A return to tried and tested tax strategies

Financial planners remain in the throes of change and the end of the financial year will present further challenges. But sticking to tried and tested tax strategies may see them through, writes Caroline Munro.

The few months before the end of the financial year are usually seen as a period of opportunity for financial planners to revise tax strategies with their clients or implement ones that afford last minute relief.

But the late release of the Henry Review and the ambiguity around the Tax Agents Services Act 2009 — which appears to have swept planners up in its new higher standards and licensing regime — has created further uncertainty for an industry already in the throes of change. And this only adds to the pressure of already existing tax traps that financial planners and their clients can easily fall into.

The Henry Review is expected to be one of the most comprehensive taxation reviews in Australian history and legislative risk is naturally one of the main concerns for many, including planners who are thinking about what tax strategies to adopt for the long term.

Dylan Byrne, tax partner at accounting and advisory practice BDO Australia, says people cannot really go out and do something today with an expectation of something changing in the Henry Review, because there is a strong likelihood that they will get it wrong.

“We’re certainly not getting people to do anything pre-emptively at the moment,” he says.

Byrne says the Government has been very careful to keep key issues in the review under wraps.

“The Government obviously doesn’t want to give anything away, and I honestly don’t know what to read into that,” he says.

MLC head of technical services Paul Sarkis says there is always an element of legislative risk when it comes to tax strategies in financial planning, and as a result people tend not to commit too much to super because the money is preserved.

“It’s very difficult to plan for the long term when you know there is a comprehensive review of the tax system,” Sarkis says.

“From an adviser’s perspective, they need to think about how easy the strategy is to unwind and the exit strategies they need to adopt for when something better comes along.”

Uncertainty about the Henry Review is exacerbated by the confusion around the tax agents licensing issue. Financial Planning Association (FPA) deputy chief executive Deen Sanders says there is genuine concern around this issue.

But he is confident that it will be resolved as Treasury has made clear in the past that it is not its intention to include financial planners under the new tax agent licensing regime.

Jeffrey Scott, executive manager of business growth services at CommInsure, says regardless of any changes, planners always have to be careful that they do not go beyond the boundaries of ‘incidental advice’ when it comes to tax.

“Unless they are an accountant or registered tax agent, they need to ensure that they are merely providing incidental tax advice,” Scott says.

“A client with complex taxation issues must talk to a tax expert.”

Byrne says that at BDO, they often have someone from their tax division in the room with the financial planner and their client.

“When you have two advisers in the room, you maximise outcomes and are at lower risk of missing something,” he says.

“It’s quite valuable being able to bounce things off each other while involving the client.”

Josef Stadler of PSK Financial Services agrees that having a good relationship with your client’s accountant is invaluable and doesn’t necessarily entail having a formal referral relationship.

“Do you know how many referrals I get back from accountants because I’m keeping them in the loop?” he says.

“Working with the client’s existing accountant can get you around the tax advice issues. But if we have to do more accreditation and licensing, that’s the industry we’re in and if you want to show yourself as a leader, get it done.

“At the end of the day, we are allowed to give non-incidental advice — we have always given tax advice and need to know how it works,” he says.

“But if you just run it by their accountant, you are giving the client the best picture.”

Changes have diluted tax effectiveness

While it is difficult to gauge whether there will be significant changes following the Henry Review and the Budget that will affect the tax effectiveness of certain strategies, one thing for certain is that recent changes have diluted some old favourites.

Byrne says there hasn’t been that much impact on tax effectiveness this financial year and not much (that they know of yet) for the next financial year.

“At this stage, tax rates are going to be the same for the 2011 financial year, subject to what happens in the Budget,” he says. As a result, he says, there is little desire to do anything special at the moment.

Sarkis says although MLC tends not to provide or recommend certain strategies that provide big upfront tax deductions, such as agribusiness, the tax effectiveness of these strategies have been diluted in recent years.

“We tended not to provide or recommend those types of strategies mainly because we’re not in that kind of business, but also because in recent years a few of them have fallen over and the tax rulings have not been as favourable as they have been in the past.”

He adds that the halving of the contributions caps last year from $50,000 to $25,000 for individuals under age 50, and from $100,000 to $50,000 for individuals 50 and over, has also made salary sacrificing less attractive.

