Structuring is ‘bread and butter’ advice for accountants. While there is plenty of material written on structuring, the information that is available usually relates to the different types of entities that can be used as ‘lego blocks’ to build a structure. To provide a slightly different slant to the topic of structuring, this article looks at some common drivers behind structuring and compares different entities in light of those drivers.
Asset protection
Generally, owning an investment property in an individual’s name is probably the most risky. If the individual gets sued for whatever reason, the property may become at risk. Having said that, there may be other reasons why an individual may want to own the property in their own name, the most common reason being the utilisation of the negative gearing benefits associated with the property.
There are potentially other ways to achieve the ‘best of both worlds’ (for example, using a discretionary trust to borrow and on-lend the funds to the individual for the property acquisition while taking security over the property) but every circumstance needs to be specifically evaluated.
Using a partnership of individuals may make it harder for creditors to seize the property because it may be difficult to make the partner who is not involved with the litigation agree to sell off their share in the property.
Having said that, there may be other alternatives to achieve better asset protection. For instance, instead of having individuals as partners of the partnership, a partnership comprising, say, discretionary trusts, may be a better alternative in some situations. Meanwhile, a company may own an investment property, provided that it does not carry on other activities that may introduce ‘contagion risk’ into the entity and put the property it owns at risk. However, there may be other reasons that will rule out this option.
For example, companies are not eligible for the 50% capital gains tax (CGT) discount even if they have held the property for at least 12 months. Further, the ownership of the shares in the company may also negate any asset protection mechanism if the shares in the company are, for instance, owned by an individual who is at risk of getting sued.
Perhaps the best asset protection vehicle remains a discretionary trust. Generally, the controller of a discretionary trust does not have any present entitlement to the income and capital of the trust (i.e., the assets of the trust), unless the trustee makes a specific resolution or the trust deed specifically operates to grant that entitlement.
In which case, it is generally difficult for creditors to sue for any property held by a discretionary trust. The only caveat to note is that if a trust is established in such a way that an individual is seen to have absolute and unfettered control over the trust, it may potentially be argued that the assets of the trust effectively belong to the individual. However, this potential risk may be addressed by carefully structuring the control of the trust when it is established.
Compared with a company and putting aside the issue of contagion risk, a discretionary trust is eligible for the 50% CGT discount if it sells a property that has been held for at least 12 months, which provides a superior taxation outcome compared with that of a company.
For completeness, a self-managed superannuation fund (SMSF) may also provide a reasonably secure asset protection mechanism but its practical use may be limited given that it is highly regulated. For instance, once capital is injected into an SMSF, it is difficult to get that capital out until the members of the fund reach their retirement age, or become permanently disabled or pass away. Therefore, an SMSF is more of a specialty vehicle that may only suit specific circumstances in the context of asset protection.
Tax losses
Many investors buy investment properties in reliance of the negative gearing benefits that may flow from the property. Negative gearing benefits are essentially the net loss generated as the allowable deductions on a property exceed the rental income derived. If the net loss can be utilised to offset other income, tax savings will be achieved to lower the operating costs of the property. If the potential future capital gain on the property exceeds the cumulative running costs of the property, the investor will be in front from an investment return perspective.
Unlike net losses generated from a business operated in an individual or partnership’s name, which are subject to the ‘non-commercial losses rules’, there are generally no restrictions in offsetting negative gearing losses from investments against other income.
Therefore, if an individual derives assessable income from other means (employment, for example), the ability to offset any negative gearing loss against such income will give rise to a tax advantage. Numerically, the higher is the marginal tax rate on which the individual is paying tax, the bigger the tax savings achieved. This is why negative gearing is by far one of the most popular tax minimisation strategies adopted by high income earners.
While an entity other than an individual may own investment properties, it would only be tax advantageous if the entity derives other income that may be offset by the negative gearing losses. Otherwise, the tax losses may be trapped in that entity until it derives income or capital gains in the future.
The only exception is a partnership – the tax losses do not get trapped in the partnership; rather, each partner is entitled to its share of tax loss in the year in which the partnership derived the loss but each partner’s eligibility to offset its share of partnership loss against other income will be contingent on any tax loss recoupment rules that may apply to the partner in its own right.
To that end, many people are not aware that the future recoupment of losses in a company or a discretionary trust are restricted by various tax loss recoupment rules. For a company to recoup its carried forward tax losses, it must pass the ‘Continuity of wnership Test’ (‘COT’).
Putting it simplistically, if the company has undergone changes to its majority underlying ownership from the beginning of the loss making year, it may fail the COT at the time of the change. In which case, the tax losses may only be recouped if the company then passes the ‘Same Business Test’ (‘SBT’), which requires the company to carry on essentially an identical business from the time when the COT was failed to the end of the loss recoupment year.
