11 minute read
Adapting to change
The proposed $3 million soft cap has already got trustees considering their strategies towards making investments via the superannuation system. Cooper Partners director and head of SMSF succession Jemma Sanderson recognises some alternative options for high net worth clients and illustrates the value advisers can add with extensive knowledge about other investment structures.
The Division 296 tax is on the horizon and despite its introduction, superannuation will remain the preferred investment vehicle in Australia. However, many high net worth (HNW) families may consider alternative structures, particularly in light of the succession position with respect to assets and structures.
The introduction of the Division 296 tax has brought to the forefront many discussions regarding succession, with a holistic review required in order to achieve the intentions and objectives of families. The succession position of many structures is complex and a deep dive is often required to understand exactly who receives what, particularly with respect to control, as control can be the inheritance itself.
It is therefore important we are equipped with the knowledge of the various alternative entities to superannuation for investment purposes. Some areas requiring attention include:
1. The return profile of the investment:
a. capital growth,
b. income generation,
c. investment horizon (short, medium or long term),
d. exit strategy,
2. The taxation profile of particular structures to ascertain which might be more appropriate in light of the above return profile, and
3. The asset protection and succession intentions of the asset and the structure.
When does it matter?
Where an asset has high capital growth potential and low income generation, such as residential property, then it may be more appropriate for such an investment to be held outside superannuation to mitigate Division 296 tax on unrealised gains with no or limited cash flow to pay the tax. This is particularly the case where the ultimate intention may be that a child or grandchild can live in the property – an objective that wouldn’t be able to be achieved with superannuation monies.
Where an asset is intended to pass to a particular child as they are running their business from the premises, perhaps such an asset could be acquired within a discretionary trust where the succession is directly to that child, circumventing the estate.
Structural considerations
There are other structures that are not superannuation, which have different profiles to consider, and different items to consider in terms of their ongoing activities such as:
Ease of operation,
Tax,
Asset protection,
Flexibility,
Estate/succession planning,
Control,
Family law.
The below outlines some considerations with the main alternatives to super, although is not exhaustive, and the underlying governing documents of any structure need to be reviewed in detail to ensure the intended outcomes are achieved.
Individual name
Generally HNWs hold assets like the primary residence in an individual’s name and often in that of the low-risk spouse. However, for asset protection purposes, this approach is not ideal.
Further, doing so can mean there will be no assets in the estate if the asset holder passes away and there can be unknown assets such as unpaid present entitlements (UPE). In addition, all income and realised gains are taxable for the individual with no real flexibility.
It is though a simple approach and easy to understand while not very tax-effective.
Discretionary family trust
These are widely used for business purposes and often house a business premises or farm. It is generally the preferred passive investment vehicle outside superannuation.
There are several advantages of using a discretionary family trust. From a tax perspective, flexible distribution of income can be achieved, small business capital gains tax (CGT) concessions will be applicable and a 50 percent CGT discount can materialise when a distribution is made to an individual.
Outside of tax, benefits available include asset protection if the trust is structured correctly and the passing of control external to the estate ensuring no loans of UPEs owed are to the testator. Protected trust arrangements can also be put in place for beneficiaries where required.
However, family trusts can be disadvantageous too. For example, UPEs can build up over time, resulting in estate planning risks and the possibility of opening the structure up to family law. Further, control can pass to unintended individuals as it can be done external to the estate. In addition, the introduction of new members with a business can be difficult due to trust valuation challenges and the possibility of having legacy liabilities exist and a lifespan limited to 80 years applies, except in South Australia.
With regard to tax, Division 7A can come into play when there is a corporate beneficiary, the principal resident exemption does not apply and reimbursement agreements can trigger section 100A of the Income Tax Assessment Act.
Companies
Investing using a company is widely used for business and the preference is not to own growth assets. Often the company is owned by a family trust to allow for more flexibility, with share class and shareholding succession being important elements.
Investing via a company has many advantages, including the structure having limited liability but no limited life cycle. It is an optimal vehicle for operating a business and it is easy to incorporate new shareholders and to implement succession plans.
Companies have a flat rate of tax applied to them, set at 25 percent for active companies and 30 percent for passive ones, and there is no obligation for any profits to be distributed each year.
Unfortunately companies are not eligible for any CGT discount on the sale of growth assets, may have a top-up tax apply in order to pay dividends and are a structure where that can be challenging with regard to small business concessions.
Investment bond
Investment bonds have been a structure available to Australian investors for many years, but have tended to be less attractive than super. However, they are experiencing a revival with more products being available on the market akin to managed funds.
