Public finances and tax reform

Everyone (well almost everyone) accepts the Australia has a public finance problem. Even those who have previously argued that our public debt levels are acceptable have begun to argue for changes to fix up our public finances.

And recently the loudest voices for public finance reform have been on the revenue side, not the expenditure side. As a result we have seen, or we may see if Labor win the next election in 2019:

  • The Multinational Anti Avoidance Law and the Diverted Profits Tax, two very big sticks to raise tax from multinationals raising about $1 billion a year.
  • A fundamental change to superannuation raising about $1 billion a year.
  • The 2% temporary budget levy on the highest income threshold that Labor say they will reinstate on 1 July 2020 if they win the election raising about $1 billion a year.
  • Labor’s proposed policy on reducing the CGT discount to 25% and limiting negative gear losses on everything other than new residential property, which will apply from 1 July 2020 and would raise a bit over $2 billion a year.
  • Labor’s proposed change to the taxation of distributions from discretionary trusts which will raise about $1 billion a year (again to apply from 1 July 2020).

There are other changes that have been, or are proposed to be made to the tax system but these are the big ticket items and combined they see an additional ~$6 billion a year in todays dollars added to the revenue side of the government’s balance sheet.

And to be honest, other than fuel excise changes, there is not much left on the revenue side to go after to fix public finances. To quote from Bob Deutsch…

Both super and negative gearing seem to be in the firing line one way or another. That leaves you with the third leg of the tripod which is discretionary trusts. 

The major revenue raising ideas for increasing taxes have all been done, or are proposed to be done (other than the political suicide of either raising the GST rate or base or removing work related deductions) and we have raised… $6billion. So is $6 billion enough?

While the current budget proposes our debt to reach its limit in 2021, there are almost no economists who believe this will happen. Most economists see a structural deficit of around $20 billion a year and so the $6 billion we have raised from these change does not even get us one third of the way.

So where do we find the other $14 billion a year? With the “pie” not growing fast (low inflation, low wage growth, low GDP growth) there is only one way left. Government expenditure control. Lets see who will propose this…

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Discretionary Trusts and Bill Shorten

Today Bill Shorten will announce…

… a minimum 30% tax on trust distributions to those over 18 years old

The only exemption we will get in the speech is that…

…it does not apply to charitable, testamentary, deceased or farming trusts

So it looks like there will be a new tax, lets call it the Discretionary Trust Distribution Minimum Tax (or DTDMT because Treasury likes acronyms).

The DTDMT will only apply to individuals who:

  • Receive a discretionary trust distribution in their individual tax return (I assume it will also cover a partnership distribution that is made up indirectly of a trust distribution or I have already worked out how to avoid the tax); AND
  • Who have other non exempt income of less than $37,000 (where the 32.5% tax rate kicks).

The tax will be the difference between what they would have paid on the discretionary trust distribution and what they would have paid at 30%.

My five thoughts are this…

  1. This does not mean there are no benefits in income streaming from discretionary trusts, but they are just less. You would still distribute to the uni student kids but instead of them paying no tax on the first $18,200, they will pay 30%… But this is still 17% less than what the other beneficiaries might have to pay! Income splitting is still worthwhile with discretionary trusts.
  2. Discretionary trusts still get asset protection and the various CGT concessions so we will still use them.
  3. Why do farmers always get all the best concessions?
  4. If the discretionary trust runs an active business, you can avoid the DTDMT by paying the beneficiaries a salary. But there are a series of provisions that can deny the deductions of excessive remuneration.
  5. If you still want perfect income splitting without the pain of the 30% DTDMT you have two choices.

    First is set up a company that has different classes of shares, one for each potential beneficiary, where the directors can choose how much to pay each beneficiary and have the income arise in this company. You lose the CGT benefits if you sell the CGT assets out of the company but you have your income splitting.
    The second idea will probably be the first thing the Commissioner reviews as you just put a company owned by each potential beneficiary (or at least the important ones) between the trust and the individuals. Effectively, instead of the individuals being the potential beneficiaries of the trust, the individual’s 100% owned company is the potential beneficiary.

