Tax reform — a dark cloud on the horizon

Financial planners are in the midst of a tax revolution. The revolution means that a tax-effective structure or strategy used by a financial planner or accountant six months ago may now not only be tax inefficient but also downright dangerous. For advisers, however, it is a tough task making the right decision for a client in an environment where the laws are yet to be finalised.

Financial planners are in the midst of a tax revolution. The revolution means that a tax-effective structure or strategy used by a financial planner or accountant six months ago may now not only be tax inefficient but also downright dangerous. For advisers, however, it is a tough task making the right decision for a client in an environment where the laws are yet to be finalised.

With more than 1,000 pages of new tax legislation and more on the way, the pages of Money Management will be filled with strategies and the pitfalls of the new tax system for the next two years. At this early stage, however, there are some indications of tax trends to look for.

Family trusts

At one stage many financial planners and their clients complained that superannuation was too complex because of constantly changing rules. Now the same can be said about family trusts. In particular, a number of tax changes over the past few years have watered down the tax effectiveness of the family trust as an investment vehicle. Moreover the Ralph reforms pose a serious new hurdle for planners using a family trust as an investment vehicle.

Let’s take the case of a client seeking to invest in the latest technology float, e.com.au. The client has an inside tip and wants to buy 10,000 shares at $1 each. The client’s accountant, who gave him the tip, has advised that the investment be made by way of the family trust.

The client uses cash in the family trust to invest in the shares on 1 March 2000. The shares float at $3 and by April 2001 the shares are worth $10. The client does not want to sell but has heard bad reports on the fortunes of the company although a possible merger is on the cards. Quite apart from the investment, the client’s tax position must be carefully considered.

If the trustee of the family trust sells in April 2001 for $100,000, having held the shares for more than a year, the trustee is able to pass through the 50 per cent CGT exemption to the beneficiaries of the family trust. This means that a beneficiary of the family trust on the highest marginal tax rate will pay tax at a maximum rate of 23.5 per cent (excluding Medicare and any other levy) courtesy of the exemption. If the total proceeds of the sale, plus the $10,000 invested capital, are distributed to a beneficiary on the highest marginal tax rate then, apart from the Medicare levy, the net amount for the beneficiary after capital gains tax is $78,500.

The trustee of the family trust, however, has decided to hold onto the shares awaiting a possible merger. The merger never arrives and in July 2001, worried about the prospects of e.com.au, the trustee sells the shares for $10 each or $100,000. In similar circumstances to the April 2001 disposal, the total proceeds including the original $10,000 capital investment are to be distributed to one beneficiary.

Let’s compare the beneficiary’s cash flow in respect of a disposal of an investment in a family trust after 30 June 2001.

The Government has announced that all family trusts are to be taxed as companies from 1 July 2001. As such there is a very real danger that a family trust beneficiary may lose the 50 per cent CGT exemption given that the new CGT rules do not apply to companies.

In our example, the sale of the e.com.au shares in July 2001 will realise a capital gain which will be taxed in the hands of the trustee at 30 per cent. This means that after paying CGT of $27,000, the trustee will be able to distribute to the beneficiary an amount of $73,000 (including the $10,000 invested capital). The beneficiary must then include the grossed up distribution in their income tax return, ie $90,000 ($63,000 plus $27,000 imputation credits). With tax payable of $42,300 (excluding the Medicare levy) on the distribution less franking credits of $27,000, net tax paid is $15,300. All in all, the net proceeds of the sale of the e.com.au shares are $57,700 after trustee and investor tax.

In summary, by waiting until after 1 July 2001, the investor may lose an extra $20,800 in tax due solely to the family trust being taxed as a company. The question the financial planner should ask the client for family trust purposes is how long will the investment be held for?

If the client is intending to dispose of it prior to 1 July 2001 then a family trust may be used. If the investment horizon is beyond 30 June 2001, the investment may be better placed in the investor’s name to guarantee the 50 per cent CGT exemption. Of course we must reiterate that the legislation introducing the entity tax regime is yet to be seen or passed by Parliament.

The above example raises the important question of what advice are financial planners currently providing in respect of investments by way of a family trust?

When it comes to tax structuring, individuals have always been on the outer. In particular the family trust, and to a lesser extent the family company, has always provided a sound structure to split investment income. As noted above, however, the taxation of a trust as a company coupled with the inability of a company to claim the 50 per cent CGT exemption in respect of the disposal of an asset, means individuals are back in favour for CGT purposes.

In particular, the ability of a high income investor to negatively gear into shares or an equity fund, coupled with the tax advantages of the 50 per cent CGT exemption and imputation credits, is hard to beat. Margin lending as well as instalment warrants, for those seeking some protection on the downside, may soon become all the rage.

In seeking to invest as an individual, however, financial advisers must point out to clients the legal downsides of individual investment, including:

? no protection for creditors

? no ability to split income

? little protection in the event of divorce or family problems

? minimal estate planning opportunities.

To close we all know that massive tax change is on the way. With this change comes an opportunity to develop knowledge and strategies to make a real difference for your clients. After all an adviser with a bag full of value-added strategies can never be replaced by a computer or the internet can they?

Grant Abbott is co-director of The Strategist Group.