SMSFs remain an important tool in providing for a tax-effective retirement. However, the limitations that come into effect from 1 July 2017 could see some clients looking for structure that offer more flexibility for their family's wealth and succession plan.
The recent changes to the superannuation law are among the most significant changes to the superannuation landscape in recent history and dramatically reduce the amount people can contribute to and maintain within a SMSF. Further, the continued tinkering by successive governments, combined with the retrospective nature of the $1.6 million pension cap, has resulted in numerous people losing faith in the superannuation system. Therefore, there are a lot of clients looking to alternatives to SMSFs as an investment vehicle for their retirement and also as a place to invest for the future of their family.
Traditionally, discretionary trusts have provided this solution for clients to invest. While these trusts have rightly held this position, the purpose of this article is to explore the advantages of holding investment assets in private companies, the benefits of which can be more effective leading up to and into retirement.
From a tax perspective, the benefits of using discretionary trusts are generally well known. These include:
- Accessing the 50 per cent CGT discount on the disposal of assets held for more than 12 months. Effectively, this means that the maximum effective tax rate, including Medicare levy, is 24.5 per cent assuming the capital gain is distributed to an individual; and
- The ability to distribute income and capital gains to a wide range of beneficiaries. This, in effect, has provided income-splitting capabilities in order to utilise the lower marginal tax rates of all potential beneficiaries.
However, over time, many benefits have been eroded and the complexity of operating trusts has increased. For example:
- The removal of the low-income rebate for minor beneficiaries;
- State governments targeting discretionary trusts for land tax purposes. Holding land in trusts can now be a very expensive exercise, particularly in view of the significant increase in prices experienced in markets such as Sydney & Melbourne;
- Bamford’s case exposing the importance of the quality of trust deeds and getting end of year distribution minutes correct; and
- The ability to use corporate beneficiaries has become complex and difficult to maintain with the interaction of Division 7A.
Furthermore, as the people move into retirement phase, the pool of beneficiaries to whom distributions may be made tends to diminish. Generally, the pool reduces to grandchildren under the age of 18, who provide little tax relief, and the retirees themselves. There can be a reluctance to distribute to adult children for a variety of reasons, including:
- They have their own jobs and provide little relief;
- Complexity with obtaining Centrelink and/or family tax benefits;
- They want to be independent and stand on their own two feet financially; and
- Asset protection and family law reasons.
Thus, the provision of a relatively low tax rate and stable platform for investment that a private company may provide could be an attractive proposition in certain circumstance. In addition, when used effectively, the loss of CGT concessions can be minimised, provided franked dividends are taken over a number of years.
What are the advantages of using a company?
The first and most compelling reason for using a company is the 30 per cent tax rate. Given individuals can be taxed up to 49 per cent, including the Medicare and the temporary budget repair levy, this can be very favourable.
The federal government has also proposed the eventual reduction to the corporate tax rate to 25 per cent. This is to ensure that the Australian corporate tax rate remains competitive with the rest of the world. New Zealand already has a corporate tax rate of 28 per cent and the Australian rate has dropped to 28.5 per cent for small businesses turning over less than $2 million.
While the drop in the corporate tax rates may not go to extent the government has indicated, it would appear to be more likely that it will fall rather than increase over time.
Combining the lower tax rate with the dividend imputation rules means that companies are really just a tax deferral rather than a tax avoidance tool. However, provided shareholders are in the position to retain profits in a company and receive dividends over a longer period of time, they could use the company to moderate personal marginal tax rates at or below 30 per cent.
A distinct advantage that a company has over a trust is its ability to retain its profits after tax. This means that in the lead-up to retirement, all income and capital can be retained and taxed at 30 per cent. Once the person is retired, aged over 60 and in receipt of tax-free superannuation benefits, these profits can be distributed as dividends. This results in the retired shareholder being able to take advantage of lower marginal tax rates and receive credit for the tax paid by the company.
Example 1: Retired individual shareholder, over 60, in receipt of a franked dividend of $25,900
Franked dividend $25,900
Franking credit $11,100
Taxable income $37,000
Tax thereon (incl. Medicare levy) $4,312
Less: Low income rebate $445
Franking credits $11,100
Refund of excess franking credit $7,233
Therefore, only $4,312 in tax and Medicare levy is paid in the hands of the shareholder on what was originally $37,000 of income in the company’s hands. This represents an effective tax rate of 10.45 per cent when taking into account the low-income rebate.
In the instance where we have two retired spouses in receipt of the franked dividends, they can receive up to $74,000 of income (including franking credits).