    There is a combination of the first and the second idea where you make the company with the classes of shares a beneficiary of the discretionary trust and the trust distributes to the company and the company splits its dividends to whoever the directors want to. Did someone say Part IVA?

This proposed change only raises $17 billion over 10 years and that will be larger at the back end so it is about $1 billion a year at the moment. Given the estimates of the tax lost due to income splitting using discretionary trusts are between $2 billion and $3.5 billion (the $3.5 billion by the Australia Institute who have an agreement with the Labor think tank so this will be dodgy) this will only half the benefit these trusts give.

In summary, using discretionary trusts will still be beneficial under president Shorten. But as always, we will find a way around their best laid plans…

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More super changes

On budget night this year the government announce two new changes to super, both relating to housing. And we now have draft legislation for both.

The first is called the First Home Super Saver Scheme (or FHSSS – now that will be easy to remember). The FHSSS will apply to voluntary superannuation contributions of up to $15,000 per year and $30,000 in total made from 1 July 2017. These contributions, along with deemed earnings (at the rate of the Shortfall Interest Charge), can be withdrawn for a home deposit from 1 July 2018. Pre-tax contributions are taxed at 15%; withdrawals will be taxed at marginal tax rates less a 30%.

You can only get a FHSSS from your super fund if you are over 18, and have not owned real property in Australia before (you can get an FHSSS if you have not owned real property but your partner who you are buying a property with has owned real property before). Once you get the FHSSS payment you must buy a house in 12 months and live in it for 6 months in the first 12 months it is practical to live in it. If you don’t sign a contract within 12 months of getting the FHSSS payment you must recontribute the amount to super or pay a 20% tax on the amount.

But the interesting thing about this change is the process of getting this money out of super. You apply to the ATO and they check your eligibility, calculate what amount can be taken out as a FHSSS,  get the super fund to send the ATO the amount, withhold the tax from it, and the ATO sends the remaining amount to the applicant. The ATO will then require the applicant to show they bought a house (or land on which to build a house) in 12 months from the day they received an amount (signed a contract) and they lived in it for 6 months of the first year the house is able to be lived in.

The second is the downsizer’s concession. From July 2018, people aged 65 and over will be able to make a non-concessional contribution into their superannuation of up to $300,000 from the proceeds of selling their home. Existing contribution caps and restrictions will not apply to this downsizer contribution at the time, but the $1.6 million transfer balance cap and Age Pension means test will continue to apply and it will count towards total superannuation balance tests in later years. The measure will apply to homes held for a minimum of ten years, and both members of a couple may take advantage of it.

The draft law states that:

  1. You don’t actually have to downsize. You could buy a bigger house or just move in with the kids and still put 2x$300k into super from the sale of the house.
  2. Both spouses can contribute even if the house is only in one name.
  3. You have 90 days from the sale to contribute to the fund.
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Foreign residents lose the main residence exemption

As part of the May Budget, the Government announced reforms to the operation of the CGT rules for foreign residents. One of these reforms is to remove the entitlement to the CGT main residence exemption for foreign residents that have dwellings that qualify as their main residence.

We now have draft legislation implementing this change and it is not what we expected. Read this carefully…

Individuals who are foreign residents at the time a CGT event occurs to a dwelling in which they have an ownership interest are not entitled to the main residence exemption.

Notice that whether or not an individual can claim the main residence exemption will depend on whether they are a foreign resident on one specific day – the day the CGT event occurs. It does not matter if for every other day the individual was a resident.

Have a look at this example from the draft EM…

Vicki acquired a dwelling on 10 September 2010, moving into it and establishing it as her main residence as soon as it was first practicable to do so.

On 1 July 2018 Vicki vacated the dwelling and moved to New York. Vicki rented the dwelling out while she tried to sell it. On 15 October 2019 Vicki finally signs a contract to sell the dwelling with settlement occurring on 13 November 2019. Vicki was a foreign resident for taxation purposes on 15 October 2019.

