The taxing issue of trusts as companies

BT Funds Management’s technical team dives into the Ralph Committee Report to review the potential implications for financial advisers and their clients. By Brian Bissaker, Peter Haggstrom and Alyson Clarke.

In September 1998, the Treasurer issued his tax reform blueprint setting out proposals for taxing all trusts as companies. Mooting radical changes to the way managed fund investors are taxed, the proposed met with considerable industry opposition.

For example, investors would only ever receive taxable dividends from managed funds, effectively making irrelevant the usual capital gains tax averaging and cost indexation provisions for distributions of capital gains and disposal of units.

Also under the original proposal, distributions to unit trust investors would be reduced by the application of company tax. Investors would be forced to claim imputation credits in their tax return with a consequential cash-flow disadvantage. This would also present a new hassle for people who don't currently lodge a tax return.

The proposal would also have a substantial adverse effect on property trust yields.

Taxing trusts as companies at the company rate of 36 per cent would hit the distribution of so-called "tax preferred" amounts. Broadly speaking, tax preferred amounts are amounts such as accelerated depreciation and building allowance which give rise to greater distributable accounting income than taxable income.

Ralph maintains flow through

The Ralph Committee examined the pros and cons of taxing trusts as companies and the Treasurer acted quickly to make it clear that widely held unit trusts which distribute all or virtually of their income annually will be treated under the current flow through approach.

Assuming the Treasurer's in-principle stance on widely held unit trusts is properly implemented, it would appear that it will be business as usual for most categories of widely held retail unit trusts. The treatment of wholesale trusts remains unclear and the industry is seeking further clarification.

Uncertainty surrounding property trusts

While the Treasurer's announcement appears to cover the broad treatment of property trusts, there remains uncertainty over the treatment of tax-preferred distributions. In his press release of February 22, the Treasurer indicated the treatment of tax-preferred amounts flowing from property trusts will be the subject of "full consultation and analysis in the context of the Review of Business Taxation".

The Ralph Report canvasses two options for the treatment of tax-preferred amounts.

Under the first option, tax preferences would essentially flow through to the individual taxpayer untaxed as now. Under a second option, the non-tax preferred income of widely held fully distributing property trusts would be taxed as now, but the tax-preferred amounts would attract company tax and be subject to the proposed imputation system.

For property trusts with controlling interests in assets such as office buildings or shopping centres, there is a suggestion to treat the trust as an active trust, subject to tax at the entity level.

The so-called "entity taxation" regime

The proposed re-designed entity taxation model will be based upon full franking of all distributions, while allowing for refunds of excess imputation credits.

Ralph considered two options directly relevant to individual investors. The first option is to apply what is termed a "deferred company tax" on all profit distributions. The second option is to apply a "resident dividend withholding tax (RDWT)" to profit distributions.

The mechanics of deferred company tax

Very simply, under the deferred company tax regime profits would be fully franked at the company rate and, according to the Review, this would remove the need for complex rules to determine whether a dividend is franked or unfranked.

Assume the entity earns $100 income, $75 of which is taxable (tax payable is $27) and $25 is tax-preferred. If the entire profit is distributed the payments would be treated as follows:

Under the Resident Dividend Withholding Tax (RDWT) option, a withholding tax would be levied on unfranked distributions (eg tax-preferred amounts) paid by resident entities to resident investors.

Unfranked distributions paid to foreign investors would be subject to the existing non-resident dividend withholding tax, generally levied at the rate of 15 per cent.

Superannuation

Ralph has proposed two options for pooled superannuation trusts (PSTs). The first option is to tax PSTs at the company tax rate of 36 per cent. Profits and franking credits would be distributed, and the superannuation fund investor could claim the franking credits and be no worse off. We believe it makes little sense to require the round robin arrangement of 36 per cent tax at the PST level and 21 per cent refund to the superannuation investor.

The second, preferred, option is to tax PSTs at 15 per cent. This essentially retains the status quo whereby PSTs remain an investment vehicle only for superannuation entities.

The only change would be taxation of profit distributions at 15 per cent. As most PSTs do not make distributions, few investors are likely to be affected. The industry will continue to lobby for this outcome.

Allocated pensions and annuities

There has been much confusion surrounding the Government's initial announcement regarding changes in taxation on allocated pension/annuity investment returns.

Consistent with further communication from Treasury late in 1998, Ralph has confirmed the aim of these changes is to tax the profit of the superannuation fund/life company, not the earnings on individual investors' accounts. The profit of the fund providing the pension would be taxed at 15 per cent, and the profit of the life company providing the annuity would be taxed at the company rate.

The changes will mean that any investment income received by the superannuation fund/life company will be included in their assessable income. However, a deduction will be allowed for investment income credited to pensioners, irrespective of whether or not it is drawn down in that year.

For example, Melissa rolls over an ETP of $80,000 to a super fund and draws down an allocated pension. In the first year the superannuation fund has investment returns on this amount of $5,800. However the superannuation fund only credits $5,000 to her account.

If Melissa draws down a pension of $4,500 in the first year, the balance of her account would then be $80,500 (that is, $80,000 + $5,000 - $4,500). The superannuation fund would include the investment return of $5,800 in its assessable income and would be allowed a deduction for the interest credited to Melissa's account of $5,000. As a result, the superannuation fund's profit of $800 would be included in its taxable income (that is, $5,800 - $5,000).

Fixed term and life annuities

Fixed term and lifetime annuities offered by life companies would be taxed similarly to allocated products.

Payments from annuities usually comprise an interest and capital component. For fixed term annuities, it is proposed that the life company would include the full investment return in assessable income and be allowed a deduction for the interest component of each payment.

For lifetime annuity products, it is anticipated that the life company could claim a deduction for the actual interest component of the pool. This treatment may have some impact on the rates offered by some life companies.

Deferred annuities

Taxing life companies under the entity regime would have the effect of taxing deferred annuities at the company tax rate.

Ralph has not proposed to exclude deferred annuities from this regime, instead suggesting these life companies set up superannuation funds or ADFs if they wish these monies to be taxed at the superannuation rate.

This will spell the end of deferred annuities. Ralph has suggested rollover relief be provided for life companies transferring their business to superannuation funds or ADFs.

Alternatively, the Government could allow existing deferred annuity policies to be taxed at 15 per cent as a transitional measure.

Life Policy Bonuses

The Government had proposed a change to the taxation treatment of bonuses paid on life investment policies to bring them in line with the redesigned imputation system.

This involved grossing up of bonuses by the amount of tax paid by the life company, making bonuses taxable in the hands of the policyholder (any excess imputation credits would be refunded) and allowing policyholders to choose when to be taxed - either when the bonus was assigned, or when the bonus was ultimately distributed.

Options suggested by Ralph for existing policies included continuing with the status quo, applying the redesigned imputation system, or applying the redesigned imputation system for policies surrendered within 10 years and retaining the current treatment for policies held for more than 10 years.