Example 2: Retired individual shareholder (Over 60) in receipt of a franked dividend of $96,180
Franked dividend $96,180
Franking credit $41,220
Taxable income $137,400
Tax thereon (incl. Medicare levy) $41,218
Less: Franking credits $41,220
Refund of excess franking credit $2
This example illustrates the point at which the personal marginal tax rates approximately equate to the corporate tax rate of 30 per cent. Consequently, around $137,400 of pre-tax company income can be paid to the shareholder without any further tax payable. In the instance where two retired spouses are in receipt of the dividends, this equates to just under $275,000 of pre-tax company income.
Overall, there can be significant room to drip feed dividends throughout the course of a client’s retirement in order to moderate the overall tax rate to less than 30 per cent.
The land tax grab on discretionary trusts
The continued rise in property values experienced in many areas, combined with the additional land tax imposed upon landholdings held in discretionary trusts by some states, means that this holding cost is a significant year-on-year impost on property investments.
The example below assumes a landholding (unimproved) value of $600,000. The comparison is the difference of holding that land in a discretionary trust versus a private company in New South Wales and Victoria.
Table 1: Land tax payable on $600,000 of unimproved land held in NSW and Victoria
Benefit of Company Holding
NSW (NSW, 2017)
VIC (Victoria, 2017)
This is now a significant disadvantage in using discretionary trusts to hold property. Given land tax is a state-based tax research into each jurisdiction is required when advising clients.
Advantages and disadvantages of using private companies
As always, client advice should be provided on a case-by-case basis. Consequently, it is imperative to weigh up the advantages and disadvantages of using various structures in providing such advice. The table below provides a brief outline and summary of these in order to assist in analysing the options. This is obviously not an exhaustive list and I am sure that other advisers will be able to come up with many more pros and cons of using this structure for investment purposes.
Table 2: Summary of key advantages of investing through a private company
Tax rate of 30%
Refer to commentary above
Dividend imputation system
Refer to commentary above
Ability to retain profits
Refer to commentary above
Dependent upon the state in which property is held. This is now a significant annual holding cost to trusts.
Borrowing and banking ease
Trusts and SMSFs are surprisingly more complex to deal with in certain banks. Establishing borrowings through a company can be a lot simpler and more cost effective than the SMSF limited recourse borrowings.
Ease of contributing capital
From 1 July 2017, non-concessional contributions to superannuation is limited to $100,000 per annum and $300,000 subject to satisfying the brought forward rules. Contributions to a company would generally be via a loan or subscribed capital.
Ability to access cash
No preservation rules and no need to satisfy conditions of release should funds be required pre-retirement in a company. There are a number of ways to access funds from a private company, including dividends and loans. Loans would be subject to the rules contained in Division 7A of the Income Tax Assessment Act 1997. However, depending on the security provided, these could be repaid over seven to a 25-year term.
Annual distribution minutes and family trust election issues can be complex with trusts. Annual independent audits and compliance for SMSFs can be a burden and lead to additional cost.
The continuous succession of companies may be advantageous. There can be issues when distributing superannuation benefits to non-dependents upon the death of a member of an SMSF.
Table 3: Summary of key disadvantages of investing through a private company
Loss of CGT discount
Individual trust beneficiaries may receive a discount on capital gains on assets held more than 12 months. SMSFs qualify for a one-third discount.
Division 7A consequences
Falling foul of these rules with companies can have significant consequences. This issue requires significant consideration and management in private companies.
Fringe benefits tax is levied upon benefits provided to employees or their associates. This is unlikely to occur where a company holds only passive investments. However, it needs to be considered and managed accordingly.
Shares held by an individual will be at risk. Superannuation benefits are currently exempt from bankruptcy and generally considered protected assets. Discretionary trusts can be quite effective from an asset protection perspective. Consideration needs to be given as to how private company shares are held.
Tax-free and tax-deferred amounts received
The receipt of these types benefits of in a company may lead to the payment of unfranked dividend. A strategy on how to best to handle these should be developed.
Land tax grouping
Common ownership and control among companies holding land may be an issue.
SMSFs will continue to be an important tool in providing for a tax-effective retirement. However, the limitations that come into effect from 1 July 2017 and the ongoing uncertainty that continuous change is providing will result in clients wanting more flexible investment structures to provide for their families’ wealth and succession plan.
Private investment companies as an alternative for holding direct investments should be considered in the toolbox of structures available to advisers. As with all advice, every client’s position should be considered on its individual merits. Generally, there is no single structure that will provide a solution that ticks all the boxes. Therefore, all available structures should be considered in the mix for the most appropriate solution for your client.
In my view, private investment companies are rising as one of the preferred structures to be considered.
Damien Butler, principal, Butler Chartered Accountants
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