The time of the CGT event A1 for the sale of the dwelling is the time the contract for sale was signed, that is 15 October 2019. As Vicki was a foreign resident at that time she is not entitled to the main residence exemption in respect of her ownership interest in the dwelling.

Note: This outcome is not affected by either the fact that Vicki previously used the dwelling as her main residence or the absence rule in section 118-145 that could otherwise have applied to treat the dwelling as Vicki’s main residence from
1 July 2018 to 15 October 2019 (assuming all of the requirements were satisfied).

Vicki was a resident for 8 of the nine years she owned the property, and it was her “main residence” for the whole 9 years, but as she was a non resident at the CGT event she get no main residence exemption at all. No apportionment at all.

Of course it works the other way around as well. There is a second example in the EM of a resident who buys a main residence, travels overseas becoming a foreign resident, and then returns to become resident and sells the property. Even though for most of the ownership period the individual was a foreign resident, as on the day of the CGT event they were a resident, they get the full main resident exemption.

The draft law also states that:

The main residence exemption no longer applies if, at the time a CGT event occurs to part of an individual’s ownership interest in a dwelling as a result of a compulsory acquisition, they are a foreign resident.
If the deceased person was a foreign resident at the time of their death then the portion of the main residence exemption accrued by the deceased in respect of the dwelling is not available to the beneficiary. If the deceased was a resident but the beneficiary in a foreign resident, the beneficiary can claim the main residence exemption for the period of the deceased ownership, but not their ownership period.
The main residence exemption will not applies if at the time a CGT event occurs to the ownership interest in a dwelling of a special disability trust, the primary beneficiary of that trust was a foreign resident or a CGT event occurs to a dwelling while it is held by the trustee of the special disability trust after the death of the principal beneficiary and at the time of death the principal beneficiary was a foreign resident.

If the gain on the property is large, will we consider becoming a resident to avoid CGT?

These rules apply to all properties purchased after 9 May 2017, but even if the property was purchased before this date, from 1 July 2019 these rules will apply.

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Unpaid Present Entitlements to a Corporate Beneficiary… Not Again

The Commissioner has released a Practical Compliance Guideline to help those who used PS LA 2010/4 to sort out their UPEs to corporate beneficiaries 7 years ago.

PSLA 2010/4 states that the Commissioner will not treat the UPE to the corporate beneficiary as a Div 7A deemed dividend if, under a written agreement, the trust pays the company interest for 7 year and then pays the principal of the UPE at the end of the 7-year interest only loan (called Option 1).

Those trustees who adopted investment Option 1 on, or before, 30 June 2011 must now repay the principal of the loan in the 2017 income year or 2018 income year!!!!

But in this new Practical Compliance Guideline, the Commissioner states that if all, or part, of the principal of the loan is not repaid at the end of the 7 years of interest only, the Commissioner will accept that a new additional 7-year loan on complying terms in accordance with section 109N may be put in place between the trust and the private company beneficiary prior to the private company’s lodgment day. This will provide a further period for the amount to be repaid with periodic payments of both principal and interest.

So it looks like the 7 year interest free loan under Option 1 becomes a 17 year loan with interest only for the first 7 years and P&I for the next 7 years.

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Tax Depreciation Changes

In the Budget the Government announced a change to tax depreciation.

They have now released draft legislation implementing this announcement.

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So what does this mean for those with rental properties and those who produce tax depreciation schedules… A lot!

Under the proposed section 40-27, entities may NOT deduct amounts under Division 40 or Subdivision 328-D for depreciating assets used in gaining or producing assessable income from the use of residential premises for residential accommodation.

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This on its own means no tax depreciation schedule for rental properties, other than the provision of the the undeducted initial construction expenditure for the 2.5% deduction under Division 43.

However, there are four exceptions. Only in these four situations will you be able to provide a tax depreciation schedule for a residential rental that has more than the one number for Division 43…

Exception 1: The entity wanting to claim the depreciation deduction is a corporate tax entity, a superannuation plan that is not a self managed superannuation fund or a large unit trust (300+ members). But don’t think you should buy all your residential rental properties in a company as if you do you lose the 50% CGT discount, which is generally worth a lot more than the depreciation deductions.