Investment bonds require the nomination of a natural person to be ‘life insured’ and are effectively a life policy. Historically they have been used to fund education as they are a good vehicle to achieve forced savings with a small cash-flow impact and provide the compounding of regular investment amounts over the relevant time horizon.
They are also beneficial for Centrelink purposes as there is no taxable income involved for the individual.
Tax on an investment bonds is levied at 30 percent on incomes and paid by the product provider. There is no tax payable within the bond on capital gains when changing investments and after 10 years drawdowns are tax-free, but with conditions attached. For example, additional contributions can’t be made after the initial contribution of greater than 125 percent of the previous year’s investment amount or the 10-year time horizon will recommence, and no drawdowns are allowed over the 10-year period.
Tax on drawdowns is also varied during the 10-year term, with earnings in years one to seven being assessable to the owner with a 30 percent offset, only two-thirds of earning assessable in years eight and nine, and only one-third of earnings being assessable in year 10.
When the insured person passes away, the bond has to be paid out, but is tax-free to the beneficiary and where the bond is surrendered due to an accident, illness or other disability to the insured individual, the account is paid out tax-free to the owner.
Other characteristics of investment bonds are that a beneficiary can be nominated directly and they can be held within a trust or company or by an individual.
In comparison to super, there is no limit on the initial investment amount and the 10-year investment horizon is considerably shorter than achieving preservation status. There is, however, no tax benefit from the contribution itself, unlike super.
Investment bonds can in fact be used to complement a superannuation strategy as death benefits can be invested in these vehicles. They can also be used in conjunction with other investment structures offering the ability for people to cap their tax rate at 30 per cent if distributions are paid out to a company.
On the negative side, investment menus could be a limitation for HNW families and careful consideration is needed when selecting the insured person, although this can be changed in situ.
Case study
The Jones family has numerous trusts and companies in place subsequent to the passing of the patriarch. The matriarch, in her mid-70s, has a substantial superannuation balance and manages the investments of the family group with the input of the two children in their 40s with young families. There are some Division 7A loans in place between the family investment company and the main family trust around $1 million. Trusts for the benefit of the children and grandchildren were set up when the patriarch died, using proceeds from superannuation and selling some illiquid/bulky assets.
The cash position across the entities is as in Table 1.
The investment opportunities in Table 2 have been presented to the family.
Generally, using the super fund will be the preferred option for the Jones family given the underlying tax rates on income and realised capital gains. But there are potential problems with this strategy. For instance, capital growth investments generating limited income may not be ideal in super given the Division 296 tax is levied on unrealised gains.
Also, the liquidity of the super fund may present issues as the matriarch’s minimum pension payments need to be made and the selling down of assets may be a necessary course of action if funds are also needed to make other investments.
The life expectancy of the matriarch must also be taken into account as to the suitability of allocations to investments with a long-term duration in the super fund.
Including the children in the SMSF could be an option, but they may not want to wait until they meet a condition of release to access any of the investment returns seeing they are only in their 40s.
All of these factors mean the Jones family should consider the other structures for their investment dollars.
Table 3 shows how this strategy might work.
The level of cash needed to invest in the optimal structure would be as in Table 4.
What about the funding?
The strategy will require additional funding as Family Investments Pty Ltd only has $1.5 million in cash, but needs $2.25 million. But this can be managed using the Jones family’s existing structures and entities.
Firstly the trust owes the company money so could repay some of this debt, which would also simplify some of the Division 7A loans.
In addition, where the investment return is income in the company, if that was earned in the trust, the trust may be likely to pay across to the company any such distribution to manage the tax position. Therefore, having such an investment in the company initially where the return profile is like this may make things easier.
Further, the company can be of benefit as it doesn’t have to declare its profit each year and so can retain it.
It is worthwhile looking to a trust structure to hold the investments with a higher and more certain capital growth profile to take advantage of the 50 percent CGT discount.
However, due to the time horizon pertaining to some of the investments, many families would opt to pay across assets to a company to repay Division 7A loans to simplify their structures and acknowledge any realised capital gain won’t be eligible for a CGT discount.
With regard to the investments that should be held by a particular trust, a suggestion would be each trust could invest an amount separately into the underlying investments. To this end, a unit trust could be set up that pools the money from each existing trust for investment purposes. Each of the existing family trusts would hold units in the new trust and that structure would make all of the investments. The existing trusts would then receive a yearly distribution from the new unit trust. However, these arrangements do come with additional complexity.
As has been demonstrated here, being equipped with the knowledge of how other structures operate is of assistance in guiding families through the maze of optimising their wealth accumulation and management, and ensuring the succession of their assets and structures accords with their objectives and intentions.