Stadler agrees that the halving of the caps has diluted the effectiveness of the strategy and has led to the increased popularity of other strategies for some of his high-net-worth clients.

“All of a sudden negative gearing and margin loans were attractive,” he says. “We focused on that quite a bit last year, especially when the markets were down.”

Sarkis says the change of the definition of income also has had an adverse effect for some.

“They definitely made it harder for people to qualify for things like the co-contribution and the spouse tax offset by broadening the definition of income,” he says.

Former Calliva Group chief executive and financial product and self-managed super fund consultant Vince Scully says following the global financial crisis and general changes in the Tax Act there are not many options left for planners, and superannuation remains the main area financial planners will consider.

“Traditionally, agribusiness, structured products, negative gearing and super were the main ones that you would look at,” he says.

“Super is probably the only one that never comes back to bite you.”

But this is not necessarily the case for many investors who can easily breach their contributions caps, incurring hefty penalties.

Easy mistakes to make

As a result of the contributions cap reductions, Scott agrees that salary sacrifice is the big pitfall that planners need to keep a close eye on.

Clients can incur large penalties if they breach the cap, and the Australian Taxation Office (ATO) has warned that some breaches can result in a tax penalty of up to 93 per cent.

“Some clients may have been making automatic salary sacrifice contributions into superannuation. If they set these up prior to July 1, 2009, then they may now be over the concessional contribution cap,” Scott says.

Sarkis agrees that many people have been falling into the trap and are not necessarily learning from the mistakes of the year before.

“A lot of people have been falling foul of those limits because they haven’t necessarily understood what counts towards those limits,” Sarkis says.

“There are a lot of little traps for people who don’t understand what counts towards the caps and they could find themselves in a position where they exceed it.

“The problem is the ATO doesn’t have a lot of flexibility because they don’t have a lot of discretion in waiving the penalties or allocating a contribution to another year.”

Sarkis says after the changes last year, financial planners and tax agents will have learnt the lesson to ask more questions of their clients.

However, it is still easy to make mistakes.

“Sometimes the client doesn’t give the adviser all the information about what contributions are being made to what funds,” he says.

“I’ve seen cases where the client has told the adviser that they are salary sacrificing and the adviser has found out later that it wasn’t salary sacrificing but after-tax contributions. Planners need to check and double-check and make sure they really understand the detail.”

Sarkis says while concerns around hefty penalties are founded, the cases where there has been a 93 per cent penalty are rare.

However, common mistakes often result in a 46.5 per cent penalty on non-concessional contributions.

Byrne says one of the ways BDO is dealing with the issue is by considering the possibility that a client has put some money into super that they have forgotten about.

“If we are doing the year-end top ups to get them up to the caps, we might get them to pay $1,000 less than the cap is or what we think the cap is,” Byrne says.

The old favourites

Nonetheless, super remains the main area to look at for effective tax strategies, and some of the key favourites are salary sacrificing bonuses to reduce tax by up to 31.5 per cent; cashing out an investment to make a personal after-tax contribution, which will reduce tax on investment earnings by up to 31.5 per cent; triggering a capital loss to offset taxable capital gains; and bringing forward tax deductions by prepaying insurance or loan premiums (see case study 2).

Byrne says the main strategies to keep in mind are making sure the maximum superannuation contributions are set aside and, if the client is in the over 55 age category, considering a transition to retirement pension that allows them to continue working, making contributions to super, but also enabling them to draw a pension out of superannuation as well.

“The advantage of that is that the tax rate on pensions coming out of super is lower than the tax on the wages that you would otherwise be getting — so you can get quite a good outcome from salary sacrificing some of the wages into super,” he says.

Sarkis says many employees will be getting bonuses in the lead up to the end of the financial year, which can be salary sacrificed for a better tax outcome. He says moving assets out of your own name into super is another good strategy to consider at this time.

“The end of the financial year is a good time for people to think about moving assets into a more tax effective structure, and there’s more incentive to do that if you are able to claim a deduction to offset any capital gains tax (CGT),” he says.

Sarkis says some of the short-term strategies to look at include tax-effective managed investment schemes or bringing forward a tax deduction by pre-paying insurance or pre-paying the interest on a geared investment portfolio.

He says in some cases a deduction may be worth more to the client this year than next if they need to offset a capital gain.

“If you made a significant capital gain, which can move you up the tax scales, getting a deduction now would be more valuable than waiting until next year,” he says.