Exception 2: The depreciation deduction arises in the course of carrying on a business. This means the an entity operating a hotel will be able to claim Division 40 deductions. But it is 100% clear at law that a rental property (or even lots of rental properties) are almost never a “business”.

Exception 3: Now we get an exception that we might actually use… The entity held the asset at the first time it was first used or installed by any entity AND the entity has been able to deduct amounts for the decline in value of the asset in all prior income years in which it has held the asset.

We need to show the entity was the first user AND they have only used it in rental properties ever. An asset will be previously used if there has been any prior use of the asset for which the entity that now holds the asset was not entitled to a tax deduction, with the exception of use as “trading stock”. The only entities that hold assets as trading stock are businesses that hold the assets for sale, like Harvey Norman, not your friend.

EXAMPLE: Craig has newly acquired a rental. This apartment is three years old and has been used as a residence for most of this time. Chris acquires with the apartment carpet. He also acquires curtains new from Retailer Co and a washing machine, that he purchases used from a friend, Jo.

Craig also purchases a new fridge, but rather than place this in the apartment, he uses it to replace his personal fridge, that he acquired a number of years ago for his personal use. He instead places his old fridge in the new apartment.

The amendments do not permit Craig to deduct an amount under Division 40 for the decline in value of the carpet, washing machine or fridge for their use in generating assessable income from the use of his apartment as a rental property as both are previously used. The carpet and washing machine are both previously used assets as it is the previous owner or Jo rather than Craig who first used or installed the assets (other than as trading stock). The fridge is previously used as, while Craig first used or installed the fridge, he has used it wholly for purposes other than taxable purposes in prior years.

The amendments do not affect Craig’s entitlement to deduct an amount under Division 40 for the decline in value of the curtains. They are not ‘previously used’ under either limb of the definition.

Exception 4: The entity first came to hold the asset when it was used in new residential premises AND prior to this time, no entity had either resided in premises or been entitled to deduct any amount AND the entity has been able to deduct in all prior income years in which it has held the asset.

What are new residential premises. This is a GST term as GST only applies to new residential premises and commercial residential premises. GST Ruling GSTR 2003/3 ‘Goods and services tax: when is a sale of real property a sale of new residential premises?’ covers what is new residential premises, but the easiest way to establish this is look at the sale contract as it will identify if it is new residential premises in the GST clause, as if it is GST will be payable. No GST payable under the contract, no tax depreciation.

EXAMPLE Hannah purchases off the plan from DevelCo. DevelCo has fitted out the apartment including curtains and furniture prior to settlement and the transfer of title to Hannah. Developer Co has also fitted out the shared areas of the complex.

All of these assets are new at the time of installation. As these assets were first installed by Developer Co, not Hannah, they are previously used and a deduction would not be available under the general rules established by these amendments.

However, a deduction is still available to Hannah for the depreciating assets (including Hannah’s share of the assets installed in the shared areas of the apartment) for the period she holds the assets as:

  • The assets have been installed ready for use in new residential premises;
  • Developer Co has not claimed any deduction for the decline in value of the assets (and nor has any other entity); and
  • No entity has resided in premises in which the assets have been installed.

When does this all apply from?

These rules apply from 1 July 2017 to assets acquired after 7.30 pm on 9 May 2017. So any rental properties purchased after this time will be subjected to these rules (unless the asset was acquired under a contract entered into before this time).

These rules also apply to private assets purchased before this date that are later used in a rental property (like moving fridge from home to rental property as we saw in the first example).

What can I include in a tax depreciation schedule for properties acquired after 9 May 2017?

  1. Properties that are not residential – Commercial is AOK
  2. Properties that are held by a company (but they will lose the 50% CGT discount)
  3. Assets that were bought by the owner from a retailer (trading stock) and always used in a rental property (never used it privately and never lived in the rental property it is in while the asset was in the property)
  4. Properties that are new residential premises (as evidenced in the contract), AND no one has lived in the residential property before and they have never live in it themselves…

I think item three assets are not going to need a tax depreciation schedule. Why? If I purchased the asset from a retailer I can’t ask anyone to estimate its cost as I know the actual costs. I have an invoice with the actual cost!

