficiaries as only half (1/2) the gain is included in the assessable
income (Div 115 of the 1997 Act), so that the effective tax rate on such gain is no
higher than (now) 23.25%.
Income and capital gains to which no beneficiary is presently entitled are taxed at
46.5%, making accumulation of such in trust, highly tax disadvantageous: s99A of the
1936 Act.
As the discretionary trust can last for 80 years, it is inherently more flexible than
holding assets personally, as the party to benefit from the holding of the asset can be
changed from time to time, as circumstances change, through a number of
generations. Generally speaking, the beneficiaries who are mere discretionary objects
of such trusts have no “interest” in the trust assets which can become devisable
property on the bankruptcy of the individual, and so such trusts are valuable asset
protection vehicles, which may also protect the particular structure from the
application of the general tax anti-avoidance provision (Part IVA) as the dominant
purpose of the structure may be seen to be asset protection: FC of T v Mochkin [2002]
FCAFC 15.
Nor is the client who is in the position of an appointor of an Australian discretionary
trust going to find the trustee in bankruptcy stepping into his shoes. In the only
decision on the point in Australia, Davies J in the Federal Court in Burton v Wily
(1994) 126 ALR 557, found on the basis that the power of appointment was a
personal right, and therefore not “property”, it was therefore not capable of being
“devisable property” for bankruptcy purposes, and so the trustee in bankruptcy could
not obtain the power of appointment so as to vest assets of a discretionary trust in
favour of the bankrupt’s creditors. I understand a Court in Florida has recently found
the exact opposite in relation to the power of appointment of an American over a tax
haven trust: United States of America v Raymond Grant and Arline Grant (S.D.Fla.
06/17/2005).
It is worth noting that the use of an Australian resident discretionary trust cannot
however, be used to defeat the interest of a spouse in an Australian family law dispute.
There is no deemed realisation of capital gains, for instance, every 10 years, which I
understand certain trusts for the benefit of UK domiciles, are subjected.
Whilst there have not been death and gift duties in Australia since 1980, there is
always and issue as to whether they could be reintroduced, as Australia is apparently,
one of only six (6) OECD countries without such taxes. Politically, this is highly
unlikely in the short to medium term.
13
Foreign source income of an Australian resident trust is taxed to Australian resident
beneficiaries who are presently entitled to it, and they are entitled to a credit for any
foreign tax paid directly on such income.
Foreign capital gains on passive assets held for more than 12 months of an Australian
resident trust are halved, in computing the gain on which an Australian resident
presently entitled beneficiary is taxed, which is consistent with the position on
holding onshore assets. Correspondingly, only half the foreign tax is creditable.
Foreign source income or capital gains of an Australian resident trust are not taxed to
foreign resident beneficiaries who are presently entitled thereto (s95 of the 1936 Act).
Note that it is the beneficiary and not the “settlor” who pays the tax assuming the
beneficiary is presently entitled to the income or capital gain. In Australia, the term
settlor of an Australian resident trust (to which Div 6 of the 1936 Act applies), only
refers to the person who provides the initial (usually small) sum or property, who is
invariably not the principal for stamp duty reasons, and for the purpose of s102 of the
1936 Act . This is in contrast to the UK where any person who settles property on a
trust either to create it, or thereafter, is referred to as a settlor.
I also note that for reasons not readily apparent, the use of a memorandum of wishes
by the principal is often overlooked, but probably as the private company trustee is
usually controlled by the principal while he is alive (unlike in an offshore trust).
However, on the demise of the principal, the beneficiaries may not see things in the
same way, and trouble can then exist if they inherit the shares in the trustee. It would
be best often, if the shares in the trustee are not left to the beneficiaries, but to a
professional adviser, who armed with a memorandum of wishes may be better able to
fulfil the wishes of the principal.