Byrne says that one of the things financial planners should perhaps be looking at in a volatile investment environment is how the client is going with CGT.

“You might find that you’ve got quite a large capital gain, in which case you might look to sell some shares that are sitting at a loss to realise that capital loss,” Byrne says.

“Everything you do from a tax perspective has to be in line with the investment imperative as well. But there may be better stocks that you can get into and if you are reducing your CGT, and you are also freeing up some cash to go into some other investments, then that seems to me to be a very good idea.”

Scott says income protection insurance premiums provide immediate tax relief.

“The insurance replaces taxable income in that if you are sick or injured and cannot work, the ATO permits a tax deduction for the premiums paid,” he says.

“Also, having private health insurance can avoid the Medicare Levy Surcharge, which is also a good way of avoiding an additional 1.0 per cent tax.”

Structured products and agribusiness are areas that have fallen out of favour following the global financial crisis and some high profile failures.

Scully says that while many investors are still cautious about structured products, having learned the hard way that capital protection still has to be paid for, most feel comfortable with borrowing to buy real estate.

“The old traditional gearing into property has found its place again,” he says, whereas previously it was less popular due to the allure of the tax effective and more exotic structured products.

Stadler says financial planners got burned recommending structured products because many did not understand the underlying protection mechanism.

“Anyone who went into these products in 2007-08, all they’ve got to do is pay that interest for the next five years so they can walk away with nothing,” he says. “If they walk away now they get 60 per cent losses.”

Investors and planners are also approaching margin loans with a lot more caution than previously, says Byrne. “A lot of people experienced difficulties as a result of borrowing money to invest in the stock market or managed funds with margin loans,” Byrne says.

“Perhaps they don’t yet have the confidence to go back and do those sorts of things, but that’s not necessarily a reflection of the investments they are buying.”

He says people may eventually warm to that strategy again, whereas that is not as likely with managed investments schemes due to the high profile collapses of Great Southern and Timbercorp. Stadler says agribusiness can still be used effectively, but in very specific circumstances and for a specific type of client.

“My view is that it has a very specific purpose and it is just tax deferral,” he says.

“If you go into agribusiness, you actually have to understand the underlying business. The whole tax deferral concept is pretty good because you can make some big money. But you have to understand that it is not a tax deduction.”

Stadler adds that when it comes to agribusiness, planners need to be careful that they’re not just driving tax but are driving for a better investment position for their client.

Scott warns that financial planners need to be mindful that each strategy varies depending upon the client’s investment time horizon and the asset type.

“For instance, there are numerous CGT concessions for small business owners that may defer, reduce or eliminate tax,” he says.

“Family trusts are also a good way of distributing income amongst family members on lower marginal taxation rates (MTR), also known as income splitting.

"Trustees of family trusts will need to be careful if a person's tax status changes (ie, they get a salary increase and move to a higher MTR), and trustees need to be aware of their reporting obligations for taxation and audit purposes.”

He adds that while planners may be concerned about one of Australia’s most comprehensive tax reviews ever, clients’ circumstances are changing all the time and, therefore, tax should be considered and discussed with them on a regular basis.

“Every time there is a life changing event, potentially there will be an impact on taxation, either immediately or in the future,” he says.

“These events include buying an investment property (tax deductions associated with gearing), purchasing a home (CGT concessions), getting married (dependents), having children (dependents), starting a new job (higher marginal tax rate), buying a business (small business CGT) ...

"Every significant change in a person's life has the ability to impact on taxable income and concessions.”

Tax for tax’s sake

Sarkis says the failure of certain managed investment schemes is a clear example as to why investment decisions should not be driven by tax alone.

“You’ve got to look at the investment fundamentals rather than just the upfront tax deduction, because with those investments that have fallen over the client may have enjoyed the tax deduction but they’ve lost their capital.”

Scott reiterates the point that planners and investors should never invest in an asset merely to get a tax deduction.

“If the investment is not worthwhile without the tax deduction, it is not a better investment with a tax deduction,” he says.

Stadler says financial planners sometimes fall into the trap of overcomplicating things when it comes to tax strategies.

“Yes, you can reduce tax, but if your client is better off repaying the mortgage, you’ve got to play out that scenario. At the end of the day, ask yourself if you run this strategy, are you going to achieve your client’s goals?”