I am also worried about where I purchase an asset from a retailer or purchase new residential premises, but I live in the house for one day (or I let an associate live in the house) after the purchase. If I do I get no depreciation. The idea of buy, living in, renovate and rent out means no depreciation deductions.

WHAT YOU MUST ASK BEFORE PREPARING A TAX DEPRECIATION SCHEDULE

Remember, you are putting yourself out as a tax depreciation expert. Therefore, you cannot argue that it is not up to you to establish if your client can claim Division 40 deductions under these new rules. If you don’t ask these questions I imagine the Tax Practitioners Board will stop you from being able to do any more tax depreciation schedules.

So you must ask:

  • Did you acquire this property after 9 May 2017? If they purchased it before we can prepare a tax depreciation schedule covering the asset they acquired with the property.
  • Is it commercial or residential? No problems if the property is commercial. Just prepare the schedule.
  • Is the entity that owns the property a company?  No problems if the entity is a company. Just prepare the schedule.
  • Is the property used in a business like a hotel? No problems if it is. Just prepare the schedule.
  • Does the sale contract confirm the property is “New Residential”? If so, has anyone lived in it before it was rented out by the entity (including the entity)? If it is new residential and no one has lived in it, prepare the schedule.

And if you have not been able to prepare the schedule yet due to any of the answers above, there may be single assets that can be depreciated. So you ask…

  • Did you buy anything from a retailer? If you did did you ever use it privately before it was put in the rental property or have you personally used the rental property? But remember, if they did they know the actual cost so you can’t estimate the cost so you then need to ask what the actual purchase price was.

My summary, if it was purchased before 9 May 2017, it is commercial or it is new residential, then you can consider offering to prepare a depreciation schedule covering Division 40. Otherwise it is ineligible for the Division 40 or the entity knows the actual costs so cannot use an estimate cost.

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Who are the Tax Dodgers?

If you read the newspapers it is those evil multinationals. But a recent speech by the Commissioner might dispel that myth. Have a look at these quotes:

The first cab off the rank will be the large market corporate tax gap which we will release formally next month. In the lead up to that formal release, today I will share with you the gap we have estimated, based on 2014–15 data.

It is approximately $2.5 billion; equivalent to about 6% of the collections for that market, and similar to the gap estimated for large corporates in the UK.

This $2.5 billion gap is way below the numbers that have been thrown around by various commentators – some wildly claiming it to be up to $50 billion.

The best ever estimate of the tax being avoided by those dodgy multinational we have ev er had, before we introduced the most onerous anti-avoidance rules in the world to apply only to them (the MAAL and the Diverted Profits Tax), is $2.5 billion a year. Given the recent changes to our tax laws this amount will be less today than in was in the 2014/15 year.

Sounds bad… But what about those poor hard done by workers…

Our early work and preliminary findings on the gaps for small business and individuals are telling us that there are likely to be bigger gaps in each of those markets than in the large market.

The industry that best comply with the tax system are those large dodgy multinationals! Its the small businesses and individuals who are much much worse.

In 2014–15, more than $22 billion was claimed for work-related expenses. While each of the individual amounts over-claimed is relatively small, the sum and overall revenue impact for the population involved could be significant – in the vicinity of, or even higher than the large market tax gap of $2.5 billion – and that’s just for this category of deductions, work-related expenses.

But would those pure individuals claim deductions they are not entitled too???

In 2014–15, around 6.3 million people made claims against clothing expenses totalling almost $1.8 billion. That would mean that almost half of the individual taxpayer population was required to wear a uniform or protective clothing or had some special requirements for things like sunglasses and hats.

The Commissioner is about the reveal the tax gap, the amount of tax “dodged”, by those evil multinationals and those pure innocent individuals. And what will the media say when the we discover that both in percentage and gross amounts the real tax dodgers are the individuals. The multinational cannot even come close to being as dodgy as the workers of Australia!

Work in tax for 5 minutes and you will know that this is 100% true…

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