The memorandum of wishes will most likely become much more common in
conjunction with the use of trustees independent of the family concerned, due to a
recent non-tax decision in Australian Securities and Investments Commission In the
Matter of Richstar Enterprises Pty Ltd (ACN 099 071 968) v Carey (No 6) [2006]
FCA 814 (29 June 2006)
http://www.austlii.edu.au/au/cases/cth/federal_ct/2006/814.html
In that case a receiver was appointed over various trust assets on the basis that the
defaulting debtor as a beneficiary and as in effective control of the trustee, had an
interest in the assets, entitling the appointment of a receiver over them under the
Corporations Act. This has caused considerable consternation, as the case didn’t even
refer to Burton v Wily. It is not known whether Richstar is on appeal, but
commentators have criticised the decision as either wrong or distinguishable. See:
http://www.taxinstitute.com.au/go/seminar-presentations/discretionary-trust-intereststhe-westpoint-litigation-presentation and http://www.taxinstitute.com.au/go/seminarpapers/discretionary-trust-interests-the-westpoint-litigation-paper In any event, the
emergence of the use of trustee companies independent of the beneficiaries, and the
greater use of such trustees out of the jurisdiction is to be expected.
14
Australian Trusts for Non Residents
As already observed, as foreign source income of an Australian resident trust, to
which a non resident is presently entitled is not subject to Australian tax, Australian
trusts could be used as conduits, especially if such foreign income can obtain the
benefit of reduced withholding or indeed, exemption of business profits, under
Australia’s double tax treaties with the source country. This may not be attractive if
the beneficiary lives in a high tax country, but could be attractive to a resident of a
low tax country who is looking to treaty shop through Australia into a country with
which his country of residence has no DTA.
Of course, there is the issue of whether Australian resident trusts have benefit of some
or all of Australia’s DTAs. Refer to OECD commentary on the model treaty on
whether trusts generally are or aren’t treated as “taxpayers” for purpose of OECD
treaties.
This possibility has been more exploited with New Zealand trusts, as they can
accumulate foreign source income, without New Zealand tax, as long as the
beneficiaries under the trust are not resident in New Zealand.
Australian taxation ruling TR2005/14 says that a NZ trust won’t be treated as a
resident of NZ for the purposes of the NZ treaty unless it has NZ source income
taxable in NZ. Interestingly the ruling reaches that conclusion when it is
acknowledged by the ATO that in the cases where the beneficiaries of such a trust are
Australian residents, the transferor trust regime would apply, but that approach seems
too hard for them, rather they simply deny the NZ trust the benefit of the lower rates
of withholding under the treaty.
Interestingly there was also a “Taxpayer Alert” which said that a scheme to use the
NZ treaty to gain exemption for business profits wouldn’t work for the same reason:
Taxpayer Alert TA2004/4.
In the current context, where there are members of a family living in Australia, with
other members living in suitable other countries, an Australian trust may be able to
have sufficient substance to allow it the benefit of at least some of Australia’s double
tax treaties for conduit treatment of third country investment income to be distributed
to the non-resident family beneficiaries, in circumstances where there may be no DTA
with between the country of residence of the beneficiary and the source country. For
beneficiaries who live in a country with a remittance basis of taxation, the beneficiary
can be made entitled to the income without it being actually paid.
Both Australia and New Zealand have a strong common law background, mature
legal systems, and highly qualified professionals to administer trusts, but the ever
present threat of legislative change, particularly of the tax laws, is likely to lead to a
preference for the use of low tax regimes. Also, where tax avoidance or evasion is
involved with trusts, there has been a disturbing tendency recently in the
Administrative Appeals Tribunal (equivalent to the UK Special Commissioners) for
the AAT has had no difficulty in effectively disregarding the offshore arrangements
said to have been put in place e.g. in Parry and Commissioner of Taxation (2004) 57
ATR 1343, where an employee benefits trust was said to have been put in place in
15
New Zealand, with AAT’s glib comments such as at paragraph 40 “that leads me to
conclude that there was in fact no fund in New Zealand”, and at paragraph 41 “I agree
with Ms Forward’s contention that Harts erected a paper mirage on behalf of its
clients”.
Another example is in relation to whether an offshore superannuation fund indeed was
set up for the purpose of providing superannuation see The Magazine Company v
Commissioner of Taxation, Case 13/2004, 2004 ATC 243 (which involved a Western
Samoan fund). Also see the result of Hickman and Commissioner of Taxation (2005)
AATA 339 (15 April 2005) where Mr Hickman said he borrowed $500,000 from
Pacific Factors Limited of Vanuatu and used the money to purchase an annuity from
Pacific Annuity Grantors Limited and at paragraph 19 where “the Commissioner did
not accept that the transactions are genuine. The respondent does not accept that the
Vanuatu companies have sufficient substance to either loan anyone $500,000, or
guarantee to payout sums of money of the order of $270,000 annually from the years
2028 to years 2042.”
