What is a trust, how are they taxed, and which one should you choose?
A trust is a relationship between:
- the trustee (who holds the legal title to trust assets for the benefit of the beneficiaries); and
- the beneficiaries (on whose behalf and benefit the trust assets are held).
Are there different types of trusts?
There are different types of trusts, for example:
- discretionary trusts;
- fixed trusts (including some unit trusts); and
- hybrid trusts.
What is a discretionary trust?
Most trusts commonly referred to as ‘family trusts’ are discretionary trusts where:
- none of the beneficiaries have an interest in the trust or its assets; and
- the trustee has discretion as to which beneficiaries (if any) receive a trust distribution from year to year.
Some discretionary trusts have one or more default beneficiaries (whether as to income and/or capital) and to the extent that there is any trust income (from year to year) or trust capital (on a winding up) to which no beneficiary is entitled, that income or capital will be distributed to the default beneficiary/ies.
What is a fixed trust (including some unit trusts)?
The concept of a fixed trust is problematic.
A fixed trust is commercially understood to be any trust giving rise to fixed (rather than discretionary) distributions. However, this commercial understanding is very different to the meaning of a fixed trust for:
- income tax purposes (e.g., the trust loss regime);
- non-arm’s length income (NALI) purposes (in relation to the taxation of superannuation funds); and
- NSW land tax purposes (to access the NSW land tax-free threshold).
In fact, there is additional uncertainty as to whether the definition of fixed trust for income tax purposes ‘covers the field’ in terms of the meaning of that phrase for NALI purposes. Taxpayers are forced to rely on an ATO administrative view that the meaning for NALI purposes is less stringent than the income tax definition notwithstanding an Administrative Appeals Tribunal decision to the contrary (see The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation  AATA 527]; Taxation Ruling TR 2006/7; Decision impact statement, The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation The Trustee for MH Ghali Superannuation Fund and Commissioner of Taxation).
The definitions for both income tax purposes and NSW land tax purposes are very strict, so much so that:
- the ATO position is that virtually no trust deed will ever satisfy the legislative definition such that most taxpayers would have to rely on the exercise of the Commissioner’s discretion to treat an interest as a fixed entitlement and by extension, the trust as a fixed trust (see Practical Compliance Guidelines PCG 20126/16); and
- most trust deeds seeking to satisfy the NSW land tax definition specifically replicate a legislative provision effectively deeming the trust to be fixed for present purposes (see subsection 3A(3B) of the Land Tax Management Act 1956 (NSW)) rather than rely on the terms of the terms of the trust deed more broadly.
What is a hybrid trust?
Hybrid trusts, as the name suggests, combine features of both fixed and discretionary trusts, for example, fixed distributions between Family A and Family B but discretionary distributions within each family.
Although they can be useful in particular circumstances, they do give rise to additional complexities in terms of achieving desired outcomes and are less popular today than they have been in years past.
How is a trust taxed?
A trust is an entity for tax purposes and must prepare a tax return, however, it is generally a ‘flow-through’ vehicle, that is:
- the beneficiaries are taxed on their share of the net income of the trust to which they are entitled; and
- the trustee itself is not taxed.
However, to the extent that there is net income of the trust to which no beneficiary is entitled, the trustee itself is taxed:
- at a flat 45% rate (excluding levies); and
- without the benefit of general 50% CGT discount on capital gains.
From a CGT perspective:
- trusts can access the general 50% CGT discount (subject to meeting the relevant conditions), however, where the capital gain flows through to one or more beneficiaries:
- the discount capital gain is grossed up; and
- eligibility for the discount is re-determined at the beneficiary level, such that individual beneficiaries effectively retain the benefit of the discount at the trust level, whereas corporate beneficiaries effectively reverse out the benefit of the discount at the trust level; and
- trusts can access the small business CGT concessions (subject to meeting the relevant conditions).
Can a trust distribute losses?
Losses (whether revenue losses or capital losses) are trapped in a trust and cannot be distributed to beneficiaries.
Revenue losses can be carried forward and offset against income in future years (subject to meeting certain loss tests) and capital losses can be carried forward and offset against future capital gains (there is no loss testing in this regard).
Which trust suits you and why?
Whether a trust suits you in the first place (compared to a sole trader/individual ownership, company, partnership, or joint venture) and if so, which trust suits you and why, depends on various factors including:
- whether you are seeking to carry on a business or hold a passive investment;
- if you are seeking to carry on a business:
- what are the anticipated working capital requirements of the business (as trusts cannot tax-effectively retain income, a trust may not be a suitable structure for a business with significant working capital requirements);
- will the business require significant debt funding (again, as trusts cannot tax-effectively retain income, principal loan repayments may result in beneficiaries being taxed on more than they receive from the trust over the life of the loan);
- will the business give rise to significant depreciation (fixed trusts/unit trusts can give rise to CGT event E4, whereby trust income sheltered from tax effectively whittles away the cost base of the trust interest/units and can ultimately give rise to current-year capital gains once the cost base is fully depleted);
- if third party equity participants are an immediate requirement or even a future possibility:
- a discretionary trust would be an inappropriate vehicle to operate a business as no one has any ‘equity’ interest in it; and
- a unit trust may be a more suitable vehicle to operate the business, however:
- they are less commercially understood than companies; and
- some investors have mandates that they can only invest in corporate vehicles; and
- some tax incentives and grants are only available to companies (e.g., R&D tax incentive; Early Stage Innovation Companies); and
- if you are seeking to hold a passive investment asset:
- will the asset be positively, neutrally, or negatively geared;
- if the asset will be negatively geared:
- how long is it likely to remain so;
- does the trust have the capacity to acquire income-producing assets whose income will be absorbed by the losses year to year;
- if the asset would otherwise give rise to NSW duty and/or land tax (e.g., residential land in NSW):
- what is the impact of surcharge duty and/or land tax on the investment returns (if any);
- should a discretionary trust deed exclude foreign persons;
- should a unit trust deed be fixed for land tax purposes;
- should any foreign persons take a maximum stake in a fixed trust or unit trust under the relevant threshold to prevent the fixed trust/unit trust itself from being a foreign person;
- will the trust carry significant debt funding (see above);
- will the asset give rise to significant depreciation (see above)?
We note that the issues outlined above are not comprehensive.
Trusts can be useful, flexible tools to carry on a business and/or hold investment assets. However, it is important to understand whether a trust is the right structure for you and if so, which type of trust suits you and why.
Whilst trusts can provide clear advantages, they also give rise to certain disadvantages in some circumstances. Discussing and weighing these advantages and disadvantages in your circumstances is the key to making fully informed decisions and the right choice for you.
If you need any assistance in structuring your new business or investment vehicle, contact Mosaic Tax legal at email@example.com or 1300 115 841.