The ability for a discretionary to recoup its tax losses is even more complicated. As a general proposition, a ‘fixed trust’ can recoup its tax losses only if it passes the ‘50% Stake Test’, which is somewhat similar to the COT applicable to companies. However, if a trust is not a fixed trust, then it has to pass a whole range of other stringent tests before it can recoup its tax losses, unless it is a ‘family trust’ that has made a Family Trust Election.
To make these rules even more difficult to apply, a precedent case has opened another can of worms, which calls to question (without any real resolution) as to whether any trust in Australia, even though normally treated as a unit trust, could in fact be a ‘fixed trust’ for the purposes of the trust loss recoupment rules. In which case, unless the trust makes a Family Trust Election, it may have trouble recouping its carried forward tax losses.
While a trust may make a Family Trust Election, once the election is made, it will effectively be restricted from making trust distributions to an outsider of the family of the person who was nominated as the ‘test individual’ in the Family Trust Election. Otherwise, any distribution made to an outsider will entail the Family Trust Distribution Tax at the highest marginal tax rate, which is currently 46.5% inclusive of Medicare Levy.
Therefore, it is generally not a good idea for multiple unrelated families to set up a discretionary trust that is expected to incur a tax loss. In fact, given the current uncertainties regarding whether a unit trust can be a fixed trust for trust loss recoupment purposes, careful consideration must be made on whether multiple families should set up a unit trust that is expected to incur future tax losses.
An SMSF does not usually have any problems recouping carried forward tax losses, courtesy of the voluminous amount of other regulations with which it must comply but once its income is no longer subject to income tax, eg, when the members of the fund are in pension phase, the value of its tax losses will effectively be neutralised.
Succession
It is a reality that death and taxes are inevitable in our lives and while you may control your structure while you are alive and have the mental capacity to do so, that may not always hold true. Therefore, succession needs to be an important consideration when setting up a structure for property investment.
If an individual owns a property, the property will be passed onto a beneficiary under the provisions of the individual’s will or, if the individual does not have a will, the property will be dealt with under normal intestacy procedures under the relevant State and Territory. If the property is owned by the deceased in partnership with someone else, the individual’s interest in the property will be dealt with in the same manner. The situation gets more complicated if the investment property is held by a company or a discretionary trust. In the case of a company, it is recognised at law as a separate legal entity that is a going concern. This means that even though the underlying owner of the property may have passed away, the company will continue to exist and own the property.
Therefore, if the underlying owner wants to ensure that the property will be passed onto an appropriate beneficiary when they die, they should specify in their will who will become the owner of the company’s shares upon their death. In other words, while the actual title of the property does not pass upon the underlying owner’s death, any succession and estate planning regarding the property pertains to passing on the control over the entity that owns the property.
In the case of a discretionary trust, it is also the control of the trust that will need to be dealt with in succession. Usually, control of a discretionary trust rests with the trustee and the appointer.
Therefore, the underlying owner may either include in the trust deed provisions relating to who will succeed as the new trustee and/or appointer of the trust upon their passing or, to make things easier, a corporate trustee may be used and the shares in the corporate trustee may be included in the underlying owner’s will such that they will be passed onto the desired beneficiary as part of the execution of the will. Again, the trick here is to ensure that the right person either becomes the new trustee and/or appointer or assumes control of the trustee.
Interestingly, it should be noted that any trust established in Australia, apart from South Australia, generally only has a limited lifespan of 80 years. Therefore, a trust is normally not a going concern as when the 80 years is up, the trust will generally terminate spontaneously and any asset of the trust will be deemed to have been disposed of to the beneficiary who assumes ownership of those assets. Such deemed disposals will most likely give rise to CGT consequences.
In respect of an SMSF, if a member dies, their benefits in the SMSF will either go to another member (if those benefits are ‘reversionary’ between spouses) or they will need to be paid out by the trustee of the SMSF to a beneficiary, which is usually in accordance with any death nomination made by the member before they die.
If an SMSF owns an investment property, the property may either be realised or transferred to the beneficiary on an ‘in-specie basis’ (i.e., the title to the property is transferred without it being sold on the market). It should be noted that if the beneficiary is not a dependent of the member, any asset transferred out of the SMSF that does not represent non-concessional contributions may give rise to a ‘death benefit tax’, which is currently levied at 16.5%.
Last words
In light of the above, it is evident that structuring for property investment may not be straightforward, depending on your individual circumstance. A structure that is ideal for one person does not mean that it will work for another. I therefore caution against adopting seemingly ‘one size fits all’ solutions in lieu of engaging professional advice in formulating a structure that will work for you.
While using a professional advisor such as an accountant will entail upfront costs, considering that a structure adopted may have far reaching commercial and taxation consequences, it is more often than not a worthwhile investment to get the structure right from the start with professional advice. Also, as your circumstance changes, tweaking or altering the structure altogether may be appropriate at times, which is why most successful investors maintain an ongoing and lifelong relationship with their accountants.
Eddie Chung is partner, tax & advisory, property & construction, at BDO (Qld) Pty Ltd. Contact eddie.chung@bdo.com.au or call (07) 3237 5927
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.