But contrast the approach of the High Court (the ultimate court of appeal) in
Equuscorp Pty Ltd v Glengallan Investments Pty Limited (2004) 57 ATR 556 where
the fact that the so called “lender” had no real money to lend, did not mean that the
borrowings written on full recourse terms could not be enforced against the
“borrower”. So in circumstances where e.g. a bill of exchange is to be used in a
“round robin” to achieve perhaps some tax purpose, if the bill is accepted by a party
that could not meet the bill on presentation, whilst there would be someone
uncertainty that the negotiation of the bill would constitute payment, the better view is
probably that it would, especially having regard to the decision in Equusorp.
Also see the decision of the Federal Court in Walstern v FC of T [2003] FCA 1428,
which involved a NZ resident super fund. Perhaps the lesson from the unsympathetic
approach of the AAT is to avoid it by going straight to the Federal Court if the
findings of fact about offshore structures, are the essence of the case, as on appeal to
the Federal Court from a decision of the AAT, the Court can only correct errors of
law.
A major issue in Australia with trusts is when the trust is said to have become a new
trust (resettled) due to the position taken by the Commissioner in his Statement of
Principles (Creation of a new trust - Statement of Principles August 2001). Originally
issued in 1999 and reissued on 29 August 2001 after he lost the Commercial
Nominees case (2001 ATC 4336) in the High Court. He says if there is more than
administrative changes with the trust deed, a new trust is created and the old trust is
deemed to dispose of all its CGT subject property, and to forefit its losses. This could
apply to an onshore or offshore trust. This emphasises the importance of careful
drafting of the deed in the first place. Many issues which may be able to be
contemplated and expressly dealt with, but if left for later amendments, may trigger
the Commissioner’s Statement of Principles. This statement is for some reason, not on
the ATO website.
An issue often overlooked is that the Australian personal services income rules (Div
87 of the 1997 Act) can apply to an offshore arrangement just as they can to an
onshore arrangment. So Australian persons using offshore trusts to derive offshore
16
income for consulting 80% or more to the one client, may be deemed to have derived
the income personally (Cf in the UK, IR35).
Australian Conduit Company Regime
Australia has also recently introduced an effective conduit regime for Australian
resident companies. For many years there was a “foreign dividend account” conduit
regime, but no exemption for capital gains tax on disposal of the shares producing the
foreign dividends. The new provisions allow Australian resident companies owned by
non-residents to flow through dividends and capital gains from foreign sources, as
long as the distribution to the non-resident shareholder takes place within a prescribed
time limit. These provisions clearly have some attraction for investment in third
countries for the benefit of family members resident outside Australia. As Australian
resident companies are less likely to be denied the benefit of Australian’s DTAs, than
trusts, the Australian conduit company regime may be attractive, subject to the need
to distribute the conduit income and gains, which may cause problems where the
shareholders are in countries with a remittance regime. See Div 802 of the 1997 Act,
inserted by Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Act
2005 with its Explanatory Memorandum accessible thought the Legal Database of the
ATO: www.ato.gov.au.
Receding application of CGT to non-residents
Having family members resident in Australia may also allow the identification of
investment situations in Australia which can then be acquired by non-resident family
members under the new Australian CGT regime, which has moved to the OECD
model treaty position, of only taxing gains in the realisation of an Australian
permanent establishments or direct or indirect interests in Australian realty.
The new Div 855 on its way through Parliament, to be effective from the date of
Royal Assent, will remove from the Australian CGT net as applies to non-residents,
shares in Australian private companies, more than 10% interests in Australian listed
companies, interests in Australian resident private trusts, more than 10% interests in
listed unit trusts, as well as options over those assets. For a recent paper on the
amendments, see http://www.taxinstitute.com.au/go/seminar-papers/foreign-residentscgt-and-stamp-duty-paper
Mutual Assistance in Tax Recovery
Unlike the position in Europe, Australia has so far only entered into a few treaties
allowing Australia to collect tax on behalf of other countries revenue authorities i.e.
USA, France and New Zealand. Australia has also signed an exchange of information
agreement with Bermuda, and is trying to negotiate other such agreements with tax
havens, outside the framework of comprehensive double tax agreements.
www.robertgordontax .com
© Robert Gordon 2006